Why the SEC will likely enact a ban on third-party solicitation

In seeking solutions to halt pay-to-play practices within the investment advisor market, the US Securities and Exchange Commission is consulting an old playbook for the municipal securities market. By Kimberly Mann of Pillsbury Winthrop Shaw Pittman

On 3 August 2009, the SEC proposed a rule under the Investment Advisers Act of 1940, intended to eliminate investment adviser participation in pay-to-play practices with government officials. Proposed rule 206(4)-5 is modeled after rules adopted or amended by the Municipal Securities Rulemaking Board in 1994, 1996 and 2005 (frequently referred to as rules G-37 and G-38) in response to questionable payments to elected officials by municipal securities dealers and others operating in the municipal markets.

Although they may be modified, it appears likely that the SEC will adopt in large measure the provisions in proposed rule 206(4)-5. In its release, the SEC acknowledged that it believes that the framework proposed has been successful in curtailing pay-to-play practices by municipal securities professionals. In addition, the SEC noted that, by adopting that approach, there would be consistency between the two pay-to-play regulatory regimes. The SEC further noted that, for firms that would be subject to both regimes, the cost of establishing policies and procedures to comply with rule 206(4)-5 may be reduced.  

If adopted, proposed rule 206(4)-5 would accomplish what the SEC was unable to pull off in 1999 when a similar proposal was abandoned because of strenuous objections from public officials and the investment advisory community. In fact, the 2009 proposal is broader than the rule proposed in 1999, ostensibly because the SEC has had the benefit of lessons learned through more than a decade of experience with rules G-37 and G-38.  Unlike the 1999 proposal, proposed rule 206(4)-5 would apply not only to investment advisers that provide or seek to provide services to government entities through private funds (also known as section 3(c)(1) or 3(c)(7) funds), but also to many registered investment companies and collective investment trusts. Moreover, in an effort to prevent circumvention, proposed rule 206(4)-5 incorporates provisions that prohibit advisers and certain covered associates from doing indirectly what they are prohibited from doing directly. 

The proposed rule would apply to advisers that are registered – or are required to be registered – with the SEC, and advisers that are exempt from federal registration under the “private adviser exemption,” meaning they do not hold themselves out as investment advisers and had fewer than 15 clients during the preceding 12 months. Advisers that are registered with state securities authorities and have less than $25 million in assets under management would not be subject to rule 206(4)-5, in large part because they are unlikely to provide advisory services to government entities. The rule as proposed would capture the overwhelming majority of investment advisers that are likely to provide such services. 

Under the proposed rule, it would be unlawful for an adviser to receive compensation for advisory services rendered to a government entity within two years after the adviser or any covered associate makes a contribution to a public official of that government entity (or a candidate for such public office) who is in a position to influence the award of advisory business. For purposes of the rule, a covered associate is a general partner, managing member or executive officer of the adviser (or other individuals with similar status), any employee who solicits government entity investors for the investment adviser, or any political action committee controlled by the investment adviser or its covered associates. The SEC has indicated that, if an adviser or any covered associate that is subject to rule 206(4)-5 makes a contribution to a public official of a government client, the adviser likely would be required to perform advisory services on an uncompensated basis for a reasonable period of time, until the government client finds a replacement adviser. In such a circumstance, there would be a need to balance the risk that a government client would be harmed by the adviser’s precipitous withdrawal from the advisory arrangement against the risk that the adviser would be compelled to provide advisory services without compensation for an indefinite period.

To prevent advisers from gaming the system by hiring or terminating covered associates after a contribution is made, the proposed rule incorporates a “look back.” Consequently, the two-year time out would continue in effect after a covered associate who makes a contribution is terminated, and would apply to any other adviser that subsequently engages that covered associate, if the engagement occurs within two years after the contribution is made. A de minimis exception would permit a covered associate who is a natural person to make contributions to officials for whom the associate is entitled to vote at the time of the contribution, provided that the associate’s contributions in the aggregate do not exceed $250 to any one official or candidate per election. The proposed rule also provides exceptions for certain contributions that are returned.

To prevent indirect payments, the proposed rule provides that it would be unlawful for an adviser or its covered associates to coordinate or solicit any person or political action committee to make contributions to an official of a government entity to which the adviser provides or seeks to provide advisory services. Similarly, payments to a political party of a state or locality where an investment adviser provides or is looking to provide investment advisory services to a government entity also would be prohibited. 

An investment adviser that is registered or required to be registered and has or seeks to have government clients (either directly or through a covered investment pool), would be required to maintain certain chronological records of contributions and payments made by the adviser and its covered associates. In addition, the adviser would need to maintain information about its covered associates and the government entities for which it provides, has provided within the preceding five years, or seeks to provide advisory services. The recordkeeping requirements are intended to assist the SEC in examining advisory firms’ compliance with rule 206(4)-5. Advisers would need to establish and implement internal procedures to manage compliance.

No third-party solicitation

Perhaps most notably, the proposed rule would prohibit advisers from paying or agreeing to pay finders, placement agents, pension consultants and other third parties to solicit government entities for advisory services. However, affiliates, partners, managing members, executive officers and employees of an adviser and employees of the adviser’s affiliates would be permitted to solicit a government entity on behalf of the investment adviser. The terms “payments” and “solicitation” are defined broadly under the proposed rule. Notably, the rule would not prohibit government entities from engaging and paying pension consultants or other third parties to recommend investment advisers to manage pension fund assets.

The confluence of recent events makes it almost a certainty that the SEC will adopt some form of pay-to-play regulation. In particular, the growing number of civil, criminal and administrative actions involving pay-to-play schemes, increased focus at the state and local levels on pay-to-play arrangements, implementation of initiatives by public pension funds to address pay-to-play practices, and mounting public and congressional pressure on the SEC to become more active in securities regulation and enforcement, make the climate ripe for adopting a comprehensive proposal. Even some investment professionals are calling for more effective regulation in this area.

The shape of the new rules
The real question is whether the SEC will opt to use the framework used in rule 206(4)-5 and rules G-37 and G-38, or choose a different approach. For example, the SEC could require registered investment advisers to adopt policies and procedures in their codes of ethics or compliance manuals to prevent them and their covered associates from engaging in pay-to-play practices. Alternatively, or perhaps additionally, the SEC may adopt rules requiring investment advisers to disclose political contributions to officials of government entities to which they provide or seek to provide advisory services. The SEC has criticised the latter approach, however, reasoning that such disclosure alone would not be effective in protecting public pension fund clients. Rule G-37 includes disclosure requirements in addition to prohibitions substantially similar to those in proposed rule 206(4)-5. 

Rules prohibiting investment advisers from using third parties to solicit government investment business have already been implemented or considered by several states. The SEC considered applying the two-year time out to contributions made by an adviser’s third-party solicitors in lieu of banning payments to solicitors, but determined that a ban would be preferable in light of difficulties advisers would have in monitoring the activities of their third-party solicitors. 

Bad news for small firms
The adoption of rule 206(4)-5 would likely have a significant effect on many investment funds and their advisers, at least in the short term. In particular, emerging fund managers may have a more difficult time attracting pension fund investors without the assistance of a third-party solicitor, which in turn could adversely affect their ability to attract other investors. On the other hand, funds that have already established relationships with government entities likely would not be affected significantly because they may not rely as heavily on the services of placement agents and other third parties to solicit public pension plan investors. In addition, many of the larger funds have affiliated entities which are licensed broker-dealers that would be permitted to solicit government entity investors under rule 206(4)-5. 

Funds that have the financial and human resources to do so may form affiliated broker-dealer firms to solicit government entity investors; however, obtaining the requisite licenses and adopting and implementing the required compliance and supervisory processes and procedures may not be feasible for many small firms. The cost of complying with rule 206(4)-5 also may put smaller and emerging funds at a disadvantage inasmuch as such funds generally have small staffs and less technological capacity. One of the unintended consequences of rule 206(4)-5 may be that it reduces the pool of advisers with which government entities invest, thereby creating an even greater dominance by top-tier firms. A reduction in the number and diversity of funds may discourage talented new managers from forming funds, diminish competition and result in less bargaining power for investors.  
In proposing rule 206(4)-5, the SEC called on an old playbook to accomplish two very different goals: halting investment adviser participation in pay-to-play practices with government officials; and advancing efforts to regulate private investment advisers and private funds. Given the regulatory climate, further attempts to apply old rules to unregistered advisers may be on the horizon. Private advisers may be wise to begin to prepare for more regulation, particularly if the Private Fund Investment Advisers Registration Act of 2009 is enacted, and private investment advisers are required to register with the SEC and comply with an assortment of new disclosure requirements.

Kimberly Mann is a corporate and securities partner in the Washington, DC office of Pillsbury Winthrop Shaw Pittman and leader of the firm’s private equity practice team.  Pillsbury’s private equity team offers a wide breadth of experience counseling on both US and international fund matters and is well versed in regulatory, financial, tax and other issues that typically arise during the life of a fund. She can be reached at kimberly.mann@pillsburylaw.com.