Alert August 18, 2009

Proposed SEC Rule Addresses “Pay to Play” Practices by Investment Advisers Seeking to Manage Money on Behalf of State and Local Governments

The SEC proposed a new rule under the Investment Advisers Act of 1940 (the “Advisers Act”) designed to address “pay to play” practices where an investment adviser makes political contributions or gifts to government officials in order to influence the selection of the investment adviser to manage money on behalf of state and local government entities (e.g., for public pension plans, retirement plans and 529 plans).  This article summarizes the principal elements of the proposed rule reflected in the formal release.

Background.  In 1999, the SEC proposed a rule designed to address pay to play issues for investment advisers, but took no final action.  In the interim, the SEC and state authorities have brought high profile cases and reached settlements regarding alleged pay to play arrangements.  The proposed rule is modeled on MSRB Rules G-37 and G-38, which were adopted to address pay to play practices for broker-dealers and municipal securities dealers in the municipal securities markets, and on the SEC’s 1999 rule proposal.

Two Year Compensation Timeout.  The proposed rule applies to any investment adviser registered with the SEC and any investment adviser that has not registered with the SEC in reliance on the exemption available under Section 203(b)(3) of the Advisers Act, which is available to advisers that do not hold themselves out to the public as investment advisers and who have fewer than 15 clients (such advisers along with registered advisers being referred to collectively as “Advisers”).  The proposed rule would prohibit an Adviser from receiving compensation for providing advisory services to a state or local government entity (including to plans or pools of assets established by the government entity or to the government entity’s officers or employees in their capacities as such) for a two-year period after the Adviser or any of its covered associates makes a political contribution to an official of that government entity with authority to directly or indirectly influence the award of advisory business.

  • An “official” under the proposed rule includes an incumbent, candidate or successful candidate for elective office.
  • A “contribution” would include any gift, subscription, loan, advance or deposit of money or anything of value made for (i) the purpose of influencing any election for federal, state or local office; (ii) payment of debt incurred in connection with any such election; or (iii) transition or inaugural expenses of the successful candidate for state or local office.  (The proposed rule includes a de minimis exception for aggregate contributions of $250 per election by an individual entitled to vote in the election and a very limited exception for certain returned contributions.)
  • A “covered associate” of an Adviser means any (i) general partner, managing member or executive officer, or other individual with a similar status or function; (ii) employee who solicits a government entity to be an advisory client of the Adviser; or (iii) political action committee controlled by the Adviser or by a person in either of the foregoing categories.

Under this two-year “time out” provision, an Adviser that had made contributions subject to the rule would not be prohibited from providing advisory services to the government client in question, but would instead be prohibited from receiving compensation for providing advisory services to the government client, which could entail providing advisory services gratis for a reasonable time until a successor adviser could be appointed.  The proposed rule also includes a “look-back” element that would attribute contributions made by a covered associate of an Adviser to other Advisers that employ that person within two years after the date of the contribution.  Thus, an Adviser would be required to implement policies and procedures designed to, among other things, determine whether it would be subject to any restrictions under the proposed rule as a consequence of engaging any particular covered associate. 

Prohibition on Payments to Third Parties to Solicit Government Advisory Clients.  The proposed rule would prohibit an Adviser from paying third parties (e.g., solicitors, finders, placement agents or pension consultants) to solicit a state or local government entity as an advisory client.  This broad ban would be subject to a narrow exception for solicitations on behalf of an Adviser by control affiliates of the Adviser (or their employees) or any of the Adviser’s employees, general partners, managing members or executive officers. 

Ban on Soliciting and Coordinating Contributions and Payments.  The proposed rule would prohibit an Adviser and its covered associates from soliciting any person or political action committee to make, or from coordinating, any contribution to an official (or candidate for office) of a government entity to which the Adviser is providing (or is seeking to provide) investment advisory services, and from soliciting payments to a political party of the state or locality where the Adviser is providing (or is seeking to provide) investment advisory services to a government entity.  This element of the proposed rule is intended to prevent an Adviser from circumventing the proposed rule by making payments to political parties, or by making or coordinating contributions through a third party “gatekeeper,” in order to influence the investment adviser selection process.

Application of the Proposed Rule to Certain Pooled Investment Vehicles.  The proposed rule treats an Adviser that manages certain types of pooled investment vehicles, referred to as “covered investment pools,” in which a government entity invests or is solicited to invest in the same manner as if the Adviser were providing (or seeking to provide) investment advisory services directly to the government entity.  Under the proposed rule, a “covered investment pool” is any (i) investment company as defined in Section 3(a) of the Investment Company Act of 1940, as amended (the “1940 Act”) or (ii) company excluded from the definition of “investment company” under Sections 3(c)(1), 3(c)(7) or 3(c)(11) of the 1940 Act.  A narrow exception would exist for an Adviser to a registered investment company whose shares are registered under the Securities Act of 1933.  Under these circumstances, the two-year “time-out” provision (triggered by contributions to a public official by the Adviser or any of its covered associates) would only apply when the registered investment company is an investment or an investment option of a plan or program of a government entity (e.g., a 529 plan).   (The proposed rule’s other prohibitions and limitations would still apply to the Adviser and its covered associates with respect to the registered investment company.)

Other Indirect Contributions or Solicitations.  Similar to Section 208(d) of the Advisers Act, the proposed rule would prohibit an Adviser and its covered associates from otherwise doing indirectly, such as by channeling contributions to officials of government entities through third parties such as spouses, attorneys or companies affiliated with the Adviser, what the rule prohibits them from doing directly.

Exemptive Relief.  The proposed rule would permit an Adviser to seek an order from the SEC exempting it from the proposed rule’s two-year time out requirement.

Recordkeeping Requirements.  In conjunction with the proposed rule, the SEC proposes to amend Rule 204-2 under the Advisers Act to require a registered investment adviser to maintain certain records about its covered associates, its advisory clients, government entities invested in certain pooled investment vehicles managed by the adviser, the adviser’s political contributions and the political contributions of its covered associates.

Public Comment.  Comments on the proposed rule are due by October 6, 2009.