FINRA Proposes Pay to Play Rules

Practical Law Legal Update w-001-0954 (Approx. 6 pages)

FINRA Proposes Pay to Play Rules

by Practical Law Corporate & Securities

Effectiveness of FINRA Rules

The proposal requires SEC approval. If approved, FINRA will announce the effective date of the proposal in a regulatory notice no later than 60 days following the SEC's approval. FINRA intends for the effective date to be no sooner than 180 days after publication of its regulatory notice and no later than 365 days after the SEC's approval of the proposal.

Proposed Pay to Play Rule

Two-Year Time Out

Proposed Rule 2030(a) would prohibit a covered member from engaging in distribution or solicitation activities for compensation with a government entity on behalf of an investment adviser that provides or is seeking to provide investment advisory services to that government entity within two years after a contribution to an official of the government entity is made by the covered member or a covered associate (including a person who becomes a covered associate within two years after the contribution is made). The purpose of the two-year time out is to discourage covered members from participating in pay to play practices by requiring a cooling-off period between the political contribution and the selection process.

The proposed rule would apply to covered members acting on behalf of any investment adviser either:

Registered (or required to be registered) with the SEC.
Unregistered under an exemption in Section 203(b)(3) of the Advisers Act for foreign private advisers.
That is an exempt reporting adviser under Rule 204-4(a) of the Advisers Act.

The proposed rule would not apply to member firms acting on behalf of advisers that are either:

Registered with state securities authorities instead of the SEC.
Unregistered in reliance on exemptions other than Section 203(b)(3) of the Advisers Act.

Key Definitions

"Covered member" would mean any FINRA member, except when that member is engaging in activities that would cause it to be a municipal advisor. A member firm that solicits a government entity for investment advisory services on behalf of an unaffiliated investment adviser may be required to register with the SEC as a municipal adviser. In that case, Municipal Securities Rulemaking Board (MSRB) rules applicable to municipal advisers, including any pay to play rule adopted by the MSRB, would apply to the member firm. If, however, the member firm solicits a government entity on behalf of an affiliated investment adviser, that activity would not cause the firm to be a municipal adviser and, therefore, the member firm would be a covered member subject to the requirements of proposed Rule 2030.

"Government entities" would include all:

State and local governments, their agencies and instrumentalities.
Public pension plans and other collective government funds, including participant-directed plans such as 403(b), 457, and 529 plans.

An "official of a government entity" would include an incumbent, candidate or successful candidate for elective office of a government entity if the office either:

Is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser.
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.

A "contribution" would include:

A gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing the election for a federal, state or local office, including any payments for debts incurred in the election.
Transition or inaugural expenses incurred by a successful candidate for state or local office.

A "covered associate" would include any:

General partner, managing member or executive officer of a covered member, or other individual with a similar status or function.
Associated person of a covered member who engages in distribution or solicitation activities with a government entity for the covered member.
Associated person of a covered member who supervises, directly or indirectly, the government entity distribution or solicitation activities of a person engaging in distribution or solicitation activities.
Political action committee controlled by a covered member or a covered associate.

Prohibition on Soliciting and Coordinating Contributions

Proposed Rule 2030(b) would prohibit a covered member or covered associate from coordinating or soliciting any person or PAC to make any:

Contribution to an official of a government entity with which the covered member is engaging in, or seeking to engage in, distribution or solicitation activities on behalf of an investment adviser.
Payment to a political party of a state or locality of a government entity with which the covered person is engaging in, or seeking to engage in, distribution or solicitation activities on behalf of an investment adviser.

A direct contribution to a political party by a covered member or its covered associates would only violate the proposed rule if the contribution was a means for the covered member to do indirectly what the rule would prohibit if done directly (for example, if the contribution was earmarked or known to be provided for the benefit of a particular government official).

Under proposed Rule 2030(e), a covered member or any of its covered associates would not be permitted to do anything indirectly that, if done directly, would violate the rule. This would prevent the funneling of payments through third parties. To trigger the two-year time out, proposed Rule 2030(e) would require a showing of intent to circumvent the rule.

Covered Investment Pools

Under proposed Rule 2030(d)(1), a covered member that engages in distribution or solicitation activities with a government entity on behalf of a covered investment pool in which a government entity invests or is solicited to invest would be treated as though the covered member was engaging in or seeking to engage in distribution or solicitation activities with the government entity on behalf of the investment adviser to the covered investment pool directly.

Exceptions and Exemptions

Proposed Rule 2030 contains exceptions that are modeled on similar exceptions in the SEC pay to play rule for:

De minimis contributions.
New covered associates.
Returned contributions.

In addition, proposed Rule 2030(f) includes an exemptive provision for covered members that is modeled on the exemptive provision in the SEC pay to play rule that would allow covered members to apply to FINRA for an exemption from the proposed rule's two-year time out. Under this provision, FINRA would be able to exempt covered members from the proposed rule's time out requirement where the covered member discovers contributions that would trigger the compensation ban both:

After they have been made.
When imposition of the prohibition would be unnecessary to achieve the rule's intended purpose.

In determining whether to grant an exemption, FINRA would take into account the varying facts and circumstances that each application presents.

De Minimis Contributions

Proposed Rule 2030(c)(1) would except from the rule's restrictions contributions made by a covered associate that is a natural person to government entity officials:

For whom the covered associate was entitled to vote at the time of the contributions, if the contributions do not exceed $350 in the aggregate to any one official per election.
If the covered associate was not entitled to vote for the official at the time of the contribution, the contribution must not exceed $150 in the aggregate per election.

Under both exceptions, primary and general elections would be considered separate elections. These exceptions are based on the theory that such contributions are typically made without the intent or ability to influence the selection process of the investment adviser.

New Covered Associates

Proposed Rule 2030(c)(2) would provide an exception from the proposed rule's restrictions for covered members if a natural person made a contribution more than six months prior to becoming a covered associate of the covered member unless the covered associate engages in, or seeks to engage in, distribution or solicitation activities with a government entity on behalf of the covered member.

The potential link between obtaining advisory business and contributions made by an individual prior to becoming a covered associate who is uninvolved in distribution or solicitation activities is likely more attenuated than for a covered associate who engages in distribution or solicitation activities.

Certain Returned Contributions

Proposed Rule 2030(c)(3) would provide an exception from the proposed rule's restrictions for covered members if the restriction is due to a contribution made by a covered associate when the:

Covered member discovered the contribution within four months of it being made.
Contribution was less than $350.
Contribution is returned within 60 days of the discovery of the contribution by the covered member.

This exception would allow a covered member to cure the consequences of an inadvertent political contribution to an official for whom the covered associate is not entitled to vote. The proposed rule would provide that:

Covered members with150 or fewer registered representatives would be able to rely on this exception no more than two times per calendar year.
All other covered members would be permitted to rely on this exception no more than three times per calendar year.
A covered member would not be able to rely on an exception more than once with respect to contributions by the same covered associate regardless of the time period.

Proposed Recordkeeping Requirements

Proposed Rule 4580 would require covered members that engage in distribution or solicitation activities with a government entity on behalf of any investment adviser that provides or is seeking to provide investment advisory services to the government entity to maintain books and records that would allow FINRA to examine for compliance with its pay to play rule.

The proposed rule would require covered members to maintain a list or other record (but not prior to the rule’s effective date) of:

The names, titles and business and residence addresses of all covered associates.
The name and business address of each investment adviser on behalf of which the covered member has engaged in distribution or solicitation activities with a government entity within the past five years.
The name and business address of all government entities with which the covered member has engaged in distribution or solicitation activities for compensation on behalf of an investment adviser, or an investment adviser managing a covered investment pool, within the past five years.
All direct or indirect contributions made by the covered member or any of its covered associates to an official of a government entity, or direct or indirect payments to a political party of a state or political subdivision thereof, or to a PAC.

The proposed rule would require that the direct and indirect contributions or payments made by the covered member or any of its covered associates:

Be listed in chronological order.
Indicate the name and title of each contributor and each recipient of the contribution or payment, as well as the amount and date of each contribution or payment.
Indicate whether the contribution was the subject of the exception for returned contributions in proposed Rule 2030.

FINRA Proposes Pay to Play Rules | Practical Law