Alert July 06, 2010

SEC Adopts Final Rule Addressing Pay-to-Play Practices for Investment Managers Seeking to Manage Money on Behalf of State and Local Authorities

The SEC issued the formal release adopting a new rule under the anti-fraud provisions of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and making related changes to existing Advisers Act rules (collectively, the “Amendments”), that are designed to address “pay to play” practices in which an investment adviser makes political contributions or gifts to government officials or candidates for office in circumstances that could suggest an attempt 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).  The Amendments include the basic elements set forth below.  Additional detail on the Amendments including the schedule of compliance dates will be provided in Goodwin Procter Client Alert that will be circulated to Alert readers.

Two Year Compensation Timeout

The Amendments make it unlawful for an investment adviser that (a) is registered with the SEC or (b) has not registered with the SEC in reliance on the “private adviser” exemption in Advisers Act Section 203(b)(3) (in each case, an “Adviser”), to receive compensation for providing advisory services to a state or local government entity (a “government entity”) for a two year period after the Adviser or certain of its related persons (“covered associates”) make a political contribution to a public official of a government entity or candidate for office with a government entity who is or will be in a position to influence the how the government entity awards advisory business.

Prohibition on Payments to Third Parties to Solicit Government Advisory Clients

The Amendments generally prohibit an Adviser from paying a third party to solicit government entities for advisory business unless the third party is a registered broker-dealer or registered investment adviser that is itself subject to pay to play restrictions.  The SEC’s decision not to adopt an absolute prohibition on the use of third party solicitors represents one of several changes from its original proposal.  (The SEC release adopting the Amendments notes that FINRA is preparing rule changes that would prohibit a FINRA member from soliciting advisory business from a government entity on behalf of an investment adviser unless the member complies with requirements prohibiting pay to play activities.)

Ban on Soliciting and Coordinating Contributions and Payments

The Amendments prohibit an Adviser and its covered associates from soliciting or coordinating (a) 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 or (b) 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.

Application of the Proposed Rule to Certain Pooled Investment Vehicles

The Amendments treat 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.  A “covered investment pool” is any (i) registered investment company that is an investment option in a plan or program of a government entity that is participant-directed (e.g., a retirement plan such as a 403(b) or 457 plan, or a college savings plan) or (ii) investment vehicle that relies on any of the exclusions from the definition of “investment company” under Sections 3(c)(1), 3(c)(7) or 3(c)(11) of the 1940 Act.  (Because the Amendments apply only to investment advisers that are registered or that rely on the private adviser exemption, a bank that is not an “investment adviser” under Section 202(a)(11) of the Act is not subject to the Amendment's various prohibitions and limitations even when the bank manages a collective investment fund that relies on Section 3(c)(11) of the 1940 Act.)

Other Indirect Contributions or Solicitations

The Amendments 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 Amendments prohibit them from doing directly.