Pay-to-Play Enforcement Actions against Investment Advisers

By April 26, 2017New in Compliance, SEC

April 9, 2017:  The U.S. Securities and Exchange Commission (“SEC”) recently announced that ten investment advisory firms agreed to pay penalties in the tens of thousands of dollars to settle charges that they violated Rule 206(4)-5 (the “Pay-to-Play Rule”) under the Investment Advisers Act of 1940. The SEC charged the firms with receiving compensation for investment advisory services that they provided for managing public pension fund assets within two years of the firms’ covered associates having made prohibited campaign contributions.

In the aftermath of the California and New York pension scandals, the Pay-to-Play rule made it illegal for employees of regulated firms to make contributions to elected officials to influence the awarding of contracts to manage public pension plan assets and other government investment accounts. The presumption is that such practices result in higher fees for inferior advisory services because the advisory contracts are not negotiated at arm’s length.


The Rule 

The rule itself is fairly direct … investment advisers registered, or required to register, with the SEC, or which are “exempt reporting advisers” to private funds or venture capital funds, may not receive compensation for providing investment advice to government entities for two years after the adviser or its covered associates make direct or indirect contributions to officials of such governments who are responsible for hiring investment advisers.

A “covered associate” of an investment adviser is defined in Rule 206(4)-5(f)(2) 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.  The rule also prohibits covered investment advisers or their covered associates from providing or agreeing to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of an adviser, unless that person is a regulated person as defined by Rule 206(4)-5(a)(2)(i)(A). 

There are three exceptions to the Pay-to-Play Rule wherein covered associates of a firm (not the firm itself) may contribute to current or prospective clients of the firm which are government entities without fear of violating the rule. They include the following:
¨       De minimis contributions: covered associates, who are natural persons, may contribute up to $350 per election to an official for whom that covered associate is entitled to vote, and a maximum contribution of $150 for any other official.
¨       New covered associates: provides an exception for certain covered associates who made a contribution more than six months prior to becoming a covered associate of the current adviser; this exception is not valid for associates that engage in distribution or solicitation activities with a government entity on behalf of the adviser, where in such case, the time-out period is two years.
¨       Returned contributions: an adviser will not be in violation of the rule if the contribution in question is returned to the contributor within the stipulated grace period.  Reliance on this exception is subject to the following additional conditions:
¨       Advisers with more than 150 registered persons may rely on this exemption three times in a calendar year;
¨       Advisers with less than 150 registered persons may rely on this exemption twice a year;
¨       The exemption may only be used once for the same registered person;
¨       The excess contribution is discovered within four months of the initial conveyance to the political office holder/aspirant; and
¨       The contribution is returned to the donor within 60 days of its discovery.

The SEC findings affirmed that ten advisory firms violated the two-year timeout period wherein they accepted advisory fees from city or state pension funds after their covered associates made campaign contributions to candidates or elected officials.  The ten firms were required to pay penalties ranging from $35,000 to $75,000 and forego compensation for two years from such government entities. 


Of Interest

Several key factors make these settlements particularly noteworthy and instructive, namely:

  • The contributions in question were small.
  • Several of the advisers charged were only “exempt reporting advisers”.
  • Several of the advisers charged had obtained returns of the prohibited contributions.

The amount of the contributions made in all cited cases was relatively small and in most cases only a few hundred dollars above the permissible limit. A few of the advisers contributed a total of $500, and in one instance a covered associate of the adviser made a contribution $50 over the de minimus limit. Of significant import … there appears to have been no specific indication that these contributions were made as part of a quid pro quo arrangement or attempt to induce an investment by a government entity.

Of the ten enforcement actions, the contributions in question were made to a state governor or candidate for governor in six instances, while in two cases, the contributions were made to the mayor of New York City.  While these political office holders/aspirants fall within the rule’s technical definition of “elected official”, many CCOs find it surprising that the SEC chose to focus its enforcement efforts on donations to such offices to the extent that Pay-to-Play is intended to thwart political contributions to political players who truly influence the awarding of asset management contracts by public funds. Nevertheless, regardless of how tenuous the office holder/aspirant’s connection is to the asset management protocol for a given political jurisdiction, the SEC is making clear that advisers and their covered associates must toe the line as it relates to Pay-to-Play compliance.

These enforcement actions should compel CCOs and covered associates alike to review their Pay-to-Play policies and procedures to avoid penalties and sanctions.


Horrigan Resources, Ltd.

Wexford, Pennsylvania                            724-934-0129         


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