Introduction
On July 1, 2010, the Securities and Exchange Commission (the “SEC”) adopted Rule 206(4)-5 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) in an effort to limit “pay to play” practices by investment advisers that provide or seek to provide investment advisory services to government entities.1 The Rule will prohibit an adviser’s receipt of compensation from a government entity for two years following any contribution by the adviser or certain of its personnel to an incumbent, candidate or successful candidate for elective office (each, an “official”) of a government entity who is or will be in a position to influence the award of advisory business. The Rule will also prohibit payments by an adviser to certain third-party solicitors for their solicitation of government entities.
Discussion of the Rule
A. Two-Year “Time Out”
The Rule prohibits SEC-registered investment advisers and advisers that are unregistered in reliance on the “private adviser” exemption available under section 203(b)(3) of the Advisers Act2 (“investment advisers”) from receiving compensation for providing advisory services to a government entity3 for a two year period after the adviser or one of its executives or restricted employees (“covered associates”)4 makes a contribution5 to an official if the official is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser or has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser.
An investment adviser is required to “look back” in time to determine whether it will be subject to any business restrictions under the Rule when employing or engaging a person who would be considered a covered associate. Therefore, if a person made a contribution to an official of a government entity in a position to influence the award of advisory business less than two years prior to such person becoming a covered associate, the Rule prohibits the investment adviser that hires, transfers or promotes the contributing covered associate from receiving compensation for providing advisory services to such government entity from the hiring, transfer or promotion date until the two-year period has run. In the case of a new covered associate who does not solicit clients for the investment adviser, only a six-month (rather than a two-year) look back applies. In either case, the two-year time out will continue in effect even after the covered associate who made the triggering contribution leaves the advisory firm.
The Rule does not apply to de minimis contributions (i.e., contributions of $350 or less, per election, by individual covered associates who were entitled to vote for the candidate at the time of the contribution and contributions of $150 or less, per election, by individual covered associates who were not entitled to vote for the candidate at the time of the contribution). In addition, the Rule provides an exception for inadvertent contributions that are made to an official for whom a covered associate is not entitled to vote, provided that the contributions, in the aggregate, do not exceed $350, per election, are discovered within four months of the date such contributions were made and are returned within sixty days of the date of discovery of such contributions by the investment adviser.6
B. Ban on Paying Certain Third Parties that Solicit Government Business
The Rule prohibits an investment adviser from providing or agreeing to provide, directly or indirectly, payment to third-parties (e.g., finders, solicitors, placement agents and pension consultants) or third-party solicitation firms for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are “regulated persons,” which include certain broker-dealers and registered investment advisers that are themselves subject to pay to play restrictions, either under the Rule or the rules of a registered national securities association (e.g., the Financial Industry Regulatory Authority, Inc.).7 The Rule does not, however, prohibit such payments to related persons of the adviser.
C. Application to Pooled Investment Vehicles
For purposes of the Rule, an investment adviser to pooled investment vehicles, including registered8 and unregistered investment companies (e.g., hedge funds, fund of funds, private equity funds and other entities that are typically excepted from the definition of investment company by section 3(c)(1), 3(c)(7) or 3(c)(11) of the Investment Company Act of 1940), in which a government entity invests or is solicited to invest will be treated as though the investment adviser were providing or seeking to provide investment advisory services directly to the government entity. The Rule prohibits an investment adviser from receiving compensation with respect to a government entity’s investment in a private investment fund managed by the investment adviser if the investment adviser or any covered associate made a contribution (other than an excepted or exempted contribution) to an official in a position to influence the investment decision.
D. Soliciting and Coordinating Contributions and Payments
The Rule prohibits an investment adviser from coordinating, or soliciting others to make, contributions for an official (or a related political party) of a government entity to which the adviser is providing or seeking to provide investment advisory services. The Rule also prohibits acts done indirectly, which, if done directly, would result in a violation of the Rule. Thus, an adviser or its covered associates could not circumvent the rule by directing or funding contributions through third parties, including, for example, consultants, attorneys, family members, friends or companies affiliated with the adviser.
E. Recordkeeping
The SEC has also adopted amendments to Rule 204-2 that require a registered investment adviser that has government clients or that provides advisory services to a covered investment pool in which a government entity investor invests to keep detailed information regarding, among other things, (i) its covered associates, (ii) all government entities to which the investment adviser provides or has provided investment advisory services, including those who are or were investing in or solicited to invest in a pooled investment vehicle managed by the investment adviser, in the past five years (but not prior to the effective date of the Rule) and (iii) all direct and indirect contributions made by the investment adviser or any of its covered associates to an official, a political party of a state or political subdivision thereof or a PAC. In addition, an investment adviser, regardless of whether it currently has a government client, must keep a list of the name and business address of each regulated person to whom the investment adviser provides or agrees to provide, directly or indirectly, payment to solicit a government entity for investment advisory services on its behalf.
F. Exemptions
An investment adviser may apply to the SEC for an order exempting it from the two-year compensation ban imposed by the Rule. An exemption will be granted based upon the facts and circumstances of the application, including whether the adviser had adopted and implemented policies and procedures reasonably designed to prevent violations of the Rule and had no actual knowledge of the contribution resulting in application of the prohibition.
G. Effective Date and Compliance Dates
The effective date of the Rule is the date that is 60 days after publication of the adopting release in the Federal Register (the “Effective Date”). Investment Advisers subject to the Rule must be in compliance with the Rule six months after the Effective Date. Accordingly, contributions that are made, solicited or coordinated prior to the date that is six months following the Effective Date will not trigger the two-year time out. Investment advisers may no longer use third parties to solicit government business except in compliance with the Rule beginning one year after the Effective Date.9 Investment advisers to a registered investment company that is an investment option of a plan or program of a government client must comply with the Rule by one year after the Effective Date.
Investment advisers who may be subject to the Rule should adopt policies and procedures that are designed to ensure compliance with the Rule prior to the compliance date of the Rule.
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If you have any questions or need more information, please contact an attorney in our Investment Management Group.
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1 Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. IA-3043 (July 1, 2010). The Rule is modeled on the rules of the Municipal Securities Rulemaking Board (see, in particular, MSRB rules G-37 and G-38).
2 As of the date of this memorandum, Section 203(b)(3) of the Advisers Act exempts from registration any investment adviser who, during the prior 12-month period, had fewer than 15 clients and does not hold itself out to the public nor acts as an investment adviser to an investment company registered under the Investment Company Act of 1940. This exemption is proposed to be eliminated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which has been adopted by the House of Representatives and remains subject to approval by the Senate.
3 “Government entity” means any state or political subdivision of a state, including any agency, authority, or instrumentality of the state or political subdivision; a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including but not limited to a “defined benefit plan” as defined in section 414(j) of the Internal Revenue Code, or a state general fund; a plan or program of a government entity; and officers, agents, or employees of the state or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity.
4 “Covered associates” means the adviser’s (i) general partners, managing members, executive officers and other individuals with a similar status or function, (ii) employees who solicit a government entity for the adviser and persons who supervise, directly or indirectly, such employees, and (iii) any political action committee (“PAC”) controlled by the adviser or by any person described in (i) or (ii) above. Under the Rule, an “executive officer” of an investment adviser means the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer of the investment adviser who performs a policy-making function or any other person who performs similar policy-making functions for the investment adviser. Furthermore, for purposes of the Rule, an adviser or its covered associate will be regarded as having “control” over a PAC if the adviser or its covered associate has the ability to direct or cause the direction of the governance or operations of the PAC.
5 A “contribution” means any gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing any election for federal, state or local office; payment of debt incurred in connection with any such election; or transition or inaugural expenses of the successful candidate for state or local office.
6 The scope of this exception is limited to the types of contributions that the SEC believes are less likely to raise pay to play concerns. Therefore, the Rule limits an adviser’s reliance on the exception to no more than two or three times per a 12-month period (based on the size of the adviser) and no more than once for each covered associate, regardless of the time period.
7 Under the definition of “regulated persons” as it applies to brokers, the SEC must find, by order, that a registered national securities association’s pay to play rules applicable to such brokers impose substantially equivalent or more stringent restrictions on them than the Rule imposes on investment advisers and that such rules are consistent with the objectives of the Rule.
8 In the case of an adviser to a publicly-offered registered investment company, the two-year time out provision would apply only when the investment company is included in a plan or program of a government entity (e.g., a 529 plan).
9 The one-year transition period will provide an opportunity for a registered national securities association to propose rules that would meet the requirements of the Rule and for the SEC to consider such rules. If, after one year following the Effective Date, a registered national securities association has not adopted such rules, advisers would be prohibited from making payments to broker-dealers for distribution or solicitation activities with respect to government entities, but would be permitted to make payments to registered investment advisers that meet the definition of “regulated person” under the Rule. The Financial Industry Regulatory Authority, Inc. has indicated that it plans to act within the one-year timeframe; if it does not, the SEC will consider whether it should take further action.
