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7 August 2009
[Federal Register: August 7, 2009 (Volume 74, Number 151)]
[Proposed Rules]
[Page 39839-39870]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07au09-18]
[[Page 39839]]
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Part IV
Securities and Exchange Commission
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17 CFR Part 275
Political Contributions by Certain Investment Advisers; Proposed Rule
[[Page 39840]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-2910; File No. S7-18-09]
RIN 3235-AK39
Political Contributions by Certain Investment Advisers
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission is proposing for
comment a new rule under the Investment Advisers Act of 1940 that would
prohibit an investment adviser from providing advisory services for
compensation to a government client for two years after the adviser or
certain of its executives or employees make a contribution to certain
elected officials or candidates. The new rule would also prohibit an
adviser from providing or agreeing to provide, directly or indirectly,
payment to any third party for a solicitation of advisory business from
any government entity on behalf of such adviser. Additionally, the new
rule would prevent an adviser from soliciting from others, or
coordinating, contributions to certain elected officials or candidates
or payments to political parties where the adviser is providing or
seeking government business. The Commission also is proposing rule
amendments that would require a registered adviser to maintain certain
records of the political contributions made by the adviser or certain
of its executives or employees. The new rule and rule amendments would
address ``pay to play'' practices by investment advisers.
DATES: Comments should be received on or before October 6, 2009.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-18-09 on the subject line; or
Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-18-09. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Melissa A. Roverts, Attorney-Adviser,
Matthew N. Goldin, Senior Counsel, Daniel S. Kahl, Branch Chief, or
Sarah A. Bessin, Assistant Director, at (202) 551-6787 or
IArules@sec.gov, Office of Investment Adviser Regulation, Division of
Investment Management, U.S. Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed rule 206(4)-5 [17 CFR 275.206(4)-5] and proposed amendments
to rules 204-2 [17 CFR 275.204-2] and 206(4)-3 [17 CFR 275.206(4)-3]
under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (``Advisers
Act'' or ``Act'').
I. Background and Introduction
II. Discussion
A. Rule 206(4)-5: ``Pay to Play'' Restrictions
1. Advisers Subject to the Rule
2. Relationship with MSRB Rules; Alternative Approaches
3. Pay to Play Restrictions
(a) Two-Year ``Time Out'' for Contributors
(1) Prohibition on Compensation
(2) Officials of a Government Entity
(3) Contributions
(4) Covered Associates
(5) ``Look Back''
(6) Exception for De Minimis Contributions
(7) Exception for Certain Returned Contributions
(b) Ban on Using Third Parties To Solicit Government Business
(c) Restrictions on Soliciting and Coordinating Contributions
and Payments
(d) Direct and Indirect Contributions or Solicitations
(e) Investment Pools
(1) Application of the Rule to Pooled Investment Vehicles
(2) Covered Investment Pools
(3) Applying the Compensation Limit to Covered Investment Pools
(f) Exemptions
B. Recordkeeping
C. Amendment to Cash Solicitation Rule
D. Transition Period
E. General Request for Comment
III. Cost/Benefit Analysis
A. Benefits
B. Costs
C. Request for Comment
IV. Paperwork Reduction Act
A. Rule 204-2
B. Rule 206(4)-3
C. Request for Comment
V. Initial Regulatory Flexibility Analysis
A. Reasons for Proposed Action
B. Objectives and Legal Basis
C. Small Entities Subject to Rule
D. Reporting, Recordkeeping, and Other Compliance Requirements
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
G. Solicitation of Comments
VI. Effects on Competition, Efficiency and Capital Formation
VII. Consideration of Impact on the Economy
VIII. Statutory Authority
I. Background and Introduction
Investment advisers provide a wide variety of advisory services to
State and local governments.\1\ Advisers manage public monies that fund
pension plans and a number of other important public programs,
including transportation, children's programs, arts programs,
environmental reclamation, and financial aid for education. In
addition, advisers provide risk management,\2\ asset allocation,\3\
financial planning \4\ and cash management services; \5\ assist in
investing proceeds from bond
[[Page 39841]]
offerings; \6\ help State and local governments find and evaluate other
advisers that manage public funds (``pension consultants''); \7\ and
provide other types of services.\8\
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\1\ See Sofia Anastopoulos, An Introduction to Investment
Advisers for State and Local Governments (2d ed. 2007); Werner Paul
Zorn, Public Employee Retirement Systems and Benefits, in Local
Government Finance, Concepts and Practices 376 (John E. Peterson and
Dennis R. Strachota, eds., 1st ed. 1991) (discussing the services
investment advisers provide for public funds).
\2\ See Robert A. Fippinger, The Securities Law of Public
Finance 669 (2d ed. 2004).
\3\ See, e.g., John H. Ilkiw, Investment Policies, Processes and
Problems in U.S. Public Sector Pension Plans: Some Observations and
Solutions from a Practitioner, in Public Pension Fund Management:
Governance, Accountability and Investment Policies (Alberto R.
Musalem and Robert J. Palacios, eds. 2004). See also Barry B. Burr,
The New $100 Billion Club, Pens. & Inv. (May 4, 1998), at 1.
\4\ See Cal. Ed. Code Sec. 22303.5 (2008) (requiring teachers'
retirement system to offer retirement planning services to
beneficiaries); CalSTRS Counseling and Workshops, available at
http://www.calstrs.com/Counseling%20and%20Workshops/index.aspx.
Other funds also offer financial planning services to their
beneficiaries. See, e.g., CalPERS Launches Online Education Classes,
U.S. States News (Mar. 3, 2008).
\5\ See Government Finance Officers Association, An Introduction
to External Money Management for Public Cash Managers 5 (1991).
\6\ See In the Matter of O'Brien Partners, Inc., Investment
Advisers Act Release No. 1772 (Oct. 27, 1998) (settled enforcement
action in which financial advisor was deemed subject to the Advisers
Act for rendering advice to municipal securities issuers
``concerning their investment of bond proceeds in securities,
including [non-government securities], and was compensated for that
advice'').
\7\ In addition to assisting public funds in selecting
investment advisers, pension consultants may also provide advice to
State and local governments on such things as designing investment
objectives, or recommending specific securities or investments for
the fund. Pension consultants may be investment advisers subject to
the Advisers Act. See Applicability of the Investment Advisers Act
of 1940 to Financial Planners, Pension Consultants, and Other
Persons Who Provide Others with Investment Advice as a Component of
Other Financial Services, Investment Advisers Act Release No. 1092
(Oct. 8, 1987) [52 FR 38400 (Oct. 16, 1987)] (``Release 1092'').
\8\ For example, public funds may retain advisers to perform
custodial services. See, e.g., Public Employee Retirement Systems,
supra note 1, at 376-77.
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Most of the public funds managed by investment advisers fund State
and municipal pension plans.\9\ These pension plans have over $2.2
trillion of assets and represent one-third of all U.S. pension
assets.\10\ They are among the largest and most active institutional
investors in the United States.\11\ The management of these funds
significantly affects publicly held companies \12\ and the securities
markets.\13\ But most significantly, their management affects taxpayers
and the beneficiaries of these funds, including the millions of present
and future State and municipal retirees \14\ who rely on the funds for
their pensions and other benefits.\15\
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\9\ For this reason, in this Release, we use the term ``public
pension plan'' interchangeably with ``government client'' and
``government entity''; however, our proposed rule would apply
broadly to investment advisory activities for government clients,
such as those mentioned here in this Background and Introduction,
regardless of whether they are retirement funds. For a discussion of
how the proposed rule would apply with respect to investment
programs or plans sponsored or established by government entities,
such as ``qualified tuition plans'' authorized by Section 529 of the
Internal Revenue Code [26 U.S.C. 529] and retirement plans
authorized by Section 403(b) or 457 of the Internal Revenue Code [26
U.S.C. 403(b) or 457], see infra section II.A.3(e) of this Release.
\10\ Board of Governors of the Federal Reserve System, Flow of
Funds Accounts of the United States, Flows and Outstandings, First
Quarter 2009 (June 11, 2009) (at table L.119). Since 2002, total
financial assets of public pension funds have grown by 13% Id.
\11\ According to a recent survey, seven of the ten largest
pension funds were sponsored by State and municipal governments. The
Top 200 Pension Funds/Sponsors, Pens. & Inv. (Sept. 30, 2008),
available at http://www.pionline.com/article/20090126/CHART/
901209995.
\12\ See Stephen J. Choi & Jill E. Fisch, On Beyond CalPERS:
Survey Evidence on the Developing Role of Public Pension Funds in
Corporate Governance, 61 Vanderbilt L.Rev. 315 (Mar. 2008) (noting,
``Collectively, public pension funds have the potential to be a
powerful shareholder force, and the example of CalPERS and its
activities have spurred many to advocate greater institutional
activism.'').
\13\ Federal Reserve reports indicate that, of the $2.2 trillion
in non-Federal government plans, $1.1 trillion are invested in
corporate equities. Flow of Funds Accounts of the United States,
supra note 10 (at table L.119).
\14\ See Paul Zorn, 1997 Survey of State and Local Government
Employee Retirement Systems 61 (1997) (``[t]he investment of plan
assets is an issue of immense consequence to plan participants,
taxpayers, and to the economy as a whole'' as a low rate of return
will require additional funding from the sponsoring government,
which ``can place an additional strain on the sponsoring government
and may require tax increases'').
\15\ The most current census data reports that public pension
funds have 18.6 million beneficiaries. 2007 Census of Governments,
U.S. Bureau of Census, Number and Membership of State and Local
Government Employee-Retirement Systems by State: 2006-2007 (2007)
(at Table 5), available at http://www.census.gov/govs/retire/
2007ret05.html.
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Public pension plan assets are held, administered and managed by
elected officials who often are responsible for selecting investment
advisers to manage the funds they oversee. Pay to play practices
undermine the fairness of the selection process when advisers seeking
to do business with the governments of States and municipalities make
political contributions to elected officials or candidates, hoping to
influence the selection process. In other cases, political
contributions may be solicited from advisers, or it is simply
understood that only contributors will be considered for selection.
Contributions, in this circumstance, may not always guarantee an award
of business to the contributor, but the failure to contribute will
guarantee that another is selected. Hence the term ``pay to play.''
Elected officials who allow political contributions to play a role
in the management of these assets violate the public trust by rewarding
those who make political contributions. Similarly, investment advisers
that seek to influence the award of advisory contracts by public
entities, by making or soliciting political contributions to those
officials who are in a position to influence the awards, compromise
their fiduciary obligations. Pay to play practices can distort the
process by which investment advisers are selected and can harm
advisers' public pension plan clients, and the pension plan
beneficiaries, which may receive inferior advisory services and pay
higher fees because, for instance, advisers must recoup contributions,
or because contract negotiations are not handled on an arm's-length
basis. Pay to play practices also may manipulate the market for
advisory services by creating an uneven playing field among investment
advisers. These practices also may hurt smaller advisers that cannot
afford the required contributions. We believe that advisers'
participation in pay to play practices is inconsistent with the high
standards of ethical conduct required of them under the Advisers Act.
Pay to play practices are rarely explicit: participants do not
typically let it be publicly known that contributions or payments are
made or accepted for the purpose of influencing the selection of an
adviser. As one court noted, in its decision upholding one of the rules
on which the proposed rule is modeled, ``[w]hile the risk of corruption
is obvious and substantial, actors in this field are presumably shrewd
enough to structure their relations rather indirectly.'' \16\ Pay to
play practices may take a variety of forms, including an adviser's
direct contributions to government officials, an adviser's solicitation
of third parties to make contributions or payments to government
officials or political parties in the State or locality where the
adviser seeks to provide services, or an adviser's payments to third
parties to solicit (or as a condition of obtaining) government
business. As a result, the full extent of pay to play practice remains
hidden and is often hard to prove.
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\16\ Blount v. SEC, 61 F.3d 938, 945 (DC Cir. 1995), cert.
denied, 517 U.S. 1119 (1996).
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The rule we are proposing today is modeled on rules G-37 and G-38
of the Municipal Securities Rulemaking Board (``MSRB''),\17\ which
address pay to play practices in the municipal securities markets.\18\
The Commission approved rule G-37 in 1994, after concluding that pay to
play practices harm municipal securities markets.\19\ MSRB rule G-37
[[Page 39842]]
prohibits a broker-dealer from engaging in municipal securities
business with a municipal issuer for two years after making a political
contribution to an elected official of the issuer who can influence the
selection of the broker-dealer.\20\ The rule also prohibits a broker-
dealer from providing or seeking to provide underwriting services to a
government if the firm or any of its ``municipal finance
professionals'' solicit contributions for a candidate or an elected
official of that government, or if they solicit payments to political
parties where the firm is providing or seeking to provide services to a
government client.\21\ MSRB rule G-38 prohibits municipal securities
dealers from making payments to consultants for soliciting municipal
securities business.\22\ We believe that MSRB rules G-37 and G-38 have
been successful in addressing pay to play practices in the municipal
securities market.\23\
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\17\ In 1999 the Commission proposed a similar rule, which also
would have been codified as rule 206(4)-5 under the Advisers Act,
had it been adopted. See Political Contributions by Certain
Investment Advisers, Investment Advisers Act Release No. 1812 (Aug.
4, 1999) [64 FR 43556 (Aug. 10, 1999)] (``1999 Proposing Release'').
The Commission also proposed amendments in 1999 to rule 204-2 [17
CFR 275.204-2] under the Advisers Act, which would have required
advisers with government clients to keep certain records relating to
the 1999 proposed rule. See id., at section II.B. We are not re-
proposing that rule or those rule amendments today; we are
withdrawing our 1999 proposal and proposing a new rule 206(4)-5 as
well as new amendments to rule 204-2.
\18\ MSRB rule G-37 and G-38 are available on the MSRB's Web
site at http://www.msrb.org/msrb1/rules/ruleg37.htm and http://
www.msrb.org/msrb1/rules/ruleg38.htm, respectively.
\19\ See In the Matter of Self-Regulatory Organizations; Order
Approving Proposed Rule Change by the Municipal Securities
Rulemaking Board Relating to Political Contributions and
Prohibitions on Municipal Securities Business and Notice of Filing
and Order Approving on an Accelerated Basis Amendment No. 1 Relating
to the Effective Date and Contribution Date of the Proposed Rule,
Exchange Act Release No. 33868 (Apr. 7, 1994) [59 FR 17621 (Apr. 13,
1994)] (``MSRB Rule G-37 Approval Order''), at sections V.A.1 and 2.
In approving MSRB rule G-37, we concluded that pay to play practices
may harm the municipal markets by fostering a selection process that
excludes those firms that do not make contributions, causes less
qualified underwriters to be retained, and undermines equitable
practices in the municipal securities industry. Id. at section V.
\20\ MSRB rule G-37(b). Shortly after MSRB rule G-37 became
effective, a municipal securities dealer challenged it as an
infringement on the constitutional rights of municipal securities
professionals. A Federal appeals court upheld the constitutionality
of MSRB rule G-37, finding that the rule is narrowly tailored to
serve a compelling government interest. See Blount, supra note 16.
\21\ MSRB rule G-37(c). A ``municipal finance professional'' is
an associated person of a broker-dealer who is ``primarily engaged''
in municipal securities activities, who solicits municipal
securities business on behalf of a broker-dealer, who supervises
associated persons primarily engaged in municipal securities
activities ``up through and including'' the chief executive officer
of the firm (or person performing similar functions), or who is a
member of the firm's executive or management committee (or person
performing similar functions). MSRB rule G-37(g)(iv).
\22\ MSRB rule G-38(a).
\23\ Others, including the MSRB, agree. See, e.g., MSRB Notice
2009-35, Request for Comment: Rule G-37 on Political Contributions
and Prohibitions on Municipal Securities Business--Bond Ballot
Campaign Committee Contributions (June 22, 2009) (``The MSRB
believes the rule has provided substantial benefits to the industry
and the investing public by greatly reducing the direct connection
between political contributions given to issuer officials and the
awarding of municipal securities business to dealers, thereby
effectively eliminating pay-to-play practices in the new issue
municipal securities market.'' [footnote omitted]); MSRB Notice
2003-32, Notice Concerning Indirect Rule Violations: Rules G-37 and
G-38 (Aug. 6, 2003) (``The impact of Rules G-37 and G-38 has been
very positive. The rules have altered the political contribution
practices of municipal securities dealers and opened discussion
about the political contribution practices of the entire municipal
industry.''); Letter from Darrick L. Hills and Linda L. Rittenhouse
of the CFA Institute to Jill C. Finder, Asst. Gen. Counsel of the
MSRB, dated Oct. 19, 2001, available at http://www.cfainstitute.org/
centre/topics/comment/2001/01msrb_ruleg37.html (stating, ``We
generally believe that the existing [MSRB] pay-to-play prohibitions
have been effective in stemming practices that compromise the
integrity of the [municipal securities] market by using political
contributions to curry favor with politicians in positions of
influence.''); Cmte. on Cap. Mkts. Reg., Interim Report of the Cmte.
on Cap. Mkts. Reg. (Nov. 30, 2006), available at http://
www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf
(stating, upon describing MSRB Rule G-37 and the 2005 amendments to
MSRB Rule G-38, ``Taken together, the MSRB's rules have largely put
an end to the old ``pay to play'' practices in municipal
underwriting.'').
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Following the adoption of MSRB rule G-37, we were increasingly
concerned that the very success of the rule may have caused pay to play
practices to migrate to an area not covered by the MSRB rules--the
management of public pension plans.\24\ Public pension plans are
particularly vulnerable to pay to play practices. Management decisions
over these investment pools, some of which are quite large, are
typically made by one or more trustees who are (or are appointed by)
elected officials. And the elected officials that govern the funds are
also often involved, directly or indirectly, in selecting advisers to
manage the public pension funds' assets. These officials may have the
sole authority to select advisers,\25\ may be members of a governing
board that selects advisers,\26\ or may appoint some or all of the
board members who make the selection.\27\
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\24\ 1999 Proposing Release, supra note 17, at section I (``We
have become particularly concerned about the possibility that the
adoption of rule G-37 has resulted in a shift of pay to play
practices to [the management of public pension funds] as political
contributions by broker-dealers are curtailed.''). See also Bill
Krueger, Money Managers Giving to Boyles, News & Observer (May 2,
1996), at A1 (noting that rule G-37 ``dried up'' a contribution
source for a State treasurer, ``so now he is getting campaign
contributions from a group [investment advisers] that is not subject
to [rule G-37]''); Gerri Willis, Filling Carl's War Chest:
Comptroller Getting Thousands From State's Money Managers, Crain's
N.Y. Bus. (Sept. 16, 1996), at 1 (noting the observation of a
securities executive that ``[b]ecause of the SEC's crackdown on the
pay to play nature of the muni bond business, the game has shifted
to asset management and brokerage'').
\25\ See, e.g., 2 NYCRR Sec. 320.2 (placement of State and
local government retirement systems assets (valued at $109 billion
as of Mar. 2009) is under the sole custodianship of the New York
State Comptroller).
\26\ See, e.g., S.C. Code Ann. Sec. Sec. 9-1-20, 1-11-10 (2008)
(board consists of all elected officials); Cal. Gov't Code Sec.
20090 (Deering 2008) (board consists of some elected officials, some
appointed members, and some representatives of interest groups
chosen by the members of those groups); Md. Code Ann., State Pers. &
Pens. Sec. 21-104 (2008) (pension board consists of some elected
officials, some appointed members, and some representatives of
interest groups chosen by the members of those groups).
\27\ See, e.g., Ariz. Rev. Stat. Ann. Sec. 38-713 (2008)
(governor appoints all nine members); Hawaii Rev. Stat. Sec. 88-24
(2008) (governor appoints three of eight members); Idaho Code Sec.
59-1304 (2008) (governor appoints all five members).
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In response to these concerns, in 1999 we proposed a rule under the
Advisers Act, modeled substantially on MSRB rule G-37, that was
designed to prevent advisers from participating in pay to play
practices affecting the management of public pension plans.\28\ In
particular, the 1999 rule proposal would have prohibited an adviser
from receiving compensation for the provision of advisory services for
two years after the advisory firm or any of its partners, executive
officers or solicitors, directly or indirectly, made a contribution to
an elected official who (or a candidate for an elected office that) has
the ability to influence the selection of the adviser.\29\ Comments on
the proposal were mixed, and some commenters that objected asserted
that pay to play was not a problem in the management of public
funds.\30\
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\28\ See 1999 Proposing Release, supra note 17.
\29\ See id., at section II.A.1.
\30\ We received 59 comment letters on our 1999 proposal.
Commenters representing beneficiaries and public pension plans
expressed concern about pay to play practices and generally favored
our proposed rule. State government officials and investment
advisers generally opposed the rule. State government officials
generally argued that there was no demonstrated need for the
proposed rule and that State laws are adequate to address any
concerns. Most advisers submitting comments opposed the rule's
breadth and complained that the consequences of violating the rule
were too harsh; some denied the existence of the problem we sought
to address. Comment letters on our 1999 proposal and a summary of
comments prepared by our staff are available in our Public Reference
Room in File No. S7-19-99. Comment letters we received
electronically are also available at http://www.sec.gov/rules/
proposed/s71999.shtml.
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Since then, it has become increasingly clear that pay to play is a
significant problem in the management of public funds by investment
advisers. In recent years, we and criminal authorities have brought a
number of actions charging investment advisers with participating in
pay to play schemes. We recently brought a civil action in Federal
court charging former New York State officials, as well as a
``placement agent,'' with engaging in a fraudulent scheme to extract
kickbacks from investment advisers seeking to manage assets of the New
York State Common Retirement Fund.\31\ Investment advisers allegedly
paid sham ``placement agent'' fees, portions of which were funneled to
public officials, as a means of obtaining public pension fund
investments in the
[[Page 39843]]
funds those advisers managed.\32\ Another settled administrative action
involved an investment adviser who allegedly paid kickbacks in return
for investment advisory business awarded by the New Mexico State
treasurer's office.\33\ In addition, we brought two separate cases
against the former treasurer of the State of Connecticut and various
other parties in which we alleged that the former treasurer awarded
State pension fund investments to private equity fund managers in
exchange for fees paid to the former treasurer's friends and political
associates.\34\ Criminal authorities have in recent years also brought
cases in New York,\35\ New Mexico,\36\ Illinois,\37\ Ohio,\38\
Connecticut,\39\ and Florida,\40\ charging defendants with the same or
similar conduct. In addition, there are a growing number of reports
about pay to play activities involving investment advisers in other
jurisdictions.\41\ These cases involving investment advisers, as well
as others involving broker-dealers, may reflect more widespread
involvement by securities professionals in pay to play activities.\42\
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\31\ See SEC v. Henry Morris, et al., Litigation Release No.
21036 (May 12, 2009).
\32\ See id.
\33\ See In the Matter of Kent D. Nelson, Investment Advisers
Act Release No. 2765 (Aug. 1, 2008); Initial Decision Release No.
371 (Feb. 24, 2009); Investment Advisers Act Release No. 2868 (Apr.
17, 2009) (in which investment adviser was barred from association
with any broker, dealer or investment adviser).
\34\ See SEC v. Paul J. Silvester et al., Litigation Release No.
16759 (Oct. 10, 2000); Litigation Release No. 20027 (Mar. 2, 2007);
Litigation Release No. 19583 (Mar. 1, 2006); Litigation Release No.
18461 (Nov. 17, 2003); Litigation Release No. 16834 (Dec. 19, 2000);
SEC v. William A. DiBella et al., Litigation Release No. 20498 (Mar.
14, 2008). See also U.S. v. Ben F. Andrews, Litigation Release No.
19566 (Feb. 15, 2006); In the Matter of Thayer Capital Partners, TC
Equity Partners IV, L.L.C., TC Management Partners IV, L.L.C., and
Frederick V. Malek, Investment Advisers Act Release No. 2276 (Aug.
12, 2004); In the Matter of Frederick W. McCarthy, Investment
Advisers Act Release No. 2218 (Mar. 5, 2004); In the Matter of Lisa
A. Thiesfield, Investment Advisers Act Release No. 2186 (Oct. 29,
2003).
\35\ See New York v. Henry ``Hank'' Morris and David Loglisci,
Indictment No. 25/2009 (NY Mar. 19, 2009) (alleging that the deputy
comptroller and a ``placement agent'' engaged in enterprise
corruption and State securities fraud for selling access to
management of public funds in return for kickbacks and other
payments for personal and political gain).
\36\ See U.S. v. Montoya, Criminal No. 05-2050 JP (D.N.M. Nov.
8, 2005) (the former treasurer of New Mexico pleaded guilty); U.S.
v. Kent Nelson, Criminal Information No. 05-2021 JP, (D.N.M. 2007)
(defendant pleaded guilty to one count of mail fraud); U.S. v.
Vigil, 523 F. 3d 1258 (10th Cir. 2008) (affirming the conviction for
attempted extortion of the former treasurer of New Mexico's
successor for requiring that a friend be hired by an investment
manager at a high salary in return for the former treasurer's
willingness to accept a proposal from the manager for government
business).
\37\ See Jeff Coen et al., State's Ultimate Insider Indicted,
Chicago Tribune (Oct. 31, 2008) (describing the thirteenth
indictment in an Illinois pay to play probe).
\38\ See Reginald Fields, Four More Convicted in Pension Case:
Ex-Board Members Took Gifts from Firm, Cleveland Plain Dealer (Sept.
20, 2006) (addressing pay to play activities of members of the Ohio
Teachers Retirement System).
\39\ See U.S. v. Joseph P. Ganim, 2007 U.S. App. LEXIS 29367 (2d
Cir. 2007) (affirming the district court's decision to uphold an
indictment of the former mayor of Bridgeport, Connecticut, in
connection with his conviction for, among other things, requiring
payment from an investment adviser in return for city business);
U.S. v. Triumph Capital Group, et al, No. 300CR217 JBA (D. Conn.
filed Oct. 10, 2000) (the former treasurer, along with certain
others, pleaded guilty--while others were ultimately convicted).
\40\ See United States v. Poirier, 321 F.3d 1024 (11th Cir.),
cert. denied sub nom., deVegter v. United States, 540 U.S. 874
(2003) (partner at Lazard Freres & Co., a municipal services firm,
was found liable for conspiracy and wire fraud for fraudulently
paying $40,000 through an intermediary to Fulton County's
independent financial adviser to secure an assurance that Lazard
would be selected for the Fulton County underwriting contract).
\41\ See, e.g., David Zahniser, California; Private Finances,
Public Role Intersect; Former Pension Board Member Had Consulted for
a Firm that Sought Work with the Panel on Which He Served, Los
Angeles Times (May 9, 2009) (discussing alleged pay to play
activities relating to a former member of the Los Angeles Fire and
Police Pensions Board); Rick Rothacker & David Ingram, Moore Defends
Pension System, Charlotte Observer (Feb. 25, 2007) (discussing
alleged pay to play activities involving North Carolina's State
treasurer); Len Boselovic, Pensions, Politics and Consultants Make
for Unsavory Bedfellows, Pittsburgh Post-Gazzette (Aug. 13, 2006)
and Jeffrey Cohan, Fund Managers `Pay to Play': Six Firms Managing
County's Pension Investments Gave to Board Members' Campaigns,
Pittsburgh Post-Gazzette (Feb. 22, 2001) (discussing alleged pay to
play activities relating to the Allegheny County Retirement Board);
Mary Williams Walsh, Political Money Said to Sway Pension
Investments, N.Y. Times (Feb. 10, 2004) (regarding a 2002 audit by
then-new controller of Luzerne County, Pennsylvania alleging pay to
play activities among various parties involved with county pension
funds).
\42\ For example, we recently brought a case against the mayor
of Birmingham, Alabama, and other defendants, alleging that while
the mayor served as president of the County Commission of Jefferson
County, Alabama, he accepted undisclosed cash and benefits through a
lobbyist as a conduit from the chairman of a Montgomery, Alabama-
based broker-dealer, in return for awarding municipal bond business
and swap transactions to the broker-dealer. See SEC v. Larry P.
Langford et al., Litigation Release No. 20545 (Apr. 30, 2008).
Several years earlier, we brought an enforcement action against the
former treasurer of the City of Chicago, to whom two registered
representatives were alleged to have made secret cash payments to
obtain a share of the city's lucrative securities investments. See
SEC v. Miriam Santos et al., Litigation Release No. 17839 (Nov. 14,
2002); Litigation Release No. 19269 (June 14, 2005). We also brought
enforcement actions against the registered representatives allegedly
involved in the scheme. See SEC v. Miriam Santos, Peter J. Burns,
and Michael F. Hollendoner, Litigation Release Nos. 19270 and 19271
(June 14, 2005). In addition, we brought a case against a broker-
dealer, two of its officers and a city official for participating in
a scheme to defraud the City of Atlanta in connection with the
purchase and sale of certain securities while providing substantial,
undisclosed monetary benefits to the city's investment officer who
was authorized to select a broker-dealer for the transactions. See
In the Matter of Pryor, McClendon, Counts & Co., Inc. et al.,
Securities Act Release No. 7673 (Apr. 29, 1999); Securities Act
Release No. 8062 (Feb. 6, 2002); Exchange Act Release No. 48095
(June 26, 2003); Securities Act Release No. 8245 (June 26, 2003);
Securities Act Release No. 8246 (June 26, 2003).
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Recognizing the harm pay to play practices cause in the management
of public funds, several States, counties, localities, and even
individual public pension funds, have undertaken to prohibit or
regulate these practices in recent years.\43\ And, most recently, in
response to pay to play scandals that have emerged in their
jurisdictions, public officials with oversight of public pension funds
have written to us expressing support for a Commission rule to prohibit
investment advisers from participating in pay to play practices,
including prohibiting the use by advisers of placement agents (or other
types of consultants) to help secure government business.\44\
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\43\ For an example of a State statutory restriction on pay to
play activities, see Ill. Pub. Act 095-0971 (2008). For an example
of a restriction pursuant to a State constitutional amendment, see
Colo. Const. amend. LIV (2008). For an example of a county
restriction, see Resolution No. 08-397 (May 8, 2008) Special Pay to
Play Restrictions for Professional Service Contracts and
Extraordinary Unspecifiable Service Contracts, Monmouth County, NJ.
For an example of a city restriction, see Ordinance 3663 (July 2,
2007), Prohibition of Redevelopment with Certain Contributors,
Township of Franklin, NJ. For an example of a particular local
government agency restriction, see Cal. Pub. Util. Code Sec.
130051.20 (2008), Contributions to Authority Members, Los Angeles
County Metropolitan Transportation Authority. For an example of a
particular public pension fund restriction, see Prohibitions on
Campaign Contributions, California State Teachers' Retirement
System, 5 CCR Sec. 24010 (2009).
\44\ See, e.g., Letter from New York City Comptroller William C.
Thompson, Jr., to Securities and Exchange Commission Chairman Mary
L. Schapiro, dated May 12, 2009, available at http://
www.comptroller.nyc.gov/press/pdfs/05-13-09_SEC-letter.pdf, at 2;
Letter from New York State Comptroller Thomas P. DiNapoli to
Securities and Exchange Commission Chairman Mary L. Schapiro, dated
May 7, 2009, available at http://www.osc.state.ny.us/press/releases/
may09/sec050709.pdf, at 1-2.
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These developments indicate that investment advisers may be playing
an increasing role in pay to play activities. We therefore believe it
is time for us to act with respect to investment advisers who may
engage in such activities.\45\
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\45\ Another reason we believe it is important for us to act is
because pay to play practices are characterized by what the Blount
court called a ``collective action problem [that tends] to make the
misallocation of resources persist.'' Blount, supra note 16 at 945-
46. Elected officials that accept contributions from State
contractors may believe they have an advantage over their opponents
that forswear the contributions, and firms that do not ``pay'' may
fear they will lose government business to those that do. See id.
See generally Mancur Olson, The Logic of Collective Action; Public
Goods and the Theory of Groups 44 (17th ed. 1998) (group members
that seek to maximize their individual personal welfare will not act
to advance common objectives absent coercion or other incentive).
See also Paul Jacobs, Donations to Pension Officials Scrutinized;
Politics: Connell, Fong Say They Are not Influenced by Contributions
from Firms Doing Business with State Systems, L.A. Times, Aug. 21,
1997, at A41 (fund contractor quoted as saying, ``[i]f you don't
contribute, you're subject to the concern that others might make
contributions'').
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[[Page 39844]]
Section 206(1) of the Advisers Act prohibits an investment adviser
from ``employ[ing] any device, scheme, or artifice to defraud any
client or prospective client.'' \46\ Section 206(2) prohibits advisers
from engaging in ``any transaction, practice or course of business
which operates as a fraud or deceit on any client or prospective
client.'' \47\ The Supreme Court has construed section 206 as
establishing a Federal fiduciary standard governing the conduct of
advisers.\48\
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\46\ 15 U.S.C. 80b-6(1).
\47\ 15 U.S.C. 80b-6(2).
\48\ Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11,
17 (1979); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,
191-192 (1963).
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Investment advisers that seek to influence the award of advisory
contracts by public pension plans, by making political contributions to
or soliciting them for those officials who are in a position to
influence the awards, compromise their fiduciary obligations to the
public pension plans.\49\ In making such contributions, the adviser
hopes to benefit from officials that ``award the contracts on the basis
of benefit to their campaign chests rather than to the governmental
entity.'' \50\ If pay to play is a factor in the selection process, the
public pension plan can be harmed in several ways. The most qualified
adviser may not be selected, potentially leading to inferior
management, diminished returns or greater losses. The pension plan may
pay higher fees because advisers must recoup the contributions, or
because contract negotiations may not occur on an arm's-length basis.
The absence of arm's-length negotiations may enable advisers to obtain
greater ancillary benefits, such as ``soft dollars,'' from the advisory
relationship, which may be directed for the benefit of the adviser,
potentially at the expense of the pension plan, thereby using a pension
plan asset for the adviser's own purposes.\51\
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\49\ See 1999 Proposing Release, supra note 17, at 3. As a
fiduciary, an adviser has a duty to deal fairly with clients and
prospective clients, and must make full disclosure of any material
conflict or potential conflict. See, e.g., Capital Gains Research
Bureau, 375 U.S. at 189, 191-192; Release 1092, supra note 7. Most
public pension plans establish procedures for hiring investment
advisers, the purpose of which is to obtain the best possible
management services. When an adviser makes political contributions
for the purpose of influencing the selection of the adviser to
advise a public pension plan, the adviser seeks to interfere with
the merit-based selection process established by its prospective
clients--the public pension plan. The contribution creates a
conflict of interest between the adviser (whose interest is in being
selected) and its prospective client (whose interest is in obtaining
the best possible management services). Even if the conflict was
acknowledged and disclosed by the adviser, disclosure may not be
effective in protecting the plan from harm. Disclosure to the
trustee or board of trustees may be futile in protecting the plan
since the trustees may be similarly conflicted, having accepted the
contribution. Disclosure to beneficiaries may also be inadequate as
they may be unable to act on the disclosure--beneficiaries generally
cannot fire the adviser or find another pension plan.
\50\ See Blount, supra note 16, at 944-45.
\51\ Cf. In re Performance Analytics, et al., Investment
Advisers Act Release No. 2036 (June 17, 2002) (settled enforcement
action in which an investment consultant for a union pension fund
entered into a $100,000 brokerage arrangement with a soft dollar
component in which the investment consultant would continue to
recommend the investment adviser to the pension fund as long as the
investment adviser sent its trades to one particular broker-dealer).
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We believe that play to play is inconsistent with the high
standards of ethical conduct required of fiduciaries under the Advisers
Act. We have authority under section 206(4) of the Act to adopt rules
``reasonably designed to prevent, such acts, practices, and courses of
business as are fraudulent, deceptive or manipulative.'' \52\ Congress
gave us this authority to prohibit ``specific evils'' that the broad
anti-fraud provisions may be incapable of covering.\53\ The provision
thus permits the Commission to adopt prophylactic rules that may
prohibit acts that are not themselves fraudulent.\54\ As noted above,
pay to play practices are rarely explicit and often hard to prove,
which makes a prophylactic rule particularly appropriate.\55\ We are
today proposing new rule 206(4)-5 under the Advisers Act designed to
eliminate adviser participation in pay to play practices.
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\52\ 15 U.S.C. 80b-6(4).
\53\ S. Rep. No. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The
Commission has used this authority to adopt seven rules addressing
abusive advertising practices, custodial arrangements, the use of
solicitors, required disclosures regarding the adviser's financial
condition and disciplinary history, proxy voting, compliance
procedures and practices, and deterring fraud with respect to pooled
investment vehicles. 17 CFR 275.206(4)-1; 275.206(4)-2; 275.206(4)-
3; 275.206(4)-4; 275.206(4)-6; 275.206(4)-7; and 275.206(4)-8.
\54\ Section 206(4) was added to the Advisers Act in Public Law
86-750, 74 Stat. 885 (1960) at sec. 9. See H.R. Rep. No. 2197, 86th
Cong., 2d Sess. (1960) at 7-8 (``Because of the general language of
section 206 and the absence of express rulemaking power in that
section, there has always been a question as to the scope of the
fraudulent and deceptive activities which are prohibited and the
extent to which the Commission is limited in this area by common law
concepts of fraud and deceit * * * [Section 206(4)] would empower
the Commission, by rules and regulations to define, and prescribe
means reasonably designed to prevent, acts, practices, and courses
of business which are fraudulent, deceptive, or manipulative. This
is comparable to Section 15(c)(2) of the Securities Exchange Act [15
U.S.C. 78o(c)(2)] which applies to brokers and dealers.''). See also
S. Rep. No. 1760, 86th Cong., 2d Sess. (1960) at 8 (``This [section
206(4) language] is almost the identical wording of section 15(c)(2)
of the Securities Exchange Act of 1934 in regard to brokers and
dealers.''). The Supreme Court, in United States v. O'Hagan,
interpreted nearly identical language in section 14(e) of the
Securities Exchange Act [15 U.S.C. 78n(e)] as providing the
Commission with authority to adopt rules that are ``definitional and
prophylactic'' and that may prohibit acts that are ``not themselves
fraudulent * * * if the prohibition is `reasonably designed to
prevent * * * acts and practices [that] are fraudulent.''' United
States v. O'Hagan, 521 U.S. 642, at 667, 673 (1997). The wording of
the rulemaking authority in section 206(4) remains substantially
similar to that of section 14(e) and section 15(c)(2) of the
Securities Exchange Act. See also Prohibition of Fraud by Advisers
to Certain Pooled Investment Vehicles, Investment Advisers Act
Release No. 2628 (Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)]
(stating, in connection with the suggestion by commenters that
section 206(4) provides us authority only to adopt prophylactic
rules that explicitly identify conduct that would be fraudulent
under a particular rule, ``We believe our authority is broader. We
do not believe that the commenters' suggested approach would be
consistent with the purposes of the Advisers Act or the protection
of investors.'').
\55\ Cf. Blount, supra note 16 at 945 (``no smoking gun is
needed where, as here, the conflict of interest is apparent, the
likelihood of stealth great, and the legislative purpose
prophylactic'').
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II. Discussion
A. Rule 206(4)-5: ``Pay To Play'' Restrictions
The rule we are proposing today is designed to protect public
pension plans from the consequences of pay to play practices by
preventing advisers' participation in such practices. As a result,
advisers and government officials may attempt to structure their
transactions in a manner intended to hide the true purpose of a
contribution or a payment. For that reason, our proposed pay to play
restrictions would capture not only direct political contributions by
advisers, but also other ways that advisers may engage in pay to play
arrangements. Rule 206(4)-5 would accomplish this through three
measures. First, the rule would make it unlawful for an adviser to
receive compensation for providing advisory services to a government
entity for a two-year period after the adviser or any of its covered
associates makes a political contribution to a public official of a
government entity that is in a position to influence the award of
advisory business.\56\
[[Page 39845]]
Proposed rule 206(4)-5 would not, therefore, ban or limit the amount of
political contributions an adviser or its covered associates could
make; rather, it would impose a two-year ``time out'' on conducting
compensated advisory business with a government client after a
contribution is made. This aspect of the proposed rule is modeled on
MSRB rule G-37 and is consistent with our 1999 proposal.
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\56\ Proposed rule 206(4)-5(a)(1) states: ``As a means
reasonably designed to prevent fraudulent, deceptive or manipulative
acts, practices, or courses of business within the meaning of
section 206(4) of the Act [15 U.S.C. 80b-6(4)], it shall be
unlawful: (1) For any investment adviser registered (or required to
be registered) with the Commission, or unregistered in reliance on
the exemption available under section 203(b)(3) of the Advisers Act
[15 U.S.C. 80b-3(b)(3)], to provide investment advisory services for
compensation to a government entity within two years after a
contribution to an official of the government entity is made by the
investment adviser or any covered associate of the investment
adviser (including a person who becomes a covered associate within
two years after the contribution is made).''
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Second, the rule would prohibit advisers from paying third parties
to solicit government entities for advisory business.\57\ That is, an
adviser would be prohibited from providing or agreeing to provide,
directly or indirectly, payment to any person who is not a related
person of the adviser for solicitation of government advisory business
on behalf of such adviser. This aspect of our proposed rule is modeled
on MSRB rule G-38.\58\ Third, the rule would also make it unlawful for
an adviser itself or through any of its covered associates to solicit
or to coordinate contributions for an official of a government entity
to which the investment adviser is seeking to provide investment
advisory services, or payments to a political party of a State or
locality where the investment adviser is providing or seeking to
provide investment advisory services to a government entity. MSRB rule
G-37 contains a similar prohibition, as did our 1999 proposal.\59\
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\57\ Proposed rule 206(4)-5(a)(2)(i).
\58\ MSRB rule G-38 was amended in 2005 to prohibit municipal
securities dealers from paying third-party solicitors to solicit
municipal securities business. In the Matter of Self-Regulatory
Organizations; Municipal Securities Rulemaking Board; Order
Approving Proposed Rule Change and Notice of Filing and Order
Granting Accelerated Approval to Amendment No. 1 to the Proposed
Rule Change Relating to Solicitation of Municipal Securities
Business under MSRB Rule G-38, Exchange Act Release No. 52278 (Aug.
17, 2005) [70 FR 49342 (Aug. 23, 2005)]. Our 1999 proposal did not
include an analogous prohibition.
\59\ See MSRB rule G-37(c); 1999 Proposing Release, supra note
17, at section II.A.2.
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We recognize that we cannot anticipate all of the ways advisers and
government officials may structure pay to play arrangements to attempt
to evade the prohibitions of our proposed rule. For that reason, we are
also proposing to include a provision that would make it unlawful for
an adviser or any of its covered associates to do anything indirectly
which, if done directly, would result in a violation of the proposed
rule. Finally, for purposes of the proposed rule, an investment adviser
to certain pooled investment vehicles in which a government entity
invests or is solicited to invest would be treated as though the
adviser were providing or seeking to provide investment advisory
services directly to the government entity.
Although today's proposal is similar to the one we made in 1999, we
are proposing a few critical changes in response to intervening
developments that we highlight in the discussion below. We have made
these changes to conform our proposal to measures undertaken in recent
years to curtail pay to play activities by the MSRB and various State
and local authorities and to deter circumvention of the restrictions
through the use of third-party placement agents or through an adviser
obtaining government clients indirectly by soliciting investment in
funds it manages.
1. Advisers Subject to the Rule
Proposed rule 206(4)-5 would apply to any investment adviser
registered (or required to be registered) with the Commission, or
unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act [15 U.S.C. 80b-3(b)(3)].\60\ We are
including this category of exempt advisers within the scope of the rule
in order to make the rule applicable to the many advisers to private
investment companies that are not registered under the Advisers
Act.\61\ The rule would not apply, however, to most small advisers that
are registered with the State securities authorities,\62\ and certain
other advisers that are exempt from registration with us.\63\ We
believe that the rule would apply to most advisers to public pension
plans.\64\ We request comment on the scope of the proposed rule. Should
we apply the rule to State-registered advisers? Should we limit the
rule only to advisers registered (or required to be registered) with
us? Should we apply the rule to advisers that are exempt from
registration in reliance on Advisers Act section 203(b)(3)? We request
comment on whether we should extend the scope of the rule to apply to
advisers exempt from registering with us pursuant to any or all of the
other categories under Advisers Act section 203(b). For example, should
we include advisers exempt from registration pursuant to any or all of
Advisers Act sections 203(b)(1) (intrastate advisers), 203(b)(2)
(advisers with only insurance company clients), 203(b)(4) (investments
advisers that are charitable organizations), 203(b)(5) (advisers that
are plans described in section 414(e) of the Internal Revenue Code of
1986 or certain persons associated with such plans), or 203(b)(6)
(certain commodity trading advisors)? \65\ To the extent that they are
able to have government clients at all, are any of these advisers
likely to engage in pay to play?
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\60\ Proposed rule 206(4)-5(a)(1) and (2). Section 203(b)(3) [15
U.S.C. 80b-3(b)(3)] exempts from registration any investment adviser
that is not holding itself out to the public as an investment
adviser and had fewer than 15 clients during the last 12 months.
\61\ See discussion infra section II.A.3(e).
\62\ Section 203A of the Advisers Act [15 U.S.C. 80b-3A]
prohibits investment advisers with less than $25 million in assets
under management from registering with the Commission; although we
do not propose to include them within the coverage of this rule,
they remain subject to the Act's general anti-fraud authority. See,
e.g., Rules Implementing Amendments to the Investment Advisers Act
of 1940, Investment Advisers Act Release No. 1633, n.154 and
accompanying text (May 15, 1997) [62 FR 28112 (May 22, 1997)]
(``Both the Commission and the States will be able to continue
bringing antifraud actions against investment advisers regardless of
whether the investment adviser is registered with the State or the
SEC.''). See also S. Rep. No. 293, 104th Cong., 2d Sess. 3-4 (1996)
(``1996 Senate Report'') at 4.
\63\ See, e.g, exemption for intrastate investment advisers
under section 203(b)(1) [15 U.S.C. 80b-3(b)(1)].
\64\ With the exception of the exemption from registration
provided for by section 203(b)(3) [15 U.S.C. 80b-3(b)(3)], advisers
that are exempt from SEC registration are unlikely to have State or
municipal government clients as providing advisory services to them
would result in the adviser no longer being eligible for the
exemption, e.g., section 203(b)(2) [15 U.S.C. 80b-3(b)(2)] and
section 203(b)(4) [15 U.S.C. 80b-3(b)(4)]. Moreover, based on a
review of a sampling of requests for proposals from State and
municipal governments for investment advisory services, a common
requirement is that the adviser be registered with the SEC or a
State. See, e.g., Request for Information Vermont Pension Investment
Committee--Vermont Manager Program RFI (Feb. 27, 2009) (stating that
eligible investment advisers must be SEC-registered with at least
$100 million in assets under management), available at: http://
www.vermonttreasurer.gov/documents/rfp/20090316_
VPICVermontManagerProgram.pdf. It also is our understanding from
discussions with representatives of the State securities regulators
that a very small percentage of State-registered advisers have State
or municipal government clients.
\65\ Our 1999 proposed rule would have applied to all investment
advisers not prohibited from registering with the Commission. See
1999 Proposing Release, supra note 17.
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We note that proposed rule 206(4)-5 would regulate the activities
of investment advisers--business organizations over which we have clear
regulatory authority under the Advisers Act. The rule would have no
effect on State laws, codes of ethics or other rules governing the
activities of State and municipal officials or employees of
[[Page 39846]]
public pension plans over whom we have no regulatory jurisdiction.\66\
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\66\ A number of commenters in 1999, including those
representing State and local officials, argued that the rule would
be an intrusion on State sovereignty. We disagree. We have a
responsibility to regulate the activities of investment advisers.
Our objectives in the proposed rule do not relate to campaign
finance, but rather to prohibiting fraudulent activity by investment
advisers. We believe our proposed rule is appropriately tailored to
those ends.
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2. Relationship With MSRB Rules; Alternative Approaches
As discussed above, we modeled proposed rule 206(4)-5 on MSRB rules
G-37 and G-38, which we believe have successfully addressed pay to play
in the municipal bond market. This approach should minimize the
compliance burdens on firms that would be subject to both rule regimes
because firms that are already subject to MSRB rules would already have
developed policies and systems for compliance that could be adapted to
meet investment adviser requirements. Certain provisions of our
proposed rule, however, are somewhat different in ways that reflect the
different statutory framework under which the rule would be adopted and
the differences between municipal underwriting and asset management.
Comment is requested on whether we should use rules G-37 and G-38 as
the models for proposed rule 206(4)-5.\67\ If not, are there
alternative models that would be more appropriate? Are there
significant differences in governments' selection process for municipal
underwriters and investment advisers that we have not addressed but
that should be reflected in the rule? Would our approach adequately
protect public pension plans, their sponsors and participants against
the adverse effects of pay to play practices?
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\67\ For instance, in 1999, we requested comment on our use of
MSRB rule G-37 as a model, and several commenters responded that,
because of distinctions between the investment adviser profession
and the municipal securities industry, we should not follow the
approach of MSRB rule G-37. Some commenters asserted that, unlike
municipal underwriters, advisers' business relationships with State
and municipal clients are ongoing and long-term and thus the two-
year ban is much more harsh a consequence. While municipal
underwritings themselves tend to be episodic, underwriting
relationships are often longstanding. As a result, the rules' time
outs may have similar effects.
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We understand many advisers have established restrictions on pay to
play practices in their codes of ethics and compliance policies.
Instead of, or in addition to, adopting a new rule to address pay to
play practices, should we amend our code of ethics rule \68\ or our
compliance rule \69\ to require all registered advisers to adopt
policies and procedures designed to prevent them from engaging in pay
to play practices? \70\ Should we instead, or also, require an
executive officer of each adviser to certify annually that the adviser
or its covered associates did not participate in pay to play? Should
some other employee of the adviser, such as the chief compliance
officer, make the certification?
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\68\ Rule 204A-1 under the Advisers Act [17 CFR 275.204A-1].
\69\ Rule 206(4)-7 under the Advisers Act [17 CFR 275.206(4)-7].
\70\ Some commenters in 1999 suggested that the better approach
would be to require advisers to adopt codes of ethics designed to
prevent pay to play practices. The Investment Counsel Association of
America (subsequently renamed the Investment Advisers Association)
submitted to the comment file relating to our 1999 proposal ``Best
Practice Pay-to-Play Guidelines for Adviser Codes of Ethics,''
advocating such an approach as an alternative to our 1999 proposal.
See http://www.sec.gov/rules/proposed/s71999/tittswo2.htm. The ICAA
offered the following three alternative policies on political
contributions, and suggested that advisers should tailor these
policies to fit their respective circumstances: (1) A contribution
ban above a certain de minimis amount (either with respect to all
political contributions or ones that fall within certain specified
parameters); (2) a pre-clearance process for contributions; or (3) a
disclosure policy with respect to contributions. At that time, codes
of ethics were voluntary. However, in 2004, the Commission adopted a
requirement that advisers adopt and implement codes of ethics that
include a standard of conduct that reflects the adviser's fiduciary
obligations, although the code of ethics rule does not directly
address pay to play practices. See Advisers Act rule 204A-1 [17 CFR
275.204A-1]; Investment Adviser Codes of Ethics, Investment Advisers
Act Release No. 2256 (July 2, 2004) [69 FR 41696 (July 9, 2004)].
See also Investment Counsel Association of America, Report on Pay-
to-Play and the Investment Advisory Profession (May 15, 2000),
available at http://www.investmentadviser.org/eweb/docs/
Publications_News/PublicDocs_UsefulWebsites/PubDoc/report
(condemning practices by which investment professionals try to gain
access to business through political contributions, and urging its
members to adopt codes of ethics designed to prevent pay to play).
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In 1999, we considered proposing a different approach to address
pay to play, which would have required an adviser to disclose
information about its political contributions to officials of
government entities to which it provided or was seeking to provide
investment advisory services. We decided not to propose such an
approach at that time because we thought that disclosure would not be
effective to protect public pension plan clients.\71\ Disclosure to a
pension plan's trustees might be insufficient because, in some cases,
the trustees would have received the contributions. Disclosure to plan
beneficiaries also would likely be insufficient because they are
generally unable to act on the information by moving their pension
assets to a different plan or reversing adviser hiring decisions.
Moreover, disclosure requirements may not stop pay to play practices
and can be circumvented.\72\ Accordingly, we do not believe that
relying on disclosure is sufficient to address these problematic
practices.\73\ We request comment on whether we should, nonetheless,
consider this approach, as well as potential alternative approaches
that may be more effective or less costly.
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\71\ In response to our 1999 Proposal, some commenters suggested
requiring advisers to disclose publicly their contributions to State
and local officials. Statutes requiring disclosure of political
contributions are designed to inform voters about a candidate's
financial supporters; an informed electorate can then use the
information to vote for or against a candidate. But, as several
other commenters correctly pointed out, our goal is not campaign
finance reform, and how voters might react to such disclosure is
not, for us, the relevant concern. Our primary concern is the
protection of advisory clients and investors who are affected by pay
to play practices whom we have the responsibility to protect under
the Advisers Act.
\72\ See infra note 158 and accompanying text regarding swap
arrangements that may be used to circumvent public disclosure.
\73\ MSRB rule G-37, however, does establish a reporting and
disclosure system for broker-dealers subject to that rule. MSRB rule
G-37(e)(ii).
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3. Pay To Play Restrictions
(a) Two-Year ``Time Out'' for Contributors
Proposed rule 206(4)-5(a)(1) would prohibit investment advisers
from providing advice for compensation to a ``government entity'' \74\
within two years after a ``contribution'' to an ``official'' of the
government entity has been made by the investment adviser or by any of
its ``covered associates.'' \75\ We are proposing that the time out be
two years long because the duration needs to be sufficiently long to
have a deterrent effect. We recognize, however, that a longer ban could
be overly harsh.\76\ We note that MSRB rule G-37 contains a two-year
time out, which appears, based on the success of the MSRB rules, to
have operated as an effective deterrent
[[Page 39847]]
in the municipal securities context.\77\ We request comment on whether
two years is an appropriate length of time.\78\
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\74\ ``Government entity'' is defined by the proposed rule as
``any State or political subdivision of a State, including any
agency, authority, or instrumentality of the State or political
subdivision, a plan, program, or pool of assets sponsored or
established by the State or political subdivision or any agency,
authority or instrumentality thereof; and officers, agents, or
employees of the State or political subdivision or any agency,
authority or instrumentality thereof, acting in their official
capacity.'' Proposed rule 206(4)-5(f)(5).
\75\ Proposed rule 206(4)-5(a)(1).
\76\ We note that, notwithstanding the proposed duration of the
rule's ``time out''--two years--the reach of the time out is
relatively narrow in the sense that it only prohibits advisers from
receiving compensation for providing advice from the particular
government entities to whose officials triggering contributions have
been made. It does not limit the adviser from receiving compensation
from other government entities as to which triggering contributions
have not been made.
\77\ See supra note 24. Several commenters in 1999 suggested
that, because advisers' business relationships with State and
municipal clients are ongoing and long-term, as compared to the
relationships between municipal underwriters and their clients, the
two-year ban is much more harsh a consequence. As we note above,
while municipal underwritings themselves tend to be episodic,
underwriting relationships are often longstanding, which may result
in the rules' time outs having similar effects. See supra note 67.
\78\ Some commenters in 1999 objected to two years as being too
long a period of time (arguing, for example, that because changing
investment advisers can be so disruptive to a pension fund that such
a fund would be extremely unlikely to return to an adviser after a
``time out,'' thereby rendering the two-year ban tantamount to a
permanent one), whereas others suggested that the period be longer
or that it track the remainder of the term of the government
official to whom the contribution was made.
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(1) Prohibition on Compensation
Investment advisers making contributions covered by the proposed
rule would not be prohibited from providing advisory services to a
government client, even after triggering the two-year time out.
Instead, an adviser would be prohibited from receiving compensation for
providing advisory services to the government client during the time
out. This approach is intended to avoid requiring an adviser to abandon
a government client after the adviser or any of its covered associates
makes a political contribution covered by the rule. An adviser subject
to the prohibition would likely, at a minimum, be obligated to provide
(uncompensated) advisory services for a reasonable period of time \79\
until the government client finds a successor to ensure its withdrawal
did not harm the client, or the contractual arrangement between the
adviser and the government client might obligate the adviser to
continue to perform under the contract at no fee.\80\ We request
comment on our proposed approach. Is there another approach that would
cause less disruption to the government client?
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\79\ Some commenters in 1999 indicated concern that government
entities that retain advisers who trigger the two-year time out--and
would therefore be unable to receive compensation for two years--
might try to delay an adviser's ability to withdraw in order to
enjoy the benefits of investment advice for free. We believe that
while an adviser's fiduciary obligations require it to act in the
best interests of its clients, they do not require it to provide
uncompensated advice indefinitely because it is prohibited from
receiving compensation under the rule--rather, the adviser may need
to continue to provide advice for only a reasonable period of time.
\80\ An investment adviser that violates the rule may be
required, under its fiduciary duties, to continue providing advisory
services to the public pension plan, for a reasonable period of
time, until the plan obtains a new adviser. See Temporary Exemption
for Certain Investment Advisers, Investment Advisers Act Release No.
1846 (Nov. 29, 1999) [64 FR 68019, 68024 (Dec. 6, 1999)] (describing
an investment adviser's fiduciary duties to an investment company in
the case of an assignment of the advisory contract).
We note that the two-year time out in MSRB rule G-37 operates to
prohibit a broker, dealer or municipal securities dealer from
engaging in all municipal securities business; it does not
distinguish between providing compensated and uncompensated
services. MSRB Rule G-37(b)(i). See also MSRB Rule G-37 Interpretive
Notices, Interpretation of Prohibition on Municipal Securities
Business Pursuant to Rule G-37 (Feb. 21, 1997) (determining that
once a dealer enters into contract and a subsequent contribution
results in a prohibition, the dealer ``should not be allowed to
continue with the municipal securities business, subject to an
orderly transition to another entity to perform such business'').
But see infra note 189 (discussing MSRB's approach to transitions in
the context of pre-existing engagements relating to municipal fund
securities, such as interests in Section 529 plans).
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(2) Officials of a Government Entity
The prohibitions in the rule would be triggered by a contribution
to an ``official'' of a ``government entity.'' Government entities
under the proposed rule include all State and local governments, their
agencies and instrumentalities, and all public pension plans and other
collective government funds.\81\ An official would include an
incumbent, candidate or successful candidate for elective office of a
government entity if the office is directly or indirectly responsible
for, or can influence the outcome of, the selection 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
selection of an investment adviser.\82\ Generally, executive or
legislative officers who hold a position with influence over the hiring
of an investment adviser are government officials under the proposed
rule.\83\ These definitions are substantively the same as those in MSRB
rule G-37.\84\
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\81\ See supra note 74.
\82\ Proposed rule 206(4)-5(f)(6). The two-year time out would
be triggered by contributions, not only to elected officials who
have legal authority to hire or select the adviser, but to elected
officials (such as persons with appointment authority) who can
influence the hiring of the adviser. A person who serves at the will
of an elected official is likely to be subject to that official's
influences and recommendations. We note that MSRB rule G-37 also
applies to elected officials empowered to appoint persons with the
authority to select which broker-dealers will receive government
business.
\83\ It is the scope of authority of the particular office of an
official, not the influence actually exercised by the individual,
that would determine whether the individual has influence over the
awarding of an investment advisory contract under the definition.
\84\ See MSRB rule G-37(g)(ii) and (g)(vi).
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We request comment on our proposed definition of ``official.'' For
instance, a candidate for Federal office may be an ``official'' under
the rule, just as such a person may be under MSRB rule G-37, not
because of the office he or she is running for, but as a result of an
office he or she currently holds.\85\ As a preliminary matter, we do
not believe that an incumbent State or local official should be
excluded from the definition solely because he or she is running for
Federal office, but we request comment on this aspect of the proposed
rule. Should such a candidate for Federal office be excluded? \86\ Are
there other persons to whom an adviser or its covered associates might
make a contribution to influence the selection of that adviser? For
example, should we expand the rule's prohibitions to apply expressly in
cases where an adviser or a covered associate gives a contribution to
others closely associated with the official--such as an official's
political action committee (``PAC''), his or her inauguration or
transition committee,\87\ a local or State political party that
provides assistance to such official,\88\ or
[[Page 39848]]
a foundation or other charitable institution associated with such
official? \89\
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\85\ Proposed rule 206(4)-5(f)(6), in relevant part, defines
``official'' as any person * * * who was, at the time of the
contribution, an incumbent, candidate or successful candidate for
elective office of a government entity * * *, '' and a ``government
entity,'' in relevant part, as ``any State or political subdivision
of a State'' (emphasis added). Accordingly, any person, including a
person running for Federal office, who meets the definition of
``official'' would be covered under the rule. See also MSRB rule G-
37(g)(ii) and (g)(vi) (defining ``issuer'' and ``official of an
issuer'', respectively); MSRB Qs & As, Question IV.2 and IV.3,
available at http://www.msrb.org/msrb1/rules/QAG-372003.htm
(explaining how G-37 applies to candidates for Federal office).
\86\ Some 1999 commenters urged that contributions to candidates
for Federal office be excluded from the rule, while others agreed
these contributions should be covered. In particular, certain
commenters asserted that this aspect of the proposed rule would have
a disparate effect on candidates for Federal office because State
and local politicians would experience limitations on their ability
to receive Federal campaign contributions while their opponents
would be subject to no such limitations. These commenters also
claimed the rule would have little effect because if the candidate
for Federal office was successful, he or she would quickly lose his
or her ability to influence the selection of an investment adviser
at the State or local level. Other commenters thought it appropriate
that the rule apply to candidates for Federal office. As noted
above, our emphasis in the proposed rule remains on the current
office of an elected official and his or her ability to affect the
selection of an investment adviser, regardless of what outside
positions that official may seek.
\87\ A contribution to an official, as opposed to a committee,
for inauguration or transition expenses would be a contribution
under the proposed rule. See infra note 93 and accompanying text.
This approach is consistent with the approach in MSRB rule G-37. We
are proposing a similar approach for reasons of regulatory
consistency; nonetheless, we have included this request for comment
on whether we should include contributions to such committees.
\88\ Under the proposed rule, such contributions or payments by
an adviser (or its covered associates) would only trigger the rule's
provisions to the extent that an adviser was trying to do indirectly
what it is prohibited from doing directly. See infra section
II.A.3(d) of this Release. In contrast, the prohibition on advisers
soliciting contributions or payments from others in proposed rule
206(4)-5(a)(2)(ii) would expressly include payments to a political
party of a State or locality where the investment adviser is
providing or seeking to provide investment advisory services to a
government entity. See infra section II.A.3(c) of this Release.
Further, our proposed amendments to rule 204-2 (in particular, rule
204-2(a)(18)(i)(D)) would expressly include a requirement that an
adviser subject to the rule make and keep records of, among other
things, all direct or indirect contributions or payments made by the
investment adviser or any of its covered associates to a political
party of a State or political subdivision thereof. Our proposed
approach to these provisions generally tracks the MSRB approach.
\89\ For a discussion of associated recordkeeping requirements,
see infra note 206 and accompanying text.
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(3) Contributions
The proposed rule covers ``contributions'' made by an investment
adviser and its covered associates. The proposed rule uses the same
definition of contribution as MSRB rule G-37.\90\ A contribution would
generally be any gift, subscription, loan, advance, deposit of money,
or anything of value \91\ made for the purpose of influencing an
election for a Federal, State or local office, including any payments
for debts incurred in such an election.\92\ It would also include
transition or inaugural expenses incurred by a successful candidate for
State or local office.\93\ We request comment on our proposed
definition of ``contribution.'' \94\ Are there additional items of
value that, as with transitional or inaugural expenses, should be
specified in and covered by the definition? For instance, should we
include the expenses an investment adviser would incur in organizing or
sponsoring a conference at which a government official is invited to
attend or is a speaker? \95\ If so, how should our rule distinguish
legitimate conferences or meetings from those that are more akin to
fundraising events? \96\ Are there items that should be excluded from
the definition?
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\90\ MSRB rule G-37(g)(i).
\91\ Commenters to our 1999 proposal raised concerns that
volunteer campaign work by advisory employees could trigger the
proposed rule's time out provision. We would not consider volunteer
campaign work by an individual to be a contribution, provided the
adviser has not solicited the individual's efforts and the adviser's
resources, such as office space, are not used. Cf. MSRB Qs & As,
Question II.12, available at http://www.msrb.org/msrb1/rules/QAG-
372003.htm.
\92\ Proposed rule 206(4)-5(f)(1). Commenters in 1999 expressed
concern that the scope of our proposed rule was too broad. These
commenters, many of whom represented investment advisers, raised
concerns that the rule as proposed could unnecessarily restrict
their employees from making any political contributions. Some
commenters questioned the constitutionality of our proposal, arguing
that the proposed rule would violate First Amendment protections for
free speech. In Blount, supra note 16, a Federal appeals court
upheld a First Amendment challenge to MSRB rule G-37. The Court left
open the question of the appropriate level of scrutiny to be
applied, but concluded that the rule satisfied even a strict
scrutiny test. We believe that the rule we are proposing today
similarly is consistent with the First Amendment. Absent provisions
to limit the application of the rule's prohibitions, it could result
in frequent inadvertent violations that would carry harsh
consequences for advisers. Accordingly, we refined the categories of
persons whose personal political contributions would be covered
under the rule and provided for a self-executing exception that
should prevent many inadvertent violations. We believe these changes
will address many of the commenters' concerns about the rule we
proposed in 1999.
\93\ Proposed rule 206(4)-5(f)(1)(iii). Transition or inaugural
expenses of a successful candidate for Federal office are not
included. Contributions to political parties are not specifically
covered by the definition and thus would not trigger the proposed
rule's two-year timeout unless they are a means to do indirectly
what the proposed rule would prohibit if done directly (for example,
the contributions are earmarked or known to be provided for the
benefit of a particular political official). See proposed rule
206(4)-5(d). Contributions to State and local political parties are,
however, subject to the proposed rule's recordkeeping requirements.
See infra section II.B and proposed rule 204-2(a)(18)(i)(D).
\94\ Commenters in 1999 urged us to adopt a rule prohibiting
only political contributions intended to influence, or made for the
purpose of influencing, adviser selection. This approach, they
argued, would eliminate the risk that innocent campaign
contributions would trigger application of the ``two-year time
out.'' Political contributions are made ostensibly to support a
candidate, however, and the burden of proving a different intent is
very difficult absent unusual evidence. As one court noted, ``actors
in this field are presumably shrewd enough to structure their
relations rather indirectly.'' Blount, supra note 16. As a result,
requiring proof of such an intent would greatly diminish, if not
eliminate, the prophylactic value of the proposed rule.
\95\ Under the proposed rule, an adviser would be prohibited
from soliciting contributions for the official. Proposed rule
206(4)-5(a)(2)(ii).
\96\ Cf. Supervision When Sponsoring Meetings and Conferences
Involving Issuer Officials, MSRB Rule G-37 Interpretive Notice (Mar.
26, 2007), available at http://www.msrb.org/msrb1/rules/notg37.htm
(rather than addressing meetings and conferences of this nature in
its rules directly, the MSRB applies a facts-and-circumstances test
on a case-by-case basis).
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(4) Covered Associates
Contributions made to influence the selection process are typically
made not by the firm itself, but by officers and employees of the firm
who have a direct economic stake in the business relationship with the
government client. For this reason, MSRB rule G-37 limits its
prohibitions to contributions made by ``municipal finance
professionals'' employed by a broker-dealer. No group analogous to
municipal finance professionals, however, exists within the typical
investment advisory firm. In many of the pay to play enforcement
actions we have brought involving investment advisers, we have alleged
that political contributions or other payments were made to influence
the selection of the advisory firm by executives of the adviser or
persons who solicit government clients on behalf of the adviser.\97\ We
therefore are proposing to limit application of the rule's ``time out''
provision to contributions made by the adviser and its ``covered
associates,'' which would include the adviser's general partners,
managing members, executive officers, or other individual with a
similar status or function.\98\ Any employee of the
[[Page 39849]]
adviser who solicits \99\ government entity clients for the investment
adviser would also be a covered associate,\100\ as would any PAC
controlled by the investment adviser or any of the adviser's covered
associates.\101\
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\97\ See, e.g., In the Matter of Barrett N. Wissman, Investment
Advisers Act Release No. 2879 (May 22, 2009) (in a settled action,
the Commission alleged that managing director of registered
investment adviser engaged in a fraudulent scheme involving
undisclosed kickback payments made by investment management firms
and others in connection with the sale of securities to the New York
Common Retirement Fund and the investment of the fund's assets in
the purchase and sale of securities); In the Matter of Thayer
Capital Partners, TC Equity Partners IV, L.L.C., TC Management
Partners IV, L.L.C., and Frederick V. Malek, Investment Advisers Act
Release No. 2276 (Aug. 12, 2004) (in a settled action, the
Commission alleged that unregistered adviser, through its chairman,
agreed to hire an inexperienced associate of the Connecticut
Treasurer as a consultant as a condition to securing a State pension
fund investment); In the Matter of Frederick W. McCarthy, Investment
Advisers Act Release No. 2218 (Mar. 5, 2004) (in a settled action,
the Commission alleged that principal and chairman of investment
management firm provided $2 million in consulting contracts to
associates of the Connecticut Treasurer in order to secure the
Treasurer's decision to invest). We have also observed this pattern
of contributions in pay to play arrangements in other contexts,
including those involving union pension funds. See, e.g., In the
Matter of William M. Stephens, Investment Advisers Act Release No.
2076 (Nov. 4, 2002) (in a settled action, the Commission alleged
that executive vice president and chief investment strategist of
registered investment adviser met with people who offered to
introduce him to the trustees of union pension funds, and he agreed
that after he and his firm became the funds' adviser, he would
arrange to divert a portion of the funds into investments controlled
by the people who made the introductions, who would, in turn, pay
kickbacks to the pension fund trustees who hired him and his firm);
In the Matter of Chris Woessner, Investment Advisers Act Release No.
2164 (Aug. 26, 2003) (Commission alleged that former vice president
of sales at registered investment adviser who was in charge of
marketing to pension plans caused his firm to direct client
commissions for the benefit of a broker-dealer and pension
consultant in exchange for the referral of a union pension fund
client to the firm).
\98\ Proposed rule 206(4)-5(f)(2)(i). Under our 1999 proposal,
the rule would have applied more broadly to ``partners'' (not just a
general partner or equivalent) and ``executive officers'' (which we
proposed to define as ``the president, any vice president in charge
of a principal business unit, division or function (such as sales,
administration or finance), any other officer who performs a policy-
making function, or any other person who performs similar policy-
making functions, for the investment adviser''). See 1999 Proposing
Release, supra note 17, at section II.A.1. Commenters in 1999
suggested that, instead of applying the rule to all partners, we
narrow the rule to apply only to a firm's general partner (or
equivalent) and other owners that have a significant ownership
interest in the firm. Commenters also suggested that we either
exclude executive officers of divisions unrelated to the firm's
solicitation and/or advisory functions or limit the rule's
application to only the most senior officers of an adviser, such as
persons required to be listed on Schedule A of Form ADV. In light of
these comments, we have included in our proposed definition of
``covered associates'' only those persons associated with an
investment adviser who we believe are more likely to have an
economic incentive to make contributions to influence the advisory
firm's selection and who we have found, in our enforcement actions,
typically make contributions.
\99\ See proposed rule 206(4)-5(f)(10) (defining ``solicit'').
\100\ Proposed rule 206(4)-5(f)(2)(ii). Several commenters in
1999 argued that we would have included too broad a category of
solicitors because our definition of ``solicitor'' would have
included any person who solicited any client for or referred any
client to the adviser. The two-year time out would have been
triggered, for example, by registered representatives who solicited
brokerage business for a firm dually registered as a broker-dealer
and as an adviser, even though the registered representatives had no
involvement with government clients. See 1999 Proposing Release,
supra note 17, at section II.A.1. We have included a narrower
category of solicitors in our current proposed rule; the two-year
time out provisions would be triggered by a contribution by a person
who solicits government entities for advisory services. Many
commenters also urged that the definition of ``solicitor'' exclude
third-party solicitors. They asserted that it was unfair to hold
advisers responsible for the actions of these solicitors, arguing
that the advisers did not control their activities. We have excluded
third-party solicitors from this two-year time out provision;
instead we are proposing to prohibit advisers from soliciting
government business through third parties, as discussed in detail in
section II.A.3(b) of this Release.
\101\ Proposed rule 206(4)-5(f)(2)(iii). Our 1999 proposal would
also have included PACs controlled by the investment adviser and the
individuals associated with the investment adviser whose
contributions would have triggered the ``time out.'' See 1999
Proposing Release, supra note 17, at section II.A.1. We have
proposed to include PACs because these vehicles, which may be
regulated by State and/or Federal election law, are often used by
corporations, interest groups, or others to make political
contributions. See, e.g., Tennessee Registry of Election Finance,
PACs FAQ, available at http://www.state.tn.us/tref/pacs/pacs_
faq.htm; Federal Election Commission, Quick Answers to PAC
Questions, available at http://www.fec.gov/ans/answers_pac.shtml.
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Under the proposed rule, the term ``executive officer'' includes
the adviser's president and any vice president in charge of a principal
business unit, division or function (such as sales, administration or
finance) or any other executive officer who, in each case, in
connection with his or her regular duties: (i) Performs investment
advisory services (or supervises someone who performs them) for an
adviser; (ii) solicits (or supervises someone who solicits) for an
adviser, including with respect to investors for a covered investment
pool; \102\ or (iii) supervises, directly or indirectly, executive
officers described in (i) or (ii).\103\ Accordingly, for instance, the
proposed rule would cover contributions by a portfolio manager who is
an executive officer, as well as contributions by anyone in the
portfolio manager's chain of supervision up to and including the
president of the adviser. The rule would also cover contributions by an
executive officer who supervises personnel who solicit advisory clients
and contributions by anyone in that executive's chain of supervision.
The rule would not, however, cover contributions by the adviser's other
executives, such as its comptroller, its head of human resources, or
its director of information services, unless the contribution is an
indirect contribution for the adviser, because the compensation of
these individuals is likely to be tied less directly to obtaining or
retaining clients.
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\102\ See discussion of covered investment pools, infra, section
II.A.3(e).
\103\ Proposed rule 206(4)-5(f)(4). Our proposed definition of
``executive officer'' in rule 206(4)-5(f)(4) is based on the same
considerations as a similar definition in Advisers Act rule 205-3
[17 CFR 275.205-3]. Whether a person is an executive officer depends
on his or her function, not title; a chief executive officer whose
title does not include ``president'' is clearly an executive
officer.
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Contributions by non-executive employees (other than those who
solicit government entity clients) would not trigger the rule's
prohibitions, unless the adviser or any of its covered associates used
the person to indirectly make a contribution.\104\ This could occur,
for example, if a firm paid a non-executive employee a bonus with the
understanding that the bonus would be used by the employee to make a
political contribution that, if made by the firm, would trigger the
rule's prohibition.\105\
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\104\ Proposed rule 206(4)-5(d).
\105\ See id. See also discussion of indirect contributions,
infra section II.A.3(c).
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As noted above, the Commission has drafted the proposed rule so
that its prohibitions are triggered by political contributions by
persons who, in the context of an advisory firm, are likely to have an
economic incentive to make contributions to influence the advisory
firm's selection and the categories of executives and employees of an
adviser that we have seen, most typically, to make political
contributions and payments in pay to play situations. We are mindful of
the burdens the proposed rule would place on advisory firms and on the
ability of persons associated with an adviser to participate in civic
affairs. We thus have narrowly tailored the rule to achieve our goal of
preventing adviser participation in pay to play practices.
We request comment on the scope of the proposed rule and, in
particular, those persons associated with the advisers whose political
contributions would trigger the application of the two-year ``time
out'' and would be prohibited from soliciting political contributions
from others. Have we included persons most likely to have an economic
incentive to make political contributions for the purpose of
influencing the selection of the adviser?
Have we covered too many persons? If so, how should we narrow the
rule? For example, are there certain executive officers of the adviser
we should not include? The proposed rule would cover all executive
officers who, as part of their regular duties, perform investment
advisory services or supervise someone who performs them. Should we
instead limit the scope to a subset of such officers? If so, how should
we define that subset? \106\ Should we extend the rule to cover all
portfolio managers, or just those portfolio managers responsible for
managing government client assets? Are there other types of employees
whose contributions should trigger the time out?
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\106\ Many 1999 commenters argued that our proposal included too
many persons whose activities are unconnected to managing public
pension money, making it too likely that an innocent political
contribution would trigger a two-year time out. We considered these
comments in narrowing the scope of persons covered by our current
proposed rule, as described above.
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Have we too narrowly drawn the rule to achieve our goals? Should
we, for example, include employees of companies that are related
persons of an adviser who solicit government entity clients for the
investment adviser? As discussed further below, we propose permitting
payments to these persons under the proposed ban on payments to third
parties because we recognize that an adviser may rely on them to assist
it in seeking government clients.\107\ Would that same rationale
support including them as ``covered associates'' of the adviser (whose
contributions would be subject the proposed rule's two-year time out
provision)? Would not including them be likely to encourage
circumvention of the rule's requirements? \108\ We also request comment
on whether we should, for example, include certain family members who,
and related businesses that, might give political contributions on the
adviser's behalf to try to
[[Page 39850]]
influence officials of government entities? \109\ Under the proposed
rule, political contributions by such persons would only result in a
violation under the rule if the adviser or its covered associates were
acting through them to do indirectly what they cannot do directly under
the rule.\110\ MSRB rule G-37 addresses this matter similarly. Should
we include beneficial owners of the adviser because they have a direct
economic stake in the adviser's business relationship with the
government client? If so, should the definition include all owners, or
only those with a significant ownership stake in an adviser, such as
those who have contributed (or that have the right to receive upon
dissolution) ten percent or more of the company's capital?
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\107\ See discussion at section II.A.3(b), infra .
\108\ See proposed rule 206(4)-5(d), however.
\109\ See, e.g., Martin Z. Braun et al., A Political Family
Affair?, The Bond Buyer (Oct. 21, 2002) (noting that spouses of
municipal finance professionals in dealer firms are making campaign
contributions to issuer officials who can influence the award of
bond business).
\110\ Paragraph (d) of proposed rule 206(4)-5. See section
II.A.3(d) of this Release.
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(5) ``Look Back''
Under the proposed rule, the two-year time out would continue in
effect after the covered associate who made the triggering contribution
left the advisory firm. Moreover, a contribution made by a covered
associate of an adviser would be attributed to any other adviser that
employs or engages the person who made the contribution within two
years after the date the contribution was made.\111\ As a result, an
investment adviser would be required to ``look back'' in time to
determine whether it would be subject to any business restrictions
under the proposed rule when employing or engaging a covered associate.
This provision, which tracks MSRB rule G-37,\112\ would prevent
advisers from circumventing the rule by channeling contributions
through departing employees, or by influencing the selection process by
hiring persons who have made political contributions. Comment is
requested on the proposed look-back requirement. For example, would a
shorter period be sufficient to prevent circumvention of the rule?
\113\ If so, what period would be appropriate? Would our proposed look-
back provision inappropriately deter politically active individuals
from joining advisory firms that provide investment advice to
government entities or are seeking to do so?
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\111\ Proposed rule 206(4)-5(a)(1). In no case would the
prohibition imposed by the proposed rule be longer than two years
from the date the covered associate makes a covered contribution.
If, for example, a covered associate becomes employed by an
investment adviser one year and six months after making a
contribution, the new employer would be subject to the proposed
rule's prohibition for the remaining six months of the two-year
period. The covered associate's employer at the time of the
contribution would be subject to the proposed rule's prohibition for
the entire two-year period regardless of whether the covered
associate remains employed by the adviser. See infra section II.B.
\112\ MSRB rule G-37(g)(iv). Cf. MSRB Qs & As, Question II.12,
available at http://www.msrb.org/msrb1/rules/QAG-372003.htm.
\113\ Commenters in 1999 urged us to reduce the look back
period, arguing that politically active individuals might be
discouraged from joining advisory firms. However, we are concerned
about the prospect of advisers seeking to circumvent the rule by
hiring individuals shortly after they have made significant
contributions that could influence government officials.
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(6) Exception for De Minimis Contributions
Proposed rule 206(4)-5 contains a de minimis exception that would
permit each covered associate who is an individual \114\ to make
aggregate contributions of $250 or less, per election, to an elected
official or candidate without triggering the rule's prohibitions if the
person making the contribution is entitled to vote for the official or
candidate.\115\ We have proposed $250 because we believe that
contributions of $250 or less are typically made without the intent or
ability to influence the selection process for investment advisers and
thus do not involve the conflicts of interest the rule is intended to
prevent, as well as for reasons of regulatory consistency. The $250
amount is the same as the de minimis amount excepted from MSRB rule G-
37.\116\ Comment is requested on the scope of the exception.\117\
Should the amount be increased or decreased, and if so, on what basis?
For instance, the MSRB has not adjusted its de minimis amount for
inflation since it was established in 1994. We have not adjusted the
$250 for inflation because of ease of reference to a round number and
because an inflation adjustment would result in an amount not
significantly higher. We request comment, however, on whether we should
adjust our amount for inflation. Should we provide a de minimis
exception for contributions to officials for whom an individual is not
entitled to vote, and if so, what would be an appropriate de minimis
amount? \118\
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\114\ Under the proposed rule, each covered associate, taken
separately, would be subject to the $250 de minimis exception for
elections in which he or she is entitled to vote. In other words,
the $250 limit applies per covered associate and is not an aggregate
limit for all of an adviser's covered associates.
\115\ Proposed rule 206(4)-5(b)(1). Under the proposed rule,
primary and general elections would be considered separate
elections. Accordingly, a covered person of an investment adviser
could, without triggering the prohibitions of the rule, contribute
up to $250 in both the primary election campaign and the general
election campaign (up to $500) of each official for whom the person
making the contribution would be entitled to vote. For purposes of
this rule, a person would be ``entitled to vote'' for an official if
the person's principal residence is in the locality in which the
official seeks election. See, e.g., In the Matter of Pryor,
McClendon, Counts & Co., Inc. et al., Exchange Act Release No. 48095
(June 26, 2003) (noting that Rule G-37 allows a person to contribute
$250 to a candidate's campaign in the primary and in the general
election, for a total of $500 during the election cycle, and
clarifying that contributions must be limited to $250 before the
primary, with an additional $250 allowed after the primary for the
general election). See also MSRB Qs & As, Question II.8, available
at http://www.msrb.org/msrb1/rules/QAG-372003.htm.
\116\ See MSRB rule G-37(b)(i).
\117\ Some commenters in 1999 suggested that the amount be
substantially higher. Some commenters thought we should raise the de
minimis amount to $1,000 to be consistent with the limits on private
contributions for candidates for Federal office. We believe that a
higher threshold--such as $1,000--would be significantly more likely
to enable a contributor to seek to exert influence over an official
with the ability to select an investment adviser, especially in a
local election. We also believe a lower amount might be too
restrictive--it could preclude individuals from supporting
candidates for whom they are able to vote at levels that are less
likely to facilitate undue influence.
\118\ Our proposed de minimis exception only applies to
contributions to a candidate for whom the contributor is entitled to
vote. Whereas the outcome of an election in which a contributor is
eligible to vote is likely to have a greater personal impact on the
contributor, there is a significantly greater likelihood that a
contributor's contribution in an election in which he or she is not
entitled to vote could be motivated by other factors, which might
include influencing a candidate. In 1999, there was a mixture of
support and criticism for limiting the exception to contributions to
officials or candidates for whom the contributor is entitled to
vote, and one commenter advocated expanding it to a $100 de minimis
exception for candidates for whom the contributor is not entitled to
vote.
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(7) Exception for Certain Returned Contributions
We are proposing a second exception from the two-year compensation
ban intended to address situations in which the adviser triggers the
ban inadvertently.\119\ We have attempted to limit the scope of this
exception to the types of contributions that we believe are unlikely to
raise pay to play concerns. This exception would be available only with
respect to contributions made by a covered associate of the investment
adviser to officials other than those for whom the covered associate
was entitled to vote at the time of the contributions and which, in the
aggregate, do not exceed $250 to any one official, per election.\120\
Further, the adviser must have discovered the
[[Page 39851]]
contribution which resulted in the prohibition within four months of
the date of such contribution \121\ and, within 60 days after learning
of the triggering contribution, must cause the contribution to be
returned to the contributor.\122\ We believe this exception should only
be available when the adviser discovered the triggering contribution,
and caused it to be returned, promptly. Our proposal generally tracks
MSRB rule G-37's ``automatic exemption'' provision.\123\
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\119\ Proposed rule 206(4)-5(b)(2).
\120\ Proposed rule 206(4)-5(b)(2)(i). To the extent that the
contribution by a covered associate of the adviser was less than
$250 and was for an official for whom the covered associate was
entitled to vote at the time of the contributions, the contribution
would not have triggered the two-year ban on account of the
exception contained in paragraph (b)(1) of the proposed rule.
\121\ Id. We believe that requiring that the adviser must have
discovered the contribution within four months provides an
appropriate time limit for the exception. On one hand, we do not
believe the exception should be available where it takes longer for
advisers to discover contributions made by covered associates
because they might enjoy the benefits of a contribution's potential
influence for too long a period of time. On the other hand, we
believe it makes sense to give advisers sufficient time to discover
contributions made by covered associates if, for example, their
covered associates disclose their contributions to the adviser on a
quarterly basis. Also, this provision is consistent with the
approach taken in MSRB rule G-37(j)(i).
\122\ Proposed rule 206(4)-5(b)(2)(i). The prompt return of the
contribution would provide some indication that the contribution
would not affect an official of a government entity's decision-
making process with regard to choosing an adviser. We have proposed
that the contribution must be returned within 60 days to give
contributors sufficient time to seek its return, but still require
that they do so in a timely manner. Also, this provision is
consistent with MSRB rule G-37(j)(i). If the recipient will not
return the contribution, the adviser would still have available the
opportunity to apply for an exemption under paragraph (e) of the
proposed rule. Paragraph (e), which sets forth factors we would
consider in determining whether to grant an exemption, includes as a
factor whether the adviser ``has taken all available steps to cause
the contributor involved in making the contribution which resulted
in such prohibition to obtain a return of the contribution.''
\123\ MSRB rule G-37(j). We did not include an equivalent
provision in our 1999 proposal, and MSRB rule G-37 contained no such
provision at that time. However, the MSRB added an ``automatic
exemption'' provision in 2003. Exchange Act Release No. 47814 (May
8, 2003) [68 FR 25917 (May 14, 2003)]. Several of the comments we
received on our 1999 proposal, while supporting the exemptive
provision we proposed at that time, expressed concern that the scope
and breadth of the rule would expose advisers to the risk of
inadvertent violations, which would necessitate frequent exemptive
applications. See, e.g., Comment Letter of the Securities Industry
Association (Oct. 29, 1999) (``SIA Comment Letter''); Comment Letter
of Morgan Stanley Dean Witter Investment Management Inc. (Nov. 1,
1999) (``MSDW Comment Letter''); Comment Letter of Fidelity
Investments (Nov. 1, 1999); Investment Counsel Association of
America Comment Letter (Nov. 1, 1999) (``Nov. ICAA Comment
Letter''); Comment Letter of Scudder Kemper Investments (Nov. 8,
1999) (``Scudder Kemper Comment Letter''); Comment Letter of
Nicholas-Applegate Capital Management (Oct. 26, 1999) (``Nicholas-
Applegate Comment Letter''); Comment Letter of Smith Barney Asset
Management and Salomon Brothers Asset Management Inc. (Nov. 1, 1999)
(``Smith Barney Comment Letter'') (suggesting, alternatively, that
the time out period be 30 days for inadvertent violations); Comment
Letter of Davis Polk & Wardwell (Nov. 1, 1999) (``Davis Polk Comment
Letter''); and Comment Letter of American Bar Association,
Subcommittees on Investment Companies and Investment Advisers and on
Private Investment Entities of the Committee on Federal Regulation
of Securities, Section of Business Law (Jan. 5, 2000) (``ABA Comment
Letter''). The exception we have proposed would help address these
concerns.
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To ensure that the exception for certain returned contributions
does not encourage an investment adviser to relax its efforts to
promote compliance with the rule's prohibitions, no adviser would be
entitled to rely on the exception more than twice per 12-month
period.\124\ And an investment adviser would not be permitted to rely
on the exception more than once with respect to contributions by the
same covered associate of the investment adviser,\125\ regardless of
the time period.
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\124\ Proposed rule 206(4)-5(b)(2)(ii). We wanted to give each
adviser more than one opportunity to refine its compliance
procedures to avoid further violations of the proposed rule but, as
noted, did not want to allow an adviser to relax its standards by
making multiple exceptions available. This will generally create
some flexibility to accommodate a covered associate's inadvertent
violation.
\125\ Proposed rule 206(4)-5(b)(2)(iii). Once a covered
associate has been made aware of an ``inadvertent'' violation, a
justification for a second violation is more questionable.
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We request comment on the proposed criteria for, and limitations
on, the exception for certain returned contributions. Are the various
time periods we proposed (discovery of contribution within four months
of it being made, return of contribution within 60 days of discovery,
and limitation of reliance on the exception twice per adviser per 12-
month period) reasonable? Would they be effective? Are there other
circumstances under which an adviser should be able to avail itself of
an exception? Alternatively, should we require that an adviser
institute special supervisory procedures (after it relies on the
exception for certain returned contributions) for the covered associate
making the contribution, including requiring pre-clearance of all
contributions, for a specified period of time?
(b) Ban on Using Third Parties To Solicit Government Business
After the adoption of rule G-37 in 1994, the MSRB observed that
municipal securities dealers sought to circumvent rule G-37 by hiring
third-party consultants to solicit government clients on their
behalf.\126\ These third-party consultants would make political
contributions or otherwise seek to exert influence designed to secure
municipal business for the municipal securities firm.\127\ Two years
later, in 1996, the Commission approved, and the MSRB adopted, rule G-
38, which required municipal dealers to disclose publicly the terms of
their agreements with consultants.\128\ In 2005, after concluding that
the required disclosure was neither adequate to prevent circumvention
of rule G-37, nor consistently being made,\129\ the MSRB (with the
[[Page 39852]]
Commission's approval) amended rule G-38 to impose a complete ban on
the use of third-party consultants to solicit government clients.\130\
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\126\ See In the Matter of Self-Regulatory Organizations; Notice
of Filing of Proposed Rule Change by the Municipal Securities
Rulemaking Board Relating to Consultants, Exchange Act Release No.
36522 (Nov. 28, 1995) [60 FR 62275 (Dec. 5, 1995)] (``The Board
believes that rules G-37 and G-20 [regarding gifts and gratuities] *
* * along with [the rule on fair dealing] set appropriate standards
for dealer conduct in the municipal securities industry. However,
the Board is concerned about dealers' increasing use of consultants
to obtain or retain municipal securities business. While the Board
believes that in many instances the use of consultants is
appropriate, it also believes that, in a number of instances, the
use of consultants may be in response to limitations placed on
dealer activities by rule G-37 and rule G-20. While both of these
rules prohibit dealers from doing indirectly what they are precluded
from doing directly, indirect activities often are difficult to
prove.'' (footnotes omitted)).
\127\ See id.
\128\ See In the Matter of Self-Regulatory Organizations; Order
Approving Proposed Rule Change by the Municipal Securities
Rulemaking Board Relating to Consultants, Exchange Act Release No.
36727 (Jan. 17, 1996) [61 FR 1955 (Jan. 24, 1996)] (``The rule
approved today is intended to provide additional information to
issuers and to the public to assist in determining the extent to
which payments to consultants influence the issuer's selection
process in connection with municipal securities business. * * *'')
(``MSRB Rule G-38 Adoption Order''). See also Municipal Securities
Rulemaking Board, Request for Comments on Revised Draft Amendments
to Rule G-38 Relating to Solicitation of Municipal Securities
Business (as modified on Oct. 12, 2004) (Sept. 29, 2004), available
at http://www.msrb.org/msrb1/archive/2004/RevRuleG-
38Solicitation.htm#revised1 (noting, with regard to MSRB rule G-38,
``As initially adopted, the rule required * * * that the dealer
disclose information about its consulting arrangements to any issuer
from which a consultant would solicit municipal securities business
on its behalf [and that the dealer disclose] to the MSRB * * * the
terms of the consulting agreements and the business obtained by the
consultants * * * [with] such disclosures made available to the
public through the MSRB Web site * * *'' (footnotes omitted)).
\129\ See Municipal Securities Rulemaking Board, Amendments
Relating to Solicitation of Municipal Securities Business Under Rule
G-38, SR-MSRB-2005-04 (Mar. 17, 2005), available at http://
www.msrb.org/msrb1/rulesandforms/sec/SR-MSRB-2005-04.pdf (``The MSRB
began its current rulemaking initiative on the solicitation on
behalf of brokers, dealers and municipal securities dealers
(``dealers'') of municipal securities business by consultants early
last year because of certain practices that could present challenges
to maintaining the integrity of the municipal securities market.
These practices include, among other things, significant increases
in recent years in the number of consultants being used, the amount
these consultants are being paid and the level of reported political
giving by consultants. The MSRB has been concerned that increases in
levels of compensation paid to consultants for successfully
obtaining municipal securities business may be motivating
consultants, who currently are not subject to the basic standards of
fair practice and professionalism embodied in MSRB rules, to use
more aggressive or questionable tactics in their contacts with
issuers.'').
\130\ See In the Matter of Self-Regulatory Organizations; Order
Approving Proposed Rule Change and Notice of Filing and Order
Granting Accelerated Approval to Amendment No. 1 to the Proposed
Rule Change Relating to Solicitation of Municipal Securities
Business under MSRB Rule G-38, Exchange Act Release No. 52278 (Aug.
17, 2005) [70 FR 49342 (Aug. 23, 2005)]. As amended, MSRB rule G-
38(a) states, ``Subject to section (c) of this rule [regarding
transitional payments], no broker, dealer or municipal securities
dealer may provide or agree to provide, directly or indirectly,
payment to any person who is not an affiliated person of the broker,
dealer or municipal securities dealer for a solicitation of
municipal securities business on behalf of such broker, dealer or
municipal securities dealer.''
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We are concerned that our adoption of a rule addressing pay to play
practices by advisers would lead to a similar use of consultants or
solicitors by investment advisers to circumvent the rule. Indeed, we
have alleged that third-party solicitors have played a central role in
each of the enforcement actions against investment advisers that we
have brought in the past several years involving pay to play
schemes.\131\ Government authorities in New York and other
jurisdictions have prohibited, or are considering prohibiting, the use
of consultants, solicitors, or placement agents by investment advisers
to solicit government investment business.\132\
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\131\ See, e.g., SEC v. Henry Morris, et al., Litigation Release
No. 20963 (Mar. 19, 2009) (the Commission's complaint alleges that
investment advisers and a placement agent, among others, engaged in
a fraudulent scheme to extract kickbacks from investment management
firms seeking to manage assets of the New York State Common
Retirement Fund); In the Matter of Kent D. Nelson, Investment
Advisers Act Release No. 2765 (Aug. 1, 2008); Initial Decision
Release No. 371 (Feb. 24, 2009); Investment Advisers Act Release No.
2868 (Apr. 17, 2009) (an administrative law judge found that an
investment adviser funneled payments through a third party to the
New Mexico State treasurer in exchange for being retained as an
adviser by the State treasurer's office); SEC v. Paul J. Silvester
et al., Litigation Release No. 16759 (Oct. 10, 2000); Litigation
Release No. 16834 (Dec. 19, 2000); Litigation Release No. 18461
(Nov. 17, 2003); Litigation Release No. 19583 (Mar. 1, 2006);
Litigation Release No. 20027 (Mar. 2, 2007) (alleging that, in order
to obtain investment contracts, investment adviser firms made
payments to associates of the Connecticut State treasurer, a portion
of which were kicked back to the treasurer). See also supra notes
31-40 (discussing other cases related to these enforcement actions).
\132\ See, e.g., Aaron Elstein, NY Pension Fund Bans
Controversial Middlemen, Crain's New York Business (Apr. 22, 2009)
(describing the New York State Comptroller's ban on placement
agents); Press Release, Office of the New York City Comptroller,
Thompson Moves to Ban Placement Agents, Asks State AG to Investigate
Quadrangle Transaction, PR-09-04-095 (Apr. 22, 2009), available at
http://www.comptroller.nyc.gov/press/2009_releases/pr09-04-095.shtm
(describing the New York City Comptroller's calls on the New York
City Pension Funds to ban placement agents); Henry Goldman, New York
City Police Pension Bans Placement Agent Use, Bloomberg (May 5,
2009) (describing the New York City Police Pension Fund's suspension
on the use of placement agents); Martin Z. Braun, New York City's
Fire Pension Bans Middlemen, Joining Two Others, Bloomberg (May 16,
2009) (describing the New York City Fire Pension Fund's suspension
on the use of placement agents); Barry Massey, NM Agency Bans
Placement Agents on Investments, Businessweek (May 26, 2009)
(describing the New Mexico State Investment Council's ban on
placement agents). See also In the Matter of the Carlyle Group, AGNY
Investigation No. 2009-071, Assurance of Discontinuance Pursuant to
Executive Law Sec. 63(15) (May 14, 2009), available at http://
www.oag.state.ny.us/media_center/2009/may/pdfs/Carlyle%20AOD.pdf;
In the Matter of Riverstone Holdings, LLC, AGNY Investigation No.
2009-091, Assurance of Discontinuance Pursuant to Executive Law
Sec. 63(15) (June 11, 2009), available at http://
www.oag.state.ny.us/media_center/2009/june/pdfs/
Riverstone%20AOD%20FINAL%20EXECUTED.pdf; and In the Matter of PCG
Corporate Partners Advisors II, LLC, AGNY Investigation No. 2009-
101, Assurance of Discontinuance Pursuant to Executive Law Sec.
63(15) (July 1, 2009), available at http://www.oag.state.ny.us/
media_center/2009/july/pdfs/PCG%20AOD%20FINAL%20EXECUTED.pdf (in
each case, banning the use of third-party placement agents pursuant
to a ``Public Pension Fund Reform Code of Conduct'' in connection
with the New York Attorney General's findings that ``private equity
firms and hedge funds frequently use placement agents, finders,
lobbyists, and other intermediaries * * * to obtain investments from
public pension funds * * *, that these placement agents are
frequently politically-connected individuals selling access to
public money, * * * and that the use of placement agents to obtain
public pension fund investments is a practice fraught with peril and
prone to manipulation and abuse.'').
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In our 1999 proposal, contributions to a government official by an
adviser's third-party solicitor, engaged by the adviser to obtain
clients, would have triggered a two-year ``time out'' for the
adviser.\133\ Several commenters opposed inclusion of contributions by
third-party solicitors as a trigger for the ``time out.'' Most argued
that this aspect of the rule was unfair and created significant
compliance challenges because these solicitors were not, according to
the commenters, controlled by advisers.\134\
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\133\ See 1999 Proposing Release, supra note 17, at section
II.A.1.
\134\ See, e.g., SIA Comment Letter; T. Rowe Comment Letter;
MSDW Comment Letter; Comment Letter of Legg Mason, Inc. (Nov. 1,
1999); American Bankers Association Comment Letter (Nov. 1, 1999);
Nov. ICAA Comment Letter; Scudder Kemper Comment Letter; Nicholas-
Applegate Comment Letter; Smith Barney Comment Letter; Davis Polk
Comment Letter; and ABA Comment Letter. We note that rule 206(4)-3
(the ``cash solicitation rule'') under the Advisers Act, among other
things, requires an adviser that engages a third-party solicitor for
clients: (i) to make a bona fide effort to ascertain whether the
solicitor has complied with the adviser's agreement with the
solicitor; and (ii) to have a reasonable basis for believing that
the solicitor has so complied. Advisers Act rule 206(4)-
3(a)(2)(iii)(C) [17 CFR 275.206(4)-3(a)(2)(iii)(C)].
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In light of these considerations, including the apparent
difficulties for advisers to monitor the activities of their third-
party solicitors, we are proposing to prohibit investment advisers from
using third-party solicitors to obtain government clients.\135\
Proposed rule 206(4)-5 would make it unlawful for any investment
adviser registered (or required to be registered) with the Commission,
or unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act [15 U.S.C. 80b-3(b)(3)], or any of its
covered associates, to provide or agree to provide, directly or
indirectly, ``payment'' to any person to solicit a government entity
for investment advisory services unless such person is: (i) A ``related
person'' of the investment adviser or, if the related person is a
company, an employee of that related person; or (ii) any of the
adviser's employees, general partners, LLC managing members, executive
officers (or other person with a similar status or function, as
applicable).\136\ The rule's prohibition on an adviser's payments to
third-party solicitors may apply to persons commonly called
``finders,'' ``solicitors,'' ``placement agents,'' or ``pension
consultants.'' \137\
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\135\ Although rule 206(4)-3 under the Advisers Act (the ``Cash
Solicitation Rule'') contemplates that certain client solicitation
activities of third parties can be undertaken where certain
conditions are met and the adviser both ``makes a bona fide effort
to ascertain whether'' and ``has a reasonable basis for believing
that'' the solicitor has complied with certain aspects of the rule
(Advisers Act rule 206(4)-3(a)(2)(iii)(C) [17 CFR 275.206(4)-
3(a)(2)(iii)(C)]), commenters' concerns about the inability of
advisers to control the political contribution activity of their
solicitors (which is not restricted under the Cash Solicitation
Rule) persuade us that a different approach is appropriate for
solicitation of government clients.
\136\ Proposed rule 206(4)-5(a)(2)(i). Advisers making payments
to solicitors must comply with the cash solicitation rule under the
Advisers Act. If this component of proposed rule 206(4)-5 is adopted
as proposed, investment advisers registered or required to be
registered with us would no longer be able to rely on the cash
solicitation rule to pay third-party solicitors to obtain government
clients. For a discussion of proposed amendments to the cash
solicitation rule, see infra section II.C.
\137\ Pension consultants provide advice to pension plans
(public or private) and their trustees with respect to their
investments, selection of money managers and other service
providers, and other investment-related matters. Many pension plans
rely heavily on the expertise and guidance of their pension
consultant in helping them to manage pension plan assets. Pension
consultants may act as third-party solicitors. Others may act as
investment advisers subject to our rule. In 2005, our Office of
Compliance Inspections and Examinations published a report
highlighting concerns relating to the Advisers Act stemming from
examinations of 24 pension consultant firms, including conflicts of
interest that arise with respect to pension consultants that provide
products and services to both pension plan advisory clients and
money managers and mutual funds on an ongoing basis. Office of
Compliance Inspections and Examinations, U.S. Securities and
Exchange Commission, Staff Report Concerning Examinations of Select
Pension Consultants (May 16, 2005), available at http://www.sec.gov/
news/studies/pensionexamstudy.pdf. Commission staff also published
on the Commission's Web site, in cooperation with the U.S.
Department of Labor, tips to assist fiduciaries of employee benefit
plans in reviewing conflicts of interest of pension consultants.
Selecting and Monitoring Pension Consultants: Tips for Plan
Fiduciaries (June 1, 2005), available at http://www.sec.gov/
investor/pubs/sponsortips.htm.
Although the terms are sometimes used interchangeably,
``finders'' typically locate buyers and/or sellers for a security on
behalf of a broker-dealer, ``solicitors'' typically locate
investment advisory clients on behalf of an investment adviser, and
``placement agents'' typically specialize in finding investors
(often institutional investors or high net worth investors) that are
willing and able to invest in a private offering of securities on
behalf of the issuer of such privately offered securities.
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[[Page 39853]]
The proposed rule would only apply to ``third-party'' solicitors
who solicit government entities for investment advisory services.\138\
The prohibition on payments to third-party solicitors would not cover
solicitations on behalf of an investment adviser by a person who is a
``related person'' of the adviser, any of the related person's
employees if the related person is a company,\139\ or any executive
officer or partner of the adviser.\140\ A contribution to a government
official by certain of these persons would instead trigger the two-year
``time out'' under paragraph (a) of the proposed rule, during which the
investment adviser could not provide investment advisory services for
compensation to the government entity whose selection of an adviser
that official could influence.\141\ We have proposed to include related
persons and their employees (if the related persons are companies) in
order to enable advisers to compensate parent companies and other
owners, subsidiaries and sister companies--as well as employees of
related companies--for government entity solicitation activities
because we recognize that there may be efficiencies in allowing
advisers to rely on these particular types of persons to assist them in
seeking clients.\142\ We request comment on whether we should include
employees of an adviser's related persons that are companies within the
group of persons not subject to the ban on payments to third parties.
Should we include only employees of certain related persons of the
adviser? If so, how should we make that determination? We also request
comment on whether there are other types of persons associated with an
investment adviser who should not be subject to the ban on payments to
third parties. We would define ``payment'' as any gift, subscription,
loan, advance or deposit of money or anything of value.\143\ We are
proposing this definition to cover the various means by which an
adviser and its covered associates may seek to compensate a third-party
solicitor.\144\ A ``finder's fee'' paid for a third-party solicitation
would be an example of a prohibited payment. It could also include
payments made to pension consultants for performing various services,
such as attending or sponsoring conferences, if those services are
intended to obtain government clients.\145\ Are there other types of
payments we should explicitly include in the definition? Are there
others that we should exclude, and, if so, why?
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\138\ Proposed rule 206(4)-5(a)(2)(i).
\139\ We would define ``related person'' as any person, directly
or indirectly, controlling or controlled by the investment adviser,
and any person that is under common control with the investment
adviser. Proposed rule 206(4)-5(f)(9). The term ``company'' is
defined in the Advisers Act, in relevant part, as ``a corporation, a
partnership, an association, a `joint-stock' company, a trust, or
any organized group of persons, whether incorporated or not.'' 15
U.S.C. 80b-2(a)(5).
\140\ More specifically, we do not include any of the following
within the prohibition on payments for solicitation of government
clients: executive officers, general partners, managing members (or,
in each case, persons with similar status or function), employees,
or ``related persons'' of the investment adviser. Proposed rule
206(4)-5(a)(2)(i). We make this distinction because related person
solicitors are subject to an adviser's (or its affiliates') control
and thus should not present the compliance challenges that advisers
pointed to with respect to third-party solicitors. See supra note
134 and accompanying text. MSRB rule G-38's exclusions are based on
two similar definitions--of ``affiliated person of the broker,
dealer or municipal securities dealer'' and of ``affiliated company
of the broker, dealer or municipal securities dealer.'' MSRB rule G-
38(b)(i) and (b)(ii).
\141\ Pursuant to proposed rule 206(4)-5(a)(1), certain
contributions by the investment adviser and its covered associates
would trigger the two-year time out. For a discussion of the two
year ``time out'' provision of the proposed rule, see supra section
II.A.3(a). We are not proposing that contributions by ``related
persons'' and their employees would trigger the two-year time out,
although we request comment on whether to include in the definition
of ``covered associate'' an employee of a related person who
solicits a government entity for the adviser. See discussion at
section II.A.3(a)(4), supra. See also proposed rule 206(4)-5(d).
\142\ For example, if an adviser's sister company has an office
in a given location, the adviser might seek the assistance of a
sister company's employee at that location to solicit local
government business on its behalf rather than relying on its own
personnel who might be located a significant distance away.
\143\ Proposed rule 206(4)-5(f)(7). MSRB rule G-38 incorporates
the definition of ``payment,'' as well as the definitions of
``issuer'' and ``municipal securities business'' from MSRB rule G-
37(g).
\144\ As well as the various means by which an adviser and its
covered associates may seek to solicit other persons or coordinate
donations to political parties. See infra section II.A.3(d).
\145\ The proposed rule's prohibition on making payments to
third-party solicitors of government clients would apply expressly
only to investment advisers and their covered associates. But see
proposed rule 206(4)-5(d) (the proposed rule's prohibitions on an
adviser and its covered associates doing indirectly what cannot be
done directly). For a discussion of this provision, see infra
section II.A.3.(d) of this Release. The proposed rule would not
prohibit government entities from retaining ``pension consultants''
(or other third-parties) and paying them to recommend particular
investment advisers for the management of public funds.
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We would broadly define ``solicit'' to mean: (i) With respect to
investment advisory services, to communicate, directly or indirectly,
for the purpose of obtaining or retaining a client for, or referring a
client to, an investment adviser; and (ii) with respect to a
contribution or payment, to communicate, directly or indirectly, for
the purpose of obtaining or arranging a contribution or payment. We are
proposing this definition to capture the types of communications in
which an investment adviser might engage that we believe should trigger
application of the rule's prohibitions--communications for the purpose
of obtaining or retaining a client or a contribution.\146\ Whether a
particular communication constitutes a ``solicitation,'' therefore,
depends on the specific facts and circumstances relating to the
communication. The nature of information conveyed in any communication
and the manner in which it is presented would be relevant factors to
consider. Does our proposed definition effectively capture the
appropriate scope of communications? If not, what types of
communications should we exclude, and why?
---------------------------------------------------------------------------
\146\ See proposed rule 206(4)-5(f)(10). MSRB rule G-38 contains
a similar definition. See MSRB rule G-38(b)(i).
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We request comment on our proposal to prohibit the use of third-
party solicitors of government business. Is our proposed prohibition on
the use of third-party solicitors an appropriate means to deter pay to
play practices? We propose to prohibit only third-party solicitors as
likely posing a significant threat to investor protection; certain
related-party solicitors would, instead, be subject to the time out
limitations of proposed rule 206(4)-5(a)(1). Is this differentiation
appropriate? If not, should we instead subject advisers to the two-year
time out for contributions made by their third party solicitors
although, as noted above, commenters in 1999 indicated that such a
requirement may impose significant compliance challenges? \147\ If the
differentiation is appropriate, should we also have a two-year look
back restriction for any contributions made by the third party? Is
there a different approach that would be effective at eliminating
circumvention of the rule through the use of third parties? For
example, should we consider narrowing the prohibition to accommodate
government solicitation activities by third parties if such third
parties (and
[[Page 39854]]
their related persons) commit not to contribute to (or solicit
contributions for) officials of any government entity from which any
adviser that hires them is seeking business? To what extent might the
proposed ban on using third parties to solicit government business
disproportionately impact the ability of certain investment advisers,
such as those that are smaller and less established, to compete in the
market to provide advisory services to government clients? Conversely,
to what extent might the proposed ban benefit smaller or less
established advisers who are currently unable or unwilling to engage in
pay to play practices to compete for government business?
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\147\ See supra note 134.
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(c) Restrictions on Soliciting and Coordinating Contributions and
Payments
Another way an adviser can attempt to influence the selection
process is by coordinating contributions for an elected official or
payments to a political party, or by soliciting others to make
contributions to an elected official or payments to a political
party.\148\ Therefore, proposed rule 206(4)-5(a)(2)(ii) would prohibit
an adviser and its covered associates from soliciting any person or PAC
to make, or from coordinating, any contribution to an official of a
government entity to which the adviser is providing or seeking to
provide investment advisory services, or any payment \149\ to a
political party of a State or locality where the investment adviser is
providing or seeking to provide investment advisory services to a
government entity.\150\ Our proposed restrictions on soliciting and
coordinating contributions and payments generally track MSRB rule G-
37.\151\ The MSRB amended its rule in 2005, with Commission approval,
to expand its prohibition on soliciting others to make, and on
coordinating, payments to State and local political parties to close
what the MSRB identified as a gap in which contributions were being
made indirectly to officials through payments to political parties for
the purposes of influencing their choice of municipal securities
dealers.\152\ The MSRB had not previously been able to deter this
misconduct, despite issuing informal guidance in both 1996 and in
2003.\153\ We are proposing a similar prohibition on soliciting or
coordinating payments to political parties in States or localities
where the investment adviser is providing or seeking to provide
investment advisory services to a government entity because we are
concerned that our adoption of a rule that only prohibits advisers from
soliciting others to make, or coordinating, contributions to officials
would lead to the development of a similar gap in which advisers could
circumvent the rule by making payments to political parties to
influence an official.\154\
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\148\ For examples of solicitation or coordination of
contributions in the municipal securities dealer context, see In the
Matter of Pryor, McClendon, Counts & Co., Inc. et al., Exchange Act
Release No. 48095 (June 26, 2003) (Commission alleged that a broker-
dealer violated rule G-37(c) because its president delivered three
$250 money orders (in other people's names) in addition to his own
personal check for $250 to the campaign of a New York City mayoral
candidate during a period when the firm was engaged in municipal
securities business with New York City); In the Matter of FAIC
Securities, Inc., Exchange Act Release No. 36937 (Mar. 7, 1996)
(Commission alleged that the broker-dealer willfully violated G-
37(c) because the firm's municipal finance professionals approved
its affiliated companies' political contributions to candidates for
office who could influence the awarding of municipal securities
business by the State of Florida and by Dade County, Florida, and
during the two-year period following those contributions, the firm
continued to seek, and was selected, to participate in negotiated
underwritings of certain municipal securities by both Dade County
and a State agency).
\149\ See supra note 143 and accompanying text for the
definition of ``payment.'' This definition is derived from the
definition of ``contribution,'' but does not include the limits on
the purposes for which such money is given, as currently set forth
in the proposed definition of contribution. We are including
``payments,'' as opposed to ``contributions,'' here to deter an
adviser from circumventing the rule's prohibitions by coordinating
indirect contributions to government officials through payments to
political parties. We noted similar concerns in the context of MSRB
Rule G-37 when we approved a recordkeeping provision in rule G-8 to
require persons subject to that rule to keep records relating to
political party payments. See SEC Order Approving Proposed Rule
Change by the Municipal Securities Rulemaking Board Relating to Rule
G-37 on Political Contributions and Prohibitions on Municipal
Securities Business, and Rule G-8, on Recordkeeping, Exchange Act
Release No. 35446 (Mar. 6, 1995) (``[S]ome [industry participants]
currently are urging dealers to make payments to political parties
earmarked for expenses other than political contributions (such as
administrative expenses or voter registration drives). Since these
payments would not constitute ``contributions'' under the rule, the
recordkeeping and reporting provisions would not apply. The MSRB is
concerned, based upon this information, that the same pay-to-play
pressures that motivated the MSRB to adopt rule G-37 may be emerging
in connection with the fundraising practices of certain political
parties described above.'').
\150\ Proposed rule 206(4)-5(a)(2)(ii). An investment adviser
would be seeking to provide advisory services to a government entity
when it responds to a request for proposal, communicates with a
government entity regarding that entity's formal selection process
for investment advisers, or engages in some other solicitation of
investment advisory business of the government entity. A violation
of paragraph (a)(2)(ii) of the proposed rule would not trigger a
two-year ban on the provision of investment advisory services for
compensation, but would be a violation of the rule. This provision
would prohibit, for example, an adviser's solicitation of a payment
to the political party of the State in which the adviser was seeking
to provide advisory services to a government entity of the State,
but would not preclude that adviser from soliciting a payment to a
local political party, unless the adviser was doing so as a means to
do indirectly what the adviser could not do directly under the
proposed rule (for example, if the adviser was soliciting the
payment as a means to funnel payments to an official of the
government entity from which the adviser was seeking business). See
proposed rule 206(4)-5(d).
\151\ See MSRB rule G-37(c). We note, however, that G-37 did not
contain a prohibition on soliciting or coordinating payments to
political parties in 1999, and our 1999 proposal did not contain
such a provision. 1999 Proposing Release, supra note 17.
\152\ See Rule G-37: Request for Comments on Draft Amendments to
Rule G-37(c), Relating to Prohibiting Solicitation and Coordination
of Payments to Political Parties, and Draft Question and Answer
Guidance Concerning Indirect Rule Violations, MSRB Notice 2005-11
(Feb. 15, 2005), available at http://www.msrb.org/msrb1/archive/
2005/2005-11.asp (``G-37(c) Notice'') (``[T]he MSRB is especially
troubled by the emergence of recent media and other reports that
issuer agents have informed dealers and [municipal finance
professionals] that, if they are prohibited from contributing
directly to an issuer official's campaign, they should contribute to
the affiliated party's ``housekeeping'' account. The MSRB is
concerned that dealers or [municipal finance professionals] who make
such payments may be doing so in an effort to avoid the political
contribution limitations embodied in Rule G-37.''); Self-Regulatory
Organizations; Municipal Securities Rulemaking Board; Order
Approving Proposed Rule Change Concerning Solicitation and
Coordination of Payments to Political Parties and Question and
Answer Guidance on Supervisory Procedures Related to Rule G-37(d) on
Indirect Violations, Exchange Act Release No. 52496 (Sept. 22, 2005)
(SEC order approving change to MSRB G-37 to prohibit soliciting or
coordinating payments to political parties).
\153\ See G-37(c) Notice, supra note 152. (``Both the 1996 Q&A
guidance and the 2003 Notice were intended to alert dealers and
[municipal finance professionals] to the realities of political
fundraising and guide them toward developing procedures that would
lead to compliance with both the letter and the spirit of the Rule.
The MSRB continues to be concerned, however, that dealer, [municipal
finance professional], and affiliated persons' payments to political
parties, including ``housekeeping,'' ``conference'' or ``overhead''
type accounts, and PACs give rise to at least the appearance that
dealers may be circumventing the intent of Rule G-37.'').
\154\ We note that a direct contribution to a political party by
an adviser or its covered associates would not trigger the two-year
time out provision of the proposed rule (although we request comment
on our proposed definition of ``contribution''), unless the
contribution was a means for the adviser to do indirectly what the
proposed rule would prohibit if done directly (for example, if the
contribution was earmarked or known to be provided for the benefit
of a particular government official). See supra note 93. We are
proposing, however, that an adviser be prohibited from soliciting
others to make, or coordinating, payments to political parties
because, as the MSRB's experience has shown, advisers could
otherwise use such means to circumvent the proposed rule's
limitations on direct contributions to government officials.
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Proposed rule 206(4)-5(a)(2)(ii) would also prohibit advisers from
seeking to influence the selection process by, for example,
``bundling'' \155\ contributions
[[Page 39855]]
or payments from its employees or others or by making or coordinating
contributions or payments through a third party, such as a
``gatekeeper.'' \156\ In a gatekeeper arrangement, political
contributions or payments are arranged by an intermediary, typically a
pension consultant, which distributes or directs contributions or
payments to elected officials or candidates.\157\ The gatekeeper
ensures that advisers not making a requisite amount of contributions or
payments are not included among the final candidates for advisory
contracts. In addition, a gatekeeper could arrange ``swaps'' of
contributions or payments between elected officials in order to obscure
the significance of the contributions or payments from public
disclosure or to circumvent plan restrictions on contributions to
trustees.\158\ Under the proposed rule, the gatekeeper in these
arrangements would be coordinating political contributions or payments
and, if the gatekeeper is an investment adviser, would itself violate
the proposed rule's restrictions on coordinating contributions or
payments.\159\ The adviser would also violate the proposed rule if it
paid the third-party solicitor to coordinate political contributions or
payments in order to obtain business.
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\155\ An employee or person acting on an adviser's behalf
``bundles'' contributions or payments by coordinating small
contributions or payments from several employees of the adviser or
others to create one large contribution or payment. For an example
of this in the context of the municipal securities industry, see In
the Matter of Pryor, McClendon, Counts & Co., Inc. et al.,
Securities Act Release No. 48095 (June 26, 2003) (``Counts[, the
president of the broker-dealer firm,] gave his administrative
assistant $750 in cash, told her to purchase three separate money
orders, and told her to make them payable for $250 each to the
candidate's campaign. Counts instructed his assistant to make out
one of the money orders as if it were from the assistant herself,
and to make out the other two as if they were from the wife of a
[firm] employee and a friend of Counts', respectively. Counts then
caused those money orders to be delivered to the candidate's
campaign together with Counts' own personal check for $250. [When
two of the three money orders were subsequently returned,] Counts
instructed his assistant to deposit the returned $500 into [the
firm]'s bank account, which she did.'').
\156\ We are proposing that solicitation of contributions of
others for an official of a government entity to which an adviser is
providing or seeking to provide investment advisory services by an
adviser or its covered associates be subject to a flat prohibition
under the rule, rather than trigger a two-year ``time out,'' because
we recognize it may be more difficult for an adviser to monitor
solicitation activities (as opposed to direct contribution
activity). For a discussion of an adviser's obligation to adopt
policies and procedures reasonably designed to prevent violations of
the Advisers Act pursuant to our ``compliance rule,'' see infra note
207 and accompanying text.
\157\ See, e.g., SEC v. Morris et al., Litigation Release No.
21001 (Apr. 15, 2009) (the Commission's complaint alleges that
placement agents acted as gatekeepers by directing investment
management firms to funnel kickbacks through various entities); In
the Matter of Kent D. Nelson, Initial Decision Release No. 371 (Feb.
24, 2009) (an administrative law judge found that an investment
adviser funneled payments through a third party to the New Mexico
State treasurer, acting as gatekeeper by extracting $4.4 million in
finder's fees from broker-dealers and siphoning $2.9 million to the
State treasurer's office to influence the office's discretionary
commitment of funds, in exchange for being retained as an adviser by
the State treasurer's office); (Investment Advisers Act Release No.
2868 (Apr. 17, 2009). Similar types of arrangements exist outside of
the context of government investments, such as in the area of union
pension funds. See, e.g., In the Matter of Duff & Phelps Investment
Management Co., Inc., Investment Advisers Act Release No. 1984
(Sept. 28, 2001) and related case In re Performance Analytics, et
al., Investment Advisers Act Release No. 2036 (June 17, 2002) (in a
settled action, the Commission alleged that an investment adviser
entered into an arrangement with gatekeeper broker-dealer in which
the adviser would direct its trades to broker-dealer if the broker-
dealer would continue to recommend the adviser to the union pension
fund board, and the broker-dealer allegedly funneled payments to
certain trustees on the pension fund board to preserve its role as
gatekeeper and to preserve the adviser's role as adviser to the
fund).
\158\ For example, Adviser A advises Plan X, while Adviser B
advises Plan Y. The ``gatekeeper'' may direct a political
contribution from Adviser A to the elected official, who is a
trustee to Plan Y, and from Adviser B to the elected official, who
is a trustee to Plan X, agreeing to place both advisers on each
plan's approved list. Persons reviewing records of the political
contributions would have no way of determining that the
contributions were swapped and that they created conflicts of
interest on the part of the advisers as well as the elected
officials.
\159\ Regardless of whether the gatekeeper is an investment
adviser, a person participating in such a scheme could, if the rule
is adopted, be considered to be aiding and abetting an adviser's
violation of the rule. See section 209(d) of the Act [15 U.S.C. 80b-
9(d)] (authorizing Commission enforcement action for aiding and
abetting a violation of the Advisers Act or any Advisers Act rule).
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We request comment on this aspect of the proposed rule, including
our proposed definitions. Is it appropriate to differentiate between
``contributions'' to officials and ``payments'' to political parties?
Are there alternative approaches that would effectively deter these
types of indirect pay to play arrangements? Do commenters believe that
our proposed inclusion of payments to State and local political parties
closes an important gap in which contributions might be made indirectly
to officials for the purposes of influencing their choice of investment
advisers? Alternatively, do commenters believe that our proposed
inclusion of political parties is unnecessary?
(d) Direct and Indirect Contributions or Solicitations
Rule 206(4)-5(d) would also prohibit acts done indirectly, which,
if done directly, would result in a violation of the rule.\160\ Thus,
an adviser and its covered associates could not circumvent the rule by
directing or funding contributions through third parties, including,
for example, consultants, attorneys, family members, friends or
companies affiliated with the adviser. This provision would also cover,
for example, situations in which contributions by an adviser are made,
directed or funded through a third party with an expectation that, as a
result of the contribution, another contribution is likely to be made
by a third party to an ``official of the government entity,'' for the
benefit of the adviser. Contributions made through gatekeepers
(described above) thus would be considered made ``indirectly'' for
purposes of the proposed rule. We request comment on this aspect of the
proposed rule.
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\160\ Proposed rule 206(4)-5(d). See also section 208(d) of the
Advisers Act [15 U.S.C. 80b-8(d)]; MSRB rule G-37(d).
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(e) Investment Pools
(1) Application of the Rule to Pooled Investment Vehicles
Pay to play activities in the context of investment pools \161\
also raise concerns about the potential for fraud.\162\ The fraud that
may result from pay to play practices can occur in a number of
circumstances involving the government official and the pooled
investment vehicle. The following are examples of pay to play
relationships involving
[[Page 39856]]
investment pools that implicate the concerns underlying this
rulemaking:
---------------------------------------------------------------------------
\161\ Investment pools may include, but are not limited to:
mutual funds, hedge funds, private equity funds, and venture capital
funds.
\162\ See, e.g., SEC v. Paul J. Silvester et al., Litigation
Release No. 16759 (Oct. 10, 2000) (action in which investment
adviser allegedly paid third party solicitors who kicked back a
portion of the money to the former Connecticut State Treasurer in
order to obtain public pension fund investments in a hedge fund
managed by the adviser); SEC v. William A. DiBella et al.,
Litigation Release No. 20498 (Mar. 14, 2008) (consultant was found
to have aided and abetted the former Connecticut State Treasurer in
a pay to play scheme involving an investment adviser to a private
equity fund who had paid third-party solicitors to obtain public
pension fund investments in the fund); In the Matter of the Carlyle
Group, AGNY Investigation No. 2009-071, Assurance of Discontinuance
Pursuant to Executive Law Sec. 63(15) (May 14, 2009), available at
http://www.oag.state.ny.us/media_center/2009/may/pdfs/
Carlyle%20AOD.pdf; In the Matter of Riverstone Holdings, LLC, AGNY
Investigation No. 2009-091, Assurance of Discontinuance Pursuant to
Executive Law Sec. 63(15) (June 11, 2009), available at http://
www.oag.state.ny.us/media_center/2009/june/pdfs/
Riverstone%20AOD%20FINAL%20EXECUTED.pdf; and In the Matter of PCG
Corporate Partners Advisors II, LLC, AGNY Investigation No. 2009-
101, Assurance of Discontinuance Pursuant to Executive Law Sec.
63(15) (July 1, 2009), available at http://www.oag.state.ny.us/
media_center/2009/july/pdfs/PCG%20AOD%20FINAL%20EXECUTED.pdf (three
settled actions brought by New York Attorney General in which
advisers allegedly paid third-party solicitors who kicked back a
portion of the money to the former New York Deputy State Treasurer
in order to obtain public pension investments in private equity
funds managed by the advisers).
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When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and the government
official directs that public monies (e.g., pension plan assets) be
invested in that adviser's pooled investment vehicle;
When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and that government
official chooses that investment adviser to be an adviser to a
government sponsored plan, such as a ``529 plan;'' \163\ and
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\163\ This practice would be covered under (a)(1) of the
proposed rule. See supra section II.A.3.(a) of this release. For a
specific discussion of the application to ``529 plans,'' see
discussion below at footnotes 176-189 and related text.
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When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and that government
official chooses that adviser's pooled investment vehicle as an
investment option in a government sponsored plan, such as a ``529
plan,'' \164\ regardless of whether the adviser is also chosen to be
the adviser to the plan.
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\164\ See Elliot Blair Smith, Fund Scandal Worries Tuition Plan
Investors, USA Today (Nov. 19, 2003), at B1 (reporting that the
former governor of Wisconsin received campaign contributions from
the founder of a mutual fund company, and subsequently the then-
governor's staff created a panel of four State employees that
selected the founder's firm to manage the State's 529 plan and
provide the plan's investment options).
---------------------------------------------------------------------------
Pay to play activities can harm public pension plans and their
beneficiaries. Such activities can cause competition in the market for
investments to be manipulated, which can distort the process by which
investment decisions regarding public investments are made, and can
result in public pension plans making inferior investments. In
addition, the pension plan may pay higher fees because advisers must
recoup the contributions, or because the contract negotiations are not
handled on an arm's-length basis.
An adviser's participation in pay to play activities may also
defraud other investors in a pooled investment vehicle. For example, in
a pay to play kickback scheme, the government investor in the pooled
vehicle would receive a kickback payment from the adviser while other
investors in the pool may pay higher advisory fees as a result of the
adviser trying to recoup the cost of the kickback. As another example,
a government investor that has engaged in a pay to play scheme with an
investment adviser may leverage the fact of the adviser's payment to
obtain additional benefits for itself that may operate as a fraud on
other investors in the pooled vehicle.
Therefore, the proposed prophylactic rule seeks to address pay to
play practices by advisers managing pooled investment vehicles.\165\
The proposed rule would subject an adviser to a covered investment pool
to the prohibitions of proposed rule 206(4)-5 \166\ so that the
government entities, the pooled investment vehicles, and the other
investors in that vehicle are also protected against the harms that may
result when advisers engage in pay to play practices.
---------------------------------------------------------------------------
\165\ See proposed rule 206(4)-5(c).
\166\ Id.
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(2) Covered Investment Pools
The proposed rule's prohibitions would be applicable only with
respect to an adviser that manages a covered investment pool.\167\ The
proposed rule would generally define ``covered investment pool'' \168\
as: (i) Any investment company as defined in section 3(a) of the
Investment Company Act of 1940 (``Investment Company Act''); \169\ or
(ii) any company that would be an investment company under section 3(a)
of that Act but for the exclusion provided from that definition by
section 3(c)(1), section 3(c)(7) or section 3(c)(11) of that Act.\170\
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\167\ See proposed rule 206(4)-5(c). As described below,
proposed rule 206(4)-5 narrows this definition to exclude certain
investment companies for the purposes of paragraph (a)(1) of the
proposed rule.
\168\ Proposed rule 206(4)-5(f)(3).
\169\ 15 U.S.C. 80a-3(a).
\170\ 15 U.S.C. 80a-3(c)(1), (7) or (11).
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Our 1999 proposal would have applied the rule only to advisers
managing private funds, such as hedge funds and private equity
funds,\171\ that are typically excepted from the definition of
investment company by either section 3(c)(1) or 3(c)(7) of the
Investment Company Act.\172\ We have expanded upon that proposal to
include advisers managing investment companies \173\ (which are
registered under the Investment Company Act \174\) as well as
collective investment trusts (which are excepted from the definition of
investment company by section 3(c)(11)).\175\ Both of these types of
collective investment pools today are used as either funding vehicles
for, or investments of, government-sponsored savings and retirement
plans. These plans include, for example, college savings plans (such as
``529 plans'' \176\) and retirement plans (such as ``403(b) plans''
\177\ and ``457 plans'' \178\). They typically allow participants to
select among pre-established investment ``options,'' or particular
investment pools (often invested in registered investment companies or
funds of funds, such as target date funds), that a government official
has directly or indirectly selected to include as investment choices
for participants.\179\
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\171\ See 1999 Proposing Release, supra note 17, at section
II.A.4.
\172\ 15 U.S.C. 80a-3(c)(1) and (7).
\173\ 15 U.S.C. 80a-3(a).
\174\ 15 U.S.C. 80a-8.
\175\ 15 U.S.C. 80a-3(c)(11). We note that a bank maintaining a
collective investment trust would not be subject to the proposed
rule if the bank falls within the exclusion from the definition of
``investment adviser'' in Section 202(a)(11)(A) of the Advisers Act
[15 U.S.C. 80b-2(a)(11)(A)]. A person who falls within the
definition of an investment adviser that provides advisory services
with respect to a collective investment trust in which a government
entity invests, however, would be subject to the rule's
prohibitions.
\176\ A 529 plan is a ``qualified tuition plan'' established
under Section 529 of the Internal Revenue Code of 1986 [26 U.S.C.
529]. States generally establish 529 plans as State trusts which are
considered instrumentalities of States for Federal securities law
purposes. As a result, the plans themselves are generally not
regulated under the Federal securities laws and many of the
protections of the Federal securities laws do not apply to investors
in them. See Section 2(b) of the Investment Company Act [15 U.S.C.
80a-2(b) and Section 202(b) of the Advisers Act [15 U.S.C. 80b-2(b)
(exempting State-owned entities from those statutes). However, the
Federal securities laws do generally apply to, and the Commission
does generally regulate, the brokers, dealers, and municipal
securities dealers that effect transactions in interests in 529
plans. See generally Sections 15(a)(1) and 15B of the Securities
Exchange Act of 1934 [15 U.S.C. 78a-15(a)(1) and 15B] (``Exchange
Act''). A bank effecting transactions in 529 plan interests may be
exempt from the definition of ``broker'' or ``municipal securities
dealer'' under the Exchange Act if it can rely on an exception from
the definition of broker in the Exchange Act. In addition, State
sponsors of 529 plans may hire third-party investment advisers
either to manage 529 plan assets on their behalf or to act as
investment consultants to the agency responsible for managing plan
assets. These investment advisers, unless they qualify for a
specific exemption from registration under the Advisers Act, are
generally required to be registered with the Commission and would
therefore be subject to our proposed rule.
\177\ A 403(b) plan is a tax-deferred employee benefit
retirement plan established under Section 403(b) of the Internal
Revenue Code of 1986 [26 U.S.C. 403(b)].
\178\ A 457 plan is a tax-deferred employee benefit retirement
plan established under Section 457 of the Internal Revenue Code of
1986 [26 U.S.C. 457].
\179\ For example, many 529 plans allow plan participants to
select among various underlying investment options to direct the
investment of their contributions. The participants' contributions
are then invested in options of the 529 plan and the plan, in turn,
invests its assets in the investment companies or other investments
on which the plan options are based. The Internal Revenue Code
requires that in order to set up a 529 plan investor contributions
must be held in a qualified trust. See 26 U.S.C. 529(b). Often, the
adviser to the 529 plan also advises the registered investment
companies that serve as the underlying investment options for the
plan. Sometimes, however, registered investment companies advised by
investment advisers that do not provide advisory services directly
to the government entity may serve as the underlying investment
options for the plan.
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[[Page 39857]]
Government-sponsored savings plans have grown enormously in recent
years.\180\ Competition for an adviser's fund to be selected as an
investment option in government-sponsored savings plans is keen,\181\
and we are concerned that advisers to pooled investment vehicles are
making political contributions to influence the decision by government
entities of the funds to be included as options in such plans. Of
course, as discussed above,\182\ proving such a direct quid pro quo or
intent to influence in a specific case often will not be possible. As
previously stated, it is precisely because of that difficulty that a
prophylactic rule is needed.\183\ We are concerned about the harmful
effects pay to play activities may have in this context on these
government-sponsored plans and their beneficiaries. Plans and their
beneficiaries may be harmed, for example, if because of an adviser's
political contributions, a government official causes a government-
sponsored plan to invest in a fund managed by that adviser that charges
higher fees or is less well managed than a fund that may have been
chosen on the basis of pure merit. In addition, pay to play practices
could be particularly damaging in the 529 context if a State offers
only one, or very few, investment options to its participants.\184\
Accordingly, we are proposing to include these other pooled investment
vehicles often managed by investment advisers.
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\180\ See Investment Company Institute, 529 Plan Program
Statistics, Dec. 2008 (May 22, 2009), available at http://
www.ici.org/research/stats/529s/529s_12-08 (indicating that 529
plan assets have increased from $8.6 billion in 2000 to $104.9
billion in the fourth quarter of 2008, and that 529 plan
participants have increased from 1.3 million in 2000 to 11.2 million
in the fourth quarter of 2008); Investment Company Institute, The
U.S. Retirement Market, 2008, 18 Research Fundamentals, No. 5 (June
2009), available at http://www.ici.org/pdf/fm-v18n5.pdf (indicating
that 403(b) plan and 457 plan assets have increased from $627
billion in 2000 to $712 billion in the fourth quarter of 2008); SEI,
Collective Investment Trusts: The New Wave in Retirement Investing
(May 2008), available at https://longjump.com/networking/
RepositoryPublicDocDownload?id=80031025axe139509557&docname=SEI%20CIT
%20White%20Paper%205.08.pdf&cid=80031025&encode=application/pdf
(citing Morningstar data indicating that collective investment trust
assets nearly tripled from 2004 to 2007 and grew by more than 150
percent between 2005 and 2007 alone).
\181\ See, e.g., Charles Paikert, TIAA-CREF Stages Comeback in
College Savings Plans, Crain's New York Business (Apr. 23, 2007)
(depicting TIAA-CREF's struggle to remain a major player in managing
State 529 plans because of increasing competition from the
industry's heavyweights); Beth Healy, Investment Giants Battle for
Share of Exploding College-Savings Market, Boston Globe (Oct. 29,
2000), at F1 (describing the increasing competition between
investment firms for State 529 plans and increasing competition to
market their plans nationally).
\182\ See supra notes 16 and 55 and accompanying text.
\183\ See, e.g. Blount, supra note 16, at 945.
\184\ See, e.g., Restrictions Lessen Benefits of State College
Savings Plans, USA Today (Dec. 1, 2003), at A20 (``[M]any States
offer only a few investment options * * * [and] limit investors to a
single fund company. * * * While plans vary, States typically have
negotiated an exclusive deal with one fund company.'').
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Under the rule, each of the pay to play prohibitions (with one
exception discussed below) would be equally applicable to an investment
adviser that manages assets of a government entity through the entity's
investment in a covered investment pool managed by that adviser. For
example, if an investment adviser subject to our rule makes a campaign
contribution to an official of a government entity in a position to
influence the decision to invest government assets in a private equity
fund managed by that adviser, the investment adviser would be
prohibited from receiving compensation with respect to the government
entity's investment in the private equity fund.
In the case of an adviser to a publicly-offered registered
investment company, however, we propose to apply the two-year ``time
out'' provision only when the investment company is included in a plan
or program of a government entity (e.g., a 529 plan).\185\ When a
government entity invests in publicly-offered securities of a
registered investment company, we are generally less concerned that the
investment company's adviser would be motivated by pay to play
considerations if, for example, the adviser has not bid for, or
solicited, the government entity's business. Moreover, in many
circumstances in which a government entity determines to make an
investment in an investment company for cash management or other
purposes, the adviser may not even be aware that a government entity
has made an investment.\186\ We are mindful that subjecting advisers
and their covered associates to the two-year ``time out'' in these
situations could create substantial compliance challenges because the
adviser would have to monitor investments by these government entities
in its investment companies to ensure that a contribution by the
adviser or its covered associates did not trigger a time out. In
contrast, we have included an exception that would subject to the two-
year time out provision an adviser to a publicly offered registered
investment company that is included in a plan or program of a
government entity because we believe pay to play concerns are more
likely to be present in that situation, and advisers will clearly know
that the government entity is a client or investor in the adviser's
investment company. As noted above, significant competition exists
among advisers to have their funds selected as investment options in
government-sponsored savings plans, which we believe may contribute to
the risk of pay to play.\187\
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\185\ Proposed rule 206(4)-5(c), (f)(3). Accordingly, the time
out provision would be applicable, for example, if a particular
mutual fund is selected to be an investment option for participants
in a 529 plan; the time out provision would not be applicable if a
State government invested its pension fund assets in that same
mutual fund. We define a ``plan or program of a government entity''
in the proposed rule as any investment program or plan sponsored or
established by a government entity, including, but not limited to, a
``qualified tuition plan,'' such as a 529 plan, a retirement plan,
such as a 403(b) plan or 457 plan, or any similar program or plan.
Proposed rule 206(4)-5(f)(8).
\186\ In contrast, where securities are privately placed, such
as securities of a private fund, the adviser (and through its
compliance program, its personnel) should be aware that an
investment from a government entity is being solicited and should
therefore be in a position to refrain from making contributions that
would trigger a ``time out'' with respect to receiving compensation
from that government entity.
\187\ See supra note 180 and accompanying text.
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We believe it is appropriate, however, to apply the other two
substantive prohibitions of the proposed rule \188\ to advisers to
pooled investment vehicles regardless of whether it is included in a
plan or program of a government entity. We believe the same concerns
regarding pay to play are raised under those prohibitions whether the
adviser is managing the government entities' assets directly or through
a pooled investment vehicle.
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\188\ Proposed rule 206(4)-5(a)(2)(i) and (ii).
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For example, an investment adviser subject to our proposed rule
that manages a registered investment company would be prohibited from
compensating a third party to solicit an investment by a government
entity in the fund or soliciting others to make contributions to
officials of a government entity that the adviser seeks to have invest
in the fund. For purposes of the two-year time out, however, a mutual
fund adviser would not need to screen for investments from government
entities to determine if a disqualifying campaign contribution has been
made if the fund is used for investment of a State government's general
assets or for investment by the State's pension fund. If the registered
investment company is to be included in that State's 529 plan, however,
the investment adviser would be subject to the two-year time out on
contributions.\189\
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\189\ The proposed rule would prohibit the receipt of
compensation from the investment company by the investment adviser,
not the inclusion of the investment company in the 529 plan, and
would also prohibit the receipt of any advisory fee to which the
adviser is entitled if it is also a direct adviser to the 529 plan.
We note that a firm retained by a government entity to
distribute interests in a 529 plan (i.e., municipal fund securities)
may be subject to MSRB rules. See Municipal Securities Rulemaking
Board, Interpretive Notice: Rule D-12: Interpretation Relating to
Sales of Municipal Fund Securities in the Primary Market (Jan. 18,
2001), available at http://www.msrb.org/msrb1/rules/NewRuleD-
12Interpretation.htm. Such a distributor may have an affiliated
investment adviser that is retained by the government entity to
provide investment advice to the 529 plan. Thus, the distributor
could be subject to MSRB rules G-37 and G-38, while the affiliated
investment adviser could be subject to our proposed rule, if
adopted. As we note above, the investment adviser's fiduciary
obligations could require it to continue to provide investment
advice without compensation after it or a covered associate gives a
contribution that triggers our proposed rule's two-year ``time out''
while MSRB rule G-37 typically would ban a firm from continuing to
engage in municipal securities business for two years after a
triggering contribution is made. See supra note 80. However, the
MSRB has provided additional flexibility in the context of contracts
to distribute securities such as interests in 529 plans. See
Municipal Securities Rulemaking Board, Interpretation on the Effect
of a Ban on Municipal Securities Business under Rule G-37 Arising
During a Pre-Existing Engagement Relating to Municipal Fund
Securities (Apr. 2, 2002), available at http://www.msrb.org/msrb1/
rules/notg37.htm (allowing a dealer that has become subject to G-
37's ban on new municipal securities business to continue receiving
compensation throughout the duration of the ban if certain
conditions are met). We are not proposing a similar approach under
our rule because it would undermine the deterrent effect of having a
two-year time out.
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[[Page 39858]]
We request comment on the definition of covered investment pool
under the proposed rule. Should we also apply the rule in the context
of government investments in structured finance vehicles in which
public funds may invest? \190\ Should we, alternatively or in addition,
limit the applicability of the proposed rule's prohibitions in the
context of registered investment companies to circumstances under which
the government entity's investment is of a sufficiently large size such
that the fund adviser is more likely to have an incentive to attempt to
influence the government entity's decision-making process? If so, how
should we define that threshold? Should we, for example, base it on the
amount of assets in the fund, such as 5 percent of the fund's assets?
Should we treat differently under the rule advisers to funds in plans
where the adviser is not the sole or primary adviser to the plan or
where a different adviser's funds are included as investment options
under the plan? For example, are there sub-advisory arrangements in
which a sub-adviser would not know or be able to influence whether, or
which, government entities are being solicited for a covered investment
pool? If so, how should we define those sub-advisers? Should we
circumscribe the rule's applicability so it is not triggered in the
context of government entity investments in particular types of funds,
such as money market funds, where the ability of the adviser to profit
might be attenuated because, for example, those particular types of
funds tend to generate lower margin or investments tend to be for
relatively short terms? Should we provide exceptions to the provision
subjecting an adviser to a two-year ``time out'' from receiving
compensation in the context of specific types of government entity
investments (such as short-term investments for cash management)?
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\190\ These might include, for example, pools exempt from the
definition of ``investment company'' under Section 3(c)(5) or (6) of
the Investment Company Act [15 U.S.C. 80a-3(c)(5) and (6)] and pools
relying on rule 3a-7 under the Investment Company Act. [17 CFR
270.3a-7]. Pursuant to our proposed definition of ``covered
investment pool,'' the rule would apply to an investment by a
government entity in a structured finance vehicle that relies on
Section 3(c)(1) or 3(c)(7) of the Investment Company Act [15 U.S.C.
80a-3(c)(1) and (7)]. See proposed rule 206(4)-5(f)(3).
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(3) Applying the Compensation Limit to Covered Investment Pools
If a government entity is an investor in a covered investment pool
at the time the contribution triggering a two-year ``time out'' is
made, the proposed rule would require the adviser to forgo any
compensation related to the assets invested or committed by that
government entity.\191\ We recognize the provisions of the proposed
rule that would require the adviser to either waive its fee or
terminate the relationship raise different issues for investment pools
than for separately managed accounts due to various structural and
legal differences.
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\191\ See discussion at Section II.A.3.(a)(1), supra. We note
that the phrase ``for compensation'' includes both profits and the
recouping of costs, so the proposed rule would not permit an adviser
to continue to manage assets at cost after a disqualifying
contribution is made.
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In the case of a private fund, the adviser typically could waive or
rebate the related fees and any performance allocation or carried
interest.\192\ The adviser may also seek to cause the pooled investment
vehicle to redeem the investment of the government entity. For many
private funds, such as venture capital and private equity funds, it may
not be possible for a government entity to withdraw its capital or
cancel its commitment without harm to the other investors. We request
comment on ways to prevent advisers to these funds from benefitting
from contributions covered by the two-year time out, while protecting
other investors in the funds.
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\192\ Some commenters on our 1999 Proposal noted that a
performance fee waiver raises various calculation issues. An adviser
making a disqualifying contribution could comply with the proposed
rule by waiving a performance fee or carried interest determined on
the same basis as the fee or carried interest is normally
calculated, e.g., on a mark-to-market basis. For arrangements like
those typically found in private equity and venture capital funds
where the fee or carry is calculated based on realized gains and
losses and mark-to-market calculations are not feasible, advisers
could use a straight line method of calculation which assumes that
the realized gains and losses were earned over the life of the
investment.
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The options for restricting compensation involving government
investors in registered investment companies are more limited, due to
both Investment Company Act provisions and potential tax
consequences.\193\ One approach that would meet the requirements of the
proposed rule would be for the adviser of a registered investment
company to waive its advisory fee for the fund as a whole in an amount
approximately equal to fees attributable to the government entity.\194\
We request comment on other options that may be available, including
alternatives that might require us to revise the proposed rule.
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\193\ See, e.g., Rule 18f-3 under the Investment Company Act.
Moreover, other regulatory considerations, such as the Employee
Retirement Income Security Act of 1974 [29 U.S.C. 18] (``ERISA''),
may impact these arrangements with respect to collective investment
trusts.
\194\ This may also be done at the class level or series level
for private funds organized as corporations.
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An adviser to a covered investment pool that serves as an
investment option in a government program such as a 529 plan might seek
to eliminate its investment pool as an option in order to comply with
or mitigate costs arising from the rule's two-year ``time out.'' As a
result, plan investors may be denied an appropriate investment
alternative. Would elimination of the option be an inappropriate
consequence we should seek to prevent? Have we appropriately applied
the rule to curb pay to play activities (that may be effectuated, for
example, through revenue sharing arrangements) while still permitting
funds to be marketed and distributed to government entities in the
ordinary course of business through compensated third parties, such as
registered broker-dealers?
(f) Exemptions
We are proposing a provision under which an adviser may apply to us
for an order exempting it from the two-year compensation ban.\195\
Under the proposed rule, the Commission could
[[Page 39859]]
exempt advisers from the rule's ``time out'' requirement where the
adviser discovers contributions that trigger the compensation ban only
after they have been made or when imposition of the prohibitions is
unnecessary to achieve the rule's intended purpose.\196\
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\195\ Rules 0-4, 0-5, and 0-6 under the Advisers Act [17 CFR
275.0-4, 0-5, and 0-6] provide procedures for filing applications
under the Act, including applications under the proposed rule.
\196\ This provision is similar to our 1999 proposal.
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In determining whether to grant an exemption from the two-year
compensation ban, we would take into account the varying facts and
circumstances that each application presents. Further, we would
consider: (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; (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 this
section; (B) prior to or at the time the contribution which 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
which 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
which 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 which resulted in the
prohibition, as evidenced by the facts and circumstances surrounding
such contribution.\197\
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\197\ Proposed rule 206(4)-5(e). If the proposed rule is
adopted, we would grant such exemptions pursuant to our authority
under Section 206A of the Advisers Act [15 U.S.C. 80b-6a].
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These factors are similar to those considered by FINRA and the
appropriate bank regulators in determining whether to grant an
exemption under MSRB rule G-37(i).\198\ As suggested above, when
applying the criteria, we expect to take into account, among other
things, the varying facts and circumstances presented by each
application. The factors are intended to assist us in determining
whether granting relief is appropriate. For example, one factor relates
to whether the adviser had and implemented reasonably designed policies
and procedures. Several other factors relate to the adviser's knowledge
of the contribution and its conduct after the contribution was
discovered. The remaining factors largely relate to the particular
facts surrounding the contribution that may affect whether it is
appropriate for us to grant relief in that situation. For example, the
same amount of money contributed in a local election may have a much
greater impact than in a Federal election. Facts regarding the timing
and amount of the contribution, the contributor's employment status at
the time of the contribution, as well as the contributor's apparent
intent or motive may suggest whether the contribution was made to
influence the selection of the adviser. We would apply these exemptive
provisions with sufficient flexibility to avoid consequences
disproportionate to the situation, while effecting the policies
underlying the rule.\199\ Should we provide for additional exemptions
from the proposed rule? We request comment on the proposed criteria for
exemptions by application. Are there additional criteria the Commission
should explicitly consider when determining whether to grant an
exemption?
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\198\ See MSRB rule G-37(i).
\199\ An adviser applying for an exemption could place advisory
fees earned between the date of the contribution triggering the
prohibition and the date on which we determine whether to grant an
exemption in an escrow account. The escrow account would be payable
to the adviser if the Commission grants the exemption. If the
Commission does not grant the exemption, the fees contained in the
account must be returned to the public fund.
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B. Recordkeeping
We are also proposing amendments to rule 204-2 \200\ to require an
investment adviser that is registered or required to be registered with
us and (i) has or seeks government clients or (ii) provides investment
advisory services to a covered investment pool in which a government
entity investor invests or is solicited to invest, to make and keep
certain records of contributions made by the adviser and its covered
associates. We believe these records would be necessary to allow us to
examine for compliance with rule 206(4)-5, if adopted.
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\200\ 17 CFR 275.204-2.
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The proposed amendments would require an adviser to make and keep
the following records: (i) The names, titles and business and residence
addresses of all covered associates of the investment adviser; (ii) all
government entities for which the investment adviser or any of its
covered associates is providing or seeking to provide investment
advisory services, or which are investors or are solicited to invest in
any covered investment pool to which the investment adviser provides
investment advisory services, as applicable; \201\ (iii) all government
entities to which the investment adviser has provided investment
advisory services, along with any related covered investment pool(s) to
which the investment adviser has provided investment advisory services
and in which the government entity has invested, as applicable, in the
past five years, but not prior to the effective date of the proposed
rule; \202\ and (iv) all direct or indirect contributions or payments
made by the investment adviser or any of its covered associates to an
official of a government entity, a political party of a State or
political subdivision thereof, or a PAC.\203\ The adviser's records of
contributions and payments would be required to be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether such
contribution or payment was subject to the exception for certain
returned contributions pursuant to proposed rule 206(4)-5(b)(2).\204\
These requirements are generally consistent with the MSRB recordkeeping
rule for broker-dealers.\205\
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\201\ We note that an adviser may identify its clients on its
books through the use of codes. See Advisers Act rule 204-2(d) [17
CFR 275.204-2(d)].
\202\ See id.
\203\ Proposed rule 204-2(a)(18)(i). We note that this provision
is intended to include records of direct contributions an adviser or
its covered associates makes under proposed rule 206(4)-5(a)(1), as
well as records of contributions or payments an adviser or its
covered associates coordinates or solicits another person or PAC to
make under proposed rule 206(4)-5(a)(2)(ii), which would be
considered indirect contributions or payments.
\204\ Proposed rule 204-2(a)(18)(ii).
\205\ MSRB rule G-8(a)(xvi). Like rule G-37, the proposed rule
requires an investment adviser to keep, in addition to records of
political contributions, records of any other ``payments'' made to
officials, political parties or PACs. See proposed amendment to rule
204-2(a)(18)(i)(D). See also supra note 149 and accompanying text
for an explanation of how the rule distinguishes between
contributions and payments. The MSRB also requires certain records
to be made and kept in accordance with disclosure requirements that
our proposed rule does not contain.
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Should we exclude de minimis contributions from the recordkeeping
requirement? Should we expand our recordkeeping requirements to cover
records of contributions or payments not just to government officials
and political parties, but also persons associated with officials of
government entities, regardless of whether contributions or payments to
these individuals trigger the prohibitions
[[Page 39860]]
contained in our proposed pay to play rule? \206\
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\206\ See supra note 89 and accompanying text.
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To manage compliance with the proposed rule effectively, we would
expect that the adviser would adopt sufficient internal procedures--
which would include keeping certain records--to prevent the rule's
prohibitions from being triggered.\207\ As discussed above, a single
contribution could, under the rule, lead to a two-year suspension of
compensated advisory activities for a government client. Therefore, we
anticipate that many, if not all, of the records that we propose to
require registered advisers make and keep under our proposed amendments
would be those an adviser undertaking a serious compliance effort would
ordinarily make and keep. We request that commenters opposing the new
recordkeeping requirements suggest alternative means that would be
sufficient to aid examinations for compliance with the proposed rule.
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\207\ See Advisers Act rule 206(4)-7 [17 CFR 275.206(4)-7]
(setting forth guidelines for advisers' compliance policies and
procedures).
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C. Amendment to Cash Solicitation Rule
We are also proposing a technical amendment to rule 206(4)-3 under
the Advisers Act, the ``cash solicitation rule.'' That rule makes it
unlawful, except under specified circumstances and subject to certain
conditions, for an investment adviser to make a cash payment to a
person who directly or indirectly solicits any client for, or refers
any client to, an investment adviser.\208\
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\208\ 17 CFR 275.206(4)-3.
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Because paragraph (iii) of rule 206(4)-3 contains provisions
regarding more general restrictions on third-party solicitors that
would cover solicitation activities directed at any client--whether a
government entity client or not--our proposed technical amendment would
be designed to note the specialized provisions prohibiting payments by
an adviser to third-party solicitors of government clients that are
contained in proposed rule 206(4)-5. Specifically, we propose to add a
new paragraph (e) to rule 206(4)-3 to alert advisers and others that
special prohibitions apply to solicitation activities involving
government entity clients under our proposed pay to play rule.\209\
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\209\ Proposed rule 206(4)-3(e).
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D. Transition Period
The prohibition and recordkeeping requirements under the proposed
rule would arise from contributions made on or after the effective date
of the rule, if adopted. As a result, firms would need to have
developed and adopted appropriate procedures to track contributions and
would need to begin monitoring contributions made by their covered
associates on that date. The Commission requests comment on whether
firms would require additional time to develop procedures to comply
with the proposed rule and, if so, how long of a transition period
following the rule's adoption would be necessary? For example, if a
transition period is necessary, would 90 days be an appropriate amount
of time? Would longer be necessary, e.g., six months, and if so, why?
E. General Request for Comment
Any interested persons wishing to submit written comments on the
proposed rule and rule amendment that are the subject of this Release,
or to suggest additional changes or submit comments on other matters
that might have an effect on the proposals described above, are
requested to do so. Commenters suggesting alternative approaches are
encouraged to submit proposed rule text.
III. Cost/Benefit Analysis
We are sensitive to the costs and benefits imposed by our rules,
and understand that there would be compliance costs with proposed rule
206(4)-5 and the proposed amendment to rule 204-2.\210\ We are mindful
of the burdens the proposed rule would place on advisory firms and
limitations it would place on the ability of certain persons associated
with an adviser to make contributions to candidates for certain offices
and to solicit contributions for certain candidates and payments to
political parties. We thus have narrowly tailored the rule to achieve
our goal of ending adviser participation in pay to play practices,
while seeking to limit these burdens.
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\210\ We are also proposing to make a conforming technical
amendment to rule 206(4)-3 to address potential areas of conflict
with proposed rule 206(4)-5. We do not expect that this technical
amendment will affect the costs associated with the rulemaking.
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The proposed rule and rule amendments would address ``pay to play''
practices by investment advisers that provide, or are seeking to
provide, advisory services to government entity clients and to certain
covered investment pools in which a government entity invests. The
proposed rule would prohibit an investment adviser from providing
advisory services for compensation to a government client for two years
after the adviser or certain of its executives or employees make a
contribution to certain elected officials or candidates. The proposed
rule would also prohibit an adviser from providing or agreeing to
provide, directly or indirectly, payment to any third party for a
solicitation of advisory business from any government entity, or for a
solicitation of a government entity to invest in certain covered
investment pools, on behalf of such adviser. Additionally, the proposed
rule would prevent an adviser from coordinating or soliciting from
others contributions to certain elected officials or candidates or
payments to certain political parties. Our proposed amendment to rule
204-2 would require a registered adviser (or adviser required to be
registered) to maintain certain records of the political contributions
made by the adviser or certain of its executive or employees.
A. Benefits
As discussed extensively throughout this release, we expect that
proposed rule 206(4)-5 would yield several important direct and
indirect benefits. At its core, the rulemaking addresses practices that
undermine the integrity of our markets. Overall, the proposed rule is
intended to address pay to play relationships that interfere with the
legitimate process by which advisers are chosen based on the merits
rather than on their contributions to political officials. The
potential for fraud to invade the various, intertwined relationships
created by pay to play arrangements is without question. Accordingly,
we believe that the proposed rule will achieve its goals of protecting
public pension plans, beneficiaries, and other investors from the
resulting harms.
Curtailing pay to play practices will help protect public pension
plans and investments of the public in government-sponsored savings and
retirement plans and programs by addressing situations in which a more
qualified adviser may not be selected, potentially leading to inferior
management, diminished returns or greater losses. By addressing pay to
play practices, we would be leveling the playing field so that the
advisers selected to manage retirement funds and other investments for
the public are more likely to be selected based on their skills and the
quality of their advisory services. These benefits could result in
substantial savings and better performance for the public pension
[[Page 39861]]
plans, their beneficiaries, and participants.\211\
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\211\ According to U.S. census data as of 2007, there are 2,547
State and local government employee retirement systems.
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By leveling the playing field among advisers competing for State
and local government business, the proposed rule could also eliminate
or minimize manipulation of the market for advisory services provided
to State and local governments. Payments made to third-party solicitors
as part of pay to play practices create artificial barriers to
competition for firms that cannot, or will not, make those
contributions or payments. They also create increased costs for firms
that may feel they have no alternative but to pay to play.
Additionally, pay to play practices potentially expose an adviser to
other costs, such as liability, defense costs and distraction from its
duties. Curtailing pay to play arrangements enables advisory firms,
particularly smaller advisory firms, to compete on merit, rather than
their ability or willingness to make contributions.
Moreover, the absence of arm's-length negotiations may enable
advisers to obtain greater ancillary benefits, such as ``soft
dollars,'' from the advisory relationship, which may be directed for
the benefit of the adviser, potentially at the expense of the pension
plan, thereby using a pension plan asset for the adviser's own
purposes.\212\ Additionally, taxpayers could benefit because they might
otherwise bear the financial burden of bailing out a government pension
fund that has ended up with a shortfall due to poor performance or
excessive fees that might result from pay to play.
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\212\ See supra note 51.
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Applying the proposed rule to government entity investments in
certain pooled investment vehicles or where a pooled investment vehicle
is an investment option in a government-sponsored plan or program would
extend the same benefits regardless of whether an adviser subject to
the proposed rule is providing advice directly to the government entity
or is managing assets for the government entity indirectly through a
pooled investment vehicle. By addressing distortions in the process by
which investment decisions are made regarding public investments, we
will provide important protections to public pension plans and their
beneficiaries, as well as participants in other important plans or
programs sponsored by government entities. Other investors in a pooled
investment vehicle also will be better protected from, among other
things, the effects of fraud that may result from an adviser's
participation in pay to play activities, such as higher advisory fees.
Finally, the proposed amendments to rule 204-2 would benefit the
public plans and their beneficiaries and participants in State plans or
programs as well as investment advisers that keep the required records.
The public pension plans, beneficiaries, and participants would benefit
from these amendments because the records required to be kept would
provide Commission staff with information to review an adviser's
compliance with proposed rule 206(4)-5 and thereby may promote improved
compliance. Advisers would benefit from the proposed amendments to the
recordkeeping rule as these records would assist the Commission in
enforcing the rule against, for example, competitors whose pay to play
activities, if not uncovered, could adversely affect the competitive
position of a compliant adviser.
B. Costs
The proposed rule and rule amendments would impose costs on
advisers that provide advisory services to government clients, though
we have tried to minimize the costs associated with an inadvertent
violation of proposed rule 206(4)-5 by including an exception for
certain returned contributions. The proposed rule would require an
adviser with government clients, and an adviser that solicits business
from government clients, to incur costs to monitor contributions made
by the adviser and its covered associates, and to establish procedures
to comply with the proposed rule and rule amendments. The initial and
ongoing compliance costs imposed by the proposed rule would vary
significantly among firms, depending on a number of factors. These
include the number of covered associates of the adviser, the degree to
which compliance procedures are automated, the extent to which an
adviser has a pre-existing policy under its code of ethics or
compliance program,\213\ and whether the adviser is affiliated with a
broker-dealer firm that is subject to rules G-37 and G-38. A smaller
adviser, for example, would likely have a small number of covered
associates, and thus expend less resources to comply with the proposed
rule and rule amendments than a larger adviser.
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\213\ See Investment Counsel Association of America Comment
Letter (May 15, 2000) (``May ICAA Comment Letter'') (``According to
our members, many investment advisers already have policies and
procedures in place to report contributions under State and local
law and to avoid pay to play issues.'').
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A large adviser is likely to spend more resources to comply with
the rule than a smaller adviser. However, based on staff observations,
a large adviser is more likely to have an affiliated broker-dealer that
is required to comply with MSRB rules G-37 and G-38.\214\ Such a large
adviser could likely use some or all of the compliance procedures
established by its broker-dealer affiliate to facilitate its compliance
with proposed rule 206(4)-5. As a result, many advisers with broker-
dealer affiliates may spend less resources to comply with the proposed
rule and rule amendments.\215\
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\214\ According to registration information available from
Investment Adviser Registration Depository (``IARD'') as of July 1,
2009, there are 1,312 SEC-registered investment advisers (or 11.57%
of the total 11,340 registered advisers) that indicate in Item
5.D.(9) of Form ADV that they have State or municipal government
clients. Of those 1,312 advisers, 108 (or 82.4%) of the largest 10%
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer; and 202 of the largest 20% (or 87.1%)
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. Conversely, only 46 (or 35.1%) of the
smallest 10% have one or more affiliated broker-dealers or are,
themselves, also registered as a broker-dealer; and only 72 of the
smallest 20% (or 31.0%) have one or more affiliated broker-dealers
or are, themselves, also registered as a broker-dealer. With respect
to broker-dealer affiliates, however, we note that our IARD data
does not indicate whether the affiliated broker-dealer is a
municipal securities dealer subject to MSRB rules G-37 and G-38.
\215\ Cf. Comment Letter of US Bancorp Piper Jaffray (Nov. 15,
1999) (``U.S. Bancorp Letter'') (``[T]he more the Rule mirrors G-37,
the more firms can borrow from or build upon compliance procedures
already in place. * * * [H]owever, [there are] many differences
between the rules that would result in significant new burdens.'').
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We anticipate that advisory firms subject to proposed rule 206(4)-5
would develop compliance procedures to monitor the political
contributions made by the adviser and its covered associates. We
estimate that the costs imposed by the proposed rule would be higher
initially, as firms establish and implement procedures and systems to
comply with the rule and rule amendments. It is anticipated that
compliance expenses would then decline to a relatively constant amount
in future years, and annual expenses are likely to be lower for small
advisers as the systems and processes should be less complex than for a
large adviser.
We estimate that approximately 1,764 investment advisers registered
with the Commission may be affected by the proposed rule and rule
amendments.\216\
[[Page 39862]]
Of the 1,764 advisers, we estimate that approximately 1,300 advisers
have fewer than five covered associates that would be subject to the
proposed rule each, a ``smaller firm''; approximately 328 advisers have
between five and 15 covered associates each, a ``medium firm''; and
approximately 136 advisers have more than 15 covered associates that
would be subject to the prohibitions of the proposed rule each, a
``larger firm'' \217\.
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\216\ This number is based on registration information available
from IARD as of July 1, 2009. As noted previously, there are 1,312
SEC-registered investment advisers (or 11.57% of the total 11,340
registered advisers) that indicate in Item 5.D.(9) of Form ADV that
they have State or municipal government clients. Based on this data
point and other responses to Item 5.D., we further estimate that 289
(or 11.57%) of the 2,502 registered investment advisers that manage
``other pooled investment vehicles'' (and do not also indicate that
they have State or municipal government clients) are advising pooled
investment vehicles in which government clients invest, and we
estimate that 79 (or 11.57%) of the 679 registered investment
advisers that manage registered investment companies (and do not
also indicate that they have State or municipal government clients)
are advising registered investment companies that are available as
an investment option in a government plan or program. The sum of
1,312, 289 and 79 is 1,680. The proposed rule also applies to those
advisers that seek to obtain government clients, and we do not know
the precise number of such advisers. We believe, however, that the
percentage of advisers is likely not great because, according to
IARD data, there has not been any appreciable growth or shrinkage
over the past five years in the percentage of SEC-registered
advisers who have State or municipal government clients; the
percentage has been almost unchanged. Accordingly, we estimate that
an additional 5% (or 84) of SEC-registered advisers are seeking
government clients, for a total of 1,764 (1,680 + 84) registered
advisers subject to the proposed rule.
\217\ These estimates are based on IARD data, specifically the
responses to Item 5.B.(1) of Form ADV, that 967 (or 73.7%) of the
1,312 registered investment advisers that have government clients
have fewer than five employees who perform investment advisory
functions related to those government clients, 244 (or 18.6%) have
five to 15 such employees, and 101 (or 7.7%) have more than 15 such
employees. We then applied those percentages to the 1,764 advisers
we believe will be subject to the proposed rule for a total of 1,300
smaller, 328 medium and 136 larger firms.
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Advisers that are unregistered in reliance on the exemption
available under section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)] would be subject to proposed rule 206(4)-5.\218\ Based on our
review of registration information on IARD and outside sources and
reports, we estimate that there are approximately 2,000 advisers that
are unregistered in reliance on section 203(b)(3).\219\ Applying the
same principles we used with respect to registered investment advisers,
we estimate that 231 of those advisers manage pooled investment
vehicles in which government client assets are invested and would
therefore be subject to the proposed rule.\220\
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\218\ The proposed amendments to rules 204-2 and 206(4)-3 would
apply only to advisers that are registered, or required to be
registered, with the Commission.
\219\ This number is based on our review of registration
information on IARD as of July 1, 2009, IARD data from the peak of
hedge fund adviser registration in 2005, and a distillation of
numerous third-party sources including news organizations and
industry trade groups.
\220\ 11.57% of 2000 is 231.4. See supra note 216.
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For purposes of this analysis, it is assumed that each exempt
advisory firm that would be subject to the proposed rule would likely
either be smaller firms or medium firms, in terms of number of covered
associates because it is unlikely that an adviser that is limited to
fewer than 15 clients would have a large number of advisory personnel
that would be covered associates.\221\
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\221\ See section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)].
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Although the time needed to comply with the proposed rule would
vary significantly from adviser to adviser, the Commission staff
estimates that firms with government clients would spend between 8
hours and 250 hours to establish policies and procedures to comply with
the proposed rule. Commission staff further estimates that ongoing
compliance with the proposed rule would require between 10 and 1,000
hours, annually. These estimates are derived in part from conversations
with industry professionals regarding broker-dealer compliance with
rule G-37 and G-38 and representatives of investment advisers that have
pay to play policies in place. In addition, advisory firms may incur
one-time costs to establish or enhance current systems to assist in
their compliance with the proposed rule. These costs would vary widely
among firms. Small advisers may not incur any system costs if they
determine a system is unnecessary due to the limited number of
employees they have or the limited number of government entity clients
they have. Large firms likely already have devoted significant
resources into automating compliance and reporting and the new rule
could result in enhancements to these existing systems. We believe such
system costs could range from the tens of thousands of dollars for
simple reporting systems, to hundreds of thousands of dollars for
complex systems used by the large advisers. As we noted previously,
large advisers are more likely to have broker-dealer affiliates that
may already have compliance systems in place for MSRB rules G-37 and G-
38 that could be used by an adviser.
Initial compliance procedures would likely be designed, and ongoing
administration of them performed, by compliance managers and compliance
clerks. We estimate that the hourly wage rate for compliance managers
is $258, including benefits, and for compliance clerks, $63 per hour,
including benefits.\222\ To establish and implement adequate compliance
procedures, we estimate that the proposed rule would impose initial
compliance costs of approximately $2,064 \223\ per smaller firm,
approximately $26,156 \224\ per medium firm, and approximately $52,313
\225\ per larger firm.\226\ It is estimated that the proposed rule
would impose annual, ongoing compliance
[[Page 39863]]
expenses of approximately $2,580 \227\ per smaller firm, $104,625 \228\
per medium firm, and $209,250 \229\ per larger firm.
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\222\ Our hourly wage rate estimate for a compliance manager and
compliance clerk is based on data from the Securities Industry
Financial Markets Association's Management & Professional Earnings
in the Securities Industry 2008, modified by Commission staff to
account for an 1800-hour work-year and multiplied by 2.93 to account
for bonuses, firm size, employee benefits and overhead.
\223\ The per firm cost estimate is based on our estimate that
development of initial compliance procedures for smaller firms would
take 8 hours of compliance manager time (at $258 per hour).
\224\ With respect to our estimated range of 8-250 hours, we
assume a medium-sized firm would take 125 hours to develop initial
compliance procedures, and such a firm would likely have support
staff. We also anticipate that a compliance manager would do
approximately 75% of the work because he/she is responsible for
implementing the policy for the entire firm. Accordingly, the per
firm cost estimate is based on our estimate that development of
initial compliance procedures for medium firms would take 93.75
hours of compliance manager time (at $258 per hour) and 31.25 hours
of clerical time (at $63 per hour).
\225\ With respect to our estimated range of 8-250 hours, we
assume a larger firm would take 250 hours to develop initial
compliance procedures, and such a firm would likely have support
staff. We also anticipate that a compliance manager would do
approximately 75% of the work because he/she is responsible for
implementing the policy for the entire firm. Accordingly, the per
firm cost estimate is based on our estimate that development of
initial compliance procedures for larger firms would take 187.50
hours of compliance manager time (at $258 per hour) and 62.5 hours
of clerical time (at $63 per hour).
\226\ Some commenters in 1999 suggested that our cost estimates,
then, were too low. See U.S. Bancorp Letter (``[W]e believe the
initial compliance cost estimates in the [1999] Release of $285 for
a small firm, $13,387.50 for a medium firm and $22,312.50 for a
large firm underestimate by orders of magnitude the initial costs of
compliance.''); Comment Letter of American Council of Life Insurance
(Nov. 1, 1999) (``Many of our member companies have observed that
the proposal's compliance cost projections are speculative and
unrealistic, especially when applied to large diversified financial
institutions like life insurers. * * * Moreover, the cost estimates
are greatly understated when the proposed rule is applied to large
diversified life insurers offering investment advice as one of
several products and services. * * * One of our larger diversified
member companies has estimated that it would cost approximately
$200,000 per year to administer compliance with the proposed rule
for the approximately 200-300 people the rule would encompass. The
company developing these estimates based its estimate of hours and
labor costs on its actual compliance with Rule G-37.''). We have
significantly increased our cost estimates from our 1999 proposal.
We also note that the scope of persons covered under the current
rule proposal is narrower than the scope of persons proposed to be
covered in 1999. See supra note 98 and accompanying text.
\227\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for smaller firms would take 10 hours
of compliance manager time (at $258 per hour) per year.
\228\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for medium firms would take 375 hours
of compliance manager time (at $258 per hour) and 125 hours of
clerical time (at $63 per hour), per year.
\229\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for larger firms would take 750 hours
of compliance manager time (at $258 per hour) and 250 hours of
clerical time (at $63 per hour), per year.
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We further anticipate that approximately one-third of advisers that
we estimate would be subject to the rule may also engage outside legal
services to assist in drafting policies and procedures.\230\ We
estimate the cost associated with such an engagement would include fees
for approximately three hours of outside legal review for a smaller
firm, 10 hours for a medium firm, and 30 hours for a large firm, at a
rate of $400 per hour. For a smaller firm we estimate a total of $1,200
in outside legal fees for each of the estimated 325 advisers that would
seek assistance, for a medium firm we estimate a total of $4,000 for
the estimated 164 advisers that would seek assistance, and for each of
the 102 larger firms we estimate a total of $12,000.\231\ Thus, we
estimate that approximately 591 investment advisers will incur these
additional costs, for a total cost of $2,270,000 among advisers
affected by the proposed rule amendments.
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\230\ Based on staff observations, we estimate 75% of larger
firms, 50% of medium firms, and 25% of smaller firms would seek to
outsource all or a portion of this type of legal work.
\231\ As noted above, we estimate 75% of larger firms, 50% of
medium firms, and 25% of smaller firms would seek the assistance of
outside counsel.
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Additionally, we expect that on average approximately five advisers
annually will apply to the Commission for an exemption from the
proposed rule.\232\ We estimate that a firm that applies for an
exemption will hire outside counsel to prepare an exemptive request,
and that counsel will spend 16 hours preparing and submitting an
application for review at a rate of $400 per hour. As a result, each
application will cost approximately $6,400, and the total estimated
cost for five applications annually will be $32,000.
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\232\ This estimate is based on staff discussions with Financial
Industry Regulatory Authority staff responsible for reviewing
exemptive applications submitted under MSRB rule G-37.
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The prohibitions of the proposed rule may also impose other costs
on advisers, covered associates, third-party solicitors, and political
officials. An adviser that becomes subject to the prohibitions of the
proposed rule would no longer be eligible to receive advisory fees from
its government client. This could limit the number of advisers able to
provide services to potential government entity clients. The adviser,
however, may be obligated to provide (uncompensated) advisory services
for a reasonable period of time until the government client finds a
successor to ensure its withdrawal did not harm the client, or the
contractual arrangement between the adviser and the government client
might obligate the adviser to continue to perform under the contract at
no fee. An adviser that provides uncompensated advisory services to a
government client would incur the direct cost of providing
uncompensated services, and may incur opportunity costs if the adviser
is unable to pursue other business opportunities for a period of time.
Advisers to government clients, as well as covered associates of the
adviser, also may be less likely to make political contributions to
political officials, possibly imposing costs on the officials if they
are unable to secure alternate funding. Under the proposed rule,
covered associates and executives may face new limitations on the
amounts and to whom they can contribute. In addition, these same
individuals could be prohibited from soliciting others to contribute or
from coordinating contributions to government officials or political
parties in certain circumstances. These limitations and prohibitions,
including if a firm chose to adopt policies or procedures that are more
restrictive than the proposed rule, could be perceived by the
individuals subject to them as costs imposed on their ability to
express their support for certain candidates for elected office and
government officials.
Because the proposed rule would prohibit advisers from compensating
third parties to solicit government entities for advisory services,
advisers that currently rely on third-party solicitors to obtain
government clients may have to bear the expense of hiring and training
in-house staff in order to continue their solicitation activities.
While third-party solicitors are not subject to the proposed rule, the
proposed ban on advisers' use of third-party solicitors may have a
substantial negative impact on persons who provide third-party
solicitation services, and if their businesses consists solely of
soliciting government entities on behalf of investment advisers, the
proposed rule could result in these persons instead being employed
directly by advisers or shifting the focus of their solicitation
activities. In addition, small investment advisers and new investment
advisers that do not have the capital to hire employees to obtain
government clients may find it difficult to enter the market to provide
advisory services to government pension plans or to obtain additional
government clients.
We also anticipate that the proposed amendment to rule 204-2 would
impose additional costs. The proposed amendments to rule 204-2 would
require that SEC-registered advisers maintain certain records of
campaign contributions by certain advisory personnel.\233\ For purposes
of the Paperwork Reduction Act, we have estimated that Commission-
registered advisers would incur approximately 3,528 additional hours
annually to comply with the proposed amendments to rule 204-2.\234\
Based on this estimate, we anticipate that advisers would incur an
aggregate cost of approximately $222,264 per year for the total hours
advisory personnel would spend in complying with the proposed
recordkeeping requirements.\235\ Unregistered advisers that would be
subject to proposed rule 206(4)-5 would not be subject to the proposed
amendments to rules 204-2 and 206(4)-3.
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\233\ One commenter in 1999 expressed the view that our proposed
amendments to the recordkeeping rule would be burdensome. See Nov.
ICAA Comment Letter (``The proposed rule, in effect, requires firms
to keep an ongoing, continuously updated list of prospective
government clients. * * * [I]t is logistically unclear how a firm
should compile this list. * * * [T]he burden of continuously
compiling this list would be significant.'') We have increased our
burden estimate from our 1999 proposal. We note that records are a
critical component of proposed rule 206(4)-5. In particular, such
records are necessary for examiners to inspect advisers for
compliance with the terms of the proposed rule. We also note that it
is typical for advisers seeking business from government entities to
do so through a request for proposal or similar process, which would
typically generate a record.
\234\ See infra note 242.
\235\ We expect that the function of recording and maintaining
records of political contributions would be performed by a
compliance clerk at a cost of $63 per hour. See supra note 222.
Therefore the total costs would be $222,264 (3,528 hours x $63 per/
hour).
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C. Request for Comment
The Commission requests comment on the effects of the proposed rule
and rule amendments on pension plan beneficiaries, participants in
government plans or programs, investors in pooled investment vehicles,
investment advisers, the advisory profession as a whole, government
entities, third party solicitors, and political action committees. We
request data to quantify the costs and value of the benefits associated
with the
[[Page 39864]]
proposed rule. Specifically, comment is requested on the costs of
establishing compliance procedures to comply with the proposed rule,
both on an initial and ongoing basis. Comment also is requested on the
costs of using compliance procedures of an affiliated broker-dealer
that the broker-dealer established as a result of rule G-37 and G-
38.\236\ In addition, we request data regarding our assumptions about
the number of unregistered advisers that would be subject to the
proposed rule, and the number of covered associates of these exempt
advisers. As discussed below, section 202(c)(1) of the Advisers Act
does not apply to proposed new rule 206(4)-5 or the proposed amendments
to rule 206(4)-3. Nonetheless, in the context of the objectives of this
rulemaking, we are interested in comments that address whether these
proposed rules will promote efficiency, competition and capital
formation. We solicit comment on the effect the proposed rule would
have on the market for investment advisory services and third-party
solicitation services. Commenters should provide analysis and empirical
data to support their views on the costs and benefits associated with
this proposal.
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\236\ See ABA Comment Letter (``Any cost-benefit analysis of the
Rule logically should begin, by analogy, with an analysis of the
costs that have been borne by Municipal Securities Professionals in
complying with MSRB Rule G-37, bearing in mind that the proposed
Rule contains no reporting requirements.'').
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IV. Paperwork Reduction Act
A. Rule 204-2
The proposed amendment to rule 204-2 contains a new ``collection of
information'' requirement within the meaning of the PRA, and the
Commission has submitted the proposed amendment to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. The title for the collection of information
is ``Rule 204-2 under the Advisers Act of 1940.'' Rule 204-2 contains a
currently approved collection of information number under OMB control
number 3235-0278. An agency may not conduct or sponsor, and a person is
not required to respond to a collection of information unless it
displays a currently valid control number.
Section 204 of the Advisers Act provides that investment advisers
registered or required to be registered with the Commission must make
and keep certain records for prescribed periods, and make and
disseminate certain reports. Rule 204-2 sets forth the requirements for
maintaining and preserving specified books and records. This collection
of information is mandatory. The Commission staff uses this collection
of information in its examination and oversight program, and the
information generally is kept confidential.\237\
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\237\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
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The current approved collection of information for rule 204-2 is
based on an average of 181.15 burden hours each year, per Commission-
registered adviser, for a total of 1,954,109 burden hours. The current
total burden is based on an estimate of 10,787 registered advisers.
The proposed amendments to rule 204-2 would require every
investment adviser registered or required to be registered that
provides or seeks to provide advisory services to government entities
to maintain certain records of contributions made by the adviser or any
of its covered associates. The proposed amendments would require an
adviser to make and keep the following records: (i) The names, titles
and business and residence addresses of all covered associates of the
investment adviser; (ii) all government entities for which the
investment adviser or any of its covered associates is providing or
seeking to provide investment advisory services, or which are investors
or are solicited to invest in any covered investment pool to which the
investment adviser provides investment advisory services, as
applicable; (iii) all government entities to which the investment
adviser has provided investment advisory services, along with any
related covered investment pool(s) to which the investment adviser has
provided investment advisory services and in which the government
entity has invested, as applicable, in the past five years, but not
prior to the effective date of the proposed rule; and (iv) all direct
or indirect contributions or payments made by the investment adviser or
any of its covered associates to an official of a government entity, a
political party of a State or political subdivision thereof, or a PAC.
An adviser to a covered investment pool in which a government entity
invests or is solicited to invest would be treated as though that
investment adviser were providing or seeking to provide investment
advisory services directly to the government client. The adviser's
records of contributions and payments would be required to be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether such
contribution or payment was subject to the exception for certain
returned contributions pursuant to proposed rule 206(4)-5(b)(2). These
records would be required to be maintained in the same manner, and for
the same period of time, as other books and records under rule 204-
2(a). This collection of information would be found at 17 CFR 275.204-
2. Advisers that are exempt from Commission registration under section
203(b)(3) of the Advisers Act would not be subject to the recordkeeping
requirements.
Commission records indicate that currently there are approximately
11,340 registered investment advisers subject to the collection of
information imposed by rule 204-2.\238\ As a result of the increase in
the number of advisers registered with the Commission since the current
total burden was approved, the total burden has increased by 100,176
hours (553 additional advisers \239\ x 181.15 hours). We estimate that
approximately 1,764 Commission-registered advisers provide, or seek to
provide, advisory services to government clients and to certain pooled
investment vehicles in which government entities invest, and would thus
be affected by the proposed rule amendments.\240\ Under the proposed
amendments, each respondent would be required to retain the records in
the same manner and for the same period of time as currently required
under rule 204-2. The proposed amendments to rule 204-2 are estimated
to increase the burden by approximately two hours per Commission-
registered adviser with government clients annually for a total
increase of 3,528 hours.\241\ The revised annual aggregate burden for
all respondents to the recordkeeping requirements under rule 204-2 thus
would be 2,057,813 hours.\242\ The revised weighted average burden per
Commission-registered adviser would be 181.46 hours.\243\
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\238\ This figure is based on registration information from IARD
as of July 1, 2009.
\239\ 11,340-10,787 = 553.
\240\ See supra note 216.
\241\ This increased burden relates only to the recordkeeping
requirements we are proposing to amend. See supra section III.B. of
this release for an explanation of other estimated costs associated
with complying with the proposed rule and rule amendments.
\242\ 1,954,109 (current approved burden) + 100,176 (burden for
additional registrants) + 3,528 (burden for proposed amendments) =
2,057,813 hours.
\243\ 2,057,813 (revised annual aggregate burden) divided by
11,340 (total number of registrants) = 181.46.
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Additionally, we expect advisory firms may incur one-time costs to
establish or enhance current systems to
[[Page 39865]]
assist in their compliance with the proposed amendments to rule 204-2.
These costs would vary widely among firms. Small advisers may not incur
any system costs if they determine a system is unnecessary due to the
limited number of employees they have or the limited number of
government entity clients they have. Large firms likely already have
devoted significant resources into automating compliance and reporting
and the new rule could result in enhancements to these existing
systems. We believe they could range from the tens of thousands of
dollars for simple reporting systems, to hundreds of thousands of
dollars for complex systems used by the large advisers.
B. Rule 206(4)-3
The proposed amendment to rule 206(4)-3 contains a revised
``collection of information'' requirement within the meaning of the
PRA, and the Commission has submitted the proposed amendment to the OMB
for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The
title for the collection of information is ``Rule 206(4)-3--Cash
Payments for Client Solicitations.'' Rule 206(4)-3 contains a currently
approved collection of information number under OMB control number
3235-0242.
Section 206(4) of the Advisers Act provides that it shall be
unlawful for any investment adviser to engage in any act, practice, or
course of business which is fraudulent, deceptive, or manipulative.
Rule 206(4)-3 generally prohibits investment advisers from paying cash
fees to solicitors for client referrals unless certain conditions are
met. The rule requires that an adviser pay all solicitors' fees
pursuant to a written agreement that the adviser is required to retain.
This collection of information is mandatory. The Commission staff uses
this collection of information in its examination and oversight
program, and the information generally is kept confidential.\244\
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\244\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
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The current approved collection of information for rule 206(4)-3 is
based on an estimate that 20% of the 10,817 Commission-registered
advisers (or 2,163 advisers) rely on the rule, at an average of 7.04
burden hours each year, per respondent, for a total of 15,228 burden
hours (7.04 x 2,163).
The proposed amendments to rule 206(4)-3 would require every
investment adviser that relies on the rule and that provides or seeks
to provide advisory services to government entities to also abide by
the limitations provided in proposed rule 206(4)-5. This collection of
information would be found at 17 CFR 275.206(4)-3. Advisers that are
exempt from Commission registration under section 203(b)(3) of the
Advisers Act would not be subject to rule 206(4)-3.
Commission records indicate that currently there are approximately
11,340 registered investment advisers,\245\ 20% of which (or 2,268) are
likely subject to the collection of information imposed by rule 206(4)-
3. As a result of the increase in the number of advisers registered
with the Commission since the current total burden was approved, the
total burden has increased by 739.2 hours (105 additional advisers
\246\ x 7.04 hours). We assume that approximately 20% of the
Commission-registered advisers that use rule 206(4)-3 (or 454 advisers)
provide, or seek to provide, advisory services to government clients
and would thus be affected by the proposed rule amendments.\247\ Under
the proposed amendments, each respondent would be prohibited from
certain solicitation activities with respect to government
clients,\248\ which would eliminate the need to enter into and retain
the written agreement required under rule 206(4)-3 with respect to
those clients. Accordingly, the proposed amendments to rule 206(4)-3
are estimated to decrease the burden by 20%, or approximately 1.4
hours, per Commission-registered adviser that uses the rule and has or
is seeking government clients annually, for a total decrease of 635.6
hours. The revised annual aggregate burden for all respondents to the
recordkeeping requirements under rule 206(4)-3 thus would be 15,331.6
hours.\249\ The revised weighted average burden per Commission-
registered adviser would be 6.76 hours.\250\
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\245\ This figure is based on registration information from IARD
as of July 1, 2009.
\246\ 2,268 (20% of current registered investment advisers) -
2,163 (20% of registered investment advisers when burden estimate
was last approved by OMB) = 105.
\247\ In light of the 11.57% of registered investment advisers
that indicate they have State or municipal government clients, we
conservatively estimate that 20% of the advisers who rely on rule
206(4)-3 are soliciting government entities to be advisory clients
or to invest in covered investment pools those advisers manage. See
supra note 214.
\248\ See proposed rule 206(4)-3(a).
\249\ 15,228 (current approved burden) + 739.2 (burden for
additional registrants) -635.6 (reduction in burden for proposed
amendments) = 15,331.6 hours.
\250\ 15,331.6 (revised annual aggregate burden) divided by
2,268 (total number of registrants who rely on rule) = 6.76.
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C. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed amendments to the
collection of information are necessary for the proper performance of
the functions of the Commission, including whether the information will
have practical utility; (ii) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collection of information; (iii)
determine whether there are ways to enhance the quality, utility, and
clarity of the information to be collected; and (iv) determine whether
there are ways to minimize the burden of the collection of information
on those who are to respond, including through the use of automated
collection techniques or other forms of information technology.
Persons desiring to submit comments on the collection of
information requirements should direct them to the Office of Management
and Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Room 3208,
Washington, DC 20503, and also should send a copy of their comments to
Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100
F Street, NE., Washington, DC 20549-1090 with reference to File No. S7-
18-09. Requests for materials submitted to OMB by the Commission with
regard to this collection of information should be in writing, refer to
File No. S7-18-09, and be submitted to the Securities and Exchange
Commission, Office of Investor Education and Advocacy, 100 F Street,
NE., Washington, DC 20549-0213. OMB is required to make a decision
concerning the collections of information between 30 and 60 days after
publication. A comment to OMB is best assured of having its full effect
if OMB receives it within 30 days after publication of this release.
V. Initial Regulatory Flexibility Analysis
The Commission has prepared the following Initial Regulatory
Flexibility Analysis (``IRFA'') regarding proposed rule 206(4)-5 and
the amendments to rules 204-2 and 206(4)-3 in accordance with section
3(a) of the Regulatory Flexibility Act.\251\
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\251\ 5 U.S.C. 603(a).
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A. Reasons for Proposed Action
Investment advisers that seek to influence the award of advisory
contracts by government entities, by making or soliciting political
[[Page 39866]]
contributions to those officials who are in a position to influence the
awards violate their fiduciary obligations. These practices--known as
``pay to play''--distort the process by which investment advisers are
selected and, as discussed in greater detail above, can harm advisers'
public pension plan clients, and thereby beneficiaries of those plans,
which may receive inferior advisory services and pay higher fees. In
addition, the most qualified adviser may not be selected, potentially
leading to inferior management, diminished returns or greater losses
for the public pension plan. Pay to play is a significant problem in
the management of public funds by investment advisers. Moreover, we
believe that advisers' participation in pay to play is inconsistent
with the high standards of ethical conduct required of them under the
Advisers Act. The proposed rule and rule amendments are designed to
prevent fraud, deception and manipulation by reducing or eliminating
adviser participation in pay to play practices.
B. Objectives and Legal Basis
Proposed rule 206(4)-5, the ``pay to play'' rule, would prohibit an
adviser registered (or required to be registered) with the Commission,
or unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act, from providing advisory services for
compensation to a government client for two years after the adviser, or
any of its covered associates, make a contribution to public officials
(and candidates) such as State treasurers, comptrollers or other
elected executives or administrators who can influence the selection of
the adviser.\252\ In addition, we are proposing to prohibit an adviser
or any of its covered associates from soliciting contributions for an
elected official or candidate or payments to a political party of a
State or locality where the adviser is providing or seeking to provide
advisory services to a government entity,\253\ and from providing or
agreeing to provide, directly or indirectly, payment to any third party
engaged to solicit advisory business from any government entity on
behalf of the adviser.\254\ Further, the prohibitions in the proposed
rule also would apply to advisers to certain investment pools in which
a government entity invests.\255\ The proposed rule amendment to rule
204-2 is designed to provide Commission staff with records to review
compliance with proposed rule 206(4)-5, and the proposed amendment to
rule 206(4)-3 would clarify the application of the cash solicitation
rule as a result of proposed rule 206(4)-5.
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\252\ Proposed rule 206(4)-5(a)(1).
\253\ Proposed rule 206(4)-5(a)(2)(ii).
\254\ Proposed rule 206(4)-5(a)(2)(i).
\255\ Proposed rule 206(4)-5(c).
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The Commission is proposing new rule 206(4)-5 and proposing to
amend rule 206(4)-3 pursuant to the authority set forth in sections
206(4) and 211(a) of the Advisers Act [15 U.S.C. 80b-6(4) and 80b-
11(a)]; to amend rule 204-2 pursuant to the authority set forth in
sections 204 and 211 of the Advisers Act [15 U.S.C. 80b-4 and 80b-11].
Section 206(4) gives us authority to prescribe means reasonably
designed to prevent fraudulent, deceptive, or manipulative acts or
practices. Section 211 gives us authority to classify, by rule, persons
and matters within our jurisdiction and to prescribe different
requirements for different classes of persons, as necessary or
appropriate to the exercise of our authority under the Act. Section 204
gives us authority to prescribe, by rule, such records and reports that
an adviser must make, keep for prescribed periods, or disseminate, as
necessary or appropriate in the public interest or for the protection
of investors.
C. Small Entities Subject to Rule
Under Commission rules, for the purposes of the Advisers Act and
the Regulatory Flexibility Act, an investment adviser generally is a
small entity if it: (i) Has assets under management having a total
value of less than $25 million; (ii) did not have total assets of $5
million or more on the last day of its most recent fiscal year; and
(iii) does not control, is not controlled by, and is not under common
control with another investment adviser that has assets under
management of $25 million or more, or any person (other than a natural
person) that had $5 million or more on the last day of its most recent
fiscal year.\256\
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\256\ 17 CFR 275.0-7(a).
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The Commission estimates that as of July 2009 there are
approximately 706 small SEC-registered investment advisers.\257\ Of
these 706 advisers, 57 indicate on Form ADV that they have State or
local government clients. The proposed rule also would apply to those
advisers that are exempt from registration with the Commission in
reliance on section 203(b)(3) of the Advisers Act. We estimate that
approximately 231 such unregistered advisers may manage pooled
investment vehicles in which government client assets are invested and
would be subject to the proposed rule.\258\ We do not have data and are
not aware of any databases that compile information regarding how may
advisers that are exempt from registration with the Commission in
reliance on section 203(b)(3) of the Advisers Act and that have State
or local government clients. It is unclear how many of these advisers
that are exempt from registration that would be subject to the rule are
small advisers for purposes of this analysis.
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\257\ This estimate is based on registration information from
IARD as of July 1, 2009.
\258\ See supra notes 217 and 220.
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D. Reporting, Recordkeeping, and other Compliance Requirements
The proposed rule would impose certain reporting, recordkeeping and
compliance requirements on advisers, including small advisers. The
proposed rule imposes a new compliance requirement by: (i) Prohibiting
an adviser from providing advisory services for compensation to
government clients for two years after the adviser or any of its
covered associates makes a contribution to certain elected officials or
candidates; (ii) prohibiting an adviser from providing or agreeing to
provide, directly or indirectly, payment to any third party engaged to
solicit advisory business from any government entity on behalf of the
adviser; and (iii) prohibiting an adviser or any of its covered
associates from soliciting contributions for an elected official or
candidate or payments to a political party of a State or locality where
the adviser is providing or seeking to provide advisory services to a
government entity.
The proposed rule amendments would impose new recordkeeping
requirements by requiring an adviser to maintain certain records about
its covered associates, its advisory clients, government entities
invested in certain pooled investment vehicles managed by the adviser,
and its political contributions as well as the political contributions
of its covered associates. An investment adviser that does not provide
or seek to provide advisory services to a government entity, or to a
covered investment pool in which a government entity invests, would not
be subject to the proposed rule and rule amendments.
As noted above, we believe that a limited number of small advisers
will have to comply with the proposed rule and rule amendments.
Moreover, to the extent small advisers tend to have fewer clients and
fewer employees that would be covered associates for purposes of the
rule, the proposal should impose lower costs on small advisers as
compared to
[[Page 39867]]
large advisers as variable costs, such as the requirement to make and
keep records relating to contributions, should be lower as there should
be fewer records to make and keep.\259\
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\259\ However, as noted above, many larger advisers with broker-
dealer affiliates may spend less resources to comply with the
proposed rule and rule amendments because they may be able to rely
on compliance procedures and systems that the broker-dealer already
has in place to comply with MSRB rules G-37 and G-38. See supra note
214 and accompanying text.
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E. Duplicative, Overlapping, or Conflicting Federal Rules
The Commission believes that there are no other Federal rules that
duplicate, overlap, or conflict with the proposed rule amendments. As
discussed above, to make clear the relationship between our rules, we
propose making a technical amendment to rule 206(4)-3 to specify that
solicitation activities involving government entity clients under our
proposed rule 206(4)-5 are subject to limitations set forth in that
rule.
F. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant impact on small entities.\260\ In
connection with the proposed rule amendments, the Commission considered
the following alternatives: (i) The establishment of differing
compliance or reporting requirements or timetables that take into
account the resources available to small entities; (ii) the
clarification, consolidation, or simplification of compliance and
reporting requirements under the proposed rule and rule amendments for
such small entities; (iii) the use of performance rather than design
standards; and (iv) an exemption from coverage of the proposed rule and
rule amendments, or any part thereof, for such small entities.
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\260\ As noted above, we considered two alternatives to certain
aspects of proposed rule 206(4)-5: A disclosure obligation and a
two-year time out for third-party solicitors. We do not believe
either alternative would accomplish our stated objective of
curtailing pay to play activities and thereby address potential
harms from those activities. See section II.A.2., as well as notes
133 and 134 and accompanying text.
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Regarding the first alternative, the Commission is not proposing
different compliance or reporting requirements for small advisers as it
may be inappropriate under the circumstances. The proposal is designed
to reduce or eliminate adviser participation in pay to play, a practice
that can distort the process by which investment advisers are selected
to manage public pension plans that can harm public pension plan
clients and cause advisers to violate their fiduciary obligations. To
establish different requirements for small advisers could diminish the
protections the proposal would provide to public pension plan clients
and their beneficiaries.
Regarding the second alternative, we will continue to consider
whether further clarification, consolidation, or simplification of the
compliance requirements is feasible or necessary, but we believe that
the current proposal is clear. The proposed rule and rule amendments
contain an approach to curtailing pay to play practices that is modeled
on established MSRB rules that have already been implemented by
financial firms of varying sizes. However, we note that we are
proposing an amendment to rule 206(4)-3, the cash solicitation rule, to
clarify that the requirements of new proposed rule 206(4)-5 apply to
solicitation activities involving government clients.
Regarding the third alternative, we consider using performance
rather than design standards with respect to pay to play practices of
investment advisers to be neither consistent with the objectives for
this rulemaking nor sufficient to protect investors in accordance with
our statutory mandate of investor protection. Design standards, which
we have employed, provide a baseline for advisory conduct as it relates
to contributions and other pay to play activities, which is consistent
with a rule designed to prohibit pay to play. The use of design
standards also is important to ensure consistent application of the
rule among investment advisers to which the rule and rule amendments
will apply.
Regarding the fourth alternative, exempting small entities could
compromise the overall effectiveness of the proposed rule and related
rule amendments. Since we intend to extend the benefit of banning pay
to play practices to clients of both small and large advisers, it would
be inconsistent to specify different requirements for small advisers.
G. Solicitation of Comments
We encourage written comments on matters discussed in this IRFA. In
particular, the Commission seeks comment on:
The number of small entities, particularly small advisers,
to which the proposed rule and rule amendments would apply and the
effect on those entities, including whether the effects would be
economically significant; and
How to quantify the number of small advisers, including
those that are unregistered, that would be subject to the proposed rule
and rule amendments.
Commenters are asked to describe the nature of any effect and
provide empirical data supporting the extent of the effect.
VI. Effects on Competition, Efficiency and Capital Formation
The Commission is proposing to amend rule 204-2 pursuant to its
authority under sections 204 and 211. Section 204 requires the
Commission, when engaging in rulemaking pursuant to that authority, to
consider whether the rule is ``necessary or appropriate in the public
interest or for the protection of investors.'' \261\ Section 202(c) of
the Advisers Act \262\ requires the Commission, when engaging in
rulemaking that requires it to consider or determine whether an action
is necessary or appropriate in the public interest, to consider, in
addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation.\263\
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\261\ 15 U.S.C. 80b-4(a).
\262\ 15 U.S.C. 80b-2(c).
\263\ In contrast, the Commission is proposing new rule 206(4)-5
and amendments to rule 206(4)-3 pursuant to its authority under
sections 206(4) and 211, neither of which requires us to consider
the factors identified in section 202(c)(1).
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We are proposing to amend rule 204-2 to require an adviser to make
and keep a list of its covered associates, the government entities the
adviser provides advisory services to or seeks to provide advisory
services to, and the contributions made by the firm and its covered
associates, as applicable, to government officials and candidates.\264\
The proposed amendment is designed to provide our examiners important
information about the adviser and its covered associates' contributions
to government officials and the government entities that the adviser
provides advisory services to or seeks to provide those services. We
believe that the proposed amendment to the Advisers Act recordkeeping
rule would not materially increase the compliance burden on advisers
under rule 204-2. Similarly, we do not believe that the proposed
amendments to the recordkeeping rule would disproportionately affect
advisers with government entity clients or potential government
clients. The amendments will apply equally to all SEC-registered
advisers. All registered advisers are already subject to a variety of
recordkeeping requirements in the course of their business and,
therefore, the proposed amendments to the recordkeeping rule should not
affect
[[Page 39868]]
efficiency. We do not anticipate that the proposed recordkeeping rule
amendments would affect capital formation.
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\264\ Proposed rule 204-2(a)(18)(i).
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The Commission requests comment whether the proposed amendment to
rule 204-2, if adopted, would promote efficiency, competition, and
capital formation. Commenters are requested to provide empirical data
to support their views.
VII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \265\ the Commission must advise OMB
whether a proposed regulation constitutes a ``major'' rule. Under
SBREFA, a rule is considered ``major'' where, if adopted, it results in
or is likely to result in: (1) An annual effect on the economy of $100
million or more; (2) a major increase in costs or prices for consumers
or individual industries; or (3) significant adverse effects on
competition, investment or innovation.
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\265\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
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We request comment on the potential impact of the proposed new rule
and proposed rule amendments on the economy on an annual basis.
Commenters are requested to provide empirical data and other factual
support for their views to the extent possible.
VIII. Statutory Authority
The Commission is proposing new rule 206(4)-5 and amendments to
rule 206(4)-3 of the Advisers Act pursuant to the authority set forth
in sections 206(4) and 211(a) of the Investment Advisers Act of 1940
[15 U.S.C. 80b-6(4), 80b-11(a)].
The Commission is proposing amendments to rule 204-2 of the
Advisers Act pursuant to the authority set forth in sections 204 and
211(a) of the Advisers Act [15 U.S.C. 80b-4 and 80b-11(a)].
List of Subjects in 17 CFR Part 275
Reporting and recordkeeping requirements; Securities.
For the reasons set out in the preamble, Title 17 Chapter II of the
Code of Federal Regulations is proposed to be amended as follows.
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The authority citation for part 275 continues to read in part as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.
* * * * *
2. Section 275.204-2 is amended by adding paragraph (a)(18) and by
revising paragraph (h)(1) to read as follows:
275.204-2 Books and records to be maintained by investment advisers.
(a) * * *
(18)(i) Books and records that pertain to Sec. 275.206(4)-5
containing a list or other record of:
(A) The names, titles and business and residence addresses of all
covered associates of the investment adviser;
(B) All government entities for which the investment adviser or any
of its covered associates is providing or seeking to provide investment
advisory services, or which are investors or are solicited to invest in
any covered investment pool to which the investment adviser provides
investment advisory services, as applicable;
(C) All government entities to which the investment adviser has
provided investment advisory services, along with any related covered
investment pool(s) to which the investment adviser has provided
investment advisory services and in which the government entity has
invested, as applicable, in the past five years, but not prior to
[effective date of this section]; and
(D) All direct or indirect contributions or payments made by the
investment adviser or any of its covered associates to an official of a
government entity, a political party of a State or political
subdivision thereof, or a political action committee.
(ii) Records relating to the contributions and payments referred to
in paragraph (a)(18)(i)(D) of this section must be listed in
chronological order and indicate:
(A) The name and title of each contributor;
(B) The name and title (including any city/county/State or other
political subdivision) of each recipient of a contribution or payment;
(C) The amount and date of each contribution or payment; and
(D) Whether any such contribution was the subject of the exception
for certain returned contributions pursuant to Sec. 275.206(4)-
5(b)(2).
(iii) For purposes of this section, the terms ``contribution,''
``covered associate,'' ``covered investment pool,'' ``government
entity,'' ``official,'' ``payment,'' and ``solicit'' have the same
meanings as set forth in Sec. 275.206(4)-5.
(iv) For purposes of this section, an investment adviser to a
covered investment pool in which a government entity invests or is
solicited to invest shall be treated as though that investment adviser
were providing or seeking to provide investment advisory services
directly to the government entity.
* * * * *
(h)(1) Any book or other record made, kept, maintained and
preserved in compliance with Sec. Sec. 240.17a-3 and 240.17a-4 of this
chapter under the Securities Exchange Act of 1934, or with rules
adopted by the Municipal Securities Rulemaking Board, which is
substantially the same as the book or other record required to be made,
kept, maintained and preserved under this section, shall be deemed to
be made, kept, maintained and preserved in compliance with this
section.
* * * * *
3. Section 275.206(4)-3 is amended by adding paragraph (e) and
removing the authority citation following the section to read as
follows:
Sec. 275.206(4)-3 Cash payments for client solicitations.
* * * * *
(e) Special rule for solicitation of government entity clients.
Solicitation activities involving a government entity, as defined in
Sec. 275.206(4)-5, shall be subject to the additional limitations set
forth in that section.
4. Section 275.206(4)-5 is added to read as follows:
Sec. 275.206(4)-5 Political contributions by certain investment
advisers.
(a) Prohibitions. As a means reasonably designed to prevent
fraudulent, deceptive or manipulative acts, practices, or courses of
business within the meaning of section 206(4) of the Act (15 U.S.C.
80b-6(4)), it shall be unlawful:
(1) For any investment adviser registered (or required to be
registered) with the Commission, or unregistered in reliance on the
exemption available under section 203(b)(3) of the Advisers Act (15
U.S.C. 80b-3(b)(3)) to provide investment advisory services for
compensation to a government entity within two years after a
contribution to an official of the government entity is made by the
investment adviser or any covered associate of the investment adviser
(including a person who becomes a covered associate within two years
after the contribution is made); and
(2) For any investment adviser registered (or required to be
registered) with the Commission, or unregistered in reliance on the
exemption available under section 203(b)(3) of the Advisers
[[Page 39869]]
Act (15 U.S.C. 80b-3(b)(3)) or any of the investment adviser's covered
associates:
(i) To provide or agree to provide, directly or indirectly, payment
to any person to solicit a government entity for investment advisory
services on behalf of such investment adviser unless:
(A) Such person is a related person of the investment adviser or,
if the related person is a company, an employee of that related person;
or
(B) Such person is an executive officer, general partner, managing
member (or, in each case, a person with a similar status or function),
or employee of the investment adviser; and
(ii) To coordinate, or to solicit any person or political action
committee to make, any:
(A) Contribution to an official of a government entity to which the
investment adviser is providing or seeking to provide investment
advisory services; or
(B) Payment to a political party of a State or locality where the
investment adviser is providing or seeking to provide investment
advisory services to a government entity.
(b) Exceptions.
(1) De minimis exception. Paragraph (a)(1) of this section does not
apply to contributions made by a covered associate, if a natural
person, to officials for whom the covered associate was entitled to
vote at the time of the contributions and which in the aggregate do not
exceed $250 to any one official, per election.
(2) Exception for certain returned contributions.
(i) An investment adviser that is prohibited from providing
investment advisory services for compensation pursuant to paragraph
(a)(1) of this section as a result of a contribution made by a covered
associate of the investment adviser is excepted from such prohibition,
subject to paragraphs (b)(2)(ii) and (b)(2)(iii) of this section, upon
satisfaction of the following requirements:
(A) The investment adviser must have discovered the contribution
which resulted in the prohibition within four months of the date of
such contribution;
(B) Such contribution must not have exceeded $250; and
(C) The contributor must obtain a return of the contribution within
60 calendar days of the date of discovery of such contribution by the
investment adviser.
(ii) An investment adviser is entitled to no more than two
exceptions pursuant to paragraph (b)(2)(i) of this section per 12-month
period.
(iii) An investment adviser may not rely on the exception provided
in paragraph (b)(2)(i) of this section more than once with respect to
contributions by the same covered associate of the investment adviser
regardless of the time period.
(c) Prohibitions as applied to covered investment pools. For
purposes of this section, an investment adviser to a covered investment
pool in which a government entity invests or is solicited to invest
shall be treated as though that investment adviser were providing or
seeking to provide investment advisory services directly to the
government entity.
(d) Further prohibition. As a means reasonably designed to prevent
fraudulent, deceptive or manipulative acts, practices, or courses of
business within the meaning of section 206(4) of Advisers Act (15
U.S.C. 80b-6(4)), it shall be unlawful for any investment adviser
registered (or required to be registered) with the Commission, or
unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act (15 U.S.C. 80b-3(b)(3)) or any of the
investment adviser's covered associates to do anything indirectly
which, if done directly, would result in a violation of this section.
(e) Exemptions. The Commission, upon application, may conditionally
or unconditionally exempt an investment adviser from the prohibition
under paragraph (a)(1) of this section. In determining whether to grant
an exemption, the Commission will consider, among other factors:
(1) 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 Advisers Act
(15 U.S.C. 80b);
(2) Whether the investment adviser:
(i) Before the contribution resulting in the prohibition was made,
adopted and implemented policies and procedures reasonably designed to
prevent violations of this section; and
(ii) Prior to or at the time the contribution which resulted in
such prohibition was made, had no actual knowledge of the contribution;
and
(iii) After learning of the contribution:
(A) Has taken all available steps to cause the contributor involved
in making the contribution which resulted in such prohibition to obtain
a return of the contribution; and
(B) Has taken such other remedial or preventive measures as may be
appropriate under the circumstances;
(3) 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;
(4) The timing and amount of the contribution which resulted in the
prohibition;
(5) The nature of the election (e.g, Federal, State or local); and
(6) The contributor's apparent intent or motive in making the
contribution which resulted in the prohibition, as evidenced by the
facts and circumstances surrounding such contribution.
(f) Definitions. For purposes of this section:
(1) Contribution means any gift, subscription, loan, advance, or
deposit of money or anything of value made for:
(i) The purpose of influencing any election for Federal, State or
local office;
(ii) Payment of debt incurred in connection with any such election;
or
(iii) Transition or inaugural expenses of the successful candidate
for State or local office.
(2) Covered associate of an investment adviser means:
(i) Any general partner, managing member or executive officer, or
other individual with a similar status or function;
(ii) Any employee who solicits a government entity for the
investment adviser; and
(iii) Any political action committee controlled by the investment
adviser or by any person described in paragraphs (f)(2)(i) and
(f)(2)(ii) of this section.
(3) Covered investment pool means any investment company, as
defined in section 3(a) of the Investment Company Act of 1940 (15
U.S.C. 80a-3(a)), or any company that would be an investment company
under section 3(a) of that Act but for the exclusion provided from that
definition by either section 3(c)(1), section 3(c)(7) or section
3(c)(11) of that Act (15 U.S.C. 80a-3(c)(1), (c)(7) or (c)(11)), except
that for purposes of paragraph (a)(1) of this section, an investment
company registered under the Investment Company Act of 1940 (15 U.S.C.
80a), the shares of which are registered under the Securities Act of
1933 (15 U.S.C. 77a), shall be a covered investment pool only if it is
an investment or an investment option of a plan or program of a
government entity.
(4) Executive officer of an investment adviser means the president,
any vice president in charge of a principal business unit, division or
function (such as sales, administration or finance), or any other
executive officer of the investment adviser who, in each case, in
connection with his or her regular duties:
[[Page 39870]]
(i) Performs, or supervises any person who performs, investment
advisory services for the investment adviser;
(ii) Solicits, or supervises any person who solicits, for the
investment adviser, including with respect to investors for a covered
investment pool; or
(iii) Supervises, directly or indirectly, any person described in
paragraph (f)(4)(i) or (f)(4)(ii) of this section.
(5) Government entity means any State or political subdivision of a
State, including:
(i) Any agency, authority, or instrumentality of the State or
political subdivision;
(ii) A plan, program, or pool of assets sponsored or established by
the State or political subdivision or any agency, authority or
instrumentality thereof; and
(iii) Officers, agents, or employees of the State or political
subdivision or any agency, authority or instrumentality thereof, acting
in their official capacity.
(6) Official means any person (including any election committee for
the person) who was, at the time of the contribution, an incumbent,
candidate or successful candidate for elective office of a government
entity, if the office:
(i) Is directly or indirectly responsible for, or can influence the
outcome of, the hiring of an investment adviser by a government entity;
or
(ii) 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 government entity.
(7) Payment means any gift, subscription, loan, advance, or deposit
of money or anything of value.
(8) Plan or program of a government entity means any investment
program or plan sponsored or established by a government entity,
including, but not limited to, a ``qualified tuition plan'' authorized
by section 529 of the Internal Revenue Code (26 U.S.C. 529), a
retirement plan authorized by section 403(b) or 457 of the Internal
Revenue Code (26 U.S.C. 403(b) or 457), or any similar program or plan.
(9) Related person of an investment adviser means any person,
directly or indirectly, controlling or controlled by the investment
adviser, and any person that is under common control with the
investment adviser.
(10) Solicit means:
(i) With respect to investment advisory services, to communicate,
directly or indirectly, for the purpose of obtaining or retaining a
client for, or referring a client to, an investment adviser; and
(ii) With respect to a contribution or payment, to communicate,
directly or indirectly, for the purpose of obtaining or arranging a
contribution or payment.
(g) Effective date. The prohibitions on providing investment
advisory services and payments to solicit, in each case as described in
this section, arise only from contributions and payments, respectively,
made on or after [the effective date of this section].
Dated: August 3, 2009.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. E9-18807 Filed 8-6-09; 8:45 am]
BILLING CODE 8010-01-P