SEC Proposed Rulemaking on “Pay to Play” Arrangements Involving Investment Advisers

July 28, 2009

On July 22, 2009, the Securities and Exchange Commission (the "SEC") unanimously voted at its open meeting to propose for public comment a rule and amendments to various existing rules under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), intended to curtail so-called "pay to play" practices involving investment advisers.  The SEC uses the phrase "pay to play" to refer to arrangements whereby investment advisers make political contributions or related payments to governmental officials in order to be rewarded with, or afforded the opportunity to compete for, contracts to manage the assets of public pension plans and other government accounts.  The proposed rule also takes a draconian approach to the use of third party solicitors and placement agents by imposing an outright ban on their engagement by investment advisers to solicit government clients. A 60 day comment period will commence upon the publication of the proposing release in the Federal Register.[1]

Policy Concerns

The SEC’s rule proposal is intended to address its policy concern that adviser selection processes involving "pay to play" are not based on merit and the best interests of public pension plans, government accounts and beneficiaries, and therefore could result in sub-par advisory services at inflated prices.  At the SEC’s open meeting, the SEC staff expressed the belief that enforcement action under the existing anti-fraud framework of the Advisers Act and additional disclosure-based rules would not be sufficient to curtail "pay to play" arrangements, which are often difficult to identify.  Therefore, the SEC is proposing a new prophylactic rule and implementing amendments to existing rules designed to make it more difficult and costly for advisers to engage in "pay to play" practices. 

The SEC proposed, but did not adopt, similar rules in 1999, Release No. IA-1812 (Aug. 4, 1999), available at http://www.sec.gov/rules/proposed/ia-1812.htm.[2]  Among the concerns expressed by commenters at that time were whether the proposed ban would deprive participants and beneficiaries of public funds of the services of highly qualified advisers, and unduly increase compliance costs and, accordingly, the costs of  investment advisory services.  During the comment process for the 1999 proposed rulemaking, the SEC encountered significant resistance from some state governments concerned about federal encroachment on states’ rights.  In the open meeting the SEC’s staff voiced optimism that increased evidence of "pay to play" practices in the adviser selection process would result in significant state-level support for the current proposed rulemaking.

Scope of Proposed Rule

Covered Advisers.  The proposed rule would apply to advisers registered under Advisers Act as well as advisers exempt from registration under Section 203(b)(3) of the Advisers Act, which generally exempts from registration advisers with fewer than 15 clients.[3]  Advisers who are not registered because they manage less than $30 million in assets would not be subject to the proposed rule. 

Covered Government Accounts.  The proposed rule would apply to state and local government investment accounts, such as public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for retirement and 529 college savings plans, 457 plans and 453(b) plans.  

Covered Arrangements.  The proposed rule would apply to direct engagements of advisers to manage government accounts as well as to investments by government accounts in the pooled investment vehicles of advisers.

Covered Executives and Employees. The proposed rule would apply to covered executives and employees.  There was little discussion at the SEC’s meeting regarding the scope of these terms; however, in its proposed Rule 206(4)-5 in 1999, the SEC defined "executive officer" to mean "the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions, for the adviser." 

Proposed Rule

Among other things, the SEC proposes to regulate covered investment advisers with respect to:

Political Contributions.  Under the proposed rule, if an adviser makes (or if its covered executives or employees make) a political contribution to an elected official in (or a candidate for) a position that can influence the selection of the adviser, the adviser would be banned from directly or indirectly providing advisory services for compensation to state or local government investment accounts for two years.  The proposed rule imposes strict liability on violations regardless of the knowledge or intent of the adviser and its covered executives and employees.  However, a de minimis exception permits a covered executive or employee to make up to $250 in contributions to otherwise prohibited officials or candidates per election if the executive or employee is entitled to vote in the election.  Based on the information released by the SEC to date, it is unclear (i) whether an adviser and its covered executives and employees would continue to be subject to this restriction following the adviser’s engagement (for instance, would political contributions to an official with influence over the exercise of redemption or withdrawal rights or term extension rights be subject to the proposed rule), and (ii) how the two year ban would be enforced in various contexts, including in the context of an investment in a private equity fund, where the covered account may have contractual restrictions on its ability to withdraw from the fund or remove the adviser. 

Banning Third Party Solicitors.  Under the proposed rule, an adviser and its covered executives and employees would be prohibited from paying a third party, such as a placement agent, to solicit a government client on behalf of the adviser.  The proposed rule does not appear to distinguish between legitimate placement agent activity and third party solicitations involving "pay to play" arrangements.  However, the proposed rule would not prohibit state or local governments from engaging third parties to assist the government in its adviser selection process.  In his prepared remarks, Commissioner Paredes voiced concern that this proposed rule may unduly affect smaller and less-established advisers who may legitimately need to rely on placement agents because of a lack of relationships.  Commissioner Paredes requested comments on this issue.  The SEC might also consider whether the proposed rule, notwithstanding permission to engage third parties to assist in adviser selection, may unduly affect smaller government accounts that do not have the staff and other resources to diligence many different advisers and, therefore, may tend to invest with the largest or best known, rather than with the best performing advisers.  The SEC will also need to address the catch-22 for advisers who will be prohibited by the proposed rule from paying placement agents to solicit investors and who may be prohibited by Section 15(a) of the Securities Exchange Act of 1934 from soliciting investors if they are not also registered as broker-dealers.

Banning Solicitation of Contributions.  Under the proposed rule, an adviser and its covered executives and employees would be prohibited from coordinating, or asking another person or political action committee to make a (i) contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser or (ii) payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government. 

Restricting Indirect Contributions and Solicitations.  Under the proposed rule, an adviser and its covered executives and employees would be prohibited from doing indirectly what they are prohibited from doing directly, such as directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser.

Recordkeeping.  Under the proposed rule, all advisers subject to the proposed rule would be required to maintain records on the political contributions and payments of the adviser and its covered executives and employees, which would be available to the SEC as part of the adviser examination process.

Relief from Proposed Rule

The SEC staff stated in the open meeting that relief from the application of the proposed rule following a violation would be considered on a case-by-case basis, although we expect that such relief would be granted sparingly.  When reviewing an application for relief, the staff stated that it would consider all relevant facts and circumstances, including (i) whether the adviser had robust policies and procedures in place to prevent violations, (ii) whether the adviser had knowledge of the prohibited conduct, and (iii) what actions the adviser took upon discovering the prohibited conduct.

Compliance Procedures

Under Rule 206(4)-7, registered advisers are required to adopt and implement written policies and procedures reasonably designed to prevent Advisers Act violations.  If the proposed rule is adopted, advisers will need to revise their compliance policies and procedures to identify the covered executives and employees from time to time, including through initial and annual certification processes and to monitor their political contributions, for instance through a pre-clearance process, and to reflect additional new recordkeeping requirements. Initial and annual training of covered executives and employees and the legal, compliance and operational personnel who will have front line compliance responsibility will also be critical.  New recordkeeping requirements will also need to be determined and implemented. 

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