August 3, 2010

SEC Adopts "Pay To Play" Rule

Arnold & Porter Advisory


On June 30, 2010, the SEC adopted new Rule 206(4)-5 (the "Rule") aimed at preventing investment advisers from making or soliciting campaign contributions in order to "buy" the investment advisory business of state and local government entities, such as (but not limited to) government pension plans. The Rule prohibits or penalizes a range of campaign contribution-related activities by investment advisory firms that have or that solicit government clients and many of those firms' current, past and future employees. The prohibitions and penalties are "prophylactic" in nature — they apply regardless of whether the particular activities actually involve attempts to influence government officials' selection of investment advisers or investment funds.

We believe that, because (i) the Rule's coverage is so broad, (ii) it is in essence a "strict liability" rule, and (iii) the consequences of even innocent mistakes in making relatively small political contributions can have costly effects, most advisers with any aspirations to manage assets for state or local government plans or entities will want to adopt procedures restricting campaign contributions to many, if not all, candidates for public office.

The Rule's main provisions:

  • penalize advisers for campaign contributions they or any of their "covered associates" (discussed below) make to the campaigns of officials who could influence (or who could appoint persons who could influence), a government entity's selection of investment advisers. The penalty takes the form of a "time out," prohibiting the adviser from receiving payment for advisory services from the government entity for 2 years after the adviser or a "covered associate" last made such a contribution;

  • prohibit advisers from paying any third party to solicit business (including investments in funds) from a government entity unless the third party is "regulated" — either as an SEC-registered investment adviser or as a registered broker-dealer that is a member of a self-regulatory organization that imposes pay-to-play rules at least as stringent as the SEC's; and

  • prohibit advisers and their "covered associates" from arranging for others to contribute to the campaigns or to the political parties of any government official or candidate for office with any government entity for which the adviser manages or seeks to manage money.

The Rule broadly makes it illegal to do anything indirectly that, if done directly, would be prohibited.

This alert describes the Rule's main provisions. Their application includes many details and nuances, including some important timing considerations. We discuss some of these below. Other questions will undoubtedly arise based on individual circumstances, particularly during the "transition" months immediately following the Rule's effective date (generally, September 13, 2010).

Any investment adviser, whether SEC-registered or not, that provides investment advice to any government entity or to any investment fund in which government entities invest or may invest, OR that may in the future want to provide advice to any such entity or fund, must consider adopting measures to comply with the new rule. These include:

  • establishing policies and procedures regarding employee campaign contributions;

  • obtaining detailed information from employees and prospective employees about past campaign contributions; and

  • maintaining records of employee campaign contributions and other elements of compliance with the Rule.


In order to determine whether the Rule applies to your firm, you should consider the following:

a.  Is your firm SEC-registered?

(1)  IF YES, your firm is covered by the Rule; proceed to Section 2.b.

(2)  IF NO, then:

(a)  Do you have more than $25 million under management?

(i)  If NO, your firm is not covered by the Rule. But you may want to continue to consider the Rule, as things you do while you are below the SEC's current registration threshold may affect your activities after you grow your AUM and become subject to SEC registration and the Rule.

(ii)  If YES, whether or not you are covered depends (at least for the moment) on the exemption on which you rely to avoid registration:

(A)  If your firm relies on the "private advisers exemption" (for advisers having fewer than 15 clients) in Section 203(b)(3) (as most venture fund advisers, most private equity fund advisers, and many hedge fund advisers do), it is covered by the Rule; proceed to Section 2.b.1

(B)  If your firm is not required to register with the SEC because of another exemptive provision, it is not covered by the Rule. Thus, entities that rely on registration exemptions for banks are not covered. Less clear is the impact that the Dodd-Frank Act may have on advisers who may not be required (or who may be prohibited) from registering with the SEC as a result of new exemptions (and bars) from SEC registration that the Act will introduce starting in July 2011. These include new exemptions from registration for certain "medium-sized" advisers2, advisers to "venture capital funds" (a term that the Dodd-Frank Act directs the SEC to define by July 2011) and "foreign private advisers" (a term that the Act defines, but that may also require SEC rulemaking to clarify). As currently constructed, the Rule (which was adopted before the Dodd-Frank Act) would not appear to apply to any of these exempt advisers. But the SEC may take further steps to cause the Rule to cover some or all of them. Thus, even if your firm may currently be exempt (or barred) from SEC registration under the Dodd-Frank Act, you may still want to act as if your firm is covered by the Rule (and keep reading), since things done while your firm is not covered may adversely affect its activities should it later become subject to the Rule.

b.  Does your firm manage money for state or local government entities (including managing funds in which state and local government entities invest)?3

(1)  If YES, your firm is covered by the Rule; proceed to Section 3 and the remainder of this alert. Note: your firm is covered not only if it manages private funds (such as venture capital, private equity, and hedge funds) in which government entities invest, but also if it (i) manages registered investment companies (mutual funds) that are investment options for government employee participant directed plans and (ii) acts as a sub-adviser for any government entity clients or any of the foregoing funds.

(2)  If NO, your firm is not covered by the Rule. But if you think your firm may want to manage money for government entities in the future, particularly if it manages an open-end vehicle, such as a hedge fund or mutual fund, that is open to new investments, you may want to continue reading. Things done while your firm is not covered may prevent it from accepting compensation for managing such assets in the future.


The Rule's first substantive provision relates to political contributions to state or local government officials. The Rule does not prohibit making such contributions, but it may fairly be viewed as penalizing them: it prohibits an adviser from receiving compensation for advisory services provided to a government entity for two years after the adviser or any "covered associate" makes a contribution to the campaign of any relevant official (discussed below). The SEC refers to this as a "time out."

a.  Contributions to which government officials will trigger a time out?

Contributions will trigger a time out if they are made to any government official whose office (i) is responsible (directly or indirectly) for or can influence a state or local government entity's decision to hire an investment manager or (ii) can appoint someone who has that authority. This includes anyone who is running for such an office, anyone who has been elected but has not yet taken office, and anyone who is in such an office. It also includes an election committee for any such a person. Although federal offices (e.g., Senator, Congressman/woman) are not themselves covered (a federal position wouldn't give them the power to influence adviser selection for a state or local governmental entity), candidates for those offices may be covered if they are currently in a covered state or local position. For example, if the California State Treasurer were to run for U.S. Congress, contributions to her Congressional campaign would trigger a time out as to California state entity clients over which the Treasurer's office has the relevant authority/influence.

What kinds of officials are in a position to "influence" adviser hiring decisions? The SEC has declined to elaborate.4 Thus, advisers must be extremely cautious, and it may be appropriate to treat essentially all elected positions as triggering time outs.  

b.  Whose contributions trigger a time out?

Contributions by an investment adviser and contributions by any of its "covered associates" will trigger a time out. There are some critical subtleties here.

"Covered Associates." The term "covered associate" includes any general partner, managing member, or executive officer of (or any person with a similar status or function at) the investment adviser. An "executive officer" includes the president, any vice president in charge of a principal business unit, division or function, and any other person who performs policy-making functions. "Covered associate" also includes any employee who solicits advisory business from government entities and anyone who supervises such an employee. This does not just mean marketing personnel and their supervisors — it includes anyone who, in his or her job, communicates, directly or indirectly, with anyone for the purpose of obtaining or retaining a government entity client. Such communications need not be a principal, or even a major part of an employee's activities. In small organizations, this can cover many employees not ordinarily considered "solicitors." A political action committee that is "controlled by" an adviser or any of its covered associates is also considered to be a "covered associate."

"Look Back." Advisers may need to make the most significant changes to their compliance programs and activities in order to address the Rule's "look back" provisions for treatment of contributions by "covered associates." Specifically, the Rule imposes a two-year, or in some cases six-month, "look back" period. Thus, if an adviser hires someone as a "covered associate" — or promotes someone to a "covered associate" position, the firm must "look back" to all contributions that person made for two years before the hiring or promotion. If, in that period, the covered associate made any covered contributions, the firm will be subject to a time out on compensation from any government entity whose officials received those contributions for the remainder of the two years that began with the contribution. This "look back" is limited to six months if the covered associate does not solicit government entity clients in his or her new position. 

c.  What sizes/types of contributions will trigger a time out?

Any covered associate contribution over $150 will trigger a time out, unless the covered associate is entitled to vote in the relevant election for the official, in which case only contributions over $350 will trigger a time out. These dollar limits apply separately for each election, with a primary election being treated as separate from a general election. There is no "de minimis" exception for contributions made by an advisory firm itself — any contribution made by the firm will trigger a time out.

The Rule defines "contribution" broadly to include any gift, subscription, loan, advance, deposit, or anything of value made for the purpose of influencing an election. It also includes funding a successful candidate's transition or inaugural expenses. It does not include the provision of personal (volunteer) services.

d.  Strict Liability

The Rule's time-out provisions apply regardless of whether (i) a contribution was made with the purpose or effect of influencing adviser-engagement decisions, (ii) the advisory firm knew, or even dreamed, at the time the contribution was made, that it might seek or obtain business from a government entity, (iii) the firm was aware that the contribution had been made, or (iv) the firm even existed at the time the contribution was made.5 Particularly in light of the "look back" provisions, an adviser must exercise diligence in its hiring and promotion decisions to be assured that new personnel have not, in the relevant look-back period, made contributions that could trigger a time out. But diligence will not prevent a time out if a covered contribution actually occurred. The SEC specifically rejected suggestions for a "due diligence inoculation," indicating that "statements" by prospective employees that they have not made relevant contributions will not protect against a time out.6 Further, a time out will continue to apply even after the covered associate who made the triggering contribution has left the adviser's employ — firing a covered associate for making an inappropriate contribution will not shorten the time out.


The Rule's second substantive provision prohibits an adviser from paying any third party (i.e., anyone not an employee or a general partner, managing member or person of similar stature within the adviser's organization) to solicit business from government entities unless the third party is a "regulated person." This includes using "placement agents" to solicit investments in funds the adviser manages.

By "regulated person," as an initial matter, the Rule means investment advisers and broker-dealers that are subject to the Rule and/or self-regulatory organization rules that the SEC finds are at least as restrictive as the Rule. Thus, SEC-registered advisers may qualify. And SEC-registered broker-dealers (particularly important for advisers to private equity funds, venture capital funds and hedge funds, for whom solicitation services generally may not legally be performed other than by a registered broker-dealer) may qualify, once FINRA has implemented a rule (currently under development) that the SEC considers adequate.

The Rule also uses the definition of "regulated person" to, in effect, impose restrictions on solicitors' activities. Thus, for an investment adviser to qualify as a "regulated person" to which a covered adviser may make payments for soliciting a government entity, not only must it be SEC-registered, but neither it, nor any of its covered associates, can have, within the two years preceding solicitation of that government entity, (i) made any contribution that would trigger a time out if the adviser or its covered associates had made the contribution or (ii) engaged in any coordination or solicitation of contributions or payments to government officials or political parties that the Rule prohibits the adviser and its covered associates from engaging in (see Section 5, below). Similarly, in order for FINRA's (or any other self-regulatory organization's) rules to enable a broker-dealer member to be a "regulated person" as to a government entity, these rules must prohibit member organizations from engaging in solicitation activities if the member organization (or any of its associated persons) has made certain contributions within two years before it begins soliciting investments from that government entity.

The Rule's provisions regarding SEC-registered investment advisers' qualification as "regulated persons" (for this discussion, "IA/Solicitors") differ structurally from the provisions regarding use of broker-dealers. This could theoretically result in different treatment of, and different compliance obligations related to, use of IA Solicitors than the treatment of and obligations related to the use of broker-dealer solicitors.7

Paying a solicitor in violation of the Rule will not necessarily trigger a time out for the paying adviser. But the SEC may exercise its general authority to assess penalties for violations of law. Further, if the solicitor's behavior that gives rise to the violation includes contributions to officials of the adviser's government entity clients, the SEC may find that the adviser has indirectly made contributions that would have triggered a time out and impose sanctions that have an effect that is the same as (or more severe than) a time out.


The Rule's third substantive provision prohibits advisers and covered associates from soliciting others to (i) contribute to officials of any government entity to which the adviser is providing or seeking to provide services or (ii) make any payment to any political party of a state or locality where the adviser is providing or seeking to provide services to a government entity. The Rule also prohibits advisers and their covered associates from "coordinating" either of those activities. The Rule and adopting release contain little guidance about what it means to "coordinate" payments, other than to note that the purpose of the provision is to prohibit advisers from "bundling" others' contributions and getting credit for those contributions with relevant government officials. While the Rule purports to define "solicit" and the SEC provides some examples of what may constitute "seeking" advisory business, the language is broad and the examples are not exclusive.


The Rule treats investments by government entities in hedge funds, venture capital funds, private equity funds, mutual funds, and other pooled vehicles the same as it does direct investment advisory engagements of the adviser by those entities. It also treats the inclusion of an adviser's fund as an investment option for participants in a participant-directed government entity benefit plan as constituting the engagement of the adviser by the government entity. It contains a few special provisions regarding recordkeeping as to mutual funds in which government entities or their employee plans invest or may invest.


The Rule generally becomes "effective" on September 13, 2010, but it provides two different dates by which advisers must comply with its substantive provisions. More specifically:

  • the time out provisions will generally apply to an adviser's or covered associate's contributions made after March 13, 2011;

  • soliciting or coordinating contributions to candidates and payments to political parties will generally be prohibited starting on March 14, 2011;

  • paying (or agreeing to pay) a third party solicitor that is not a "regulated person" will generally be prohibited starting September 13, 20118 (in part, to give FINRA and the SEC time to complete and implement rules regarding broker-dealers' contribution-related activities);

  • as exceptions to the general effective times above, the Rule's time-out provisions and its prohibitions will not apply to activities related to registered investment companies (mutual funds) that are investment options of a government plan or program until September 13, 2011; and

  • recordkeeping applicable to the various affected activities will generally become required at the time the substantive provisions related to those activities become effective.


As noted, the Rule is prophylactic in nature. While some definitions contain subjective references (such as actions being "intended" to cause certain things or "seeking" to obtain business), the Rule's compensation time-out provisions in particular are strict and unaffected by an adviser's innocent intent relating to, or even lack of knowledge of, the offending contributions or activities — even if the advisor has rigorously implemented well-designed compliance procedures. The Rule contains limited exceptions from the time-out provisions for a very limited number of returned contributions, if discovered and recovered in a short period of time and if other conditions are met. And it provides a process by which an adviser may obtain a discretionary exemption from the SEC for certain limited occurrences of innocent, accidental prohibited contributions. But generally, even the most innocent offending contribution can create a costly time out.

Each SEC-registered adviser must maintain certain records of, among other things, the identities of all "covered associates," all government entities to which it has provided investment advisory services in the past five years (including entities that have invested in funds the adviser manages), campaign contributions and payments to PACs and political parties that it and its covered associates have made, and information about each "regulated person" with which it has an arrangement to pay for soliciting government entity clients and investments.

Rule 206(4)-7 requires that advisers maintain policies and procedures reasonably intended to ensure compliance with laws and rules. The new Pay-to-Play Rule necessitates the adoption of new procedures. Particularly in light of the Rule's "strict liability" approach to imposing time outs, covered advisers should adopt and rigorously enforce policies that include, at least the following (noting possible variations):

  • Require preclearance for any campaign contribution, any volunteer political activity, and any other involvement in any campaign activity, by any covered associate. Particularly, because of difficulties in determining whether a particular state or local government office will be considered covered, some firms may choose simply to prohibit covered personnel from contributing to and working for campaigns for state and local office and possibly state and local political parties. Other firms, particularly those that do not expect to have government clients, may permit contributions to and work for campaigns for federal office, without preclearance, where the candidate is not currently a state or local government official. But this approach involves covered associate discretion and will expose the firm to the risk that a covered associate may commit an innocent error.

  • As an adjunct to preclearance requirements, require prompt reporting by covered personnel of each campaign contribution and each acceptance of a position with or provision of services to a political campaign or political party. Firms may even wish to supplement this with quarterly or annual "round up" reports (similar to personal securities transaction reports) in which personnel confirm that they have not made contributions, accepted positions or provided services in the preceding period (other than as reported).

  • Clearly identify exactly who will be subject to these restrictions and reporting and other requirements. Amendments to the Advisers Act recordkeeping rule require SEC-registered advisers to maintain a list of all "covered associates." But, because of ambiguities in the definition of that term, and the potential that employees' roles may evolve, some firms (particularly smaller firms) may choose to apply substantive limitations and reporting requirements beyond the strict definition of "covered associate."
  • As part of the application or promotion process for each person the firm is considering hiring for or assigning to a "covered associate" position, require detailed reporting of all campaign contributions he or she has made over the preceding two years, and information regarding the acceptance of a position with or provision of services to a political campaign or political party.

Firms may also want to consider imposing at least some of these provisions on covered persons' spouses9 and conducting independent inquiry about some of the employee-provided information described above, such as searching public campaign contribution reports, for covered persons (and candidates for hiring or promotion to covered positions) in all jurisdictions in which the firm has or can envision seeking government entity clients.


This alert describes the Rule and related rule amendments in general terms. Each adviser that may have or may seek to have government entity clients must evaluate its particular needs in light of the specific and detailed terms of the Rule. We are happy to help in any way.

1 But note that the Dodd-Frank Act, signed by President Obama on July 21, 2010, will eliminate the "private advisers exemption" under Section 203(b)(3) registration exemption as of July 21, 2011 (and will replace it with a new "Section 203(b)(3)" exemption for "foreign private advisers"). As discussed BELOW, further SEC rulemaking will be required to clarify the effect of the Dodd-Frank Act on the Rule.
2 The Dodd-Frank Act leaves in place the $25 million minimum AUM threshold for SEC registration, but adds a new bar (effective starting in July 2011) that will further prohibit SEC registration by any investment adviser who: (i) is required to be registered as an investment adviser under applicable state law and, if so registered, would be subject to examination by the relevant state regulator; (ii) has more than $25 million but less than $100 million (or whatever higher thresholds the SEC deems appropriate) of assets under management; and (iii) is not acting as an adviser to a registered investment company (mutual fund) or business development company, unless the bar from SEC registration would require the investment adviser to register with 15 or more states. Separately, the Act directs the SEC to exempt from registration any investment adviser who: (i) acts solelyas an adviser to one or more "private funds"; and (ii) has assets under management in the United States of less than $150 million.
3 While the main focus of the SEC's commentary is on government pension plans, the Rule defines the term "government entity" broadly. It includes any state or political subdivision of a state, including any pool of assets sponsored or established by the state or political subdivision (or other instrumentality of a state or political subdivision), as well as a plan or program of a state or political subdivision and state general funds. This includes participant-directed benefit plans. Depending on how a particular state's university systems, and retirement plans for those systems, are organized, it may include university endowments and benefit plans as well.
4 The SEC's adopting release noted that "state and municipal statutes vary substantially with respect to whom they entrust with the management of public funds" and asserted that an attempt to identify specific officials would therefore be both underinclusive and overinclusive. As a result, it gave no further guidance on the type or level of influence meant to be covered.
5 The Rule does include limited exceptions for certain returned contributions, if the return was achieved rapidly and other limiting conditions are satisfied. It also contains procedures for seeking exemption from the SEC of application of the time-out provisions if specified conditions are met.
6 While the SEC suggests obtaining full disclosure of all contributions from prospective employees, it appears this is a strict liability rule, and no amount of inquiry can prevent a covered contribution from triggering a time out, even if, after due inquiry, the adviser was unaware of it.
7An IA Solicitor cannot be a "regulated person" for purposes of soliciting a government entity if it or its associated persons have, in fact, made relevant contributions or coordinated or solicited relevant contributions or payments during the two-year period. Thus, paying an IA Solicitor that has engaged in such behavior in the relevant period is strictly prohibited, regardless of whether the paying adviser knows of the disqualifying behavior — much as with "covered associates." And, as with "covered associates," the paying adviser must monitor the IA Solicitor's behavior and cease paying if the IA Solicitor engages in disqualifying behavior during the term of agreement with the paying adviser. The portions of the "regulated person" definition covering broker-dealers do not include the requirement that no contribution has been made for two years. They merely require that a broker dealer be subject to qualifying FINRA rules. In fact, the definition does not even require that the broker-dealer comply with those rules. It would appear that failure to comply might subject the broker-dealer to sanctions, perhaps even an obligation to return payments it receives, but would not necessarily result in the imposition of any penalty or sanction on the paying adviser. The SEC's release adopting the Rule contains some observations that appear to confirm this distinction in how IA/Solicitors and broker-dealers are treated. However, we suspect that, in applying the Rule and imposing sanctions on violations, the SEC may seek to limit these distinctions.
8 Conforming revisions to Rule 206(4)-3, which regulates registered advisers' arrangements to pay for soliciting investment advisory clients also become effective September 13, 2011.
9 Although the SEC specifically declined to include a covered associate's spouse and other family members in the definition of "covered associate," in its adopting release, the SEC repeatedly referred to the importance of the Rule's prohibition on doing indirectly what may not be done directly. Contributions that appear to have been made in a spouse's name should therefore be avoided.

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