Tag: Rule 206(4)-5

SEC Issues Second Exemptive Relief from Pay-to-Play

compliance politics and money

It’s been about a year since the Securities and Exchange Commission granted its first exemptive order Rule 206(4)-5 when an adviser accidentally violated the pay-to-play rule. The SEC has now issued its second relief order. Ares Real Estate Management Holdings filed for exemptive relief after a senior partner wrote a $1,100 check to Colorado Governor John Hickenlooper’s campaign.

The Colorado governor appoints members to the Board of Trustees for Colorado’s pension system. That system was investor in one of Ares’ older funds.

Ares had compliance policies and procedures that require pre-approval of all political contributions. The employee thought the limitation didn’t apply in this situation because the adviser was not seeking new investments from the Colorado public pension fund.

The Colorado system had not made a new investment in an Ares fund since 2007. That’s six years before the contribution was made and three years before Hickenlooper was elected governor.

Since it’s a closed-end private fund, the investor has no right to redeem and is locked in for the fund’s duration.

After finding the problem, Ares put the fees into escrow pending an outcome of the exemptive order. Ares also walled that employee off from the Colorado investment to avoid tainting the relationship.

A big pile of cash was at stake for Ares. Over $1 million in fees could be generated over the two year ban.

It is great that the SEC granted the relief. But the case is an example of the problem with the Rule 206(4)-5. It is too broad. The contribution amounts were relatively small and had no connection to the investment.

Money in politics is a problem. It’s noble that the SEC has taken a stance. However, it’s contrary to the current law that political contributions are considered free speech. the SEC is taking a big club to the problem.

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Lawsuit Against SEC’s Political Contribution Rule

USDC for DC Meade_and_Prettyman_Courthouse

The New York Republican State Committee and the Tennessee Republican Party brought suit against the Securities and Exchange Commission challenging its political contributions rule for investment advisers, . The complaint seeks an injunction against the enforcement of the rule’s political contribution restrictions on contributions to federal candidates.

The first attack on the rule is that Federal Election Campaign Act gave the Federal Election Commission exclusive jurisdiction over federal campaigns. I don’t know enough about that law to opine on that argument.

The second attack is that the rule exceeds the SEC’s statutory authority. They look to the release for Rule 206(4)-5 and the SEC’s own statement that the rule may prohibit acts that are not themselves fraudulent. The problem is that the SEC is confusing payments to state officials as a quid pro quo for business with legal campaign contributions.

As for expertise, the parties point out that the SEC has no specialized knowledge of campaign finance or elections.

The third attack is that the rule violates the First Amendment to the US Constitution. One focal point of the argument is that the rule distorts the ability to give to candidates running for the same office. I pointed this out in the 2012 Republican presidential primaries. Contributions were limited to Rick Perry, but none of the other candidates.

Although some of the arguments could be used to take down the entire rule, the parties are only seeking to exclude it from application to federal candidates. In my view that would be an improvement. It would make it a much clearer rule. The only published relief under the rule was when the Ohio State Treasurer was running for US Senate. The employee thought the rule did not apply to federal candidates.

I don’t like the political contributions rule. It takes innocent, legal behavior, with no fraudulent intent, and turns it into a regulatory violation. Campaign finance is a problem, but the SEC rule does little to help the problem.

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Meade and Prettyman Courthouse by AgnosticPreachersKid
CC BY-SA 3.0

SEC Charges Private Equity Firm With Pay-to-Play Violations

compliance politics and money

The SEC has brought its first case under the pay-to-play rule for registered investment advisers. It’s just as horrible as I thought it would be.

The Securities and Exchange Commission enacted Rule 206(4)-5 to address pay-to-play abuses involving campaign contributions made by registered investment advisers and their key employees. The concern was contributions to government officials who are in a position to influence the selection of advisers to manage government client assets, including public pension assets. The SEC perceived that there is a culture of making contributions in exchange for investment.

TL Ventures sponsored private equity funds. The Pennsylvania State Employees’ Retirement System is an investor in two funds. The City of Philadelphia Board of Pensions and Retirement is an investor in one fund. The commitments were made in 1999 and 2000. As a limited partner in the fund, neither government pension fund had the right to withdraw its contribution or to make a bigger contribution.

In 2011, a covered associate of TL Ventures made a $2500 campaign contribution to the Mayor of Philadelphia. The Mayor appoints three of the nine members of the City of Philadelphia Board of Pensions and Retirement. Therefore the Mayor has indirect influence over the investment decisions and contributions are subject to Rule 206(4)-5.

In 2011, a covered associate of TL Ventures made a $2000 contribution to the Governor of Pennsylvania. The Governor appoints six of the eleven members of the board of the Pennsylvania State Employees’ Retirement System. Therefore the Governor has indirect influence over the investment decisions and contributions are subject to Rule 206(4)-5.

In this case, the dollar amounts are not huge. In the current race for Governor, Ed Rendell and Bob Casey have together spent $31.5 million. The violation in this case was $2500. I assume the Covered Associate lived in Pennsylvania. Therefore the cap under Rule 206(4)-5 was $350.

The contributions were made more than 10 years after the investment decision was made. There is no statement of malice or bad intent by TL Ventures. But Rule 206(4)-5 does not require a showing of quid pro quo or actual intent to influence an elected official or candidate. You make a contribution; you violate the rule.

The SEC action also includes a charge of failing to register with the SEC. TL Ventures tried to structure its business to avoid registration. TL Ventures managed venture capital funds and therefore was able to be an exempt reporting adviser. Its affiliate, Penn Mezzanine, had less than $150 million under management and therefore would be subject to state registration, not SEC registration. The SEC has stated that it will treat two or more affiliated advisers that are separate legal entities but are operationally integrated as a single adviser. The SEC found that the operations of the two were integrated. Therefore, the firm should have registered with the SEC.

The firm ended up paying a disgorgement of $256,697. I assume that translates to the two years worth of fees that TL Ventures collected from the government pension funds.

The amounts are relatively small. The firm was not currently soliciting the government pension funds for business. There is no finding of malice or egregious behavior.

Good luck going to sleep tonight.

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Pay to Play and the Supreme Court

Supreme Court

The US Supreme Court struck down some campaign finance limitations in McCutcheon v. Federal Election Commission. My first question was whether this court ruling would impact the Securities and Exchange Commission’s Rule 206(4)-5. The answer is “no.”

Mr. McCutcheon wanted to contribute $1776 dollars to a long list of political candidates. Each individual contribution is less than the $2600 federal limit. But the sheer number of candidates and political groups he targeted would violate the aggregate limits.

It was this aggregate limit that the Supreme Court struck down. The case did not strike down the individual limit.

The First Amendment protects political campaign contributions as a type of free speech. Therefore, any restrictions on political contributions must promote a compelling state interest and undertake the least restrictive means to further the state interest.

The Supreme Court has found that the government can regulate campaign contributions that target “quid pro quo” corruption or its appearance. Individual campaign contributions can be limited to prevent the dollars for political favors problem. That is a compelling state interest.

SEC Rule 206(4)-5 is specifically targeted at the corruption or appearance of corruption problem. The SEC can point to specific instances of government investments being tied to political contributions. It’s unlikely that the SEC’s pay-to-play rule will be overturned anytime soon.

References:

Image of the Supreme Court is by Matt H. Wade

Some Relief for a Fund Manager Under the Political Contributions Rule

Politician: Holding Out a Stack of Money

SEC Rule 206(4)-5 for investment advisers and fund managers limits the ability of a firm’s employees to make political contributions. It’s a nasty rule. Violation of the rule does not require any bad intent. The breadth of affected political candidates is long, diverse, and hard to discover.

Anthony Yoseloff worked at Davidson Kempner Capital Management which ran a private investment fund. Three of the investors in the fund were Ohio public pension plans. Under the SEC Rule, Yoseloff would be limited in making political contributions to politicians who could directly or indirectly influence the decision to invest in the private investment fund.

Yoseloff gave a $2500 donation to the federal senate campaign of Joshua Mandel. Yoseloff though federal elections were exempt from the political contributions limit. He was wrong. Mandel was the Ohio Treasurer and had the power to appoint trustees to the Ohio pension plans. Yoseloff had violated the rule and the firm was at risk of losing two years worth of management fees from Ohio pension plans.

The firm applied for exemption from the SEC, hoping the innocent mistake would not cost them thousands of dollars. (tens of thousands? hundreds of thousands?)

The rule does provide for exemptive relief. This case may be the first such relief.

Here’s what the SEC said mattered in the ruling granting the relief:

  • The Ohio pension plans established the investment relationship on a arms’ length basis prior to the date of the contribution
  • Only one investment was made after the contribution
  • The firm had pay-to-play policies and procedures compliant with the rule’s requirements and implemented compliance testing
  • After discovering the contribution, the firm requested it’s return from the candidate
  • The firm set up an escrow account to hold the fees.
  • The contribution was consistent with Mr. Yoseloff’s past contributions.
  • Mr. Yoseloff mistakenly thought the contribution policy was not applicable to federal candidates.

Thankfully, the SEC is showing some relief from this oppressive rule that distorts political campaigns. Mr. Yoseloff could have given the $2500 to Sherrod Brown, the other candidate in the election, and there would have been no problem. In the 2012 republican presidential primaries, of the 10 candidates only Rick Perry was limited by the SEC rule.

On the other hand, there was a long history of pay-to-play in the municipal finance industry that was snuffed out by the MSRB rules. (This SEC rule was based on those.) We have several instances of politicians and investment advisers/fund managers doing bad things to steer investments. I understand the need.

Clearly the firm is trying to run tests on political contributions. It found the contribution because the federal database allows you to search by “employer name.” The Ohio state database does not. If the contribution was made to the treasurer’s state campaign, the firm may never have discovered it. Most of the state election finance databases that I’ve reviewed do not allow you to search by employer. This effectively limits the ability to monitor contributions. Yet another problem with the rule.

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SEC Brings a Pay-to-Play Action

The Securities and Exchange Commission filed a “pay-to-play” case against Goldman Sachs and one of its former investment bankers, Neil M.M. Morrison. The SEC alleges that Goldman and Morrison made undisclosed campaign contributions to then-Massachusetts state treasurer Timothy P. Cahill while he was a candidate for governor.

The case was brought under the Municipal Securities Rule on pay-to-play: MSRB Rule G-37. The SEC’s investment adviser/private fund rule on pay to play, Rule 206(4)-5, is based closely on that MSRB rule.

The SEC’s order found that Goldman Sachs did not disclose any of the contributions on MSRB forms and did not  keep records of the contributions in violation of MSRB rules.

Goldman Sachs agreed to settle the charges by paying $7,558,942 in disgorgement, $670,033 in prejudgment interest, and a $3.75 million penalty. This is the largest fine ever imposed by the SEC for Municipal Securities Rulemaking Board pay-to-play violations. The SEC’s case against Morrison continues.

According to the SEC’s order against Goldman Sachs, Morrison worked in the firm’s Boston office and solicited underwriting business from the Massachusetts treasurer’s office beginning in July 2008. Morrison was substantially engaged in working on Cahill’s political campaigns. Before joining Goldman Sachs, between January 2003 and June 2007, Morrison was employed by the Massachusetts Treasurer’s Office, which included positions as the first deputy treasurer, chief of staff and assistant treasurer, reporting directly to Cahill.

Morrison participated extensively in Cahill’s gubernatorial campaign, often during working hours from his Goldman Sachs office, and used Goldman Sachs resources (such as phones, e-mail and office space). The SEC claims that Morrison’s use of Goldman Sachs work time and resources for campaign activities constituted valuable in-kind campaign contributions to Cahill that were attributable to Goldman Sachs and disqualified the firm from engaging in municipal underwriting business with certain Massachusetts municipal issuers for two years after the contributions.

While Morrison was an employee and working on the Cahill campaign, Goldman Sachs participated in 30 prohibited underwritings with Massachusetts issuers and earned more than $7.5 million in underwriting fees.

According to the complaint, this seems like an egregious violation of the pay-to-play rules. It does highlight that items beyond cash contributions could be considered a “contribution” under the pay-to-play rule.

We would not consider a donation of time by an individual to be a contribution, provided the adviser has not solicited the individual’s efforts and the adviser’s resources, such as office space and telephones, are not used….

A covered associate’s donation of his or her time generally would not be viewed as a contribution if such volunteering were to occur during non-work hours, if the covered associate were using vacation time, or if the adviser is not otherwise paying the employee’s salary

Sec Release IA-3403 page 46 and footnote 157 (.pdf)

From a compliance perspective, the question is how to value the use of time in the office, email, and phone usage. I suppose you can add up long distance charges. For employees you can use their hourly rate to determine time spent.  For Morrison, it appears that even using a very conservative measurement  of his time and the Goldman resources, the value would be many times in excess of the $250 limit under the MSRB rule. (The SEC limit is $350 if you can vote for the person.)

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Senate Races and SEC Limits on Political Contributions

Last year a new rule from the Securities and Exchange Commission went into effect that limited the ability of investment advisers and private fund managers to make political campaign contributions. The purpose was to prevent some illicit pay-to-play activity by government officials who control government sponsored investment funds. With the close of the national political conventions and selection of the Republican and Democratic tickets, it’s clear how the pay-to-play rule for investment advisers will affect the presidential fund-raising.

It won’t.

Let’s take a look at Congress and see how  Rule 206(4)-5 affects campaign contributions for some of the currently competitive Senate races.

Connecticut

Chris Murphy is currently a member of the US House of Representatives. Therefore, donations to him would not be limited by the rule.

Linda McMahon does not currently hold a political office. She was the former CEO of World Wrestling Entertainment. Therefore, donations to her would not be limited by the rule.

Indiana

Joe Donnelly is a member of the U.S. House of Representatives. Therefore, donations to him would not be limited by the rule.

Richard Mourdock is the current  State Treasurer of Indiana. That position raises a red flag and requires further research. The Treasurer or his nominee serves on the Board of Trustees of the Indiana Public Retirement System, the state’s largest pension system. If your firm want access to those government investment funds, you will need to limit donations to Mr. Mourdock.

Massachusetts

Scott Brown is the incumbent Senator. Therefore, donations to Mr. Brown would not be limited by the rule.

Elizabeth Warren is a professor at Harvard and does not currently hold a political office. Therefore, donations to her would not be limited by the rule.

Missouri

Claire McCaskill is the incumbent Senator. Therefore, donations to her would not be limited by the rule.

Todd Akin is a Republican member of the United States House of Representatives. Therefore, donations to him would not be limited by the rule.

Montana

Jon Tester is the incumbent Senator seeking reelection. Therefore, donations to him would not be limited by the rule.

Denny Rehberg is currently a member of the US House of Representatives. Therefore, donations to him would not be limited by the rule.

Nevada

Shelley Berkley is a member of the United States House of Representatives. Therefore, donations to her would not be limited by the rule.

Dean Heller is the incumbent Senator. Therefore, donations to him would not be limited by the rule.

North Dakota

Heidi Heitkamp is a former Attorney General, but does not currently hold a political office. Therefore, donations to her would not be limited by the rule.

Rick Berg is a member of the United States House of Representatives. Therefore, donations to him would not be limited by the rule.

Ohio

Sherrod Brown is the incumbent Senator. Therefore, donations to Mr. Brown would not be limited by the rule.

Josh Mandel is the current Treasurer of Ohio. Donations to Mr. Mandel are limited by the rule. The Treasurer appoints members to the state retirement system boards who select investment and investment advisers.

Virginia

Tim Kaine is a former Governor of Virginia. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

George Allen is also a former Governor of Virginia and was a former US Senator from Virginia. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

Wisconsin

Tammy Baldwin is currently a member of the US House of Representatives. Therefore, donations to her would not be limited by the rule.

Tommy Thompson was a former governor of Wisconsin, but does not currently hold a political office. Therefore, donations to him would not be subject to the rule. If he was still the sitting governor, donations to him would have been limited.

Also keep in mind that contributions to state and local political parties are also limited by the rule.

Even if the contributions to a particular candidate are not limited by the rule, an investment adviser is still required to keep a record of all campaign contributions.

Senate Map is from Real Clear Politics

The Vice President and SEC’s Pay to Play Rule

Now that the Democratic and Republican conventions have ended and the presidential tickets are final, we can look at how the SEC’s new rule on political contributions will affect the November election. It won’t.

Early in the Republican contest for the nomination, Rick Perry was on the watch list under Rule 206(4)-5. Since he could directly or indirectly control several state pension funds in the State of Texas, contributions to Governor Perry would be subject to the rule. That means limiting contributions to $350.

It’s clear how the rule worked for Presidential nominees. It was not clear to me how the rule would work with the vice presidential candidates. The office itself does not control a government pension fund. But you need to look to the candidates current office as well under the Rule.

If Mr. Romney had selected a sitting governor, such as New Jersey’s Chris Christie, the SEC rule would have limited political contributions to the Republican ticket. In most states, Governors appoint board members for the state pension funds. It’s not clear whether that nomination would have tainted past contributions to the Republican campaign.

With Mitt Romney’s selection of Paul Ryan as his vice presidential running mate, we don’t have to look for the answer yet. Mr. Ryan is an incumbent U.S. Congressman and is not associated with selecting advisers or investments for a government pension fund.

Based on a quick glance of the other tickets, it looks like the pay-to-play rule does not apply to most of the other political parties looking to grab a few votes in November.

The Libertarian Party is on the ballot in most states. It’s candidates Former Governor Gary Johnson (New Mexico) and
Former Superior Court Judge Jim Gray (California) do not currently hold political office.

The Green Party weaved its way through the ballot process and managed to get on the ballot in about half of the states. Neither Dr. Jill Stein (Massachusetts) nor Cheri Honkala (Pennsylvania) currently hold political office.

I’m a bit confused by the ballot of the Party of Socialism and Liberation. Their presidential candidate, Peta Lindsay, and their vice presidential candidate, Yari Osorio, are both under the Constitution’s mandated minimum age for their respective offices. In addition Mr Osorio is foreign born, making him further ineligible to hold the office.

I have no comment on Rosanne Barr’s presidential campaign.

Pay to Play and Cash Solicitations

The Securities and Exchange Commission extended the date by which registered investment advisers must comply with the ban on third-party solicitation in Rule 206(4)-5 under the Investment Advisers Act. The SEC is extending the compliance date in order to ensure an orderly transition. Since solicitors will need to registered as an investment adviser or a broker/dealer or a municipal advisor.

Part of the rule was reliant on FINRA coming up with a rule to meet the requirements under the definition of “registered person” in 206(4)-5(f)(9)(ii)(B) for broker-dealers. FINRA has not done that yet. (Isn’t FINRA supposed to be more effective than the SEC?)

It’s not just FINRA, the the Municipal Securities Rulemaking Board has not finished its rules for municipal advisers under 206(4)-5(f)(9)(iii).

My IACCP symposium also raised the limitations in Rule 206(4)-3. That rule prohibits the use of solicitors in fundraising unless certain requirements are met. The rule specifically refers to “clients” with no further elaboration. For a private fund, that raises the distinction between the fund as a client and the fund investors as limited partners in the fund.

Fortunately, there is an interpretative letter ruling on the topic

We believe that Rule 206(4)-3 generally does not apply to a registered investment adviser’s cash payment to a person solely to compensate that person for soliciting investors or prospective investors for, or referring investors or prospective investors to, an investment pool managed by the adviser.

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New York City “Pay-to-Play” Law is Upheld

The U.S. Court of Appeals for the Second Circuit upheld a New York City “pay-to-play” law against various constitutional challenges: Ognibene v. Parkes. The Pay to play law is in Local Law 34 and it:

  1. Lowers the caps applicable to campaign contributions from parties that have “business dealings” with New York City
    • to $400 (otherwise $4,950 applies to contributors not within the purview of the Law) for candidates for city-wide offices,
    • to $320 (otherwise $3,850) for candidates for borough offices, and
    • to $250 (otherwise $2,750) for candidates for city council,
  2. Prohibits public matching for contributions from the Affected Persons, and
  3. extends a ban on contributions from corporations to apply to partnerships, LLCs, and LLPs.

“Business dealings” include, among other things, “contracts for investment of pension funds” and transactions with “lobbyists”.

The plaintiffs in Ognibeneh include Republican Party members, the New York State Conservative Party, lobbyists, and other business interests. They challenged the Law as a violation of the First Amendment, the Fourteenth Amendment, and the Voting Rights Act. They lost in the district court and made this appeal. In affirming the district court’s decision, the Second Circuit considered whether the aforementioned provisions of the Law were “closely drawn to address a sufficiently important state interest” and found that each was sufficiently closely-drawn.

The Second Circuit agreed with the district court that the “doing business” contribution limits are “closely drawn” because combating corruption and the public perception of corruption is a sufficiently important justification for placing limits on donations to a candidate. The court draws a distinction from restrictions on independent corporate campaign expenditures which were struck down in Citizens United as overly burdensome limitations on speech.

The court was not persuaded that actual “evidence of recent scandals” was needed to justify the contribution limits. “[T]o require evidence of actual scandals for contribution limits would conflate the interest in preventing actual corruption with the separate interest in preventing apparent corruption.” Finding “no doubt that the threat of corruption or its appearance is heightened when contributors have business dealings with the City” and citing studies by the City Council on the issue, the court held that it is “reasonable and appropriate” to place additional limitations on contributions by Affected Persons.

The court drew another distinguish between the Green Party case in Connecticut and this law. The Connecticut law challenged in Green Party put in place a total ban on contributions, as opposed to mere limits.  However, “if the appearance of corruption is particularly strong due to recent scandals, therefore, a ban may be appropriate.”

Of course, pay-to-play laws are not unique to New York City. The SEC’s Rule 206(4)-5 enacted a similar limit on campaign contributions. Anyone challenging the SEC rule would have to look at this case and realize the SEC rule would like stand up to court scrutiny.

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Image is New York City celebrating the surrender of Japan. They threw anything and kissed anybody in Times Square., 08/14/1945 from the US National Archives