(This article appeared in Business Crimes Bulletin, an ALM publication covering financial and white-collar crime. For Corporate Counsel, Litigators, Managing Partners, Defense Attorneys. Visit the website to learn more.)
On Jan. 17, 2017, 10 investment advisory firms were sanctioned by the Securities and Exchange Commission (SEC) for violations of the so-called “pay-to-play” prohibition of the Investment Advisers Act Rule 206(4)-5 (http://bit.ly/2mGR461) (the Rule). The firms accepted fees from public pension funds within two years of the firms’ associates making campaign contributions to individuals with potential influence over the funds (SEC Release 2007-15). The firms agreed to censure, cease and desist, and fines up to $100,000 despite the lack of connection between the contributions and any action by a public official.
These settlements follow the expansion late last year of the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board’s (MSRB) authority to also sanction “pay-to-play” under a strict liability rule. The new rules and amped-up enforcement (the only other case under the Rule was in 2014) reflect regulators’ focus on the interaction between money managers and public officials. While it remains unclear both when the regulators will invoke their authority to enforce the nearly limitless strict liability provision of the rules and how they will determine the appropriate remedy, the recent settlements and the SEC’s handling of exemptive relief petitions may provide some clues.
The Pay-to-Play Rule
The SEC’s Pay-to-Play Rule, enacted in 2010 and modeled on MSRB Rule G-37 (http://bit.ly/2n7phcu), bars an investment adviser from taking compensation from a government entity for two years after a “covered associate” of the adviser coordinates, solicits, or makes a political contribution to certain government officials or political parties. Under the Rule, the SEC has discretion to exempt advisers from the Rule’s draconian penalty of disgorging years of fees if they meet certain, largely subjective, criteria.
In August 2016, the SEC approved FINRA’s own proposed pay-to-play rules, including FINRA Rule 2030, which imposes similar restrictions as the SEC’s Pay-to-Play Rule on member firms engaging in government distribution or solicitation activities on behalf of investment advisers. See Release No. 34-78683 (http://bit.ly/2lEOspv). Effective August 2016, the MSRB had also revised its pay-to-play rules by extending the rules to municipal advisers. See Rule G-37 (http://bit.ly/2n7phcu).
Settlements Reveal Little About the SEC’s Analysis
In June 2014, TL Ventures Inc. was censured, ordered to disgorge over $250,000 in fees, and ordered to pay a penalty of $35,000 because in 2011 — over a decade after the pensions at issue invested — the firm’s managing director made two donations totaling $4,500 to a mayoral candidate and the Governor of Pennsylvania. See Release No. IA-3859 (http://bit.ly/2mmKfpp). TL Ventures’ exemption application was denied even though the firm was winding down its operations at the time of the contribution, had not engaged in any fundraising since 2008, and the contributor had no contact with officials.
This seemingly harsh outcome was followed on Jan. 17 of this year with sanctions against 10 firms. Again, there is no corruption or a quid pro quo. Indeed, each of the sanctioned firms had received the public investment in their funds years — frequently more than 10 years — before the prohibited contributions. The contributions were generally tiny (mostly $50 to $150 over the de minimus exception within the rule), were typically returned by the campaigns relatively quickly, and were generally given to public officials who had no direct involvement with investment decisions (such as the six contributions to Governors whose only role was to appoint a member to an investment board).
Nonetheless, in the spirit of “if you build it they will come,” the new Public Finance Abuse Unit of the SEC cast a broad net and sent a message of (almost) no tolerance by imposing significant penalties, although it did not enforce the presumably even more draconian disgorgement remedy. Further, by characterizing the violations as “willful,” the firms may be open to additional sanctions; for instance, under Section (9)b of the Investment Company Act, the SEC can impose prohibitions on serving as an investment adviser for any registered investment company.
The SEC’s exact analysis is opaque, as it appears the amount or number of the contributions, whether they were returned, the number of covered associates and the amount of the pension’s investment were not determinative. It may be notable that the lowest penalties involved two of the smallest contributions (Release Nos. IA-4614 (http://bit.ly/2mZSadP); IA-4613 (http://bit.ly/2lZDKFz)); and the highest penalty was imposed on NGN Capital, in a case which involved a pattern of four contributions by a single covered associate (Release No. IA-4612 (http://bit.ly/2lZRRKM)).
While the violations in this industry sweep can fairly be characterized as minor, indeed technical, it remains unclear why the TL Ventures sanction is more severe for conduct that likewise appears not to implicate genuine corruption, even indirectly. However, certain factors cited by the SEC in granting exemptive relief may indicate what separated the 10 recent enforcement actions from the exemptive petitions granted in recent years and may give an insight into the SEC’s approach to future cases.
Effectiveness of the Firm’s Compliance Program
In the past two years, eight exemption applications were granted and, while the SEC has not been explicit about its reasoning, certain common themes have emerged.
First, the contributor generally had no role in soliciting investments and most had limited — if any — contact with the government client. For example, Starwood Capital Group Management LLC’s Chief Operating Officer contributed to, but had no contact with, the government client, and did not supervise anyone who did. Release No. IA-4182 (http://bit.ly/2mHcmk1). Similarly, at Brookfield Asset Management, the senior managing partner who contributed was head of the real estate platform whose only contact with the government client’s representatives was a presentation on Brookfield’s real estate platform. Release No. IA-4337 (http://bit.ly/2mk6ZER). On the other hand, Lime Rock Management, where a managing director who contributed to Governor Kasich was also a member of the firm’s investment committee, was denied an exemption and sanctioned in January. Release No. IA-4611(http://bit.ly/2m6xgty).
Second, the violations were typically discovered relatively quickly during internal compliance testing or from certifications pursuant to the firms’ compliance program. Only one of the eight exemptions involved a contribution discovered separately from the adviser’s compliance systems. See Starwood, Release No. IA-4182. By contrast, Pershing Square Capital Management — which, despite having pay-to-play policies in place, only discovered the contribution in response to SEC information requests two years after the donation instead of through any internal compliance function — was denied an exemption and sanctioned in the recent group of 10. Release No. IA-4608 (http://bit.ly/2neIFap).
Third, there was potential confusion about the scope of the rule or a demonstrated pre-existing personal relationship with the candidate. For example, Fidelity noted that “[t]he Contributor’s decision was based entirely on the personal friendship he maintained with the Recipient.” Release No. IA-4220 (http://bit.ly/2mmKBfC). In other matters, there was confusion about the scope of the Rule: In two instances the contribution was made to “exploratory committees.” See Crescent Capital Group, L.P., Notice No. IA-4140 (http://bit.ly/2nfyU7V); Starwood, Release No. IA-4182. In one application by Angelo, Gordon & Co. L.P., the contribution was made before the contributor worked for the adviser. See Release No IA-4418 (http://bit.ly/2mz6c2a).
The SEC is clearly continuing to strictly enforce the pay-to-play Rule, even in circumstances where there is no evidence of a quid pro quo or corruption.
Those subject to the Rule, as well as the newly enacted FINRA and expanded MSRB rules, would be well advised to review their compliance programs to assure they either prohibit contributions or require pre-clearance. They must also make certain that everyone covered by the Rule is trained about its scope, and certifies that they have been trained and that they are in compliance with the rules.
Those defending enforcement actions now know that despite the TL Ventures resolution and several analogous MSRB actions that ordered large disgorgements, the recent settlements — imposing an average penalty of $66,000 — demonstrate that disgorgement of fees is not automatic when the SEC is persuaded to impose a more narrowly tailored remedy. The SEC seems unbent by what would appear to be mitigating facts, like the return of the contribution, a lack of corrupt wrongdoing, the fact that the recipient of the contribution had no direct power over investment selection, or the time gap between the investment and any later contribution. Accordingly, making a persuasive case will turn on other factors, many of course unique to each particular matter. That said, a handful that seem to have some persuasive power include that:
The adviser’s policies promptly discovered the contributions and appeared effectively designed to prevent a pattern of violations;
The contributor’s role at the adviser did not place him in close contact with the government client or involve him in the solicitation of investments; and
There is actual confusion or a demonstrated personal relationship clearly motivating the contribution, and no indication of a desire to influence the government official.
While the wisdom and fairness of a broad prophylactic strict liability rule that vests regulators with largely unguided discretion to impose truly draconian penalties for innocent behavior is subject to debate — and is perhaps a question the new SEC management will revisit — at the moment it is full speed ahead with new rules and aggressive enforcement.
This article appeared in Business Crimes Bulletin, an ALM publication covering financial and white-collar crime. For Corporate Counsel, Litigators, Managing Partners, Defense Attorneys. Visit the website to learn more.
Joseph F. Savage, Jr., a member of this newsletter’s Board of Editors, is a partner in Goodwin Procter LLP’s Securities Litigation & White Collar Defense group. Stephanie M. Aronzon is an associate in the firm’s Business Litigation group.
The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.