SEC Release: "Pay-to-Play" Rule 206(4)-5 |
SEC “Pay to Play” Rule 206(4)-5
Effective today, March 14, 2011, investment advisers are expected to be in compliance with the SEC’s new “pay to play” Rule 206(4)-5 under the Investment Advisers Act. Adopted last July, the rule imposes restrictions on political contributions by investment advisers and certain of their executives and employees, in order to curtail advisers’ use of such contributions to influence government officials responsible for awarding advisory contracts for public pension plans or other government funds.
Rule 206(4)-5 applies to all investment advisers that are registered or required to be registered under the Investment Advisers Act, as well as unregistered advisers relying on the Investment Advisers Act’s de minimis exemption under Section 203(b)(3). The provisions are outlined below. There is a substantial degree of ambiguity in the rule as written, however, particularly in the definition of “covered associates” and in the “catch-all” provision designed to prohibit circumvention of the rule.
Two-Year “Time-Out” Period Following Contributions
The centerpiece of Rule 206(4)-5 is its imposition of a two-year “time-out” period following an investment adviser’s covered political contribution. If an adviser or a “covered associate” of the adviser makes a political “contribution” to an “official” of a government entity who is in a position to influence the selection of the government entity’s investment adviser, then the adviser is prohibited from receiving compensation for providing advisory services to that government entity for two years. Charitable contributions to a political action committee (PAC) or local political party do not trigger the time-out if the contributions are not attributable to a particular candidate. However, in recognition of the fundamental complexity of campaign finance, the SEC rule contains a blanket prohibition to prevent an adviser and its covered associates from doing indirectly what they cannot do directly as a means of circumventing the rule. For example, an advisor and its covered associates cannot “earmark” PAC contributions for the benefit of particular candidates, or deliberately funnel contributions through affiliated companies or family members as a means to circumvent the rule, as determined by the SEC. (Because of this issue, various PACs are ensuring that their policies prohibit earmarking of contributions for particular candidates.)
Key terms are defined as follows:
- An “official” of a government entity is covered if his office can directly or indirectly influence the hiring of an investment adviser (or has the authority to appoint anyone who can influence such a hiring decision). The SEC opted for such a broad definition because state and municipal statutes vary widely with respect to whom they entrust with the hiring of advisers and the management of public funds.
- A “contribution” is broadly defined as anything of value provided for the purpose of influencing a federal, state, or local election, or inaugural expenses incurred by a successful candidate for state or local office.
- A “covered associate” includes (i) any partner, managing member, or executive officer (or any person who performs a “policy-making function”); (ii) any employee who solicits a government entity for the adviser (or directly or indirectly supervises such an employee); and (iii) any PAC controlled by the adviser or a covered associate. Notably, spouses of a “covered associate” are not included.
“Look-back” Period
A “look-back” provision is included to discourage advisers from channeling contributions through departing employees. For newly-hired employees, advisers should include as part of their hiring protocol a review to determine whether any covered associates recently made a contribution that would be imputed to the hiring firm. All covered associates who solicit clients require a two-year “look-back,” which means a covered associate’s contributions will be imputed to the adviser if made within two years prior to the date the person became a covered associate.
For covered associates who do not solicit clients, the look-back period is six months. Should a covered associate change advisers, a covered contribution results in a time-out for the covered associate’s new adviser for the remainder of the applicable look-back period.
Exceptions to the Rule
De minimis exception: The rule provides an exception for de minimis contributions that do not trigger the two-year time-out period. The exception allows covered associates who are natural persons to make contributions of up to $350 for elections in which the covered associate is entitled to vote, or up to $150 for elections in which the covered associate is not entitled to vote. Primary and general elections count as separate elections.
Returned contribution exception: In limited cases, an adviser may cure the consequences of an inadvertent employee contribution. The contribution must be less than $350, the adviser must have discovered the contribution within four months, and the contributor must recollect the contribution within sixty days after the adviser discovers the contribution.
Restrictions on Investment Advisor Solicitation Activities
An adviser and its covered associates are prohibited from paying anyone to solicit a government entity for advisory services on the adviser’s behalf. This prohibition does not apply to solicitations made by “regulated persons,” or investment advisers or broker-dealers who are themselves subject to prohibitions against participating in pay-to-play practices either by the SEC or by national securities associations (such as FINRA) with rules that are substantially equivalent to the SEC’s pay-to-play rule. Advisers must be in compliance with this provision by September 13, 2011.
Additionally, to prevent the practice of “bundling” small employee contributions or by making contributions indirectly through a political party, an adviser and its covered associates are prohibited from soliciting or collecting contributions for (i) any official of a government entity to which the adviser provides advisory services; and (ii) any political party of a state or locality in which the adviser provides advisory services to a government entity.
Recordkeeping Requirements
Lastly, the SEC amended Rule 204-2 under the Investment Advisers Act to impose additional recordkeeping requirements on advisers to a government entity. For a period of five years, an adviser must (i) maintain lists of covered associates, government entities advised, and third-party solicitors used; and (ii) track all direct and indirect contributions made by the adviser and its covered associates.
Application
Investment advisers must decide how best to manage the unique risks associated with its employees’ political activities, factoring the size, investor base, compliance culture, nature and extent of its employees’ political activism, and relevant state and local laws. This may range from instituting pre-clearance policies for employee contributions and updating employee handbooks to a simple firm-wide ban on political contributions, although, in some states such as California, state law may not permit this practice. Similarly, firms will need to look to state law to determine which state and local officials possess the legal authority to influence the hiring of investment advisers, as, for example, some states have rules by which members of state legislatures may influence government pension plans while many do not.
At a minimum, advisers will need to establish or update their compliance policies and procedures governing the engagement of solicitation agents and political contributions of “covered associates,” particularly during the hiring process. As noted, this may present a challenge, as the precise definition of “covered associates” remains unclear.
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This information is not intended as legal advice. Readers should seek specific advice before acting with regard to the subjects mentioned herein.
Patomak Global Partners LLC is a financial services consultancy based in the Washington, DC area. Since early 2009, our firm's experienced consultants have provided an array of regulatory compliance services to private equity firms, hedge funds, mutual funds, and other investment advisors and investment companies. This communication is intended to highlight regulatory and compliance developments for these clients and other interested colleagues. If you would like to sign up for future emails or electronic alerts, please email info@patomak.com.