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SEC Adopts Rule to Restrict “Pay-to-Play” by Private Fund Managers and Other Advisers

Private Equity Alert John P. Vail

On June 30, 2010, the Securities and Exchange Commission (the "SEC") approved a new rule designed to curtail the influence of "pay-to-play" practices by investment advisers. Among the rule's provisions, there is a prohibition on an investment adviser providing advisory services to a government entity for compensation for two years, if the adviser, or certain of the adviser's executives or employees, makes a political contribution to an elected official of such government entity who is in a position to influence the selection of the adviser.

Upon becoming effective, the rule will not be limited only to registered investment advisers. It will also apply to unregistered advisers to hedge funds and private equity funds who solicit government entities to become investors in their funds.

The adoption of the rule evidences the concern expressed by the SEC over the last year about pay-to-play practices and the SEC's belief that such practices were causing public plans and their beneficiaries to receive subpar advisory services for excessive fees. It also follows an increase in enforcement efforts by the SEC and state attorneys general against investment advisers, placement agents and government officials who were involved in illegal kickback schemes relating to public funds. The most high profile investigation was the recent one conducted by the New York attorney general of the alleged payment of kickbacks by advisers seeking to provide services to the New York State Common Retirement Fund.

A number of public pension funds, including the California Public Employees Retirement System ("CALPERS") and the New York State Common Retirement Fund, have adopted (or are in the process of adopting) policies restricting the use of placement agents by the investment advisers that desire to do business with such funds. During recent months, many of these public funds provided comments to the SEC on its proposed rule. Such funds were divided on the merits of the rule; some embraced it while others expressed criticism that the rule could result in unintended consequences. Despite some objections and concerns by certain government plans and other affected parties, the SEC found it necessary to move forward with its own initiative to address pay-to-play practices. In its adopting release, the SEC repeatedly emphasizes the fiduciary nature of the investment adviser/client relationship and the need to preserve its integrity.

The SEC's new antifraud rule is based upon Rules G-37 and G-38 of the Municipal Securities Rulemaking Board, which the SEC believes significantly curbed pay-to-play practices in the municipal securities market. The rule is also an offspring of a rule proposed by the SEC in 1999, which was never adopted because of strong opposition.

Advisers Subject to the Rule

The new rule, Advisers Act Rule 206(4)-5 (the "Rule"), applies to all registered investment advisers and unregistered hedge fund advisers, private equity fund advisers, and other advisers that rely on the so-called "private adviser exemption" from registration set forth in Section 203(b)(3) of the Investment Advisers Act of 1940. This exemption exempts from registration advisers that have fewer than 15 clients during the previous 12 months and do not hold themselves out to the public as investment advisers.[1] The Rule will not, however, apply to most small advisers (with less than $25 million of assets under management) that are registered with state authorities instead of the SEC.

The Rule would also make "covered associates" of the investment adviser subject to the prohibitions on paying third-party solicitors and soliciting or coordinating contributions for officials or political parties. A "covered associate" of an investment adviser is: (i) any general partner, managing member or executive officer, or other individual with a similar status or function; (ii) any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and (iii) any political action committee controlled by the investment adviser or its covered associates.

An "executive officer" means: (i) the president; (ii) any vice president in charge of a principal business unit, division
or function (such as sales, administration or finance); (iii) any other officer who performs a policymaking function; or
(iv) any other person who performs similar policymaking functions.

The Two-Year "Time out"

The Basic Rule

The primary provision of the Rule prohibits investment advisers from providing investment advisory services for compensation to any "government entity" within two years after a contribution to an "official" of the government entity is made by the adviser or any covered associate (which includes a person who becomes a covered associate within two years after the contribution is made). The SEC explains this provision as an effort to discourage advisers from participating in pay-to-play practices by requiring a "cooling-off period" during which the effects of a political contribution on the selection process can be expected to dissipate.

Key Definitions in the Rule

The term "government entity" means any state or political subdivision of a state, including: (i) any agency, authority, or instrumentality of the state or political subdivision; (ii) a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to, a "defined benefit plan" as defined in Section 414(j) of the Internal Revenue Code, or a state general fund; (iii) a plan or program of a government entity; and (iv) officers, agents, or employees of the state or political subdivision, or any agency, authority or instrumentality thereof, acting in their official capacity.

For purposes of the foregoing, a "plan or program of a government entity" means any participant-directed investment program or plan sponsored or established by a state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to, a "qualified tuition plan" authorized by section 529 of the Internal Revenue Code,
a retirement plan authorized by section 403(b) or 457 of the Code or any similar program or plan.

A "contribution" for purposes of the Rule means any gift, subscription, loan, advance, or deposit of money or anything
of value made for: (i) the purpose of influencing any election for federal, state or local office; (ii) payment of debt incurred in connection with any such election; or (iii) transition or inaugural expenses of the successful candidate for state or local office.

The Rule applies to contributions that are made to "officials." The term "official" is defined as any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (i) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity; or (ii) 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 by a government entity.

Exceptions to Two-Year "Time Out"

There are certain limited exceptions to the two-year "time out" restriction. One is for de minimus contributions made by a covered associate that is a natural person to officials for whom the covered associate was entitled to vote at the time of the contributions and which, in the aggregate, do not exceed $350 to any one official, per election, or to officials for whom the covered associate was not entitled to vote at the time of the contributions and which, in the aggregate, does not exceed $150 to any one official, per election.

There is also an exception for any adviser that is prohibited from providing advisory services for compensation as a result of a contribution made by a covered associate upon the satisfaction of the following requirements:

  1. The adviser has discovered the contribution which resulted in the prohibition within four months of the contribution.

  2. The contribution does not exceed $350.
  3. The contributor obtains a return of the contribution within 60 calendar days of the date of discovery of such contribution by the adviser.

In any calendar year, an investment adviser that has more than 50 employees is entitled to no more than three exceptions from the two-year "time out" by reason of the returned contribution exception. An adviser that has 50 or fewer employees is entitled to no more than two such exceptions.

The "Look Back" Provision

Advisers should also be aware of an important "look back" element of the Rule. It attributes to an adviser contributions made by a person within two years (or, in some cases, six months) of becoming a covered associate of that adviser (which includes a current employee who has been promoted to a position covered by the Rule). This means that when an employee becomes a covered associate, the adviser must "look back" to that employee's contributions to determine whether the "time out" applies to the adviser. This is designed to stop advisers from going around the Rule by influencing the adviser selection process through the hiring of persons who have made political contributions. However, there is an exception to the "look back" rule. The two-year "time out" will not be triggered by a contribution of a natural person more than six months prior to becoming a covered associate, unless he or she, after becoming a covered associate, solicits clients. In other words, the two-year "look back" applies only to covered associates who solicit clients for an investment adviser.

Exemptions

An adviser is also entitled to seek an exemption from the SEC to the two-year ban with respect to any particular contribution. In deciding whether to grant an exemption, the SEC will consider a number of factors, including (x) whether the adviser adopted and implemented policies and procedures reasonably designed to prevent violations of the Rule prior to the date of the contribution prompting the "time out" and (y) whether, prior to the contribution, the adviser had no actual knowledge of the contribution.

Ban on Payments to Third Parties

The SEC was also concerned about the use by investment advisers of third parties to circumvent the Rule. In the SEC's original proposing release, an actual ban was suggested on the use by advisers of third-party solicitors to obtain government clients. The SEC noted that "placement agents" played a central role in the enforcement actions that authorities have brought involving pay-to-play schemes. Several states have imposed outright bans on the use of third parties to solicit government bodies.

The total ban, however, received strong negative reaction from many parties in the months before the SEC's adoption of the Rule. Therefore, the SEC retained the ban on using third-party solicitors to obtain government clients, but added an exception for any third party solicitor that is a "regulated person." Specifically, the Rule provides that it is unlawful for an adviser to provide or agree to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of such adviser unless the person is a "regulated person" or is an executive officer, general partner, managing member or employee of the adviser.

"Solicit" is defined broadly to include any communication, direct or indirect, for the purpose of obtaining a client for, or referring a client to, an adviser.

A "regulated person" is (i) an investment adviser registered with the SEC that has not, and whose covered associates have not, within two years of soliciting a government entity: (A) made a contribution to an official of that government entity other than a de minimus contribution; and (B) coordinated or solicited any person or political action committee to make any such contribution; or (ii) a "broker" or "dealer" registered with the SEC and a member of a national securities association registered with the SEC under the Securities Exchange Act of 1934, such as the Financial Industry Regulatory Authority ("FINRA"). However, for a broker-dealer to be a "regulated person," the securities association (i.e., FINRA) must prohibit its members from engaging in distribution or solicitation activities if certain political contributions have been made, and they must have a rule that the SEC finds is substantially equivalent or more stringent than the Rule.

The SEC noted that FINRA is in the process of preparing rules that would prohibit its members from soliciting government business on behalf of an adviser unless they comply with pay-to-play rules. Therefore, the SEC is delaying application of the prohibition on compensating third-party solicitors for one year to give FINRA the time to enact its rule.

Prohibition on Soliciting or Coordinating Contributions

The Rule prohibits an adviser and its covered associates from coordinating or soliciting any person or political action committee to make any contribution to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services, or any payment to a political party of a state or locality where the adviser is providing or seeking to provide services to a government entity. According to the SEC, this restriction is intended to prevent an adviser from circumventing the prohibition on direct contributions by "bundling" a large number of small employee contributions to influence an election, or making contributions indirectly through a state or local political party.

Investment Pools

The Rule will also apply to an adviser that manages a "covered investment pool" in which a government entity makes an investment. The term "covered investment pool" essentially includes three types of pooled investment vehicles:

  1. A registered investment company that is an investment option of a plan or program of a government entity. An example is a "529" plan where a participant can select a pooled investment vehicle that is sponsored or advised by an investment adviser as a funding vehicle or investment option of such plan.

  2. A private fund, such as a hedge fund, venture capital fund or private equity fund that is exempt from registration under the Investment Company Act of 1940 pursuant to Sections 3(c)(1) or 3(c)(7).
  3. A collective investment trust that is exempt from the Investment Company Act of 1940.

The SEC states in its adopting release that the Rule does not obligate a government entity to withdraw its investment or cancel its commitment to a covered investment pool in the event its adviser has made a disqualifying contribution. It also does not require an adviser to stop providing advice to the pool. Rather, it only prohibits the adviser from receiving compensation for its advice. If a government entity is an investor in a fund at the time a contribution triggering a two-year "time out" is made, the adviser must forego any compensation related to the assets invested or committed by that government entity. There may be several options for an adviser in these circumstances. In the case of a hedge fund that is highly liquid, the adviser could seek to cause the fund to redeem the investment of the government entity. In other more illiquid pools such as venture capital funds and private equity funds, the SEC suggested that the adviser could comply with the Rule by waiving or rebating the portion of its fees, or any performance allocation or carried interest attributable to assets of the government client. In the case of a registered investment company, an adviser could waive its advisory fee for the fund as a whole in an amount approximately equal to the fees that are attributable to the government entity or permit the government to continue to pay its portion of the fee, but require the adviser to rebate that portion of the fee to the fund as a whole.

New Recordkeeping Requirements

The SEC also adopted new recordkeeping requirements for registered investment advisers that have (or intend to have) government clients or provide investment advisory services to a covered investment pool in which a government entity invests. The amendments to Section 204-2 would require a registered investment adviser to keep the following records: (i) the names, titles, and business and residence addresses of all covered associates of the adviser; (ii) all government entities to which the adviser provides or has provided investment advisory services, or which are or were investors in any covered investment pool to which the investment adviser provides or has provided advisory services in the past five years, but not prior to the effective date of the rule (described below); (iii) all direct or indirect contributions made by the investment adviser 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 political action committee; and (iv) the name and business address of each "regulated person" to whom the adviser provides or agrees to provide, directly or indirectly, payment to solicit a government entity for advisory services on its behalf.

The records of contributions and payments would be required to be listed in chronological order identifying (i) each contributor and recipient, (ii) the amounts and dates of each contribution or payment; and (iii) whether such contribution or payment was subject to the exception for certain returned contributions.

Effective Date

The Rule and the amendments to Rules 204-2 are effective 60 days after their publication in the Federal Register. However, the SEC realized that investment advisers will need some time before they can have appropriate systems in place to comply with the Rule. Therefore, investment advisers subject to the Rule are generally given six months from the Rule's effective date to be in compliance. Advisers may no longer use third parties to solicit government business except in compliance with the Rule starting June 30, 2011. However, if they advise registered investment companies that are covered investment pools, they have until one year after the effective date to comply. Advisers subject to the new recordkeeping requirements must comply with them commencing six months after the effective date.

Quarles & Brady Comments

As stated above, investment advisers are being given time to comply with the new Rule and create internal systems that will enable them to monitor the political contributions that are made by their covered associates. The SEC also indicated its intent not to have the Rule affect the 2010 elections for which some advisory personnel may already have committed to make political contributions. Notwithstanding the delayed implementation of the Rule for investment advisers subject to the Rule, private equity managers and hedge fund managers should begin their planning if they desire to continue to have government entities as investors in their funds:

  • If a fund manager currently has a government entity in one of its funds, or intends to solicit government entities to participate in one or more future funds, it should develop an appropriate policy and set of procedures to comply with the Rule. The SEC expects advisers to put an appropriate compliance program in effect and has indicated that the existence of such program will be a factor in its determination of whether an adviser will be granted an exemption for any particular contribution that otherwise would be a disqualifying contribution. The existence of an appropriate compliance program is also likely to be a factor for the SEC in any future enforcement effort with respect to the Rule.

  • As a part of such policy a manager will need to identify the personnel that will be considered covered associates under the Rule. It will also need to amend its hiring procedures in order to make appropriate inquiry of any candidate for employment who may become a covered associate, so it is aware of all political contributions previously made by such candidate that could trigger a two-year "time out."
  • Fund managers that are registered investment advisers should commence the maintenance of records in accordance with the amendments to Rule 204-2. Managers that are not registered should also consider maintaining these same records in order to have appropriate proof in the event of a subsequent SEC investigation.
  • The manager that is planning to solicit government clients as investors in its funds should be prepared to do so only directly or through the "regulated persons" permitted by the Rule. In fact, in some jurisdictions a manager must realize that a complete ban on third party placement agents could be in effect. Fund managers should consider these limitations in their negotiation of engagement letters with third-party solicitors.
  • A manager should consider increasing its due diligence of any potential placement agent to investigate whether its status as a "regulated person" is in order and whether it had any "pay-to-play" issues in the past.
  • Managers should consider how they will deal with the triggering of a disqualifying contribution. If they desire to have the right to redeem the investment of a government entity under such circumstances, they should build this flexibility into fund documents and consider disclosing this as an investment risk in any private placement memorandum or other disclosure document. If the fund manager will waive compensation, such as a performance fee or carried interest, it must consider the manner by which it will value such waiver. The SEC's adopting proposal suggests that a hedge fund manager will likely determine the waived amount on the same basis as the fee it normally calculated (i.e., on a mark-to-market basis). Private equity fund managers, on the other hand, that calculate their fee or carry on the basis of realized gains and losses and where mark-to-market calculations are not feasible, will likely need to use a different methodology.

There are many parts of the Rule that will require analysis in the months ahead as advisers begin to attempt to put appropriate compliance programs in place.

For more details on Rule 206(4)-5, or if you have any questions, please contact John P. Vail at (312) 715-5042 / john.vail@quarles.com or your Quarles & Brady LLP attorney.




[1] As of the date of this publication, the so-called "private adviser exemption" in Section 203(b)(3) is expected to be eliminated by the Dodd-Frank Wall Street Reform and Consumer Protection Act currently before Congress. If the Act is adopted, it can be expected that the SEC will amend new Rule 206(4)-5 to address the Act's technical elimination of the exemption while retaining the Rule's application to private equity fund managers, hedge fund managers, and other private fund advisers through some other means.