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

On June 30, 2010, the Securities and Exchange Commission (the “SEC”) adopted Rule 206(4)-5 (the “Final Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) in an effort to curtail “pay to play” practices by investment advisers. Pay to play practices are those in which political contributions or other payments are made by or on behalf of an investment adviser to elected officials or candidates who can influence the awarding of contracts to manage the accounts of state and local governmental entities, including state and local governments, their agencies and instrumentalities, and plans or pools of assets established by the government entity or the government entity’s officers or employees in their capacities as such (such as public pension plans, retirement plans and 529 plans) (“Government Entities”). In connection with the adoption of the Final Rule, the SEC also adopted related changes to existing record-keeping and cash solicitation rules under the Advisers Act. The formal SEC release adopting the Final Rule and related rule amendments is available here.

Summary

The Final Rule generally prohibits investment advisers (including certain managers of pooled investment vehicles such as registered investment companies, hedge funds, private equity funds, venture capital funds and collective instrument trusts) from providing advisory services for compensation to a Government Entity for two years after the adviser or certain of its executives or employees makes a contribution to certain elected officials or candidates. The Final Rule also generally prohibits investment advisers from paying third parties to solicit a Government Entity on behalf of such adviser unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. In addition, the Final Rule generally prohibits investment advisers that are providing or seeking to provide advisory services to a Government Entity from soliciting or coordinating payments to political parties in jurisdictions where the investment adviser is providing (or seeking to provide) investment advisory services and prohibits soliciting or coordinating contributions from others to certain elected officials or candidates.

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 several high profile cases and reached settlements regarding alleged pay to play arrangements. As discussed in Goodwin Procter’s August 18, 2009 Financial Services Alert, in August 2009, the SEC proposed a new rule to curtail pay to play practices based on rules adopted by the Municipal Securities Rulemaking Board.   After considering approximately 250 comment letters on the proposed rule, the SEC adopted the Final Rule, which includes a number of substantive changes from the proposed rule.

Investment Advisers Affected

The Final Rule applies to any investment adviser that has (or is seeking) clients that are Government Entities and (i) is registered with the SEC or (ii) has not registered with the SEC in reliance on the “private adviser” 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 and registered advisers being referred to collectively as “Advisers”). The proposed Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), however, would, if enacted, effectively eliminate the private adviser exemption. The Dodd-Frank Act would also create additional Advisers Act registration exemptions, such as one for advisers to “venture capital funds.”  The parameters of these exemptions (e.g., what constitutes a “venture capital fund”) would be defined by SEC rulemaking, and it is anticipated that any such rulemaking would include consideration of the appropriate application of the Final Rule in light of the changes effected by the Dodd-Frank Act.

Key Elements

The Final Rule has three key elements:

  • Two-Year Compensation Time Out.  Advisers are prohibited from receiving compensation for providing advisory services to a Government Entity 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 who has the authority to directly or indirectly influence the award of advisory business. This prohibition includes (i) a look-back provision encompassing prior contributions by newly hired associates, (ii) a de minimis exception for contributions by individual covered associates and (iii) a limited cure provision covering contributions by covered associates to officials for whom they are not entitled to vote. An “official” includes an incumbent, candidate or successful candidate for elective office of a Government Entity who (i) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser or (ii) has the authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser.

    A “contribution” includes any gift, subscription, loan, advance, deposit of money or anything of value made for (i) the purpose of influencing any election for federal, state or local office, (ii) the payment of debt incurred in connection with any such election or (iii) the transition or inaugural expenses of the successful candidate for state or local office.

    A “covered associate” of an Adviser includes 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 and any person who supervises, directly or indirectly, such employee, or (iii) political action committee controlled by the Adviser or by a person in either of the foregoing categories.

    There are de minimis exceptions to the general rule for contributions by individual covered associates (but not the Adviser itself) for aggregate contributions of $350 per candidate, per election by an individual entitled to vote in the election and aggregate contributions of $150 to a candidate for whom an individual is not entitled to vote. There is also an exception that provides an Adviser with a limited ability to cure the consequences of an inadvertent political contribution by a covered associate to an official for whom the covered associate is not entitled to vote. This exception is available for contributions that, in the aggregate, do not exceed $350 to any one official, per election. The Adviser must have discovered the contribution that resulted in the prohibition within four months of the date of such contribution and, within 60 days after learning of such contribution, the contributor must obtain the return of such contribution.

    The Final Rule does not (i) impose a ban on political contributions or limit the amount of any political contributions that may be made by an Adviser and its covered associates or (ii) prohibit an Adviser from providing advisory services to the Government Entity in question. Instead, under the two-year “time out” provision, an Adviser that has made contributions subject to the rule is prohibited from receiving compensation (including management fees and carried interest) for providing advisory services to the Government Entity, which could entail providing advisory services gratis for a reasonable time until a successor adviser could be appointed. The Final Rule also includes a “look-back” element that attributes prior contributions made by a newly hired covered associate of an Adviser to that Adviser if those contributions were made within (i) two years prior to the date the covered associate was hired, in the case of covered associates who solicit clients for the Adviser or (ii) six months prior to the date the covered associate was hired, in the case of covered associates who do not solicit clients for the Adviser. Thus, an Adviser will 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 hiring a new covered associate.
  • Prohibition on Using Third Parties to Solicit Government Business. Advisers and their covered associates are prohibited from providing (or agreeing to provide), directly or indirectly, any payment to third parties (e.g., solicitors, finders, placement agents or pension consultants) to solicit a Government Entity for advisory services on the Adviser’s behalf. This general prohibition is subject to exceptions for: (i) solicitations on behalf of an Adviser by any of the Adviser’s employees, general partners, managing members or executive officers; and (ii) solicitations made by “regulated persons,” which include certain investment advisers and broker-dealers that are themselves registered with the SEC and, in the case of broker-dealers, subject to the oversight of a registered national securities association (such as FINRA) that has restrictions that are substantially equivalent or more stringent than those in the Final Rule. In a March 15, 2010 letter to the staff of the SEC, the FINRA staff agreed to create rules that would impose pay to play regulatory requirements “as rigorous and expansive” as those in the Final Rule, as discussed further in Goodwin Procter’s March 23, 2010  Financial Services Alert. The SEC release adopting the Final Rule confirms 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.
  • Restrictions on Soliciting and Coordinating Contributions and Payments. An Adviser and its covered associates are prohibited from soliciting or coordinating: (i) any contribution to an official of a Government Entity to which the Adviser is providing (or seeking to provide) investment advisory services; or (ii) any payment to a political party of a state or locality where the investment adviser is providing (or seeking to provide) investment advisory services to a Government Entity. These restrictions are intended to prevent an Adviser from circumventing the Final Rule by, for instance, making payments to political parties or coordinating a large number of small employee contributions to influence an election in order to affect the investment adviser selection process.

Application to Certain Pooled Investment Vehicles

The Final Rule treats an Adviser that manages certain types of pooled investment vehicles (including registered investment companies, hedge funds, private equity funds, venture capital funds and collective instrument trusts), 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) investment company registered under 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. However, an Adviser to a registered investment company is subject to the pay to play prohibitions set forth in the Final Rule only if the registered investment company is an investment option of a plan or program of a Government Entity that is participant-directed (e.g., a 403(b), 457 or 529 plan), regardless of whether the registered investment company’s shares are registered under the Securities Act of 1933.

Other Indirect Contributions or Solicitations

Similar to Section 208(d) of the Advisers Act, the Final Rule prohibits an Adviser and its covered associates from otherwise doing indirectly what the rule prohibits them from doing directly, such as by channeling contributions to officials of Government Entities through third parties such as spouses, attorneys or companies affiliated with the Adviser.

Exemptive Relief

The Final Rule permits an Adviser to seek an order from the SEC exempting it from the two-year time out requirement. The SEC may exempt an Adviser from the time out requirement in cases where the Adviser discovers contributions that trigger the ban on compensation only after such contributions have been made and where imposition of the prohibition is unnecessary to achieve the Final Rule’s intended purpose.

Recordkeeping Requirements

The SEC has adopted amendments to Rule 204-2 under the Advisers Act to require a registered investment adviser that has clients that are Government Entities, or that provides investment advisory services to a covered investment pool in which a Government Entity invests, to maintain certain records that will allow the SEC to examine for compliance with the Final Rule. In addition, an Adviser, regardless of whether it currently has a Government Entity client, must keep a list of the names and business addresses of each regulated person to whom the adviser provides or agrees to provide, directly or indirectly, payment to solicit a Government Entity on its behalf.

Amendment to Cash Solicitation Rule

The SEC has adopted a technical amendment to Rule 206(4)-3 under the Advisers Act to alert Advisers to the special prohibitions that apply to solicitation activities involving Government Entities under the Final Rule.

Effective Date and Compliance Dates

The Final Rule and the amendments to Rules 204-2 and 206(4)-3 will be effective 60 days after publication in the Federal Register (the “Effective Date”). Generally, Advisers must be in compliance with the Final Rule as of the six-month anniversary of the Effective Date. Any contributions made or solicited prior to the six-month anniversary of the effective date will not be covered by the Final Rule and therefore will not trigger the two-year compensation time out. However, the SEC has provided an extended compliance date of one year from the Effective Date in the following cases:

  • For Advisers to registered investment companies that are covered investment pools to comply with the Final Rule and amended Rule 204-2’s recordkeeping requirements, in each case with respect to those registered investment companies
  • For all Advisers to comply with the Final Rule’s prohibition on using third parties to solicit government business

Recommendations

In developing compliance procedures to address the requirements of the Final Rule, we recommend that considerable emphasis be placed on the training element given the severe consequences if an Adviser or one of its covered associates violates the Final Rule’s prohibition on political contributions in a manner that cannot be addressed through the exception for returned contributions or SEC exemptive relief. Private fund managers should adopt a political contribution policy well in advance of their next fundraising. In addition, we recommend that agreements entered into with any third-party solicitor, finder, placement agent or pension consultant (“Placement Agent”) include: (i) a representation that such Placement Agent is a registered adviser or broker-dealer; and (ii) provisions that either (a) require the Placement Agent to meet the Final Rule’s definition of “regulated person” or (b) prohibit the Placement Agent from directly or indirectly soliciting a Government Entity for investment advisory services for the Adviser or an investment in any covered investment pool managed by the Adviser.

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