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SEC Passes “Pay-to-Play” Rule to Protect Government Investors

Investor Services Alert John P. Vail

Last week the Securities and Exchange Commission (the "SEC") approved new Rule 206(4)-5 that is designed to curtail the influence of "pay-to-play" practices by investment advisers with respect to their existing and prospective government clients.[1] Among the Rule's provisions is a prohibition on an investment adviser providing services to a government entity for compensation for two years if the adviser, or certain of the adviser's executives or employees, make a political contribution to an elected official of such government entity who is in a position to influence the selection of the adviser.

Government pension plans, which are considered government entities for purposes of the Rule, have over $2.6 trillion of assets and represent one-third of all U.S. pension assets.[2] The SEC noted that such plans are the largest and most active institutional investors in the United States. Government pension plans have had significant influence on publicly held companies and the securities markets in general. Of most importance to the SEC, however, is the fact that the management of public funds has an effect on taxpayers and the beneficiaries of public pension plans and other government funds.

In its adopting release, the SEC states that elected officials who allow political contributions to play a role in how public monies are managed and use the assets as rewards to contributors are violating the public trust. Recent years have evidenced an increase in enforcement actions by the SEC and state attorneys general against advisers, placement agents and government officials involved in kickback practices relating to public funds. The most notable pay to play abuses to date were related to the management of the assets of the New York Common Retirement Fund.

The SEC issued its proposal for new Rule 206(4)-5 (the "Rule") in August 2009 and received over 250 comment letters from interested parties. Public pension plans and their officials were divided on the Rule's merits; some embraced the Rule, while others were very critical and concerned that the proposal may result in unintended hardships for public plans.

The SEC noted that a number of commenters suggested that, in lieu of the Rule, the SEC adopt a requirement that an adviser include in its code of ethics a policy that prohibits political contributions made for the purpose of influencing the selection of the adviser. Other parties suggested alternative compliance procedures that would encourage advisers to avoid pay-to-play practices. The SEC, however, did not believe that codes of ethics or compliance procedures alone would be enough to stop pay-to-play practices, particularly when senior officers were the ones directly or indirectly involved in the practices. Therefore, the SEC indicated its view that a specific rule with "prophylactic" prohibitions was necessary to address the conduct.

The Rule applies to registered investment advisers and hedge fund advisers, private equity fund advisers and other advisers that rely on the so-called "private adviser" exemption under Section 203(b)(3) of the Investment Advisers Act of 1940. The Rule treats an investment adviser to a hedge fund or private equity fund in which a government entity invests or is solicited to invest, as though such adviser were providing or seeking to provide advisory services directly to the government entity.

A "government entity" is defined as 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 a 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, employees of the state or political subdivision, or any agency, authority or instrumentality thereof, acting in their official capacity.

Quarles & Brady Comments

During the past few years certain government entities have adopted their own policies to address "pay-to-play" practices with respect to their investment advisory needs. Whether or not a government entity has an existing policy, it should consider the impact of the Rule on their future advisory relationships:

  • Government entities should learn about the details of the Rule. A thorough discussion of the Rule can be found in our Client Alert which can be found here.

  • Government entities may want to consider supplementing their due diligence with respect to any existing or future adviser with specific inquiries as to its policies and procedures to comply with the Rule.
  • Inquiries to a potential adviser are appropriate to determine whether it has used a placement agent or other third party in connection with seeking the government entity's business. If so, such government entity may want to obtain detailed information regarding the placement agent, including a copy of the agreement between the adviser and the placement agent.
  • Specific inquiry may also be appropriate to determine how a prospective adviser plans to address a political contribution that would commence the two-year "timeout" under the Rule. The SEC indicates that the adviser can continue to provide services during such two-year period, but without compensation. Whether this is a likely scenario remains to be seen. An adviser may wish to terminate its relationship with the government entity rather than abide by the two-year ban. A government entity should carefully consider the consequences that it would face if an adviser terminated its services because of a disqualifying contribution by the adviser. These consequences should be anticipated and addressed as the government entity negotiates is advisory contract with an adviser.
  • A government investor should closely review the documents for any new hedge fund, private equity fund or other such fund to determine whether there are any provisions that are designed by the manager to address issues that the manager may face under the Rule.

Each government entity will need to individually consider how the Rule will impact it. For more details on
Rule 206(4)-5, or if you have any questions, please contact John P. Vail at (312) 715-5042, / [email protected]
or your Quarles & Brady LLP attorney.

[1] "Pay-to-play," for purposes hereof, means the practice by an investment adviser of seeking to influence government officials to award an advisory contract to it by making or soliciting political contributions to those officials.

[2] SEC Release No. IA-3043.

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