Preventing pay-to-play

Private equity advisors registered with the Securities and Exchange Commission (SEC) are subject to what is commonly known as the ‘pay-to-play’ rule. 

Since the rule was first adopted in July 2010, it has been interpreted by SEC staff, amended and, most recently, the focus of no-action relief. Numerous state and local governments have also proposed and/or adopted similar legislation or regulations that either prohibit advisors and their employees from making contributions to political figures, or require advisors and their soliciting personnel to register as lobbyists.

The rule essentially has three prongs:

First, it restricts the ability of investment advisors and certain of their employees from directly making political contributions to certain political candidates. Moreover the rule prohibits advisors from providing investment advisory services to a government entity for compensation for a two-year period after the advisor or any of its covered associates makes a contribution to an official of that government entity.

Thomas  Harman

Secondly, to prevent circumvention of the first prong of the rule, the rule also imposes limitations on the ability of advisors and their covered associates to use third-party solicitors or to engage in political fundraising. Specifically, advisors and covered associates cannot pay any person to solicit a government entity for advisory services on its behalf unless such person is either an employee, executive officer or general partner/managing member of the advisor, or is a ‘regulated person.’ As amended in June 2011, the rule defines regulated person to include not only other advisors subject to the rule, but also registered broker-dealers and registered municipal advisors that are themselves subject to a pay-to-play rule that the SEC has deemed equivalent.

Thirdly, the rule specifically includes a blanket prohibition restricting all advisors and their covered associates from doing ‘anything indirectly which, if done directly’ would violate the rule. This extra layer of prevention signals the SEC’s heightened concern about indirect payments and puts advisors on notice that the SEC will not tolerate attempts to ‘game’ the rule.

RECORD-KEEPING REQUIREMENTS

Coupled with the rule are amendments to the general books and records rule (Rule 204-2 under the Advisers Act), which impose additional recordkeeping obligations on advisors that provide investment advisory services to a government entity or a covered investment pool (such as a private equity fund) in which a government entity is an investor. Such advisors must collect and maintain:

• The names, titles and business and residence addresses of all covered associates of the advisor.

John O'brien

• All government entities to which the advisor provides or has provided investment advisory services (directly or indirectly through a covered investment pool) in the past five years.

• All direct and indirect contributions made by the advisor or its covered associates to an official of a government entity or direct or indirect payments made to a political party or PAC.

• The name and business address of each regulated person to which the advisor agrees to provide direct or indirect payment to solicit a government entity.

CONCLUSION

The laws surrounding political contributions and lobbyists registration are multi-tiered and difficult to navigate. Certain practices that have become common in the private equity industry could now lead to violations of the rule or other state or local regulations, such as interaction with representatives of a government pension plan during a due diligence meeting or hosting an annual investors meeting at which attendees are provided with food or gifts. Private equity firms should ensure that business representatives are well trained in advance of any due diligence meetings with current or prospectus government entity clients. 

Another issue facing firms is how to design their procedures for investigating and reviewing political contributions to PACs or state and local political parties. This is also a concern for the politicians because candidates and parties do not want to lose vital campaign contribution revenue due to fears of violating pay-to-play rules. As a result, many state, federal and local political parties have altered their contribution forms so contributors can direct their donations to a general fund and not toward a particular candidate. 

Thomas Harman is a partner in Morgan Lewis’s investment management and securities industry practice in Washington, DC. John O’Brien is an associate in Morgan Lewis’s investment management practice in Philadelphia.

The above article is an edited chapter from our US Private Equity Fund Compliance Companion, available by clicking HERE.