[Federal Register Volume 75, Number 134 (Wednesday, July 14, 2010)]
[Rules and Regulations]
[Pages 41018-41071]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-16559]
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Part IV
Securities and Exchange Commission
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17 CFR Part 275
Political Contributions by Certain Investment Advisers; Final Rule
Federal Register / Vol. 75, No. 134 / Wednesday, July 14, 2010 /
Rules and Regulations
[[Page 41018]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-3043; File No. S7-18-09]
RIN 3235-AK39
Political Contributions by Certain Investment Advisers
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission is adopting a new rule
under the Investment Advisers Act of 1940 that prohibits 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 also prohibits 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, unless such third parties
are registered broker-dealers or registered investment advisers, in
each case themselves subject to pay to play restrictions. Additionally,
the new rule prevents 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 adopting rule
amendments that 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
address ``pay to play'' practices by investment advisers.
DATES: Effective Date: September 13, 2010.
Compliance Dates: Investment advisers subject to rule 206(4)-5 must
be in compliance with the rule on March 14, 2011. Investment advisers
may no longer use third parties to solicit government business except
in compliance with the rule on September 13, 2011. Advisers to
registered investment companies that are covered investment pools must
comply with the rule by September 13, 2011. Advisers subject to rule
204-2 must comply with amended rule 204-2 on March 14, 2011. However,
if they advise registered investment companies that are covered
investment pools, they have until September 13, 2011 to comply with the
amended recordkeeping rule with respect to those registered investment
companies. See section III of this Release for further discussion of
compliance dates.
FOR FURTHER INFORMATION CONTACT: Melissa A. Roverts, Senior Counsel,
Matthew N. Goldin, Branch Chief, Daniel S. Kahl, Branch Chief, or Sarah
A. Bessin, Assistant Director, at (202) 551-6787 or [email protected],
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 adopting rule 206(4)-5 [17
CFR 275.206(4)-5] and 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'').\1\
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\1\ 15 U.S.C. 80b. Unless otherwise noted, when we refer to the
Advisers Act, or any paragraph of the Advisers Act, we are referring
to 15 U.S.C. 80b of the United States Code, at which the Advisers
Act is codified, and when we refer to rule 206(4)-5, rule 204-2,
rule 204A-1, rule 206(4)-3, or any paragraph of these rules, we are
referring to 17 CFR 275.206(4)-5, 17 CFR 275.204-2, 17 CFR 275.204A-
1 and 17 CFR 275.206(4)-3, respectively, of the Code of Federal
Regulations, in which these rules are published.
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Table of Contents
I. Background
II. Discussion
A. First Amendment Considerations
B. Rule 206(4)-5
1. Advisers Subject to the Rule
2. Pay to Play Restrictions
(a) Two-Year ``Time Out'' for Contributions
(1) Prohibition on Compensation
(2) Officials of a Government Entity
(3) Contributions
(4) Covered Associates
(5) ``Look Back''
(6) Exceptions for De Minimis Contributions
(7) Exception for Certain Returned Contributions
(b) Ban on Using Third Parties to Solicit Government Business
(1) Registered Broker-Dealers
(2) Registered Investment Advisers
(c) Restrictions on Soliciting and Coordinating Contributions
and Payments
(d) Direct and Indirect Contributions or Solicitations
(e) Covered Investment Pools
(1) Definition of ``Covered Investment Pool''
(2) Application of the Rule
(3) Subadvisory Arrangements
(f) Exemptions
D. Recordkeeping
E. Amendment to Cash Solicitation Rule
III. Effective and Compliance Dates
A. Two-Year Time Out and Prohibition on Soliciting or
Coordinating Contributions
B. Prohibition on Using Third Parties to Solicit Government
Business and Cash Solicitation Rule Amendment
C. Recordkeeping
D. Registered Investment Companies
IV. Cost-Benefit Analysis
A. Benefits
B. Costs
1. Compliance Costs Related to Rule 206(4)-5
2. Other Costs Related to Rule 206(4)-5
(a) Two-Year Time Out
(b) Third-Party Solicitor Ban
3. Costs Related to the Amendments to Rule 204-2
V. Paperwork Reduction Act
A. Rule 204-2
B. Rule 206(4)-3
C. Rule 206(4)-7
D. Rule 0-4
VI. Final Regulatory Flexibility Analysis
A. Need for the Rule
B. Significant Issues Raised by Public Comment
C. Small Entities Subject to Rule
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
E. Agency Action to Minimize Effect on Small Entities
VII. Effects on Competition, Efficiency and Capital Formation
VIII. Statutory Authority
I. Background
Investment advisers provide a wide variety of advisory services to
State and local governments,\2\ including managing their public pension
plans.\3\ These pension plans have over $2.6 trillion of assets and
represent one-third of all U.S. pension assets.\4\ They are among the
largest and most active institutional investors in the United
States;\5\ the management of these funds affects
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publicly held companies \6\ and the securities markets.\7\ But most
significantly, their management affects taxpayers and the beneficiaries
of these funds, including the millions of present and future State and
municipal retirees \8\ who rely on the funds for their pensions and
other benefits.\9\ Public pension plan assets are held, administered
and managed by government officials who often are responsible for
selecting investment advisers to manage the funds they oversee.
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\2\ 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, Local
Government Finance, Concepts and Practices 376 (John E. Peterson &
Dennis R. Strachota eds., 1st ed. 1991) (discussing the services
investment advisers provide for public funds).
\3\ To simplify the discussion, we use the term ``public pension
plan'' interchangeably with ``government client'' and ``government
entity'' in this Release. However, our rule applies broadly to
investment advisory activities for government clients, such as those
mentioned here in this Section of the Release, 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 section
II.B.2(e) of this Release.
\4\ Board of Governors of the Federal Reserve System, Flow of
Funds Accounts of the United States, Flows and Outstandings, Fourth
Quarter 2009 78 tbl.L.119 (Mar. 11, 2010). Since 2002, total
financial assets of public pension funds have grown by 28%. Id.
\5\ 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.
\6\ See Stephen J. Choi & Jill E. Fisch, On Beyond CalPERS:
Survey Evidence on the Developing Role of Public Pension Funds in
Corporate Governance, 61 Vand. L. Rev. 315 (2008) (``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.'').
\7\ Federal Reserve reports indicate that, of the $2.6 trillion
in non-Federal government plans, $1.5 trillion is invested in
corporate equities. Board of Governors of the Federal Reserve
System, supra note 4, at 78 tbl.L.119.
\8\ See Paul Zorn, 1997 Survey of State and Local Government
Employee Retirement Systems 61 (1997) (hereinafter ``1997 Survey'')
(``[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'').
\9\ 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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Elected officials who allow political contributions to play a role
in the management of these assets and who use these assets to reward
contributors violate the public trust. Moreover, they undermine the
fairness of the process by which public contracts are awarded.
Similarly, investment advisers that seek to influence government
officials' awards of advisory contracts by making or soliciting
political contributions to those officials compromise their fiduciary
duties to the pension plans they advise and defraud prospective
clients. These practices, known as ``pay to play,'' distort the process
by which advisers are selected.\10\ They can harm pension plans that
may subsequently receive inferior advisory services and pay higher
fees. Ultimately, these violations of trust can harm the millions of
retirees that rely on the plan or the taxpayers of the State and
municipal governments that must honor those obligations.\11\
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\10\ Among other things, pay to play practices 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.
\11\ See 1997 Survey, supra note 8.
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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, ``[w]hile the risk of corruption is
obvious and substantial, actors in this field are presumably shrewd
enough to structure their relations rather indirectly.'' \12\ 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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\12\ Blount v. SEC, 61 F.3d 938, 945 (D.C. Cir. 1995), cert.
denied, 517 U.S. 1119 (1996).
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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
or appointed trustees 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,\13\ may be members of a governing board that selects
advisers,\14\ or may appoint some or all of the board members who make
the selection.\15\
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\13\ See, e.g., 2 N.Y. Comp. Codes R. & Regs. tit. 2 Sec. 320.2
(2009) (placement of State and local government retirement systems
assets (valued at $109 billion as of March 2009) is under the sole
custodianship of the New York State Comptroller).
\14\ 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).
\15\ 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 Ann.
Sec. 59-1304 (2008) (governor appoints all five members).
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Numerous developments in recent years have led us to conclude that
the selection of advisers, whom we regulate under the Investment
Advisers Act, has been influenced by political contributions and that,
as a result, the quality of management service provided to public funds
may be negatively affected. We have been particularly concerned that
these contributions have been funneled through ``solicitors'' and
``placement agents'' that advisers engage (or believe they must engage)
in order to secure a client relationship with a public pension plan or
an investment from one.\16\ As we will discuss in more detail below, in
such an arrangement the contribution may be made in the form of a
substantial fee for what may constitute no more than an introduction
service by a ``well connected'' individual who may use the proceeds of
the fee to make (or reimburse himself for having made) political
contributions or provide some form of a ``kickback'' to an official or
his or her family or friends.\17\
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\16\ For example, in one recent action we alleged that, in
connection with a pay to play scheme in New York State, investment
advisers paid sham ``placement agent'' fees, portions of which were
funneled to public officials, as a means of obtaining public pension
fund investments in the funds those advisers managed and that
participants, in some instances, concealed the third-party
solicitor's role in transactions from the investment management
firms that paid fees to the solicitor by making misrepresentations
about the solicitor's involvement and covertly using one of the
solicitor's legal entities as an intermediary to funnel payments to
the solicitor. SEC v. Henry Morris, et al., Litigation Release No.
20963 (Mar. 19, 2009).
\17\ See id. (along with the Commission's complaint in the
action, available by way of a hyperlink from the litigation
release). See also, e.g., In the Matter of Quadrangle Group LLC,
AGNY Investigation No. 2010-044 (Apr. 15, 2010) (finding 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* * *''); Complaint, Cal. v. Villalobos, et
al., No. SC107850 (Cal. Super. Ct., W. Dist. of L.A. County, May 5,
2010), available at http://ag.ca.gov/cms_attachments/press/pdfs/n1915_filed_complaint_for_civil_penalties.pdf (alleging, inter
alia, that a top executive and a board member at CalPERS accepted
various gifts from a former CalPERS board member, ``known among
private equity firms as a person who attempts to exert pressure on
CalPERS' representatives,'' who was acting as a placement agent
trying to secure investments from the California public pension
fund).
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The details of pay to play arrangements have been widely reported
as a consequence of the growing number of actions that we and State
authorities have brought involving investment advisers seeking to
manage the considerable assets of the New York State Common Retirement
Fund.\18\ In
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addition, we have brought enforcement actions against the former
treasurer of the State of Connecticut and other parties in which we
alleged that the former treasurer awarded State pension fund
investments to private equity fund managers in exchange for payments,
including political contributions, funneled through the former
treasurer's friends and political associates.\19\ Criminal authorities
have in recent years brought cases in New York,\20\ New Mexico,\21\
Illinois,\22\ Ohio,\23\ Connecticut,\24\ and Florida,\25\ charging
defendants with the same or similar conduct.
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\18\ See SEC v. Henry Morris, et al., Litigation Release No.
21036 (May 12, 2009); In the Matter of Quadrangle Group LLC, AGNY
Investigation No. 2010-044 (Apr. 15, 2010); In the Matter of GKM
Newport Generation Capital Servs., LLC, AGNY Investigation No. 2010-
017 (Apr. 14, 2010); In the Matter of Kevin McCabe, AGNY
Investigation No. 2009-152 (Apr. 14, 2010); In the Matter of Darius
Anderson Platinum Advisors LLC, AGNY Investigation No. 2009-153
(Apr. 14, 2010); In the Matter of Global Strategy Group, AGNY
Investigation No. 2009-161 (Apr. 14, 2010); In the Matter of Freeman
Spogli & Co., AGNY Investigation No. 2009-174 (Feb. 1, 2010); In the
Matter of Falconhead Capital, LLC, AGNY Investigation No. 2009-125
(Sept. 17, 2009); In the Matter of HM Capital Partners I, LP, AGNY
Investigation No. 2009-117 (Sept. 17, 2009); In the Matter of Ares
Management LLC, AGNY Investigation No. 2009-173 (Feb. 17, 2010); In
the Matter of Levine Leichtman Capital Partners, AGNY Investigation
No. 2009-124 (Sept. 17, 2009); In the Matter of Access Capital
Partners, AGNY Investigation No. 09-135 (Sept. 17, 2009); In the
Matter of The Markstone Group, AGNY Investigation No. 10-012 (Feb.
28, 2010); In the Matter of Wetherly Capital Group, LLC and DAV/
Wetherly Financial, L.P., AGNY Investigation No. 2009-172 (Feb. 8,
2010) (in each case, banning the use of third-party placement agents
pursuant to a ``Pension Reform Code of Conduct'').
\19\ 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) (2007 U.S. Dist. LEXIS 73850 (D.
Conn., May 8, 2007), aff'd 587 F.3d 553 (2nd Cir. 2009)). 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).
\20\ 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).
\21\ 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 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).
\22\ See Jeff Coen, et al., State's Ultimate Insider Indicted,
Chi. Trib., Oct. 31, 2008, available at http://www.chicagotribune.com/news/local/chi-cellini-31-oct31,0,6465036.story (describing the thirteenth indictment in an
Illinois pay to play probe); Ellen Almer, Oct. 27, 2000, available
at http://www.chicagobusiness.com/cgi-bin/news.pl?id=775 (discussing
the guilty plea of Miriam Santos, the former treasurer of the City
of Chicago, who told representatives of financial services firms
seeking city business that they were required to raise specified
campaign contributions for her and personally make up any shortfall
in the amounts they raised). See also SEC v. Miriam Santos, et al.,
Litigation Release No. 17839 (Nov. 14, 2002); Litigation Release No.
19269 (June 14, 2005) (355 F. Supp. 2d 917 (N.D. Ill. 2003)).
\23\ 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).
\24\ 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.
2000) (the former treasurer, along with certain others, pleaded
guilty--while others were ultimately convicted). One of the
defendants, who had been convicted at trial, recently won a new
trial. U.S. v. Triumph Capital Group, et al., 544 F.3d 149 (2d Cir.
2008).
\25\ 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
convicted 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).
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Allegations of pay to play activity involving State and municipal
pension plans in other jurisdictions continue to be reported.\26\ In
the course of this rulemaking we received a letter from one public
official detailing the role of pay to play arrangements in the
selection of public pension fund managers and the harms it can inflict
on the affected plans.\27\ In addition, other public officials wrote to
express support for a Commission rule to prohibit investment advisers
from participating in pay to play arrangements.\28\
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\26\ See, e.g., Aaron Lester, et al., Cahill Taps Firms Tied to
State Pension Investor, Boston.com, Mar. 21, 2010 (suggesting that
an investment adviser may have bundled out-of-State donations to the
Massachusetts State Treasurer's campaign in return for a State
pension fund investment management contract); Kevin McCoy, Do
Campaign Contributions Help Win Pension Fund Deals, USA Today, Aug.
28, 2009; Ted Sherman, Pay to Play Alive and Well in New Jersey,
NJ.com, Nov. 28, 2009 (noting more generally that pay to play
continues to occur with government contracts of all kinds in New
Jersey); Imogen Rose-Smith and Ed Leefeldt, Pension Pay to Play
Casts Shadow Nationwide, Institutional Investor, Oct. 1, 2009
(suggesting connections between a private equity fund principal's
fundraising activities and pension investments in the fund). See
also sources cited supra note 17.
\27\ Comment Letter of Suzanne R. Weber, Erie County Controller
(Oct. 6, 2009) (``Weber Letter'') (``I have seen money managers
awarded contracts with our fund which involved payments to
individuals who served as middlemen, creating needless expense for
the fund. These middlemen were political contributors to the
campaigns of board members who voted to contract for money
management services with the companies who paid them as
middlemen.''). See also Comment Letter of David R. Pohndorf (Aug. 4,
2009) (``Pohndorf Letter'') (noting that when the sole trustee of a
major pension fund changed several years ago, a firm managing some
of the fund's assets ``began to receive invitations to fundraising
events for the new trustee with suggested donation amounts.'').
\28\ See, e.g., Comment Letter of New York State Comptroller
Thomas P. DiNapoli (Oct. 2, 2009) (``DiNapoli Letter''); Comment
Letter of New York City Mayor Michael R. Bloomberg (Sept. 9, 2009)
(``Bloomberg Letter''). See also Comment Letter of Kentucky
Retirement Systems Trustee Chris Tobe (Sept. 18, 2009) (``Tobe
Letter'') (suggesting the negative effects of pay to play activities
on the Kentucky Retirement System's investment performance).
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On August 3, 2009, we proposed a new antifraud rule under the
Advisers Act designed to prevent investment advisers from obtaining
business from government entities in return for political contributions
or fund raising--i.e., from participating in pay to play practices.\29\
We modeled our proposed rule on those adopted by the Municipal
Securities Rulemaking Board, or MSRB, which since 1994 has prohibited
municipal securities dealers from participating in pay to play
practices.\30\ We believe these rules have significantly curbed pay to
play practices in the municipal securities market.\31\
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\29\ Political Contributions by Certain Investment Advisers,
Investment Advisers Act Release No. 2910 (Aug. 3, 2009) [74 FR 39840
(Aug. 7, 2009)] (the ``Proposing Release'').
\30\ MSRB rule G-37 was approved by the Commission and adopted
in 1994. 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)]. The MSRB's pay to play rules include MSRB rules G-37 and G-
38. They 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.
\31\ See Proposing Release, at n.23. See also infra note 101;
Comment Letter of the Municipal Securities Rulemaking Board (Oct.
23, 2009) (``MSRB Letter''); Comment Letter of Common Cause (Oct. 6,
2009) (``Common Cause Letter'').
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[[Page 41021]]
Along the lines of MSRB rule G-37,\32\ our proposed rule would have
prohibited 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.\33\ It also would have prohibited an
adviser and certain of its executives and employees 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.\34\ In addition,
similar to MSRB rule G-38,\35\ our proposed rule would have prohibited
the use of third parties to solicit government business.\36\ We also
proposed amendments to rule 204-2 under the Advisers Act that would
have required registered advisers to maintain certain records regarding
political contributions and government clients. As discussed in more
detail below, our proposed rule departed in some respects from the MSRB
rules to reflect differences between advisers and broker-dealers and
the scope of the statutory authority we have sought to exercise.
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\32\ See MSRB rule G-37(b). Our proposal, like MSRB rule G-37,
was designed to address our concern that pay to play activities were
``undermining the integrity'' of the relevant market, in particular
the market for the provision of investment advisory services to
government entity clients. See Blount, 61 F.3d at 939 (referring to
the MSRB's concerns that pay to play practices were ``undermining
the integrity of the $250 billion municipal securities market'' as
its motivation for proposing MSRB rule G-37).
\33\ Proposed rule 206(4)-5(a)(1). See also MSRB rule G-37(b).
\34\ Proposed rule 206(4)-5(a)(2)(ii). See also MSRB rule G-
37(c).
\35\ See MSRB rule G-38(a).
\36\ Proposed rule 206(4)-5(a)(2)(i).
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We received some 250 comment letters on our proposal, many of which
were from advisers, third-party solicitors, placement agents, and their
representatives.\37\ Public pension plans and their officials were
divided--some embraced the rule, including one that stated that the
rule is an important means to ``increase transparency and public
confidence in the investment activities of all public pension funds,''
\38\ while others were critical, arguing, for example, that our
proposal ``may result in unintended hardships being placed upon public
pension funds.'' \39\ We received no letters from plan beneficiaries
whom we sought to protect with the proposed rule,\40\ although two
public interest groups supported it strongly.\41\ Advisers, third-party
solicitors and placement agents, fund sponsors, and others whose
business arrangements could be affected by the rule generally supported
our goal of eliminating advisers' participation in pay to play
practices involving public plans.\42\ Nonetheless, most of them
objected to our adoption under the Advisers Act of a rule similar to
MSRB rules G-37 and G-38.\43\ Most particularly opposed the proposed
prohibition on payments to third parties for soliciting or marketing to
government entities modeled on MSRB rule G-38.\44\ Several urged that,
if we were to adopt a rule based on the approach taken in our proposal,
we should broaden exceptions and exemptions under the rule to
accommodate certain business arrangements.\45\ We respond to these
comments below.\46\
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\37\ Other commenters included pension plans and their
officials, trade associations, law firms, and public interest
groups. Comments letters submitted in File No. S7-25-06 are
available on the Commission's Web site at: http://www.sec.gov/comments/s7-18-09/s71809.shtml.
\38\ Comment Letter of New York City Comptroller William C.
Thompson, Jr. (Oct. 6, 2009) (``Thompson Letter'').
\39\ Comment Letter of Executive Director and Secretary to the
Board of Trustees of the State Retirement and Pension System of
Maryland R. Dean Kenderdine (Oct. 5, 2009).
\40\ We note, however, that subsequent to our proposal, AFSCME,
which represents 1.6 million State and local employees and retirees,
issued a report that strongly endorses sanctions to prevent pay to
play activities. AFSCME, Enhancing Public Retiree Pension Plan
Security: Best Practice Policies for Trustees and Pension Systems
(2010), available at http://www.afscme.org/docs/AFSCME-report-pension-best-practices.pdf.
\41\ See, e.g., Common Cause Letter; Comment Letter of Fund
Democracy/Consumer Federation of America (Oct. 6, 2009) (``Fund
Democracy/Consumer Federation Letter'').
\42\ See, e.g., Comment Letter of the Investment Adviser
Association (Oct. 5, 2009) (``IAA Letter'') (noting ``support [for]
measures to combat pay to play activities, i.e., the practice of
investment advisers or their employees making political
contributions intended to influence the selection or retention of
advisers by government entities. Pay to play practices undermine the
principle that advisers are selected on the basis of competence,
qualifications, expertise, and experience. The practice is unethical
and undermines the integrity of the public pension plan system and
the process of selecting investment advisers.''); Comment Letter of
John R. Dempsey (Aug. 8, 2009) (``Dempsey Letter'') (noting applause
for efforts ``to stop the `pay-to-play' practice which only serves
to undermine public trust in investment advisors and regulators.'');
Comment Letter of Barry M. Gleicher (Sept. 7, 2009) (noting strong
support for the proposal ``with no modifications. * * * The Rule is
necessary to curb elaborated practices that would deprive taxpayers
and beneficiaries of cost effective and honest administration of
pension funds''); Tobe Letter.
\43\ See, e.g., IAA Letter (``We respectfully submit, however,
that the structure of the MSRB rules is not appropriately tailored
to the investment advisory business. * * * We believe the Commission
should make significant changes to the Proposal, which would permit
it to accomplish its important goals.''); Comment Letter of Wesley
Ogburn (Aug. 4, 2009) (``Ogburn Letter''); Comment Letter of the
Third Party Marketers Association (Aug. 27, 2009) (``3PM Letter'');
Comment Letter of Preqin (Aug. 28, 2009) (``Preqin Letter I'')
(suggesting that institutional private equity investors polled
favored a private equity specific proposal rather than relying on
the framework from the municipal securities industry); Comment
Letter of Dechert LLP (Oct. 22, 2009) (``Dechert Letter''); Comment
Letter of the Committee on Federal Regulation of Securities of the
Section of Business Law of the American Bar Association (Oct. 13,
2009) (``ABA Letter''); Comment Letter of Fidelity Investments (Oct.
7, 2009) (``Fidelity Letter''); Comment Letter of Sutherland Asbill
& Brennan LLP (Oct. 6, 2009) (``Sutherland Letter''); Comment Letter
of the Investment Company Institute (Oct. 6, 2009) (``ICI Letter'');
Comment Letter of the Massachusetts Mutual Life Insurance Company
(Oct. 6, 2009) (``MassMutual Letter''); Comment Letter of Skadden,
Arps, Slate, Meagher & Flom LLP (Oct. 6, 2009) (``Skadden Letter'');
Comment Letter of the Managed Funds Association (Oct. 6, 2009)
(``MFA Letter'').
\44\ See, e.g., Comment Letter of Ounavarra Capital, LLC (Aug.
28, 2009) (``Ounavarra Letter'') (noting that banning third-party
marketers in the municipal securities industry did not adversely
affect most bankers' ability to conduct basic marketing whereas
banning third-party marketers for small advisers could have a
stronger impact on advisers that have either no or very limited
marketing capability of their own); Comment Letter of MVision
Private Equity Advisers USA LLC (Sept. 2, 2009) (``MVision Letter'')
(arguing that, whereas placement agents for municipal bond offerings
are usually regulated entities, the restrictions in the municipal
securities arena were targeted at consultants who offer only their
contacts and influence with government officials and provided no
valuable services to the financial services industry or investors);
Comment Letter of Kalorama Capital (Sept. 8, 2009) (arguing that a
better analogy, at least with respect to the operation of third-
party marketers, is to the licensed professional presenting an IPO
to a pension fund). For further discussion of these comments, see
section II.B.2(b) of this Release.
\45\ See, e.g., Comment Letter of the Committee on Investment
Management Regulation and the Committee on Private Investment Funds
of the Association of the Bar of the City of New York (Oct. 26,
2009) (``NY City Bar Letter'') (arguing that broker-dealer rules
have sufficient safeguards and that adopting the proposed pay to
play rule will interfere with traditional distribution
arrangements); Dechert Letter; Sutherland Letter; MFA Letter.
\46\ Particular comments on the various aspects of our proposal
are summarized in the corresponding sub-sections of section II of
this Release.
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II. Discussion
As discussed in more detail below, we have decided to adopt rule
206(4)-5, which we have revised to reflect comments we received. For
the reasons we discuss above and in the Proposing Release, we believe
rule 206(4)-5 is a proper exercise of our rulemaking authority under
the Advisers Act to prevent fraudulent and manipulative conduct.
The Commission regulates investment advisers under the Investment
Advisers Act of 1940. Section 206(1) of the Advisers Act prohibits an
investment adviser from employ[ing] any device, scheme or artifice to
defraud any client
[[Page 41022]]
or prospective client.'' \47\ Section 206(2) prohibits an investment
adviser from engaging in ``any transaction, practice, or course of
business which operates as a fraud or deceit upon any client or
prospective client.'' \48\ The Supreme Court has construed section 206
as establishing a Federal fiduciary standard governing the conduct of
advisers.\49\
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\47\ 15 U.S.C. 80b-6(1).
\48\ 15 U.S.C. 80b-6(2).
\49\ 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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We believe that pay 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.'' \50\ Congress
gave us this authority to prohibit ``specific evils'' that the broad
antifraud provisions may be incapable of covering.\51\ The provision
thus permits the Commission to adopt prophylactic rules that may
prohibit acts that are not themselves fraudulent.\52\
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\50\ 15 U.S.C. 80b-6(4).
\51\ 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 advisers' financial
conditions and disciplinary histories, 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.
\52\ Section 206(4) was added to the Advisers Act in Public Law
86-750, 74 Stat. 885, at sec. 9 (1960). See H.R. Rep. No. 2197, 86th
Cong., 2d Sess., at 7-8 (1960) (``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., at 8 (1960) (``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, 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.'').
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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 they advise and defraud prospective clients.\53\
In making such contributions, the adviser hopes to benefit from
officials who ``award the contracts on the basis of benefit to their
campaign chests rather than to the governmental entity'' \54\ or by
retaining a contract that might otherwise not be renewed. If pay to
play is a factor in the selection or retention process, the public
pension plan can be harmed in several ways. The most qualified adviser
may not be selected or retained, potentially leading to inferior
management or performance. 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 might be used for the benefit of the adviser,
potentially at the expense of the pension plan, thereby using the
pension plan's assets for the adviser's own purposes.\55\
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\53\ See Proposing Release, at section I; Political
Contributions by Certain Investment Advisers, Investment Advisers
Act Release No. 1812 (Aug. 4, 1999) [64 FR 43556 (Aug. 10, 1999)]
(``1999 Proposing Release''). 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, 191-92;
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)]. 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).
\54\ See Blount, 61 F.3d at 944-45.
\55\ 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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As we discuss above, pay to play practices are rarely explicit and
often hard to prove.\56\ In particular, when pay to play involves
granting of government advisory business in exchange for political
contributions, it may be difficult to prove that an adviser (or one of
its executives or employees) made political contributions for the
purpose of obtaining the government business, or that it engaged a
solicitor for his or her political influence rather than substantive
expertise.\57\ Pay to play practices by advisers to public pension
plans, which may generate significant contributions for elected
officials and yield lucrative management contracts for advisers, will
not stop through voluntary efforts. This is, in part, because these
activities create a ``collective action'' problem in two respects.\58\
First, government officials who participate may have an incentive to
continue to accept contributions to support their campaigns for fear of
being disadvantaged relative to their opponents. Second, advisers may
have an incentive to participate out of concern that they may be
overlooked if they fail to make contributions.\59\ Both the stealth in
which these practices occur and the inability of markets to properly
address them argue strongly for the need for us to adopt the type of
[[Page 41023]]
prophylactic rule that section 206(4) of the Advisers Act authorizes.
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\56\ Cf. Blount, 61 F.3d 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'').
\57\ See id. at 944 (``actors in this field are presumably
shrewd enough to structure their relations rather indirectly'').
\58\ Collective action problems exist, for example, where
participants may prefer to abstain from an unsavory practice (such
as pay to play), but nonetheless participate out of concern that,
even if they abstain, their competitors will continue to engage in
the practice profitably and without adverse consequences. As a
result, collective action problems, such as those raised by pay to
play practices, call for a regulatory response. For further
discussion, see infra note 459 and accompanying text.
\59\ In our view, the collective action problem we are trying to
address is analogous to the one noted in the case upholding MSRB
rule G-37. See Blount, 61 F.3d at 945 (``Moreover, there appears to
be a collective action problem tending to make the misallocation of
resources persist''). For a discussion of concerns raised regarding
our proposed rule that are similar to those raised regarding MSRB
rule G-37, see section II.A of this Release.
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A. First Amendment Considerations
The Commission believes that rule 206(4)-5 is a necessary and
appropriate measure to prevent fraudulent acts and practices in the
market for the provision of investment advisory services to government
entities by prohibiting investment advisers from engaging in pay to
play practices. We have examined a range of alternatives to our
proposal, carefully considered some 250 comments we received on the
proposal and made revisions to the proposed rule where we concluded it
was appropriate. We believe the rule represents a balanced response to
the developments we discuss above regarding pay to play activities
occurring in the market for government investment advisory services.
The rule provides specific prohibitions to help ensure that adviser
selection is based on the merits, not on the amount of money given to a
particular candidate for office, while respecting the rights of
industry participants to participate in the political process. The rule
is not unique; Congress, for instance, has barred Federal contractors
from making contributions to public officials.\60\
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\60\ 2 U.S.C. 441c.
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Before we address particular aspects of the rule, we would like to
respond to commenters' assertions that the fact that the rule's
limitations on compensation are triggered by political contributions
represents an infringement on the First Amendment guarantees of freedom
of speech and association.\61\ These commenters acknowledge that
selection of an investment adviser by a government entity should not be
a ``pay back'' for political contributions, but argue that the rule
impermissibly restricts the ability of advisers and certain of their
employees to demonstrate support for State and local officials.
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\61\ See, e.g., Comment Letter of W. Hardy Callcott (Aug. 3,
2009) (``Callcott Letter I''); Comment Letter of W. Hardy Callcott
(Jan. 21, 2010) (``Callcott Letter II''); Comment Letter of the
National Association of Securities Professionals, Inc. (Oct. 6,
2009) (``NASP Letter''); Comment Letter of Caplin & Drysdale,
Chartered (Oct. 6, 2009) (``Caplin & Drysdale Letter''); Comment
Letter of the Securities Industry and Financial Markets Association
(Oct. 5, 2009) (``SIFMA Letter''); ABA Letter; Sutherland Letter;
Comment Letter of IM Compliance LLC (Oct. 6, 2009) (``IM Compliance
Letter''); Comment Letter of the American Bankers Association (Oct.
6, 2009) (``American Bankers Letter'').
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The Commission is sensitive to, and has carefully considered, these
constitutional concerns in adopting the rule. Though it is not a ban on
political contributions or an attempt to regulate State and local
elections, we acknowledge that the two-year time out provision may
affect the propensity of investment advisers to make political
contributions. Although political contributions involve both speech and
associational rights protected by the First Amendment, a ``limitation
upon the amount that any one person or group may contribute to a
candidate or political committee entails only a marginal restriction
upon the contributor's ability to engage in free communication.''\62\
Limitations on contributions are permissible if justified by a
sufficiently important government interest that is closely drawn to
avoid unnecessary abridgment of protected rights.\63\
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\62\ Buckley v. Valeo, 424 U.S. 1, 20 (1976). See also
SpeechNow.org, et al. v. FEC, 599 F.3d 686 (D.C. Cir. 2010);
McConnell v. FEC, 540 U.S. 93, 135-36 (2003).
\63\ Buckley, 424 U.S. at 25. See also FEC v. Wisconsin Right to
Life, Inc., 551 U.S. 449 (2007); Republican Nat'l Comm. v. FEC, No.
08-1953, 2010 U.S. Dist. LEXIS 29163 (D.D.C. Mar. 26, 2010) (three
judge panel). This standard is lower than the strict scrutiny
standard employed in reviewing such forms of expression as
independent expenditures. Under the higher level of scrutiny, a
restriction must be narrowly tailored to serve a compelling
governmental interest. Blount, 61 F.3d at 943. See also Citizens
United v. FEC, 130 S. Ct. 876 (2010) (distinguishing restrictions on
``independent expenditures'' from restrictions on ``direct
contributions'' and leaving restrictions on direct contributions
untouched while striking down a restriction on independent
expenditures as unconstitutional). We note that in Blount, 61 F.3d
at 949, the court upheld MSRB rule G-37 even assuming that strict
scrutiny applied. For the reasons stated by the court in that
decision, we believe that Rule 206(4)-5 would be upheld under a
strict scrutiny standard as well as under the standard the Supreme
Court has applied to contribution restrictions.
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Prevention of fraud is a sufficiently important government
interest.\64\ We believe that payments to State officials as a quid pro
quo for obtaining advisory business as well as other forms of ``pay to
play'' violate the antifraud provisions of section 206 of the Advisers
Act. As discussed in our Proposing Release, ``pay to play''
arrangements are inconsistent with an adviser's fiduciary obligations,
distort the process by which investment advisers are selected, can harm
advisers' public pension plan clients and the beneficiaries of those
plans, and can have detrimental effects on the market for investment
advisory services.\65\ The restrictions inherent in rule 206(4)-5 are
in the nature of conflict of interest limitations which are
particularly appropriate in cases of government contracting and highly
regulated industries.\66\ Pursuant to our authority under section
206(4) of the Advisers Act, which we discuss above, we may adopt rules
that are reasonably designed to prevent such acts, practices and
courses of business.
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\64\ Blount, 61 F.3d at 944.
\65\ See Proposing Release, at section I. The prohibitions on
solicitation and coordination of campaign contributions are
justified by the same overriding purposes which support the two-year
time out provisions. The provisions are intended to prevent
circumvention of the time out provisions in cases where an
investment adviser has or is seeking to establish a business
relationship with a government entity. Absent these restrictions,
solicitation and coordination of contributions could be used as
effectively as political contributions to distort the adviser
selection process. The solicitation and coordination restrictions
relate only to fundraising activities and would not prevent advisers
and their covered employees from expressing support for candidates
in other ways, such as volunteering their time.
\66\ 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)] (noting, in connection with the Commission's approval of MSRB
rule G-37, that the restrictions inherent in that pay to play rule
``are in the nature of conflict of interest limitations which are
particularly appropriate in cases of government contracting and
highly regulated industries.'').
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As detailed in the following pages, we have closely drawn rule
206(4)-5 to accomplish its goal of preventing quid pro quo arrangements
while avoiding unnecessary burdens on the protected speech and
associational rights of investment advisers and their covered
employees. The rule is therefore closely drawn in terms of the conduct
it prohibits, the persons who are subject to its restrictions, and the
circumstances in which it is triggered. The United States Court of
Appeals for the District of Columbia Circuit upheld the similarly
designed MSRB rule G-37 in Blount v. SEC.\67\ Indeed, the Blount
opinion has served as an important guidepost in helping us shape our
rule.\68\
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\67\ 61 F.3d at 947-48.
\68\ Notwithstanding the Blount decision, some commenters
asserted that subsequent Supreme Court jurisprudence, including
Randall v. Sorrell, 548 U.S. 230 (2006), and Citizens United, 130 S.
Ct. 876 (decided following the closing of the comment period for
rule 206(4)-5), would result in the proposed rule being found
unconstitutional because it is not narrowly tailored to advance the
Commission's interests in addressing pay to play by investment
advisers. See, e.g., Callcott Letter I; Callcott Letter II; NASP
Letter; American Bankers Letter. We disagree. The cases cited by
commenters are distinguishable. Citizens United deals with certain
independent expenditures (rather than contributions to candidates),
which are not implicated by our rule. Randall involved a generally
applicable State campaign finance law limiting overall contributions
(and expenditures), which the Court feared would disrupt the
electoral process by limiting a candidate's ability to amass
sufficient resources and mount a successful campaign. Randall, 548
U.S. at 248-49. By contrast, our rule is not a general prohibition
or limitation, but rather is a focused effort to combat quid pro quo
payments by investment advisers seeking governmental business.
Comparable restrictions targeted at a particular industry have been
upheld under Randall because the loss of contributions from such a
small segment of the electorate ``would not significantly diminish
the universe of funds available to a candidate to a non-viable
level.'' Green Party of Conn. v. Garfield, 590 F. Supp. 2d 288, 316
(D. Conn. 2008). See also Preston v. Leake, 629 F. Supp. 2d 517, 524
(E.D.N.C. 2009) (differentiating the ``broad sweep of the Vermont
statute'' that ``restricted essentially any potential campaign
contribution'' from a statute that ``only applies to lobbyists'');
In re Earle Asphalt Co., 950 A.2d 918, 927 (N.J. Super. Ct. App.
Div. 2008), aff'd 957 A.2d 1173 (N.J. 2008) (holding that a
limitation on campaign contributions by government contractors and
their principals did not have the same capacity to prevent
candidates from amassing the resources necessary for effective
campaigning as the statute in Randall). One commenter expressly
dismissed arguments that Randall would have implications for the
Commission's proposed rule. Fund Democracy/Consumer Federation
Letter.
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[[Page 41024]]
First, the rule is limited to contributions to officials of
government entities who can influence the hiring of an investment
adviser in connection with money management mandates.\69\ These
restrictions are triggered only in situations where a business
relationship exists or will be established in the near future between
the investment adviser and a government entity.\70\
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\69\ See section II.B.2(a)(2) of this Release (discussing the
definition of ``official'' of a government entity for purposes of
rule 206(4)-5).
\70\ See section II.B.2(a)(1) of this Release (discussing the
prohibition on compensation for providing advisory services to the
client during rule 206(4)-5's two-year time out).
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Second, the rule does not in any way impinge on a wide range of
expressive conduct in connection with elections. For example, the rule
imposes no restrictions on activities such as making independent
expenditures to express support for candidates, volunteering, making
speeches, and other conduct.\71\
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\71\ See Citizens United, 130 S. Ct. at 908-09 (noting that a
government interest cannot be sufficiently compelling to limit
independent expenditures by corporate entities). See also
SpeechNow.org, 599 F.3d at 692 (spelling out the different standards
of constitutional review established by the Supreme Court for
restrictions on independent expenditures and direct contributions).
Some commenters expressed concern, for example, that rule 206(4)-5
may quell volunteer activities, deter employees of investment
advisers from running for office, or chill charitable contributions.
See, e.g., Caplin & Drysdale Letter; NASP Letter. We have expressly
clarified that volunteer activities and charitable contributions
generally would not trigger the rule's time out provision and that
employees running for office would not be subject to the
contribution limitation. See infra notes 157 and 139, respectively.
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Third, it does not prevent anyone from making a contribution to any
candidate, as covered employees may contribute $350 to candidates for
whom they may vote, and $150 to other candidates. A limitation on the
amount of a contribution involves little direct restraint on political
communication, because a person may still engage in the symbolic
expression of support evidenced by a contribution.\72\ Furthermore, the
rule takes the form of a restriction on providing compensated advisory
business following the making of contributions rather than a
prohibition on making contributions in excess of the relevant
ceilings.\73\
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\72\ Buckley, 424 U.S. at 21. See also section II.B.2(a)(6) of
this Release (discussing the de minimis exceptions to covered
associates' contributions triggering the two-year time out). Some
commenters raised constitutional concerns regarding the levels of
the de minimis exception in our proposal. See, e.g., Callcott Letter
I; Callcott Letter II; Caplin & Drysdale Letter; IM Compliance
Letter; Sutherland Letter. As discussed below, we have both raised
the amount of the de minimis exception in line with inflation and
added an additional exception.
\73\ See section II.B.2(a)(1) of this Release (discussing the
two-year time out on receiving compensation for advisory services).
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Fourth, the rule only applies to investment advisers that are
registered with us,\74\ or unregistered in reliance on section
203(b)(3) of the Advisers Act, that have (or that are seeking)
government clients.\75\ It applies only to the subset of the
significantly broader set of advisers over which we have antifraud
authority that we believe are most likely to be engaged by government
clients to manage public assets either directly or though investment
pools.\76\
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\74\ Unless indicated expressly otherwise, each time we refer to
a ``registered'' investment adviser in this Release, we mean an
adviser registered with the Commission.
\75\ See section II.B.1 of this Release (discussing advisers
covered by the rule). One commenter raised constitutional concerns
by arguing that the rule would apply beyond the advisory business of
an adviser that solicits government clients, no matter how separate
the other product or service offerings of the adviser are from the
governmental business. ABA Letter. But we believe we have made clear
that the rule's time out provisions, which are designed to eliminate
quid pro quo arrangements and ameliorate market distortions, apply
only with respect to the provision of advisory services to
government clients, which is consistent with our authority under the
Advisers Act. See section II.B.2(a)(1) of this Release.
\76\ See section II.B.1 of this Release.
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Finally, the rule is not a restriction on contributions that is
applicable to the public and is not intended to eliminate corruption in
the electoral process. Rather, it is focused exclusively on conduct by
professionals subject to fiduciary duties, seeking profitable business
from governmental entities. The rule is targeted at those employees of
an adviser whose contributions raise the greatest danger of quid pro
quo exchanges,\77\ and it covers only contributions to those
governmental officials who would be the most likely targets of pay to
play arrangements because of their authority to influence the award of
advisory business.\78\
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\77\ See section II.B.2(a)(4) of this Release (discussing the
definition of ``covered associates,'' whose contributions could
trigger the two-year time out).
\78\ See section II.B.2(a)(2) of this Release (discussing the
definition of ``official'' of a government entity for purposes of
the rule 206(4)-(5)). Some commenters argued that the definition of
``official'' we included in our proposal was ambiguous. See, e.g.,
Caplin & Drysdale Letter. In response, we have provided additional
guidance. See section II.B.2(a)(2) of this Release.
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B. Rule 206(4)-5
We are today adopting new rule 206(4)-5 under the Advisers Act that
is designed to protect public pension plans and other government
investors from the consequences of pay to play practices by deterring
advisers' participation in such practices.\79\ As we noted in the
Proposing Release, advisers and government officials might, in order to
circumvent our rule, attempt to structure their transactions in a
manner intended to hide the true purpose of a contribution or
payment.\80\ Therefore, our pay to play restrictions are intended to
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 prohibits several principal avenues for pay to play
activities.
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\79\ Rule 206(4)-5 is targeted to a concrete business
relationship between contributors and candidates' governmental
entities. It is not intended to restrict the voices of persons and
interest groups, reduce the overall scope of election campaigns, or
equalize the relative ability of all votes to affect electoral
outcomes. Indeed, if investment advisers do not seek government
business from those to whom they and their covered associates make
contributions or for whom they solicit contributions, the rule's
limitations will not be triggered. Rather, the rule is intended to
prevent direct quid pro quo arrangements, fraudulent and
manipulative acts and practices, and improve the mechanism of a free
and open market for investment advisory services for government
entity clients. With pay to play activities, the conflict of
interest is apparent, the likelihood of stealth in the arrangements
is great, and our regulatory purpose is prophylactic. See Blount, 61
F.3d at 945 (describing the court's similar characterization of MSRB
rule G-37).
\80\ Proposing Release, at section II.A.
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First, the rule makes 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 or candidate for such office who is or will be in a position to
influence the award of advisory business.\81\
[[Page 41025]]
Importantly, as we noted in the Proposing Release, rule 206(4)-5 would
not 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.\82\ This first prohibition is
substantially similar to our proposal. However, as discussed below, we
have made certain modifications to some of the definitions of terms in
this prohibition.\83\
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\81\ Rule 206(4)-5(a)(1) makes it unlawful for any investment
adviser covered by the rule 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, as defined in the rule,
of the investment adviser (including a person who becomes a covered
associate within two years after the contribution is made). As noted
below, an ``official'' includes 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 hiring of an investment adviser or has
the authority to appoint any person who is directly or indirectly
responsible for or can influence the outcome of the hiring of an
investment adviser. See section II.B.2(a)(2) of this Release.
\82\ Proposing Release, at section II.A.
\83\ See generally section II.B.2(a) of this Release.
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Second, the rule generally prohibits advisers from paying third
parties to solicit government entities for advisory business unless
such third parties are registered broker-dealers or registered
investment advisers, in each case themselves subject to pay to play
restrictions.\84\ That is, an adviser is prohibited from providing or
agreeing to provide, directly or indirectly, payment to any person for
solicitation of government advisory business on behalf of such adviser
unless that person is registered with us and subject to pay to play
restrictions either under our rule or the rules of a registered
national securities association.\85\ This represents a modification
from our proposal, which included a flat ban without an exception for
any brokers or investment advisers.\86\ As discussed below, commenters
persuaded us that the objective of the rule in eliminating pay to play
activities of advisers could be preserved if the third parties they
hire are themselves registered investment advisers subject to
Commission oversight or are broker-dealers subject to pay to play
restrictions imposed by a registered national securities association
that the Commission must approve.
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\84\ Rule 206(4)-5(a)(2)(i) makes it unlawful for any investment
adviser covered by the rule and its covered associates (as defined
in the rule) 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 such
person is a regulated person or 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.
``Regulated person'' is defined in rule 206(4)-5(f)(9). See section
II.B.2(b) of this Release for a discussion of this definition.
\85\ See section II.B.2(b) of this Release. While our rule would
apply to any registered national securities association, the
Financial Industry Regulatory Authority, or FINRA, is currently the
only registered national securities association under section 19(a)
of the Exchange Act [15 U.S.C. 78s(b)]. As such, for convenience, we
will refer directly to FINRA in this Release when describing the
exception for certain broker-dealers from the rule's ban on advisers
paying third parties to solicit government business on their behalf.
The Commission's authority to consider rules proposed by a
registered national securities association is governed by section
19(b) of the Exchange Act [15 U.S.C. 78s(b)] (``No proposed rule
change shall take effect unless approved by the Commission or
otherwise permitted in accordance with the provisions of this
subsection.'').
\86\ See Proposing Release, at section II.A.3(b).
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Third, the rule makes it unlawful for an adviser itself or any of
its covered associates to solicit or to coordinate: (i) Contributions
to an official of a government entity to which the investment adviser
is seeking to provide investment advisory services; or (ii) 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.\87\ We are adopting this aspect of the rule as
proposed.
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\87\ Rule 206(4)-5(a)(2)(ii) makes it unlawful for any
investment adviser covered by the rule and its covered associates to
coordinate, or to solicit any person [including a 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. See section II.A.2.(c) of this Release.
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Fourth, as it is not possible for us to anticipate all of the ways
advisers and government officials may structure pay to play
arrangements to attempt to evade the prohibitions of our rule, the rule
includes a provision that makes 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 rule.\88\ This provision
in the rule we are adopting today is identical to our proposal.\89\
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\88\ Rule 206(4)-5(d) makes it unlawful for any investment
adviser covered by the rule and its covered associates to do
anything indirectly which, if done directly, would result in a
violation of this section. See section II.B.2(d) of this Release.
\89\ See Proposing Release, at section II.A.3(d).
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Finally, for purposes of our rule, an investment adviser to certain
pooled investment vehicles in which a government entity invests or is
solicited to invest will be treated as though the adviser were
providing or seeking to provide investment advisory services directly
to the government entity.\90\ This provision is substantially similar
to our proposal, although we have made certain modifications described
below.\91\
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\90\ Rule 206(4)-5(c) states that, for purposes of rule 206(4)-
5, 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. See section II.B.2(e) of this Release.
\91\ See section II.B.2(e) of this Release.
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1. Advisers Subject to the Rule
Rule 206(4)-5 applies to registered investment advisers and certain
advisers exempt from registration. In particular, it applies 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)).\92\ The rule would not, however, apply to most small advisers
that are registered with State securities authorities instead of the
Commission,\93\ or advisers that are unregistered in reliance on
exemptions other than section 203(b)(3) of the Advisers Act.\94\
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\92\ 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. 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.
\93\ Advisers with less than $25 million of assets under
management are prohibited from registering with the Commission by
section 203A of the Advisers Act [15 U.S.C. 80b-3A].
\94\ The rule would also not apply to certain other advisers
that are exempt from registration with the Commission. See, e.g.,
section 203(b)(1) of the Advisers Act [15 U.S.C. 8b-3(b)(1)]
(exempting from registration intrastate investment advisers). As
explained in the Proposing Release, we believe these advisers are
unlikely to advise public pension plans. See Proposing Release, at
n.64 and accompanying text. The rule would also not apply to persons
who are excepted from the definition of investment adviser under
section 202(a)(11) of the Advisers Act [15 U.S.C. 80b-2(a)(11)]. For
a discussion, in particular, of the exclusion of banks and bank
holding companies which are not investment companies from the
Advisers Act's definition of ``investment adviser,'' see infra note
274.
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We received limited comment on this aspect of the rule. One
commenter explicitly agreed with the scope of our proposed rule, noting
that it would capture most, if not all, advisers that provide
discretionary management with respect to public pension fund assets,
regardless of whether they are registered.\95\ Other commenters
recommended that the rule apply more
[[Page 41026]]
broadly to all advisers that may manage assets of government
entities.\96\ The primary effect of such an expansion of the rule would
be to apply it to smaller firms, the regulatory responsibility for
which Congress has previously allocated to the State securities
authorities.\97\ It is our understanding that few of these firms manage
public pension plans or other public funds.\98\ Accordingly, we have
decided to adopt this provision as proposed.
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\95\ Comment Letter of the California Public Employees'
Retirement System (Oct. 6, 2009) (``CalPERS Letter'') (``CalPERS
agrees that the scope of the proposed rule would capture most if not
all external managers who have discretion over the investment of
public pension fund assets, including hedge fund managers, real
estate managers, private equity managers, traditional long-only
managers, money managers, and others, regardless of whether the
managers are registered investment advisors. CalPERS supports
application of the rule to investment advisers, as defined in the
proposed rule.'').
\96\ These suggestions included applying the rule to all
registered (including SEC-registered and State-registered) and
unregistered advisers (see, e.g., 3PM Letter (arguing that selective
application of the rule could lead to convoluted organizational
structures designed to bypass its reach and that the proposal
represents the kind of patchwork regulation that will lead to the
kind of inconsistency the Commission is seeking to correct), and
extending the rule to State-registered advisers (see, e.g., Comment
Letter of the Cornell Securities Law Clinic (Oct. 6, 2009)
(``Cornell Law Letter'')).
\97\ Amendments to the Advisers Act in 1996 placed the
regulatory responsibility for these advisers in the hands of State
regulators. See section 203A of the Advisers Act [15 U.S.C. 80b-3a]
enacted as part of Title III of the National Securities Markets
Improvement Act of 1996, Public Law 104-290, 110 Stat. 3416 (1996)
(codified in scattered sections of the United States Code).
\98\ See Proposing Release, at n.64. We did not receive any
comment challenging our understanding.
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2. Pay to Play Restrictions
(a) Two-Year ``Time Out'' for Contributions
Rule 206(4)-5(a)(1) prohibits investment advisers from receiving
compensation for providing advice to a ``government entity'' 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.'' \99\ The rule does not ban political
contributions and does not limit the amount of any political
contribution. Instead, the rule imposes a ban--a ``time out''--on
receiving compensation for conducting advisory business with a
government client for two years after certain contributions are made.
The two-year time out is intended to discourage advisers from
participating in pay to play practices by requiring a ``cooling-off
period'' during which the effects of a political contribution on the
selection process can be expected to dissipate.
---------------------------------------------------------------------------
\99\ Rule 206(4)-5(a)(1).
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Rule 206(4)-5(a)(1) is based largely on MSRB rule G-37 under which
a broker-dealer is prohibited from engaging in the municipal securities
business for two years after making a political contribution.\100\ As
noted above and as explained in the Proposing Release, we modeled the
rule on the MSRB rules because we believe that they have significantly
curbed pay to play practices in the municipal securities market.\101\
We also pointed out that our approach would minimize the compliance
burdens on firms that would be subject to both rule regimes. But we
requested comment on our proposed approach and whether alternative
models might be appropriate.
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\100\ Proposing Release, at section II.A.2.
\101\ See id. at n.23 (citing others, including the MSRB, who
agree that the MSRB rules have been effective: MSRB, MSRB Notice
2009-62, Amendments Filed to Rule G-37 Regarding Contributions to
Bond Ballot Campaigns (Dec. 4, 2009), available at http://msrb.org/msrb1/archive/2009/2009-62.asp (``Rule G-37, in effect since 1994,
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 brokers, dealers and municipal
securities dealers (``dealers''), thereby effectively assisting with
eliminating pay-to-play practices in the new issue municipal
securities market.''); MSRB, 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, 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 (Oct. 19, 2001), available at http://www.cfainstitute.org/Comment%20Letters/20011019.pdf (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.''); Comm. on Capital
Mkts. Regulation, Interim Report of the Committee on Capital Markets
Regulation (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.'')). See
also Comment letter of Professors Alexander W. Butler, Larry Fauver
and Sandra Mortal (Sept. 30, 2009) (``Butler Letter'') (citing
Alexander W. Butler, Larry Fauver & Sandra Mortal, Corruption,
Political Integrity, and Municipal Finance, 22 R. of Fin. Stud.
2673-705 (2009)).
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Several commenters supporting the rule explicitly addressed the
appropriateness of the MSRB approach. One, for example, asserted that
the proposed rule ``appropriately expands upon MSRB G-37 and G-38.''
\102\ Another agreed that the MSRB rules ``provide an appropriate
regulatory analogy for addressing [pay to play] issues.'' \103\ Many
other commenters, however, sought to distinguish advisers and municipal
securities dealers, and asserted that, because of the differences
between the two, MSRB rule G-37 is an inappropriate model on which to
base an investment adviser pay to play rule.\104\ Some argued that the
long-term nature of advisory relationships is fundamentally different
from discrete municipal underwriting transactions, and consequently,
the two-year time out is more disruptive and severe for advisers and
the governments that retain them than for municipal securities dealers
who are simply banned from obtaining ``new'' business as opposed to
terminating a long-term relationship.\105\ Some commenters asserted
that the relationships are different because advisers provide ongoing
and continuous advice as a fiduciary, rather than a one-time
transaction such as an underwriting, and that advisory services are
typically subject to an open competitive bid process instead of through
negotiated transactions that are typical of municipal
underwritings.\106\
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\102\ Common Cause Letter.
\103\ Comment Letter of Credit Suisse Securities (USA) LLC
(Sept. 14, 2009) (``Credit Suisse Letter'').
\104\ See, e.g., IAA Letter; ICI Letter; SIFMA Letter; ABA
Letter; Dechert Letter; Skadden Letter; Comment Letter of Jones Day
(Oct. 5, 2009) (``Jones Day Letter''); Comment Letter of Simpson
Thacher & Bartlett LLP on behalf of Park Hill Group LLC and its
affiliates (Sept. 21, 2009) (``Park Hill Letter''); Comment Letter
of Monument Group, Inc. (Sept. 18, 2009) (``Monument Group
Letter''). One commenter suggested, in particular, that the rule's
two-year time out provision is outside of our authority because it
imposes an ``automatic penalty, subject only to discretionary post
facto review.'' Comment Letter of Edwin C. Laurenson (Dec. 31,
2009). We disagree. The two-year time out is not a penalty. Rather,
it is a ``cooling-off period'' to dissipate any effects of a quid
pro quo. A violation of the provision would result from receiving,
or continuing to receive, payment after making the contribution, not
from the making of the contribution itself.
\105\ See, e.g., IAA Letter; ABA Letter; Dechert Letter; Skadden
Letter; Jones Day Letter; Park Hill Letter; Monument Group Letter.
But see Credit Suisse Letter (``G-37 and G-38 provide an appropriate
regulatory analogy''); Butler Letter (``This practice [municipal
underwriting pay to play] was analogous to the type of pay to play
currently under consideration by the Commission'').
\106\ See, e.g., IAA Letter; ICI Letter; SIFMA Letter; ABA
Letter; Dechert Letter; Skadden Letter; Jones Day Letter; Park Hill
Letter; Monument Group Letter.
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We disagree that the differences between municipal securities
underwriting and money management are sufficient to warrant an
alternative approach. Commenters are correct that municipal securities
underwriters provide episodic services rather than ongoing services
often provided by money managers. But underwriters seek to provide
repeated, if not ongoing, services, and the imposition of a two-year
time out can have considerable
[[Page 41027]]
competitive consequences to a broker-dealer whose government client
must employ the services of a competitor whose services it may continue
to employ after MSRB rule G-37's two-year time out has run its course.
That advisers are in a fiduciary relationship with their public pension
plan clients argues for at least as significant consequences for
participation in pay to play practices that can harm these clients.
Our decision to adopt a rule based on the MSRB model is influenced
primarily by our judgment that the MSRB rules have significantly curbed
pay to play practices in the municipal securities market\107\ and that
alternative approaches, including those suggested by commenters, would
fail to provide an adequate deterrent to pay to play activities. We
considered each of the principal suggestions offered by commenters.
---------------------------------------------------------------------------
\107\ See supra notes 31 and 101 and accompanying text.
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Some commenters suggested requiring advisers to disclose their
contributions to State and local officials.\108\ Statutes requiring
disclosure of political contributions are, in part, 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.\109\
But voters' possible reactions, if any, to such disclosure would not
necessarily resolve the concerns we are trying to address in this
rulemaking. Our concern is protecting advisory clients and investors
whom we have the responsibility to protect under the Advisers Act--
namely, the public pension plans and their beneficiaries who are
affected by pay to play practices.\110\ Disclosure to a plan's trustees
might be insufficient where the trustee (particularly a sole trustee)
has received the contributions and is presumably well aware of the
conflicts involved. Moreover, and as we pointed out in the Proposing
Release, requiring advisers to disclose political contributions to
beneficiaries would be unlikely to protect them since most cannot act
on the information by moving their pension assets to a different plan
or by reversing the plan trustees' adviser hiring decisions.\111\ Not
all beneficiaries may be entitled to vote (or withhold their vote) for
the official to whom a contribution was made, and those that are may
need to wait a substantial period of time until a future election to
exercise their vote. Further, as beneficiaries may constitute only a
small proportion of the electorate, they may not be able to influence
an election; therefore, reliance on the electoral process may be
insufficient to protect government plans and their beneficiaries from
pay to play. In addition, even if the fact of a contribution is
disclosed (which is required in many states), the contribution's true
purpose is unlikely to be disclosed.
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\108\ See, e.g., SIFMA Letter; Preqin Letter I; Comment Letter
of Triton Pacific Capital, LLC (Sept. 1, 2009) (``Triton Pacific
Letter''); Comment Letter of the State Association of County
Retirement Systems (Sept. 8, 2009); Comment Letter of CapLink
Partners (Sept. 9, 2009) (``CapLink Letter''); Comment Letter of
Parenteau Associates, LLC (Aug. 7, 2009) (``Parenteau Letter'').
\109\ See Buckley, 424 U.S. at 67 (1976) (noting that campaign
financing disclosure requirements ``deter actual corruption and
avoid the appearance of corruption by exposing large contributions
and expenditures to the light of publicity'').
\110\ As discussed above, our purposes in this rulemaking are
preventing fraud, protecting investors and maintaining the integrity
of the adviser selection process, not campaign finance reform. See
section I of this Release.
\111\ See Proposing Release, at section II.A.2. Some commenters
made the same points. See, e.g., NY City Bar Letter; Cornell Law
Letter; 3PM Letter. See also Blount, 61 F.3d at 947 (explaining, in
the context of the municipal securities industry, the potential
inadequacy of disclosure to address pay to play concerns, that
``disclosure would not likely cause market forces to erode `pay to
play * * *''' because the ``* * * purpose of protecting the
integrity of the market [would] * * * `be achieved less
effectively.''').
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Several commenters suggested that the Commission adopt a
requirement that an adviser include in its code of ethics\112\ a policy
that prohibits contributions made for the purpose of influencing the
selection of the adviser.\113\ Several commenters recommended,
similarly, that we require advisers to adopt policies and procedures
\114\reasonably designed to prevent and detect contributions designed
to influence the selection of an adviser.\115\ Many of these commenters
suggested that preclearance of employee contributions could be required
under an adviser's code of ethics or compliance policies and
procedures.\116\ One commenter asserted that an advantage of this
approach is that it would allow an adviser to customize sanctions based
on the severity of the violation.\117\
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\112\ Registered investment advisers are required to have codes
of ethics under the Advisers Act. See Advisers Act rule 204A-1.
\113\ See, e.g., IAA Letter; ABA Letter; Comment letter of the
National Society of Compliance Professionals, Inc. (Oct. 6, 2009)
(``NSCP Letter''); NY City Bar Letter; Fidelity Letter.
\114\ Registered investment advisers are required to adopt and
implement policies and procedures reasonably designed to prevent
violation by the adviser or its supervised persons of the Advisers
Act and the rules the Commission has adopted thereunder. See
Advisers Act rule 206(4)-7.
\115\ See, e.g., ABA Letter; NY City Bar Letter; IAA Letter; ICI
Letter; NSCP Letter.
\116\ See, e.g., IAA Letter; NY City Bar Letter; ABA Letter.
\117\ ABA Letter.
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We do not, however, believe that codes of ethics or compliance
procedures alone would be adequate to stop pay to play practices,
particularly when the adviser or senior officers of the adviser are
involved either directly or indirectly. First, it is those senior
officers who, as noted below, have the greatest incentives to engage in
pay to play and therefore are most likely to make contributions, who
would themselves ultimately be responsible for enforcing their own
compliance with the firm's ethics code or compliance procedures.
Second, violations of codes of ethics or compliance procedures do not
themselves establish violations of the Federal securities laws.
Moreover, the comments suggesting these alternatives would have us
require the codes or procedures be designed to prevent or detect
contributions intended to influence the selection of the adviser by a
government entity. As discussed extensively above and in our Proposing
Release, pay to play is an area in which intent is often very difficult
to prove, and is often hidden in the guise of legitimate conduct.\118\
Political contributions are made ostensibly to support a candidate; the
burden on a regulator or prosecutor of proving a different intent
presents substantial challenges absent unusual evidence. Commenters
would thus have us give the adviser, which stands to benefit from the
contribution, the discretion to determine whether contributions were
intended to influence its selection by the government entity. We do not
believe codes of ethics or policies and procedures alone, without a
rule providing for specific, prophylactic prohibitions, are adequate to
address this type of conduct.\119\
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\118\ See, e.g., Proposing Release, at n.16 and accompanying
text.
\119\ We note that, under our rules, an adviser's code of ethics
must require compliance with the rule we are today adopting (rule
204A-1(a)(2)) and the adviser must adopt policies and procedures
designed to prevent violation of the rule (rule 206(4)-7(a)).
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On balance, we believe that adopting a two-year time out for
investment advisers similar to the two-year time out applicable to
broker-dealers underwriting municipal securities is appropriate. Our
years of experience with MSRB rule G-37 suggests that the ``strong
medicine'' provided by that rule has both significantly curbed
participation in pay to play and provides a reasonable cooling-off
period to mitigate the effect of a political contribution. We are
sensitive about
[[Page 41028]]
potential implications of the operation of the rule on public pension
funds, which could lose the services of an investment adviser subject
to a time out. While we have designed the rule to reduce its
impact,\120\ investment advisers are best positioned to protect these
clients by developing and enforcing robust compliance programs designed
to prevent contributions from triggering the two-year time out.
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\120\ See, e.g., section II.B.2(a)(6) of this Release
(discussing the de minimis exceptions to the two-year time out);
section II.B.2(f) of this Release (discussing the rule's exemptive
provision).
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(1) Prohibition on Compensation
As noted above, investment advisers subject to new rule 206(4)-5
are not prohibited from providing advisory services to a government
client, even after triggering the two-year time out. Instead, an
adviser is prohibited from receiving compensation for providing
advisory services to the government client during the time out.\121\ We
have taken this approach to enable an adviser to act consistently with
its fiduciary obligations so it will not have to abandon a government
client after making a triggering contribution, but rather may provide
uncompensated advisory services for a reasonable period of time to
allow the government client to replace the adviser.\122\ We are
adopting this element of the rule as proposed.
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\121\ Rule 206(4)-5(a)(1) makes it unlawful for investment
advisers covered by the rule to provide investment advisory services
for compensation to a government entity within two years after a
triggering contribution. Under the rule, the two-year time out
begins to run once the contribution is made and not when the
contribution is discovered either by our examination staff or by the
adviser. The adviser, therefore, should return all such compensation
promptly upon discovering the triggering contribution. For the
application of the rule to investments by government entities in
pooled investment vehicles, see section II.B.2(e) of this Release.
\122\ Proposing Release, at section II.A.3(a)(1). An investment
adviser's fiduciary duties may require it to continue providing
advisory services for a reasonable period of time under these
circumstances. For another instance in which an adviser's fiduciary
duties may require its continued provision of services, see
Temporary Exemption for Certain Investment Advisers, Investment
Advisers Act Release No. 1736 (July 22, 1998) [63 FR 40231, 40232
(July 28, 1998)] (describing an investment adviser's fiduciary
duties to an investment company in the case of an assignment of the
advisory contract).
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One commenter supported the prohibition on compensation as the
least disruptive option to government clients,\123\ while others argued
that the prohibition on compensation was unreasonable and, in some
cases, difficult or near impossible to implement.\124\ A coalition of
commenters representing State and local governments asserted that, due
to restrictions on accepting uncompensated services under State and
local law, it was unlikely that government entities would accept
uncompensated services even if an adviser were willing or required to
provide them.\125\ Commenters representing advisers took the opposite
view, expressing concern that they would be locked into providing
uncompensated services for extended periods of time as a result, and
wanted the Commission to provide guidelines as to what a reasonable
amount of time is for a government client to claim or move its
assets.\126\ One asserted that it would be unreasonable to require
advisers to provide uncompensated services altogether.\127\
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\123\ Cornell Law Letter.
\124\ See, e.g., ICI Letter; Jones Day Letter. Some commenters
argued for more flexibility in sanctions (Skadden Letter; ABA
Letter; Fidelity Letter; ICI Letter; MassMutual Letter; Comment
Letter of Wells Fargo Advisors (Oct. 6, 2009) (``Wells Fargo
Letter''); IAA Letter).
\125\ Comment Letter of the National Conference of State
Legislatures, National Association of Counties, National League of
Cities, International City/County Management Association, National
Association of State Auditors, Comptrollers and Treasurers,
Government Finance Officers Association, National Association of
State Retirement Administrators, National Conference on Public
Employee Retirement Systems, and National Council on Teacher
Retirement (Oct. 6, 2009) (``National Organizations Letter''). With
respect to direct advisory relationships, because restrictions on
governments receiving services without payment would be a function
of particular State or local laws, we believe government entities
and their advisers are in the best position to work out arrangements
that are consistent with both State and local law and the
compensation prohibition of our rule. With respect to investments by
government entities in pooled investment vehicles, in particular,
such restrictions could be avoided. See section II.B.2(e)(2) of this
Release (describing possible arrangements for continued payment to
investment pools even after a time out is triggered).
\126\ See, e.g., Comment Letter of Davis Polk & Wardwell LLP
(Oct. 6, 2009) (``Davis Polk Letter'') (recommending that three
months would be reasonable); ICI Letter (suggesting 30 days). Other
commenters raised concern regarding the potential harm of a time out
to government investors for whom identifying new managers may be a
lengthy process. See, e.g., NASP Letter. We believe, however, that,
on balance, pension funds and their beneficiaries are best served by
the rule's deterrent effect against engaging in pay to play
activities. An adviser's fiduciary obligations to continue to
provide services for a reasonable amount of time, combined with the
extended compliance dates described in section III of this Release
which should afford the ability of market participants to organize
themselves in a way to adapt to the rule's requirements, should be
sufficient to minimize the impact on pension plans to the extent
they need to prepare to transition to a new money manager after a
two-year time out is triggered.
\127\ Jones Day Letter. Other commenters argued that the specter
of a two-year time out might cause some firms to ban or require pre-
clearance of all employees' contributions. See, e.g., Caplin &
Drysdale Letter. Although the rule does not require this approach,
as a result of commenters' assertions, we address this possibility
in our cost-benefit analysis. See section IV of this Release.
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Few of the commenters who opposed this provision appeared to favor
its elimination, which would require the adviser to immediately cease
providing advisory services upon making a triggering contribution.\128\
Rather, they appeared to oppose the two-year time out more
generally.\129\
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\128\ See, e.g., Davis Polk Letter; ICI Letter.
\129\ See, e.g., National Organizations Letter; ICI Letter;
Jones Day Letter; Dechert Letter.
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We are not persuaded by their arguments. We believe the prohibition
on compensation is both appropriate and administrable. The incentives
to engage in pay to play may be significant, precisely because of the
long-term nature of many advisory relationships from which the adviser
could benefit for several years. As a result, the consequences of
engaging in pay to play need to be commensurate with these incentives
for the prophylactic rule to have a meaningful deterrent effect.\130\
We acknowledge that the rule will involve compliance costs and could
adversely affect an adviser's business.\131\ On the other hand, a
political contribution would not affect the ability of an adviser to
provide compensated services to other clients, including other
government clients. Moreover, the fiduciary obligations of an adviser
would not require it to provide uncompensated advice indefinitely--
rather, the adviser may need to continue to provide advice for only a
reasonable period of time during which its client can seek to obtain
advisory services from others.\132\
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\130\ This deterrent effect is the basis for our view that the
two-year time out should not apply only to ``new business'' and that
advisers should not be able to ``negotiate'' for lesser
consequences. See supra note 124 (pointing to commenters who called
for more flexibility regarding the two-year time out). As we point
out above, our concerns extend to contributions designed to enable
advisers to retain contracts that might not otherwise be renewed.
\131\ For a discussion of costs and other burdens that may be
imposed by our rule, see generally sections IV-V of this Release.
\132\ See supra note 122 and accompanying text. The amount of
time a client might need in good faith to find and engage a
successor to the adviser would, in our view, be the primary
consideration of the length of a reasonable period, which may depend
in part on such matters as applicable law, the client's customary
process of finding and engaging advisers and the types of assets
managed by the adviser that is subject to the time out. In some
cases, a client may be able to quickly engage a ``transition
adviser'' to manage its assets until a permanent successor is found.
See, e.g., Illinois State Board Sets Transition Manager RFP,
Pensions & Investments, Feb. 8, 2010 available at http://www.pionline.com/article/20100208/PRINTSUB/302089976. In other
cases, the client may be required by the law under which it operates
to undertake a specified process to obtain a new manager, such as a
solicitation for proposals from potential managers.
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[[Page 41029]]
Some commenters urged us to permit advisers to continue to receive
compensation during the two-year time out for services provided
pursuant to an existing management contract,\133\ without
distinguishing whether the contract was acquired as a result of
political contributions. One commenter further suggested specifically
that we permit advisory services to continue to be provided by the
adviser at cost during the time out to remove the profit motive of pay
to play.\134\ We are also not persuaded by their suggestions. Allowing
contracts acquired as a result of political contributions to continue
uninterrupted would eviscerate the rule. Were a ``free pass'' available
for contracts merely because they were entered into prior to discovery
of a contribution, advisers would be strongly incentivized against
``discovering'' contributions.\135\ Because no new business from a
government client may even be available to the adviser until the two-
year period has run its course, advisers whose contributions succeeded
in acquiring a management contract for two years or more could escape
any consequences under such an exception.\136\ Further, in our
judgment, the potential loss of profits will not operate as an adequate
deterrent. It is our understanding that being selected to manage public
pension plan assets has a reputational value that itself contributes to
advisory profits by attracting additional assets under management
regardless of the profits derived directly from the management of
government client assets.\137\
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\133\ See, e.g., Dechert Letter; Fidelity Letter; ICI Letter;
Jones Day Letter (in some instances, pointing to the MSRB's approach
of not necessarily applying MSRB rule G-37's two-year time out when
a contribution is made after a business contract is signed). See
MSRB, Interpretation on the Effect of a Ban on Municipal Securities
Business under Rule G-37 Arising During a Pre-Existing Engagement
Related to Municipal Fund Securities, MSRB Rule G-37 Interpretive
Notice (April 2, 2002), available at http://msrb.org/msrb1/archive/ContributionsNotice.htm). As we explain above, due to the long-term
nature of typical advisory contracts and our belief that the
consequences of giving a contribution need to be commensurate with
the potential benefits obtained, we are not taking this approach.
\134\ Dechert Letter.
\135\ An approach that applied the two-year time out only to new
business would preclude the adviser from receiving compensation only
from additional contracts that might be awarded by the government
entity during the two-year period. In our judgment, the risk of the
potential loss of additional advisory contracts for a two-year
period would provide an inadequate deterrent to contributions
designed to influence the award of such additional advisory
contracts.
\136\ We are concerned that limiting application of the rule to
new business could invite abuse. For example, pension officials
seeking contributions after a contract has been awarded could
attempt to offer an adviser additional assets to manage under the
existing contract with the condition that the adviser subsequently
make political contributions.
\137\ See, e.g., Kevin McCoy, Do Campaign Contributions Help Win
Pension Fund Deals, USA Today, Aug. 28, 2009, available at http://www.usatoday.com/money/perfi/funds/2009-08-26-pension-fund-political-donations_N.htm (referring to advisory firms winning
management mandates from pension funds, stating: ``The awards
generate lucrative fees and lend prestige that could help lure new
clients.''); Louise Story, Quadrangle Facing Questions Over Pension
Funds, N.Y. Times, Apr. 21, 2009, available at http://www.nytimes.com/2009/04/22/business/22quadrangle.html (highlighting
an indirect benefit of a pension fund investment, stating: ``the
prestige associated with it helped the firm lure other big
investors.'').
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(2) Officials of a Government Entity
The rule's two-year time out is triggered by a contribution to an
``official'' of a ``government entity.'' \138\ An official includes 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 hiring of an investment
adviser or has authority to appoint any person who is directly or
indirectly responsible for, or can influence the outcome of, the hiring
of an investment adviser.\139\ Government entities include all State
and local governments, their agencies and instrumentalities, and all
public pension plans and other collective government funds, including
participant-directed plans such as 403(b), 457, and 529 plans.\140\
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\138\ Rule 206(4)-5(a)(1) makes it unlawful for covered
investment advisers 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 of its covered associates.
\139\ Rule 206(4)-5(f)(6). For purposes of the rule, we would
not interpret the definition of ``official'' as covering an
individual who is also a ``covered associate'' of the adviser.
Accordingly, under the rule, a covered associate who is an incumbent
or candidate for office is not limited to contributing the de
minimis amount to his or her own campaign. The MSRB takes a similar
view with respect to its rule G-37. MSRB, Questions and Answers
Concerning Political Contributions and Prohibitions on Municipal
Securities Business: Rule G-37, MSRB rule G-37 Interpretive Notice,
available at http://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/Rule-G37-Frequently-Asked-Questions.aspx (``MSRB Rule
G-37 Q&A''), Question II.10 (May 24, 1994).
\140\ Rule 206(4)-5(f)(5).
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The two-year time out is thus triggered by contributions, not only
to elected officials who have legal authority to hire the adviser, but
also to elected officials (such as persons with appointment authority)
who can influence the hiring of the adviser. We have not modified this
approach from our proposal.\141\ As we noted in the Proposing Release,
a person appointed by an elected official is likely to be subject to
that official's influences and recommendations.\142\ 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.\143\ We are adopting these provisions as
proposed.\144\
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\141\ See Proposing Release, at section II.A.3(a)(2).
\142\ Id.
\143\ As such, executive officers or legislators whose official
position gives them the authority to influence the hiring of an
investment adviser generally would be ``government officials'' under
the rule. For example, a State may have a pension fund whose board
of directors, which has authority to hire an investment adviser, is
constituted, at least in part, by appointees of the governor and
members of the State legislature. See, e.g., The Commonwealth of
Pennsylvania Public School Employees' Retirement Board, Statement of
Organization, By-Laws and Other Procedures (rev. Jun. 11, 2009),
art. II, sec. 2.1, available at http://www.psers.state.pa.us/org/board/policies/201001_bylaws.pdf (noting that the board shall be
composed of, inter alia, two persons appointed by the Pennsylvania
State Governor, two Pennsylvania State senators and two members of
the Pennsylvania State house of representatives). In such
circumstances, the governor and the members of the State legislature
serving on the board would be officials of the government entity.
Conversely, a public official who is tasked with performing an audit
of the selection process but has no influence over hiring outcomes
would not be an official of a government entity for purposes of the
rule.
\144\ These definitions and their application are substantively
the same as those in MSRB rule G-37. See MSRB rule G-37(g)(ii) and
(g)(vi).
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Some commenters asserted that the rule should be more specific as
to which public officials to whom a contribution is made would trigger
application of the rule in order to reduce uncertainty and compliance
burdens.\145\ But State and municipal statutes vary substantially with
respect to whom they entrust with the management of public funds, and
any effort we make in a rule of general application to identify
specific officials who are in a position to influence the selection of
an adviser would certainly be over-inclusive in some circumstances and
under-inclusive in others.\146\ Others
[[Page 41030]]
urged that triggering contributions should be limited to contributions
to officials directly responsible for the selection of advisers.\147\
Excluding from the application of the rule contributions to those who
are in a position to indirectly influence the selection of an
investment adviser could simply lead officials to re-structure their
relationships to avoid application of the rule to advisers that may
contribute to those officials.
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\145\ See, e.g., IAA Letter; NSCP Letter; Comment Letter of T.
Rowe Price Associates, Inc. (Oct. 6, 2009) (``T. Rowe Letter''); MFA
Letter; Davis Polk Letter. For a discussion of the potential costs
involved in identifying officials to whom contributions could
trigger the rule's prohibitions, see section IV of this Release
(presenting our cost-benefit analysis). Another commenter suggested
that advisers should be able to rely on certifications from
candidates and officials regarding whether their office would render
them an ``official'' for purposes of the rule--i.e., identifying the
range, if any, of public investment vehicles over which the relevant
office directly or indirectly influences the selection of investment
advisers or appoints individuals who do). Caplin & Drysdale Letter.
We are concerned that such a safe harbor would undercut the purposes
of the rule, not least because officials will be incentivized to
offer such certifications liberally (and will presumably sometimes
do so inappropriately) to encourage contributions.
\146\ Like us, the MSRB does not specify which officials have
the authority to influence the granting of government business for
purposes of its rule G-37. See MSRB, Campaign for Federal Office,
MSRB Rule G-37 Interpretive Notice (May 31, 1995), available at
http://msrb.org/msrb1/rules/interpg37.htm (``The Board does not make
determinations concerning whether a particular individual meets the
definition of ``official of an issuer.'').
\147\ See, e.g., IAA Letter; NASP Letter; NY City Bar Letter;
Davis Polk Letter.
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Two commenters argued that the rule should not cover contributions
to candidates for Federal office,\148\ while another contended that it
should.\149\ Under our rule, as proposed, a candidate for Federal
office could be an ``official'' under the rule not because of the
office he or she is running for, but as a result of an office he or she
currently holds.\150\ So long as an official has influence over the
hiring of investment advisers as a function of his or her current
office, contributions by an adviser could have the same effect,
regardless to which of the official's campaigns the adviser
contributes. For that reason, we are not persuaded that an incumbent
State or local official should be excluded from the definition solely
because he or she is running for Federal office.\151\
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\148\ See, e.g., NSCP Letter; Dechert Letter.
\149\ Fund Democracy/Consumer Federation Letter.
\150\ As a result, if a State or municipal official were, for
example, a candidate for the U.S. Senate, House of Representatives,
or presidency, an adviser's contributions to that official would be
covered by the rule. MSRB rule G-37's time out provision is also
triggered by contributions to State and local officials running for
Federal office. See MSRB Rule G-37 Q&A, Questions IV.2-3.
\151\ Under certain circumstances, a State or municipal official
running for Federal office could remove herself from being an
``official'' for purposes of rule 206(4)-5 by eliminating her
ability to influence the outcome of the hiring of an investment
adviser. This might occur, for example, if she were to: (i) Formally
withdraw from participation in or influencing adviser hiring
decisions; (ii) be leaving office, so that he or she could not
participate in subsequent decision-making; and (iii) have held
direct influence over the adviser hiring process (as opposed to, for
example, having designated an appointee with such influence who
would remain in a position to influence such hiring).
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(3) Contributions
The rule's time out provisions are triggered by contributions made
by an adviser or any of its covered associates.\152\ A contribution is
defined to include a gift, subscription, loan, advance, deposit of
money, or anything of value 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.\153\ It also includes
transition or inaugural expenses incurred by a successful candidate for
State or local office.\154\ The definition is the same as we proposed
and as the one used in MSRB rule G-37.\155\
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\152\ Rule 206(4)-5(a)(1) makes it unlawful for covered
investment advisers 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 of its covered associates. As suggested
above, we are concerned that contributions may be used ``as the
cover for what is much like a bribe: a payment that accrues to the
private advantage of the official and is intended to induce him to
exercise his discretion in the donor's favor, potentially at the
expense of the polity he serves.'' Blount, 61 F.3d at 942
(describing the Commission's approval of MSRB rule G-37 as based on
a wish to curtail this function).
\153\ Rule 206(4)-5(f)(1).
\154\ MSRB rule G-37 also covers payment of transition or
inaugural expenses as contributions for purposes of its time out
provision. See MSRB Rule G-37 Q&A, Question II.6. However, under
neither rule does a contribution include the transition or inaugural
expenses of a successful candidate for Federal office. Contributions
to political parties are not specifically covered by the definition
and thus would not trigger the rule's two-year time out unless they
are a means to do indirectly what the rule prohibits if done
directly (for example, the contributions are earmarked or known to
be provided for the benefit of a particular political official). We
also note that ``contributions'' are not intended to include
independent ``expenditures,'' as that term is defined in 2 U.S.C.
431 & 441b (the Federal statutory provisions limiting contributions
and expenditures by national banks, corporations, or labor
organizations invalidated by Citizens United v. Federal Election
Commission, 130 S. Ct. 876 (2010) (holding that corporate funding of
independent political broadcasts in candidate elections cannot be
limited under the First Amendment)). Indeed, it is our intent that,
under the rule, advisers and their covered associates ``are not in
any way restricted from engaging in the vast majority of political
activities, including making direct expenditures for the expression
of their views, giving speeches, soliciting votes, writing books, or
appearing at fundraising events.'' Blount, 61 F.3d at 948.
\155\ MSRB rule G-37(g)(i).
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We received requests that we clarify the application of the rule to
some common circumstances that may arise in the course of an adviser's
relationship with a government client.\156\ We would not consider a
donation of time 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 and telephones, are not used.\157\
Similarly, we would not consider a charitable donation made by an
investment adviser to an organization that qualifies for an exemption
from Federal taxation under the Internal Revenue Code,\158\ or its
equivalent in a foreign jurisdiction, at the request of an official of
a government entity to be a contribution for purposes of rule 206(4)-
5.\159\
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\156\ See, e.g., Caplin & Drysdale Letter; Callcott Letter I
(volunteer activities); NASP Letter (charitable contributions);
Sutherland Letter; IAA Letter (entertainment expenses and conference
expenses). We address entertainment and conference expenses in
section II.B.2(c) of this Release (which discusses the prohibition
on soliciting or coordinating contributions from others).
\157\ See Proposing Release, at n.91. A covered associate's
donation of his or her time generally would not be viewed as a
contribution if such volunteering were to occur during non-work
hours, if the covered associate were using vacation time, or if the
adviser is not otherwise paying the employee's salary (e.g., an
unpaid leave of absence). But see rule 206(4)-5(d) (prohibiting an
adviser from doing indirectly what the rule would prohibit if done
directly). The MSRB deals similarly with this issue. See MSRB Rule
G-37 Q&A, Question II.19.
\158\ Section 501(c)(3) of the Internal Revenue Code (26 U.S.C.
501(c)(3)) contains a list of charitable organizations that are
exempt from Federal income taxation.
\159\ The MSRB deals similarly with this issue. See MSRB Rule G-
37 Q&A, Question II.18. But see rule 206(4)-5(d) (prohibiting an
adviser from doing indirectly what the rule would prohibit if done
directly).
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The few commenters that addressed the definition of
``contribution'' generally urged us to adopt a narrower version. Some,
for example, recommended that contributions be expressly limited to
political contributions and more explicitly exclude expenditures not
clearly made for the purpose of influencing an election.\160\ We are
not narrowing our definition. We are instead adopting our definition as
proposed due to our concern that ``contributions'' may also take the
form of payment of election-related debts and transition or inaugural
expenses. Further, our definition of ``contribution'' already requires
that the payment be made for the purpose of influencing an election for
a Federal, State or local office.\161\ We believe that the scope of our
proposed definition is appropriate in light of the conduct we are
seeking to address.
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\160\ See, e.g., National Organizations Letter; NASP Letter.
\161\ Rule 206(4)-5(f)(1).
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Commenters were divided as to whether contributions to PACs or
local political parties should trigger the two-year time out.\162\ Such
contributions were not explicitly covered by the proposed rule and do
not necessarily
[[Page 41031]]
trigger the two-year time out in MSRB rule G-37.\163\ In some cases,
such contributions may effectively operate as a funnel to the campaigns
of the government officials.\164\ In other cases, however, they may
fund general party political activities or the campaigns of other
candidates.\165\ Therefore, we have decided not to explicitly include
all such contributions among those that trigger the time out, although
they may violate the provision of the rule, discussed below, which
prohibits an adviser or any of its covered persons from indirect
actions that would result in a violation of the rule if done
directly.\166\
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\162\ See, e.g., CalPERS Letter; NSCP Letter (should not apply
to contributions to PACs or State or local parties, unless a
particular candidate directly solicits contributions for those
entities); Comment Letter of James J. Reilly (Aug. 24, 2009)
(``Reilly Letter'') (contributions to political parties should be
included because in State and local elections contributions to
political parties may effectively amount to contributions to an
individual candidate); SIFMA Letter.
\163\ See, e.g., MSRB, Payments to Non-Political Accounts of
Political Organizations, MSRB rule G-37 Interpretive Letter (Sept.
25, 2007), available at http://msrb.org/msrb1/rules/interpg37.htm
(explaining that not all payments to political organizations that,
in turn, make contributions to officials trigger Rule G-37's time
out). With regard to solicitations from a PAC or a political party
with no indication of how the collected funds will be disbursed,
advisers should inquire how any funds received from the adviser or
its covered associates would be used. For example, if the PAC or
political party is soliciting funds for the purpose of supporting a
limited number of government officials, then, depending upon the
facts and circumstances, contributions to the PAC or payments to the
political party might well result in the same prohibition on
compensation for providing investment advisory services to a
government entity as would a contribution made directly to the
official. Our approach is consistent with the MSRB's. See MSRB Rule
G-37 Q&A, Question III.5.
\164\ See, e.g., Reilly Letter.
\165\ See, e.g., Caplin & Drysdale Letter (explaining that
``leadership PACs,'' for example, are commonly established by
officeholders to donate to other candidates and issues).
\166\ See section II.B.2(d) of this Release. For the MSRB's
approach to this issue, see MSRB Rule G-37 Q&A, Question III.4. But
see rule 206(4)-5(d) (noting that the rule's definition of
``official'' of a government entity includes any election committee
for that person).
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The MSRB rule G-37 definition of ``contribution'' has, in our view,
proved to be workable. The types of contributions relevant to money
managers and elected officials are unlikely to be different than those
made to influence the awarding of municipal securities business by
broker-dealers. On balance, we believe that the MSRB's definition of
``contribution,'' which we mirrored in our proposal, achieves the goals
of this rulemaking. Therefore, we are adopting the definition as
proposed.
(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.\167\ Accordingly, under the rule, contributions by
each of these persons, which the rule defines as ``covered
associates,'' trigger the two-year time out.\168\ A ``covered
associate'' of an investment adviser is defined as: (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 any person who
supervises, directly or indirectly, such employee; and (iii) any
political action committee controlled by the investment adviser or by
any of its covered associates.\169\
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\167\ Proposing Release, at section II.A.3(a)(4). Based on
enforcement actions, we believe that such persons are more likely to
have an economic incentive to make contributions to influence the
advisory firm's selection. See id.
\168\ Rule 206(4)-5(a)(1).
\169\ Rule 206(4)-5(f)(2).
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Owners. Contributions by sole proprietors are contributions by the
adviser itself.\170\ If the adviser is a partnership, the rule covers
contributions by the adviser's general partners.\171\ If the adviser is
a limited liability company, the rule covers contributions made by
managing members.\172\ A contribution by an owner that is a limited
partner or non-managing member (of a limited liability company) is not
covered, however, unless the limited partner or non-managing member is
also an executive officer or solicitor (or person who supervises a
solicitor) covered by the rule, or unless the contribution is an
indirect contribution by the adviser, executive officer, solicitor, or
supervisor.\173\ Similarly, if the adviser is a corporation,
shareholder contributions are not covered unless the shareholder is
also an executive officer or solicitor covered by the rule, or unless
the contribution is an indirect contribution by the adviser, executive
officer, solicitor, or supervisor.\174\
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\170\ We note, however, that a sole proprietor may, in a
personal capacity, avail herself or himself of the de minimis
exceptions described in section II.B.2(a)(6) of this Release.
\171\ Rule 206(4)-5(f)(2)(i).
\172\ Id.
\173\ See rule 206(4)-5(a)(1), (d) and (f)(2)(i)-(ii).
\174\ Id.
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Executive Officers. Contributions by an executive officer of an
investment adviser trigger the two-year time out.\175\ Executive
officers include: (i) The president; (ii) any vice president in charge
of a principal business unit, division or function (such as sales,
administration or finance); (iii) any other officer of the investment
adviser who performs a policy-making function; or (iv) any other person
who performs similar policy-making functions for the investment
adviser.\176\ Whether a person is an executive officer depends on his
or her function, not title; for example, an officer who is the chief
executive of an advisory firm but whose title does not include
``president'' is nonetheless an executive officer for purposes of the
rule.
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\175\ The definition of ``covered associate'' includes, among
others, any executive officer or other individual with a similar
status or function. Rule 206(4)-5(f)(2)(i).
\176\ Rule 206(4)-5(f)(4).
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The definition reflects changes we have made from our proposal that
are designed to clarify the rule and to tailor it to apply to those
officers of an investment adviser whose position in the organization is
more likely to incentivize them to obtain or retain clients for the
investment adviser (and, therefore, to engage in pay to play practices)
while still achieving our objectives. We have clarified that ``other
executive officers'' under the rule--i.e., those other than the
president and vice presidents in charge of principal business units or
functions--include only those officers or other persons who perform a
policy-making function for the investment adviser.\177\ This
limitation, which was recommended by commenters,\178\ excludes persons
who enjoy certain titles as a formal matter but do not engage in the
kinds of activities that we believe should trigger the prohibitions in
the rule.\179\ We have
[[Page 41032]]
also modified the definition to remove the limitation that the officer,
as part of his or her regular duties, performs or supervises any person
who performs advisory services for the adviser, or solicits or
supervises any person who solicits for the adviser. We agree with the
commenter who asserted that ``* * * all of the adviser's executive
officers should be included because the nature of their status alone
creates a strong incentive to engage in pay to play practices.'' \180\
Even if these senior officers are not directly involved in advisory or
solicitation activities, as part of senior management, their success
within the advisory firm is likely to be tied to the firm's success in
obtaining clients.\181\
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\177\ Rule 206(4)-2(f)(4). This modification also aligns the
definition more closely with the definition of ``executive officer''
in our other rules. See, e.g., rule 205-3(d)(4) under the Advisers
Act [17 CFR 275.205-3(d)(4)] (defining executive officer for
purposes of determinations of who is a qualified client exempting an
adviser from the prohibition on entering into, performing, renewing
or extending an investment advisory contract that provides for
compensation on the basis of a share of the capital gains upon, or
the capital appreciation of, the funds, or any portion of the funds,
under the Advisers Act) and rule 3c-5(a)(3) [17 CFR 270.3c-5(a)(3)]
under the Investment Company Act of 1940 [15 U.S.C. 80a]
(``Investment Company Act'') (defining executive officer for
purposes of determinations of the number of beneficial owners of a
company excluded from the definition of ``investment company'' by
section 3(c)(1) of the Investment Company Act, and whether the
outstanding securities of a company excluded from the definition of
``investment company'' by section 3(c)(7) of the Investment Company
Act are owned exclusively by qualified purchasers, as defined in
that Act). It also more closely aligns the definition to the MSRB
approach. See MSRB rule G-37(g)(v).
\178\ See, e.g., Sutherland Letter.
\179\ Several commenters urged us expressly to exclude from the
definition the CEO, officers and employees of a parent company. See,
e.g., SIFMA Letter; ICI Letter; MFA Letter; Skadden Letter.
Depending on facts and circumstances, there may be instances in
which a supervisor of an adviser's covered associate (who, for
example, engages in solicitation of government entity clients for
the adviser) formally resides at a parent company, but whose
contributions should trigger the two-year time out because they
raise the same conflict of interest issues that we are concerned
about, irrespective of that person's location or title. In other
words, whether a person is a covered associate ultimately depends on
the activities of the individual and not his or her title. We
recently considered a similar issue in a report addressing whether
MSRB rule G-37 could include contributions by employees of parent
companies as triggering that rule's time out provision, see Report
of Investigation Pursuant to Section 21(a) of the Securities
Exchange Act of 1934: JP Morgan Securities, Inc., Exchange Act
Release No. 61734 (Mar. 18, 2010), available at http://www.sec.gov/litigation/investreport/34-61734.htm (``This Report serves to remind
the financial community that placing an executive who supervises the
activities of a broker, dealer or municipal securities dealer
outside of the corporate governance structure of such broker, dealer
or municipal securities dealer does not prevent the application of
MSRB Rule G-37 to that individual's conduct.''). The MSRB also takes
the view that it is an individual's activities and not his or her
title that may render his or her contributions a trigger for that
rule's time out provision. See MSRB Rule G-37 Q&A, Question IV.18.
\180\ See Fund Democracy Letter.
\181\ Commenters also suggested that our definition exclude vice
presidents in charge of business units, divisions or functions whose
function is unrelated to investment advisory or solicitation
activities. See, e.g., IAA Letter. For the reasons described above,
we do not believe such an exclusion is appropriate.
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Employees who Solicit Government Clients. Contributions by any
employee who solicits a government entity for the adviser would trigger
the two-year time out.\182\ An employee need not be primarily engaged
in solicitation activities to be a ``covered associate'' under the
rule.\183\ We are also including persons who supervise employees who
solicit government entities because we believe these persons are
strongly incentivized to engage in pay to play activities to obtain
government entity clients.\184\ We have revised this aspect of the
definition to include all supervisors of those solicitors that solicit
government entities because we believe the incentives to engage in pay
to play exist for all such supervisors, not just those that have a
certain level of seniority.
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\182\ We are not adopting the suggestion of several commenters
that we treat third-party solicitors the same way as employees. See,
e.g., 3PM Letter; Triton Pacific Letter; Comment Letter of Arrow
Partners, Inc. Partner Ken Rogers (Sept. 2, 2009) (``Arrow
Letter''). We explained in the Proposing Release that we determined
not to propose this approach out of concern for the difficulties
that advisers may have when monitoring the activities of their
third-party solicitors. See Proposing Release, at nn.135 and
accompanying text. Commenters did not persuade us that these
concerns can reasonably be expected to be overcome. Therefore,
whereas contributions by covered associates of the adviser trigger
the two-year compensation time out, an adviser is prohibited from
hiring third parties to solicit government business on its behalf
unless the third party is a ``regulated person.'' See section
II.B.2(b) of this Release. Our approach is similar to MSRB's rule G-
38, which restricts third-party solicitation activities differently
from the two-year time out. See MSRB rule G-38.
\183\ The MSRB also takes the approach that an associated person
need not be ``primarily engaged'' in activities that would make his
or her contributions trigger rule G-37's time out provision,
particularly where he or she engages in soliciting business. See
MSRB Rule G-37 Q&A, Question IV.8.
\184\ Rule 206(4)-5(f)(2)(ii). The proposed rule would only have
applied to senior officers who supervise employee solicitors. See
proposed rule 206(4)-5(f)(4)(ii). MSRB rule G-37 also applies to
supervisors of persons who solicit relevant business from government
entities. See MSRB Rule G-37 Q&A, Question IV.14.
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Rule 206(4)-5 defines ``solicit'' to mean, 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.\185\ Commenters asked us to provide
further guidance on what we mean by ``solicit.'' \186\ The
determination of whether a particular communication is a solicitation
is dependent upon the specific facts and circumstances relating to such
communication. As a general proposition any communication made under
circumstances reasonably calculated to obtain or retain an advisory
client would be considered a solicitation unless the circumstances
otherwise indicate that the communication does not have the purpose of
obtaining or retaining an advisory client. For example, if a government
official asks an employee of an advisory firm whether the adviser has
pension fund advisory capabilities, such employee generally would not
be viewed as having solicited advisory business if he or she provides a
limited affirmative response, together with either providing the
government official with contact information for a covered associate of
the adviser or informing the government official that advisory
personnel who handle government advisory business will contact him or
her.\187\
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\185\ Rule 206(4)-5(f)(10)(i). We are adopting this definition
as proposed.
\186\ See, e.g., Skadden Letter.
\187\ Similarly, if a government official is discussing
governmental asset management issues with an employee of an adviser,
the employee generally would not be viewed as having solicited
business if he or she provides a limited communication to the
government official that such alternative may be appropriate,
together with either providing the government official with contact
information for a covered associate or informing the government
official that advisory personnel who handle asset management for
government clients will contact him or her. In these examples,
however, if the adviser's employee receives compensation such as a
finder's or referral fee for such business or if the employee
engages in other activities that could be deemed a solicitation with
respect to such business, the employee generally would be viewed as
having solicited the advisory business. Our interpretation of what
it means to ``solicit'' government business is consistent with the
MSRB's. See MSRB, Interpretive Notice on the Definition of
Solicitation under Rules G-37 and G-38 (June 8, 2006), available at
http://msrb.org/msrb1/rules/notg38.htm.
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Political Action Committees. A covered associate includes a
political action committee controlled by the investment adviser or by
any of its covered associates.\188\ Under the rule, we would regard an
adviser or its covered associate to have ``control'' over a political
action committee if the adviser or its covered associate has the
ability to direct or cause the direction of the governance or
operations of the PAC.\189\
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\188\ Rule 206(4)-5(f)(2)(iii) (which we are adopting as
proposed). One commenter suggested that we define a ``political
action committee,'' or PAC, as any organization required to register
as a political committee under Federal, State or local law. Caplin &
Drysdale Letter. But we have not included this definition of PAC
because we do not believe a definition linked to the registration
status of a political committee would serve our purpose of deterring
evasion of the rule as registration requirements vary among election
laws. We note, however, that we would construe the term PAC to
include (but not necessarily be limited to) those political
committees generally referred to as PACs, such as separate
segregated funds or non-connected committees within the meaning of
the Federal Election Campaign Act, or any State or local law
equivalent. See Federal Election Commission, Quick Answers to PAC
Questions, available at http://www.fec.gov/ans/answers_pac.shtml#pac. Determination of whether an entity is a PAC covered
by our rule would not, in our view, turn on whether the PAC was, or
was required to be, registered under relevant law.
\189\ One commenter suggested a similar interpretation of
``control.'' Caplin & Drysdale Letter. For the MSRB's approach to
this definition, see MSRB Rule G-37 Q&A, Question IV.24.
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Two commenters asserted that we should narrow the definition of
``covered associate'' with respect to political action committees.\190\
Specifically, they asserted that the definition should only include
PACs controlled by the adviser and not those controlled by other
covered associates, which could be a separate legal entity over which
the adviser may have little influence.\191\ We are not adopting this
suggestion. As we discussed in the Proposing Release, PACs are often
used to make political contributions.\192\ The
[[Page 41033]]
recommended changes would permit an executive of the adviser or another
covered person of the adviser to use a PAC he or she controls to evade
the rule. Even where the adviser itself does not control such PACs
directly, we are concerned about their use to evade our rule where they
are controlled by covered associates (whose positions in the
organization, as we note above, are more likely to incentivize them to
obtain or retain clients for the investment adviser).\193\
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\190\ SIFMA Letter; Sutherland Letter.
\191\ Id.
\192\ Proposing Release, at n.101.
\193\ Advisers are responsible for supervising their supervised
persons, including their covered associates. We have the authority
to seek sanctions where an investment adviser, or an associated
person, has failed reasonably to supervise, with a view to
preventing violations of the Federal securities laws or rules, a
person who is subject to the adviser's (or its associated person's)
supervision and who commits such violations. Sections 203(e)(6) and
203(f) of the Advisers Act [15 U.S.C. 80b-3(e)(6) and (f)].
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Other Persons. Several commenters urged that our definitions be
broadened to encompass other persons whose contributions should trigger
the two-year time out.\194\ One urged that in some cases all employees
should be covered associates because of the likelihood they could
directly benefit from engaging in pay to play.\195\ Another urged that
the definition of covered associate include affiliates of the adviser
that solicit government business on the adviser's behalf, any director
of the adviser, and any significant owner of the adviser.\196\ These
suggestions would expand the rule to a range of persons that could
engage in pay to play activities.\197\ In our judgment, however,
contributions from these types of persons are less likely to involve
pay to play unless the contributions were made by these persons for the
purpose of avoiding application of the rule, which could result in the
adviser's violation of a separate provision of the rule.\198\ We do not
believe that the incremental benefits of capturing conduct of other
individuals less likely to engage in pay to play based on the record
before us today outweigh the additional burden such an expansion would
impose.\199\ Thus, we are not expanding the definition as these
commenters have suggested.
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\194\ See, e.g., Fund Democracy/Consumer Federation Letter;
DiNapoli Letter (suggesting the rule also cover contributions from
family members); Ounavarra Letter.
\195\ Ounavarra Letter.
\196\ Fund Democracy/Consumer Federation Letter.
\197\ See, e.g., supra note 179 (discussing why we have chosen
not to limit the definition of ``executive officer'' in other ways
as suggested by some commenters).
\198\ See Rule 206(4)-5(d). We also note that the MSRB takes a
similar approach. See, e.g., MSRB Rule G-37 Q&A, Question IV.9
(noting that the universe of those whose contributions above the de
minimis level per se trigger the two-year time out is limited and
does not include their consultants, lawyers or spouses). The MSRB
also leaves contributions by affiliates and personnel beyond those
identified as triggering the two-year time out to be addressed by a
provision prohibiting municipal securities dealers from doing
indirectly what they are prohibited from doing directly under rule
G-37. See MSRB Rule G-37(d).
\199\ In this instance, as in others, we are sensitive to First
Amendment concerns that further expansion of the scope of covered
associates could broaden the rule's scope beyond what is necessary
to accomplish its purposes.
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Other commenters urged us to narrow our definition of ``covered
associate'' to include fewer persons.\200\ For example, one commenter
recommended that the definition of ``covered associate'' expressly
exclude all ``support personnel.'' \201\ Another suggested that we
limit the definition to those who solicit government clients with a
``major purpose'' of obtaining that government client.\202\ Expressly
excluding all ``support personnel'' is unnecessary because, in almost
all cases, such persons would not be ``covered associates,'' as that
term is defined in the rule. We have not limited the definition to
those who solicit government clients with a ``major purpose'' of
obtaining that government client because we believe that our rule's
definition of ``solicit,'' as discussed above, adequately takes into
account the purpose of the communication and adding an additional
element of intent may exclude employees who have an incentive to engage
in pay to play practices.
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\200\ See, e.g., T. Rowe Price Letter; NSCP Letter; Skadden
Letter.
\201\ T. Rowe Price Letter.
\202\ Skadden Letter.
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(5) ``Look Back''
The rule attributes to an adviser contributions made by a person
within two years (or, in some cases, six months) of becoming a covered
associate of that adviser.\203\ In other words, when an employee
becomes a covered associate, the adviser must ``look back'' in time to
that employee's contributions to determine whether the time out applies
to the adviser.\204\ If, for example, the contributions were made more
than two years (or, pursuant to the exception described below for non-
solicitors, six months) prior to the employee becoming a covered
associate, the time out has run; if the contribution was made less than
two years (or six months) from the time the person becomes a covered
associate, the rule prohibits the adviser that hires or promotes the
contributing covered associate from receiving compensation for
providing advisory services from the hiring or promotion date until the
two-year period has run.\205\ The look-back provision, which is similar
to that in MSRB rule G-37, is designed to prevent advisers from
circumventing the rule by influencing the selection process by hiring
persons who have made political contributions.\206\
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\203\ Rule 206(4)-5(a)(1). The ``look back'' applies to any
person who becomes a covered associate, including a current employee
who has been transferred or promoted to a position covered by the
rule. A person becomes a covered associate for purposes of the
rule's look-back provision at the time he or she is hired or
promoted to a position that meets the definition of ``covered
associate'' in rule 206(4)-5(f)(2). For a discussion of the
definition of ``covered associate,'' see section II.B.2(a)(4) of
this Release.
\204\ Rule 206(4)-5(a)(1) (including among those covered
associates whose contributions can trigger the two-year time out a
person who becomes a covered associate within two years after the
contribution is made); Rule 206(4)-5(b)(2) (excepting from the two-
year look back those contributions made by a natural person more
than six months prior to becoming a covered associate of the
investment adviser unless such person, after becoming a covered
associate, solicits clients on behalf of the investment adviser).
\205\ In no case would the prohibition imposed by the 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 (and engages in solicitation
activity for it) 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. We also note that the rule's exemptive process may be
available in instances where an adviser believes application of the
look-back provision would yield an unintended result. Rule 206(4)-
5(e). For a discussion of the rule's exemptive provision, see
section II.B.2(f) of this Release.
\206\ Similarly, to prevent advisers from channeling
contributions through departing employees, advisers must ``look
forward'' with respect to covered associates who cease to qualify as
covered associates or leave the firm. 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 a covered
associate or remains employed by the adviser. Thus, dismissing a
covered associate would not relieve the adviser from the two-year
time out. MSRB rule G-37 also includes a ``look-forward provision.''
See MSRB Rule G-37 Q&A, Question IV.17 (`` * * * any contributions
by [an] associated person [who leaves the dealer's employ] (other
than those that qualify for the de minimis exception under Rule G-
37(b)) will subject the dealer to the rule's ban on municipal
securities business for two years from the date of the
contribution'').
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We received many comments on our proposed look-back provision,\207\
which would have applied the two-year look back with respect to all
contributions of new covered associates.\208\ One commenter asserted
that such a provision is necessary to prevent advisers from
circumventing the
[[Page 41034]]
prohibitions on pay to play.\209\ Most commenters, however, argued that
the rule should not contain a look-back provision or should contain a
shorter one because it could prevent advisers from hiring qualified
individuals who have made unrelated political contributions,\210\ or it
could be disruptive to public pension plans seeking to hire qualified
managers.\211\ While some urged that we eliminate the look-back
provision altogether,\212\ most asked us to shorten the period to three
to six months.\213\ Others suggested alternative approaches to the look
back, including adopting a higher contribution threshold to trigger the
look-back provision \214\ or permitting advisers to hire and promote
persons to be covered associates who have made prohibited
contributions, but not permitting them to solicit government clients or
otherwise create firewalls between them and government clients.\215\
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\207\ See, e.g., Fund Democracy/Consumer Federation Letter; ICI
Letter; Davis Polk Letter; NY City Bar Letter; Fidelity Letter;
Wells Fargo Letter; MFA Letter; IAA Letter; NASP Letter; American
Bankers Letter; Comment Letter of Seward & Kissel LLP (Oct. 6. 2009)
(``Seward & Kissel Letter''); Park Hill Letter; Dechert Letter;
Skadden Letter.
\208\ See Proposing Release, at section II.A.3(a)(5).
\209\ Fund Democracy/Consumer Federation Letter.
\210\ See, e.g., ICI Letter; Davis Polk Letter; NY City Bar
Letter; Fidelity Letter; Wells Fargo Letter; MFA Letter.
\211\ See, e.g., Comment Letter of Connecticut Treasurer Denise
L. Nappier (Sept. 10, 2009) (``CT Treasurer Letter''); CalPERS
Letter.
\212\ See, e.g., IAA Letter; ICI Letter; Wells Fargo Letter;
NASP Letter; American Bankers Letter; MFA Letter; Seward & Kissel
Letter.
\213\ See, e.g., ICI Letter (three-month look back); IAA Letter
(six-month look back); Park Hill Letter (six-month look back); Wells
Fargo Letter (six-month look back); Davis Polk Letter (six-month
look back); Dechert Letter (six-month look back); MFA Letter (six-
month look back).
\214\ See, e.g., Wells Fargo Letter; NSCP Letter.
\215\ See, e.g., Comment Letter of Strategic Capital Partners
(Oct. 1, 2009) (``Strategic Capital Letter''); Comment Letter of B.
Jack Miller (Oct. 3, 2009); Comment Letter of RP Realty Partners,
LLC Chief Financial Officer Jerry Gold (Oct. 2, 2009); SIFMA Letter.
---------------------------------------------------------------------------
Upon consideration of the comments, we believe that applying the
full two-year look back to all new covered associates may be
unnecessary to achieve the goals of the rulemaking. We are adopting a
suggestion offered by several commenters to shorten the look-back
period with respect to certain new covered associates whose
contributions are less likely to be involved in pay to play.\216\ Under
an exception to the rule, the two-year time out is not triggered by a
contribution made by a natural person more than six months prior to
becoming a covered associate, unless he or she, after becoming a
covered associate, solicits clients.\217\ As a result, the two-year
look back applies only to covered associates who solicit for the
investment adviser.\218\
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\216\ See, e.g., MFA Letter; Fidelity Letter; Dechert Letter;
Wells Fargo Letter; Skadden Letter. The MSRB shortened the look-back
period under MSRB rule G-37 to six months for certain municipal
finance professionals in response to similar industry concerns about
the impact on hiring. See MSRB, Amendments Filed to Rule G-37
Concerning the Exemption Process and the Definition of Municipal
Finance Professional (Sept. 26, 2002), available at http://www.msrb.org/msrb1/archive/g%2D37902notice.htm.
\217\ Rule 206(4)-5(b)(2). An adviser is subject to the two-year
time out regardless of whether it is ``aware'' of the political
contributions. Thus, statements by prospective employees regarding
whether they have made relevant contributions are insufficient to
inoculate the adviser, as some commenters urged (see, e.g., IAA
Letter; ICI Letter; NSCP Letter; Caplin & Drysdale Letter), to
ensure that investment advisers are not encouraged to relax their
efforts to promote compliance with the rule's prohibitions.
Nonetheless, advisers who advise or are considering advising any
government entity should consider requiring full disclosure of any
relevant political contributions from covered associates or
potential covered associates to ensure compliance with rule 206(4)-
5. Advisers are required to request similar reports about securities
holdings by Advisers Act rule 204A-1(b)(1)(ii) [17 CFR 275.204A-
1(b)(1)(ii)], which requires each of a firm's ``access persons'' to
submit an initial ``holdings report'' of securities he or she
beneficially owns at the time he or she becomes an access person,
even though the securities would likely have been acquired in
transactions prior to becoming an access person. For a discussion of
an adviser's recordkeeping obligations with regard to records of
contributions by a new covered associate during that new covered
associate's look-back period, see infra note 428.
\218\ See rule 206(4)-5(f)(2) (defining covered associate of an
investment adviser as: (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 any person who supervises, directly or
indirectly, such employee).
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The potential link between obtaining advisory business and
contributions made by an individual prior to his or her becoming a
covered associate that is uninvolved in solicitation activities is
likely more attenuated and therefore, in our judgment, should be
subject to a shorter look back. We have modeled this shortened look-
back period \219\ on the MSRB's six-month look back for certain
personnel, which it implemented as a result of feedback it received
from dealers that indicated the two-year look back was negatively
affecting in-firm transfers and promotions and ``preclud[ing] them from
hiring individuals who had made contributions, even though the
contributions (which may have been relatively small) were made at a
time when the individuals had no reason to be familiar with Rule G-
37.'' \220\ This approach balances commenters' concerns about the
implications for their hiring decisions with the need to protect
against individuals marketing to prospective investment adviser
employers their connections to, or influence over, government entities
those advisers might be seeking as clients.\221\
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\219\ See rule 206(4)-5(b)(2).
\220\ MSRB, Self-Regulatory Organizations; Notice of Filing of
Proposed Rule Change by the Municipal Securities Rulemaking Board
Relating to Amendments to Rules G-37, on Political Contributions and
Prohibitions on Municipal Securities Business, G-8, on Books and
Records, Revisions to Form G-37/G-38 and the Withdrawal of Certain
Rule G-37 Questions and Answers, Exchange Act Release No. 47609
(April 1, 2003) [67 FR 17122 (Apr. 8, 2003)]. See also MSRB, Self-
Regulatory Organizations; Order Granting Approval of a Proposed Rule
Change and Amendment No. 1 Thereto by the Municipal Securities
Rulemaking Board Relating to Amendments to Rules G-37, on Political
Contributions and Prohibitions on Municipal Securities Business, G-
8, on Books and Records, Revisions to Form G-37/G-38 and the
Withdrawal of Certain Rule G-37 Questions and Answers, Exchange Act
Release No. 47814 (May 8, 2003) [68 FR 25917 (May 14, 2003)]
(Commission order approving amendments to MSRB rule G-37); MSRB rule
G-37(b)(iii).
\221\ We are not adopting the suggestion of commenters to
exclude from the look-back provision contributions made before a
merger or acquisition by an adviser by not attributing the
contributions of the acquired adviser to the acquiring adviser. See,
e.g., Dechert Letter; ICI Letter. We believe that an acquisition of
another adviser could raise identical concerns where the acquired
adviser has made political contributions designed to benefit the
acquiring adviser. Rule 206(4)-5 is not intended to prevent mergers
in the investment advisory industry or, once a merger is
consummated, to hinder the surviving adviser's government advisory
business unless the merger was an attempt to circumvent rule 206(4)-
5. Thus, the adviser may wish to seek an exemption from the ban on
receiving compensation pursuant to rule 206(4)-5(a) from the
Commission. The MSRB takes the same approach to this issue. See MSRB
Rule G-37 Q&A, Question II.16.
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(6) Exceptions for De Minimis Contributions
Rule 206(4)-5 permits individuals to make aggregate contributions
without triggering the two-year time out of up to $350, per election,
to an elected official or candidate for whom the individual is entitled
to vote,\222\ and up to $150, per election, to an elected official or
candidate for whom the individual is not entitled to vote.\223\ These
de minimis exceptions are available only for contributions by
individual covered associates, not the investment adviser itself.\224\
Under both exceptions,
[[Page 41035]]
primary and general elections would be considered separate
elections.\225\
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\222\ For purposes of rule 206(4)-5, 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.
For example, if a government official is a State governor running
for re-election, any covered associate of an adviser who resides in
that State may make a de minimis contribution to the official
without causing a ban on that adviser being compensated for
providing advisory services for that government entity. In the
example of a government official running for President, any covered
associate in the country can contribute the de minimis amount to the
official's Presidential campaign. The MSRB has issued a similar
interpretation of what it means to be ``entitled to vote'' for
purposes of MSRB rule G-37. See MSRB Reports, Vol. 16. No. 1
(January 1996) at 31-34.
\223\ See Rule 206(4)-5(b)(1) (excepting ``de minimis''
contributions to ``officials'' (see supra note 139 and accompanying
text) from the rule's two-year time out provision).
\224\ Id. Under the rule, each covered associate, taken
separately, would be subject to the de minimis exceptions. In other
words, the limit applies per covered associate and is not an
aggregate limit for all of an adviser's covered associates. But see
supra note 170 (pointing out that a sole proprietor may, in a
personal capacity, avail herself or himself of the de minimis
exceptions even though his or her contributions are otherwise
considered contributions of the adviser itself).
\225\ Accordingly, a covered person of an investment adviser
could, without triggering the prohibitions of the rule, contribute
up to the limit in both the primary election campaign and the
general election campaign of each official for whom the person
making the contribution would be entitled to vote. The MSRB takes
the same approach of excepting from rule G-37's time out trigger
contributions up to the rule's de minimis amount for each election
(including a primary and general election). See MSRB Rule G-37 Q&A,
Question II.8. See also In the Matter of Pryor, McClendon, Counts &
Co., Inc., et al., Exchange Act Release No. 48095 (June 26, 2003)
(noting that contributions must be limited to MSRB rule G-37's de
minimis amount before the primary, with the same de minimis amount
allowed after the primary for the general election).
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We proposed a $250 de minimis exception for contributions to
candidates for whom a covered associate is entitled to vote,\226\ which
reflects the current de minimis exception in MSRB rule G-37.\227\ Many
commenters urged us to increase the de minimis amount (either to a
larger number or by indexing it to inflation), arguing that a
contribution as large as $1,000 would be unlikely to influence the
award of an advisory contract by a public pension plan.\228\
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\226\ See Proposing Release, at section II.A.3(a)(6).
\227\ See MSRB rule G-37(b)(i).
\228\ See, e.g., SIFMA Letter; NASP Letter; Comment Letter of
Philip K. Holl (Oct. 5, 2009) (``Holl Letter''); NSCP Letter; Caplin
& Drysdale Letter; Cornell Law Letter; ICI Letter; MFA Letter;
Seward & Kissel Letter; Callcott Letter II; Comment Letter of the
California State Teachers' Retirement System (Oct. 6, 2009) (adopted
policies that limit contributions to board members by those seeking
investment relationships with the fund to $1,000). Several
commenters suggested our proposed de minimis limit could be subject
to a challenge on constitutional grounds. For a discussion of, and
response to, these comments, see supra note 72 and accompanying
text.
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The $1,000 amount suggested by some commenters strikes us as a
rather large contribution that could influence the hiring decisions,
depending upon the size of the jurisdiction, the amount of campaign
contributions to opposing candidates, and the competitiveness of the
primary or prospective election. Instead, we are taking the suggestion
of several commenters \229\ that we should increase the de minimis
amount to reflect the effects of inflation since the MSRB first
established its $250 de minimis amount in 1994.\230\ We may consider
increasing the $350 amount in the future if, for example, the value of
it decreases materially as a result of further inflation.
---------------------------------------------------------------------------
\229\ See, e.g., Caplin & Drysdale Letter (recommending that we
index the de minimis threshold for inflation); Cornell Law Letter
(recommending that we index the de minimis threshold for inflation).
See also Callcott Letter I.
\230\ We multiplied the $250 de minimis amount that we proposed
(which was adopted by the MSRB in 1994) by the annual consumer price
index (a measure of inflation) change since 1994, as reported by the
Bureau of Labor Statistics (available at http://www.bls.gov/data/).
The result was approximately $365 in 2009; we rounded it down to
$350 for administrative convenience.
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Commenters also urged us to eliminate the condition that a covered
associate must be able to vote for the candidate.\231\ They asserted
that persons can have a legitimate interest in contributing to
campaigns of people for whom they are unable to vote.\232\ We
acknowledge that persons can have such an interest, such as in large
metropolitan areas where a covered associate may work and live in
different jurisdictions. But commenters did not confine their
recommendations to such circumstances and we remain concerned that
contributions by executives of advisers living in distant jurisdictions
may be less likely to be made for purely civic purposes. Accordingly,
we have added a de minimis exception for contributions of up to $150 to
officials for whom a covered associate is not entitled to vote, which
is lower than the de minimis exception of $350 for candidates for whom
a covered associate is entitled to vote. We believe that $150 is a
reasonable amount for the additional de minimis exception we are
adopting because of the more remote interest a covered associate is
likely to have in contributing to a person for whom he or she is not
entitled to vote.
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\231\ See, e.g., T. Rowe Price Letter; Dechert Letter; MFA
Letter; NASP Letter; Callcott Letter I; Cornell Law Letter; IAA
Letter.
\232\ See, e.g., T. Rowe Price Letter; Dechert Letter; MFA
Letter; NASP Letter; Callcott Letter I; Cornell Law Letter.
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(7) Exception for Certain Returned Contributions
We are adopting, largely as proposed, an exception that will
provide an adviser with a limited ability to cure the consequences of
an inadvertent political contribution to an official for whom the
covered associate making it is not entitled to vote.\233\ The exception
is available for contributions that, in the aggregate, do not exceed
$350 to any one official, per election.\234\ The adviser must have
discovered the contribution which resulted in the prohibition within
four months of the date of such contribution \235\ and, within 60 days
after learning of the triggering contribution, the contributor must
obtain the return of the contribution.\236\
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\233\ Rule 206(4)-5(b)(3).
\234\ Rule 206(4)-5(b)(3)(i). We note that a contribution would
not trigger the two-year ban at all to the extent it falls within
the de minimis exception described in rule 206(4)-5(b)(1). See
section II.B.2(a)(6) of this Release for a discussion of this
exception.
\235\ Id.
\236\ Rule 206(4)-5(b)(3)(i).
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The scope of this exception is limited to the types of
contributions that we believe are less likely to raise pay to play
concerns. The prompt return of the contribution provides an indication
that the contribution would not affect an official of a government
entity's decision to award an advisory contract.\237\ The relatively
small amount of the contribution, in conjunction with the other
conditions of the exception, suggests that it was unlikely to be made
for the purpose of influencing the award of an advisory contract.
Repeated triggering contributions suggest otherwise or that the adviser
has not implemented effective compliance controls. Therefore, the rule
limits an adviser's reliance on the exception to no more than two or
three per 12-month period (based on the size of the adviser),\238\ and
no more than once for
[[Page 41036]]
each covered associate,\239\ regardless of the time period.\240\
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\237\ The 60-day limit is designed 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 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.
\238\ Rule 206(4)-5(b)(3)(ii). The approach we have taken will
generally create some flexibility to accommodate a limited number of
contributions by covered associates that would otherwise trigger the
two-year time out. In a modification from our proposal that we
believe is responsive to certain commenters' concerns (see note 251
and accompanying text below), ``larger'' advisers may avail
themselves of three automatic exceptions, instead of two, in any
calendar year. Rule 206(4)-5(b)(3)(ii). In contrast, our proposal
would have permitted each adviser, regardless of its size, to rely
on the automatic exception twice each year. The rule identifies a
``larger'' adviser for these purposes as any adviser who has
reported in response to Item 5.A on its most recently filed Form
ADV, Part 1A [17 CFR 279.1] that it has more than 50 employees. Id.
Investment Adviser Registration Depository (IARD) data as of April
1, 2010 indicate that approximately 10 percent of registered
advisers have more than 50 employees (and would therefore be limited
to three ``automatic'' exceptions per calendar year instead of two).
In particular, the data indicate that there are 11,607 registered
investment advisers. Of those, 1,072 advisers (9.2% of the total)
have indicated in their responses to Item 5.A of Part 1A of Form ADV
that they have more than 50 employees. We chose the 50 employee cut-
off because the number of employees is independently reported on
Form ADV (and therefore cross-verifiable)--each adviser filing Form
ADV must check a box indicating an approximation of the number of
employees it has, choosing among 1-5, 6-10, 11-50, 51-250, 251-500,
501-1,000, or more than 1,000--and because we believe that
inadvertent violations of the rule are more likely at advisers with
greater numbers of employees. We think that the twice per year limit
is appropriate for small advisers and the three times per year limit
is appropriate for larger advisers. We do not believe it is
appropriate for there to be greater variation in the number of times
advisers may rely on the exception than that based either on their
size or on other characteristics. We are seeking to encourage robust
monitoring and compliance.
\239\ Rule 206(4)-5(b)(3)(iii). Once a covered associate has
been made aware of an ``inadvertent'' violation, a justification for
a second violation would be more questionable.
\240\ Although we have included different allowances for larger
and smaller advisers (based on the number of employees they report
on Form ADV), our approach otherwise generally tracks MSRB rule G-
37's ``automatic exemption'' provision. See MSRB rule G-37(j).
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Commenters who addressed it generally supported our inclusion of an
automatic exception provision,\241\ although several suggested
modifications.\242\ Some urged us to eliminate the requirement that the
contributor succeed in obtaining the return of the contribution.\243\
We are not making this change, which could undermine our goals in
adopting the rule if it led to contributors asking for the return of a
contribution where such requests were expected to be refused by the
government official. We would have to discern whether the contributor
itself, who may (or whose employer may) be seeking to influence
government officials, has tried ``hard enough'' to get the contribution
back.
---------------------------------------------------------------------------
\241\ See, e.g., T. Rowe Price Letter; NSCP Letter; CT Treasurer
Letter; Skadden Letter; ICI Letter; IAA Letter.
\242\ See, e.g., NY City Bar Letter; Dechert Letter; IAA Letter.
\243\ See, e.g., T. Rowe Price Letter; NSCP Letter; CT Treasurer
Letter.
---------------------------------------------------------------------------
Other commenters recommended an alternative exception for
inadvertent contributions that would not require that an otherwise-
triggering contribution be returned.\244\ They contended that such an
exception should be available to advisers with policies and procedures
in place to prevent pay to play that include sanctions for employees
violating the policies.\245\ Such an approach excludes any objective
indication that the contribution was inadvertent. As noted above,
policies and procedures are required to ensure compliance with our
rule. But policies and procedures alone, without critical objective
criteria, such as obtaining a return of the contribution, are
insufficient in our view to justify an exception to our prophylactic
rule.
---------------------------------------------------------------------------
\244\ See, e.g., IAA Letter (suggesting that we require, as a
condition for such an exception, that ``such contribution resulted
in an inadvertent violation, meaning violations that are not
reasonably known or condoned by the investment adviser and where the
contributor lacked intent to influence the award of the advisory
contract or violate the rule in making the contribution, as
evidenced by the facts and circumstances surrounding such
contribution'').
\245\ See, e,g., IAA Letter; Dechert Letter; NY City Bar Letter.
---------------------------------------------------------------------------
Some commenters urged us to modify or eliminate the requirement
that the contribution be discovered by the adviser within four
months.\246\ We believe, however, that four months is the appropriate
timeframe. We believe advisers should have a reasonable amount of time
to discover contributions made by covered associates if, for example,
their covered associates disclose their contributions to the adviser on
a quarterly basis.\247\ The absence of such a time limitation would
encourage advisers not to seek to discover such contributions if they
believed they could simply rely on the exception any time a
contribution happened to come to light.
---------------------------------------------------------------------------
\246\ See, e.g., T. Rowe Price Letter (arguing that, if an
adviser has in place procedures to require covered associates to
report all contributions no less frequently than quarterly, and an
associate fails to report a contribution in violation of the
procedures, the discovery of a prohibited contribution outside this
four-month window should not preclude the use of this exception.).
But see Fund Democracy/Consumer Federation Letter (urging us to
consider shortening the time in which a contribution must be
discovered for the exception to be available to one month).
\247\ Quarterly compliance reporting is familiar to advisory
personnel. See, e.g., rule 204A-1 under the Advisers Act (requiring
that, under an adviser's code of ethics, personnel report personal
securities trading activity at least quarterly). 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. The condition that the contribution be
discovered within four months is consistent with the MSRB's
approach. See MSRB rule G-37(j)(i).
---------------------------------------------------------------------------
A number of commenters suggested the exception be allowed for all
contributions regardless of dollar amount, while a few recommended
raising the dollar amount to $1,000.\248\ As we noted above, we view
the limitation on the amount of such a contribution, in conjunction
with the other conditions of the exception, important to the rule
because it is more likely that the contribution was, in fact,
inadvertent. We have modified this ``automatic'' exception from our
proposal by raising the limit on contributions eligible for the
exception to $350, the same amount we have adopted as a de minimis
threshold for contributions to an official for whom a covered associate
is entitled to vote.\249\ In addition, at the suggestion of commenters
who argued that our proposed limitation on the annual use of such
exception failed to take into consideration the different size of
advisers,\250\ we have modified our proposal to permit use of the
exception three times in any year by an adviser that has reported on
its Form ADV registration statement that it had more than 50 employees
who perform investment advisory functions.\251\
---------------------------------------------------------------------------
\248\ See, e.g., SIFMA Letter; NASP Letter; Holl Letter; NSCP
Letter; ICI Letter; MFA Letter.
\249\ Rule 206(4)-5(3)(i)(B). No automatic exception is
available for any contributions to an official for whom the covered
associate is entitled to vote that exceed the de minimis $350
amount. As explained above, we believe that $350 is the appropriate
de minimis threshold for contributions to officials for whom a
covered associate is entitled to vote and $150 is the appropriate de
minimis threshold for contributions to officials for whom a covered
associate it not entitled to vote. See section II.B(6) of this
Release. Because these thresholds are different, we anticipate that
covered associates could mistakenly make contributions up to the
higher threshold under the mistaken belief that they are entitled to
vote for an official when in fact they are not entitled to do so. So
long as those contributions are returned and the other conditions of
the exception are met, we believe they should be eligible for the
automatic exception.
\250\ See, e.g., Skadden Letter; T. Rowe Price Letter; NSCP
Letter; ICI Letter; IAA Letter.
\251\ See supra note 238.
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The exception is intended to provide advisers with the ability to
undo certain mistakes. Because it operates automatically,\252\ we
believe it should be subject to conditions that are objective and
limited in order to capture only those contributions that are unlikely
to raise pay to play concerns.\253\
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\252\ The exception is ``automatic'' in the sense that an
adviser relying on it may do so without notifying the Commission or
its staff. However, we note that the recordkeeping obligations for
registered advisers mandate specifically that an adviser maintain
records regarding contributions with respect to which the adviser
has invoked this exception. Rule 204-2(a)(18)(ii)(D). See also
section II.D of this Release.
\253\ As discussed below in section II.B.2(f) of this Release,
in other circumstances, advisers can apply to the Commission for an
exemption from the rule's two-year time out. See rule 206(4)-5(e).
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(b) Ban on Using Third Parties To Solicit Government Business
Rule 206(4)-5 makes it unlawful for any investment adviser subject
to the rule or any of the adviser's covered associates to provide or
agree to provide, directly or indirectly,
[[Page 41037]]
payment \254\ to any person to solicit \255\ government clients for
investment advisory services on its behalf.\256\ The prohibition is
limited to third-party solicitors. Thus, the prohibition does not apply
to any of the adviser's employees, general partners, managing members,
or executive officers.\257\ Contributions by these persons, however,
may trigger the two-year time out. As discussed in more detail below,
the prohibition also does not apply to certain ``regulated persons''
that themselves are subject to prohibitions against engaging in pay to
play practices.\258\
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\254\ The term ``payment'' is defined in rule 206(4)-5(5)(f) as
any gift, subscription, loan, advance, or deposit of money or
anything of value. Depending on the specific facts and
circumstances, payment can include quid pro quo arrangements whereby
a non-affiliated person solicits advisory business for the adviser
in exchange for being hired by the adviser to provide other
unrelated services. This approach is consistent with the MSRB's with
regard to MSRB rule G-38's third-party solicitor ban. See MSRB,
Interpretive Notice on the Definition of Solicitation under Rules G-
37 and G-38 (June 8, 2006), available at http://msrb.org/msrb1/rules/notg38.htm. But see infra note 257 (discussing the provision
of professional services by third parties).
\255\ For the definition of what it means to ``solicit'' a
client or prospective client to provide investment advisory
services, which we are adopting as proposed, see text accompanying
note 185. This definition is consistent with the definition the MSRB
employs for similar purposes in rule G-38, the MSRB's rule that
restricts third-party solicitation activity. MSRB rule G-38(b)(i).
\256\ Rule 206(4)-5(a)(2)(i). See also Proposing Release, at
section II.A.3(b).
\257\ Rule 206(4)-5(a)(2)(i). We note that, so long as non-
affiliated persons providing legal, accounting, or other
professional services in connection with specific investment
advisory business are not being paid directly or indirectly by an
investment adviser for communicating with a government entity (or
its representatives) for the purpose of obtaining or retaining
investment advisory business for the adviser--i.e., they are paid
solely for their provision of legal, accounting, or other
professional services with respect to the business--they would not
become subject to the ban on payments by advisers to third-party
solicitors. This approach is similar to the MSRB's with regard to
MSRB rule G-38's third-party solicitor ban. See MSRB, Interpretive
Notice on the Definition of Solicitation under Rules G-37 and G-38
(June 8, 2006), available at http://msrb.org/msrb1/rules/notg38.htm.
\258\ This exception, which is responsive to commenters'
concerns, is a modification of our proposal. As discussed below, we
also eliminated an exception in our proposal that would have applied
to ``related persons'' of the adviser and, if such ``related
person'' were a company, an employee of the ``related person.'' See
Proposing Release, at section II.A.3(b).
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We proposed to prohibit advisers from paying third parties in order
to prevent advisers from circumventing the rule.\259\ We observed in
the Proposing Release that solicitors or ``placement agents'' have
played a central role in actions that we and other authorities have
brought involving pay to play schemes; \260\ in several instances,
advisers allegedly made significant payments to placement agents and
other intermediaries in order to influence the award of advisory
contracts.\261\ We noted that government authorities in New York and
other jurisdictions have prohibited or are considering limiting or
prohibiting the use of consultants, solicitors, or placement agents by
investment advisers to solicit government business.\262\ We considered
the MSRB's experience with solicitors, which ultimately led it to ban
municipal securities dealers from hiring consultants to solicit
government clients after concluding that less restrictive approaches
were ineffective to prevent circumvention of MSRB rule G-37.\263\ We
recalled comment letters we received in 1999 from advisers asserting
that they should not be held accountable for the political
contributions of their third-party solicitors whom, they asserted,
advisers lacked the ability to control.\264\
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\259\ See Proposing Release, at section II.A.3(b).
\260\ Id. at sections I and II.A.3(b).
\261\ Id. at section II.A.3(b).
\262\ Id. Since our proposal, a few State and local governments
have undertaken actions to prohibit or regulate pay to play
practices involving placement agents in response to concerns about
to pay to play activities in their jurisdictions. For example, New
York City Comptroller John C. Liu announced reforms relating to how
the New York City pension funds make investments (including
prohibitions on gifts and campaign contributions, strict rules on
employees of the Office of New York City Comptroller, employees and
trustees of the New York City pension systems, fund managers, and
placement agents, and an expansion of the ban on private equity
placement agents to include placement agents to other types of funds
while providing an exclusion for legitimate placement agents who
provide value-added services). See Office of the New York City
Comptroller, Comptroller Liu Announces Major Reforms to Pension Fund
Investments, Press Release, Feb. 18, 2010, available at http://www.comptroller.nyc.gov/press/2010_releases/pr10-02-022.shtm. A
bill was introduced in California that would treat placement agents
soliciting government entity clients as lobbyists and therefore
restrict them from charging contingency fees. See Assem. B. 1743,
2009-10 Leg., Reg. Sess. (Cal. 2010), available at http://info.sen.ca.gov/pub/09-10/bill/asm/ab_1701-1750/ab_1743_bill_20100208_introduced.html. See also Cal. Gov't. Code Sec. 86205(f)
(Deering 2010). Another law was passed in California on an emergency
basis imposing new disclosure obligations and prohibitions regarding
placement agents. See Assem. B. 1854, 2009-10 Leg., Reg. Sess. (Cal.
2010) available at http://info.sen.ca.gov/pub/09-10/statute/ch_0301-0350/ch_301_st_2009_ab_1584. See also CalPERS, CalPERS
Releases Placement Agent Disclosures, Press Release, Jan. 14, 2010,
available at http://www.calpers.ca.gov/index.jsp?bc=/about/press/pr-2010/jan/agent-disclosures.xml. (discussing recent actions by
CalPERS to make public more than 600 placement agent disclosures
from the fund's external managers).
\263\ See Proposing Release, at n.130 and accompanying text. See
also MSRB Letter (``Due to concerns regarding questionable practices
by some consultants and a determination by the MSRB that it would be
in the public interest to make the process of soliciting municipal
securities business fully subject to the MSRB rules of fair practice
and professionalism, the MSRB rescinded its original rule in 2005
and adopted new Rule G-38, on solicitation of municipal securities
business, to prohibit dealers from using paid third-party
consultants to obtain municipal securities business on their
behalf.'').
\264\ 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'').
Comments on that proposal received electronically (comment file S7-
19-99) are available at http://www.sec.gov/rules/proposed/s71999.shtml. Among the commenters on the 1999 Proposing Release who
argued that advisers should not be held accountable for the
political contributions of their third-party solicitors are: Comment
Letter of Davis Polk (Nov. 1, 1999); Comment Letter of Legg Mason
(Nov. 1, 1999); Comment Letter of MSDW (Nov. 1, 1999). At least one
commenter on our 2009 proposal, although opposing the proposed
third-party solicitor ban, took the same view. See MFA Letter (``We
strongly agree with the SEC's comment in the Release that ``covered
associates'' should not include employees of entities unaffiliated
with an investment adviser, such as the employees of a third-party
placement agent. An investment adviser would not have the authority
or capability to monitor and restrict political contributions made
by individuals not employed by the adviser.'').
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The record before us raised deeply troubling concerns about
advisers' use of third-party solicitors to engage in pay to play
activities.\265\ We were concerned that a rule that failed to address
the use of these solicitors would be ineffective were advisers simply
to begin using solicitors and placement agents that have made political
contributions or payments funded in part or in whole by the fees they
receive from advisers.\266\ Therefore, we proposed to prohibit advisers
from engaging third parties to solicit government clients on their
behalf.\267\ In doing so, we requested comments on alternative
approaches we could take.\268\ We wanted to know whether there might be
a more effective means to accomplish our objectives, or means that
would be less restrictive.
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\265\ See Proposing Release, at section I; section I of this
Release. Moreover, ``no smoking gun is needed where, as here, the
conflict of interest is apparent, the likelihood of stealth great,
and the legislative purpose prophylactic.'' Blount, 61 F.3d at 945.
\266\ See Proposing Release, at section II.A.3(b). Some
commenters have supported this approach. See, e.g., Fund Democracy/
Consumer Federation Letter (``Permitting advisers to circumvent pay-
to-play restrictions by hiring solicitors would eviscerate the heart
of the direct prohibition against advisers' bribing politicians in
return for money management contracts.''). We also noted commenters'
concerns regarding the difficulties advisers face in monitoring the
activities of their third-party solicitors. See Proposing Release,
at section II.A.3(b).
\267\ See Proposing Release, at section II.A.3(b).
\268\ See id.
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We received a large number of comments on this question. We
received letters from the New York State Comptroller and New York City
Comptroller that expressed strong support for the ban on using third
[[Page 41038]]
parties to solicit government plans.\269\ One commenter supporting the
ban pointed out the key role that placement agents have played in pay
to play practices.\270\ It expressed concern that adopting the rule
without the ban would exacerbate the problem by placing more pressure
on advisers to pay ``well-connected'' placement agents for access since
the advisers will be limited in their contributions.\271\ Another
commenter expressed the view that ``the most egregious violations of
the public trust in this area have come from placement agents and those
seeking finder's fees. The outright ban on their use to deter pay-to-
play schemes is entirely appropriate.'' \272\
---------------------------------------------------------------------------
\269\ DiNapoli Letter; Thompson Letter (as indicated in note 262
above, NYC Comptroller Liu recently announced his office's approach
to third-party solicitors).
\270\ Fund Democracy/Consumer Federation Letter.
\271\ Id.
\272\ Common Cause Letter. See also Cornell Law Letter
(generally supporting the prohibition on using third-party
solicitors ``given that third-party solicitors have played a central
role in each of the enforcement actions against investment advisors
that the Commission has brought in the past several years involving
pay-to-play schemes.'').
---------------------------------------------------------------------------
Most commenters, including many representing advisers, broker-
dealers, placement agents and solicitors, and some government
officials, however, strongly opposed the ban. Many asserted that
solicitors, consultants and placement agents provide valuable services
both for advisers seeking clients and for the public pension plans that
employ them and that banning their use would have several deleterious
effects.\273\ Several claimed that the rule would favor banks because
banks are excluded from the definition of ``investment adviser'' under
the Advisers Act and therefore are not subject to the Commission's
rules, including rule 206(4)-5.\274\ Others claimed the rule would
favor larger investment advisers (which have internal marketing
departments) over smaller firms.\275\ Other commenters asserted the ban
would harm smaller pension funds that do not have the resources to
conduct a search for advisers on their own, and harm advisers that rely
on the services that placement agents provide.\276\ A number of
commenters argued that the prohibition would reduce competition by
reducing the number of advisers competing for government business,\277\
and limit the universe of investment opportunities presented to public
pension funds.\278\
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\273\ See, e.g., Comment Letter of Senator Christopher J. Dodd
(Feb. 2, 2010) (``Dodd Letter''); NY City Bar Letter; Dechert
Letter; ABA Letter; Comment Letter of Teacher Retirement System of
Texas (Oct. 12, 2009); Comment Letter of Bryant Law (Oct. 9, 2009)
(``Bryant Law Letter''); Comment Letter of Probitas Partners (Oct.
6, 2009) (``Probitas Letter''); Comment Letter of Larry Simon (Oct.
6, 2009) (``Simon Letter''); Comment Letter of MarketCounsel, LLC
(Oct. 6, 2009); ICI Letter; Comment Letter of Colorado Public
Employees' Retirement Association (Oct. 6, 2009); Skadden Letter.
\274\ See Advisers Act section 202(a)(11)(A) [15 U.S.C. 80b-
2(a)(11)(A)] (excepting from the definition of ``investment
adviser,'' and therefore from regulation under the Advisers Act, ``a
bank, or any bank holding company as defined in the Bank Holding
Company Act of 1956, which is not an investment company * * *.'').
We discuss possible competitive effects of our rule's
inapplicability to banks in section VI of this Release. We believe
that the concerns the rule is designed to address, as discussed
throughout this Release, warrant its adoption, notwithstanding these
potential competitive effects.
\275\ See, e.g., SIFMA Letter; IAA Letter; MFA Letter; Comment
Letter of National Conference on Public Employee Retirement Systems
(Oct. 6, 2009) (``NCPERS Letter''); Comment Letter of European
Private Equity & Venture Capital Association (Sept. 9, 2009) (``EVCA
Letter''); Seward & Kissel Letter; Comment Letter of Sadis &
Goldberg LLP (Oct. 2, 2009) (``Sadis & Goldberg Letter''); Comment
Letter of State of Wisconsin Investment Board (Aug. 31, 2009) (``WI
Board Letter''); Comment Letter of the Executive Director of Georgia
Firefighters' Pension Fund, James R. Meynard, (Sept. 3, 2009) (``GA
Firefighters Letter''); Comment Letter of Minnesota State Board of
Investment (Sept. 8, 2009) (``MN Board Letter''); Comment Letter of
Illinois Public Pension Fund Association (Sept. 29, 2009) (``IL Fund
Association Letter''); Comment Letter of Melvyn Aaronson, Sandra
March and Mona Romain, Trustees of the Teachers' Retirement System
of the City of New York (Oct. 1, 2009) (``NYC Teachers Letter'');
Comment Letter of the Texas Association of Public Employee
Retirement Systems (Oct. 6, 2009) (``TX Public Retirement Letter'');
Comment Letter of the Pennsylvania Public School Employees'
Retirement Board (Oct. 6, 2009) (``PA Public School Retirement
Letter''); Comment Letter of the California State Association of
County Retirement Systems (Sept. 8, 2009) (``CA Assoc. of County
Retirement Letter''); Caplin & Drysdale Letter; Comment Letter of
Paul Ehrmann (Aug. 10, 2009) (``Ehrmann Letter''); Comment Letter of
Joseph Finn (Aug. 10, 2009) (``Finn Letter''); Comment Letter of the
Managing Partner of The Savanna Real Estate Fund I, LLP, Nicholas
Bienstock (Aug. 11, 2009) (``Savanna Letter''); Comment Letter of
Atlantic-Pacific Capital, Inc. (Aug. 12, 2009) (``Atlantic-Pacific
Letter''); Comment Letter of Tricia Peterson (Aug. 14, 2009)
(``Peterson Letter''); Comment Letter of Devon Self Storage Holdings
(US) LLC (Aug. 21, 2009) (``Devon Letter''); Comment Letter of
Thomas Capital Group, Inc. (Aug. 24, 2009) (``Thomas Letter'');
Comment Letter of Stephen R. Myers (Aug. 26, 2009) (``Myers
Letter''); Comment Letter of Chaldon Associates LLC (Aug. 26, 2009)
(``Chaldon Letter''); Comment Letter of The Meridian Group (Aug. 26,
2009) (``Meridian Letter''); Comment Letter of Benedetto, Gartland &
Company, Inc. (Sept. 30, 2009) (``Benedetto Letter''); Comment
Letter of the Partners of CSP Securities, LP and Capstone Partners,
LP (Sept. 17, 2009) (``Capstone Letter''); Comment Letter of
Presidio Partners LLC Managing Partner Alan R. Braxton (Sept. 21,
2009) (``Braxton Letter''); Comment Letter of Littlejohn & Co., LLC
(Sept. 14, 2009) (``Littlejohn Letter''); Comment Letter of Alta
Communications (Sept. 18, 2009) (``Alta Letter''); Comment Letter of
Charles River Realty Investors LLC (Sept. 23, 2009) (``Charles River
Letter''); Comment Letter of W. Allen Reed (Sept. 19, 2009) (``Reed
Letter''); Comment Letter of Glovista Investments LLC (Sept. 23,
2009) (``Glovista Letter''); Comment Letter of The Blackstone Group
(Sept. 14, 2009) (``Blackstone Letter''); Park Hill Letter. Two
commenters noted that the ban would result in less transparency as
these services go ``in-house.'' CalPERS Letter; Bryant Law Letter.
Others commented on the effects on minority and women-owned firms.
See, e.g., NYC Teachers Letter, Myers Letter; GA Firefighters
Letter; MN Board Letter; Blackstone Letter.
\276\ See, e.g., Dodd Letter; NY City Bar Letter; Dechert
Letter; ABA Letter; Probitas Letter; Seward & Kissel Letter; MFA
Letter.
\277\ See, e.g., Seward & Kissel Letter; Meridian Letter; NY
City Bar Letter; Probitas Letter; Simon Letter; MFA Letter.
\278\ See, e.g., SIFMA Letter; IAA Letter; Strategic Capital
Letter; Alta Letter; Benedetto Letter; Comment Letter of Jim Glantz
(Sept. 24, 2009) (``Glantz Letter''); Comment Letter of Venera
Kurmanaliyeva (Sept. 15, 2009) (``Kurmanaliyeva Letter''); Park Hill
Letter.
---------------------------------------------------------------------------
Many of these commenters conceded that there is a problem with
placement agents and other intermediaries, but asserted it is caused by
a few bad actors, for which an entire industry should not be
penalized.\279\ A common theme among many commenters was that the rule
failed to distinguish ``illegitimate'' consultants and placement agents
from the ``legitimate'' ones who provide an important service.\280\
---------------------------------------------------------------------------
\279\ See, e.g., Comment Letters of Brady Pyeatt (Aug. 4, 2009)
& (Oct. 6, 2009); Comment Letter of Andrew Wang (Aug. 10, 2009);
Comment Letter of Monomoy Capital Management, LLC (Aug. 25, 2009)
(``Monomoy Letter''); Comment Letter of Ted Carroll (Aug. 4, 2009);
Comment Letter of James C. George (Sept. 10, 2009) (``George
Letter''); Comment Letter of Ariane Capital Partners LLC (Sept. 17,
2009); Blackstone Letter; Comment Letter of Nancy Fossland (Sept.
16, 2009); Comment Letter of Steven A. Friedmann (Sept. 14, 2009);
Comment Letter of Keith P. Harney (Sept. 15, 2009); Comment Letter
of Robert F. Muhlhauser III (Sept. 14, 2009); Comment Letter of XT
Capital Partners, LLC (Sept. 30, 2009); CapLink Letter.
\280\ See, e.g., Bryant Law Letter; Comment Letter of Hedgeforce
(Oct. 6, 2009) (``Hedgeforce Letter'').
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We believe that many of the comments overstate the likely
consequences of adoption of the rule. First, the rule will not prevent
public pension plans from hiring their own consultants--i.e., using
their own resources--to assist them in their search for an investment
adviser.\281\ These consultants would have access to information about
smaller advisers whose services may be appropriate for the plan. Many
public pension plans already make--or are required to make--specific
accommodations for so-called ``emerging money managers'' that otherwise
may have difficulty getting noticed by public pension plans.\282\
[[Page 41039]]
Second, these commenters failed to consider the potentially significant
costs of hiring consultants and placement agents,\283\ which already
may make them unavailable to smaller advisers. Eliminating the cost of
pay to play may, in fact, provide greater access to pension plans by
those advisers which are unable to afford the costs of direct or
indirect political contributions or placement agent fees.\284\ We
expect that prohibiting pay to play may reduce the costs to plans and
their beneficiaries of inferior asset management services arising from
adviser selection based on political contributions rather than
investment considerations.\285\ Finally, commenters failed to identify
any meaningful way in which our rule might distinguish ``legitimate''
from ``illegitimate'' solicitors or placement agents. Even solicitors
and placement agents that engage in pay to play may appear to operate
``legitimately.'' \286\
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\281\ See Fund Democracy/Consumer Federation Letter (``The
proposed ban would ``deny access'' to nothing. There is nothing [in
the proposed rule] preventing pension funds from retaining their own
consultants whose sole responsibility is to the pension fund and its
beneficiaries.'').
\282\ See, e.g., Randy Diamond, CalPERS CIO Joe Dear says
Emerging Managers Don't Need Placement Agents, Pensions &
Investments, Feb. 24, 2010, available at http://www.pionline.com/article/20100224/REG/100229965; Michael Marois, CalPERS, Blackstone
Clash over Placement Agent ``Jackpot'' Fees, Bloomberg (Apr. 7,
2010), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=acPNrTn1q7pw (quoting CalPERS CIO Joe Dear,
``There's clear evidence in past practice that it's possible to
develop an investment relationship with us by making a normal
approach, without the assistance of a contingent-paid placement
agent.''); Ohio Pub. Employees Ret. Sys., Ohio-Qualified and
Minority Manager Policy (May 2006), available at https://www.opers.org/pdf/investments/policies/Ohio-Qualified-Minority-Manager-Policy.pdf; Teachers' Ret. Sys. of the State of Ill., Fiscal
Year 2009 Annual Report on the use of Women, Minority and Disabled-
Owned (W/MBE) Investment Advisors and Broker/Dealers (Aug. 31,
2009), available at http://trs.illinois.gov/subsections/investments/minorityrpt.pdf; Md. State Ret. and Pension Sys., Terra Maria: The
Maryland Developing Manager Program, available at http://www.sra.state.md.us/Agency/Investment/Downloads/TerraMariaDevelopingManagerProgram-Description.pdf; Thurman V.
White, Jr., Progress Inv. Mgmt. Co., Successful Emerging Manager
Strategies for the 21st Century, 3 (2008), available at http://www.progressinvestment.com/content/files/successful_emerging_manager_strategies.pdf (containing a ``representative list of known
U.S. Pension Plans that have committed assets to emerging manager
strategies'').
\283\ One commenter made a similar point: ``The proposed ban
would simply replace the indirect cost of placement agents incurred
by pension plan sponsors with the direct cost of hiring their own
placement agents--without the conflict of interest and potential for
abuse that relying on advisers' placement agents creates. It is not
the cost of independent advice that the Commission has not accounted
for in its proposal, but the cost of conflicts that critics have
failed to acknowledge in their analysis.'' Fund Democracy/Consumer
Federation Letter.
\284\ At least one commenter agreed. See Butler Letter (``[W]e
find some evidence that the pay to play practices by underwriters
[before rule G-37 was adopted] distorted not only the fees, but
which firms were allocated business. The current proposal mentions
that pay to play practices may create an uneven playing field among
investment advisers by hurting smaller advisers that cannot afford
to make political contributions. We find evidence that is consistent
with this view [in our research on pay to play by municipal
underwriters]. During the pay to play era, municipal bonds were
underwritten by investment banks with larger underwriting market
shares compared to afterward. One interpretation of this result is
that smaller underwriters were passed over in favor of larger
underwriters (who presumably had deeper pockets for political
contributions).''). As we indicated in the Proposing Release, pay to
play practices may hurt smaller advisers that cannot afford the
required contributions. 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. See Proposing Release, at sections I and IV.
\285\ See Tobe Letter (describing an under-performing money
manager that was fired after the commenter, a pension official,
began to inquire into how it was selected); Weber Letter (``I have
seen money managers awarded contracts with our fund which involved
payments to individuals who served as middlemen, creating needless
expense for the fund. These middlemen were political contributors to
the campaigns of board members who voted to contract for money
management services with the companies who paid them as
middlemen.'').
\286\ See Blount, 61 F.3d at 944 (``actors in this field are
presumably shrewd enough to structure their relations rather
indirectly'').
---------------------------------------------------------------------------
Some commenters suggested alternatives to our proposed ban to
address our concern that pay to play activities are often carried out
through or with the assistance of third parties.\287\ Several
commenters, for example, suggested that we instead require greater
disclosure by advisers of payments to solicitors.\288\ Such an approach
could be helpful to give plan fiduciaries information necessary for
them to satisfy their legal obligations and uncover abuses,\289\ but it
would not be useful when plan fiduciaries themselves are participants
in the pay to play activities.\290\ In addition, as one commenter
pointed out, the MSRB had already sought unsuccessfully to address the
problem of placement agents and consultants engaging in pay to play
activities on their principals' behalf through mandating greater
disclosure.\291\
---------------------------------------------------------------------------
\287\ We note that, in addition to the alternatives discussed
below, some commenters called for approaches outside the scope of
our authority, such as an outright ban on all political
contributions by third-party solicitors, the imposition of criminal
penalties, or modification of the structure of pension boards. See,
e.g., Monomoy Letter (arguing that the Commission or the appropriate
criminal authority should mandate jail time for public officials and
intermediaries where the official gets a benefit from a public fund
investment in a particular fund, that all managers of intermediaries
who receive fees in such transactions should be banned from the
financial services industry for life, and that all members of the
general partner (manager) of the fund in which the investment is
made be banned from the financial services industry for life);
NCPERS Letter (arguing that the most effective method of eliminating
pay to play is by having multiple trustees on public pension
boards); Thomas Letter (suggesting that stronger internal control
procedures, segregation of duties and dispersed or committee
approval of granting pension business could help prevent pay to play
activities, each of which historically has involved a complicit
senior public plan fund official); Comment Letter of the
Massachusetts Pension Reserves Investment Management Board (Aug. 26,
2009) (``PRIM Board Letter''); Preqin Letter I (acknowledging that
it is outside the remit of the Commission, but arguing that there
should be better oversight of public pension funds, and investment
committees should consist of a minimum number of members in order to
prevent a sole official being responsible for the investment-
decision process); Triton Pacific Letter (arguing that the
Commission should adopt regulation of pension officials who are
often responsible for initiating pay to play arrangements).
\288\ Several commenters urged us to require advisers to
disclose to clients their payments to third-party solicitors and
placement agents. See, e.g., ABA Letter; 3PM Letter; ICI Letter; NY
City Bar Letter; Comment Letter of Forum Capital Securities, LLC
(Oct. 5, 2009) (``Forum Letter''); Jones Day Letter; CapLink Letter.
Some asserted that existing disclosure requirements, such as those
included in the Commission's investment adviser cash solicitation
rule, are sufficient to address pay to play. See, e.g., Comment
Letter of Steven Rubenstein (Aug. 17, 2009) (``Rubenstein Letter'')
(noting that Advisers Act rule 206(4)-3 [17 CFR 275.206(4)-3], the
``cash solicitation rule,'' is adequate as is, but ``just needs to
be followed''); Thomas Letter (supporting ``enforcement of existing
disclosure rules''); Chaldon Letter (arguing that, in the scandals
that have recently occurred, if the fee sharing arrangements had
been disclosed to pension fund boards, no law or regulation would
have been violated, and that third-party marketers should adhere to
current law instead of banning a legitimate business practice);
Comment Letter of Ray Wirta (Sept. 4, 2009) (arguing that all that
is necessary is that penalties should be heightened, enforcement
stepped up and results highly publicized); Arrow Letter (arguing
that enforcement of the Advisers Act and FINRA requirements have
ensured lawful and ethical business practices for decades); 3PM
Letter (arguing that the rule's scope could be extended to include
various additional disclosures). But we do not believe, for the
reasons described above, that enforcement of existing obligations
alone is sufficient to deter pay to play activities.
\289\ Some public pension plans have adopted policies requiring
advisers they hire to disclose information about placement agents,
including their political connections. See, e.g., Cal. Pub.
Employees Ret. Sys., CalPERS Adopts Placement Agent Policy--Requires
Disclosure of Agents, Fees, Press Release (May 11, 2009), available
at http://www.calpers.ca.gov/index.jsp?bc=/about/press/pr-2009/may/adopts-placement-agent-policy.xml.
\290\ For examples of cases in which plan fiduciaries themselves
have allegedly participated in pay to play activities involving
placement agents, see New York v. Henry ``Hank'' Morris and David
Loglisci, Indictment No. 25/2009 (NY Mar. 19, 2009) (a public
official was alleged to be a beneficiary of the pay to play
activities); SEC v. Paul J. Silvester, et al., Litigation Release
No. 16759, Civil Action No. 3:00-CV-19411 DJS (D. Conn. 2000)
(former Connecticut State Treasurer was alleged to be a beneficiary
of a pay to play scheme in which an investment adviser to a private
equity fund had paid third-party solicitors to obtain public pension
fund investments in the fund). See also Proposing Release, at n.49
(discussing additional reasons why we believe a disclosure approach
would not effectively address our concerns regarding pay to play
activities).
\291\ Cornell Law Letter (``For example, after concluding that
required disclosure was neither adequate to prevent circumvention
nor consistently being made, the [MSRB] amended its own rules on
pay-to-play practices in the municipal securities markets to impose
a complete ban on the use of third-party consultants to solicit
government clients.'' (citations omitted)). See also 3PM Letter
(acknowledging that, although increased transparency by all parties
involved in the investment process who might have the ability to
exert influence, including advisers, third-party marketers, public
officials or other trustees, etc., is necessary to minimize the
adverse effects of pay to play, the issue will not be completely
solved by disclosure).
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[[Page 41040]]
Other commenters recommended that we rely on voluntary industry
codes of conduct.\292\ But we believe, in light of the growing body of
evidence of advisers' use of third-party solicitors to engage in pay to
play activities we describe above, that voluntary actions are
insufficient to deter pay to play, which may yield lucrative management
contracts.\293\ As we discuss above, pay to play involves a
``collective action'' problem that is unlikely to be resolved by
voluntary actions.\294\ Elected officials who accept contributions from
State contractors may believe they have an advantage over their
opponents who foreswear the contributions, and firms that do not
``pay'' may fear that they will lose government business to those that
do.\295\
---------------------------------------------------------------------------
\292\ See, e.g., MVision Letter (arguing that self-regulatory
initiatives such as the EVCA's Code of Conduct for Placement Agents
are working and that many public pension plans' own anti-pay to play
policies have been successful); EVCA Letter (describing its Code of
Conduct that prohibits pay to play and is supported by various
stakeholders and arguing that it, along with strong punishment of
wrongdoers, should restore confidence in the process). Another
commenter suggested a code of conduct enforceable by regulators.
Comment Letter of Charlie Eaton on behalf of a Coalition of
Professional Institutional Placement Agents (Sept. 9, 2009)
(proposing an industry Code of Conduct that could be enforced by
FINRA and the Commission, which should ban firms that do not adhere
from doing business with all potential investors, public and
private). In our view, the rule we are adopting today not only
essentially serves this purpose, but more appropriately reflects
prohibitions we, instead of others, have determined appropriately
address our concerns.
\293\ See Proposing Release, at sections I and II.A.3(b). See
also section I of this Release.
\294\ See supra note 58 and accompanying text.
\295\ See Blount, 61 F.3d at 945-46 (describing the parallel
dynamics applicable in municipal underwriting, ``As beneficiaries of
the practice, politicians vying for State or local office may be
reluctant to stop it legislatively; some, of course, may seek to
exploit their rivals' cozy relation with bond dealers as a campaign
issue, but if they refuse to enter into similar relations, their
campaigns will be financially handicapped. Bond dealers are in a
still worse position to initiate reform: Individual firms that
decline to pay will have less chance to play, and may even be the
object of explicit boycott if they do.'').
---------------------------------------------------------------------------
Other commenters recommended that we amend our rules to require
that advisers amend their codes of ethics to monitor contributions by
third-party solicitors.\296\ But advisers using third-party solicitors
to circumvent pay to play restrictions are well aware of these
payments, and are unlikely to be deterred by a monitoring requirement.
In addition, adviser codes of ethics are unlikely to be a sufficient
means to induce third-party solicitors to be transparent about their
own pay to play activities.
---------------------------------------------------------------------------
\296\ See, e.g., ABA Letter; 3PM Letter; ICI Letter; NY City Bar
Letter; Forum Letter; Jones Day Letter.
---------------------------------------------------------------------------
Instead of suggesting alternative approaches, other commenters
urged us to apply the rule more narrowly by exempting from the ban
solicitors that are registered broker-dealers or associated persons of
broker-dealers.\297\ Some were concerned that the rule would interfere
with traditional distribution arrangements of mutual funds and private
funds, which are usually distributed by registered broker-dealers that
may be compensated by the adviser in some form.\298\ Many argued that
registration as a broker-dealer generally differentiates placement
agents that provide ``legitimate'' services from those that merely
offer political influence.\299\ Others expressed concern that some
broker-dealer firms that rely on placement agent business could be
harmed.\300\ We recognize that services that commenters have identified
as beneficial would typically require broker-dealer registration. But
registration under the Exchange Act does not preclude a broker-dealer
from participating in pay to play practices--MSRB rules G-37 and G-38
do not apply, for example, to broker-dealers soliciting investments on
behalf of investment companies or private funds.\301\ Thus, amending
our rule to limit third parties soliciting governments to broker-
dealers registered under the Exchange Act would not achieve the
prophylactic purpose of this rulemaking. We believe that our approach
is appropriate in light of the concerns we are seeking to address.\302\
---------------------------------------------------------------------------
\297\ See, e.g., Davis Polk Letter; Comment Letter of UBS
Securities LLC (Oct. 2, 2009) (``UBS Letter'').
\298\ See, e.g., SIFMA Letter; NY City Bar Letter; Monomoy
Letter; IAA Letter. Mutual fund distribution fees are typically paid
by the fund pursuant to a 12b-1 plan, and therefore generally would
not constitute payment by the fund's adviser. As a result, such
payments would not be prohibited by rule 206(4)-5 by its terms.
Where an adviser pays for the fund's distribution out of its
``legitimate profits,'' however, the rule would generally be
implicated. For a discussion of a mutual fund adviser's ability to
use ``legitimate profits'' for fund distribution, see Bearing of
Distribution Expenses by Mutual Funds, Investment Company Act
Release No. 11414 (Oct. 28, 1980) [45 FR 73898 (Nov. 7, 1980)]
(explaining, in the context of the prohibition on the indirect use
of fund assets for distribution, unless pursuant to a 12b-1 plan,
``[h]owever, under the rule there is no indirect use of fund assets
if an adviser makes distribution related payments out of its own
resources * * *. Profits which are legitimate or not excessive are
simply those which are derived from an advisory contract which does
not result in a breach of fiduciary duty under section 36 of the
[Investment Company] Act.''). For private funds, third parties are
often compensated by the adviser or its affiliated general partner
and, therefore, those payments are subject to the rule. Structuring
such a payment to come from the private fund for the purpose of
evading the rule would violate the rule. See Rule 206(4)-5(d).
\299\ See, e.g., Bryant Law Letter; Hedgeforce Letter; Comment
Letter of Girard Miller (Aug. 8, 2009); Comment Letter of Frank
Schmitz (Aug. 11, 2009) (``Schmitz Letter''); Atlantic-Pacific
Letter; Rubenstein Letter; Thomas Letter; Monomoy Letter; MVision
Letter; Comment Letter of Lime Rock Management (Sept. 28, 2009);
Benedetto Letter; Strategic Capital Letter; Comment Letter of
Portfolio Advisors, LLC (Oct. 2, 2009) (``Portfolio Advisors
Letter''); UBS Letter; Comment Letter of Brian Fitzgibbon (Oct. 5,
2009); Comment Letter of GenNx360 Capital Partners, L.P. (Oct. 5,
2009).
\300\ Comment Letter of the National Association of Independent
Broker-Dealers (Oct. 5, 2009).
\301\ At least one commenter suggested that there are
``inherent'' safeguards in the broker-dealer regulatory regime
sufficient to protect against pay to play practices. See, e.g., ABA
Letter. But the broker-dealer regulatory regime does not
specifically address pay to play activities, as demonstrated by the
MSRB's adoption of rules G-37 and G-38.
\302\ We acknowledge that there are costs associated with our
rule. For further analysis of these, along with the benefits, see
sections I and IV of this Release.
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Several commenters proposed that we achieve our goals by permitting
advisers to engage solicitors and placement agents that are registered
broker-dealers and subject to rules similar to those adopted by the
MSRB.\303\ One asserted that such rules would be ``a logical extension
of the already-existing regulatory scheme governing broker-dealers.''
\304\ Another agreed, arguing that such rules would be consistent with
the approach the MSRB took when it adopted MSRB rule G-38, the effect
of which was to sweep ``all solicitors of municipal business
(underwriting, sales and advisory) into the broker-dealer registration
regime'' where they would be subject to oversight of a registered
broker-dealer and are required to conform their municipal securities
activities to applicable MSRB rules,
[[Page 41041]]
including MSRB rule G-37.\305\ Others suggested we could similarly
achieve our goals by permitting advisers to engage as solicitors
registered investment advisers that are themselves subject to pay to
play restrictions under an Advisers Act rule.\306\
---------------------------------------------------------------------------
\303\ Skadden Letter (``The Commission and FINRA could directly
impose and enforce restrictions on such broker-dealers.''); Davis
Polk Letter (``Registered broker-dealers that provide legitimate
placement agent services could be required by the Commission to
comply with ``pay-to-play'' restrictions''); Credit Suisse Letter
(preclude an investment adviser from using a placement agent that is
not subject to pay to play restrictions analogous to rule G-37);
Comment Letter of the President of M Advisory Group J. Daniel
Vogelzang (Sept. 18, 2009) (``M Advisory Letter'') (treat ``[a]ll
placement agents, investment advisers and consultants * * * exactly
the same regarding prohibited political contributions; i.e., a two-
year ban on doing business with any governmental agency to which a
prohibited political contribution is made.''). See also Comment
Letter of Hudson Capital Management (NY), L.P. (Oct. 5, 2009)
(suggesting Commission take measures to properly license and
regulate third-party solicitors); SIFMA Letter (``The pay-to-play
and political activity of registered placement agents involved in
soliciting government investment could * * * be directly regulated
under the Exchange Act.''). We believe our rule, as adopted, which
allows advisers to pay certain regulated third parties to solicit
government clients on their behalf, addresses these concerns. See
infra notes 312-26 and accompanying text.
\304\ Davis Polk Letter.
\305\ SIFMA Letter (``Although Rule G-38(a) specifically
prohibits a municipal dealer from paying a fee to a nonaffiliated
person for solicitation of municipal securities business, the
policies underlying Rule G-38 were to bring solicitors within the
purview of the Federal securities laws--not to exclude the
involvement of registered broker-dealers, including those registered
broker-dealers not affiliated with advisers and private funds.'').
See also Monument Group Letter (``We believe that MSRB Rule G-38 is
not analogous to the proposed rule. Rule G-38 permits a broker-
dealer that is unaffiliated with an issuer to market that issuer's
securities to a public pension plan or any other investor. Proposed
Rule 206(4)-5(a)(2)(i) prevents this and seeks to entirely
disintermediate the process between the issuer of a security and the
ultimate investor.''); Credit Suisse Letter (``[W]e strongly believe
that a more complete analogy to the MSRB Pay-to-Play Rules would not
preclude regulated broker-dealers from performing placement agent
services in the context of municipal investors, as the Proposed Rule
would do. Notably, the MSRB Pay-to-Play Rules do not preclude SEC-
registered broker-dealers from acting as placement agents to
municipal issuers. Instead, the MSRB Pay-to-Play Rules subject such
placement agents to ``pay-to-play'' restrictions and requirements
and preclude them from retaining unregulated third-party finders and
solicitors.'').
\306\ See, e.g., IAA Letter.
---------------------------------------------------------------------------
We are persuaded by these comments and have decided to revise the
proposed rule to permit advisers to make payments to certain
``regulated persons'' to solicit government clients on their
behalf.\307\ As described in more detail below, ``regulated persons''
include certain broker-dealers and registered investment advisers that
are themselves subject to prohibitions against participating in pay to
play practices and are subject to our oversight and, in the case of
broker-dealers, the oversight of a registered national securities
association, such as FINRA.\308\ As one commenter observed, ``the
Commission would have the direct authority to determine these
restrictions as well as the oversight, control and enforcement of
penalties over any violations. The restrictions could be tailored to
operate with the same underlying purpose and effect on [solicitors] as
the ``pay-to-play'' restrictions imposed on investment advisers.''
\309\ We believe that the application of such rules would provide an
effective deterrent to these solicitors or placement agents from
participating in pay to play arrangements because political
contributions or payments would subject solicitors to similar
consequences, as discussed below.\310\ Because rule 206(4)-5 prohibits
an adviser from compensating a registered adviser solicitor for
solicitation activities if that adviser solicitor does not meet the
definition of ``regulated person,'' the adviser that hired the
solicitor must immediately cease compensating a solicitor that no
longer meets these conditions.\311\
---------------------------------------------------------------------------
\307\ See Rule 206(4)-5(a)(2)(i).
\308\ Rule 206(4)-5(f)(9). See supra note 85 (noting that, in
this Release, we will refer directly to FINRA, currently the only
registered national securities association). As noted below, under
the definition of ``regulated persons'' as it applies to brokers,
the Commission must find, by order, that a registered national
securities association's pay to play rule applicable to such brokers
imposes substantially equivalent or more stringent restrictions on
them than rule 206(4)-5 imposes on investment advisers and that such
rule is consistent with the objectives of rule 206(4)-5. Rule
206(4)-5(f)(9)(ii)(B).
\309\ Davis Polk Letter.
\310\ Another group of commenters argued that third-party
solicitors should be treated as covered associates--that is, their
contributions should trigger the two-year ban for advisers that hire
them. See, e.g., ABA Letter; 3PM Letter; ICI Letter; NY City Bar
Letter; Forum Letter; Jones Day Letter. In explaining our rejection
of this approach in the Proposing Release, we noted that this
approach--which we included in our 1999 pay to play proposal--was
criticized by commenters at that time. See Proposing Release, at
section II.A.3(b). They primarily argued that it was unfair to
impute the activities of third parties to advisers, especially given
what they perceived as the harsh consequences caused by a triggering
contribution--i.e., a two-year time out imposed on the adviser. See
id. They further argued that an approach in which contributions by
third-party solicitors triggered a two-year time out for an adviser
would create over-burdensome compliance challenges because the
adviser could not meaningfully control the contribution activities
of such third parties. See id. We continue to be sympathetic to
these concerns and believe that an approach in which a contribution
by a third party triggered a two-year time out for the adviser that
hires the third party as a solicitor could lead to unfair
consequences. See, e.g., Capstone Letter; Monument Group Letter;
Park Hill Letter. For example, if a solicitor gives a triggering
contribution in order to assist one client, we are concerned about
the harsh result that such a contribution could have on all of the
solicitor's other clients seeking business with the same prospective
government entity client.
\311\ It would be a violation of the rule for an adviser to
compensate a third party for solicitation of government entity
clients at any time that third party did not meet the definition of
``regulated person,'' regardless of whether the ``regulated person''
failed to meet the definition at the time it was hired or
subsequently.
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In light of our decision to permit advisers to make payments to
certain ``regulated persons,'' described below, to solicit government
clients on their behalf, we no longer believe that our proposed
exception from the prohibition on advisers paying third-party
solicitors for payments to related persons and employees of related
person companies of the adviser is necessary.\312\ We had proposed the
exception to enable advisers to compensate these persons for government
entity solicitation activities because we recognized there may be
efficiencies in allowing advisers to rely on these particular types of
persons to assist them in seeking clients. We requested comment
regarding whether the exception would undermine the rule's efficacy by
allowing advisers to compensate certain employees of related person
companies whose contributions would not have triggered the two-year
time out. Although we did not receive comment specifically addressing
our concern,\313\ we believe the approach we are adopting that allows
advisers to pay ``regulated persons'' to solicit government entities on
their behalf will still allow advisers to use employees of certain
related companies--i.e., of those related companies that qualify as
``regulated persons''--as solicitors.\314\
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\312\ See Proposing Release, at section II.A.3(b).
\313\ One commenter asked that we clarify the proposed exception
for related parties (Sutherland Letter) and another recommended a
case-by-case determination of whether independent contractors may be
eligible for the exception, due to concern for life insurance agents
who may not technically have qualified as ``employees'' for purposes
of the exception (Skadden Letter). As noted, however, we have
eliminated this exception in favor of allowing advisers to pay
``regulated persons,'' affiliated or not, to solicit government
clients on their behalf.
\314\ We acknowledge that some advisers may have to bear certain
additional costs of hiring outside parties as a result of our
elimination of our proposal's ``related person'' exception, which
would have allowed advisers to compensate related persons that are
not registered broker-dealers or advisers for solicitation
activities. For a discussion of costs relating to the rule, see
section IV of this Release. But, we also note that the rule, as
adopted, does not favor an adviser with affiliates (which our
proposal would have allowed an adviser to use to solicit on its
behalf) over another adviser without affiliates. Instead, our rule,
as adopted, allows an adviser to pay a ``regulated person''
affiliated or not, to solicit on its behalf.
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(1) Registered Broker-Dealers
Registered national securities association rules of similar scope
and consequence as the rule we are today adopting could sufficiently
satisfy the concerns that led us to propose to prohibit advisers from
paying brokers to solicit potential government clients. Advisers could
not easily use placement agents covered by such rules to circumvent
rule 206(4)-5. Under this approach, placement agents would be deterred
from engaging in pay to play directly on account of the registered
national securities association's rules. There would be no need for the
Commission to prove in an enforcement action that a contribution by a
placement agent amounted to an indirect contribution by the investment
adviser because the placement agent itself could be charged with
violating the registered national securities association's rules.
Therefore, as adopted, rule 206(4)-5 allows an adviser to compensate
``regulated persons,'' which includes registered brokers subject to a
registered national securities
[[Page 41042]]
association's rules, for soliciting government clients on its
behalf.\315\ An adviser may engage a registered broker to solicit
government clients on its behalf so long as the broker continues to
meet the definition of ``regulated person'' throughout its engagement
as a solicitor by the adviser.
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\315\ Rule 206(4)-5(a)(2)(i) (which prohibits advisers and their
covered associates from providing or agreeing to provide, directly
or indirectly, payment to any third party other than a regulated
person to solicit a government entity for investment advisory
services on behalf of such investment adviser). Rule 206(4)-5
defines a ``regulated person'' to include a ``broker,'' as defined
in section 3(a)(4) of the Securities Exchange Act of 1934 [15 U.S.C.
78c(a)(4)] or a ``dealer,'' as defined in section 3(a)(5) of that
Act [15 U.S.C. 78c(a)(5)], that is registered with the Commission,
and is a member of a registered national securities association
registered under section 15A of that Act [15 U.S.C. 78o-3], provided
that (A) the rules of the association prohibit members from engaging
in distribution or solicitation activities if certain political
contributions have been made; and (B) the Commission finds that such
rules impose substantially equivalent or more stringent restrictions
on broker-dealers than [rule 206(4)-5] imposes on investment
advisers and that such rules are consistent with the objectives of
[rule 206(4)-5]. The rule's definition of ``regulated person'' also
includes certain investment advisers. See infra text accompanying
note 323.
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For a broker-dealer to be a ``regulated person'' under rule 206(4)-
5, the broker-dealer must be registered with the Commission and be a
member of a registered national securities association that has a rule:
(i) That prohibits members from engaging in distribution or
solicitation activities if certain political contributions have been
made; and (ii) that the Commission finds both to impose substantially
equivalent or more stringent restrictions on broker-dealers than rule
206(4)-5 imposes on investment advisers and to be consistent with the
objectives of rule 206(4)-5.\316\ We have included the requirement that
a broker-dealer, in order to qualify as a regulated person, be subject
to a pay to play rule of a registered national securities association
of which it is a member so that brokers seeking to act as placement
agents for investment advisers are, in turn, adequately deterred from
engaging in pay to play activities on behalf of those advisers by such
a rule.
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\316\ Rule 206(4)-5(f)(9)(ii).
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FINRA has informed us that it is preparing rules for consideration
that would prohibit its members from soliciting advisory business from
a government entity on behalf of an adviser unless they comply with
requirements prohibiting pay to play activities.\317\ FINRA has said
its rule would impose regulatory requirements on member brokers \318\
``as rigorous and as expansive'' as would be imposed on investment
advisers by rule 206(4)-5, and that in developing its proposal it
intends to ``draw closely upon all the substantive and technical
elements of the SEC's proposal as well as our regulatory expertise in
examining and enforcing the MSRB rules upon which the SEC's proposal is
based.'' \319\ The rules, including any recordkeeping requirements,
would be enforced by FINRA, which has substantial experience enforcing
MSRB rules G-37 and G-38.\320\
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\317\ See Letter from Richard G. Ketchum, Chairman & Chief
Executive Officer, FINRA, to Andrew J. Donohue, Director, Division
of Investment Management, U.S. Securities and Exchange Commission
(Mar. 15, 2010), available at http://www.sec.gov/comments/s7-18-09/s71809-252.pdf (``Ketchum Letter'') (``[w]e believe that a
regulatory scheme targeting improper pay to play practices by
broker-dealers acting on behalf of investment advisers is * * * a
viable solution to a ban on certain private placement agents serving
a legitimate function''). See also Letter from Andrew J. Donohue,
Director, Division of Investment Management, U.S. Securities and
Exchange Commission, to Richard G. Ketchum, Chairman & Chief
Executive Officer, FINRA (Dec. 18, 2009), available at http://www.sec.gov/comments/s7-18-09/s71809-252.pdf.
\318\ As used in this Section, ``broker'' means a ``broker'' or
``dealer,'' as each term is defined in section 3(a) of the
Securities Exchange Act of 1934 [15 U.S.C. 78c(a)].
\319\ Ketchum Letter.
\320\ See MSRB, About the MSRB: Enforcement of Board Rules,
available at http://msrb.org/msrb1/whatsnew/default.asp
(``Responsibility for examination and enforcement of Board rules is
delegated to the Financial Industry Regulatory Authority for all
securities firms, and to the Federal Deposit Insurance Corporation,
the Federal Reserve Board, the Comptroller of the Currency, and the
Office of Thrift Supervision for banks.'').
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For the Commission to adopt a rule prohibiting advisers from using
placement agents until FINRA adopts a rule could impose substantial
hardships on a significant number of advisers and solicitors that wrote
to us. It could also disrupt pension funds' investment opportunities.
Therefore, as we discuss in more detail below, we are delaying
application of the prohibition on compensating third-party solicitors
for one year from the effective date of this rule, in part to give
FINRA time to propose such a rule.\321\
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\321\ For a discussion of transition issues, see section III of
this Release.
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(2) Registered Investment Advisers
We are also permitting advisers covered by the rule to pay
solicitors for government clients that are registered investment
advisers subject to similar limitations.\322\ Under the rule, a
``regulated person'' includes (in addition to a registered broker
subject to the conditions described above), an investment adviser that
is registered with the Commission under the Advisers Act, provided that
the solicitor and its covered associates have not, within two years of
soliciting a government entity: (i) Made a contribution to an official
of that government entity (other than a de minimis contribution, as
permitted by the rule); or (ii) coordinated, or solicited any person
(including a PAC) to make, any contribution to an official of a
government entity to which the investment adviser that hired the
solicitor is providing or seeking to provide investment advisory
services, or payment to a political party of a State or locality where
the investment adviser that hired the solicitor is providing or seeking
to provide investment advisory services to a government entity.\323\
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\322\ Rule 206(4)-5(a)(2)(i) (which prohibits advisers and their
covered associates from providing or agreeing to provide, directly
or indirectly, payment to any third party other than a regulated
person to solicit a government entity for investment advisory
services on behalf of such investment adviser).
\323\ Rule 206(4)-5(f)(9)(i).
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We received comments urging us to permit advisers to compensate
registered investment advisers for soliciting government officials,
subject to rules or rule amendments the Commission could adopt under
the Advisers Act.\324\ We believe such an allowance is appropriate for
similar reasons to those for permitting advisers to compensate broker-
dealers subject to pay to play rules we have determined meet our
objectives under rule 206(4)-5. We have direct oversight authority over
investment advisers registered with us. Accordingly, we believe it is
appropriate to allow them to act as third-party solicitors for other
advisers. Therefore, the rule, as adopted, limits the advisers that
another adviser may pay to solicit government entities on its behalf to
those advisers that are registered with the Commission \325\ and that
have neither made the types of political contributions that would
trigger the two-year time out nor otherwise engaged in activities
(e.g., bundling of contributions) that the adviser could not engage in
under the rule.\326\
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\324\ See, e.g., IAA Letter.
\325\ We are not including within the definition of ``regulated
person'' investment advisers registered solely with State securities
authorities as some commenters suggested. See id. We do not have
regulatory authority over those advisers as we do over advisers who
are registered with us (and as we do over FINRA in connection with
its oversight of brokers and dealers and enforcement of its own
rules). In fact, such advisers are subject neither to our oversight
nor to the recordkeeping rules we are adopting today.
\326\ Importantly, a person that is registered under the
Exchange Act as a broker-dealer and under the Advisers Act as an
investment adviser could potentially be a ``regulated person'' under
the rule if it met the conditions for either prong of the
definition. Such a regulated person should follow the rules that
apply to the services it is performing, rather than complying with
both investment adviser and broker-dealer pay to play requirements.
The Exchange Act generally requires brokers and dealers to register
with the Commission and become members of at least one self-
regulatory organization. Exchange Act sections 15(a), 15(b)(8) [15
U.S.C. 78o(a), (b)(8)]. Section 3(a)(4)(A) of the Exchange Act
generally defines a ``broker'' as any person engaged in the business
of effecting transactions in securities for the account of others
[15 U.S.C. 78c(a)(4)(A)]. See, e.g., Definition of Terms in and
Specific Exemptions for Banks, Savings Associations, and Savings
Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange
Act of 1934, Exchange Act Release No. 44291, at n.124 (May 11, 2001)
[66 FR 27759 (May 18, 2001)] (``Solicitation is one of the most
relevant factors in determining whether a person is effecting
transactions.''); Strengthening the Commission's Requirements
Regarding Auditor Independence, Exchange Act Release No. 47265, at
n.82 (Jan. 28, 2003) [68 FR 6006 (Feb. 5, 2003)] (noting that a
person may be ``engaged in the business,'' among other ways, by
receiving compensation tied to the successful completion of a
securities transaction). See also Persons Deemed Not to Be Brokers,
Exchange Act Release No. 22172, at sec. II.A (Jun. 27, 1985) [50 FR
27940 (Jul. 9, 1985)] (noting that attorneys, accountants, insurance
brokers, financial service organizations and financial consultants
are engaged in the business of effecting transactions in securities
for the account of others if they are retained by an issuer
specifically for the purpose of selling securities to the public and
receive transaction based-compensation for their services).
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[[Page 41043]]
Advisers compensating other advisers that qualify as ``regulated
persons'' for soliciting government entities must adopt policies and
procedures reasonably designed to prevent a violation of the rule.\327\
Such policies and procedures should include, among other things, a
careful vetting of candidates and ongoing review of ``regulated
person'' investment advisers acting as solicitors currently being used.
Such review would need to determine whether the adviser (and its
covered persons) acting as a solicitor has made political contributions
or otherwise engaged in conduct that would disqualify it from the
definition of ``regulated person'' and thereby preclude the hiring
adviser from paying it for the solicitation activity.
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\327\ See Advisers Act rule 206(4)-7 [17 CFR 275.206(4)-7]
(requiring advisers to adopt and implement compliance policies and
procedures).
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(c) Restrictions on Soliciting and Coordinating Contributions and
Payments
Rule 206(4)-5 prohibits advisers and covered persons from
coordinating or soliciting \328\ any person or PAC to make (i) any
contribution \329\ to an official of a government entity to which the
adviser is providing or seeking to provide investment advisory
services,\330\ or (ii) any payment \331\ 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.\332\
These restrictions are intended to prevent advisers from circumventing
the rule's prohibition on direct contributions to certain elected
officials such as by ``bundling'' a large number of small employee
contributions to influence an election, or making contributions (or
payments) indirectly through a State or local political party.\333\
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\328\ Rule 206(4)-5(f)(10)(ii) (defining ``solicit,'' with
respect to a contribution or payment, as communicating, directly or
indirectly, for the purpose of obtaining or arranging a contribution
or payment). Some commenters requested that we provide guidance
regarding when an adviser would be deemed to be soliciting
contributions for purposes of the rule. See, e.g., Caplin & Drysdale
Letter. An adviser that consents to the use of its name on
fundraising literature for a candidate would be soliciting
contributions for that candidate. Similarly, an adviser that
sponsors a meeting or conference which features a government
official as an attendee or guest speaker and which involves
fundraising for the government official would be soliciting
contributions for that government official. Whether a particular
activity involves a solicitation or coordination of a contribution
or payment for purposes of the rule will depend on the facts and
circumstances, thus we have not attempted to draw a bright line. The
MSRB takes a similar approach. See MSRB, Solicitation of
Contributions, MSRB Interpretive Letter (May 21, 1999), available at
http://msrb.org/msrb1/rules/interpg37.htm (determination of whether
activity constitutes ``soliciting'' under rule G-37 is a facts and
circumstances analysis). See also supra note 255.
\329\ In the case of the fundraising meeting or conference
described as an example in note 328, expenses incurred by the
adviser for hosting the event would be a contribution by the
adviser, thereby triggering the two-year ban on the adviser
receiving compensation for providing advisory services to the
government entity over which that official has influence. See
section II.B.2(a) of this Release. Such expenses may include, but
are not limited to, the cost of the facility, the cost of
refreshments, any expenses paid for administrative staff, and the
payment or reimbursement of any of the government official's
expenses for the event. The de minimis exception under rule 206(4)-
5(b)(1) would not be available with respect to these expenses
because they would have been incurred by the firm, not by a natural
person. See MSRB, 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 in
its rules directly, the MSRB applies a facts and circumstances test
on a case-by-case basis).
\330\ 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 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.
\331\ A payment is defined as any gift, subscription, loan,
advance, or deposit of money or anything of value. Rule 206(4)-
5(f)(7). This definition is similar to the definition of
``contribution,'' but broader, in the sense that it does not include
limitations on the purposes for which such money is given (e.g., it
does not have to be made for the purpose of influencing an
election). We are including the broader term ``payments,'' as
opposed to ``contributions,'' here to deter an adviser from
circumventing the rule's prohibitions by coordinating indirect
contributions to government officials by making payments to
political parties.
\332\ Rule 206(4)-5(a)(2)(ii). This provision prohibits, for
example, an adviser from soliciting a payment to the political party
of a State if the adviser is providing or seeking to provide
advisory services to the State, but would not preclude that adviser
from soliciting a payment to a local political party (as long as the
adviser is not also providing or seeking to provide advisory
services to a government entity in that locality). In these
circumstances, the rule would, however, prohibit an adviser from
soliciting the payment to a local political party as a means to
indirectly make payments to the State party. See rule 206(4)-5(d).
\333\ We note that this provision is not limited to the bundling
of employee contributions. Another example of conduct that would be
prohibited by this section would be an adviser or its covered
associates soliciting contributions from professional service
providers.
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We received only a few comments on this provision. One supporter of
our proposal asserted that it ``would close an important gap in which
contributions might be made indirectly to government officials for the
purpose of influencing their choice of investment advisers.'' \334\
Most commenters that addressed the provision focused on the prohibition
relating to contributions and payments to State and local political
parties where the adviser is providing, or seeking to provide, advisory
services. One State official suggested that this prohibition would
unfairly affect states with strict limitations on individual
contributions to candidates as they are now more reliant on party money
for campaigns.\335\ Another State official, however, explained the
importance of the provision by pointing out that it is often difficult
or impossible to differentiate between individuals seeking an office
and the political party, which often merely passes contributions it
receives on to the candidate, and may direct successful candidates to
place pension business with contributors.\336\
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\334\ Cornell Law Letter.
\335\ CT Treasurer Letter. In upholding restrictions targeted at
a particular industry, courts have found that the loss of
contributions from a small segment of the electorate ``would not
significantly diminish the universe of funds available to a
candidate to a non-viable level.'' Green Party of Conn. v. Garfield,
590 F. Supp. 2d 288, 316 (D. Conn. 2008); see also Preston v. Leake,
629 F. Supp. 2d 517, 524 (E.D.N.C. 2009) (differentiating the
``broad sweep of the Vermont statute'' that ``restricted essentially
any potential campaign contribution'' from a statute that ``only
applies to lobbyists''); In re Earle Asphalt Co., 950 A.2d 918, 927
(N.J. Super. Ct. App. Div. 2008), aff'd 957 A.2d 1173 (N.J. 2008)
(holding that a limitation on campaign contributions by government
contractors and their principals did not have the same capacity to
prevent candidates from amassing the resources necessary for
effective campaigning as the statute in Randall). See supra note 68.
\336\ Reilly Letter.
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We are adopting this provision, as proposed. These restrictions on
soliciting and coordinating
[[Page 41044]]
contributions and payments close what would otherwise be a potential
gap in the rule as advisers could circumvent its limitations on direct
contributions through soliciting and coordinating others to make
contributions to influence an election or a government official's
investment adviser selection process.\337\ We disagree that this
prohibition would unfairly affect candidates in states that limit
individual contributions, because the rule is non-discriminatory and
would affect contributions (and payments) to all candidates equally
that were being bundled or made through a gatekeeper for the benefit of
an investment adviser seeking or doing business with the State or local
government.
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\337\ We note that a direct contribution to a political party by
an adviser or its covered associates would not violate the rule,
unless the contribution was a means for the adviser to do indirectly
what the 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 section II.B.2(d) of this
Release. The MSRB amended rule G-37 in 2005 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. The MSRB had not previously been able to deter this
misconduct, despite issuing informal guidance in both 1996 and 2003.
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 (``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.''); 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).
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(d) Direct and Indirect Contributions or Solicitations
Rule 206(4)-5(d) prohibits acts done indirectly, which, if done
directly, would violate the rule.\338\ As a result, an adviser and its
covered associates could not funnel payments through third parties,
including, for example, consultants, attorneys, family members, friends
or companies affiliated with the adviser as a means to circumvent the
rule.\339\ We emphasize, however, that contributions by these other
persons would not otherwise trigger the rule's two-year time out.\340\
We received no comments on this aspect of the proposed rule and are
adopting it as proposed.
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\338\ Paragraph (d) of the rule is substantially similar to
section 208(d) of the Advisers Act [15 U.S.C. 80b-8(d)], which
states, ``It shall be unlawful for any person indirectly, or through
or by any other person, to do any act or thing which it would be
unlawful for such person to do directly under the provisions of this
title or any rule or regulation thereunder.'' MSRB rule G-37
contains a similar provision. See MSRB rule G-37(d).
\339\ 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
contributions, 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 thus would be
considered to be made ``indirectly'' for purposes of the rule. In
approving MSRB rule G-37, the Commission stated: ``[rule G-37(d)] is
intended to prevent dealers from funneling funds or payments through
other persons or entities to circumvent the [rule]'s requirements.
For example, a dealer would violate the [rule] if it does business
with an issuer after contributions were made to an issuer official
from or by associated persons, family members of associated persons,
consultants, lobbyists, attorneys, other dealer affiliates, their
employees or PACs, or other persons or entities as a means to
circumvent the rule. A dealer also would violate the rule by doing
business with an issuer after providing money to any person or
entity when the dealer knows that the money will be given to an
official of an issuer who could not receive the contribution
directly from the dealer without triggering the rule's prohibition
on business.'' 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)].
\340\ Like MSRB rule G-37(d), rule 206(4)-5(d) requires a
showing of intent to circumvent the rule in order for such persons
to trigger the time out. See Blount, 61 F.3d at 948 (``In short,
according to the SEC, the rule restricts such gifts and
contributions only when they are intended as end-runs around the
direct contribution limitations.'').
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(e) Covered Investment Pools
Rule 206(4)-5 includes a provision that applies each of the
prohibitions of rule 206(4)-5 to an investment adviser that manages
assets of a government entity through a hedge fund or other type of
pooled investment vehicle (``covered investment pool'').\341\ For
example, a political contribution to a government official that would,
under the rule, trigger the two-year time out from providing advice for
compensation to the government entity would also trigger a two-year
time out from the receipt of compensation for the management of those
assets through a covered investment pool. This provision extends the
protection of the rule to public pension plans that increasingly access
the services of investment advisers through hedge funds and other types
of pooled investment vehicles they sponsor or advise.
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\341\ See rule 206(4)-5(c). We discuss the types of pooled
investment vehicles that are ``covered investment pools'' below at
section II.B.2.(e)(1) of this release.
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This provision will generally affect two common types of
arrangements in which a government official is in a position to
influence investment of funds in pooled investment vehicles. The first
is the investment of public funds in a hedge fund or other type of
pooled investment vehicle. The other is the selection of a pooled
investment vehicle sponsored or advised by an investment adviser as a
funding vehicle or investment option in a government-sponsored plan,
such as a ``529 plan.'' \342\
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\342\ We note that if an adviser is selected by a government
entity to advise a government-sponsored plan (regardless of whether
the plan selects one of the pools the adviser offers or manages as
an option available under its plan), the prohibitions of the rule
directly apply. See rule 206(4)-5(a)(1) and (a)(2).
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An adviser that makes political contributions to steer assets to a
pooled investment vehicle it manages facilitates fraud by implementing
a government official's quid pro quo scheme.\343\ Public pension plan
beneficiaries are harmed when a government official violates the public
trust, for example, by failing to disclose that the government official
has directed the investment of the plan's assets in a pooled investment
vehicle not because of the vehicle's financial merits but rather
because the official has received a political contribution.\344\ By
engaging in such conduct, the adviser engages in a scheme to defraud
the beneficiaries of the government plan or program.\345\ Additionally,
an investment adviser to a pooled investment vehicle that is an
investment option in a government plan or program may prepare
information about the pooled investment vehicle that may be used by
plan officials to evaluate the vehicle and by pension plan
beneficiaries to decide whether to allocate assets to the vehicle. Such
an adviser engages in or facilitates an act, practice, or course of
business which is fraudulent, deceptive, or manipulative when the
adviser does not disclose that it made a contribution for the purpose
of inducing an investment by the government officials and that the
[[Page 41045]]
government officials sponsoring the plan chose the vehicle as an
investment option for beneficiaries not solely on the basis of its
merits, but rather as the consequence of improper quid pro quo
payments.\346\ The rule also operates to prevent an adviser from
engaging in pay to play practices indirectly through an investment pool
that it would not be permitted to do if it directly managed (or sought
to directly manage) the assets of a government entity.\347\
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\343\ SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009).
\344\ Id. at 566.
\345\ See id. at 568-69; section 206(4) of the Advisers Act. See
also Exchange Act rule 10b-5 [17 CFR 240.10b-5].
\346\ See, e.g., Oran v. Stafford, 226 F.3d 275, 285-86 (3d Cir.
2000) (``a duty to disclose may arise when there is * * * an
inaccurate, incomplete or misleading prior disclosure''); Glazer v.
Formica Corp., 964 F.2d 149, 157 (2d Cir. 1992) (``when a
corporation does make a disclosure--whether it be voluntary or
required--there is a duty to make it complete and accurate'')
(quoting Roeder v. Alpha Industries, Inc., 814 F.2d 22, 26 (1st Cir.
1987). See also Exchange Act Rule 10b-5(b).
\347\ See rule 206(4)-5(d). See also section 208(d) of the Act.
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Although a few commenters asserted that the rule or parts of it
should not apply to pooled investment vehicles,\348\ none made a
persuasive argument that the problems the rule is designed to address
are not present in the management of public pension plan and other
public monies invested in pooled investment vehicles. As we discussed
in the Proposing Release,\349\ when a decision to invest public funds
in a pooled investment vehicle is based on campaign contributions, the
public pension plan may make inferior investment choices and may pay
higher fees. And such pension plans may invest in pooled investment
vehicles that pay substantially higher advisory fees and assume
significantly greater risks than other investment alternatives.\350\
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\348\ See, e.g., Comment Letter of Abbott Capital Management,
LLC (Oct. 6, 2009) (``Abbott Letter''); ICI Letter; NY City Bar
Letter; SIFMA Letter; Skadden Letter; Sutherland Letter.
\349\ See Proposing Release, at section II.A.3.(e)(2).
\350\ See, e.g., Nanette Burns, Can Retirees Afford This Much
Risk? Business Week (Sept. 17, 2007), available at http://www.businessweek.com/magazine/content/07_38/b4050048.htm (asserting
that public pension plan assets are increasingly being invested in
higher risk alternative investments, including hedge funds); Hannah
M. Terhune, Accounts Training, Money Science (Dec. 11, 2006),
available at http://www.moneyscience.com/Hedge_Fund_Tutorials/Hedge_Fund_Management_and_Performance_Fees.html (noting an
``enormous difference in rewards for the managers of hedge funds
versus those of mutual funds'' because hedge fund managers are
entitled to performance fees).
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We find nothing in the structure of pooled investment vehicles or
the variety of investment strategies they employ that suggests a reason
for treating advisers to pooled investment vehicles differently from
advisers to separately managed advisory accounts, except, as we discuss
below, registered investment companies to which we apply a more limited
version of the rule. That an investment in a pooled investment vehicle
may not involve a direct advisory relationship with a government
sponsored plan does not change the nature of the fraud or the harm that
may be inflicted as a consequence of the adviser's pay to play
activity.
Indeed, many of our recent enforcement cases alleged political
contributions or kickbacks designed to induce public officials to
invest public pension plan assets in pooled investment vehicles.\351\
We are concerned that our failure to apply the rule to advisers who
manage assets through these vehicles would ignore an area where there
has been considerable growth, both in the amount of public assets
invested in such pooled investment vehicles and allegations of pay to
play activity involving public pension plans.\352\ We believe a failure
to apply the rule in this area could, in some cases, even encourage the
use of covered investment pools as a means of avoiding application of
the rule.
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\351\ See, e.g., SEC v. Paul J. Silvester, et al., Litigation
Release No. 16759, Civil Action No. 3:00-CV-19411 DJS (D. Conn.)
(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, Civil
Action No. 3:04 CV 1342 (EBB) (D. Conn.) (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). There are examples of
pay to play activity in the context of pooled investment vehicles in
other jurisdictions as well. See, e.g., supra note 18 (listing
various actions relating to the recent pay to play allegations
surrounding the New York Common Retirement Fund). See also Guilty
Plea in Fraud Case Tied to New York Pension, Associated Press (Dec.
4, 2009), available at hhttp://www.nytimes.com/2009/12/04/nyregion/04pension.html (describing the guilty plea of an adviser to a
venture capital fund to charges that he helped his company land a
lucrative deal with New York's public pension fund by giving nearly
$1 million worth of illegal gifts to State officials).
\352\ See, e.g., Investment Company Institute, 529 Plan Program
Statistics, Mar. 2009 (Feb. 5, 2010), available at http://www.ici.org/research/stats/529s/529s_03-09 (indicating that 529
plan assets have increased from $8.6 billion in 2000 to $100.3
billion in the first quarter of 2009, and that 529 plan accounts
have increased from 1.3 million in 2000 to 11.2 million in the first
quarter of 2009); 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). See also Michael Marois,
CalPERS, Blackstone Clash over Placement Agent `Jackpot' Fees,
Bloomberg (Apr. 7, 2010), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=acPNrTn1q7pw (noting that placement
agents working for private equity, hedge funds, venture capital and
real estate firms typically earn the equivalent of 0.5 percent to 3
percent of the money they place under the management of their
client, quoting California State Treasurer Bill Lockyer, a member of
the CalPERS board, ``[t]he contingency fees are too much of a
jackpot for the placement agents * * * [they] invite corrupt
practices'').
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Nonetheless, as described in more detail below, we have made
several changes from the proposal to more narrowly tailor the
applicability of the rule to pooled investment vehicles in order to
achieve our regulatory purpose while reducing compliance burdens that
commenters brought to our attention. In addition, we have made certain
clarifying changes to the rule, as described below.
(1) Definition of ``Covered Investment Pool''
Under the rule, a ``covered investment pool'' \353\ includes: (i)
Any investment company registered under the Investment Company Act of
1940 that is an investment option of a plan or program of a government
entity; 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.\354\ Accordingly, it includes such unregistered pooled
investment vehicles as hedge funds, private equity funds, venture
capital funds and collective investment trusts.\355\ It also
[[Page 41046]]
includes registered pooled investment vehicles, such as mutual funds,
but only if those registered pools are an investment option of a
participant-directed plan or program of a government entity.\356\ These
plans or programs may include college savings plans like ``529 plans''
\357\ and retirement plans like ``403(b) plans'' \358\ and ``457
plans'' \359\ that 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.\360\
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\353\ Rule 206(4)-5(f)(3).
\354\ 15 U.S.C. 80a-3(c)(1), (7) or (11). We note that a bank
maintaining a collective investment trust would not be subject to
the 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 non-bank 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 with respect to all of its government entity
clients, including the collective investment trust in which a
government entity invests, unless another exemption is available.
\355\ One commenter questioned the Commission's authority to
apply the rule in the context of covered investment pools in light
of the opinion of the Court of Appeals for the District of Columbia
Circuit in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
Sutherland Letter. That case created some uncertainty regarding the
application of sections 206(1) and 206(2) of the Advisers Act in
certain cases where investors in a pool are defrauded by an
investment adviser to that pool. See 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)],
(adopting rule 206(4)-8 [17 CFR 275.206(4)-8]). In addressing the
scope of the exemption from registration in section 203(b)(3) of the
Advisers Act and the meaning of ``client'' as used in that section,
the Court of Appeals expressed the view that, for purposes of
sections 206(1) and (2), the ``client'' of an investment adviser
managing a pool is the pool itself, not an investor in the pool. In
its opinion, the Court of Appeals distinguished sections 206(1) and
(2) from section 206(4) of the Advisers Act, which applies to
persons other than clients. Id. at n.6. See also United States v.
Elliott, 62 F.3d 1304, 1311 (11th Cir. 1995). Section 206(4) permits
us to adopt rules proscribing fraudulent conduct that is potentially
harmful to investors in pooled investment vehicles. We are adopting
rule 206(4)-5 under this authority.
\356\ Rule 206(4)-5(f)(8).
\357\ 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
Exchange Act [15 U.S.C. 78a-15(a)(1) and 15B]. 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 as investment advisers and would therefore be subject to
our rule.
\358\ 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)].
\359\ 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].
\360\ We would consider a registered investment company to be an
investment option of a plan or program of a government entity where
the participant selects a model fund or portfolio (such as an age-
based investment option of a 529 plan) and the government entity
selects the specific underlying registered investment company or
companies in which the portfolio's assets are invested.
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We proposed to include in the definition of ``covered investment
pool'' the types of pooled investment vehicles that are likely to be
used as funding vehicles for, or investments of, government-sponsored
savings and retirement plans. We explained that we included registered
investment companies because of the significant growth in government-
sponsored savings plans in recent years, which increasingly use these
funds as investment options,\361\ and the increased competition among
advisers for selection of their fund as an investment option for these
plans.\362\ We were concerned that advisers to pooled investment
vehicles, including registered investment companies, may make political
contributions to influence the decision by government officials to
include their funds as options in such plans.
---------------------------------------------------------------------------
\361\ See supra note 352 and accompanying text.
\362\ See, e.g., Charles Paikert, TIAA-CREF Stages Comeback in
College Savings Plans, Crain's New York Bus., 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). See also AnnaMaria Andriotis, 529
Plan Fees are Dropping, SmartMoney, Dec. 16, 2009, available at
http://www.smartmoney.com/personal-finance/college-planning/529-plan-fees-are-dropping-but-for-how-long/?hpadref=1 (``Costs on these
plans are falling for a few reasons, and the biggest one has little
to do with the State of the economy: The nature of their contracts
creates competition. When a contract for a State 529 plan expires,
program managers compete against each other and may lower their fees
to try to secure the new contract.'').
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We recognized in our proposal, however, that an adviser to a
registered investment company might have difficulty in identifying when
or if a government investor was a fund shareholder for purposes of
preventing the adviser (or its covered associates) from making
contributions that would trigger a two-year time out.\363\ Therefore,
we proposed to only include publicly offered registered investment
companies in the definition of covered investment pool for purposes of
the two-year time out provision to the extent they were investments or
investment options of a plan or program of a government entity.\364\
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\363\ See Proposing Release, at nn. 185-87 and accompanying
text.
\364\ See proposed rule 206(4)-5(f)(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)) * * * 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.'').
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Several commenters asserted that an adviser to a publicly offered
investment company would have similar difficulties in identifying
government investors in registered investment companies for purposes of
complying with other provisions of the rule.\365\ One opposed
application of the rule to registered investment companies ``even if
the [company] is not included in a plan or program of a government
entity,'' \366\ although several generally urged us to exclude
registered investment companies from the rule altogether.\367\ Another
commenter urged us to apply the rule's recordkeeping requirements
(discussed below) prospectively and after a period of time that would
be adequate to enable funds to redesign their processes and systems to
capture information about whether an investor is a ``government
entity,'' which would be necessary to comply with the rule and our
proposed amendment to the Act's recordkeeping rule.\368\ Some noted
that identifying government investors would be particularly challenging
when shares were held through an intermediary.\369\
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\365\ See Davis Polk Letter; Fidelity Letter; ICI Letter; NSCP
Letter; Comment Letter of Standard & Poor's Investment Advisory
Services LLC and Standard & Poor's Securities Evaluations, Inc.
(Oct. 5, 2009) (``S&P Letter''); SIFMA Letter; T. Rowe Price Letter.
\366\ T. Rowe Price Letter.
\367\ Fidelity Letter; ICI Letter; NSCP Letter; SIFMA Letter. We
disagree that registered investment companies should be excluded
from our rule. Pay to play activity is fraudulent, regardless of
whether it occurs in the context of a pooled investment vehicle or a
separately managed account. One commenter asserted that the
existence of a regulatory regime applicable to investment companies
precludes the need for pay to play prohibitions with respect to
these pools. See ICI Letter. However, existing laws and regulations
applicable to investment companies do not specifically address pay
to play practices.
\368\ ICI Letter. See also section II.D of this Release.
\369\ See T. Rowe Price Letter; ICI Letter, Fidelity Letter.
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We continue to believe for the reasons discussed above \370\ and in
the Proposing Release, that advisers to registered investment companies
should be subject to the rule. In response to comments, we have
modified our
[[Page 41047]]
proposal to include a registered investment company in the definition
of covered investment pool, for purposes of all three of the rule's pay
to play prohibitions, but only if it is an investment option of a plan
or program of a government entity.\371\ We believe this approach
strikes the right balance between applying the rule in those contexts,
discussed in the Proposing Release,\372\ in which advisers to
registered investment companies may be more likely to engage in pay to
play conduct, while recognizing the compliance challenges relating to
identifying government investors in registered investment companies
\373\ that may result from a broader application of the rule. When an
adviser's investment company is an investment option in a participant-
directed government plan or program, we believe it is reasonable to
expect the adviser will know (or can reasonably be expected to acquire
information about) the identity of the government plan.\374\ We
recognize that when shares are held through an intermediary, an adviser
may have to take additional steps to identify a government entity.\375\
Therefore, we have provided advisers to registered investment companies
with additional time to modify current systems and processes.\376\
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\370\ See supra notes 361-362 and accompanying text.
\371\ Rule 206(4)-5(f)(3).
\372\ Proposing Release, at nn.185-87 and accompanying text. See
also supra notes 352 and 362 and accompanying text (describing the
growth in government-sponsored savings plans in recent years and the
increased competition for an adviser's fund to be selected as an
investment option of such a plan).
\373\ Identifying government investors in other types of covered
investment pools does not generally present similar compliance
challenges. See, e.g., rule 2(a)(51) under the Investment Company
Act [17 CFR 270.2(a)(51)] (defining ``qualified purchaser,'' as that
term is used in section 3(c)(7) of that Act); Rule 501(a) of
Regulation D under the Securities Act of 1933 (``Securities Act'')
[17 CFR 230.501(a)] (defining ``accredited investor'' for purposes
of limited offerings without registration under the Securities Act
of 1933); and Advisers Act rule 205-3 (creating an exception from
the prohibition against an adviser receiving performance-based
compensation from clients that are not ``qualified clients,'' and
which is relied on by many advisers to funds that are exempt from
Investment Company Act registration under section 3(c)(1) of that
Act).
\374\ With respect to a 529 plan, for example, an adviser would
know that its investment company is an investment option of the plan
and will know the identity of the government entity investor because
a 529 plan can only be established by a State, which generally
establishes a trust to serve as the direct investor in the
investment company, while plan participants invest in various
options offered by the 529 trust. The rule does not require an
adviser to identify plan participants, only the government plan or
program. See rule 206(4)-5(f)(5)(iii) (defining a ``government
entity'' to include a plan or program of a government entity. The
definition does not include the participants in those plans or
programs).
\375\ For example, while 403(b) plans and 457 plans are
generally associated with retirement plans for government employees,
they are not used exclusively for this purpose. For instance,
certain non-profit or tax-exempt entities can establish these types
of plans. We also understand that it is not uncommon for
contributions of 403(b) and 457 plans to be commingled into an
omnibus position that is forwarded to the fund, making it more
challenging for an adviser to distinguish government entity
investors from others.
\376\ See section III.D of this Release. We received several
letters addressing this concern. ICI Letter; T. Rowe Price Letter;
Fidelity Letter.
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We have also made several minor changes from our proposal intended
to clarify and simplify application of the rule. First, at the
suggestion of commenters,\377\ we are clarifying that an adviser to a
registered investment company is only subject to the rule--i.e., the
investment company is only considered a covered investment pool--if the
investment company is an investment option of a plan or program of a
government entity that is participant-directed.\378\ This change
reflects our intent, as demonstrated by the examples we give in the
definition (i.e., 529 plans, 403(b) plans, and 457 plans) that the
definition is intended to encompass those covered investment pools that
have been pre-selected by the government sponsoring or establishing the
plan or program as part of a limited menu of investment options from
which participants in the plan or program may allocate their account.
We have also added, as additional examples to the definition of
``government entity,'' a defined benefit plan and a State general fund
to better distinguish these pools of assets from a plan or program of a
government entity.\379\ We have also made minor organizational changes
within the definition of government entity from our proposal to make
clear that such pools are not ``plans or programs of a government
entity.''
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\377\ See, e.g., ICI Letter; Davis Polk Letter; SIFMA Letter.
\378\ Rule 206(4)-5(f)(8).
\379\ Rule 206(4)-5(f)(5).
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Finally, we have simplified the definition of ``covered investment
pool'' as it applies to registered investment companies. The definition
as adopted includes investment companies registered under the
Investment Company Act that are an option of a plan or program of a
government entity, regardless of whether, as proposed, their shares are
registered under the Securities Act of 1933 (``1933 Act''). As
discussed above, under the rule as adopted an adviser to a registered
investment company is only subject to the rule if the company is an
investment option of a plan or program. As a result, we believe it is
unnecessary to distinguish between registered investment companies
based on whether their shares are registered under the 1933 Act,
although we understand that those shares will typically be registered
where the fund is an option in a plan or program of a government
entity.
(2) Application of the Rule
Under rule 206(4)-5 (and as proposed) an investment adviser is
subject to the two-year time out if it manages a covered investment
pool in which the assets of a government entity are invested.\380\ The
rule does not require a government entity's withdrawal of its
investment or cancellation of any commitment it has made. Indeed, the
rule prohibits advisers not from providing advice subsequent to a
triggering political contribution, but rather from receiving
compensation for providing advice. If a government entity is an
investor in a covered investment pool at the time a contribution
triggering a two-year ``time out'' is made, the adviser must forgo any
compensation related to the assets invested or committed by that
government entity.\381\
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\380\ Rule 206(4)-5(c).
\381\ As we noted above and in the Proposing Release, the phrase
``for compensation'' includes both profits and the recouping of
costs, so an adviser is not permitted to continue to manage assets
at cost after a disqualifying contribution is made. Proposing
Release, at n.191. See also supra note 137 and accompanying text. As
we discussed above in section II.B.2(a)(1) of this Release, we are
not persuaded by commenters who suggested permitting the adviser to
be compensated at cost following payment of a triggering
contribution or payment. See, e.g., Dechert Letter; NY City Bar
Letter. In our judgment, the potential loss of profits from the
government client alone may be insufficient to deter pay to play
activities. However, costs specifically attributable to the covered
investment pool and not normally incurred in connection with a
separately managed account, such as costs attributable to an annual
audit of the pool's assets and delivery of its audited financial
statements, would not be considered compensation to the adviser for
these purposes.
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Application of the two-year time out may present different issues
for covered investment pools than for separately managed accounts due
to various structural and legal differences. Having made a contribution
triggering the two-year time out, the adviser may have multiple options
available to comply with the rule in light of its fiduciary obligations
and the disclosure it has made to investors. For instance, in the case
of a private pool, the adviser could seek to cause the pool to redeem
the investment of the government entity.\382\
[[Page 41048]]
Such redemptions may be relatively simple matters in the case of, for
example, a highly liquid private pool.\383\ Commenters pointed out to
us that, for some private pools, such as venture capital and private
equity funds, a government entity's withdrawal of its capital or
cancellation of its commitment may have adverse implications for other
investors in the fund.\384\ In such cases, the adviser could instead
comply with the rule by waiving or rebating the portion of its fees or
any performance allocation or carried interest attributable to assets
of the government client.\385\
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\382\ To the extent the adviser may seek to cause the private
pool to redeem the investment of a government entity investor under
these circumstances, it should consider disclosing this as an
investment risk in a private placement memorandum, prospectus or
other disclosure document to current and prospective investors in
such a fund. See, e.g., Rule 502 of Regulation D under the
Securities Act [17 CFR 230.502] (addressing disclosure obligations
for non-accredited investors who purchase securities in a limited
offering pursuant to rules 505 or 506 of Regulation D under the
Securities Act [17 CFR 230.505 or 17 CFR 230.506].
\383\ We understand that other types of pooled investment
vehicles, including private equity and venture capital funds,
already have special withdrawal and transfer provisions related to
the regulatory and tax considerations applicable to certain types of
investors, such as those regulated by the Employee Retirement Income
Security Act of 1974 (``ERISA'') [29 U.S.C. 18]. See generally James
M. Schell, Private Equity Funds--Business Structure and Operations
(Law Journal Press 2000) (2010).
\384\ See Abbott Letter; ICI Letter; NY City Bar Letter.
\385\ As we noted in the Proposing Release, some commenters to
our 1999 Proposal asserted that a performance fee waiver raises
various calculation issues. See Proposing Release, at n.192. An
adviser making a disqualifying contribution could comply with rule
206(4)-5 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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For registered investment companies, the options for restricting
compensation involving government investors are more limited, due to
both Investment Company Act provisions and potential tax
consequences.\386\ In our proposal, we suggested one approach that
would meet the requirements of the rule--an adviser of a registered
investment company could waive its advisory fee for the fund as a whole
in an amount approximately equal to fees attributable to the government
entity.\387\ One commenter agreed with our approach,\388\ while another
commenter suggested we could, alternatively, permit the government
entity to continue to pay its portion of the advisory fee, but require
the adviser to rebate that portion of the fee to the fund as a
whole.\389\ We believe either approach would meet the requirements of
the rule we are adopting today.
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\386\ See Proposing Release, at n.193 and accompanying text.
See, e.g., rule 18f-3 under the Investment Company Act [17 CFR
270.18f-3]. Moreover, other regulatory considerations, such as those
under ERISA, may impact these arrangements with respect to
collective investment trusts.
\387\ This may also be done at the class level or series level
for private funds organized as corporations.
\388\ ICI Letter.
\389\ NY City Bar Letter.
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(3) Subadvisory Arrangements
A number of commenters urged that we exclude from the rule
subadvisers to covered investment pools because, being in a subordinate
role to the adviser, they may have no involvement in the adviser's
solicitation activities including no ability to identify government
entities being solicited, and therefore should not be held accountable
for the adviser's actions.\390\ None of these commenters, however,
indicated that a subadviser could not obtain from the adviser the
information necessary to comply with the rule. Additionally, no
commenter provided us with a basis to distinguish advisers from
subadvisers that would be adequate to avoid undermining the
prophylactic nature of our rule. ``Subadviser'' is not defined under
the Act,\391\ and significant variation exists in subadvisory
relationships.\392\ There is no readily available way to draw
meaningful distinctions between advisers and subadvisers by, for
example, looking at who controls marketing and solicitation
activities,\393\ who has an advisory contract directly with the
government client,\394\ or other factors. In addition, subadvisers
generally have the same economic incentives as advisers to obtain new
business and increase assets under management. We are concerned that
under the approaches suggested by commenters, an adviser that sought to
avoid compliance with the prophylactic provisions of our rule and
engage in pay to play could organize itself to operate as a subadviser
in such an arrangement. We therefore believe it is not appropriate to
exclude subadvisers from the rule.
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\390\ See, e.g., IAA Letter; S&P Letter; Skadden Letter; Davis
Polk Letter.
\391\ ``Subadviser'' also is not defined under the Investment
Company Act, which requires that both advisory and subadvisory
contracts (``which contract, whether with such registered company or
with an investment adviser of such registered company * * * '') be
approved by a vote of a majority of the outstanding voting
securities of the registered investment company. See section 15(a)
of the Investment Company Act [15 U.S.C. 80a-15(a)].
\392\ See, e.g., Investment Company Institute, Board Oversight
of Subadvisers (Jan. 2010), available at http://www.ici.org/pdf/idc_10_subadvisers.pdf (providing guidance to mutual fund boards
of directors with respect to overseeing subadvisory arrangements and
recognizing that ``there is no one `correct' approach to effective
subadvisory oversight by fund boards'' because there are a wide
variety of potential subadvisory arrangements).
\393\ See, e.g., Davis Polk Letter (suggesting that we limit the
application of the prohibitions to a subadviser to a covered
investment pool that has the ability to control the soliciting,
marketing or acceptance of government clients); S&P Letter
(suggesting that we limit the application of the prohibitions to a
subadviser to a covered investment pool that: (1) Has the ability to
control the soliciting, marketing or acceptance of government
clients; and (2) is not a related person of the investment adviser
or distributor or other investment pool).
\394\ See, e.g., IAA Letter; Skadden Letter. See also sections
2(a)(20) and 15(a) of the Investment Company Act (treating a
subadviser as an adviser to a registered investment company even in
the absence of a direct contractual relationship with the investment
company).
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We are, however, providing some guidance that may assist advisers
in subadvisory and fund of funds arrangements in complying with the
rule.\395\ First, by the terms of the rule, if an adviser or subadviser
makes a contribution that triggers the two-year time out from receiving
compensation, the subadviser or adviser, as applicable, that did not
make the triggering contribution could continue to receive compensation
from the government entity,\396\ unless the arrangement were a means to
do indirectly what the adviser or subadviser could not do directly
under the rule.\397\ Second, advisers to underlying funds in a fund of
funds arrangement are not required to look through the investing fund
to determine whether a government entity is an investor in the
investing fund unless the investment were made in that manner as a
means for the adviser to do indirectly
[[Page 41049]]
what it could not do directly under the rule.\398\
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\395\ See, e.g., IAA Letter (requesting clarification as to how
the rule would apply when an adviser becomes subject to the
compensation ban after hiring a subadviser or vice versa). See also
Fidelity Letter; MFA Letter; SIFMA Letter (each expressing concern
about how the rule would apply in the fund of funds context).
\396\ We understand that, under some advisory arrangements, the
government entity has a contract only with the adviser and not the
subadviser. Under those circumstances, it would be consistent with
the rule for an adviser that has triggered the two-year time out to
pass through to the subadviser that portion of the fee to which the
subadviser is entitled, as long as the adviser retains no
compensation from the government entity and the subadviser (and its
own covered associates) has not triggered a time out as well.
\397\ See Rule 206(4)-5(d). For instance, an adviser that hires
an affiliated subadviser to manage a covered investment pool in
which a government entity invests so that the adviser could make
contributions to that government entity would be doing indirectly
what it would be prohibited from doing directly under the rule. A
subadviser would be providing ``investment advisory services for
compensation to a government entity'' regardless of whether the
subadviser is paid directly by the government entity or by the
adviser.
\398\ See rule 206(4)-5(d).
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(f) Exemptions
An adviser may apply to the Commission for an order exempting it
from the two-year compensation ban.\399\ Under this provision, which we
are adopting as proposed, we can 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, and when
imposition of the prohibition is unnecessary to achieve the rule's
intended purpose. This provision will provide advisers with an
additional avenue by which to seek to cure the consequences of an
inadvertent violation by the adviser that falls outside the limits of
the rule's de minimis exception and exception for returned
contributions,\400\ such as when a disgruntled employee makes a greater
than $350 contribution as he or she exits the firm. In determining
whether to grant an exemption, we will take into account the varying
facts and circumstances that each application presents. Among other
factors, we will 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 rule 206(4)-5; (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.\401\ We intend to apply
these factors with sufficient flexibility to avoid consequences
disproportionate to the violation, while effecting the policies
underlying the rule.
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\399\ 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 rule 206(4)-5.
\400\ See sections II.B.2(a)(6) and (7) of this Release,
describing exceptions to the two-year time out prohibition of the
rule.
\401\ See Rule 206(4)-5(e). 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).
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We received limited comment on this provision. A few commenters
suggested that the operation of the rule should toll until a decision
is made about an applicant's request.\402\ We are concerned that such
an approach could encourage frivolous applications and encourage
applicants to delay the disposition of their applications. As we
explained in the Proposing Release, an adviser seeking an exemption
could place into an escrow account any advisory fees earned between the
date of the contribution triggering the prohibition and the date on
which we determine whether to grant an exemption.\403\ Some commenters
recommended the rule build in a specified length of time for the
Commission to respond to requests for relief.\404\ We recognize that
applications for an exemptive order will be time-sensitive and will
consider such applications expeditiously. We note that the escrow
arrangements discussed above may lessen the hardship on advisers.
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\402\ ICI Letter; Skadden Letter.
\403\ See Proposing Release, at n.199. 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 would be returned to the government entity client. In
contrast, MSRB rule G-37, on which rule 206(4)-5 is based, does not
permit a municipal securities dealer to continue to engage in
municipal securities business with an issuer while an application is
pending. See MSRB Rule G-37 Q&A, Question V.1.
\404\ IAA Letter; ICI Letter; NASP Letter (each suggesting all
applications be granted if they are not acted upon in 30 days);
Skadden Letter (suggesting a 45-day deadline).
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D. Recordkeeping
We are adopting amendments to rule 204-2 to require registered
investment advisers that have government clients, or that provide
investment advisory services to a covered investment pool in which a
government entity investor invests, to make and keep certain records
that will allow us to examine for compliance with new rule 206(4)-
5.\405\ The rule amendments reflect several changes from our proposal,
which are discussed below. These requirements are similar to the MSRB
recordkeeping requirements for brokers, dealers and municipal
securities dealers.\406\
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\405\ Rule 204-2(a)(18) and (h)(1). An adviser is required to
make and keep these records only if it provides investment advisory
services to a government entity or if a government entity is an
investor in any covered investment pool to which the investment
adviser provides investment advisory services. Advisers that solicit
government clients on behalf of other advisers are also subject to
the amended recordkeeping requirements. Advisers that are exempt
from Commission registration under section 203(b)(3) of the Advisers
Act, however, are not subject to the recordkeeping requirements
under amended 204-2 unless they do register with us, although as
discussed earlier, supra note 92 and accompanying text, they are
subject to rule 206(4)-5. Advisers keeping substantially the same
records under rules adopted by the MSRB are not required to keep
duplicate records. Rule 204-2(h)(1).
\406\ MSRB rule G-8(a)(xvi). The MSRB also requires certain
records to be made and kept in accordance with disclosure
requirements that our rule does not contain.
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Amended rule 204-2 requires registered advisers that provide
investment advisory services to a government entity, or to a covered
investment pool in which a government entity is an investor, to make
and keep records of contributions made by the adviser and covered
associates to government officials (including candidates), and of
payments to State or local political parties and PACs.\407\ The
adviser's records of contributions and payments must be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether a
contribution was subject to rule 206(4)-5's exception for certain
returned contributions.\408\ The rule also requires an adviser that has
government clients to make and keep a list of its covered
associates,\409\ and the government entities to which the adviser has
provided advisory services in the past five years.\410\ Similarly,
advisers to covered investment pools must make and keep a list of
government entities that invest, or have invested in the past five
years, in a covered investment pool, including any government entity
that selects a covered investment pool to be an option of a plan or
program of a government entity, such as a 529, 457 or 403(b)
[[Page 41050]]
plan.\411\ An investment adviser, regardless of whether it currently
has a government client, must also keep a list of the names and
business addresses of each regulated person to whom the adviser
provides or agrees to provide, directly or indirectly, payment to
solicit a government entity on its behalf.\412\ The amended rule
reflects several changes from our proposal, which we describe below.
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\407\ Contributions and payments by PACs controlled by the
adviser or a covered associate would also have to be recorded as
these PACs are ``covered associates'' under the rule. Rule 206(4)-
5(f)(2)(iii). See section II.B.2(a)(4) of this Release.
\408\ Rule 204-2(a)(18)(ii).
\409\ The adviser must record the name, title(s), and business
and residence addresses of each covered associate. Rule 204-
2(a)(18)(i)(A).
\410\ Advisers do not have to maintain a record of government
entities that were clients before the effective date. For additional
information regarding the implementation of rule 206(4)-5, see
section III of this Release.
\411\ Amended rule 204-2 does not require an adviser to a
covered investment pool that is an option of a government plan or
program to make and keep records of participants in the plan or
program, but only the government entity. See supra note 374.
Consistent with changes we have made to the definition of covered
investment pool, we note that an adviser's recordkeeping obligations
with respect to a registered investment company apply only if such
an investment company is an option of a plan or program of a
government entity. See section II.B.2(e) of this Release.
\412\ Rule 204-2(a)(18)(i)(D).
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First, in response to comments,\413\ we have limited the rule to
provide that only records of contributions,\414\ not payments,\415\ to
government officials and candidates are required to be kept under the
rule.\416\ We have made this change because, unlike contributions,
which are one type of payment, all payments do not trigger the two-year
time out. As a result of this change, the recordkeeping obligations
better reflect the activities of an adviser or a covered associate that
could result in the adviser being subject to the two-year time out.
Commenters also argued that we should not require, as proposed,
advisers to maintain records of payments to PACs.\417\ Although those
payments do not trigger application of the two-year time out, payments
to PACs can be a means for an adviser or covered associate to funnel
contributions to a government official without directly contributing.
We are, therefore, adopting the amendment to require advisers to keep
records of payments to PACs as these records will allow our staff to
identify situations that might suggest an intent to circumvent the
rule.\418\
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\413\ Fidelity Letter; IAA Letter; SIFMA Letter.
\414\ See supra note 153 and accompanying text (defining
``contribution'').
\415\ See supra note 331 (defining ``payment'').
\416\ Rule 204-2(a)(18)(i)(C).
\417\ See, e.g., IAA Letter; SIFMA Letter.
\418\ Accordingly, as part of a strong compliance program, an
adviser or covered associate that receives a general solicitation to
make a contribution to a PAC should consider inquiring about how the
collected funds would be used to determine whether the PAC is
closely associated with a government official to whom a direct
contribution would subject the adviser to the two-year time out. See
section II.B.2(d) of this Release and rule 206(4)-5(d). The MSRB
takes a similar approach regarding whether a payment to a PAC is an
indirect contribution to a government official. See MSRB Rule G-37
Q&A, Questions III.4 and III.5.
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Second, an investment adviser to a registered investment company
must maintain records identifying government entity investors only if
the investments are made as part of a plan or program of a government
entity or provide participants in the plan or program with the option
of investing in the fund.\419\ This change would narrow the records
required to those necessary to support the rule as modified from our
proposal, and we believe addresses commenters' concerns regarding the
ability of advisers to registered investment companies to identify
government entity investors.\420\ As discussed above, we believe it is
reasonable to expect advisers to know the identity of the government
entity when a registered fund they advise is part of a plan or program.
In addition, as commenters suggested, we are providing a substantial
transition period for advisers to registered investment companies that
should allow these advisers to make the necessary changes to account
documents and systems to allow them to identify government entities
that provide one or more of the investment companies they advise as an
investment option.\421\
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\419\ Rule 204-2(a)(18)(i)(B). Amended rule 204-2 does not
require an adviser to a covered investment pool that is an option of
a government plan or program to make and keep records of
participants in the plan or program, but only the government entity.
For a discussion of the application of the rule to a covered
investment pool that is an option of a government plan or program,
see supra note 371 and accompanying text. Consistent with changes we
have made to the definition of covered investment pool, we note that
an adviser's recordkeeping obligations with respect to a registered
investment company apply only if such an investment company is an
option of a plan or program of a government entity. See section
II.B.2(e) of this Release.
\420\ Advisers to covered investment pools that are relying on
Investment Company Act exclusions in sections 3(c)(1), 3(c)(7) and
3(c)(11) must identify government entity investors regardless of
whether they are an investment option of a plan or program of a
government entity. Rule 204-2(a)(18)(i)(B).
\421\ See section III of this Release.
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Third, the amended rule requires an adviser to maintain a list of
only those government entities to which it provides, or has provided in
the past five years, investment advisory services.\422\ We are not
requiring, as proposed, a list of government entities the adviser
solicited for advisory business.\423\ Some commenters expressed
concerns about the potential scope of this requirement and noted that
solicitation does not trigger rule 206(4)-5's two-year time out, rather
it is providing advice for compensation that does so.\424\ In light of
these concerns, and the record before us today, we are not requiring
advisers to maintain lists of government entities solicited that do not
become clients.
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\422\ See rule 204-2(a)(18)(i)(B).
\423\ See proposed rule 204-2(a)(18)(i)(B).
\424\ Dechert Letter; SIFMA Letter; Skadden Letter.
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Fourth, as discussed above, rule 206(4)-5 permits an adviser to use
certain third parties to solicit on its behalf. We are, therefore,
requiring that advisers that provide or agree to provide, directly or
indirectly, payment to advisers or broker-dealers registered with the
Commission that act as regulated persons under rule 206(4)-5 to
maintain a list of the names and business addresses of each such
regulated person.\425\ These records will enable the Commission's staff
to review and compare the regulated person's records to those of the
adviser that hired the regulated person.
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\425\ Rule 204-2(a)(18)(i)(D). If an adviser does not specify
which types of clients the regulated person should solicit on its
behalf (e.g., that it should only solicit government entities), the
adviser could satisfy this requirement by maintaining a list of all
of its regulated person solicitors. Supra note 412.
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Finally, the amendments require advisers to make and keep records
of their covered associates, and their own and their covered
associates' contributions, only if they provide advisory services to a
government client.\426\ Commenters had expressed concerns that
requiring advisers with no government business to make and keep these
records could be unnecessarily intrusive to employees and burdensome on
advisers.\427\ In light of those concerns, and the record before us
today, we are not requiring advisers with no government business to
make and keep these records.\428\ As a consequence, an adviser with no
government clients would not have to require employees to report their
political contributions.
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\426\ Rule 204-2(a)(18)(iii).
\427\ IAA Letter; Dechert Letter; SIFMA Letter.
\428\ Although advisers that do not have government entity
clients are not required to maintain records under the amendments,
the look-back requirements of rule 206(4)-5 continue to apply. As a
result, an adviser that has not maintained records of the firm's and
its covered associates' contributions would have to determine
whether any contributions by the adviser, its covered associates,
and any former covered associates would subject the firm to the two-
year time out prior to accepting compensation from a new government
entity client. The same applies to newly-formed advisers. The
records an adviser develops during this determination process, would
fall under the adviser's obligation to maintain records of all
direct or indirect contributions made by the investment adviser or
its covered associates to an official of a government entity, or
payments to a political party of a State or political subdivision
thereof, or to a political action committee. Rule 204-
2(a)(18)(i)(C).
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E. Amendment to Cash Solicitation Rule
We are adopting, as proposed, a technical amendment to rule 206(4)-
3 under the Advisers Act, the ``cash solicitation rule.'' That rule
makes it
[[Page 41051]]
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.\429\
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\429\ 17 CFR 275.206(4)-3.
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Paragraph (iii) of the cash solicitation rule contains general
restrictions on third-party solicitors that cover solicitation
activities directed at any client, regardless of whether it is a
government entity client. New paragraph (e) to rule 206(4)-3 alerts
advisers and others that special prohibitions apply to solicitation
activities involving government entity clients under rule 206(4)-
5.\430\
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\430\ Rule 206(4)-3(e). We received no comments on this proposed
amendment.
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III. Effective and Compliance Dates
Rule 206(4)-5 and the amendments to rules 204-2 and 206(4)-3 are
effective on September 13, 2010. Investment advisers subject to rule
206(4)-5 must be in compliance with the rule on March 14, 2011.
Investment advisers may no longer use third parties to solicit
government business except in compliance with the rule on September 13,
2011.\431\ Advisers to registered investment companies that are covered
investment pools must comply with the rule by September 13, 2011.\432\
Advisers subject to rule 204-2 must comply with amended rule 204-2 on
March 14, 2011. However, if they advise registered investment companies
that are covered investment pools, they have until September 13, 2011
to comply with the amended recordkeeping rule with respect to those
registered investment companies.
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\431\ Rule 206(4)-5(a)(2).
\432\ Rule 206(4)-5(f)(3).
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A. Two-Year Time Out and Prohibition on Soliciting or Coordinating
Contributions
We are providing advisers with a six month transition period to
give them time to identify their covered associates and current
government entity clients and to modify their compliance programs to
address new compliance obligations under the rule.\433\ Accordingly,
rule 206(4)-5's prohibition on providing advisory services for
compensation within two years of a contribution will not apply to, and
the rule's prohibition on soliciting or coordinating contributions will
not be triggered by contributions made before March 14, 2011.\434\ We
believe that the length of the transition period should address
commenters' concerns that advisers have sufficient time to implement
policies and procedures regarding contributions to avoid violations of
the rule and that the rule not affect the 2010 elections for which some
advisory personnel may already have committed to make political
contributions.\435\
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\433\ Section III.D of this Release addresses when advisers to
``covered investment pools'' that are registered investment
companies must comply with the rule; section III.E of this Release
addresses transition considerations specific to certain other pooled
investment vehicles.
\434\ Likewise, these prohibitions do not apply to contributions
made before March 14, 2011 by new covered associates to which the
look back applies. See section II.B.2(a)(5) of this Release for a
discussion of the rule's look-back provision. For example, if an
individual who becomes a covered associate of an adviser on or after
March 14, 2011 made a contribution before March 14, 2011, that new
covered associate's contribution would not trigger the two-year time
out for the adviser. On the other hand, if an individual who later
becomes a covered associate made the contribution on or after March
14, 2011, the contribution would trigger the two-year time out for
the adviser if it were made less than, as applicable, six months or
two years before the individual became a covered associate.
\435\ Commenters recommended that we provide advisers with six
months to one year as a transition for rule 206(4)-5. See Davis Polk
Letter; MFA Letter; ICI Letter; IAA Letter; NASP Letter; Skadden
Letter.
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B. Prohibition on Using Third Parties To Solicit Government Business
and Cash Solicitation Rule Amendment
Advisers must comply with the new rule's prohibition on making
payments to third parties to solicit government entities for investment
advisory services on September 13, 2011.\436\ Before this compliance
date, advisers are not prohibited by the rule from making payments to
third-party solicitors regardless of whether they are registered as
broker-dealers or investment advisers.\437\
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\436\ Rule 206(4)-5(a)(2).
\437\ We note, however, that the antifraud provisions of the
Federal securities laws continue to apply during the transition
period.
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We have provided an extended transition period to provide advisers
and third-party solicitors with sufficient time to conform their
business practices to the new rule, and to revise their compliance
policies and procedures to prevent violation of the new rule. In
addition, the transition period will provide an opportunity for a
registered national securities association to propose a rule that would
meet the requirements of rule 206(4)-5(f)(9)(ii)(B) and for the
Commission to consider such a rule. If, after one year, a registered
national securities association has not adopted such rules, advisers
would be prohibited from making payments to broker-dealers for
distribution or solicitation activities with respect to government
entities, but would be permitted to make payments to registered
investment advisers that meet the definition of ``regulated person''
under the rule.\438\ We understand from our staff, however, that FINRA
plans to act within the timeframe; if they do not, we will consider
whether we should take further action.
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\438\ See rule 206(4)-5(f)(9)(i).
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Finally, the compliance date for the technical amendment to the
cash solicitation rule, rule 206(4)-3, which is intended to alert
advisers that rule 206(4)-5 is applicable to solicitations of a
government entity, is one year from the effective date, as the
amendment to the cash solicitation rule need only be operative when
rule 206(4)-5's third-party solicitor provisions are in effect.
C. Recordkeeping
As discussed above, the amendments to rule 204-2 apply only to
investment advisers with clients who are government entities. Such
advisers must comply with the amended rule on March 14, 2011 except as
noted below. By March 14, 2011, these advisers must begin to maintain
records of all persons who are covered associates under the rule and
keep records of political contributions they make on and after that
date. Advisers must also make and keep a record of all government
entities that they provide advisory services to on and after March 14,
2011. Advisers are not, however, required to look back for the five
years prior to the effective date to identify former government
clients. Advisers that pay regulated persons to solicit government
entities for advisory services on their behalf must make and keep a
list of those persons beginning on and after September 13, 2011.\439\
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\439\ Rule 204-2(a)(18)(i)(D).
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D. Registered Investment Companies
Advisers to registered investment companies that are ``covered
investment pools'' under the rule \440\ must comply with rule 205(4)-5
with respect to those covered pools September 13, 2011. During the
transition period, contributions by the adviser or its employees to
government entity clients that have selected an adviser's registered
investment company as an investment option of a plan or program will
not trigger the prohibitions of rule 206(4)-5.\441\
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\440\ A registered investment company is only a covered
investment pool if it is an investment option of a plan or program
of a government entity, such as a 529 plan, 403(b) plan or 457 plan.
See rule 206(4)-5(f)(3).
\441\ Advisers to covered investment pools other than registered
investment companies--i.e., companies that would be investment
companies under section 3(a) of the Investment Company Act but for
the exclusion provided from that definition by either section
3(c)(1), section 3(c)(7) or section 3(c)(11)--are subject to the
six-month transition period. We believe advisers to these types of
funds, because the interests in them are typically held in the name
of the investor, should be able to identify government entities
without significant difficulty.
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[[Page 41052]]
We have provided for an extended compliance date to respond to
concerns expressed by commenters that an adviser to a registered
investment company may require additional time to identify government
entities that have selected that registered investment company as an
investment option when shares of the fund are held through omnibus
arrangements such that the identity of the fund investor is not readily
available to the adviser.\442\ The changes we have made to the proposed
rule that limit the application of the two-year time out with respect
to registered investment companies to those that are options in a plan
or program of a government entity,\443\ together with this extended
compliance date should provide advisers to registered investment
companies sufficient time to put into place those system enhancements
or business arrangements, such as those with intermediaries, that may
be necessary to identify those government plans or programs in which
the funds serve as investment options.\444\
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\442\ See ICI Letter; T. Rowe Price Letter.
\443\ See section II.B.2(a) of this Release.
\444\ A few commenters recommended that the rule apply only to
new government investors in registered investment companies after
the effective date of the rule. See ICI Letter; T. Rowe Price
Letter. We do not believe this would be appropriate because pay to
play can be just as troubling in the context of an adviser renewing
an advisory contract (or including a registered investment company
as an investment option in a plan or program) as one that is
endeavoring to obtain business for the first time.
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As noted above, we are providing for an extended compliance date
for advisers that manage registered investment companies that are
covered investment pools under the rule, which we are applying, for the
same reasons, to recordkeeping obligations that arise as a result of
those covered investment pools. Thus, advisers to these covered
investment pools must make and keep a record of all government entity
investors on and after September 13, 2011.\445\
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\445\ Amended rule 204-2 does not require an adviser to a
covered investment pool that is an option of a government plan or
program to make and keep records of participants in the plan or
program, but only the government entity. See supra note 411.
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IV. Cost-Benefit Analysis
We are sensitive to the costs and benefits imposed by our rules,
and understand that there will be costs associated with compliance with
rule 206(4)-5 and the amendments to rule 204-2.\446\ We recognize that
the rule and amendments will place burdens on advisers that provide or
seek to provide advisory services to government entities, and that
advisers may in turn choose to limit 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 believe there are practical, cost-
effective means to comply with the rule without an adviser imposing a
blanket ban on political contributions by its covered associates. We
have closely drawn the rule, and modified it based on comments
received, to achieve our goal of addressing adviser participation in
pay to play practices, while seeking to limit the burdens imposed by
the rule.
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\446\ As proposed, we are also making a conforming technical
amendment to rule 206(4)-3 to address potential areas of conflict
with proposed rule 206(4)-5. We do not believe that this technical
amendment affects the costs associated with the rulemaking. It will
benefit advisers because it provides clarity about the application
of our rules when they potentially overlap.
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The rule and rule amendments are designed to address pay to play
practices by investment advisers that provide advisory services to
government entity clients and to certain covered investment pools in
which a government entity invests. The rule prohibits 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 rule also prohibits an adviser from
providing or agreeing to provide, directly or indirectly, payment to
any third party that is not a ``regulated person'' 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 rule prevents an adviser
from coordinating or soliciting from others contributions to certain
elected officials or candidates or payments to certain political
parties. The rule applies both to advisers registered with us (or
required to be registered) and those 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)). Our amendment to rule 204-2 requires a
registered adviser to maintain certain records of the political
contributions made by the adviser or certain of its executives or
employees, as well as records of the regulated persons the adviser pays
or agrees to pay to solicit government entities on the adviser's
behalf.
In the Proposing Release, we requested 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.\447\ We requested that commenters provide analysis
and empirical data to support their views on the costs and benefits
associated with the proposal. For example, we requested comment on the
costs of establishing compliance procedures to comply with the proposed
rule, both on an initial and ongoing basis and on the costs of using
compliance procedures of an affiliated broker-dealer that the broker-
dealer established as a result of MSRB rules G-37 and G-38. In
addition, we requested 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. Finally,
in the context of the objectives of this rulemaking, we sought comments
that address whether these rules will promote efficiency, competition
and capital formation, and what effect the rule would have on the
market for investment advisory services and third-party solicitation
services.
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\447\ Proposing Release, at section III.C.
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We received approximately 250 comment letters on the proposal.
Almost all of the commenters agreed that pay to play is a serious issue
that should be addressed. One commenter stated that ``the benefits
derived from the application of pay to play limitations to public
sector advisory services will far outweigh any temporary dislocations
that may occur as private and public sector professionals make the
necessary adjustments to their activities to transition to the
Commission's new standards.'' \448\ Many, however, expressed concern
about costs,\449\ particularly those related to the proposed ban on
payments to third parties. Some suggested that the
[[Page 41053]]
Commission underestimated the costs of compliance with the rule and
rule amendments.\450\ As discussed below, many of the commenters that
did comment specifically on the costs and benefits of the proposal did
not provide empirical data to support their views.
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\448\ MSRB Letter. See also Thompson Letter; Common Cause
Letter; Fund Democracy/Consumer Federation Letter (each identifying
benefits of the rule).
\449\ See, e.g., Davis Polk Letter (generally commenting that
any benefits of the proposed rule were outweighed by its likely
costs). See also ICI Letter; Monument Group Letter.
\450\ See, e.g., SIFMA Letter (``While SIFMA believes that
addressing practices that potentially undermine the merit-based
selection of investment advisers is an important and laudable
effort, the SEC appears to have underestimated the compliance costs
the Proposed Rule will impose on covered parties.''); ICI Letter
([I]n relying on the estimates for compliance with the MSRB rules,
the Commission significantly underestimates the compliance and
recordkeeping burdens associated with the proposed rule.''); Davis
Polk Letter (``We believe that the Commission may have substantially
underestimated the number of investment advisers that will be
affected by the Proposed Rule and its costs and market effects in
concluding that many of the aspects of the Rule would impose only
minimal additional costs and burdens on investors and investment
advisers.''). The commenters who addressed our estimates, however,
did so in general terms and did not provide specific suggestions as
to how they should be modified. See the discussion below regarding
changes from the proposed rule that we believe mitigate some of the
costs.
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A. Benefits
As we discuss extensively throughout this Release, we expect that
rule 206(4)-5 will yield several important direct and indirect
benefits. Overall, the 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. We believe that rule 206(4)-5 will
reduce the occurrence of fraudulent conduct resulting from pay to play
and thus will achieve its goals of protecting public pension plans,
beneficiaries, and other investors from the resulting harms. One
commenter who agreed with us commended the proposed rule as a ``strong
start in controlling corruption, balancing the rights of the advisors
and their executives with the very real detriment to the public which
the numerous cases of pay-to-play involving public pension funds and
other public entities have caused.'' \451\
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\451\ Common Cause Letter.
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Addressing 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. One commenter who
agreed, observed, ``[w]hen lucrative investment contracts are awarded
to those who pay to play, public pension funds may end up receiving
substandard services and higher fees, resulting in lower earnings.''
\452\ One public official commenter detailed the role of pay to play
arrangements in the selection of public pension fund managers and the
harm it can inflict on the affected plans,\453\ while other officials
wrote to us explicitly expressing support for a Commission rule.\454\
By addressing pay to play practices, we will help level 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 the quality of their advisory services. These benefits, although
difficult to quantify, could result in substantial savings and better
performance for the public pension plans, their beneficiaries, and
participants.\455\ Two commenters noted that the rule would promote the
interests of plan beneficiaries.\456\
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\452\ Bloomberg Letter.
\453\ Weber Letter (``I have seen money managers awarded
contracts with our fund which involved payments to individuals who
served as middlemen, creating needless expense for the fund. These
middlemen were political contributors to the campaigns of board
members who voted to contract for money management services with the
companies who paid them as middlemen.''). See also Pohndorf Letter
(noting that when the sole trustee of a major pension fund changed
several years ago, a firm managing some of the fund's assets ``began
to receive invitations to fundraising events for the new trustee
with suggested donation amounts''); Tobe Letter (suggesting the
negative effects of pay to play activities on the Kentucky
Retirement System's investment performance).
\454\ See, e.g., DiNapoli Letter; Bloomberg Letter.
\455\ According to the most recently available US census data,
as of 2008, there are 2,550 State and local government employee
retirement systems. http://www.census.gov/govs/retire/. See also
Fund Democracy/Consumer Federation Letter (``These practices
adversely affect the economic interests of millions of America's
public servants.'').
\456\ Comment Letter of John C. Emmel (Sept. 18, 2009) (``one
more step to foster a level playing field for investors * * * where
advisors' priorities trump those of the investing public''); Comment
Letter of George E. Kozel (Aug. 31, 2009) (``Kozel Letter'')
(``Their interests lie in obtaining the highest fees not in
producing benefits for the pensioners. * * *'').
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By leveling the playing field among advisers competing for State
and local government business, the rule will help minimize or eliminate
manipulation of the market for advisory services provided to State and
local governments.\457\ For example, direct political contributions or
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.\458\ They
also increase costs for firms that may feel they have no alternative
but to pay to play. The rule addresses a collective action problem
created by this dynamic analogous to the one identified in the Blount
opinion.\459\ One commenter emphasized the importance of restoring
public confidence in the investment activities of all public pension
funds.\460\ Indeed, at its core, the rulemaking addresses practices
that undermine the integrity of the market for advisory services, as
underscored by another commenter.\461\
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\457\ See DiNapoli Letter (advocating for a ``level playing
field for investors and investment advisers that protects the
integrity of the decision-making process [for hiring an investment
adviser]''); Bloomberg Letter (``Pay to play practices clearly
undermine the open competitive process by which government contracts
are to be awarded.'').
\458\ See supra note 453.
\459\ See Blount, 61 F.3d at 945-46 (discussing the harms of pay
to play: ``Moreover, there appears to be a collective action problem
tending to make the misallocation of resources persist.''). See also
text accompanying notes 291-294 of this release. Collective action
problems are a class of market failures calling for a regulatory
response, and exist, for example, where participants may prefer to
abstain from an unsavory practice (such as pay to play), but
nonetheless participate out of concern that, even if they abstain,
their competitors will continue to engage in the practice profitably
and without adverse consequences.
\460\ Thompson Letter. See also Bloomberg Letter.
\461\ Common Cause Letter (``Pay-to-play has not only the
potential to compromise an investment adviser's ethical and legal
duties under the Investment Advisers Act of 1940, but in several
high profile cases across the nation, has already done so,
negatively impacting the public perception of government decision
making and, in some cases, costing the taxpayer millions of dollars
and placing billions of dollars in pension funds at risk.''). See
also Dempsey Letter (noting applause for efforts ``to stop the `pay-
to-play' practice which only serves to undermine public trust in
investment advisors and regulators'').
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Allocative efficiency is enhanced when government clients award
advisory business to advisers that compete based on price, performance
and service and not the influence of pay to play, which in turn enables
advisory firms, particularly smaller advisory firms, to compete on
merit, rather than their ability or willingness to make
contributions.\462\ In addition, taking into account the effects of
analogous practices in the underwriting of municipal securities prior
to MSRB rule G-37,\463\ we believe a merit-based competitive process
may result in the allocation of public pension monies to different
advisers who may well deliver better investment performance and lower
advisory fees than those advisers
[[Page 41054]]
whose selection was influenced by pay to play.
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\462\ See Comment Letter of Budge Collins (Sept. 30, 2009) (the
rule would ``level the playing field for the rest of us who have
never made contributions to elected officials who sit on investment
management committees'').
\463\ One commenter cited a study containing evidence that
before rule G-37 was adopted, underwriters' pay to play practices
distorted underwriting fees as well as which firms were hired by
government issuers. See Butler Letter.
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As adopted, the rule contains a prohibition against advisers
directly or indirectly compensating a third party to solicit government
entities on its behalf, unless the third-party solicitor is a
``regulated person'' subject to pay to play restrictions. This
exception enables advisers and pension plans (and their beneficiaries)
to continue to benefit from the services of third-party solicitors,
such as the placement of interests in private funds, while at the same
time benefitting from a Commission rule that prohibits pay to play
practices.\464\
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\464\ Commenters, both on the Proposing Release and our 1999
proposal, argued that treating third-party solicitors as covered
associates would create significant compliance challenges because
these solicitors were not controlled by advisers. See supra note 264
and accompanying text.
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Our rule may also benefit pension plans by preventing harms that
can result when an adviser is not negotiating at arm's length with a
government official. For example, as a result of pay to play, an
adviser may 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.\465\ Additionally, taxpayers may benefit from our rule
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.\466\
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\465\ See supra note 55 and accompanying text.
\466\ See Kozel Letter (supporting the Commission's proposal and
asserting that the persons who engage in pay to play practices know
that any shortfalls would be covered by taxpayers); Bloomberg Letter
(``Because the City is legally obligated to make up any short fall
in the pension system assets to ensure full payment of pension
benefits, pay to play practices can potentially harm all New
Yorkers.''). See also Common Cause Letter; 1997 Survey, supra note 8
(``[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'').
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In addition to the general benefits of addressing pay to play
practices by investment advisers noted above, we believe the specific
provisions of the rule, including the two-year time out, the ban on
using third parties to solicit government business, and the
restrictions on soliciting and coordinating contributions and payments
will likely result in similar benefits to those that have resulted from
MSRB rules G-37 and G-38, on which our rule is closely modeled. The
MSRB rules have prohibited municipal securities dealers from
participating in pay to play practices since 1994.\467\ As we have
stated previously, we believe these rules have significantly curbed pay
to play practices in the municipal securities market, and are likely to
be similarly effective in deterring pay to play activities by
investment advisers.\468\
---------------------------------------------------------------------------
\467\ MSRB rule G-37 was approved by the Commission and adopted
by the MSRB in 1994. See supra note 66.
\468\ See supra notes 101-107 and accompanying text.
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Applying the 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 will extend
the same benefits regardless of whether an adviser subject to the 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 are providing
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 amendments to rule 204-2 will 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 will benefit from these
amendments because the records required to be kept will provide
Commission staff with information to review an adviser's compliance
with rule 206(4)-5 and thereby may promote improved compliance.
Advisers will benefit from the amendments to the recordkeeping rule as
these records will assist the Commission in enforcing the rule against,
for example, a competitor whose pay to play activities, if not
uncovered, could adversely affect the competitive position of a
compliant adviser.
B. Costs
We acknowledge that the rule and rule amendments will impose costs
on advisers that provide or seek to provide advisory services to
government clients directly, or indirectly through pooled investment
vehicles. We discuss these costs below, along with a number of
modifications we have made to the proposed rule and proposed amendments
that will reduce costs.
1. Compliance Costs Related to Rule 206(4)-5
Rule 206(4)-5 requires an adviser with government clients to incur
costs to monitor contributions made by the adviser and its covered
associates and to establish procedures to comply with the rule. The
initial and ongoing compliance costs imposed by the rule will vary
significantly among firms, depending on a number of factors. Our
estimated compliance costs, discussed below, take into account
different ways a firm might comply with the rule. These factors include
the number of covered associates of the adviser, the degree to which
compliance procedures are automated (including policies and procedures
that could require pre-clearance), the extent to which an adviser has a
pre-existing policy under its code of ethics or compliance
program,\469\ and whether the adviser is affiliated with a broker-
dealer firm that is subject to MSRB rules G-37 and G-38. A smaller
adviser, for example, will likely have a small number of covered
associates, and thus expend less resources to comply with the rule and
rule amendments than a larger adviser.
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\469\ One commenter stated that many investment advisers already
have pay to play policies and procedures in place within the
framework of their codes of ethics. See IAA Letter (advocating for
regulation that would address pay to play practices through an
adviser's code of ethics, as an alternative to the approach taken in
proposed rule 206(4)-5).
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Although a larger adviser is likely to spend more resources to
comply with the rule, based on staff observations, a larger adviser is
more likely to have an affiliated broker-dealer that is required to
comply with MSRB rules G-37 and G-38.\470\ As we learned from a broker-
[[Page 41055]]
dealer with an investment adviser affiliate that commented on our 1999
proposal, ``the more the Rule mirrors G-37, the more firms can borrow
from or build upon compliance procedures already in place. * * *''\471\
Accordingly, we believe some advisers with broker-dealer affiliates may
spend fewer resources to comply with the rule and rule amendments. We
recognize, as some commenters pointed out, that MSRB rules G-37 and G-
38 compliance systems may not be easily extensible in all cases, and we
acknowledge that the range of efficiencies created in these
circumstances will vary.\472\ A prominent concern of these commenters
related to a proposed recordkeeping amendment which would have required
advisers to keep records of solicitations-- something that is not
required under MSRB recordkeeping rule G-8. As previously discussed, we
are not adopting that proposed amendment, which may address the concern
noted by commenters.
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\470\ According to registration information available from
Investment Adviser Registration Depository (``IARD'') as of April 1,
2010, there are 1,332 SEC-registered investment advisers (or 11.48%
of the total 11,607 registered advisers) that indicate in Item
5.D.(9) of Form ADV that they have State or municipal government
clients. Of those 1,332 advisers, 113 (or 85.0%) of the largest 10%
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. 204 of the largest 20% (or 76.7%)
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. Conversely, only 40 (or 30.1%) of the
smallest 10% have one or more affiliated broker-dealers or are,
themselves, also registered as a broker-dealer; and only 67 of the
smallest 20% (or 25.2%) 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.
Also, as one commenter asserted, private fund managers may be among
the larger advisers, based on assets under management, but they are
unlikely to have an affiliated broker-dealer that has already
adopted similar procedures to comply with MSRB rules G-37 and G-38
because most private fund managers are not involved in municipal
underwriting. MFA Letter. We acknowledge that a private fund manager
generally would be less likely to have an affiliated broker-dealer
from which it can borrow or build upon compliance procedures;
however, we also expect that a private fund manager would use less
resources than other large registered advisers to comply with the
rule because a private fund manager is not subject to rule 206(4)-7,
the Advisers Act compliance rule, and would likely have fewer
employees and covered associates than a larger organization.
\471\ Comment Letter of US Bancorp Piper Jaffray Inc. (now,
``Piper Jaffray & Co.'') (Nov. 15, 1999).
\472\ SIFMA Letter. See also ICI Letter.
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We anticipate that advisory firms subject to rule 206(4)-5 will
develop compliance procedures to monitor the political contributions
made by the adviser and its covered associates.\473\ We estimate that
the costs imposed by the rule will be higher initially, as firms
establish and implement procedures and systems to comply with the rule
and rule amendments. We expect 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.
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\473\ Investment advisers registered with the Commission are
required to adopt and implement policies and procedures reasonably
designed to prevent violation by the adviser or its supervised
persons of the Advisers Act and the rules the Commission has adopted
thereunder. See rule 206(4)-7.
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We estimate that approximately 1,697 investment advisers registered
with the Commission may be affected by the rule and rule
amendments.\474\ Of the 1,697 advisers, we estimate that approximately
1,271 advisers have fewer than five covered associates that would be
subject to the rule (each, a ``smaller firm''); approximately 304
advisers have between five and 15 covered associates (each, a ``medium
firm''); and approximately 122 advisers have more than 15 covered
associates that would be subject to the prohibitions of the rule (each,
a ``larger firm'').\475\
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\474\ This estimate is based on registration information from
IARD as of April 1, 2010, applying the same methodology as in the
Proposing Release. As previously noted, according to responses to
Item 5.D(9) of Part 1 of Form ADV, 1,332 advisers have clients that
are State or municipal government entities, which represents 11.48%
of all advisers registered with us. 10,275 advisers have not
responded that they have clients that are State or municipal
government entities. Of those, however, responses to Item 5.D(6) of
Part 1 of Form ADV indicate that 2,486 advisers have some clients
that are other pooled investment vehicles. Estimating that the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 285 of these advisers would be subject to the rule
(2,486 x 11.48% = 285). Out of the 10,275 that have not responded
that they have clients that are State or municipal government
entities, after backing out the 2,486 which have clients that are
other pooled investment vehicles, responses to Item 5.D(4) of Part 1
of Form ADV indicate that 699 advisers have some clients that are
registered investment companies. Estimating that roughly the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 80 of these advisers would be subject to the rule (699
x 11.48% = 80). Although we limited the application of rule 206(4)-5
with respect to registered investment companies to those that are
investment options of a plan or program of a government entity, we
continue to estimate that 80 advisers would have to comply with the
recordkeeping provisions because of the difficulty in further
delineating this estimated number. Therefore, we estimate that the
total number of advisers subject to the rule would be: 1,332
advisers with State or municipal clients + 285 advisers with other
pooled investment vehicle clients + 80 advisers with registered
investment company clients = 1,697 advisers subject to rule. We
expect certain additional advisers may incur compliance costs
associated with rule 206(4)-5. We anticipate some advisers may be
subject to the rule because they solicit government entities on
behalf of other investment advisers. Additionally, some advisers
that do not currently have government clients may seek to obtain
them in the future. In doing so, they likely would conduct due
diligence to confirm they would not be prohibited from receiving
compensation for providing investment advisory services to the
government client.
\475\ This estimate is based on registration information from
IARD as of April 1, 2010. These estimates are based on IARD data,
specifically the responses to Item 5.B.(1) of Form ADV, that 997 (or
74.9%) of the 1,332 registered investment advisers that have
government clients have fewer than five employees who perform
investment advisory functions, 239 (or 17.9%) have five to 15 such
employees, and 96 (or 7.2%) have more than 15 such employees. We
then applied those percentages to the 1,697 advisers we believe will
be subject to the proposed rule for a total of 1,271 smaller, 304
medium and 122 larger firms.
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One commenter disagreed with us basing our cost estimates on an
assumption that most registered advisers would have fewer than five
covered associates because the commenter expects most advisers to
require all or most of their employees to receive approval prior to
making any political contributions in order to avoid inadvertently
triggering the rule.\476\ Although the rule does not require this
approach and the changes we have made to the rule (e.g., modified
definition of covered associate) should help address the concerns of
this commenter that led to the assertion, we recognize that some
advisers may voluntarily restrict all of their employees' political
contributions in such a manner. This type of pre-screening process
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. We also received a comment
that our estimates should take into account turnover of personnel.\477\
Our cost estimate assumes a certain level of turnover; although these
categories are based on an adviser's number of covered associates, we
have not calculated per-covered associate costs associated with this
rulemaking. The categories of smaller, medium and larger advisers are
based on an estimated number of covered associates, but are not
intended to represent a static population of covered associates within
each category. For instance, in estimating the ongoing burdens on
advisers to comply with the rule, we implicitly incorporated a greater
degree of turnover at larger advisers in estimating that they would
incur 1,000 hours annually as compared to the estimated 10 hours for a
small adviser.
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\476\ See MFA Letter.
\477\ ICI Letter.
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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 rule 206(4)-5.\478\ 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).\479\ Applying the same
[[Page 41056]]
principles we used with respect to registered investment advisers, we
estimate that 230 of those advisers manage pooled investment vehicles
in which government client assets are invested and would therefore be
subject to the rule.\480\ For purposes of this analysis, it is assumed
that each unregistered advisory firm that would be subject to the rule
would either be a smaller firm or a medium firm in terms of number of
covered associates because it is unlikely that an adviser that operates
outside of public view and is limited to fewer than 15 clients \481\
would have a large number of advisory personnel that would be covered
associates. One commenter agreed that most of these unregistered
advisers would be small, although the commenter based its assessment on
assets under management, not on the adviser's likely number of covered
associates.\482\
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\478\ The amendments to rules 204-2 and 206(4)-3, however, only
apply to advisers that are registered, or required to be registered,
with the Commission.
\479\ This number is based on our review of registration
information on IARD as of April 1, 2010, 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.
\480\ 11.48% of 2000 is 230. See supra note 474.
\481\ See section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)] (advisers who rely on this exception from registration must
have fewer than 15 clients in a 12-month period) .
\482\ 3PM Letter.
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Some commenters asserted that our estimated number of advisers
subject to the proposed rule was too low.\483\ One claimed that the
number of advisory firms exempted from registration in reliance on
Section 203(b)(3) may be ``over two times our estimate,'' but provided
statistics about the number of unregistered pooled investment vehicles,
not the number of advisers to those pools.\484\ Other commenters did
not provide empirical data or suggest alternative formulas by which to
recalculate our estimate. Additionally, another seemed to misunderstand
our estimates.\485\
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\483\ See Davis Polk Letter; MFA Letter; 3PM Letter.
\484\ 3PM Letter. See also Davis Polk Letter (citing to 3PM
Letter on this proposition).
\485\ Davis Polk Letter (suggesting that we failed to take into
account the costs likely to be borne by unregistered investment
advisers). See supra notes 479 and 480 and accompanying text;
Proposing Release, nn.219-20 and accompanying text (providing an
estimate of the number of unregistered advisers we expect to be
subject to this rule, and that must develop compliance systems).
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As we stated in the Proposing Release,\486\ although the time
needed to comply with the rule will vary significantly from adviser to
adviser, as discussed in detail below, the Commission staff estimates
that firms with government clients will spend between 8 hours and 250
hours to establish policies and procedures to comply with the rule.
Commission staff further estimates that ongoing compliance with the
rule will require between 10 and 1,000 hours annually. In addition,
advisory firms may incur one-time costs to establish or enhance current
systems to assist in their compliance with the 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.
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\486\ See Proposing Release, at section III.B.
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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 $294, including benefits, and for compliance clerks, $59 per hour,
including benefits.\487\ To establish and implement adequate compliance
procedures, we estimate that the rule would impose initial compliance
costs of approximately $2,352 per smaller firm,\488\ approximately
$29,407 per medium firm,\489\ and approximately $58,813 per larger
firm.\490\ It is estimated that the rule would impose annual, ongoing
compliance expenses of approximately $2,940 per smaller firm,\491\
$117,625 per medium firm,\492\ and $235,250 per larger firm.\493\
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\487\ 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 2009, modified by Commission staff to
account for an 1800-hour work-year and multiplied by 5.35 (in the
case of compliance managers) or 2.93 (in the case of compliance
clerks) to account for bonuses, firm size, employee benefits and
overhead. The calculations discussed in this release are updated
from those included in the Proposing Release to incorporate data
from the most recently updated version of this publication.
\488\ 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 $294 per hour).
Accordingly, the per firm cost estimate is $2,352 (8 x $294).
\489\ With respect to our estimated range of 8-250 hours, we
assume a medium 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 or 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 $294 per hour (or $27,563), and
31.25 hours of clerical time, at $59 per hour (or $1,844), for a
total estimated cost of $29,407.
\490\ 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 $294 per hour (or $55,125), and
62.5 hours of clerical time, at $59 per hour (or $3,688), for a
total estimated cost of $58,813.
\491\ 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 $294 per hour, for a total estimated
cost of $2,940 per year.
\492\ 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 $294 per hour (or $110,250), and 125
hours of clerical time, at $59 per hour (or $7,375), for a total
estimated cost of $117,625 per year.
\493\ 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 $294 per hour (or $220,500) and 250
hours of clerical time, at $59 per hour (or $14,750), for a total
cost of $235,250 per year.
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In establishing these estimates, which are calculated in the same
manner as those we included in the Proposing Release, we took into
consideration comments in 1999 that suggested our cost estimates were
too low.\494\ Our staff, in developing the estimates contained in the
Proposing Release, also engaged in conversations with industry
professionals regarding broker-dealer compliance with rules G-37 and G-
38 and representatives of investment advisers that have pay to play
policies in place.\495\ We significantly increased our cost estimates
from the 1999 proposal as a result. Some commenters on the proposed
rule asserted that our projected costs are too low, but did not provide
empirical data or formulas for us to review.\496\ One commenter
indicated that, ``as a practical matter, although there may be
significant differences in the number of hours dedicated to ongoing
annual compliance between firms of different sizes, the estimated
number of hours needed to develop initial compliance procedures will be
similar for all firms, regardless of size. The initial effort of
designing and implementing new policies and procedures and educating
personnel will require similar effort and upfront fixed costs.'' \497\
We disagree. Although there are some aspects of implementing
[[Page 41057]]
a compliance program that would be similar among all firms regardless
of their number of covered associates, we expect most costs will vary
significantly among firms of different sizes as they engage in such
activities as developing and monitoring reporting mechanisms to track
covered associate contributions, revising their codes of ethics,
training their employees, and performing routine quality control tests.
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\494\ See Proposing Release, at n.226 and accompanying text.
\495\ Id. at section III.B.
\496\ See, e.g., ICI Letter; MFA Letter; SIFMA Letter.
\497\ See Davis Polk Letter.
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In the Proposing Release, we estimated that 75% of larger advisory
firms, 50% of medium firms, and 25% of smaller firms that are subject
to the rule may also engage outside legal services to assist in
drafting policies and procedures, based on staff observations. In
addition, we also estimated 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 larger firm. One commenter suggested that we had underestimated both
the percentage of advisers that would engage outside counsel and the
number of hours that outside counsel would spend lending their
assistance, but did not provide alternative estimates.\498\ Based on
our staff's experience administering the compliance program rule, we
continue to believe that our estimates for the number of firms that
will retain outside counsel for review of policies and procedures are
appropriate. Based on this comment, however, we have revisited the
number of hours we estimated outside counsel would spend reviewing
policies and procedures and have increased these estimates. We now
estimate the cost associated with such an engagement would include fees
for approximately eight hours of outside legal review for a smaller
firm, 16 hours for a medium firm, and 40 hours for a larger firm, at a
rate of $400 per hour.\499\ Consequently, for a smaller firm we
estimate a total of $3,200 in outside legal fees for each of the
estimated 318 advisers that would seek assistance, for a medium firm we
estimate a total of $6,400 for the estimated 152 advisers that would
seek assistance, and for each of the 92 larger firms we estimate a
total of $16,000. Thus, we estimate that approximately 562 investment
advisers will incur these additional costs, for a total cost of
$3,462,400 \500\ among advisers affected by the rule amendments.\501\
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\498\ Id.
\499\ In the Proposing Release we estimated the hourly cost of
outside counsel to be $400 based on our consultation with advisers
and law firms who regularly assist them in compliance matters. We
did not receive comment on this estimate and continue to believe
that it is an accurate estimate.
\500\ (318 x $3,200 = $1,017,600) + (152 x $6,400 = $972,800) +
(92 x $16,000 = $1,472,000) = $3,462,400.
\501\ One commenter asserted that a greater number of firms
would seek assistance of counsel, regardless of size, but did not
provide data to support its assertion. Davis Polk Letter.
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One commenter suggested that, due to the complexity of, and
variation among, State and local laws, it might be more difficult than
we had accounted for in the proposal for an adviser to determine with
certainty who could be a covered official, and as a result, a greater
number of advisers would seek the help of outside counsel to make this
determination than we estimated.\502\ Although the commenter did not
provide an estimate of how many firms might seek such assistance, we
believe that the additional guidance we have provided in the discussion
of officials will address this commenter's concerns and result in fewer
consultations with outside counsel than anticipated. In addition, it is
our understanding from discussions with those involved in advising on
compliance with MSRB rules G-37 and G-38 that a small percentage of
persons subject to the rule seek legal assistance to make these
determinations. Our rule uses substantially similar definitions of
``official'' of a ``government entity'' to those used in the MSRB
rules; therefore we expect that the percentage of advisory firms that
would retain legal counsel to make these determinations would be
similarly small. Moreover, we anticipate that the advisers that are
most likely to need assistance identifying officials of government
entities are larger advisers, whose businesses tend to be national in
scope and whose clients are located throughout the country. If all 122
of the larger advisory firms we estimate are subject to the rule retain
legal counsel at a rate of $400 per hour, for approximately 20 hours
per year, those advisers would incur an estimated total of $976,000 in
legal fees.\503\
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\502\ Caplin & Drysdale Letter. See also IAA Letter; MFA Letter.
\503\ $400 x 20 = $8,000, and $8,000 x 122 = $976,000.
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In the Proposing Release, we estimated that approximately five
advisers annually would apply to the Commission for an exemption from
the rule, based on staff discussions with the FINRA staff responsible
for reviewing exemptive applications submitted under MSRB rule G-37,
and that outside counsel would spend 16 hours preparing and submitting
an application. We received criticism that these approximations were
too low.\504\ Given that the advisory industry is much larger than the
municipal securities industry, and in light of the number of comment
letters we received that expressed concern about inadvertent violations
of the rule that would not qualify for the exception for returned
contributions, our staff estimates that approximately seven advisers
annually would apply to the Commission for an exemption from the rule.
Although we may initially receive more than seven applications a year
for an exemption, over time, we expect the number of applications we
receive will significantly decline to an average of approximately seven
annually. We continue to believe that a firm that applies for an
exemption will hire outside counsel to prepare an exemptive request,
but based on commenters concerns have raised the number of hours
counsel will spend preparing and submitting an application from 16
hours to 32 hours, at a rate of $400 per hour.\505\ As a result, each
application will cost approximately $12,800, and the total estimated
cost for seven applications annually will be $89,600.
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\504\ See Davis Polk Letter; ICI Letter.
\505\ The hourly cost estimate of $400 is based on our
consultation with advisers and law firms who regularly assist them
in compliance matters.
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2. Other Costs Related to Rule 206(4)-5
The prohibitions of the rule may also impose other costs on
advisers, covered associates, third-party solicitors, and political
officials.
(a) Two-Year Time Out
An adviser that becomes subject to the prohibitions of the rule
would no longer be eligible to receive advisory fees from its
government client. This would result in a direct loss to the adviser of
revenues and profits relating to that government client, although
another adviser that the government client subsequently chose to retain
would see an increase in revenues and profits. The two-year time out
could also limit the number of advisers able to provide services to
potential government entity clients. An adviser that triggers the two-
year time out 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
[[Page 41058]]
provides uncompensated advisory services to a government client would,
at a minimum, 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 contributions to
government officials, including candidates, potentially resulting in
less funding for these officials. Under the rule, advisers and covered
associates will be subject to new limitations on the amounts and to
whom they can contribute without triggering the rule's time out
provision. In addition, these same persons will be prohibited from
soliciting others to contribute or from coordinating contributions to
government officials, including candidates, or payments to political
parties in certain circumstances. These limitations and prohibitions,
including if a firm chooses to adopt policies or procedures that are
more restrictive than the 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.\506\ In addition to these costs, the rule's impact on
advisers' and employees' contributions will introduce some inefficiency
into the allocation of contributions to candidates and officials as the
rule impacts contributions regardless of whether they are being made
for the purpose of engaging in pay to play.
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\506\ One commenter suggested that the proposed rule would
inhibit individuals who work for an investment adviser from running
for office because, if they were successful, it may cost their
former employer business. Caplin & Drysdale Letter. We have
addressed this comment by making it clear that an individual can
contribute to his or her own campaign without triggering the rule.
See supra note 139.
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We have made several modifications to the rule from the proposal
that will reduce these costs or burdens. We are creating a new
exception to the two-year time out for contributions made by a natural
person more than six months prior to becoming a covered associate
unless he or she, after becoming a covered associate, solicits clients
on behalf of the investment adviser.\507\ This modification will
decrease the burdens on both employees and employers in terms of
tracking and limiting employee contributions prior to becoming employed
or promoted by an investment adviser. In terms of narrowing the scope
of ``covered investment pools,'' we included a registered investment
company in the definition of covered investment pool, for purposes of
all three of the rule's pay to play prohibitions, only if it is an
investment option of a plan or program of a government entity.\508\ As
noted above, we believe this approach strikes the right balance between
applying the rule in those contexts in which advisers to registered
investment companies are more likely to engage in pay to play conduct
while recognizing the compliance challenges and costs that may result
from a broader application of the rule. We are also broadening the
exception to the rule's time out provision in several respects that
should further decrease the compliance costs associated with the two-
year time out and will lower any perceived costs on covered associates'
ability to express their support for candidates. We are increasing the
aggregate contribution amount eligible for the exception for certain
returned contributions from $250 to $350 to any one official per
election,\509\ and we are increasing the number of times an adviser is
permitted to rely on the returned contributions exception from two to
three per calendar year for advisers with more than 50 employees.\510\
Furthermore, we are making the same adjustment from $250 to $350 for
contributions eligible for the de minimis exception,\511\ and we are
adopting a de minimis exception for contributions not exceeding $150
made by individuals who are not entitled to vote for the
candidate.\512\
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\507\ Rule 206(4)-5(b)(2).
\508\ Rule 206(4)-5(f)(3) and (f)(8).
\509\ Rule 206(4)-5(b)(3).
\510\ Id.
\511\ Rule 206(4)-5(b)(1).
\512\ See id.
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Several commenters highlighted the costs of the two-year time out
to the adviser and government entity client, as well as pension fund
beneficiaries, stating that the time out could force termination of
long-standing relationships and may result in a permanent termination
of the advisory relationship.\513\ We acknowledge that advisers subject
to the time out may lose a government client's business beyond the two-
year period and are sensitive to the concerns of commenters regarding
the operation of the rule on public pension funds, including the
burdens they may face in replacing managers and the possibility that
some managers may no longer seek to manage public plan assets as a
result of the rule. We believe that these costs are necessary to
accomplish our goal of addressing pay to play and are justified by the
benefits of rule 206(4)-5. As discussed above, rule 206(4)-5 is modeled
on the pay to play rules adopted by the MSRB, which have significantly
curbed pay to play practices in the municipal securities market. We
believe that adopting a two-year time out similar to the time out
applicable under the MSRB rules is appropriate, and that the fiduciary
relationship advisers have with public pension plans argues for a
strong prophylactic rule. Finally, while we have designed the rule to
reduce its impact,\514\ investment advisers are best positioned to
protect government clients by developing and enforcing robust
compliance programs designed to prevent contributions from triggering
the two-year time out.
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\513\ See, e.g., ICI Letter (``[E]xisting State and local
government clients may be harmed by the forced termination of a
mutually beneficial business relationship, despite receiving free
services for a period of time, because the government client is
subject to the costs associated with selecting a new adviser, and
plan beneficiaries are subject to the costs associated with
portfolio commissions and other restructuring costs. Consequently,
our members believe that the two-year ban will operate as a
permanent ban because a government entity will be unlikely to go
through the process of identifying and hiring a replacement adviser,
and then return to the original adviser after the ban ends.''). See
also IAA Letter; NASP Letter; SIFMA Letter.
\514\ See, e.g., section II.B.2(a)(6) of this Release
(discussing the de minimis exceptions to the two-year time out);
section II.B.2(f) of this Release (discussing the rule's exemptive
provision).
---------------------------------------------------------------------------
Commenters also noted, particularly, the potential harm of the two-
year time out to government clients and to other investors in a fund
that holds illiquid securities when a government investor redeems its
interests in the fund as a result of the fund adviser's triggering
contribution.\515\ As we note above, however, our rule does not require
an adviser that has triggered the time out to redeem the interests of a
government investor or cancel its commitment. The adviser may have
multiple options available from which to select to comply with the rule
in light of its fiduciary obligations and the disclosure it has made to
investors. The adviser could instead comply with the rule by waiving or
rebating the portion of its fees or any performance allocation or
carried interest attributable to the government client.\516\
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\515\ CT Treasurer Letter; NY City Bar Letter.
\516\ See supra note 385 and accompanying text.
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Most of the comments we received about the costs of this aspect of
the proposed rule, however, focused on the costs of an inadvertent
violation.\517\ We understand that there will be costs, sometimes quite
significant, as a result
[[Page 41059]]
of inadvertent violations. However, with these potential costs in mind,
we have taken additional steps to decrease the likelihood of
inadvertent violations of the rule. First, as discussed above, we
shortened the look back with respect to most covered associates. We
expect this new exception will provide an additional mechanism for
advisers to avoid the cost of a time out as a result of an inadvertent
violation and will largely address commenters' concerns about the
screening burdens for new or promoted employees that this aspect of the
proposal would have imposed on advisers.\518\ Second, as discussed
above, we are increasing to $350 the amount eligible for an exception
for certain returned contributions from what we had proposed, we are
increasing the number of times an adviser is permitted to rely on the
returned contributions exception, and we are also adopting an
additional de minimis exception for certain contributions not exceeding
$150. Last, we note that an adviser's implementation of a strong
compliance program will reduce the likelihood, and therefore costs, of
inadvertent violations.
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\517\ See, e.g., IAA Letter (``We are concerned that the
Commission has not considered the significance of the sanctions
imposed as a result of an adviser's inadvertent violation of the
rule.'').
\518\ IAA Letter (``Under the Proposal, investment advisers
would be required to screen for and eliminate potential employment
candidates based upon contributions made for a period of up to
twenty-four months before the person would begin employment with the
adviser. This requirement * * * would be extremely costly and
burdensome to implement.''); Wells Fargo Letter (``The ``look back''
provision is too draconian. * * * [A] compliance system [will be]
costly to develop and arduous to implement * * * [and] it would also
impose severe limitations on the career opportunities of those newly
entering the investment advisory world who are weighed down by
political contributions that were completely innocuous when
made.'').
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One commenter asserted that the proposed rule would put advisers at
a competitive disadvantage to other providers of advisory services to
government plans that would not be subject to it, such as banks and
insurance companies.\519\ As we stated earlier, we believe that the
concerns that we are trying to address with the rule justify its
adoption, notwithstanding the potential competitive effects that
advisers may face as a result of the limits on our jurisdiction. We
also do not view competition by means of engaging in practices such as
pay to play as an interest that we need to protect.
---------------------------------------------------------------------------
\519\ NY City Bar Letter.
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(b) Third-Party Solicitor Ban
Under our proposal, advisers would have been prohibited from
compensating any third party to solicit government entities for
advisory services, other than ``related persons.'' \520\ As a result,
advisers that rely on third-party solicitors to obtain government
clients would have had to bear the expense of hiring and training in-
house staff in order to continue their solicitation activities,\521\ a
result that commenters said would be particularly costly for small and
new investment advisers.\522\ In addition, third-party solicitors might
also have experienced substantial negative consequences under the
proposed rule.\523\ We heard from many commenters on this issue,
offering various perspectives on how the costs would outweigh the
benefits of the proposed prohibition.\524\ A few commenters asserted
that this proposal would have a significant adverse effect on efficient
capital formation in that it would make it more difficult for private
equity and venture capital managers to obtain funding that they in turn
can invest in portfolio companies.\525\ As other commenters pointed
out, this aspect of our proposed rule might also have placed a
significant burden on public pension plans,\526\ particularly smaller
plans because third-party solicitors provide services that plans may
value, including serving as placement agent for alternative investments
and serving a screening function with respect to those investments
presented to the pension plan.\527\
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\520\ Proposed rule 206(4)-5(a)(2)(i)(a).
\521\ See, e.g., Comment Letter of Greenhill & Co., LLC (Oct. 2,
2009) (``The elimination of placement agents would add a significant
administrative and cost burden to fund sponsors seeking
investors.''). See also Alta Letter; Atlantic-Pacific Letter;
Braxton Letter; Benedetto Letter; CA Assoc. of County Retirement
Letter; Capstone Letter; EVCA Letter; GA Firefighters Letter;
Glovista Letter; IL Fund Association Letter; MN Board Letter; Myers
Letter; NCPERS Letter; NYC Teachers Letter; PA Public School
Retirement Letter; Reed Letter; Myers Letter; TX Public Retirement
Letter; WI Board Letter; Credit Suisse Letter (``Moreover, by
performing these functions, placement agents enable investment
advisers to focus on their core expertise, investment management,
and to avoid the necessity of developing the costly in-house
resources necessary to raise capital directly.'').
\522\ See, e.g., MFA Letter (``[M]anagers that engage placement
agents, particularly small and offshore managers, would lose the
ability to market their services to government clients or incur
significantly higher costs to hire internal marketing personnel; and
managers that hire internal personnel could spend substantial
amounts to register as a broker-dealer.''). See also SIFMA Letter;
IAA Letter; Seward & Kissel Letter; Sadis & Goldberg Letter; WI
Board Letter; GA Firefighters Letter; MN Board Letter; IL Fund
Association Letter; NYC Teachers Letter; TX Public Retirement
Letter; PA Public School Retirement Letter; Ehrmann Letter; Finn
Letter; Savanna Letter; Atlantic-Pacific Letter; Peterson Letter;
Devon Letter; Chaldon Letter; Meridian Letter; Benedetto Letter;
Capstone Letter; Braxton Letter; Littlejohn Letter; Alta Letter;
Charles River Letter; Reed Letter; Glovista Letter; Blackstone
Letter; Park Hill Letter.
\523\ Proposing Release, at 89. See also Thomas Letter (``The
ban would very likely cripple many legitimate placement agents--most
of whom are currently regulated by the SEC and FINRA--as the public
pension plans are the largest source of capital for alternative
investments.''); Comment Letter of the Managing Partner of Bridge 1
Advisors, LLC Robert G. McGroarty (Sept. 24, 2009) (``Bridge 1
Letter''); SIFMA Letter.
\524\ See, e.g., Davis Polk Letter (``While we strongly support
the underlying purpose of the Proposed Rule, we believe that this
ban on all third-party solicitors is overly expansive and the costs
inflicted on both investment advisers and government clients from
lack of access to the valuable services provided by most third-party
solicitors outweigh any expected benefits to be gained from its
adoption.''); Capstone Letter (suggesting that many placement agent
firms are small businesses helping investment managers that are,
themselves, minority- or women-owned small businesses, and that,
together, they are creating jobs and helping other businesses by
efficiently directing capital); Monument Letter (making a similar
comment regarding the minority and female ownership of placement
agents); Glantz Letter; Comment Letter of Indian Harbor Partner
Robert W. Stone (Aug. 13, 2009) (``Indian Harbor Letter'');
Kurmanaliyeva Letter; M Advisory Letter (adding that the investment
management industry as a whole will incur ``dramatic job losses'');
Parenteau Letter.
\525\ Alta Letter; Benedetto Letter; Comment Letter of Berkshire
Property Advisors, LLC (Sept. 29, 2009) (``Berkshire Letter'');
Bridge 1 Letter; Comment Letter of Hampshire Real Estate Companies
(Sept. 29, 2009); Comment Letter of Thomas J. Mizo on behalf of HFF
Securities L.P. (Sept. 24, 2009); M Advisory Letter; Monument Group
Letter; Comment Letter of Psilos Group Managers, LLC (Sept. 28,
2009).
\526\ See, e.g., Park Hill Letter (``The Commission has
commented that if the Placement Agent Ban is adopted, Public Pension
Investors can seek to engage placement agents themselves in order to
continue to have access to their services in helping to find the
best Fund Sponsors. However, that would impose costs on Public
Pension Investors that they do not currently incur. Moreover, as the
Commission has acknowledged in its cost-benefit analysis, if the
Placement Agent Ban were adopted, Fund Sponsors who do not have in-
house marketing staffs would be disproportionately disadvantaged
relative to larger firms that have those internal resources in the
competition for obtaining access to Public Pension Investors and
other institutional investors.''); Thomas Letter (``A ban on
placement agents would have significant unintended consequences for
public pension plans. * * * [For instance, the] incremental effort
by investment staffs to perform due diligence on promising but
possibly ill-prepared investment managers will raise the cost and
lessen the overall pension fund portfolio performance.''); Comment
Letter of Austin F. Whitman (Sept. 21, 2009) (``Without access to
placement agents, government pensions would be significantly
disadvantaged relative to their private sector peers, with limited
access (and benefit from) the services described above.''); ABA
Letter. But see Fund Democracy/Consumer Federation Letter (``The
proposed ban would simply replace the indirect cost of placement
agents incurred by pension plan sponsors with the direct cost of
hiring their own placement agents--without the conflict of interest
and potential for abuse that relying on advisers' placement agents
creates.'').
\527\ See, e.g., Ogburn Letter; Schmitz Letter (highlighting the
valuable ``pre-vetting'' function of placement agents, especially in
light of pension funds' budgetary pressures and lean staffs);
Savanna Letter (discussing the ``pre-screening'' effect that
reputable placement agent client selection provides for pension
professionals); Atlantic-Pacific Letter; Indian Harbor Letter;
Peterson Letter; Rubenstein Letter; Comment Letter of R[eacute]al
Desrochers (Aug. 20, 2009) (noting that from the perspective of a
former pension fund investment officer, ``[t]he skill sets of
certain placement agents streamlined what they brought to our
attention and made our internal process much more efficient.'');
Devon Letter; Thomas Letter; Myers Letter; PRIM Board Letter
(``[T]he Commission should strongly resist the politically expedient
suggestion that an outright ban on the use of placement agents is
somehow good for plan sponsors; nothing could be further than the
truth.''); Meridian Letter; Comment Letter of Norman G. Benedict
(Sept. 30, 2009) (indicating that, from the perspective of a retired
public pension chief investment officer, placement agents provide an
essential and invaluable service, particularly with providing access
to private equity fund investments, which often yielded higher
returns than more traditional, publicly traded securities);
Berkshire Letter; Comment Letter of The British Private Equity and
Venture Capital Association (Sept. 18, 2009) (``BVCA Letter'')
(``Placement agents are not just a crude middleman in the
fundraising process''); CT Treasurer Letter; Credit Suisse Letter
(describing four key functions its placement agent group performs);
Portfolio Advisors Letter (noting that among the valuable services
provided are: ``(1) Helping new fund sponsors to become more
established among the institutional investor community; (ii) helping
sponsors to complete RFPs, provide information and respond to
questions, which, in turn, gives the public pension plans and other
investors a broader pool of investment options; and (iii) serving as
intermediaries in uniting capital with fund sponsors who can put the
money to work by investing in businesses and creating value'');
George Letter; Comment Letter of Rahul Mehta (Sept. 11, 2009);
Touchstone Letter; SIFMA Letter.
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[[Page 41060]]
Others argued, for similar reasons as those expressed above, that
it would also harm public pension plans to ban payments to third
parties because it would decrease competition by reducing the number of
advisers competing for government business \528\ and limit the universe
of investment opportunities presented to public pension funds.\529\
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\528\ See, e.g., Seward & Kissel Letter; Meridian Letter; SIFMA
Letter; Comment Letter of Oakpoint Advisors (Aug. 26, 2009); Comment
Letter of SeaCrest Investment Management, LLC (Sept. 25, 2009).
\529\ See, e.g., Braxton Letter (stressing not only the
increased costs that public pension funds will likely face, but also
the likely reduction in creative investment strategies and
opportunities available as a result of smaller and emerging funds
being forced out of the market); BVCA Letter; CT Treasurer Letter;
SIFMA Letter; IAA Letter; Strategic Capital Letter; Alta Letter;
Benedetto Letter; Glantz Letter; Kurmanaliyeva Letter; Park Hill
Letter.
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We believe our decision to modify the proposed rule to permit
advisers to make payments to certain ``regulated persons'' to solicit
government clients on their behalf,\530\ as described in more detail
above, should alleviate many of these concerns, including those from
private equity and venture capital managers on capital formation.\531\
In particular, we believe the concerns expressed by private equity and
venture capital managers regarding the effects of the rule on capital
formation have been substantially addressed by the modification for
payments to ``regulated persons.'' We expect advisers that engage the
services of regulated person solicitors will incur limited costs to
initially confirm and subsequently monitor the solicitor's eligibility
to be a ``regulated person.'' Nevertheless, we expect this exception to
the third-party solicitor ban will substantially reduce the costs
commenters associated with this aspect of the proposal.
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\530\ See Rule 206(4)-5(a)(2)(i).
\531\ Our decision not to adopt the ``related person'' exception
contained in the proposed rule does not diminish our belief. As we
noted above, we believe our modification of the ban to allow
advisers to pay ``regulated persons'' to solicit government entities
on their behalf will still allow advisers to use employees of
certain related companies--i.e., of those related companies that
qualify as ``regulated persons''--as solicitors.
---------------------------------------------------------------------------
We acknowledge, however, that the third-party solicitor ban will
nonetheless have a substantial negative impact on persons who provide
third-party solicitation services that are not regulated persons,
including State-registered advisers.\532\ If their businesses consist
solely of soliciting government entities on behalf of investment
advisers, the rule could result in these persons instead being employed
directly by regulated persons, shifting the focus of their solicitation
activities, seeking to change their business model to shift their
source of payment from investment advisers to pension plans, or going
out of business.\533\ In addition, we acknowledge that the third-party
solicitor ban may adversely affect both competition and allocative
efficiency in the market for advisory services where third-party
solicitors that are not regulated persons participate. We have
carefully considered these effects. As discussed above, however, we do
not have regulatory authority to oversee the activities of State-
registered advisers through examination and our recordkeeping rules.
Nor do we have authority over the states to oversee their enforcement
of their rules, as we do with FINRA. As a result, we have not included
State-registered advisers in the definition of regulated person.\534\
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\532\ As we note above, State-registered advisers are subject
neither to our oversight nor to the recordkeeping rules we are
adopting today.
\533\ See supra note 523.
\534\ See supra note 325 and accompanying text.
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In addition, some commenters suggested that the third-party
prohibition could have a negative impact on the efficient allocation of
capital for government plans, particularly small ones, and advisers
that seek to manage these assets directly (not through a covered
investment pool).\535\These small government plans may, as a result of
the rule's ban on payments to third parties, have fewer managers to
select from to the extent that larger advisers choose not to
participate in this market. In addition, both government plans and
advisers that seek these government clients may have to hire internal
staff, respectively, to identify potential advisers and potential
government clients to the extent these functions are not internalized.
However, these commenters did not discuss the potentially significant
costs that exist today of hiring third-party solicitors, and that
eliminating the cost of pay to play may, in fact, provide greater
access to pension plans by those advisers that are currently unable to
afford the costs of direct or indirect political contributions or
third-party solicitor fees.\536\ We expect that prohibiting pay to play
will reduce the costs to plans and their beneficiaries that may result
when adviser selection is based on political contributions rather than
investment considerations.\537\
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\535\ See, e.g., 3PM Letter; Bryant Law Letter.
\536\ At least one commenter agreed. See Butler Letter (``[W]e
find some evidence that the pay to play practices by underwriters
[before rule G-37 was adopted] distorted not only the fees, but
which firms were allocated business. The current proposal mentions
that pay to play practices may create an uneven playing field among
investment advisers by hurting smaller advisers that cannot afford
to make political contributions. We find evidence that is consistent
with this view [in our research on pay to play by municipal
underwriters]. During the pay to play era, municipal bonds were
underwritten by investment banks with larger underwriting market
shares compared to afterward. One interpretation of this result is
that smaller underwriters were passed over in favor of larger
underwriters (who presumably had deeper pockets for political
contributions).'').
\537\ See supra notes 452 & 453 and accompanying text
(describing commenters' observations about some of the pay to play
costs to plans and their beneficiaries).
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3. Costs Related to the Amendments to Rule 204-2
The amendments to rule 204-2 require SEC-registered advisers with
government clients to maintain certain records of campaign
contributions by certain advisory personnel and records of the
regulated persons the adviser pays or agrees to pay to solicit
government entities on its behalf.\538\ Records are a critical
complement to rule 206(4)-5. In particular, such records are necessary
for examiners to inspect advisers for compliance with the terms of the
rule.
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\538\ Unregistered advisers that would be subject to rule
206(4)-5 would not be subject to the amendments to rule 204-2.
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As described below, for purposes of the Paperwork Reduction Act of
1995 (``PRA''),\539\ we have estimated that Commission-registered
advisers would incur approximately 3,394 additional hours annually to
comply with the
[[Page 41061]]
amendments to rule 204-2.\540\ Based on this estimate, we anticipate
that advisers would incur an aggregate cost of approximately $200,246
per year for the total hours advisory personnel would spend in
complying with the recordkeeping requirements.\541\ In addition, we
expect advisory firms may incur one-time costs to establish or enhance
current systems to assist in their compliance with the amendments to
rule 204-2. For purposes of the PRA, we have estimated that some small
and medium firms will incur start-up costs, on average, of $10,000, and
larger firms will incur, on average, $100,000. As a result, the
amendments to rule 204-2 are estimated to increase the PRA non-labor
cost burden by $20,080,000.\542\
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\539\ 44 U.S.C. 3501.
\540\ See infra note 559 and accompanying text.
\541\ We expect that the function of recording and maintaining
records of political contributions would be performed by a
compliance clerk at a cost of $59 per hour. See supra note 487.
Therefore, the total costs would be $200,246 (3,394 hours x $59 per/
hour).
\542\ ($10,000 x 788) + ($100,000 x 122) = $7,880,000 +
$12,200,000 = $20,080,000.
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We received a number of specific comments on this aspect of the
proposal, many of which included assertions about cost burdens
associated with maintaining records related to unsuccessful
solicitations, and urged us to reconsider the benefits to be gained
from such a requirement in light of the costs.\543\ We were persuaded
by these commenters to eliminate provisions of the proposed amendments
to the recordkeeping rule that would have required advisers to maintain
a list of government entities that the adviser solicits.\544\ Instead,
an adviser must only retain records of existing government entity
clients and investors as well as records of regulated persons that the
adviser pays or agrees to pay to solicit government entities on its
behalf for a five-year period. Additionally, we have narrowed the scope
of the amended rule to apply only to advisers with government entity
clients; an adviser is only required to make and keep these records if
it provides investment advisory services to a government entity or a
government entity is an investor in any covered investment pool to
which the investment adviser provides investment advisory
services.\545\ We have also limited the rule to provide that only
records of contributions, not payments, to government officials and
candidates are required to be kept under the rule. Additionally,
because rule 206(4)-5 applies to an adviser to a registered investment
company only if it is an investment option of a participant-directed
plan or program of a government entity,\546\ such investment advisers
will only have to identify government entities that provide plan or
program participants the option of investing in the fund, which
addresses many commenters' concerns about recordkeeping burdens that
would have been imposed on advisers to registered investment companies
under the proposed rule.\547\
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\543\ MassMutual Letter (``[T]he requirement to maintain records
of each governmental entity being solicited would require a diverse
financial services company like MassMutual to undertake significant
legacy software system modifications or build an entirely new system
to track each instance of a ``solicitation,'' which could include
phone calls, meetings, or responses to governmental requests. This
system would then need to aggregate data across multiple business
lines, many with existing systems that may not have the ability to
share this data in a useful format. All of these are costly and time
consuming activities to meet a requirement that appears to add
little value to the Commission's efforts to ensure compliance with
the Proposed Rule.''). See also Davis Polk Letter; Dechert Letter;
Holl Letter; SIFMA Letter; Skadden Letter.
\544\ See proposed rule 204-2(a)(18)(i)(B).
\545\ Rule 204-2(a)(18)(iii). See NASP Letter (``Many advisers
do not have governmental clients but will still have to collect the
information or attestations which would increase compliance costs
while providing no public benefit at all.'')
\546\ See supra note 353 and accompanying text.
\547\ See, e.g., ICI Letter.
---------------------------------------------------------------------------
We anticipate that commenters' general concerns that we may have
underestimated the burdens we presented in our proposal will be offset
by what we believe will be a reduction in burdens as a result of the
various modifications from our proposal described above. In addition,
we have revised the rule to require advisers to maintain a list of
regulated persons that solicit on an adviser's behalf, but expect
advisers to already have this information in the normal course of
business, including in some instances, to comply with existing
requirements of rule 206(4)-3.
V. Paperwork Reduction Act
A. Rule 204-2
The amendment to rule 204-2 contains a ``collection of
information'' requirement within the meaning of the PRA. In the
Proposing Release, the Commission solicited comment on the proposed
amendment to the collection of information requirement.\548\ The
Commission also submitted the proposed amendment's collection of
information requirement to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11 under control number 3235-0278. The title for the collection of
information is ``Rule 204-2 under the Investment 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 sponsor, or conduct, and a person is not required to respond to, a
collection of information unless it displays a currently valid OMB
control number.
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\548\ See Proposing Release, at section IV.
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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 collection of information under rule
204-2 is necessary for the Commission staff to use in its examination
and oversight program, and the information generally is kept
confidential.\549\ The respondents are investment advisers registered
or required to be registered with us.
---------------------------------------------------------------------------
\549\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
---------------------------------------------------------------------------
Today's amendments to rule 204-2 require every investment adviser
registered or required to be registered that provides advisory services
to (or pays or agrees to pay regulated persons to solicit) government
entities to maintain certain records of contributions made by the
adviser or any of its covered associates and regarding regulated
persons the adviser pays or agrees to pay for soliciting government
entities on its behalf. The amendments require such 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 to which the investment adviser
provides or has provided investment advisory services, or which are or
were investors in any covered investment pool to which the investment
adviser provides or has provided investment advisory services, as
applicable, in the past five years, but not prior to the effective date
of the rule; (iii) all direct or indirect contributions made by the
investment adviser or any of its covered associates to an official of a
government entity, or payments to a political party of a State or
political subdivision thereof, or to a political action committee; and
(iv) the name and business address of each regulated person to whom the
investment adviser provides or agrees to provide, directly or
indirectly, payment to solicit a government entity for investment
advisory services on its behalf, in accordance with rule 206(4)-
5(a)(2)(i).
The adviser's records of contributions and payments are required to
be listed
[[Page 41062]]
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 rule 206(4)-5(b)(2). An investment
adviser is only required to make and keep current the records referred
to in (i) and (iii) above if it provides investment advisory services
to a government entity or a government entity is an investor in any
covered investment pool to which the adviser provides investment
advisory services. The records required by amended rule 204-2 are
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 will be found at 17 CFR 275.204-2. Advisers
that are exempt from Commission registration under section 203(b)(3) of
the Advisers Act are not subject to the recordkeeping requirements.
The amendments to rule 204-2 that we are adopting today differ from
our proposed amendments in several respects. We have tailored certain
of the requirements from our proposal. First, we have limited the rule
to provide that only records of contributions, not payments, to
government officials, including candidates, are required to be kept
under the rule. Second, investment advisers to registered investment
companies only have to identify--and keep records regarding--government
entities that invest in a fund as part of a plan or program of a
government entity, including any government entity that selects the
fund as an investment option for participants in the plan or
program.\550\ Third, we are not adopting provisions of the proposed
amendments to the recordkeeping rule that would have required advisers
to maintain a list of all government entities that they have solicited.
In addition, we have revised the rule so that only those advisers that
have government entity clients must make and keep certain required
records, unlike the proposal, which would have required all registered
advisers to maintain records of contributions and covered associates.
We are also adopting a requirement that advisers maintain records of
regulated persons they pay to solicit government entities on their
behalf, to reflect that rule 206(4)-5 permits advisers to compensate
these solicitors.
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\550\ Under our proposal, investment advisers to registered
investment companies would have had to identify and keep records
regarding government entities that invest in the funds regardless of
whether they were part of a plan or program of a government entity.
For a discussion of this modification, see section II.B. of this
Release.
---------------------------------------------------------------------------
As noted above, we requested comment on the PRA analysis contained
in the Proposing Release. Although a few commenters expressed general
concerns that the paperwork burdens associated with our proposed
amendments to rule 204-2 might be understated, commenters representing
advisers to registered investment companies suggested that the proposal
significantly underestimated the burden attributed to these covered
investment pools.\551\ With respect to registered investment companies,
commenters noted that the proposed recordkeeping requirements required
advisers to identify government investors in registered investment
companies regardless of whether the fund was part of a plan or program
of a government entity, and as a result the proposed amendments to the
recordkeeping rule would have been difficult to comply with as fund
shareholder records do not necessarily identify government investors.
---------------------------------------------------------------------------
\551\ See ICI Letter (``[I]n relying on the estimates for
compliance with the MSRB rules, the Commission significantly
underestimates the compliance and recordkeeping burdens associated
with the proposed rule.'').
---------------------------------------------------------------------------
As a result of these comments, we recognize that we may have
underestimated the recordkeeping burden for advisers to registered
investment companies that would have been subject to proposed rule
206(4)-5. However, we believe that our change to the definition of
``covered investment pool'' from the proposal to only include those
registered investment companies that are an investment option of a plan
or program of a government entity addresses the recordkeeping concerns
commenters expressed regarding these covered investment pools and
lowers recordkeeping burdens by limiting the records relating to
registered investment companies that an investment adviser must keep
under the rule.\552\ In addition, the other changes we highlight
above--other than the requirement to keep records regarding regulated
persons--would lessen the recordkeeping requirements relative to our
proposal and thereby diminish our burden estimates. We anticipate that
commenters' general concerns that we may have underestimated the
burdens we presented in our proposal, as well as the burden associated
with the additional requirement to maintain a list of regulated persons
that solicit on an adviser's behalf, will be offset by what we believe
will be a reduction in burdens as a result of the various modifications
from proposed amendments to the recordkeeping rule, as described above.
Moreover, notwithstanding the fact that the amendments we are adopting
reduce advisers' recordkeeping obligations relative to our proposal, we
are increasing our estimates to address the additional investment
advisers who have registered with us since our proposal was issued.
---------------------------------------------------------------------------
\552\ See Rule 204-2(a)(18)(i)(B).
---------------------------------------------------------------------------
Prior to today's amendments, the approved collection of information
for rule 204-2, set to expire on March 31, 2011, was based on an
average of 181.15 burden hours each year, per Commission-registered
adviser, for a total of 1,954,109 burden hours. In addition, the
currently-approved collection of information for Rule 204-2 includes a
non-labor cost estimate of $13,551,390. The total burden is based on an
estimate of 10,787 registered advisers.
Commission records indicate that currently there are approximately
11,607 registered investment advisers subject to the collection of
information imposed by rule 204-2.\553\ 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 148,543
hours.\554\ In addition, the total non-labor cost burden has increased
to $14,581,509 as a result of this increase in the number of registered
advisers.\555\
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\553\ This figure is based on registration information from IARD
as of April 1, 2010. The figures we relied on in our Proposing
Release were based on registration information from IARD as of July
1, 2009. See Proposing Release, at section IV.
\554\ 11,607 - 10,787 = 820. 820 additional advisers x 181.15
hours = 148,543 hours.
\555\ We estimate that non-labor costs attributed to rule 204-2
will increase in the same proportion as the increase in the
estimated hour burden for the rule. (2,102,652 hours/1,954,109
hours) x $13,551,390 currently approved non-labor cost estimate =
$14,581,509.
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In our Proposing Release, we estimated 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 rule amendments.\556\ One commenter argued that this
estimate was too low because it underestimates the number of investment
advisers unregistered in reliance on Section 203(b)(3) of the Advisers
Act and estimated to be subject to the Proposed Rule.\557\ Unregistered
[[Page 41063]]
advisers are not subject to rule 204-2's recordkeeping requirements. As
a result, they are not included in our estimates for purposes of this
analysis. We continue to believe our estimates are appropriate,
although we have revised this number for purposes of both our cost-
benefit analysis above and our PRA analysis to reflect both an increase
in the number of registered advisers since the proposal and the
modification from our proposal to not require records of unsuccessful
solicitations. We now estimate that approximately 1,697 registered
advisers provide advisory services to government clients and to certain
pooled investment vehicles in which government entities invest, and
would thus be affected by the rule amendments.\558\
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\556\ See Proposing Release, at section IV.
\557\ Davis Polk Letter (``The cost benefit analysis is based
solely on an estimated 1,764 registered investment advisers and does
not account for the costs and burdens of compliance attributable to
investment advisers exempt from registration. The estimated number
of investment advisers unregistered in reliance on section 203(b)(3)
of the Advisers Act (2,000) and estimated to be subject to the
Proposed Rule (231), appears to be low. In its comment letter, the
Third Party Marketers Association notes that the number of advisory
firms exempted from registration may be `over two times the estimate
of the Commission. * * *''' (citations omitted)). The Davis Polk
Letter does not offer any of its own estimates for the number of
unregistered advisers, and the 3PM Letter references statistics
regarding the number of funds, not the number of advisers.
\558\ This estimate is based on registration information from
IARD as of April 1, 2010, applying the same methodology as in the
Proposing Release. As previously noted, according to responses to
Item 5.D(9) of Part 1 of Form ADV, 1,332 advisers have clients that
are State or municipal government entities, which represents 11.48%
of all advisers registered with us. 10,275 advisers have not
responded that they have clients that are State or municipal
government entities. Of those, however, responses to Item 5.D(6) of
Part 1 of Form ADV indicate that 2,486 advisers have some clients
that are other pooled investment vehicles. Estimating that the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 285 of these advisers would be subject to the rule
(2,486 x 11.48% = 285). Out of the 10,275 that have not responded
that they have clients that are State or municipal government
entities, after backing out the 2,486 which have clients that are
other pooled investment vehicles, responses to Item 5.D(4) of Part 1
of Form ADV indicate that 699 advisers have some clients that are
registered investment companies. Estimating that roughly the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 80 of these advisers would be subject to the rule (699
x 11.48% = 80). Although we limited the application of rule 206(4)-5
with respect to registered investment companies to those that are
investment options of a plan or program of a government entity, we
continue to estimate that 80 advisers would have to comply with the
recordkeeping provisions because of the difficulty in further
delineating this estimated number. Therefore, we estimate that the
total number of advisers subject to the rule would be: 1,332
advisers with State or municipal clients + 285 advisers with other
pooled investment vehicle clients + 80 advisers with registered
investment company clients = 1,697 advisers subject to rule. We
expect certain additional advisers may incur compliance costs
associated with rule 206(4)-5. We anticipate some advisers may be
subject to the rule because they solicit government entities on
behalf of other investment advisers. In the Proposing Release, our
estimates included an estimated burden attributable to advisers that
do not currently have government clients but that may begin to seek
them. The revision to the recordkeeping rule that eliminated the
requirement to maintain records of government entities that an
adviser solicits has eliminated the need for this additional burden
estimate.
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Under the amendments, each respondent is required to retain the
records in the same manner and for the same period of time as currently
required under rule 204-2. The amendments to rule 204-2 are estimated
to increase the burden by approximately 2 hours per Commission-
registered adviser with government clients annually for a total
increase of 3,394 hours.\559\ The revised annual aggregate burden for
all respondents to the recordkeeping requirements under rule 204-2 thus
would be 2,106,046 hours.\560\ The revised average burden per
Commission-registered adviser would be 181.45 hours.\561\
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\559\ 2 x 1,697 = 3,394.
\560\ 1,954,109 (current approved burden) + 148,543 (burden for
additional registrants) + 3,394 (burden for proposed amendments) =
2,106,046 hours.
\561\ 2,106,046 (revised annual aggregate burden) divided by
11,607 (total number of registrants) = 181.45.
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Additionally, as we noted in the Proposing Release and reiterate
above, we expect advisory firms may incur one-time costs to establish
or enhance current systems to assist in their compliance with the
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.
As a result of these one-time costs, we estimate that there will be
an increase to the total non-labor cost burden. We estimated above that
the non-labor cost burden has increased to $14,581,509 as a result of
the increase in the number of registered advisers since the collection
was last approved.\562\ We believe the one-time costs could vary
substantially among smaller, medium, and larger firms as smaller and
medium firms may be able to use non-specialized software, such as a
spreadsheet, or off-the-shelf compliance software to keep track of the
information required by the rule while larger firms are more likely to
have proprietary systems. Based on IARD data we estimate that there are
approximately 1,271 smaller firms, 304 medium firms, and 122 larger
firms.\563\ We estimate that one half of the smaller and medium firms
will not incur these one-time start up costs because they will use
existing tools for compliance. We expect the other half of smaller and
medium firms will incur one-time start up costs on average of $10,000,
in the event they have a greater number of employees and government
clients, and larger firms, that likely have the most employees and
government clients, will incur one-time start up costs on average of
$100,000. As a result, the amendments to rule 204-2 are estimated to
increase the non-labor cost burden by $20,080,000.\564\ Due to this
increase, we now estimate the revised total non-labor cost burden for
rule 204-2 to be $34,661,509.
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\562\ See supra note 555.
\563\ This estimate is based on registration information from
IARD as of April 1, 2010. These estimates are based on IARD data,
specifically the responses to Item 5.B.(1) of Form ADV, that 997 (or
74.9%) of the 1,332 registered investment advisers that have
government clients have fewer than five employees who perform
investment advisory functions, 239 (or 17.9%) have five to 15 such
employees, and 96 (or 7.2%) have more than 15 such employees. We
then applied those percentages to the 1,697 advisers we believe will
be subject to the proposed rule for a total of 1,271 smaller, 304
medium and 122 larger firms.
\564\ [$10,000 x 788] + [$100,000 x 122] = $7,880,000 +
$12,200,000 = $20,080,000.
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B. Rule 206(4)-3
The amendment to rule 206(4)-3 contains a revised collection of
information requirement within the meaning of the PRA. In the Proposing
Release, the Commission published notice soliciting comment on the
collection of information requirement.\565\ The Commission submitted
the revised collection of information requirement to OMB for review in
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. Rule 206(4)-3
contains a currently approved collection of information under OMB
control number 3235-0242. The title for the collection of information
is ``Rule 206(4)-3--Cash Payments for Client Solicitations.'' As noted
above, an agency may not sponsor, or conduct, and a person is not
required to respond to, a collection of information unless it displays
a currently valid OMB control number.
---------------------------------------------------------------------------
\565\ See Proposing Release, at section IV.
---------------------------------------------------------------------------
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
[[Page 41064]]
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.\566\
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\566\ Section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].
---------------------------------------------------------------------------
The Commission is adopting amendments to rule 206(4)-3 under the
Advisers Act. The amendments to rule 206(4)-3, which are identical to
our proposed amendments, 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 rule
206(4)-5. This collection of information is 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.
We requested comment on the PRA analysis contained in Proposing
Release. We received no comment on this portion of our analysis. In
addition, we have not modified our amendments to rule 206(4)-3 relative
to our proposal.
The current approved collection of information for rule 206(4)-3,
set to expire on March 31, 2011, is based on an estimate that 20
percent 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).
Commission records indicate that currently there are approximately
11,607 registered investment advisers,\567\ 20 percent of which (or
2,321) 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 1,112.32 hours (158
additional advisers \568\ x 7.04 hours). We estimate that approximately
20 percent of the Commission-registered advisers that use rule 206(4)-3
(or 464 advisers) \569\ provide, or seek to provide, advisory services
to government clients.\570\ Under the amendments, each respondent would
be prohibited from certain solicitation activities, subject to the
exception for ``regulated persons,'' with respect to government
clients, activities that otherwise would have been covered by rule
206(4)-3.\571\ Thus, they would not need to enter into and retain the
written agreement required under rule 206(4)-3 with respect to those
third parties they are prohibited from paying to solicit government
entities.
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\567\ This figure is based on registration information from IARD
as of April 1, 2010. The figures we relied on in our Proposing
Release were based on registration information from IARD as of July
1, 2009.
\568\ 2,321 (20% of current registered investment advisers)--
2,163 (20% of registered investment advisers when burden estimate
was last approved by OMB) = 158.
\569\ 2,321 x 20 percent = 464.
\570\ In light of the 11.48% 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 558.
\571\ Rule 206(4)-3(a).
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In the Proposing Release, we estimated a decrease to the burden due
to the prohibition on paying third party solicitors to be 20% of the
annual burden. As a result of the revised ban on using third parties,
we now estimate that the amendments to rule 206(4)-3 will only decrease
the burden by 15 percent,\572\ or approximately 1.06 hour,\573\ per
Commission-registered adviser that uses the rule and has or is seeking
government clients annually, for a total decrease of 491.84 hours.\574\
The revised annual aggregate burden for all respondents to the
recordkeeping requirements under rule 206(4)-3 thus would be 15,848.48
hours.\575\ The revised average burden per Commission-registered
adviser would be 6.83 hours.\576\
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\572\ In our proposal, which would have banned the use of third-
party solicitors altogether, we estimated a 20 percent decrease in
the burden under rule 206(4)-3. But, to account for the regulated
persons exception to the third-party solicitor ban in adopted rule
206(4)-5, we have modified our estimate to only a 15 percent
decrease. That is because our staff estimates that one quarter (or 5
percent) of the proposal's estimated burden reduction relating to
entering into and retaining the written agreement required under
rule 206(4)-3 will be retained as investment advisers engage third
parties that are regulated persons to solicit on their behalf.
\573\ 7.04 x 15 percent = 1.06.
\574\ 464 x 1.06 = 491.84.
\575\ 15,228 (current approved burden) + 1,112.32 (burden for
additional registrants)--491.84 (reduction in burden for amendments)
= 15,848.48 hours.
\576\ 15,848.48 (revised annual aggregate burden) divided by
2,321 (total number of registrants who rely on rule) = 6.83.
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C. Rule 206(4)-7
As a result of the adoption of rule 206(4)-5, rule 206(4)-7
contains a revised collection of information requirement within the
meaning of the PRA. In the Proposing Release, the Commission estimated
that registered advisers would spend between 8 hours and 250 hours to
establish policies and procedures to comply with rule 206(4)-5.\577\
Rule 206(4)-7 contains a currently approved collection of information
under OMB control number 3235-0585. The title for the collection of
information is ``Investment Advisers Act Rule 206(4)-7, Compliance
procedures and practices.'' As noted above, an agency may not sponsor,
or conduct, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
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\577\ See Proposing Release, at section III.B.
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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)-7, in part, requires registered investment advisers to
adopt and implement written policies and procedures reasonably designed
to prevent violation of the Federal securities laws. This collection of
information is mandatory. The purpose of the information collection
requirement is to ensure that registered advisers maintain
comprehensive, written internal compliance programs. It also assists
the Commission's staff in its examination and oversight program.
Information obtained in our examination and oversight program generally
is kept confidential.\578\
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\578\ Section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].
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As we previously noted, we expect that registered investment
advisers subject to rule 206(4)-5 will modify their compliance programs
to address new obligations under that rule. The current approved
collection of information for rule 206(4)-7, set to expire on March 31,
2011, is based on 10,817 registered advisers that were subject to the
rule at an average burden of 80 hours each year per respondent for a
total of 865,360 burden hours.
Commission records indicate that currently there are approximately
11,607 registered investment advisers.\579\ 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
63,200 hours (790 x 80 hours). In addition, although the time needed to
comply with rule 206(4)-5 will vary significantly from adviser to
adviser, as discussed in detail below, the Commission staff estimates
that firms with government clients will spend between 8 hours and 250
hours to implement policies and procedures to comply with the rule,
depending on the
[[Page 41065]]
firm's number of covered associates.\580\ Of the 1,697 registered
advisers that we estimate may be affected by rule 206(4)-5,\581\ we
estimate that approximately 1,271 are smaller firms, 304 are medium
firms, and 122 are larger firms.\582\ We anticipate that smaller firms
will spend 8 hours, medium firms will spend 125 hours, and larger firms
will spend 250 hours,\583\ for a total of 78,668 hours,\584\ to
implement policies and procedures. Our estimates take into account our
staff's observation that some registered advisers have established
policies regarding political contributions, which can be revised to
reflect the new requirements. The revised annual aggregate burden for
all respondents to comply with rule 206(4)-7 thus would be 1,007,228
hours.\585\
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\579\ This figure is based on registration information from IARD
as of April 1, 2010.
\580\ See section IV.B.1. of this Release (describing the cost
estimates associated with compliance with rule 206(4)-5).
\581\ See supra note 558. 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)] are not subject to rule 206(4)-
7 and, therefore, are not reflected in this burden estimate pursuant
to the PRA.
\582\ See supra note 475.
\583\ See supra notes 489-491.
\584\ (1,271 x 8 = 10,168) + (304 x 125 = 38,000) + (122 x 250 =
30,500) = 78,668.
\585\ 865,360 (current approved burden) + 63,200 (burden for
additional registrants) + 78,668 (burden attributable to rule
206(4)-5) = 1,007,228 hours.
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D. Rule 0-4
Rule 0-4 under the Advisers Act,\586\ entitled ``General
Requirements of Papers and Applications,'' prescribes general
instructions for filing an application seeking exemptive relief with
the Commission. The requirements of rule 0-4 are designed to provide
the Commission with the necessary information to assess whether
granting the orders of exemption is necessary and appropriate, in the
public interest and consistent with the protection of investors and the
intended purposes of the Act. In light of the adoption of rule 206(4)-
5, which contains a provision for seeking an exemptive order from the
Commission, we are revising the collection of information requirement
for rule 0-4. Rule 0-4 contains a currently approved collection of
information under OMB control number 3235-0633. As noted above, an
agency may not sponsor, or conduct, and a person is not required to
respond to, a collection of information unless it displays a currently
valid OMB control number.
---------------------------------------------------------------------------
\586\ 17 CFR 275.0-4.
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The current approved collection of information contains an
estimated total annual hour burden of one hour for administrative
purposes because most of the work of preparing an application is
performed by outside counsel and, therefore, imposes minimal, if any,
hourly burden on respondents. Because we expect that all, or
substantially all, of the work of preparing an application for an
exemptive order under rule 206(4)-5 will also be performed by outside
counsel, we continue to believe that the current estimate of one hour,
in the unlikely event the adviser does perform an administrative role,
is sufficient. As a result, we are not increasing our estimated hourly
burden in connection with the adoption of rule 206(4)-5.
The current approved collection of information also contains an
estimated total annual cost burden of $355,000, which is attributed to
outside counsel legal fees. In the Proposing Release, we estimated that
approximately five advisers annually would apply to the Commission for
an exemption from rule 206(4)-5.\587\ We also estimated that an
advisory firm that applies for an exemption would hire outside counsel
to prepare their exemptive requests, and that counsel would spend 16
hours preparing and submitting an application for review at a rate of
$400 per hour, for a per application cost of $6,400 and a total
estimated cost for five applications annually of $32,000.
---------------------------------------------------------------------------
\587\ See Proposing Release, at Section III.B.
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The Commission requested public comment on these estimates in the
Proposing Release, and we received comments indicating that our
estimate of five exemptive application submissions per year is too
low.\588\ We did not receive comments on our cost estimates. Given that
the advisory industry is much larger than the municipal securities
industry, and in light of the number of comment letters we received
that expressed concern about inadvertent violations of the rule that
would not qualify for the exception for returned contributions, our
staff estimates that approximately seven advisers annually would apply
to the Commission for an exemption from the rule. Although we may
initially receive more than seven applications a year for an exemption,
over time, we expect the number of applications we receive will
significantly decline to an average of approximately seven annually. We
continue to believe that a firm that applies for an exemption will hire
outside counsel to prepare an exemptive request, but based on
commenters' concerns have raised the number of hours counsel will spend
preparing and submitting an application from 16 hours to 32 hours, at a
rate of $400 per hour.\589\ As a result, each application will cost
approximately $12,800, and the total estimated cost for seven
applications annually will be $89,600. The total estimated annual cost
burden to applicants of filing all applications has therefore increased
to $444,600.\590\
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\588\ See Davis Polk Letter; ICI Letter.
\589\ The hourly cost estimate of $400 is based on our
consultation with advisers and law firms who regularly assist them
in compliance matters.
\590\ $355,000 + $89,600 = $444,600.
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VI. Final Regulatory Flexibility Analysis
The Commission has prepared the following Final Regulatory
Flexibility Analysis regarding 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.\591\ We prepared an Initial Regulatory
Flexibility Analysis (``IRFA'') in conjunction with the Proposing
Release in August 2009.\592\ The Proposing Release included, and
solicited comment, on the IRFA.
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\591\ 5 U.S.C. 604(b).
\592\ See Proposing Release, at section V.
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A. Need for the Rule
Investment advisers that seek to influence the award of advisory
contracts by government entities, by making or soliciting political
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.\593\
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 rule and rule amendments
we are adopting today are designed to prevent fraud, deception, and
manipulation by reducing or eliminating adviser participation in pay to
play practices.
---------------------------------------------------------------------------
\593\ See section I of this Release, for more information about
the need for the Commission to take action to prevent pay to play
practices.
---------------------------------------------------------------------------
Rule 206(4)-5, the ``pay to play'' rule, prohibits an investment
adviser registered (or required to be registered)
[[Page 41066]]
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, makes 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.\594\ In addition, the
rule we are adopting prohibits an adviser and 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,\595\ and from providing or agreeing to provide, directly or
indirectly, payment to any third party, other than a ``regulated
person,'' engaged to solicit advisory business from any government
entity on behalf of the adviser.\596\ Further, the prohibitions in the
rule also apply to advisers to certain investment pools in which a
government entity invests or that are investment options of a plan or
program of a government entity.\597\ The amendment we are adopting to
rule 204-2 is designed to provide Commission staff with records to
review compliance with rule 206(4)-5, and the amendment to rule 206(4)-
3 clarifies the application of the cash solicitation rule as a result
of the adoption of rule 206(4)-5.\598\
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\594\ Rule 206(4)-5(a)(1).
\595\ Rule 206(4)-5(a)(2)(ii).
\596\ Rule 206(4)-5(a)(2)(i). ``Regulated person'' is defined in
rule 206(4)-5(f)(9).
\597\ Rule 206(4)-5(c).
\598\ For a more detailed discussion of the prohibitions
contained in rule 206(4)-5, see section II.B.2 of this Release. For
a more detailed discussion of the amendments to rules 204-2 and
206(4)-3, see sections II.D and II.E, respectively, of this Release.
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B. Significant Issues Raised by Public Comment
In the Proposing Release, we requested comment on the IRFA, in
particular, on the number of small entities, particularly small
advisers, to which the 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. We received a number of
comments related to the impact of our proposal on small advisers. The
commenters argued that the proposed rule, particularly the provision
that would have prohibited advisers from directly or indirectly
compensating any third party to solicit government business on its
behalf, would be disproportionately expensive for, and would impose an
undue regulatory burden on, smaller firms.\599\
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\599\ See supra note 522.
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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.\600\
---------------------------------------------------------------------------
\600\ 17 CFR 275.0-7(a).
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The Commission estimates that as of April 2010 there are
approximately 708 small SEC-registered investment advisers.\601\ Of
these 708 advisers, 61 indicate on Form ADV that they have State or
local government clients, and would, therefore, be affected by the
rule.\602\ The rule also applies to those advisers that are exempt from
registration with the Commission in reliance on section 203(b)(3) of
the Advisers Act. As noted above, 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).\603\ Applying the same principles we
used with respect to registered investment advisers, we estimate that
230 of those advisers manage pooled investment vehicles in which
government client assets are invested and would therefore be subject to
the rule.\604\ Based on the current number of registered advisers
subject to the rule that are small entities, we estimate that
approximately 4 percent of unregistered advisers,\605\ or nine, would
be subject to the rule are small entities.\606\
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\601\ This estimate is based on registration information from
IARD as of April 1, 2010. We have estimated the number of small
advisers by reference to advisers' responses to Item 12.A, B and C
of Part 1 of Form ADV.
\602\ This estimate is based on registration information from
IARD as of April 1, 2010. We have estimated the number of small
advisers with State or local government clients by reference to
advisers' responses to Item 5.D(9) of Part 1 of Form ADV.
\603\ This number is based on our review of registration
information on IARD as of April 1, 2010, 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.
\604\ 11.48% of 2000 is 230. See supra note 474.
\605\ 61 registered small entities subject to the rule/1,697
registered advisers subject to the rule = 3.6%.
\606\ 230 x 4% = 9.2. Because these advisers are not registered
with us, we do not have more precise data about them, and we are not
aware of any databases that compile information regarding how many
advisers that are exempt from registration with the Commission in
reliance on section 203(b)(3) of the Advisers Act have State or
local government clients, and how many of these advisers would be
small entities for purposes of this analysis. We sought comments on
this issue, but none of the comments we received provided any
estimates or empirical data. However, we address above commenters
who generally questioned our estimates. See supra notes 482-484 and
accompanying text. We expect certain additional advisers may incur
compliance costs associated with rule 206(4)-5. Some advisers may be
subject to the rule because they solicit government entities on
behalf of other investment advisers.
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D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
The rule imposes certain reporting, recordkeeping and compliance
requirements on advisers, including small advisers. The rule imposes a
new compliance requirement by: (i) Prohibiting an adviser from
providing investment 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, other than
a ``regulated person,'' 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 rule amendments 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, its
solicitors, and its political contributions, as well as the political
contributions of its covered associates.\607\ An investment adviser
that does not provide or seek to provide advisory services to a
government entity, or to a covered investment pool
[[Page 41067]]
in which a government entity invests, is not subject to rule 206(4)-5
and certain recordkeeping requirements under amended rule 204-2.
---------------------------------------------------------------------------
\607\ See supra notes 559-564 and accompanying text (providing
the revised estimated hour burden and non-labor cost burden to
comply with amended rule 204-2, for purposes of the PRA).
---------------------------------------------------------------------------
As noted above, we believe that a limited number of small advisers
\608\ will have to comply with rule 206(4)-5 and the amendments to
rules 204-2 and 206(4)-3. To the extent small advisers tend to have
fewer clients and fewer employees that would be covered associates for
purposes of the rule, the rule should impose lower costs on small
advisers as compared to large advisers because variable costs, such as
the requirement to make and keep records relating to contributions,
should be lower due to the likelihood that there would be fewer records
to make and keep.\609\ Moreover, as discussed above, the rule and
amendments were modified from what we had proposed in several ways that
we expect will substantially minimize compliance burdens on small
advisers.
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\608\ See section VI.C of this Release.
\609\ However, as noted above, many larger advisers with broker-
dealer affiliates may spend fewer 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
section IV.B.
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E. Agency Action To Minimize Effect on Small Entities
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.\610\ In
considering whether to adopt rule 206(4)-5 and the amendments to rules
204-2 and 206(4)-3, 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 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 rule and rule amendments, or
any part thereof, for such small entities.
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\610\ 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 Proposing Release, at section
II.A.2, including nn.133 and 134 and accompanying text.
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Regarding the first alternative, the Commission is not adopting
different compliance or reporting requirements for small advisers as it
may be inappropriate to do so 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 rule and rule amendments would provide to public
pension plan clients and their beneficiaries.
Regarding the second alternative, we considered whether further
clarification, consolidation, or simplification of the compliance
requirements would be feasible or necessary, and would reduce
compliance requirements. As a result, we have simplified the compliance
requirements by limiting the recordkeeping obligations to better
reflect the activities of an adviser or a covered associate that could
result in the adviser being subject to the two-year time out, including
not requiring advisers to maintain records of unsuccessful
solicitations of government entities and payments (as opposed to
contributions) by advisers or covered associates to government
officials.\611\ Moreover, we are amending rule 206(4)-3, the cash
solicitation rule, to clarify that the requirements of new rule 206(4)-
5 apply to solicitation activities involving government clients.\612\
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\611\ See supra note 423 and accompanying text.
\612\ See section II.D. of this Release.
---------------------------------------------------------------------------
Regarding the third alternative, we considered 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 rule and related rule
amendments. Banning pay to play practices benefits clients of both
small and large advisers, and it would be inconsistent to specify
different requirements for small advisers.
As discussed above, several commenters suggested alternative
approaches to our rule.\613\ Such alternatives include, for example:
(i) That we require advisers to disclose their contributions to State
and local officials; (ii) that we require advisers to include in their
codes of ethics a policy that prohibits contributions made for the
purpose of influencing the selection of the adviser; (iii) that we
require advisers to adopt policies and procedures reasonably designed
to prevent and detect contributions designed to influence the selection
of an adviser; (iv) that we mandate preclearance of employee
contributions; and (v) that we allow an adviser to customize sanctions
based on the severity of the violation.\614\ While it may be true that
some of these approaches could diminish the compliance burdens on
advisers, including small advisers, as we explain above, we considered
these alternative approaches and do not believe they would
appropriately address the kind of conduct at which our rule is
directed.\615\
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\613\ See generally section II.B.2(a) of this Release.
\614\ See id.
\615\ See id.
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We are sensitive to the burdens our rule amendments will have on
small advisers. We believe that the rule we are adopting today contains
a number of modifications from what we had proposed that will alleviate
many of the commenters' concerns regarding small advisers. Most
notably, as described above, we have created an exception to the third-
party solicitor ban for ``regulated persons,'' which will, for
instance, allow advisers to continue to use third party placement
agents to sell interests in covered investment pools they manage
instead of incurring additional costs to hire internal marketing staff,
a result that could have disproportionally affected small
advisers.\616\ Moreover, as discussed above, we have modified the
exceptions to the rule's two-year time out provisions in certain
respects to reduce the likelihood of an inadvertent or minor violation
of the rule, including a shortened look back of six months for certain
new covered associates whose contributions are less likely to involve
pay to play and a new de minimis exception for contributions to
officials for whom a covered associate is not entitled to vote.\617\ We
have also limited certain recordkeeping requirements we had proposed in
order to achieve our
[[Page 41068]]
goals in a way that balances the costs and benefits of the rule,
including not requiring records of unsuccessful solicitations or
payments (that are not contributions) by advisers or covered associates
to government officials.\618\
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\616\ See section II.B.2(b) of this Release.
\617\ See sections II.B.2(a)(5) and (6) of this Release.
\618\ See sections II.D and III.B.3. of this Release.
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VII. Effects on Competition, Efficiency and Capital Formation
We are adopting amendments to rule 204-2 pursuant to our 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.'' \619\ Section 202(c) of the Advisers Act
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.\620\
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\619\ 15 U.S.C. 80b-4.
\620\ 15 U.S.C. 80b-2(c). In contrast, we are adopting rule
206(4)-5 and amendments to rule 206(4)-3 pursuant to our authority
set forth in sections 206(4) and 211. For a discussion of the
effects of these amendments on competition, efficiency and capital
formation, see sections IV, V, and VI of this Release.
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In the Proposing Release, we solicited comment on whether, if
adopted, the proposed amendments to rule 204-2 would promote
efficiency, competition and capital formation. We further encouraged
commenters to provide empirical data to support their views on any
burdens on efficiency, competition or capital formation that might
result from adoption of the proposed amendments. We did not receive any
empirical data in this regard concerning the proposed amendments. We
received some general comments, addressed below, asserting that the
proposed amendments to require registered advisers to maintain books
and records relating to investment advisory services they provide to
government entities would have an adverse impact on competition.
We are amending rule 204-2 to require a registered adviser to make
and keep a list of its covered associates, the government entities to
which the adviser directly or indirectly provides advisory services,
the ``regulated person'' solicitors the adviser retains, and the
contributions made by the firm and its covered associates, as
applicable, to government officials and candidates.\621\ The amendments
are designed to provide our examiners important information about the
adviser and its covered associates' contributions to government
officials, the government entities to which the adviser directly or
indirectly provides advisory services, and the solicitors it retains.
These amendments may also benefit advisers as records required under
the amended rule will assist the Commission in enforcing the rule
against, for example, an adviser whose pay to play activities, if not
uncovered, could adversely affect the competitive position of a
compliant adviser.
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\621\ Rule 204-2(a)(18)(i).
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Although we believe that the amendments to the Advisers Act
recordkeeping rule will require advisers to incur both one-time costs
to establish and enhance current systems to assist in their compliance
with the amendments and ongoing costs to maintain records, these costs
will be borne by all registered advisers that have government entity
clients or that pay regulated entities to solicit government clients on
their behalf. As the amendments to the recordkeeping rule do not
disproportionally affect any particular group of advisers with
government entity clients and do not materially increase the compliance
burden on advisers under rule 204-2, we do not believe that they will
affect competition across registered investment advisers. Some
commenters asserted that certain asset managers that provide advice to
government entities but are not subject to the Advisers Act
recordkeeping rule, such as banks and advisers that are exempt from
registration under the Act, may be at a competitive advantage to
registered advisers that must incur the costs of keeping records under
the rule.\622\ While we acknowledge these entities could potentially
obtain a competitive advantage for this reason, we do not believe the
costs attributable to the amendments to rule 204-2 will have a
significant impact on registered advisers such that the advantage
gained by asset managers not subject to the Advisers Act recordkeeping
rule will be substantial.\623\ Moreover, exempt advisers or persons
that do not meet the definition of investment adviser are not subject
to rule 204-2.\624\ Finally, we also note that banks may be subject to
laws and rules that do not apply to registered advisers.
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\622\ SIFMA Letter (``The books and records requirement under
the Proposed Rule are under inclusive. * * * As an initial matter,
the books and records requirements apply only to some of the
advisers covered by the Proposed Rule--although the Proposed Rule
applies to a substantial number of entities who are exempt from
registration under the Advisers Act, the Proposed Rule's additional
books and records only modify the rules that apply to registered
investment advisers.'').
\623\ In addition, we note that advisers not subject to the
amendments to rule 204-2 may nonetheless maintain some of the
required records as part of a strong compliance program.
\624\ See section 204 of the Advisers Act, 15 U.S.C. 80b-4 (that
provides the Commission authority to prescribe recordkeeping for
advisers, other than those specifically exempted from registration).
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We believe that the amendments to rule 204-2 may, to a limited
extent, affect efficiency and capital formation with respect to the
allocation of public pension plan assets. The amendments to rule 204-2
will allow our staff to examine for compliance with rule 206(4)-5.
Authority to examine records may improve registered investment
advisers' compliance with rule 206(4)-5, which may reduce the adverse
effects of political contributions on the selection of investment
advisers. While the amendments to the rule will not affect the
aggregate amount of pension fund assets available for investment,
limiting the effects of political contributions on the investment
adviser selection process should improve the mechanism by which capital
is formed and allocated to investment opportunities.
VIII. Statutory Authority
The Commission is adopting new rule 206(4)-5 and amending 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 amending 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.
0
For the reasons set out in the preamble, Title 17 Chapter II of the
Code of Federal Regulations is amended as follows.
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
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.
* * * * *
0
2. Section 275.204-2 is amended by adding paragraph (a)(18) and by
revising paragraph (h)(1) to read as follows:
[[Page 41069]]
Sec. 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 to which the investment adviser
provides or has provided investment advisory services, or which are or
were investors in any covered investment pool to which the investment
adviser provides or has provided investment advisory services, as
applicable, in the past five years, but not prior to September 13,
2010;
(C) All direct or indirect contributions made by the investment
adviser or any of its covered associates to an official of a government
entity, or direct or indirect payments to a political party of a State
or political subdivision thereof, or to a political action committee;
and
(D) The name and business address of each regulated person to whom
the investment adviser provides or agrees to provide, directly or
indirectly, payment to solicit a government entity for investment
advisory services on its behalf, in accordance with Sec. 275.206(4)-
5(a)(2).
(ii) Records relating to the contributions and payments referred to
in paragraph (a)(18)(i)(C) 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) An investment adviser is only required to make and keep
current the records referred to in paragraphs (a)(18)(i)(A) and (C) of
this section if it provides investment advisory services to a
government entity or a government entity is an investor in any covered
investment pool to which the investment adviser provides investment
advisory services.
(iv) For purposes of this section, the terms ``contribution,''
``covered associate,'' ``covered investment pool,'' ``government
entity,'' ``official,'' ``payment,'' ``regulated person,'' and
``solicit'' have the same meanings as set forth in Sec. 275.206(4)-5.
* * * * *
(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.
* * * * *
0
3. Section 275.206(4)-3 is amended by adding paragraph (e) and removing
the authority citation at the end of 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.
0
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 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 such person is a
regulated person or 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 $350 to any one official, per election, or to officials for whom
the covered associate was not entitled to vote at the time of the
contributions and which in the aggregate do not exceed $150 to any one
official, per election.
(2) Exception for certain new covered associates. The prohibitions
of paragraph (a)(1) of this section shall not apply to an investment
adviser as a result of a contribution made by a natural person more
than six months prior to becoming a covered associate of the investment
adviser unless such person, after becoming a covered associate,
solicits clients on behalf of the investment adviser.
(3) 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)(3)(ii) and (b)(3)(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 $350; 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.
[[Page 41070]]
(ii) In any calendar year, an investment adviser that has reported
on its annual updating amendment to Form ADV (17 CFR 279.1) that it has
more than 50 employees is entitled to no more than three exceptions
pursuant to paragraph (b)(3)(i) of this section, and an investment
adviser that has reported on its annual updating amendment to Form ADV
that it has 50 or fewer employees is entitled to no more than two
exceptions pursuant to paragraph (b)(3)(i) of this section.
(iii) An investment adviser may not rely on the exception provided
in paragraph (b)(3)(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 the 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 any person who supervises, directly or
indirectly, such employee; 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:
(i) An investment company registered under the Investment Company
Act of 1940 (15 U.S.C. 80a) that is an investment option of a plan or
program of a government entity; or
(ii) Any company that would be an investment company under section
3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(a)), 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)).
(4) Executive officer of an investment adviser means:
(i) The president;
(ii) Any vice president in charge of a principal business unit,
division or function (such as sales, administration or finance);
(iii) Any other officer of the investment adviser who performs a
policy-making function; or
(iv) Any other person who performs similar policy-making functions
for the investment adviser.
(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 pool of assets sponsored or established by the State or
political subdivision or any agency, authority or instrumentality
thereof, including, but not limited to a ``defined benefit plan'' as
defined in section 414(j) of the Internal Revenue Code (26 U.S.C.
414(j)), or a State general fund;
(iii) A plan or program of a government entity; and
(iv) 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 participant-
directed investment program or plan sponsored or established by a State
or political subdivision or any agency, authority or instrumentality
thereof, 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) Regulated person means:
(i) An investment adviser registered with the Commission that has
not, and whose covered associates have not,
[[Page 41071]]
within two years of soliciting a government entity:
(A) Made a contribution to an official of that government entity,
other than as described in paragraph (b)(1) of this section; and
(B) Coordinated or solicited any person or political action
committee to make any contribution or payment described in paragraphs
(a)(2)(ii)(A) and (B) of this section; or
(ii) A ``broker,'' as defined in section 3(a)(4) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)) or a ``dealer,'' as defined
in section 3(a)(5) of that Act (15 U.S.C. 78c(a)(5)), that is
registered with the Commission, and is a member of a national
securities association registered under section 15A of that Act (15
U.S.C. 78o-3), provided that:
(A) The rules of the association prohibit members from engaging in
distribution or solicitation activities if certain political
contributions have been made; and
(B) The Commission, by order, finds that such rules impose
substantially equivalent or more stringent restrictions on broker-
dealers than this section imposes on investment advisers and that such
rules are consistent with the objectives of this section.
(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.
By the Commission.
Dated: July 1, 2010.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-16559 Filed 7-13-10; 8:45 am]
BILLING CODE 8010-01-P