SEC to Ban So Called “Pay to Play” Activities
Kelley Drye Client Advisory
On July 22, 2009, the Securities and Exchange Commission (“SEC”) announced it will shortly be issuing a proposed rule restricting political contributions by investment firms and other persons who are involved in providing investment advisory services to state and local governments. The rule is colloquially called a “pay to play” rule. Examples of state and local governmental programs that purchase investment advisory services include defined benefit pension plans for governmental employees, “401k” type retirement plans for governmental employees, and state-administered college savings “529” plans used by members of the public. A similar rule was proposed in 1999, but was never issued.
We expect that this new proposed rule could extend as far as to cover hedge funds, broker-dealers and anyone managing or advising a government fund, not just investment advisors. For its part, the SEC’s 1999 proposed rule was limited to SEC-registered entities. If the 2009 proposed rule does not extend further to cover all investment advisers working with state and local governments, state and local governments may step in and impose their own varying pay to play restrictions to investment advisers or those managing government funds. In the past decade, roughly a dozen states and many cities and counties, including New Jersey, Illinois, and New York City, have already acted, to impose registration requirements and political contribution limitations and prohibitions on their contractors.
In addition, New York Attorney General Andrew Cuomo recently issued a “Code of Conduct” that he is imposing as a condition of settlement on investment firms ensnared in the New York pension fund investigation. AG Cuomo is also publicly asking other investment firms to voluntarily incorporate his Code, as a matter of their internal policy. Other states, such as New Mexico, are developing their own investment policy restrictions in reaction to the kinds of public concerns about investment adviser retention practices that led to New Mexico Governor Bill Richardson’s decision not to pursue confirmation as President Obama’s Secretary of Commerce. These various codes, policies and proposed rules have certain similarities but also significant differences, which can create a confusing legal and compliance maze for investment companies who aspire to do business in multiple jurisdictions.
We will be monitoring these developments and tracking the varying requirements imposed by the Federal Government, states, and localities.
The SEC Proposed RuleThe proposed SEC rule is expected to be similar to the current Rule G-37 issued by the Municipal Securities Rulemaking Board (“MSRB”) in 1994, which restricts the political contributions of broker-dealers and employees who are involved in the underwriting and issuance of municipal securities such as government bonds. The SEC’s announcement of the proposed rule explained:
Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.
The selection process can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term “pay to play.” . . .For her part, SEC Chairman Mary Schapiro identified the “corrupting and distortive influence of pay to play practices” as a principal rationale for the proposed rule.
Restricting Political ContributionsThe proposed rule will seek to restrict a wide range of direct and indirect political support for elected officials. Most directly, as does MSRB Rule G-37, the proposed rule would generally prohibit a contribution from an investment adviser to an elected official in a position to influence the selection of an investment adviser. The penalty for violating the prohibition would be severe: under the proposed rule, an investment adviser who makes such a prohibited political contribution would be barred for two years from providing advisory services for compensation, either directly or through a fund. The SEC rule would apply both to political incumbents as well as candidates for a position that can influence the selection of an adviser.
Also consistent with MSRB Rule G-37, the SEC’s proposed rule would apply not only to the investment advisory firm, but also to certain executives and employees of the adviser. It is likely that the SEC rule will require internal record keeping regarding the identities of affected executive officers and employees. Political contribution activity by these officers’ and employees’ spouses will most likely also need to be monitored. As described in more detail below, the SEC proposed rule will extend its prohibitions and limitations to “indirect” contributions from an investment adviser and its personnel as well as direct contributions.
The proposed rule would, however, contain a so-called de minimis provision, allowing an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.
Banning Solicitation of ContributionsThe proposed SEC rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:
- Make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser.
- Make a payment to a political party organization for the state or locality where the adviser is seeking to provide advisory services to the government.
Restricting Indirect Contributions and SolicitationsFinally, as does MSRB Rule G-37, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.
In practical terms, implementation of the new SEC rule, as proposed, will mean that investment advisers working with state and local governments will most likely be required to pre-clear most of their and their officers’ and employees’ political contributions, prescreen all new employees, and make some attempt at tracking employees when they leave. Similar requirements necessitated municipal broker-dealers making extensive investments in compliance, monitoring and training programs when MSRB Rule G-37 was implemented.
It is also worth noting that law firms, their attorneys, and other firms that work with investment advisory firms may have to be careful, lest their own independent decisions on political contributions might come into question. While an investment adviser may, for instance, consider including in its contract with a vendor that the vendor not make political contributions solicited by covered employees of the adviser, issues of proof could nonetheless exist in an individual instance regarding a third party’s motives for making a political contribution. The uncertainty could potentially chill appropriate individual political activity. Of course, the details of the SEC’s proposed rule may provide additional clarification, and the notice and comment process may provide an opportunity to obtain more specificity.
Banning Third-Party SolicitorsThe proposed SEC rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser. Notably, the activities of these placement agents may ultimately have served as the initial impetus for the revival of this SEC proposed rule.
Approval and PublicationThe SEC’s press release announcing the proposed rule’s approval and imminent publication in the Federal Register noted that the proposed rule will include a 60-day period for public comment.
Multi-Jurisdictional OverlaysIn response to the large scale investigation into corruption of the New York State Pension Fund, stemming originally from an investigation of former Comptroller Alan Hevesi’s administration of New York State’s $122 billion pension fund, Attorney General Andrew Cuomo has been requiring companies to agree to his own “Code of Conduct” as past of any settlement with his office. This code of conduct bans the use of placement agents, lobbyists or third parties to interact with public pension fund officials and influence their investment decision-making. The code also restricts investment firms, executives, placement agents, employees and family members from making campaign contributions to elected or appointed officials who can influence public pension funds’ investment decisions for two years prior to doing business with the fund. There is an allowance for an aggregate $300 contribution made to a covered recipient for whom the donor can vote.
AG Cuomo’s Code of Conduct will have undoubtedly influenced the content of the SEC’s proposed new rule as the latest pension fund scandals unfold. However, this Code of Conduct differs significantly from the similar rule the SEC proposed in 1999 but never implemented. For example, the Code of Conduct requires significant record keeping and reporting on a semi-annual basis and also requires a certification that the investment company is compliant with the terms of the Code, including annual training of all relevant investment firm personnel. In addition, the Code of Conduct extends not just to the investment company, but to its subsidiaries and affiliates. Furthermore, perceived conflicts of interests must be promptly disclosed in writing to the pension fund and if needed, to law enforcement and the Attorney General’s office. A firm, moreover, has an immediate duty to cure any such conflict. Finally, a violation of the Code of Conduct can result in up to a ten year disqualification from doing business with a New York public pension fund, whereas a violation of the proposed SEC rule would result in a two year ban on doing business with the government fund at issue.
No matter what rule the SEC ultimately implements, one can reasonably expect that the New York AG’s Code of Conduct will require investment firms doing business with New York’s state and local pension funds to undertake specific compliance steps that differ from or are in addition to those required to comply with the SEC rule. Other states and localities may also impose their own requirements, whether by law, executive order, or ad hoc enforcement action.
Campaign and Political Law PracticeKelley Drye helps its clients succeed in the political arena by guiding them past the legal pitfalls that might lead to investigations, criminal and civil penalties, and public scandal. Through our comprehensive, continuing focus on evolving campaign finance rules and the tactics of enforcement authorities, we shape clients’ advocacy programs, compliance approaches and defensive measures to reduce vulnerabilities and address problems.
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Under MSRB Rule G-37, broker-dealers are prohibited from engaging in municipal securities business with a government issuer for two years after making a political contribution to an elected official of the issuer who can influence the selection of the broker-dealer. The prohibition applies to contributions made by the broker-dealer or any of its “municipal finance professionals, including the chain of supervisory employees above the MFPs as well as the dealer’s executive officers. Rule G-37 also requires a two-year “look back” and a six month to one year “look forward” period to ascertain that no contributions were made prior to employment or after employment is terminated so as to avoid circumvention of the rule.