On March 14, the Securities and Exchange Commission’s “pay-to-play” rule, officially known as the Advisers Act Rule 206(4)-5, went into effect. The rule restricts advisors’ and their employees’ ability to make political contributions to government officials to influence the selection of advisors to public pension funds and other government entities. Advisors are crying foul, however, stating that the SEC rule encroaches on their First Amendment rights to free speech, and some securities attorneys maintain that lawsuits could indeed be filed against the SEC arguing this constitutionality issue—and possibly others.
Advisors and industry professionals have other issues with the SEC’s rule. Applying the pay-to-play rule “is extremely difficult because you have these very broad definitions that are sweeping and vague in their application,” says Michael Koffler, a partner in the financial services practice at the law firm Sutherland. “Obviously, the SEC could not have envisioned every scenario that exists; there are a lot of questions [like] ‘Does this [rule] apply to this situation?’” There are, he concludes, many “gray areas” in the rule.
Another irritant is that the Dodd-Frank Act required municipal advisors to register with the SEC by October 2010. To enable these advisors to temporarily register, the SEC adopted an interim final temporary rule, and the agency is now proposing new rules that would establish a permanent registration for municipal advisors and impose certain record-keeping requirements on them, including the agency’s pay-to-play rule. The comment period on that permanent rule expired on Feb. 22. The SEC received nearly 800 comment letters stating that the rule was “too broad” in defining who is a municipal advisor, says Lynette Kelly Hotchkiss, executive director of the Municipal Securities Rulemaking Board (MSRB). “The SEC has until the end of the year to give clarity on who is a municipal advisor,” Hotchkiss says. “There are people who are clearly municipal advisors—about 700 advisors have been registered with MSRB already since Dodd-Frank. There’s a lot of gray area—some are clearly municipal advisors and some are clearly not.”
A 16-Year Lineage
The MSRB’s rule G-37 was the first federal pay-to-play rule to take effect in 1994, and all subsequent pay-to-play rules, including the SEC’s, have been modeled on G-37. MSRB’s Hotchkiss calls G-37 “the lynchpin on which all other [pay-to-play] rules are based.” It’s important to note that G-37 was challenged in court for infringing on free-speech rights, but the courts declined to rule against it. After G-37, state and local governments started issuing their own pay-to-play rules, which are “broader, have different limits and cover more people,” Hotchkiss says.
While the SEC’s pay-to-play rule became effective on March 14, the SEC is allowing a six month transition period to provide time to identify “covered associates” and current government clients, and to modify compliance programs to address obligations under the rule. Therefore, contributions made before March 14, 2011 will not trigger the “two-year timeout” period.
Under the rule, a “covered associate” includes any general partner, managing member, executive officer and any other individual having a similar status or function; any employee who solicits a government entity on behalf of the advisor, and any direct or indirect supervisor of such person; and any political action committee (PAC) controlled by the investment advisor or any individuals identified above.
As the law firm Venable explains in a recent alert on the rule to clients, the “cornerstone” of the new regulatory framework under the SEC’s pay-to-play rule is a “two-year ban on investment advisors receiving any compensation for providing advisory services to a government entity if the advisor or one of its ‘covered associates’ makes a non-exempt political contribution to a public official or candidate who can influence the award of advisory business.” The two-year compensation ban “includes both management fees and carried interest, meaning an advisor could forfeit millions of dollars in fees for even a minor violation.”
Pay-to-play practices can occur in a variety of ways, including through direct contributions to government officials, solicitation of third parties to make contributions or payments to government officials or political parties, or payments to third parties to solicit government business. Rule 206(4)-5 prohibits political contributions by certain employees of investment advisors. “The failure to comply, even if inadvertent, may subject an advisor to significant forfeitures, potential penalties and other sanctions,” the law firm Venable notes.
Venable’s alert warns its advisor clients as well that investment advisors subject to the SEC’s pay-to-play rules “will need to educate employees and implement policies and procedures in order to prevent an inadvertent violation.” Advisors will also need to “carefully monitor all new hires, promotions and other staffing changes in order to not run afoul of the rules,” as well as comply with the rule’s recordkeeping requirements.
The Genesis of the Rule
When the SEC proposed its pay-to-play rule in July 2009, SEC Chairman Mary Schapiro said that “pay-to-play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices.” The SEC’s proposal “would significantly curtail the corrupting and distortive influence of pay-to-play practices.”
Andrew “Buddy” Donohue, who was then head of the SEC’s Division of Investment Management, said that these pay-to-play “practices are almost always harmful.” He said that there’s “been a troubling increase in the number of advisors who are involved in pay-to-play practices,” adding that advisors who are involved in such practices “violate their fiduciary duties and fraud provisions.”
The SEC’s Rule 206(4)-5 was approved last year in the wake of “pay-to-play” scandals involving public pension funds in California, New York, New Mexico and other states, according to the law firm Venable.
Confounding the pay-to-play issue even more is a new proposed MSRB pay-to-play rule, G-42. Under Dodd-Frank, the MSRB was given “an expanded mandate to increase jurisdiction,” the MSRB’s Hotchkiss explains. “So we now have the ability to write rules that regulate broker-dealer behavior, but also the behavior of municipal advisors.” The proposed rule G-42, which is out for public comment, “governs political campaign contributions for municipal advisors.” The MSRB’s board was meeting to review the rule in mid-April.
Causes of Confusion
It is this “proliferation” of pay-to-play rules, says Peter LaVigne, a partner in the financial services practice at the law firm Goodwin Procter, which is causing lots of confusion among advisors. “The SEC rule is only one of many. There are various state and local rules that cover a similar area, and it’s this explosion of pay-to-play rules that is making it extremely hard [for advisors] to do business, especially when you are trying to solicit retirement funds and pension plans.”
Advisors are “unclear” about all of the state and local pay-to-play restrictions, LaVigne says, “because it’s not always easy to find out what they are.” Ki Hong, a partner in the law firm Skadden Arps’ Washington office, says there are 16 states that have pay-to-play laws, with New Jersey being the first state to adopt not one, but three pay-to-play laws in 2004.
The SEC’s pay-to-play restriction has “lack of clarity as well,” LaVigne argues, because one class that’s covered in the SEC’s proposed rule for municipal advisors are “persons who solicit municipal entities on behalf of an investment advisor.” There is a “disagreement between the SEC and the practitioners, myself included, about whether that covers people who solicit municipal entities to invest in funds or whether it only solicits municipal entities to become clients of the advisor.” Why is that significant? Because in Rule 206(4)-5, notes LaVigne, the SEC said that “you couldn’t use a solicitor to solicit municipal entities unless the solicitor was either an investment advisor or a broker-dealer subject to similar pay-to-play rules.” But because BDs are not subject to pay-to-play rules, the SEC, LaVigne says, told FINRA to start drafting [pay-to-play] rules, and meanwhile the [SEC] gave an extension of that part of the rule until September of this year. The SEC said to FINRA: Start [crafting] these rules and we’ll give investment advisors until September before they have to stop using a broker” to solicit funds. However, when the MSRB rolled out its proposed pay-to-play rule, G-42, “the SEC came out and said ‘anyone soliciting on behalf of these funds for an investment advisor is going to have to register as a municipal advisor anyway and they will be subject to the MSRB rule and therefore we don’t need the FINRA rule.’ So the SEC reportedly told FINRA [to] just stand down and stop drafting [its pay-to-play] rule now.”
Misinterpretation and Compliance
Practitioners argue that the “SEC is misinterpreting the MSRB rule to say it covers people who solicit on behalf of funds,” LaVigne continues. “So we’re running into a problem where in September there will be a gap because BDs aren’t going to be able to solicit on behalf of investment advisors.” Regarding the SEC’s municipal advisor rule, he says, “if the SEC doesn’t alter its view on what it means to solicit on behalf of an investment advisor, there will probably be a lawsuit.”
Various law firms have been warning their advisory clients in special alerts about how to comply with the pay-to-play rules, and the consequences for non-compliance. As the Venable firm warned its clients: “The penalties for non-compliance are significant, and a single impermissible political contribution could result in an investment adviser forfeiting millions of dollars in fees.”
Attorney Hong of Skadden Arps says the SEC’s pay-to-play rule is troubling because it’s based on the MSRB’s rule G-37, “which is meant to deal with the municipal bond underwriting business—a very transaction-oriented business—not an ongoing service” that investment advisors provide. Plus, he says, advisors have a fiduciary duty.
The SEC’s rule states that a “two-year ban” would be placed on investment advisors receiving any compensation for providing advisory services to a government entity if the advisor or one of its “covered associates” makes a non-exempt political contribution to a public official or candidate who can influence the award of advisory business. So the way that the SEC’s pay-to-play rule tries to accommodate that difference between its rule and G-37 is “that instead of not being able to do the business for two years, it says [advisors] can’t be compensated for the business for two years,” Hong says. “And because of [an advisor’s] fiduciary duty, you can’t dump a client immediately. The SEC recognizes that [the advisor] may have to provide services while the client looks for another advisor. So, in some extreme cases, the advisor could have to provide free services for two years.”
Koffler of the law firm Sutherland also wonders how the SEC’s pay-to-play rule applies to “two-tier structure issues” in products like variable insurance contracts with subaccounts. “There is not much guidance as to how the [pay-to-play] rule applies” to variable contracts of this sort, he says. If you have a variable contract with “subaccounts that invest in underlying funds and the underlying funds are managed by an unaffiliated investment advisor, how does the rule apply to that underlying advisor?”