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.

• SEC v. Charles E. LeCroy and Douglas W. MacFaddin; Motion to Dismiss