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

August 7, 2009

On August 3, 2009, the Securities and Exchange Commission (the “SEC”) published for comment new Rule 206(4)-5 under the Investment Advisers Act to prohibit “pay to play” arrangements by most 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 proposing release may be found at http://www.sec.gov/rules/proposed/2009/ia-2910.pdf.

The SEC unanimously voted at its open meeting on July 22, 2009 to seek comment on proposed Rule 206(4)-5.  Comments must be submitted to the SEC by October 6, 2009.  Please see Gibson Dunn’s alert on the open meeting.

Under the proposed rule, a covered investment adviser would be (i) banned from providing advisory services to a state or local government entity for two years if it (or its “covered associates,” as defined below) makes a political contribution of more than $250 to an official of the government entity who is in a position to influence the selection of the adviser, (ii) prohibited from paying unrelated third parties, such as placement agents, to solicit government clients, and (iii) prohibited from soliciting or coordinating certain political contributions to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services, or a political party of a state or locality where the government entity is located.  These prohibitions would supplement the current requirements on cash payments for client solicitations under Advisers Act Rule 206(4)-3.

Scope of Proposed Rule

Covered Investment Advisers.  The substantive provisions of the proposed rule would generally apply to advisers registered (or required to be registered) under the Advisers Act, as well as advisers exempt from registration under Section 203(b)(3) of the Advisers Act, which generally exempts from registration those advisers with fewer than 15 clients.  Managers of most hedge funds, private equity funds, venture capital funds and other private funds in the United States rely on this exemption from registration.  Consequently, such managers, even if not registered, generally would be subject to the proposed rule.[1] The SEC believes that most investment advisers to public pension plans would be covered by the proposed rule.  As discussed further below, however, the supplemental record keeping requirements under proposed Rule 204-2(a)(18) of the Advisers Act would not extend to those advisers exempt from registration under Section 203(b)(3) of the Advisers Act.

Covered Associates.  According to the proposing release, the SEC designed the proposed rule so that its prohibitions are triggered by political contributions by persons who the SEC believes, based on its experience in recent enforcement actions, are likely to have an economic incentive to make contributions to influence the adviser’s selection.  Thus, the provisions of the proposed rule would extend to the activities of an adviser’s “covered associates,” which 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 for the adviser; and (iii) political action committee controlled by the adviser or by any person in clause (i) or (ii) above.  An adviser’s “related persons” (i.e., any person directly or indirectly controlling or controlled by the adviser, and any person that is under common control with the adviser) and the employees of such related persons would not be “covered associates.”

Under paragraph (f)(5) of the proposed rule, “executive officers” of an adviser would be the president, any vice president in charge of a principal business unit, division or function, or any other executive officer of the adviser who in connection with his or her regular duties: (a) performs, or supervises any person who performs, investment advisory services for the adviser; (b) solicits, or supervises any person who solicits, for the adviser; or (c) supervises, directly or indirectly, any person described in clauses (a) or (b) above.  According to the proposing release, an adviser’s other executives, such as the comptroller, the head of human resources or the director of information services would not be “executive officers” for purposes of the proposed rule because the compensation of these individuals is less likely to be tied directly to obtaining or retaining clients.

Covered Government Entities.  The government entities covered by the proposed rule would be any state or political subdivision of a state, including (a) any agency, authority, or instrumentality of the state or political subdivision; (b) any investment program, pool of assets, or plan sponsored or established by the state or any political subdivision thereof, including public pension plans, 529 college savings plans, 403(b) and 457 retirements plans and any similar program or plan.[2]   For purposes of the proposed rule, an adviser to a “covered investment pool” in which a government entity invests will be treated as though the adviser were providing or seeking to provide investment advisory services directly to the government entity.

Covered Investment Pools.  A “covered investment pool” generally is proposed to mean any investment company, as defined in the Investment Company Act of 1940, as amended, or any company that would otherwise be an investment company but for the exclusions provided under Sections 3(c)(1), 3(c)(7) or 3(c)(11) of the Investment Company Act.  Consequently, most hedge funds, private equity funds, venture capital funds and other private funds in the United States would be “covered investment pools.”

Proposed Rule

Political Contributions (Proposed Rule 206(4)-5(a)(1))

An adviser would be prohibited from providing investment advisory services for compensation to any government entity within two years after the adviser or any covered associate makes a “contribution”[3] to any person who was at the time of the contribution an incumbent or candidate for elective office, if such office (i) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by such 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 adviser by such government entity.

The two year ban would continue even upon the departure of the applicable covered associate, and the contributions of such covered associate would be attributed to any other adviser that employs or engages such covered associate during the two years after the relevant contribution.  According to the proposing release, the purpose of this extension of the ban is to prevent advisers from circumventing the rule by channeling contributions through departing employees or by influencing the selection process by hiring persons who made political contributions.  The SEC has not proposed to restrict  the contributions of “related persons” and their employees, but seeks comment on whether they should also be covered.

In the context of a covered investment pool, if the two-year time out is triggered, advisers would be required to forego management fees, profits interests (including traditional carried interest and incentive fees) and recouping of costs related to the assets invested or committed by the applicable government entity.  To comply with this aspect of the ban, advisers would be required to waive or rebate any such compensation or, alternatively, terminate the relationship with the applicable government entity.  The adviser may also seek to cause the covered investment pool to redeem the investment of the government entity; however, for many private funds, such as venture capital and private equity funds, it may not be possible for a government entity to withdraw its capital or cancel its commitment without harm to the other investors (and contractual restrictions on withdrawals may apply).  The SEC has solicited comment on how to protect other investors in this context.  Advisers to covered investment pools should review their fund documentation to assess the potential implications of a violation of the proposed rule.

If an adviser seeks to cease providing investment advisory services to a government entity as a result of the ban, the proposing release indicates that an adviser’s fiduciary duties may require it to continue providing such services, at no fee, for a reasonable period of time.

As a practical matter, the significant implications of the two year ban with respect to adviser compensation may result in many advisers and their covered associates opting to discontinue political contributions of more than $250 (and any political contributions with respect to elections in which the covered associate making the contributions is not entitled to vote), for fear of violating the proposed rule or potentially missing future opportunities to provide investment advisory services to government entities.

Third Party Solicitors (Proposed Rule 206(4)-5(a)(2)(i))

An adviser and its covered associates would be prohibited from providing payment to any person to solicit a government entity for investment advisory services on behalf of such adviser.  This prohibition would not apply to the solicitation activities of an adviser’s related persons, employees of a related person, or its executive officers, general partners, managing members or employees.  The proposed rule would not prohibit government entities from retaining third parties, such as pension consultants, and paying them to recommend particular investment advisers for the management of public funds.

The strict prohibition on the use of third party solicitors, such as placement agents, would likely have a number of consequences.  For example, investment advisers and their related persons may seek to bolster the ranks of their investor relations staff in order to perform placement and solicitation activities in-house.  The SEC will 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.  Government entities with limited staffs would likely not be able to conduct a thorough adviser selection process without engaging a third party consultant.

Solicitation of Contributions (Proposed Rule 206(4)-5(a)(2)(ii))

An adviser and its covered associates would be prohibited from coordinating, or soliciting any person or political action committee to make, a (i) contribution to any incumbent or candidate for elective office, if such office: (a) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by such government entity; or (b) has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by such government entity, or (ii) payment to a political party of the state or locality where the adviser is providing or seeking to provide advisory services to a government entity.

Indirect Contributions and Solicitations (Proposed Rule 206(4)-5(d))

An adviser and its covered associates would be prohibited from doing anything indirectly which, if done directly, would result in a violation of the proposed rule, such as directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser.

Exceptions and Exemption to Proposed Rule on Political Contributions

The SEC proposes to provide two limited exceptions from the general ban on prohibited contributions under Rule 206(4)-5(a)(1).

First, a de minimis exception would permit a covered associate who is a natural person to contribute up to $250 to an otherwise prohibited official or candidate per election if the covered associate is entitled to vote in the election.  Primary and general elections would be treated as separate elections.  The adviser would be required to make and keep records on contributions that satisfy the de minimis exception.  We would also advise advisers to include a procedure for documenting and approving these contributions in their compliance procedures, with particular care to make sure that the $250 limit is not exceeded, because, as discussed below, the SEC proposes to limit advisers’ ability to cure noncompliance with this exception.

Second, an adviser will not be subject to the two-year time out if (i) within four months of the date of a contribution by a covered associate the adviser discovers the contribution would have triggered the ban; (ii) such contribution was equal to or less than $250; and (iii) the contributor obtains a return of the contribution within 60 calendar days of the date of discovery of such contribution by the adviser.  The SEC proposes that an adviser may rely on this exception no more than two times in any 12-month period,  but not more than once with respect to contributions made by the same covered associate.

In addition to the two exceptions discussed above, the proposed rule provides that the SEC may, upon application, grant an adviser conditional or unconditional exemptions with respect to the application of Rule 206(4)-5(a)(1) as a result of any prohibited contribution.  In addition to the standard general exemptive authority granted to the SEC, the proposed rule also outlines the conditions for an “inadvertent violation” exemption based on an adviser’s procedures to prevent violations and actions to prevent any of the abuses that the proposed rule is intended to address.  Among the specific steps that an adviser could take in hopes of qualifying for this essentially retroactive exemption would be placing advisory fees earned between the date of the prohibited contribution and the date on which the SEC’s determines whether to grant an exemption in an escrow account that would be payable to the adviser only if the SEC grants the exemption.  If the SEC does not grant the exemption, the fees contained in the account would have to be returned to the government entity.

In addition, contributions and activities made or conducted prior to the effectiveness of any final rule would be outside the scope of the proposed rule’s prohibitions, but would still need to be evaluated in connection with an investment adviser’s fiduciary duty and disclosure of conflicts of interest.

Recordkeeping and Compliance

Under the proposed rule, registered advisers (and those required to be registered) would be required to maintain additional records documenting the contributions and payments of the adviser and its covered associates, which would be available to the SEC in its examination process.  Advisers who are exempt from registration as investment advisers pursuant to Section 203(b)(3)[4] would not be subject to such record keeping requirements.

Non-exempt advisers would be required to maintain the following records:

• the names, titles and business and residence addresses of covered associates, including those that are political action committees;
• records of government entities to which the adviser or any covered associate is providing or seeking to provide advisory services, or that invest or are solicited to invest in covered investment pools to which the adviser provides advisory services;
• going back five years (but not prior to the effective date of the rule), records of government entities to which the adviser provided advisory services and the covered investment pools that the adviser provided advisory services to and in which a government entity invested; and
• records in chronological order of direct or indirect contributions or payments made by the adviser or any covered associate to an official or a political party of a state or political subdivision thereof, or a political action committee (including the name and title of each contributor and recipient, the amount involved and whether it was returned under the exception described above).

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 review and update their compliance policies and procedures to identify the covered associates, 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. Advisers will also need to adopt procedures to identify the political contributions of newly hired and promoted employees who qualify as covered associates.  Initial and annual training of covered associates 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.

Gibson Dunn attorneys advise clients on the full spectrum of regulatory, business, and compliance issues confronting the securities industry. Our clients include global investment banks; executing, clearing, and prime brokers; alternative trading systems and exchanges; institutional and retail brokers, proprietary trading firms, market makers, and exchange specialists, and M&A advisory firms. We also represent registered and unregistered investment advisers on a variety of regulatory and compliance issues.

Gibson, Dunn & Crutcher attorneys are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work or any of the following: 

Washington, D.C.
Barry R. Goldsmith (202-955-8580, [email protected])
Amy L. Goodman (202-955-8653, [email protected])
Jonathan P. Goodman (202-887-3669, [email protected])
K. Susan Grafton (202-887-3554, [email protected])
John H. Sturc (202-955-8243, [email protected])
C. William Thomas, Jr. (202-887-3735, [email protected])

New York
Edward D. Nelson (212-351-2666, [email protected])
Mark K. Schonfeld (212-351-2433, [email protected])
Edward D. Sopher (212-351-3918, [email protected])

California
Jennifer Bellah Maguire (213-229-7986, [email protected])
Gerard J. Kenny (949-451-3856, [email protected])

© 2009 Gibson, Dunn & Crutcher LLP

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