Adviser Pays $95,000 Fine for Pay-to-Play Foot Fault in a Timely Reminder this Election Season

For firms that provide advisory services to government entities, the Advisers Act Rule 206(4)-5, the “Pay-to-Play” Rule, can be a major headache. The rule limits investment advisers, including exempt reporting advisers, from making political contributions to state and local government officials and candidates with the authority to influence the selection of an investment manager for a public pension fund. The rule imposes an onerous penalty with a long lifespan – investment advisers are prohibited from receiving compensation for managing a government entity’s investments for two years after either the firm, a “covered associate” or a political action committee (PAC) they control, makes a political contribution to a state or local official who can influence the hiring of the investment adviser.  The rule allows an adviser or “covered associate” to make de minimis contributions of $350 per election cycle for candidates running for offices that the covered associate can vote for and $150 for other candidates. The rule does not apply to contributions to federal officials and candidates, except when the state or local official is running for federal office. Covered associates include employees who solicit government entities for the adviser.

Recent Case

In this case, the SEC settled with an adviser who was the sponsor and adviser to a private fund. The Michigan Public Employees’ Retirement Fund made a $100 million commitment to invest in the fund in 2017 (see a similar case here).  The adviser ran afoul of the Pay-to-Play Rule by hiring an individual who made a $7,150 campaign contribution to a Michigan government official, presumably Michigan’s governor, in December 2019.  The individual made this contribution more than six months before getting hired by the firm for a position that would be considered a “covered associate” under the rule. After being hired, the individual asked for, and got, the contribution returned.  These facts indicate that the firm had a policy and procedure to comply with the Pay-to-Play Rule and vetted the employee before hire. It is also fair to assume that the firm asked the employee to request the contribution return.

There are some exceptions to the rule, including one for returned contributions. In this case, however, the covered associate’s contribution exceeded the $350 limit and was not returned within 60 days after the firm learned of the contribution as required.

In this situation, the campaign contribution triggered the rule’s two-year look-back provision because the new employee was a covered associate. This meant that the adviser could not receive compensation for its advisory services for the government entity for two years because of the covered associate’s campaign contribution, which was made six months before hire.

Exceptions and Exemptive Orders

As previously stated, the rule has a few narrow exceptions. In addition to the one for returned contributions, there is an exception for new covered associates. Contributions made by an individual more than six months before becoming a covered associate of an investment adviser do not trigger the rule.  If, however, the associate solicits clients for the adviser, then the two-year look-back applies.

Advisers have another avenue for avoiding the severe consequences of the Pay-to-Play Rule, the exemptive process. The SEC has been willing to issue exemptive orders to firms with robust compliance programs that promptly address contributions made in violation of the Pay-to-Play Rule (see Advisers Act Release No. 6224, Advisers Act Release No. 6244, and Advisers Act Release No. 6221). This route may be less palatable since the process is public, requires the assistance of legal counsel, takes time, and requires the firm to live with additional conditions the Commission imposes.

Effect of Walz on Democratic Ticket

With Governor Walz on the Democratic ticket for vice president, firms that either provide or intend to provide advisory services to Minnesota government entities, such as a public employee pension fund, should be aware of the potential for violating the Pay-to-Play Rule if they, or their covered associates, intend on contributing to the Harris campaign. These firms must consider whether (i) the Minnesota Governor is directly or indirectly responsible for, or can influence, the outcome of, the hiring of an investment adviser by that Minnesota government entity, or (ii) 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 by that Minnesota government entity.

Compliance Tips for the Pay-to-Play Rule

Just in case you are a little rusty on the application of the Pay-to-Play Rule, here are our compliance tips:

• Identify governmental entities. Advisers must be able to identify government entities they serve along with any government entities invested in or solicited to invest in private funds managed by the firm. Identification of government entities should be part of the client onboarding process. Advisers Act Rule 204-2 requires that a firm maintain a list of all government entities to which the adviser has provided investment advisory services in the past five years.
• Identify covered associates and applicable look-back time frames. The SEC views the definition of covered associate very broadly. This includes general partners, managing members and executive officers and others with similar status or function. It also includes any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employees. A political action committee (PAC) controlled by the investment adviser is also a covered associate.  In the Final Release for Rule 206(4)-5, the SEC said, “[a]n employee need not be primarily engaged in solicitation activities to be a “covered associate” under the rule.”  Firms should consider all employees and independent contractors who are involved in the sales and relationship management process to be “covered persons.”
• Institute pre–clearance processes for campaign contributions. Because of the rule’s complexity, we recommend that firms that solicit government business require all employees to obtain approval before making a “campaign contribution” (see next point for more details), whether it is a local or state election. Contributions to candidates for federal office are not covered unless they happen to be state or local officials at the time of the contribution.
• Understand that “campaign contributions” are broadly defined. Campaign contributions include not only money but in-kind contributions such as payment for services or use of facilities, personnel or other resources to benefit any federal, state or local candidate campaign, political party committee, or other political organization, including a successful candidate’s inaugural committee or transition team. Volunteering to work on a campaign outside of working hours is not considered a campaign contribution but may be subject to firm pre-approval.
• Pre-employment and new “covered associate” vetting for campaign contributions. Firms should be aware of any contributions made by individuals within two years of becoming a covered associate, regardless of whether the individual was employed by the firm when the contribution was made. The look-back period is only six months for employees who are not involved in soliciting clients. The vetting should take place before hiring or promotion.
• Verify whether donations to PACs and political parties are allowed. Although contributions to a political party or non-adviser affiliated PACs do not usually trigger the Pay-to-Play Rule, the rule prohibits firms from circumventing the intent of the rule. Therefore, firms should consider a written representation from a PAC that the contributions will not be earmarked for a specific candidate or will only be spent on overhead costs associated with the PAC’s operations.
• Institute Periodic Testing. The firm’s compliance program should include periodic testing to ensure that employees are not making political contributions in violation of its policies and procedures. OpenSecrets.org is a free database that provides data on donors to local political campaigns.
• Consider state and local laws. Many states and municipalities have adopted laws and regulations limiting how investment managers can solicit investment advisory business. Make sure your firm understands and complies with these rules.

Venture Capital Funds Adjustment for Inflation

Unlike many of the SEC’s recent rules, the SEC’s proposal to adopt new Rule 3c-7 under the Investment Company Act received only two comments and has relatively little impact on the venture capital market. The final rule increases the dollar threshold for defining a “qualifying venture capital fund” under Section 3(c)(1)(C) of the Investment Company Act from $10 million to $12 million. The SEC was required to adjust this dollar threshold for inflation under the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.  The new rule becomes effective 30 days after publication in the Federal Register.

For the uninitiated, a company that is in the business of “investing, reinvesting or trading securities” must register with the SEC as an investment company under the Investment Company Act of 1940.  Registration is expensive, requires compliance with legal reporting and disclosure requirements, and subjects the investment company to the SEC’s regulatory oversight.  There are exceptions to registration requirements for investment companies. Section 3(c)(1) exempts private funds with no more than 100 beneficial owners who qualify as accredited investors.  A private fund may have up to 250 beneficial owners if it meets the definition of a “qualifying venture capital fund.” A qualifying venture capital fund is a private fund that pursues a capital strategy, invests no more than 20% of its committed capital in non-qualifying investments, restricts borrowing and leverage to 15% of the fund size, and limits limited partner redemption rights to extraordinary circumstances.

Photo by Didier VEILLON on Unsplash

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