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.”