Sunday, September 12, 2010

SEC Charges State of New Jersey with Securities Fraud Involving Pension Funding

In an historic first, the Securities and Exchange Commission (SEC) charged the State of New Jersey with securities fraud for misrepresenting and failing to disclose to investors in its municipal bond offerings that it was underfunding the state’s two largest pension plans. The SEC’s order also found that New Jersey failed to provide certain present and historical financial information regarding its pension funding in its bond disclosure documents. While the enforcement action focused on the bond offering disclosures, a number of findings could be viewed as calling into question the pension plans’ use of certain approved actuarial and accounting methodologies. Some are concerned that the SEC’s perceived problems in this area could have an impact on the Governmental Accounting Standards Board’s current review of governmental standards.

On August 18, 2010, the SEC announced its settlement with New Jersey, which is the first state ever charged by the SEC for violations of the Federal securities laws. No individuals were charged in connection with the case, and New Jersey agreed to settle without admitting or denying the SEC’s findings. The SEC’s order requires the State of New Jersey to cease and desist from committing or causing any violations and any future violations of the anti-fraud provisions of securities law (Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933).

While State and local governments are exempt from the registration and reporting provisions of the Securities Act and the Exchange Act, and the SEC’s authority to establish rules for accounting and financial reporting does not extend to municipal securities issuers, State and municipal securities issuers are nevertheless still subject to the antifraud provisions of Securities law. That is, any disclosures and other statements made to the market in connection with the offer or sale of securities cannot contain misrepresentations or omissions of material facts, and the SEC can take enforcement action if such misrepresentations or omissions are done with the intent to deceive, manipulate or defraud.

According to the SEC, the official statements that New Jersey used to offer and sell more than $26 billion worth of municipal bonds between 2001 and 2007 “created the false impression that the Teachers’ Pension and Annuity Fund (TPAF) and the Public Employees’ Retirement System (PERS) were being adequately funded,” according to a press release accompanying the SEC’s announcement . (An “official statement” is a document prepared by an issuer of municipal bonds that discloses material information regarding the issuer and the particular offering.)

The SEC claimed that this action masked the fact that the state “was unable to make contributions to TPAF and PERS without raising taxes, cutting other services or otherwise affecting its budget.” As a consequence, the SEC found that investors were not provided adequate information to evaluate the state’s ability to fund the pensions or assess their impact on the state’s financial condition.

While the SEC’s order primarily deals with New Jersey’s failures to adequately disclose pension underfunding and its potential effects on the state’s financial health, some of the findings in the SEC’s cease and desist order (see Findings Nos. 41, 42 and 43) suggest that certain accounting methodologies—currently permissible under existing GASB standards—are nevertheless problematic.

For example, the SEC said the state’s five-year smoothing method produced net unsmoothed losses, and the resulting difference between the actuarial value of assets and their market value reduced the State’s pension contributions. However, smoothing, by its very nature, virtually always produces actuarial values different from market values. Furthermore, smoothing could have produced net unsmoothed gains, depending on whether gains or losses were being smoothed, thereby increasing pension contributions. Nevertheless, the SEC faulted New Jersey for failing to adequately disclose the (presumably only negative impact) that smoothing can have.

The SEC also found New Jersey’s use of a closed 30-year amortization period meant that the state “has been unable to and will continue to be unable to effectively amortize” its pension plans’ unfunded actuarial accrued liability. Some actuaries have questioned this finding, noting that the use of a closed 30-year amortization will not cause the unfunded actuarial liability to rise indefinitely. Rather, it will be reduced to zero over a 30-year period. What the SEC really appears to have problems with is the use of a rolling 30-year amortization, which is not uncommon in the public sector for amortizing gains and losses.

If so, this could be very problematic for public plans, as the SEC, while acknowledging that this was a “recognized actuarial method,” still found that the disclosure of this methodology’s impact on funding was inadequate.

Finally, the SEC complained that the bond offering documents did not provide asset and funded ratio information on a market value basis, although it noted they were available in the state plans’ actuarial reports. Again, due to the significant difference between the actuarial value and market value of plan assets, the SEC found “the actuarial value did not accurately present the current value of the pension plans.” What this essentially appears to be saying is that the actuarial value is not “accurate,” and therefore it must be false and misleading unless it is acknowledged to be inaccurate?

The SEC has historically had problems with smoothing. Their staff expressed serious reservations in a June 2005 staff report prepared pursuant to the Sarbanes-Oxley Act of 2002, and seemed to suggest that additional disclosures would not necessarily solve the problem:
“The Staff also believes that the complex series of smoothing mechanisms, and the disclosures to explain them, render financial statements more difficult to understand and reduce transparency. SFAS No. 87 does require certain disclosures that help explain the effect of SFAS No. 87’s many netting and smoothing provisions. In this case, however, the disclosures seem designed to compensate for less than desirable accounting. A recent FASB project revised the disclosure requirements to provide even more information. While the disclosures are quite detailed, the Staff notes that it has long been accepted that ‘good disclosure doesn’t cure bad accounting.’ The combination of the accounting and disclosure provisions contribute to the length and complexity of financial statements, a common complaint among users and preparers alike. Revisions to the guidance that eliminate optional smoothing mechanisms would allow significant reduction in disclosures without a loss of important information.” (Emphasis added.) 
More recently, James Kroeker, the SEC’s chief accountant, said in May of 2009 that the Commission would look “very skeptically” at pension funds that change accounting methods to “smooth out” losses incurred in response to the financial crisis. Kroeker reportedly said at the 28th annual SEC Financial Reporting Institute Conference that the SEC would also be scrutinizing any attempt to reduce the transparency of a pension fund’s assets by changing amortization schedules.

It therefore would appear that there is more going on here than simple problems with inadequate disclosure. It is well-known that the SEC has concerns with GASB and feels that they should have control over it in the same way they have effective control of FASB, thanks to Sarbanes-Oxley. This indirect criticism of methodologies currently permitted by GASB could be seen as an effort to further this cause.

Will GASB potentially see this as a message to “clean up their act” or lose their independence? Does the New Jersey settlement send a message to GASB that its current plans to restrict amortization, eliminate smoothing, and move to a market valuation of assets—as expressed in its recent “Preliminary Views” on making changes to public pension accounting and disclosure—is the right direction to follow?

Finally, what does the SEC’s action in this area portend? The Enforcement Division of the Securities and Exchange Commission (SEC) has a new “Municipal Securities and Public Pensions Unit,” which was responsible in part for the New Jersey action. This unit’s purpose is to look at problems in the municipal securities market and at public pension funds; and when it was created, it was specifically announced that the unit would “focus on misconduct in the $2.8 trillion municipal securities market and at public pension funds.” (Emphasis added.) The unit’s director, Elaine Greenberg, has also said that her focus will be on “public pension accounting and disclosure violations,” along with pay-to-play and public corruption violations.

It is clear from the New Jersey case that Ms. Greenberg’s office has begun its efforts in this regard. Also, a “confidential informal inquiry” into “Certain Public Pension Fund Activities” that was sent from her office to a number of NCTR and NASRA members last year is another sign. While this inquiry dealt with a range of issues, including pay-to-play payments as well as solicitations, and conflict of interest policies, there was also a lengthy section of questions dealing with “Disclosure of Unfunded or Underfunded Liabilities,” in which plans were asked about disclosure documents (“Official Statements”) prepared in connection with their State’s general obligation bonds or similar State-supported bond issues.

These questions dealt with such things as changes in actuarial asset valuation methods, actuarial cost methods, or amortization methods, and asked for both the effect of those changes and “how the change was disclosed in the Official Statements of the bond issuer.” Other questions in this section asked for detailed information about what had been included in these Official Statements, and then inquired if the State has changed its Official Statements in the last five years to include or exclude any of this information. If so, the SEC also asked the plans to provide an explanation as to why such information was excluded or included.

Clearly, based on these kinds of questions, it would seem that the SEC is assuming that the pension plan is directly involved with both the preparation of these Official Statements, as well as the decision-making process involving what is or is not contained in them. This apparent blurring of the distinction between the plan and the employer/bond issuer was made even clearer in a series of questions in the survey asking about “pension holidays” and payments of less than the annual required contribution (ARC), and the reasons the employer made these decisions. Unfortunately, given the broad appointment powers of a New Jersey governor, the recent action there may only serve to bolster this misimpression.

Therefore, it now appears clear that the SEC’s inquiries were indeed attempting to determine possible links between pension plans’ funded status and potential misrepresentations or omissions regarding this status that are contained in disclosure documents prepared in connection with their sponsor’s bond issues.

Of course, this ultimately raises the question of how “accuracy” is measured. Misrepresentations can clearly occur if the issuer simply fails to accurately disclose information provided to it by the pension plan. But what if the real question is whether the pension plan itself failed to accurately measure its funded status in the first place, which then produced the inaccuracies in the issuer’s public disclosures—even though the information provider to the issuer was otherwise accurately disclosed? Findings 41, 42 and 43 in the New Jersey settlement suggest that this may indeed be the case.

Therefore, is this recent action, in part, about the SEC’s interest in positioning itself to become the arbiter of such judgment calls? Is Ms. Greenberg’s unit part of the SEC’s efforts to acquire the same type of statutory authority over financial accounting and reporting standards for State and local governments as it has over publicly held companies? Is the SEC beginning to try to do indirectly what it is not permitted to do directly?
SEC New Jersey Settlement (Finding 41 begins on page 12)

SEC Adopts New Proxy Access Rule

After almost a decade of fits and starts, the Securities and Exchange Commission (SEC) has finally approved major reforms of its rules governing shareowner access to the corporate proxy for the purpose of nominating directors. Despite vigorous opposition from the business community, the SEC voted on a straight 3-2 party-line vote to require, under certain circumstances, a company’s proxy materials to provide shareholders with information about, and the ability to vote for, a shareholder’s, or group of shareholders’, nominees for director (new Rule 14a-11). The new rules would also provide that companies generally must include in their proxy materials, again under certain circumstances, shareholder proposals that seek to establish a procedure in the company’s governing documents for the inclusion of one or more shareholder director nominees in the company’s proxy materials (amended Rule 14a-8). But the new rules do not come without strings attached that, in the view of some, seriously diminish the potential benefits to investors. It is also expected that the new rules would be the subject of a serious legal challenge.

On August 25th, the SEC voted to adopt proxy access reforms that institutional investors in general, and many public pension plans in particular, have been seeking for years. The Council of Institutional Investors (CII) hailed the action as “historic,” and Ann Yerger, CII’s executive director, said it was “ground-breaking for U.S. shareowners.” “Access to the proxy will invigorate board elections and make boards more responsive to shareowners and more vigilant in their oversight of companies,” she insisted.

Not everyone agreed. David Hirschmann, president and CEO of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, called it a “special interest-driven rule” and said it is “a giant step backwards for average investors.” “Using the proxy process to give labor union pension funds and others greater leverage to try to ram through their agenda makes no sense,” according to Hirschmann. SEC Commissioner Kathleen Casey (R) agreed, and voted against the new rule, warning that it “is so fundamentally and fatally flawed that it will have great difficulty surviving judicial scrutiny.” She was joined in voting against the rule by Commissioner Troy Paredes (R), who, in objecting to the fact that shareowners could not vote to “opt out” from under the rule’s requirements, complained that this “displace[s] private ordering and state law and negate[s] the import and effect of shareholder choice when it comes to determining the contours of proxy access.”

The main features of the new rule and the amended rule are as follows:

New Exchange Act Rule 14a-11, requiring companies to include shareholder nominees for director in the company’s proxy materials, if the shareholder and their nominees meet certain conditions:
  • Shareholders, either individually or as a group that is aggregating their holdings, will be eligible to have their nominee included in the proxy materials if they own at least 3 percent of the total voting power of the company’s securities that are entitled to be voted on at the election of directors at the annual meeting. Borrowed shares and shares sold short cannot be included in determining the 3 percent threshold, but loaned shares that may be recalled (and will be recalled prior to the annual meeting) may be counted.
  • Shareholder(s) must have held their shares continuously for at least three years and will be required to continue to own at least the required amount of securities through the date of the meeting at which directors are elected. Shareholders must not be holding the securities for the purpose of changing control of the company.
  • Each shareholder or group of shareholders will be able to include at least one nominee, but no more than 25 percent of the company’s board of directors, whichever is greater. The 25 percent limit will be based on the total directors on the board. Therefore, a company will not be able to limit shareholder nominees by holding staggered elections. If more than one shareholder or group seeks to nominate candidates, and the total would exceed the 25 percent cap, the group with the highest percentage of voting stock will be given priority, and not, as originally proposed last year, the first group to file a notice of intent to seek such nominees.
  • Nominating shareholders will be required to file with the SEC, as well as with the company, a new Schedule 14N, which is a Notice of Intent, which will be made available to the public. The new Schedule 14N will require, among other things, disclosure of the amount and percentage of the voting power of the securities owned by the nominating shareholder, the length of ownership, and a statement that the nominating shareholder intends to continue to hold the securities through the date of the meeting. It will also identify the specific nominee or nominees, including biographical information and a description of the nature and extent of the relationships between the nominating shareholder and the nominee(s) and the company. This information will also be included in the company’s proxy materials, similar to the disclosure currently required in a contested election.
  • The new rule will apply to all Exchange Act reporting companies, including investment companies, other than companies whose only public securities are debt securities. “Smaller reporting companies”—generally, an issuer that had a public float of less than $75 million—are also subject to the rule, and not exempted. However, they will be given a three-year phase-in period. During that time, the new rule will not apply to them; and the SEC plans to study the potential impact on those issuers and may make further revisions to its rule based on this study. Foreign companies that come within the definition of “foreign private issuer” are not currently subject to the SEC’s proxy rules and would not be subject to these new rules.
  • Shareholders must submit nominees no later than 120 days before the anniversary date of the mailing of the company’s proxy statement in the prior year. Initially, shareholders will be able to submit nominees for inclusion in the next proxy statement if the 120-day deadline falls on or after the effective date of the rules. Thus, assuming that the new rule is noticed in the Federal Register very shortly, as expected, it will become effective in early November 2010 (60 days after it is noticed), meaning that it generally would be available for use at companies that mailed their proxy statement for their last annual meeting no earlier than around the second week in March 2010.
Amended Exchange Act Rule 14a-8(i)(8), requiring companies to include in their proxy materials, under certain circumstances, proposals that seek to establish a procedure in the company’s governing documents for the inclusion of shareholder director nominees in company proxy materials:
  • Shareholder proposals by qualifying shareholders that seek to establish such procedures in the company’s governing documents could no longer be excluded. (Before this change, Rule 14a-8(i)(8) permitted companies to exclude shareholder proposals that relate to elections.) However, companies will still be permitted to exclude a shareholder proposal pursuant to Rule 14a-8(i)(8) if it (1)would disqualify a nominee who is standing for election; (2) would remove a director from office before his or her term expired; (3) would question the competence, business judgment, or character of one or more nominees or directors; (4) would seek to include a specific individual in the company’s proxy materials for election to the board of directors; or (5) otherwise could affect the outcome of the upcoming election of directors.
  • In order to qualify to offer such proposals, a shareholder must have continuously held at least $2,000 in market value (or 1 percent, whichever is less) of the company’s securities entitled to be voted on the proposal at the meeting, for a period of one year prior to submitting the proposal. (This is the current eligibility rule, and does not change.)
  • A company would not be required to include in its proxy materials a shareholder proposal that seeks to limit the availability of the new Rule 14a-11. However, shareholders would be allowed to propose additional means, other than Rule 14a-11, for inclusion of shareholder nominees in company proxy materials. Therefore, under the Proposal, a shareholder proposal that sought to provide an additional means for including shareholder nominees in the company’s proxy materials pursuant to the company’s governing documents would not be deemed to conflict with Rule 14a-11 simply because it would establish different eligibility thresholds or require more extensive disclosures about a nominee or nominating shareholder than would be required under Rule 14a-11. However, as the SEC has noted, a shareholder proposal would conflict with proposed Rule 14a-11 “to the extent that the proposal would purport to prevent a shareholder or shareholder group that met the requirements of proposed Rule 14a-11 from having their nominee for director included in the company’s proxy materials.”
  • In order to have a proposal included in a company’s proxy materials, the rules are similar to the new Rule 14a-11 requirements. That is, a shareholder must submit the proposal no later than 120 days before the anniversary date of the mailing of the company’s proxy statement in the prior year, and shareholders will be able to submit proposals for inclusion in the next year’s proxy statement if the 120-day deadline falls on or after the effective date of the rules.
Will the new rule and the existing rule change truly make a difference for institutional investors? Some would argue that, despite “The sky is falling” cries of the business community, the new Rule 14a-11 may not really do that much. After all, the SEC’s reforms do not change any state or foreign corporate law rules governing the nomination and election of directors.

On the other hand, they do provide for the inclusion of nominees properly nominated by shareholders on a company’s proxy statement, thereby significantly reducing shareholder costs. Also, a company may not choose to “opt out” of the new rule, nor can it increase the percentage and holding thresholds -- even if the shareholders were actually to approve these changes.

And speaking of these thresholds, will the 3-percent/three-year minimum requirement unduly restrict access? First, it could have been worse. During the conference between the House and Senate on what eventually became the Dodd-Frank law, the Senate conferees actually made a proffer to mandate that the SEC issue proxy access rules with thresholds of 5 percent ownership with a two-year holding period.

This percentage of ownership was so high that even the ten largest public pensions plans, combined, would be unlikely to be able to meet it. Eventually, this proffer was rejected, and the new law confirmed the authority of the SEC to issue such proxy access rules as it deemed appropriate, with no mandate to do so.

However, there are those who say that shareholders, even when grouped together, rarely own a 3 percent stake in the largest companies. For example, the 20 biggest public pension plans, combined, reportedly own only 2.8 percent of Goldman Sachs. It is estimated that, for the 20 largest U.S. companies by market cap, the smallest investment shareholders would need in order to qualify to nominate a director is $3.5 billion.

The rule, as originally proposed by the SEC in May of last year, would have provided a tiered ownership threshold with shorter holding periods. For the largest companies, shareholders would only have been required to own at least 1 percent of the voting securities; the percentage would have increased to 3 percent for medium companies, and to 5 percent for the smallest firms. In all cases, the holding requirement would only have been one year.

However, the SEC said that it believed that the 3 percent threshold, while higher for many companies and lower for others than the thresholds originally advanced, “properly balances our belief that Rule 14a-11 should facilitate shareholders’ traditional state law rights to nominate and elect directors with the potential costs and impact of the amendments on companies.” According to the SEC, “The ownership threshold we are establishing should not expose issuers to excessively frequent and costly election contests conducted through use of Rule 14a11, but it is also not so high as to make use of the rule unduly inaccessible as a practical matter.”

As for the increase in the holding period from one to three years—many prognosticators had expected two—the SEC said that it thought a three-year holding period “reflects our goal of limiting use of the rule to significant, long-term holders” and “strikes the appropriate balance in providing shareholders with a significant, long-term interest with the ability to have their nominees included in a company’s proxy materials while limiting the possibility of shareholders attempting to use Rule 14a-11 inappropriately.” By this, the SEC was referring to concerns that hedge funds or private equity funds could use proxy access in lieu of proxy fights. The required three-year period in the final rule should make it less likely that this will be the case.

Then there is the matter of majority voting, another important goal for institutional investors. But requirements for such often do not apply in contested elections for directors. Accordingly, some observers have pointed out that one effect of the new Rule 14a-11 will be to restore plurality voting for directors in most elections where shareholders use the new process for nominating directors. On the other hand, a vote of any sort might not be taking place but for the new rule.

Finally, there is the underlying issue of the rule’s legality. Although institutional investor proponents worked hard to have language included in Dodd-Frank that underscored the SEC’s authority to act in this area, this authority is still likely to be challenged.

The SEC, in approving the final rule, stressed that Dodd-Frank provided the SEC with explicit authority to make rules addressing shareholder access to company proxy materials. As the SEC underscored, not only do they believe they “have the authority to adopt Rule 14a-11 under Section 14(a) as originally enacted,” but that, “[i]n any event, Congress confirmed our authority in this area and removed any doubt that we have authority to adopt a rule such as Rule 14a-11.”

The SEC also made it clear that not only does it believe it has the statutory authority to act, but the new Rule 14a-11 is also constitutional. The Commission insists that proxy regulations do not infringe on corporate First Amendment rights (quoting from the Supreme Court’s decision in Pacific Gas and Electric Company v. Public Utilities Comm’n of California, 475 U.S. 1, 14 n.10 (1986)) both because “management has no interest in corporate property except such interest as derives from the shareholders,” and because such regulations “govern speech by a corporation to itself” and therefore “do not limit the range of information that the corporation may contribute to the public debate.”

Even if statements in proxy materials are viewed as more than merely internal communications, the SEC insists that this communication is of a commercial—not political—nature, and “regulation of such statements through Rule 14a-11 is consistent with applicable First Amendment standards.”

But these definitive assertions are unlikely to keep opponents away from the courthouse. The U.S. Chamber of Commerce has proven itself very willing to challenge SEC rules, and has said that it has retained counsel to review whether to file suit to block access. According to the Chamber’s David Hirschmann, “The Chamber will carefully review the rule that was approved today and will continue to fight this flawed approach using every method available.”

Implementation of SEC’s New “Pay-to-Play” Rule Begins

On June 30, 2010, the Securities and Exchange Commission (SEC) formally adopted new rules intended to combat perceived “pay-to-play” practices by certain investment advisers to governmental plans. The new rules would also limit the use of so-called “third party marketers” by investment advisers in connection with pension plan business. While the new rules will not apply until 2011, investment advisers are already considering what steps to take to ensure that they are in compliance. In addition, some of the specifics of the rules are raising questions in connection with governmental appointment authority. The application to swaps has also been raised as a potential issue, and certain provisions in the new Dodd–Frank law have also somewhat muddied the waters with regard to some investment advisers.

To briefly recap, under the new SEC “Pay-to-Play” rules:
  • An investment adviser who makes certain political contributions to an elected official (incumbents as well as candidates) in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation. There is a de minimis provision that permits contributions of up to $150 per election per candidate, and up to $350 per election if the contributor is entitled to vote for the candidate.

  • An adviser would be prohibited from asking another person or political action committee (PAC) to make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser, or to make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

  • An adviser would be prohibited from paying a third party, such as a placement agent, to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or broker-dealer subject to similar pay-to-play restrictions.
The SEC rule becomes effective on September 12, 2010 (60 days after the Rule was published in the Federal Register on July 14, 2010). This means that the investment adviser rules regarding contributions will take effect six months later, in March of 2011. Contributions made before that date will not be affected. However, for advisers who manage “covered investment pools,” such as mutual funds, in which government entities have invested or are solicited to invest, the two-year “time-out” rule will not apply for one year, or until September of 2011.

The placement agent ban will also not take effect for one year from the effective date, or September of 2011. This is to permit the Financial Industry Regulatory Authority (FINRA) to draft pay-to-play rules of its own for broker-dealers.

Nevertheless, many investment advisors and fund managers are already setting up internal compliance policies governing political contributions of “covered associates,” prohibiting them from making contributions to certain political candidates or coordinating contributions or political fundraisers. (A covered associate is generally (1) any general partner, managing member or executive officer; or (2) any employee who solicits a government entity for the investment adviser, as well as such employees’ supervisors.)

Also, because of the rule’s “look back” provision, many advisers and fund managers are setting up procedures to make sure that individuals being considered for vacancies in (and promotions to) covered associate positions have not made political contributions within the past two years that would violate the rule. (Briefly, the “look back” provision means that when an employee becomes a covered associate, the adviser must consider his or her past contributions to determine whether the time-out would apply.) However, there is an exception so that the two-year time out will not be triggered by a contribution made by a person more than six months prior to becoming a covered associate, unless he or she, after becoming a covered associate, solicits clients. Thus, the two-year look back will apply only to covered associates who solicit for the investment adviser.

Finally, placement agents and third party marketers are also coming under additional scrutiny, as advisors are being careful to determine if these individuals will qualify as “regulated persons” as defined by the new rule. Otherwise, if retained, they are being kept away from soliciting governmental entities.

An interesting glitch involving exactly which advisers are technically covered by the Pay-to-Play rule has developed thanks to a provision in the Dodd-Frank financial markets reform law. Specifically, the SEC’s new rule covers all advisers that are registered (or required to be registered) with the SEC, and those that are unregistered due to their reliance on the “private adviser exemption” from registration provided by Section 203(b)(3) of the Advisers Act (which essentially exempts advisers with fewer than 15 clients during the last 12 months).

However, Dodd-Frank deletes this private adviser exemption in Section 203(b)(3), and creates new exemptions to registration for advisers who only advise private funds and have less than $150 million in assets under management, and for venture capital fund managers. Are these advisers still considered to be covered by the Pay-to-Play rule? Probably, but it may be necessary for there to be further formal SEC action taken to make this clear.

The application of the new rule to swaps may also become somewhat of an issue. While it appears to be clear that the rule applies to advisers and broker dealers in securities, it would not apply to derivatives and other products, such as commodities, that are not within the SEC’s jurisdiction. But what if a swap is security-based?

A U.S. District Court is currently looking at this question in a case involving two former JPMorgan Chase bankers who have been sued by the SEC in connection with an alleged pay-to-play scheme in Jefferson County, Alabama, that involved about $5 billion in bond and interest-rate swap business. The two bankers attempted to have the case dismissed, arguing that the SEC didn’t have jurisdiction over swaps based on an interest-rate index, rather than an index of securities.

The judge effectively ruled that at this stage in the case, this disputed question of fact had yet to be settled, and refused to throw the case out. Thus, the issue of when swap dealers and swap advisers may be subject to the SEC’s Pay-to-Play rule is by no means settled. The Motion to Dismiss could be the precursor of some interesting arguments in this area. (The case is Securities and Exchange Commission v. Charles E. LeCroy and Douglas W. MacFaddin., 09-CV-02238, U.S. District Court for the Northern District of Alabama (Birmingham).

Finally, questions are also starting to be raised with regard to the SEC rule’s application to public pension trustees who are themselves appointed by other appointees. It is clear from the release accompanying the new Rule that “The two-year time out is…triggered by contributions, not only to elected officials who have legal authority to hire the adviser, but also to elected officials (such as persons with appointment authority) who can influence the hiring of the adviser.” However, the Rule does not appear to directly address the situation—not uncommon among public plans—where the person with appointment authority who is actually responsible for naming a person to the pension board is a non-elected official, but who has himself been appointed by an elected official.

In such cases, would a contribution to the elected official who “appointed the appointer” trigger the two-year time out? Informal discussions with SEC staff suggest that it would not. Similar informal conversations with staff at the Municipal Securities Rulemaking Board (MSRB) also indicate that the MSRB’s rule, on which the SEC approach was admittedly modeled, would also be unlikely to reach back to the appointing elected official in such a case, unless the facts and circumstances suggested otherwise. However, the MSRB has issued no formal guidance or written opinion on this type of situation.

While the onus of the new Pay-to-Play rule would appear to fall primarily on the investment adviser who triggers the two-year ban on compensated services, the impact on a pension plan of the abrupt termination of long-standing investment adviser relationships could also be very serious. As NCTR and other national organizations pointed out to the SEC in a joint comment letter on the proposed rule last year, investment adviser services are ongoing, often long-standing, relationships that provide important stability and continuity in the investment functions of government.

The sudden requirement to terminate such an investment adviser relationship will interfere with such continuity and may, for a period of time, leave the plan or government without the adequate professionals needed to focus on investing billions of dollars of employee and taxpayer money. This is particularly true for the many public plans that do not have internal investment staff and, therefore, rely on professional investment advisers to assist in investing their funds.

With actual application of the new rule to advisers just a little more than six months away, these and other questions will need to be addressed if its implementation is to go as smoothly as possible. Otherwise, the SEC’s Pay-to-Play rule could have a far more deleterious impact on public plans than on the investment adviser it is intended to discipline. Robyn, please indent and “Bold” the following 1 hyperlink, with a bullet, if possible.


President’s Economic Recovery Board
The President’s Economic Recovery Advisory Board (PERAB) has approved a new report to President Obama on tax reform options that includes several proposals dealing with retirement security and pensions. Options include consolidating retirement accounts and harmonizing statutory requirements; integrating IRA and 401(k)-type contribution limits and disallowing nondeductible contributions; reducing retirement account leakage; simplifying rules for employers sponsoring plans; and simplifying disbursements.

The PERAB is an outside advisory panel and is not part of the Obama Administration. Their report is meant to provide helpful advice to the Administration as it considers options for tax reform in the future. The report does not represent Administration policy. It is not clear how seriously this report will be taken, but some of its options could turn up in the President’s next budget or as revenue offsets to help fund tax legislation on the Hill.
House Committee Clears Bill to Require Shareholder Approval of Political Spending
On July 29, the House Financial Services Committee approved the “Shareholder Protection Act” (H.R. 4790), which would require companies to hold an annual shareholder vote on how much money to spend on political activities. All Republicans on the panel opposed the bill, as did three Democrats.

The legislation was in response to the Supreme Court’s “Citizens United” ruling in January, which struck down a long-time ban on political spending by corporations and unions.

The bill would also direct the Securities and Exchange Commission to issue rules requiring corporations to disclose any materials for political activities created with or purchased using company funds and would hold officers and directors who authorize political expenditures without shareholder approval liable for three times the amount of dollars spent.
New Report on Local Government Retiree Health Care Funding
A new issue brief from the Center for State and Local Governments finds that the economy has slowed the ability of local governments to address long-term funding of their retiree health care obligations. The new brief finds that many jurisdictions are making sweeping changes in their retiree health care plans:
  • 36 percent have increased or plan to increase the years of service required to vest.
  • 11 percent have increased the retirement age.
  • 39 percent have eliminated or plan to eliminate retiree health benefits for new hires.