On June 30, 2010, the SEC voted unanimously to adopt Rule 206(4)-5 (the “Rule”) under the Advisers Act. The Rule seeks to curtail “pay to play” practices by investment advisers. The Rule will become effective on September 13, 2010, and compliance will generally be required by March 14, 2011, except that compliance with the prohibition on the use of third-party solicitors and certain provisions relating to certain registered investment companies (and related recordkeeping requirements) will be required by September 13, 2011.
I. Scope of the Rule
To Whom Does the Rule Apply?
The Rule applies to all investment advisers that are registered (or required to be registered) with the SEC, or that are exempt from registration under Section 203(b)(3) of the Advisers Act (collectively, “Investment Advisers”), and that provide advisory services to a state or local government entity or to an investment pool in which a state or local governmental entity invests.
An “investment pool” includes:
(A) Any investment company registered under the Investment Company Act that is an investment option of a plan or program of a government entity; or
(B) Any company that would be an investment company under section 3(a) of the Investment Company Act but for the exclusion provided from that definition by section 3(c)(1), section 3(c)(7) or section 3(c)(11) of the Investment Company Act.
Please note that the Dodd-Frank Act will replace current Section 203(b)(3) of the Advisers Act (the exemption for advisers to a limited number of clients) with an exemption for certain foreign investment advisers. The SEC has not yet provided guidance on whether it will amend the Rule due to the changes pursuant to the Dodd-Frank Act.
II. Specifics of the Operation of the Rule
What Does the Rule Do?
There are three key elements of the Rule: (i) a two-year “time-out” from receiving compensation for providing advisory services to certain government entities after certain political contributions are made, (ii) a prohibition on soliciting contributions and payments, and (iii) a prohibition from paying third parties for soliciting government clients.
The Rule prohibits an Investment Adviser from receiving compensation from a “government entity” for two years after the Investment Adviser or any of its “covered associates” makes a political “contribution” to an “official” of the government entity. During the two-year “time-out” period, the Investment Adviser is only prohibited from receiving compensation from a government entity; the Investment Adviser can still provide advisory services to the government entity.
An “official” is any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (i) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity, or (ii) has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.
“Government entity” includes all state and local governments, their agents, and instrumentalities, as well as all public pension plans and other collective government funds, including participant-directed plans such as 403(b), 457, and 529 plans. These entities are typically pension plans that are separate legal entities from state and local governments, but have elected officials as board members.
A “covered associate” includes (i) any general partner, managing member or executive officer,1 or other individual with a similar status or function; (ii) any employee who solicits2 a government entity for the Investment Adviser and any person who supervises, directly or indirectly, such employees; and (c) any PAC controlled by the Investment Adviser or one of its covered associates. Whether a person is a covered associate ultimately depends on his or her activities, and is not based on his or her title. For example, an Investment Adviser’s limited partners, non-managing members and shareholders would not generally be considered covered associates, unless such persons were otherwise covered by the Rule (e.g., as an executive officer of the Investment Adviser).
A “contribution” includes (i) a gift, subscription, loan, advance, deposit of money or anything of value made for the purpose of influencing an election for a federal, state or local office, including any payments for debts incurred in such an election; or (ii) transition or inaugural expenses incurred by a successful candidate for state or local office. The Rule uses the same definition of “contribution” as Municipal Securities Rulemaking Board (“MSRB”) Rule G-37.
Please note the following:
- The SEC would not interpret an official to include an individual that is also a covered associate of the Investment Adviser. As a result, a covered associate can contribute more than the de minimis amount to his or her own campaign.
- A person holding federal office would not generally be considered an official of a government entity under the Rule. However, a candidate for federal office could be considered an official under the Rule. For example, a state governor that can appoint the directors of the state’s public pension fund would be considered an “official” during the time that the governor is a candidate for U.S. Senate.
- Contributions to political parties are not explicitly prohibited by the Rule. However, the “time-out” could be triggered by a contribution to a PAC or political party that is intended to support a limited number of government officials, or if the contribution is intended as a means for the Investment Adviser to do indirectly what it could not do directly. Accordingly, Investment Advisers should inquire as to how such contributions will be used.
- Payments made by an investment pool (e.g., mutual fund distribution fees paid pursuant to a 12b-1 plan) rather than by the Investment Adviser do not generally implicate the Rule. However, where an Investment Adviser pays the fund’s distribution fees out of its legitimate profits, the Rule would generally be implicated. In addition, it is a violation of the Rule for an Investment Adviser to structure a payment to be made by a fund for the purpose of evading the Rule.
- Contributions do not include making independent expenditures to express support for candidates, making speeches or charitable contributions. In addition, volunteering would not be considered a contribution, provided the Investment Adviser has not solicited the individual’s efforts and the Investment Adviser’s resources, such as office space and telephones, are not used. For example, volunteering would not be viewed as a contribution if it occurred during non-work hours, such as vacation time or during an unpaid leave of absence.
- The Rule will not prevent public pension plans from hiring their own consultants to assist them in their search for an investment adviser.
Under the Rule, when a person becomes a covered associate (including when an existing employee is transferred or promoted), the Investment Adviser must “look back” in time to that person’s prior contributions to determine whether the “time-out” provisions of the Rule apply to the Investment Adviser. If the person is involved in soliciting clients, then the Investment Adviser is required to look back two years. If the person is not involved in soliciting clients, then the Investment Adviser is only required to look back six months. The “look-back” provision, which is similar to that in MSRB Rule G-37, is prophylactic since it bars advisers from influencing the selection process by hiring persons who have made political contributions.
(2) Soliciting Contributions and Payments
The Rule bars an Investment Adviser and its covered associates from soliciting or coordinating: (i) contributions to an official of a government entity to which the Investment Adviser is seeking to provide investment advisory services, or (ii) “payments” 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.
A “payment” is any gift, subscription, loan, advance or deposit of money or anything of value. While similar to the definition of contribution, a payment is not limited based on the purposes for which it is given.
Pursuant to this provision, an Investment Adviser is prohibited from:
- indirectly making political contributions to politicians through, for example, spouses, lawyers or affiliated companies;
- “bundling” a large number of small employee contributions to influence an election in the state or locality in which the Investment Adviser is seeking business;
- soliciting contributions from professional service providers;
- consenting to the use of its name on fundraising literature for a candidate; and
- sponsoring a meeting or conference which features an official as an attendee or guest speaker and which involves fundraising for the official (and, in this case, expenses incurred by the Investment Adviser for hosting the event (such as the cost of the facility or refreshments, or reimbursement of any of the official’s expenses for the event) would be a contribution by the Investment Adviser, thereby triggering the two-year “time-out” provisions of the Rule).
An Investment Adviser would be seeking to provide advisory services to a government entity when it responds to a request for proposal, communicates with a government entity regarding that entity’s formal selection process for investment advisers or engages in some other solicitation of investment advisory business of the government entity. A violation of this provision would not trigger the two-year “time-out”, but would be a violation of the Rule.
(3) Prohibition on Third Party Solicitation
The Rule prohibits an Investment Adviser or any of its covered associates from paying any person to solicit a government entity unless such person is (i) a “regulated person” (i.e., a registered investment adviser or broker-dealer) that is subject to prohibitions against engaging in pay-to-play practices or (ii) one of the Investment Adviser’s employees, general partners, managing members, or executive officers (although contributions by these persons may trigger the two-year time out). This provision is a change from the initial proposal, which would have completely barred the use of solicitors.
The prohibition does not extend to non-affiliated persons providing legal, accounting or other professional services in connection with specific investment advisory business that are not being paid directly or indirectly for communicating with the government entity for the purpose of obtaining or retaining investment advisory business for the Investment Adviser.
The Rule permits an Investment Adviser to compensate a registered broker-dealer for soliciting government clients so long as the broker-dealer is (i) registered with the SEC, and (ii) a member of a registered national securities association that has a rule (a) that prohibits members from engaging in distribution or solicitation activities if certain political contributions have been made, and (b) that the SEC finds both to impose substantially equivalent or more stringent restrictions on broker-dealers than the Rule imposes on Investment Advisers and to be consistent with the objectives of the Rule.
Note that the SEC stated that it has been informed by the Financial Industry Regulatory Authority (“FINRA”) that FINRA “is preparing rules for consideration that would prohibit its members from soliciting advisory business from a government entity on behalf of an adviser unless they comply with requirements prohibiting pay-to-play activities.”
Registered Investment Advisers
Similarly, the Rule permits an Investment Adviser to compensate an investment adviser registered with the SEC for soliciting government clients so long as the registered investment adviser and its covered associates have not, within two years of soliciting a government entity: (i) made a contribution to an official of that government entity (other than a de minimis contribution, as permitted by the Rule), or (ii) coordinated, or solicited any person (including a PAC) to make, any contribution to an official of a government entity to which the Investment Adviser that hired the solicitor is providing or seeking to provide investment advisory services, or payment to a political party of a state or locality where the Investment Adviser that hired the solicitor is providing or seeking to provide investment advisory services to a government entity.
III. Other Provisions of Interest
There is a catch-all provision in the Rule that “prohibits acts done indirectly, which, if done directly, would violate the Rule.” As a result, an Investment Adviser and its covered associates are not permitted to funnel payments through third parties, including, for example, “consultants, attorneys, family members, friends or companies affiliated with the adviser as a means to circumvent the Rule.”
De Minimis Exception
Like MSRB Rule G-37, the Rule has a de minimis exception for contributions to officials for whom the contributor can vote. The exception permits individual contributions up to $350 per official (per election) for whom the employee is entitled to vote. In addition, contributions that in the aggregate do not exceed $150 per election per official will not violate the Rule, even if the contributor is not entitled to vote for the official. These de minimis exceptions are available only for contributions by individual covered associates, not the Investment Adviser. Under both exceptions, primary and general elections are considered separate elections.
Returned Contributions Exception
The Rule contains an exception that will provide an Investment Adviser “with a limited ability to cure the consequences of an inadvertent political contribution to an official for whom the covered associate making it is not entitled to vote.” The exception is available for a limited number of contributions that, in the aggregate, do not exceed $350 to any one official, per election.3 The Investment Adviser must have discovered the offending contribution within four months of the date the contribution was made and, within 60 days after learning of the triggering contribution, the contributor must obtain the return of the contribution.
The SEC may exempt an Investment Adviser from the two-year “time out” requirement after an offending contribution is discovered when the exemption is necessary or appropriate in the public interest. In determining whether to grant the exemption, the SEC will consider whether:
(A) the Investment Adviser adopted and implemented policies and procedures reasonably designed to prevent violations the Rule before the making the contribution resulting in the prohibition;
(B) prior to or at the time the contribution was made, the Investment Adviser had no actual knowledge of the contribution; and
(C) after learning of the contribution, the Investment Adviser:
(1) has taken all available steps to cause the contributor involved in making the contribution which resulted in such prohibition to obtain a return of the contribution; and
(2) has taken such other remedial or preventive measures as may be appropriate under the circumstances.
In these instances, the SEC will also look to other factors, including: whether the contributor was a covered associate or an employee of the Investment Adviser, or was seeking employment at the time of the contribution; the timing and amount of the contribution that resulted in the prohibition; the nature of the election (e.g., federal, state or local); and the contributor’s apparent intent or motive in making the contribution.
The SEC amended the books and records requirements in Rule 202-2 under the Advisers Act (the “Recordkeeping Amendment”). The Recordkeeping Amendment requires registered investment advisers that provide investment advisory services to government entities to “make and keep a record of all political contributions made by the advisers and their covered associates” in the past five years. However, registered investment advisers are not required to look back for the five years prior to the effective date to identify former government clients. The records required to be kept pursuant to the Recordkeeping Amendment are similar to the MSRB Rule G-8 recordkeeping requirements for brokers, dealers and municipal securities dealers.
The Recordkeeping Amendment requires a registered investment adviser to make and keep, among other records, the following records:
(A) The names, titles, and business and residence addresses of all covered associates of the registered investment adviser that provide advisory services to government clients;
(B) All government entities to which the registered investment adviser provides or has provided investment advisory services, or which are or were investors in any covered investment pool to which the registered investment adviser provides or has provided investment advisory services, as applicable, in the past five years, but not prior to September 13, 2010;
(C) All direct or indirect contributions made by the registered investment adviser or any of its covered associates to an official of a government entity, or payments to a political party of a state or political subdivision thereof, or to a political action committee (note that the registered investment adviser is not required to keep records of all payments); and
(D) The name and business address of each regulated person to whom the registered investment adviser provides or agrees to provide, directly or indirectly, payment to solicit a government entity for investment advisory services on its behalf, in accordance with the Rule. If the registered investment adviser does not specify which types of clients the regulated person should solicit on its behalf, it could satisfy this requirement by maintaining a list of all of its regulated person solicitors.
The records required to be maintained pursuant to (C) above must be kept in chronological order and indicate the name of each contributor, the name and title of each recipient of a contribution or payment, the amount and date of each contribution or payment, and whether an exception for certain returned contributions applies.
With respect to a registered investment company that is an investment option of a plan or program of a government entity, the registered investment company is only required to keep records relating to the government entity, and not with respect to participants in the plan or program.
The records above are only required if advisory services are provided to a government entity or a government entity is an investor in any covered investment pool to which the registered investment adviser provides services. The records are not required to be kept if the registered investment adviser only solicits to provide advisory services to the government entity.
Amendment to Cash Solicitation Rule
The SEC amended the “cash solicitation rule” under the Advisers Act (Rule 206(4)-3). New paragraph (e) alerts registered investment advisers and others that solicitation activities involving government entity clients are subject to the Rule.
Investment Advisers will have a six-month transition period (ending on March 14, 2011) to identify their covered associates and current government entity clients and modify their compliance programs to address new obligations under the Rule. In addition, effective March 14, 2011, Investment Advisers will be subject to the two-year “time out” requirement as a result of political contributions, and the Recordkeeping Amendments become effective. The prohibition on the use of third-party solicitors and the requirement to maintain related records, as well as the prohibitions and recordkeeping requirements relating to a registered investment company that is an investment option of a plan or program of a government entity, become effective on September 13, 2011. The Rule does not affect the 2010 elections for which some advisory personnel may already have committed to make political contributions.
The full text of the Rule can be found at http://www.sec.gov/rules/final/2010/ia-3043.pdf.
Please direct questions to any of the listed attorneys or to any other Bingham attorney with whom you ordinarily work on related matters:
Amy Natterson Kroll, Partner, Broker-Dealer Group
David C. Boch, Partner, Broker-Dealer Group
Toby R. Serkin, Partner, Investment Management Group
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
Timothy P. Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area