The SEC is seeking comments by October 6 on its proposed new rules under the Investment Advisory Act of 1940, as amended (IAA). If adopted, these rules would significantly curtail certain "pay to play" practices by investment advisers.
The proposed new rules would prohibit investment advisers from
- providing advisory services for compensation to a government client under certain circumstances;
- providing or facilitating payments to any third party for the solicitation of advisory business from any government agency; and
- soliciting for, or coordinating contributions to, certain elected officials, candidates or political parties when the adviser is either providing or seeking government business.
The proposed rules would also require registered investment advisers under the IAA to maintain certain records of political contributions made by the adviser or certain of its executives. The SEC believes that the new rules restricting pay-to-play practices by investment advisers are necessary because these practices undermine the fairness of the selection process by governmental agencies that either may be influenced by or, in some cases, require contributions as a cost of doing business with the government.
Background
The SEC has authority under Section 206(4) of the IAA to adopt rules that are reasonably designed to prevent business practices that are fraudulent or manipulative, including practices that are not themselves manipulative. In 1999, the SEC proposed rules that would have prohibited investment advisers from receiving compensation for advisory services for two years after the firm or any of its officers contributed money to an elected official (or a candidate for office) who had the ability to influence the selection of the adviser. In response to mixed reviews and strong opposition to the rules by government officials and investment advisers, the SEC declined to adopt the rules. The SEC states that in recent years, however, it has become clear that pay-to-play schemes have become a significant problem, citing numerous actions by the SEC and criminal authorities charging investment advisers with pay-to-play schemes.
One such recent civil action brought by the SEC in May of this year charged several former New York state officials as well as a placement agent with extracting kickbacks from investment advisers seeking to manage assets of the New York State Common Retirement Fund. The scheme involved the alleged payment by the investment advisers of sham placement agent fees, portions of which were then paid to public officials in return for public pension fund investments in the funds managed by the advisers. Another recently settled SEC administrative action this year involved an alleged kickback scheme in which an investment adviser made sham payments in return for investment advisory business awarded by the New Mexico state treasurer's office. The SEC also cites criminal actions brought in recent years in New York, New Mexico, Ohio, Connecticut, Florida and Illinois for similar conduct by investment advisers as further evidence that pay-to-play practices have almost certainly become widespread in the securities industry.
Proposed New Rules
Proposed new Rule 206(4)-5 would prohibit both direct political contributions by advisers and other pay-to-play practices that advisers employ to capture new investment from public pension plans. Specifically, the new rule would make it unlawful for an adviser to accept compensation for providing advisory services to a government entity for two years after the adviser or any of its covered associates (including partners, executives and certain affiliates and agents) contribute funds (except for certain inadvertent or de minimis contributions) to an elected official (or a candidate) who is in a position to influence the award of investment advisory work. Modeled on Municipal Securities Rulemaking Board (MSRB) rule G-37, the proposed rule is consistent with the SEC's 1999 proposal and stops short of imposing an outright ban or limit on the amount of political contributions by an adviser or its covered associates.
New Rule 206(4)-5 also would prohibit advisers from paying, directly or indirectly, third parties to solicit government entities for advisory business. Thus, this part of the rule, which is modeled after MSRB rule G-38 as amended in 2005, would prohibit any payments by an investment adviser to an unrelated party. Finally, the proposed rule, like MSRB rule G-37, would make it illegal for an adviser itself, or through a covered associate, to solicit or to coordinate contributions for any government official of a government agency from which the adviser seeks investment advisory business. Likewise, the rule would make it unlawful for any such contributions to be made or coordinated by an investment adviser to a political party of a state or locality where the adviser is currently providing or seeking to provide investment advisory services to a government entity.
Because the SEC recognizes that it cannot anticipate all of the ways that advisers and government officials may structure pay-to-play schemes, the proposed rule would include a provision prohibiting an adviser and covered associates from doing anything indirectly that, if done directly, would violate the rule. In addition, the restrictions under the proposed rule would apply to certain pooled investment vehicles in which a government entity invests or is solicited to invest as though the investment adviser was advising or seeking to advise the government entity directly. Although the proposed rule is similar to the SEC's proposal in 1999, the SEC has made changes to conform the restrictions to those adopted by the MSRB and various state and local authorities. Unlike the 1999 proposal, Rule 206(4)-5 has broader coverage aimed, for example, at prohibiting advisers from using third-party placement agents.
The proposed new rule would apply to most advisers – both registered and certain exempt advisers – to public pension plans. The SEC is requesting comment on whether the rule should be limited to investment advisers registered under the IAA or whether advisers that are exempt from registration should be covered as well. Noting that the proposed rule would have no effect on state laws, codes of ethics or other governing rules for activities of state and city officials or employees of public pension plans, the SEC is asking for comments on whether the scope of the rule should be broadened to cover state-registered advisers.
Under the proposed rule, the SEC could exempt advisers from the two-year "time out" requirement in situations in which the adviser discovers contributions that trigger the compensation ban after they have been made or when imposing the restrictions will not achieve the purposes underpinning the rule. In determining whether to grant an exemption, the SEC would consider the following:
- whether the exception is appropriate in light of the policies of the rule and the protection of investors;
- whether the investment adviser had procedures in place to prevent violations of the rule prior to the triggering contribution; and
- whether, after learning about the contribution that triggered the prohibition, the adviser took all available steps to cause the contributor to recover the contribution and other remedial measures that were appropriate under the circumstances.
The factors to be considered by the SEC are similar to those presently considered by FINRA and MSRB in determining whether to grant exemptions under their respective anti-manipulation rules. The SEC stated that it would apply the proposed exemptive provisions with flexibility to avoid imposing draconian consequences that are disproportionate to a specific situation. It requests comments on whether additional exemptions should be included in the final rule.
The SEC also is proposing amendments to Rule 204-2 of the IAA that would require a registered investment adviser to make and keep certain records of contributions made by the adviser and its associates if it has or seeks government clients or provides investment advisory services to a covered investment pool in which a government entity invests or is solicited to invest. The purpose of the amendment is to provide necessary compliance records related to proposed Rule 206(4)-5. The records would include the following information:
- the names, titles and business and residence addresses of all covered associates;
- the names of all government entities for which the investment adviser or any of its associates provides or seeks to provide advisory services;
- the names of all government entities to which the investment adviser has provided investment advisory services in the past five years; and
- all direct or indirect contributions or payments to an official of a government entity or to a political party or to a PAC, in chronological order with specific information related to each contribution.
Conclusion
The SEC's proposed rule and rule amendments would significantly restrict pay-to-play practices by investment advisers that provide or seek to provide advisory services to government entities. The SEC regards these practices as undermining the integrity of financial markets and believes that the proposed rule will better protect public pension plans, their beneficiaries and other investors. In addition to leveling the playing field among advisers, the proposed rule should, according to the SEC, minimize market manipulation and artificial barriers to competition. The SEC estimates that the compliance costs associated with the new rules would vary significantly among firms, depending upon the number of covered associates of the adviser, whether the firm's compliance procedures are automated, whether the adviser has pre-existing policies under its compliance program, and whether the adviser is affiliated with a broker-dealer that is subject to MSRB rules. On balance, the SEC believes that the estimated compliance costs associated with the proposed new rules will be dwarfed by the benefits to market participants and enhanced investor confidence.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
