Tag: Rule 206(4)-5

Presidential Campaign Season and the SEC’s Pay-to-Play Rule

the great seal fo the state of iowa

With the recent Iowa Straw Poll, the presidential campaign season is getting into full gear. That also means that campaign fundraising is in full gear. I thought it would be useful to apply the SEC’s new Pay-to-play for Investment Advisors to the crop of presidential contenders.

Under SEC Rule 206(4)-5, investment advisors are limited in their ability to give campaign contributions to political candidates who can directly or indirectly influence the hiring of an investment advisor by a government-sponsored investment entity. A campaign contribution in violation of the rule means the investment advisor can not collect fees from the applicable government-sponsored investor for two years. The rule applies to registered investment advisors and fund managers that had been exempt under the now-repealed, private fund manager exemption.

The president of the United States is not an office that can directly or indirectly influence the hiring of an investment advisor, so that position is not one that is limited by the SEC Rule. However, you also need to look at the candidate’s current office to see if that position is one that is limited.

That means campaign contributions to the incumbent president, Barack Obama, are not limited by the rule. Some of his potential competitors are limited.

  1. Michele Bachmann. Her current office in the US House of Representatives is not limited by the rule.
  2. Ron Paul. His current office in the US House of Representatives is not limited by the rule.
  3. Tim Pawlenty. As Governor of Minnesota, contributions to his campaign would have been limited had he still been in office. He finished his term on January 3, 2011, which pre-dates the March 13, 2011 effective date of the rule.
  4. Rick Santorum. He does not currently hold a political office and is therefore not limited by the rule.
  5. Herman Cain. He does not currently hold a political office and is therefore not limited by the rule.
  6. Rick Perry. As the current Governor of Texas, he appoints trustees to the
  7. Mitt Romney. He does not currently hold a political office and is therefore not limited by the rule.
  8. Newt Gingrich. He does not currently hold a political office and is therefore not limited by the rule.
  9. Jon Huntsman. He does not currently hold a political office and is therefore not limited by the rule.
  10. Thaddeus McCotter. His current office in the US House of Representatives is not limited by the rule.

Registered Investment Advisors, private fund managers getting ready to register with Securities and Exchange Commission, and their employees need to be very cautious about making contributions to Governor Perry if they have a Texas state sponsored fund as a client or investor, or hope to have one as a client or investor in the next two years.

The rule also applies to placement agents. They must either be a registered investment advisor subject to SEC Rule 206(4)-5 or a municipal adviser subject to MSRB Rule G-42.

It is very obvious that SEC Rule 206(4)-5 can cause significant distortions in the political campaign.

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Controls on Political Contributions

In the face of some pay-to-play scandals involving investment advisers and government sponsored investment fund officials, the Securities and Exchange Commission slapped restrictions on the ability of investment advisers and fund managers to make political contributions. Rule 206(4)-5 prohibits an investment manager or fund manager from collecting fees for two years if the firm or “covered associates” make a political contribution to certain elected officials. The ban applies to politicians who can directly or indirectly influence the decision to hire or can directly or indirectly appoint the person who can make the decision.

In talking with other compliance officers, firms are all over the place on how they are putting restrictions and controls in place to prevent the disastrous results that come from violating the rule.

  1. Complete ban on political candidates
  2. Pre-clear all political contributions
  3. Pre-clear any contributions in excess of the de minimis amount of $350/$150
  4. Here’s the rule don’t break it

Regardless of the restrictions, the SEC Rule also imposes a record-keeping obligation on the compliance program. “Covered associates” must report all political contributions.

You can do a periodic certification of the contributions they have made. Since political contribution are in the public records, theoretically you can check the records to make sure that they are not failing to report.

I decided to try some public record searches to see if this was a realistic control.

I assumed the federal databases would be the best so I went to the Federal Election Commission’s Advanced Transaction Query By Individual Contributor. It allows you to search by company name. That makes it easy to run a broad search to find who in the organization has made campaign contributions.

That was a good start, but the least relevant. For the most part, federal elected officials do not control government-sponsored retirement funds. The big exception is if the candidate is currently a state or local official looking to go to Washington.

I turned next to Massachusetts Office of Campaign and Political Finance. Their OCPF Searchable Campaign Finance Database & Electronic Filing System makes it easy to search by employer.

Then I tried California, New York, and Virginia. They were both terrible and I could not find a way to search by employer.

Washington State’s Public Disclosure Commission allows you to search by employer.

The SEC rule just went into effect in March, so I get the sense that compliance programs are evolving as they work with the restrictions and controls. I’m interested to hear you are doing, whether you are searching campaign databases, and the resources you are using. Feel free to leave a comment (anonymous if you like) or send a confidential email to [email protected].

SEC Answers Questions About the Pay to Play Rule

The staff of the Division of Investment Management at the Securities and Exchange Commission has prepared responses to some questions about Rule 206(4)-5 under the Investment Advisers Act of 1940.

Here are a few that caught my eye:

Question II.6. Covered Associates’ Family Members.

Q: Are contributions by an advisory employee’s family members covered under the rule?

A: Generally not. However, rule 206(4)-5 and section 208(d) of the Advisers Act prohibit doing anything indirectly which would be prohibited if done directly (see rule 206(4)-5(d)).

Question II.7. Independent Contractors.

Q: If certain personnel of an investment adviser are considered “independent contractors,” rather than “employees,” for state law or tax law purposes, will they still be regarded as covered associates if they solicit or supervise those who solicit government entities on behalf of the adviser?

A: The term “employee” is not defined in the Advisers Act. The staff interprets the term “employee” to include “independent contractors” acting on behalf of an investment adviser (see Interpretive Release No. IA-1000, at II.C.3).

Question III.1. Foreign Governments.

Q: Does the definition of government entity include foreign governments?

A: No.

You can’t run political contributions through your spouse to avoid this rule and you can’t hire someone as an independent contractor to try and circumvent the rule. You can contribute to the political campaigns of foreign officials, but that raises issues elsewhere.

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SEC’s Pay-to-Play Rule Is Effective Today

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If you have (or want to have) government investors in your private fund then you need to be in compliance with Rule 206(4)-5 starting today.

Summary (from the SEC):

The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The new rule also prohibits an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers.

Limitations on Political Contributions

It is now unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

  1. directly or indirectly influence the hiring of an investment adviser, or
  2. has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

Record-Keeping

The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

  1. its covered associates
  2. all government entities that are investors
  3. all contributions made to an “official of a government entity”
  4. all contributions made to a political party
  5. all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

Covered Associates

The limitation on contributions only applies to “covered associates.” they key will be identifying who in the organization falls into this category. Who is a Covered Associate?

  1. Any general partner, managing member or executive officer, or other individual with a similar status or function;
  2. Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
  3. Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Good luck.

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Pay to Play Rules for Placement Agents

The SEC imposed strict limitations on the ability of investment advisers to make political contributions when their clients include government bodies when it issued Rule 206(4)-5. They don’t want government investment decisions decided campaign contributions. This limitation also applies to private investment funds under the language of the rule and the changes to the Investment Advisers Act made by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The SEC carried this limitation over to placement agents used by investment advisers. The placement agent needs to be subject to similar limitations. That means the placement agent would need to be a registered investment adviser or otherwise regulated. At first the SEC expected FINRA to create a new rule to govern pay-to play. Instead, Section 975 of Dodd-Frank Wall Street Reform and Consumer Protection Act created a new category of regulated persons called a “municipal adviser.” This new category will regulated by the Municipal Securities Rulemaking Board.

The MSRB has issued a proposed draft of new Rule G-42 that would limit a placement agent’s ability to make political contributions.

One major difference between this draft of Rule G-42 and SEC Rule 206(4)-5 is the definition of de minimis political contribution. The SEC allows a contribution of $350 per election cycle for candidate you can vote for or $150 for a candidate you can’t vote for. The MSRB definition would be $250 for candidate that you can vote for.

Violating the rule means you are banned from

  • engaging in municipal advisory business with a municipal entity for compensation,
  • soliciting third-party business from a municipal entity for compensation, or
  • receiving compensation for the solicitation of third-party business from a municipal entity,

for two years after any contribution to an official of such municipal entity in excess of the de minimis amount.

Proposed Rule G-42 for municipal advisers is similar to Rule G-37 for those in the municipal securities business. I expect that comments will argue that the de minimis amount should match up with the SEC’s de minimis amount.

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Placement Agents and the MSRB

In addition to laying out the changes to Form ADV, in Release No. IA-3110 the SEC also took a slightly different course on regulating placement agents. Rule 206(4)-5, released in July 2010, required placement agents to either be registered with the SEC as an investment adviser and subject to the limitation on campaign contributions, or register with FINRA. The FINRA registration was subject to enactment of a similar pay-to-play rule by FINRA.

The SEC has abandoned FINRA for the MSRB when it comes to regulating placement agents that interact with government sponsored plans.

Section 975 of Dodd-Frank Wall Street Reform and Consumer Protection Act created a new category of regulated persons called a “municipal adviser.” This new category will regulated by the Municipal Securities Rulemaking Board.

The MSRB is undertaking a rule-making to subject municipal advisers to the pay-to-play rules in place for municipal securities dealers under MSRB Rule G-37.

“Municipal advisors” include businesses and individuals that advise municipal entities concerning municipal financial products and municipal securities, as well as businesses and individuals who solicit certain types of business from municipal entities on behalf of unrelated broker-dealers, municipal advisors, or investment advisers.

In comparing the de minimis amounts under Rule 206(4)-5 and MSRB Rule G-37, the MSRB only allows for contributions up to $250 for candidates the person can actually vote for. The SEC rule is $350 for a candidate you can vote for and $150 for a candidate you can’t vote for. Both have a two-year ban for violation of the rules.

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A Closer Look at the new SEC Rule 206(4)-5 on Pay to Play

Over the weekend, the Securities and Exchange Commission released the full text of Rule 206(4)-5 in Release No. IA-3043. I made few notes during the broadcast of the open meeting, but there were lots of unanswered questions.

Rule 206(4)-5 is only 12 pages long, but Release IA-3043 also includes another 190 pages of commentary and discussion.

Summary (from the SEC):

The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The new rule also prohibits an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers.

Limitations on Political Contributions

It is unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

  1. directly or indirectly influence the hiring of an investment adviser, or
  2. has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

A primary election is separate election from the general election. [Release page 63]

Those are increases from the proposed rule.

Who is a Covered Associate?

  1. Any general partner, managing member or executive officer, or other individual with a similar status or function;
  2. Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
  3. Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Placement Agent Ban

The rule retreated from the complete ban on placement agents that was in the draft rule. The SEC seems willing to put a ban in place. For now, the rule allows you to use a placement agent provided that they are either an SEC registered investment adviser or a SEC registered broker dealer. The extra limit on the broker dealer is that they have be subject to a an equivalent restriction on political contributions. Something that  is not yet place. Apparently, FINRA is working on pay-to-play regulations for broker-dealers.

Does Rule 206(4)-5 Apply to Private Funds?

Rule 206 (4)-5 will apply to registered investment advisers and unregistered investment advisers who are relying on the small adviser exception to registration. (Of course, that exception is scheduled to be eliminated shortly as part of the financial reform legislation.)

Also, the rule deems the adviser to a “covered investment pool” to be providing investment advisory services directly to the investor in the pool.

Therefore, private equity fund managers and their employees will be subject to this rule. Even venture capital fund managers who managed to keep a registration exemption in the financial reform bill will need comply with this new rule.

The financial reform bill is bumping the SEC registration up to $100 million from $25 million. That means a bunch of advisers and small funds will fall out from having to comply with this rule since it does not apply to state-registered advisers.

Record-Keeping

The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

  1. its covered associates
  2. all government entities that are investors
  3. all contributions made to an “official of a government entity”
  4. all contributions made to a political party
  5. all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

What’s a Contribution?

“[A]ny gift, subscription, loan, advance, or deposit of money or anything of value made for:

(i) The purpose of influencing any election for federal, state or local office;
(ii) Payment of debt incurred in connection with any such election; or
(iii) Transition or inaugural expenses of the successful candidate for state or local office.”

Cash donations are clearly contributions. The release says that volunteer activity is not a contribution.[Release Page 23]

Effective Date

The rule has not made its way into the federal register, but will be effective 60 days after publication.

The limitations on political contributions and the record-keeping requirments have a compliance deadline of six months after the effective date. That means you need to get ready by the end of this calendar year, with the actual deadline likely to be in early March.

The limitation on the use of third parties to solicit government business has a compliance deadline one year after the effective date. That will likely be sometime during the summer of 2011.

SEC Votes on Pay to Play

At Wednesday’s Open Meeting the Securities and Exchange Commission took up the discussion of their proposed rules on pay-to-play for investment advisers. The proposal is a new Rule 206 (4)-5 under the Investment Advisers Act. The Commission voted unanimously to adopt the rule.

The rule will have three main prongs:

Two Year Time-Out

An investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

There will be two de minimis exceptions. For an official the person can vote for, you can contribute up to $300 350. That exception is lowered to $150 if you are not entitled to vote for the official.

There is a limited ability to get a return of a political contribution for inadvertent violations. It sounds like this will be difficult.

There was a mention that the political contributions limitation may not affect all employees of an investment adviser.

Coordination

The proposed rule also would prohibit an adviser from coordinating, or asking another person or political action committee to:

  1. Make a contribution to an elected official (or candidate) who can influence the selection of the adviser.
  2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

The SEC does not want investment advisers to be gatekeepers or aggregaters for political contributions to elected officials who select investment advisers for government funds.

Placement Agents and Solicitors

The third prong would prohibit advisers from hiring third party persons to act as agents or solicitors for an investment adviser unless the third party is a regulated person subject to pay-to-play regulation similar to this rule. The placement agents will need to a registered investment adviser or broker-dealer.

The comments to the flat ban resulted in the most comments to the rule. This is the biggest change to the final rule will vary from proposed rule.

They are going to keep a close eye on placement agents. If there continues to be a problem, the SEC is prepared to put a complete ban in place.

Catch-All

There is a catch-all provision is the rule that prohibits indirect violation of the rules.

Applicability

Rule 206 (4)-5 will apply to registered investment advisers and unregistered investment advisers who are relying on the small adviser exception to registration. (Of course, that exception is likely to be eliminated shortly as part of the financial reform legislation.) Private equity fund managers and their employees will be subject to this rule.

There will be a one year period before the placement agent limitations are effective. This is designed to give FINRA time to enact its new regulations on pay-to-play.  It’s not clear if the one-year period is applicable for the other parts of Rule 206 (4)-5.

First Amendment

Commissioner Casey raised a concern that the rule not violate the first amendment rights to engage in the political process. She thought the rule struck a good balance. Commissioner Parades was concerned about rogue employees making contributions in violation of the policy.

Full Text

As is typical with the SEC rules, the final text of Rule 206 (4)-5 was not released at the time of the vote. Keep an eye out for the final release and its detailed requirements.

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