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SEC Will Extend Pay-To-Play Regulation to Investment Advisers

七月 23, 2009

 

At a July 22, 2009 open meeting, the Securities and Exchange Commission (“SEC”) unanimously voted to propose a rule intended to stop investment advisers from engaging in pay-to-play activities with respect to state and local government investment management opportunities (“the proposed rule”). The proposed rule, if adopted, would represent the first new federal pay-to-play law in more than 15 years and would impose significant new restrictions on the activities of investment advisers who seek to manage state and local government assets. Some highlights of the proposed rule and guidance with respect to possible compliance measures are set forth below.[1]

Overview of the Proposed Rule

The proposed rule is aimed at addressing the concern that investment advisers are being selected to manage public investments based on political contributions instead of their investment management credentials. The proposed rule would apply to investment advisers that are registered with the SEC and to those exempt from registration because they have fewer than fifteen clients under section 203(b)(3) of the Investment Advisers Act (“covered advisers”).[2]

The proposed rule incorporates requirements similar to those applicable to municipal securities dealers under Municipal Securities Rulemaking Board (“MSRB”) Rule G-37.[3] Under the proposed rule, covered advisers would be:

  1. subject to a two-year ban from managing state or local government assets and other government investment accounts (e.g., state pension funds, state-directed 529 college savings plans, or any state or local government-controlled fund), if the adviser, an affiliated PAC, or certain of its executives or employees, makes a direct or indirect campaign contribution to a person who either holds or is a candidate for an office (“covered office”) that has the power to influence the selection of investment advisers for that state or local government (“the two-year ban”);
  2. banned from using third parties—including placement agents or other solicitors—to assist the adviser in obtaining state or local government advisory business or assets (“the third-party solicitor ban”);
  3. banned from coordinating, arranging, or soliciting contributions to persons who either hold or are candidates for a covered office (“the anti-arranging ban”); and
  4. required to keep records of and regularly disclose to the SEC campaign contributions made by the firm, covered employees, or PACs.

The Two-Year Ban

Based on statements made by the SEC during its open meeting, the two-year ban would apply if the contribution is made by the investment adviser firm itself, by any firm-controlled PAC, or by certain key employees of the firm.[4] Further, indirect campaign contributions or any other form of “conduit” payments (e.g., made by family members, affiliates) which circumvent the rule would also trigger the two-year ban.[5] The proposed rule contains an exception for contributions of $250 or less made to candidates for whom the contributor can vote that is similar to the exception in MSRB Rule G-37.

The two-year ban is a strict liability rule; inadvertent violations would trigger the ban on business, regardless of intent. The SEC intends to provide investment advisers with an exemptive relief process for violations similar to the process currently available to municipal dealers, but expects that exemptive relief would only be granted on a case-by-case basis and only to firms who both have robust policies and procedures and who act promptly on discovery of the violation. Exemptions under comparable provisions applicable to municipal securities dealers are rarely granted; the SEC is likely to exercise similar restraint under the proposed rule.

The Third-Party Solicitor Ban

The third-party solicitor ban would prohibit investment advisers from using third parties to solicit advisory business from state and local governments, including the use of third-party solicitors or placement agents (even those registered as broker-dealers with the SEC) to raise assets. Covered advisers would be required to solicit government advisory business themselves or, presumably, through the use of affiliated entities (e.g., an affiliated broker-dealer).[6] During the open meeting, the SEC asked specifically for public comment on the potential anti-competitive issues that might be raised by this ban, particularly with respect to smaller advisers that may not have the resources to solicit government business on their own.

What was not discussed during the open meeting was how covered advisers engaged in the business of advising funds, could avoid triggering the broker-dealer registration requirements of Section 15 of the Securities Exchange Act of 1934 (“Exchange Act”) if deprived of the use of unaffiliated registered broker-dealers. The placement of a limited partnership or membership interest in a fund is a securities transaction, generally requiring the involvement of a registered broker-dealer. If an issuer does not utilize a registered broker-dealer to place these securities interests, it must either curtail its solicitation activities to such an extent as to not trigger the broker-dealer registration requirements of the Exchange Act or rely on the strict limitations of the “issuer’s exemption” of rule 3a4-1 under the Exchange Act. This is one of several issues that will need to be clarified during the comment process as it appears to be in conflict with staff guidance under the Exchange Act. Without clarification, covered advisers to funds would either need to form an affiliated broker-dealer to place the interests in its funds or place the interests themselves but in a very limited fashion.

The Anti-Arranging Ban

In addition to the two-year ban and the third-party solicitor ban, the proposed rule also bans advisers from “arranging” or other solicitations of contributions from others. Specifically, the anti-arranging ban prohibits an adviser from coordinating with or asking another person or PAC to either (1) make a contribution to any candidate or elected official who can influence the selection of the adviser, or (2) make a payment to a political party in the state or locality where the adviser seeks advisory business.

Preparing For Pay-to-Play Compliance

Due to substantial penalties associated with the proposed rule and the danger that such penalties will be triggered through lack of care, it is vital that covered advisers evaluate and revise their compliance systems to provide reasonable assurance of compliance with the requirements of the proposed rule. For many advisers, developing an effective compliance system may start with policies and procedures developed over the years by municipal dealers in the G-37 context. Effective pay-to-play compliance programs under G-37 include:

  • Written procedures reflecting all relevant requirements of the pay-to-play rule;
  • An assessment of, or “ring fencing,” certain employees whose campaign contributions could trigger the two-year ban and who are otherwise covered by the pay-to-play rule. This list must be constantly updated to include new “covered” employees and to remove employees no longer covered (i.e., because they either left the firm or changed positions within the firm);
  • Requiring all covered employees (and certain family members) to pre-clear their political contributions through the compliance officer or his or her designee; and
  • Training covered employees and key legal and compliance staff on an annual basis on the pay-to-play procedures, including procedures dealing with contributions to third party entities that could be used as conduits to covered officials.

After the SEC formally issues its proposed rule, there will be a 60-day period of notice and comment for interested parties to weigh in on the rule. We encourage our clients to take part in the comment process. The proposed rule will likely create significant compliance requirements for many covered advisers and may require potential restructuring of certain business activities.


Notes:

[1]  The details of the proposed rule are expected to be released in the near future, at which time we will circulate an updated client alert.

[2]  State-registered investment advisers are exempt from the proposed rule because the SEC believes the limits on the size of the assets they may manage without registering with the SEC makes it unlikely that state-registered advisers will manage a significant amount of assets for states and local governments.

[3]  MSRB Rule G-37 bans municipal dealers from underwriting bonds for two years if the dealers (or certain of their employees who are engaged in municipal securities activities) have made campaign contributions to government officials who can influence the selection of dealers. MSRB Rule G-38 prohibits municipal dealers from paying non-affiliates for soliciting municipal business on behalf of the dealer.

[4]  Although the precise scope of those employees and associates who will be covered will only be known once the proposal is released, the SEC’s staff did comment that the scope of coverage will be narrower than the scope of the 1999 proposed rule that included most executives and any employee who solicited government officials.

[5]  We expect the limitation of conduit payments will be based on Rule G-37(d).

[6]  The staff’s stated reliance on MSRB Rule G-38 suggests that affiliates would not be considered “third-parties” for purposes of the proposed rule.


If you would like to discuss this matter further, please contact Barbara Stettner at (202) 383-5283, Charles Borden at (202) 383-5269, any of the following lawyers, or your primary contact at O’Melveny & Myers LLP.

 

Barbara Stettner

(202) 383-5283

Charles Borden

(202) 383-5269

Bill Satchell

(202) 383-5342

Christopher Salter

(202) 383-5371

Kathryn Sanders

(213) 430-6376

David DeMuro

(212) 326-2892

Amena Piracha

(202) 383-5299

 

Adam Hellman

(202) 383-5419

 


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. O'Melveny attorneys Barbara Stettner and Charles Borden, and summer associate Ramesh Nagarajan contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.