SEC adopts rules targeting pay to play practices by investment advisers | Practical Law

SEC adopts rules targeting pay to play practices by investment advisers | Practical Law

This article is part of the PLC Global Finance August 2010 e-mail update for the United States.

SEC adopts rules targeting pay to play practices by investment advisers

Practical Law UK Legal Update 2-503-1156 (Approx. 4 pages)

SEC adopts rules targeting pay to play practices by investment advisers

by Nathan J. Greene and John D. Reiss, Shearman & Sterling LLP
Published on 31 Aug 2010 • USA (National/Federal)
This article is part of the PLC Global Finance August 2010 e-mail update for the United States.
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On 1 July 2010, the US Securities and Exchange Commission (SEC) unanimously adopted rules under the US Investment Advisers Act of 1940, targeted at pay to play practices among investment advisers that manage or seek to manage assets for US state and local government bodies. New SEC Rule 206(4)-5 under the Advisers Act comes into effect on 13 September 2010.
On 1 July 2010, the US Securities and Exchange Commission (SEC) unanimously adopted rules under the Investment Advisers Act of 1940, targeted at pay to play practices among investment advisers that manage or seek to manage assets for US state and local government bodies (such as public pension plans and, of significance to mutual funds, state college savings plans or state and local employee savings plans).
Pay to play practices, as described by the SEC, generally involve advisers making or arranging, or being solicited to make, political contributions while also seeking investment advisory business from a government body. Often, the contributions are made not with the expectation of actually swaying the selection process one way or another, but simply with the understanding that only contributors will be seriously considered for the business. According to the SEC, these practices both violate the fiduciary duties of investment advisers and distort the adviser selection process by steering business to advisers that are not necessarily the most qualified or reasonably priced.
New SEC Rule 206(4)-5 under the Advisers Act comes into effect on 13 September 2010, and its various provisions are phased in over the course of a year from that date. The new rules contain four main elements that (except with respect to placement agents as discussed below) substantially track the terms of the original SEC rule proposals made last summer.

Political contributions (the two-year ban)

Advisers will be prohibited from providing compensated advisory services to a government entity (which includes all US state and local (but not federal) government and government-sponsored agencies, instrumentalities, plans, programmes, pools of assets, and so on) for a period of two years after the adviser or any of its "covered associates" makes a "contribution" (after 14 March 2011) to an "official" of the government entity. This two-year ban is sufficiently punitive that it should operate to fundamentally change how advisory firms treat their own and their employees' political contributions.

Restriction on use of placement agents, solicitors, finders

Investment advisers will be limited, as of 13 September 2011, to dealing with "regulated persons" when hiring (or otherwise agreeing to pay, directly or indirectly) any unaffiliated third party, such as a placement agent, to solicit advisory business from a US state or local government entity on the adviser's behalf. This requirement represents a significant roll-back from the full prohibition that the SEC had proposed on using third party solicitors for this purpose.

Prohibition on soliciting or arranging certain political contributions

Investment advisers will be prohibited from soliciting or arranging contributions or payments to certain elected officials, candidates for public office, or political parties of a state or locality for which the adviser provides or is seeking to provide advisory services. This prohibition would restrict an adviser from, for example, "bundling" de minimis contributions of its covered associates.

New record-keeping requirements

SEC-registered investment advisers will be subject to extensive new record-keeping obligations related to these types of political activities. New required records include:
  • Beginning 14 March 2011, a list containing certain information for all covered associates.
  • Beginning 14 March 2011, a list of all US state and local government entities for which the adviser currently or in the past five years (but not before 13 September 2010) has provided advisory services.
  • A chronological listing and description of all direct and indirect political contributions made by the adviser or any covered associates.
  • A list of regulated persons used by the investment adviser to solicit US state and local government advisory business from 13 September 2011 onward.
There are a number of exceptions to the rules:
  • US$350/US$150 de minimis exceptions. The two-year ban is not triggered by a contribution of no more than US$350 made by a natural person (that is, not the firm itself, just personnel) to an official for whom the contributor is entitled to vote, or a contribution of no more than US$150 made by a natural person to an official for whom the contributor is not entitled to vote (this exception is an addition to the SEC's original proposed rules).
  • Twice-each-year (or thrice-each-year) exception. Though not a generous exception, the two-year ban is also not triggered by a contribution made by a covered associate provided that the contribution was for no more than US$350, the contribution was discovered by the adviser within four months of the date of contribution (putting an obvious premium on a robust compliance framework), and that the contribution must be returned within 60 days of discovery by the adviser. This exception can be relied on only once per covered associate and twice per year per adviser for advisers with 50 or fewer professional employees, or three times per year per adviser for larger advisers.
  • Registered investment company exception. Advisers to US registered investment companies are subject to the two-year ban only when that investment company is selected as an option for a government investment plan (for example, a 529 plan) but not simply because a government entity invests in the investment company. Also, application of the new rules generally to registered investment companies is not required until 13 September 2011.
  • Case-by-case exception. The SEC has reserved the right, on application by an adviser, to conditionally or unconditionally exempt the adviser from any or all of the rule's prohibitions.
In response to the new rules, advisers will inevitably need to build-out their compliance procedures (for example, employee and pre-hire questionnaires regarding political contribution activity, contribution pre-clearance procedures, suitability analysis with respect to third-party solicitors). It should also be noted that because the rules prohibit actions taken indirectly that would, if done directly, violate any of the prohibitions listed above, the SEC has reserved wide latitude to invoke these rules against advisers that attempt to creatively circumvent them (for example, directing contributions through family members).
For more information, see Shearman & Sterling memorandum, SEC Adopts Rules Targeting “Pay to Play” Practices by Investment Advisers.