In 2011, so-called “pay-to-play” prohibitions under the Investment Advisers Act Rule 206(4)-5 (the Rule) went into effect. A recent U.S. Securities and Exchange Commission (SEC) exemptive order application addresses one instance in which an investment adviser found itself in violation of the Rule and applied for a curative ruling.1 First, a little background.
Pay-to-play is the practice of making campaign contributions and related payments to elected officials in order to influence the awarding of contracts for the management of public pension plan assets and other government investment accounts. The rules adopted by the SEC address – and ban – not only direct political contributions by investment advisers, but also other indirect payment mechanisms that some advisers have used or could use for similar purposes. The Rule mandated strict prohibitions, with certain very limited exceptions, on contributions and activities with regard to municipal and state pension plans that could be construed as “pay-to-play.”
The Rule’s two-year time out is triggered by a political “contribution” to an “official” of a “government entity.” The date of the contribution starts the time out. A governmental “official” includes an incumbent, candidate, or successful candidate for elective office of a state or local government entity, if the office is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser, or 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 state or a political subdivision of a state.
Pepper Point: The Rule does permit individuals to make aggregate contributions, without triggering the two-year time out, of up to $350, per election, to an elected official or candidate for whom the individual is entitled to vote, and up to $150, per election, to an elected official or candidate for whom the individual is not entitled to vote. These de minimis exceptions are available only for contributions by individual covered associates, not the investment adviser itself. Under both exceptions, primary and general elections would be considered separate elections.
While the Rule does not directly affect contributions to federal campaigns, if a politician is, as of the date a contribution is made, an applicable state- or local-level office holder, the Rule applies with full force with respect to that individual, even with respect to the federal campaign.
Pepper Point: The trigger is whether a contribution is made by a covered associate of the adviser to an applicable elected official or candidate for an office, not whether the elected official or candidate actually aids the investment adviser in any way – for example, a contribution to a one-in-a-million third-party candidate who ultimately wins 0.1 percent of the vote is disqualifying in the same manner and to the same extent that a contribution to a “sure-thing” incumbent who ultimately wins 99.9 percent of the vote in an applicable election.
In what appears to be a case of first impression since the Rule was adopted, the Rule’s “escape clause” has been invoked: a manager applied to the SEC for relief under the exemptive procedures contained in subpart (e) of the Rule. The procedure allows the “Commission, upon application, [to] conditionally or unconditionally exempt an investment adviser from the [two-year compensation time out provision]....”
An investment adviser needs to apply for an order exempting itself from the two-year time out if it believes it can sustain the exemption. It is up to the SEC to determine if the look-back provision would yield an unintended result. The factors to be taken into account, in determining whether relief is to be allowed include:
(i) whether the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Advisers Act of 1940, as amended
(ii) whether the investment adviser: (a) before the contribution resulting in the prohibition was made, adopted and implemented policies and procedures reasonably designed to prevent violations of the Rule; (b) before or at the time the contribution that resulted in such prohibition was made, had no actual knowledge of the contribution; and (c) after learning of the contribution, (1) has taken all available steps to cause the contributor involved in making the contribution that resulted in such prohibition to obtain a return of the contribution, and (2) has taken such other remedial or preventive measures as may be appropriate under the circumstances
(iii) whether, at the time of the contribution, the contributor was a covered associate or otherwise an employee of the investment adviser, or was seeking such employment
(iv) the timing and amount of the contribution that resulted in the prohibition
(v) the nature of the election (e.g., federal, state or local), and
(vi) the contributor’s apparent intent or motive in making the contribution that resulted in the prohibition, as evidenced by the facts and circumstances surrounding such contribution.
As noted in the Application, the investment adviser in question (the Adviser) is the investment adviser to several state public pension funds – funds overseen, in the state in question, by boards of between nine and 11 trustees. In each case, one of the trustees is appointed by the State Treasurer. The triggering contribution occurred as follows: on May 11, 2011, a managing member of the Adviser (the Covered Associate) and his spouse each made separate $2,500 contributions to the federal senate campaign of the State Treasurer.2 The Adviser and its employees (other than the Covered Associate in question) did not learn about the contribution of the Covered Associate until November 2011, when it was uncovered as part of a compliance test that included random testing of public campaign contribution databases for the names of Adviser employees.
Pepper Point: Unless a Covered Associate solicits his or her spouse to make a contribution or it is shown that the spousal contribution is an indirect contribution by the Covered Associate, the political activities of a spouse are ignored under the Rule (although not under certain state and local rules of similar coverage). In this case, the Adviser made the affirmative representation that the Covered Associate had not solicited “any person” and the relief requested was just for the Covered Associate’s “contribution.”
The Adviser represented to the SEC that the contribution was returned by the candidate and that the Adviser’s internal compliance policies were updated as a result of the event to require full pre-clearance of all future contributions by the Adviser and its Covered Associates. The error apparently was the result of a mistaken belief on the part of the Covered Associate that all contributions to federal campaigns were permissible and exempt from his firm’s pay-to-play policies and procedures.
Additional facts recited in the application for relief were:
Pepper Point: The investment adviser in question appears to have made extensive efforts to correct the error and prevent reoccurrence. The application for relief reflects that an error was apparently committed without violative intent, that it did not influence any client decisions, that it was internally discovered and disclosed in reasonably short order, that it was corrected (to the extent possible), and that it caused no substantive harm.
Pepper Point: The deadline for requests for a hearing from “interested persons” was November 12, 2013 and no request was received by the SEC. As a result, the order granting an exemption from Rule 206(4)-5(a)(1) was granted.3 Despite what would appear to be a very positive fact pattern, the process has been long and likely costly.4 It should serve as a warning to other advisers to avoid pay-to-play violations. Pre-clearing all contributions, while not required, should be seen as a prudent cautionary step for investment advisers with significant volumes of work from state and municipal clients.
1 See October 17, 2013 Release No. IA-3693- Notice of Application, as available at http://www.sec.gov/rules/ia/2013/ia-3693.pdf (the Application). The application was filed on October 16, 2012, and an amended and restated application was filed on July 5, 2013. The order granting the requested exemption went effective on November 13 without a hearing.
2 The State Treasurer in question was unsuccessful in his U.S. Senate bid and remained the State Treasurer.
4 The two years’ worth of client fees in question had been placed in an escrow account and would be recovered by the Adviser if the exemptive order is granted.
Gregory J. Nowak and Matthew R. Silver