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). 

Exemptions

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.

NOT LEGAL ADVICE

Horrigan Resources, Ltd.

Wexford, Pennsylvania                            724-934-0129                   www.horriganresources.com

March 9, 2017:  The law of unintended consequences has struck again … this time its target is the investment advisory community wherein advisers who eschew custody and indeed have written policies which prohibit custody, may in fact retain custody and therefore be noncompliant with U.S. Securities and Exchange Commission (“SEC”) Rule 206(4)-2 pursuant to the Investment Advisers Act of 1940, as amended (“Advisers Act”).

The occurrence of unintended custody is a process wherein the custodian and the client, without adviser participation or direct knowledge, execute a custodian agreement which conveys to the adviser access to client funds. Advisers prohibiting client custody under this scenario are now deemed to have client custody.  If you are such an adviser, the SEC wants you to know that your firm has the obligation to fully comply with Custody Rule 206(4)-2. Read More

March 3, 2017:  The evolution of investment adviser business models to reflect “robo-adviser” services represents a fast-growing trend within the advisory industry.  Initially perceived as a service offering directed to the millennial target market, in an era of rising competition in the asset management industry, this business model is now perceived as having the real potential to be a “win-win” for both advisers and retail investors across the board. The robo-model is rapidly gaining traction with the adviser industry as it provides the means to arrest and possibly reverse compressed fee schedules while introducing significant efficiencies in the business of marketing, developing, and executing invest advice.

As always, there is a catch to the happy-ending, in this case, the SEC and its oversight of all registered investment advisers.  The SEC has been monitoring and engaging with robo-advisers to evaluate how robo-advisers meet their compliance obligations under the Investment Advisers Act.  Additionally, the Commission held a “Fintech Forum” in 2016 that included an informative panel on the robo-adviser evolution. Collectively, these efforts have informed the SEC to the point where the Commission was comfortable issuing IM Guidance Update 2017-02 “Robo-Advisers” in late February 2017, focusing upon the robo-adviser business model and the unique compliance challenges it places upon registered advisers. Read More

January 17, 2017:  The SEC recently announced 2017 exam priorities with an expansion of 2016 exam priorities to include electronic investment advice (aka “robo-advisers”) and a continuation of the ongoing effort to protect senior investors as the Commission continues to focus upon products and sales practices which target senior investors.

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) retains primary responsibility along with the Asset Management Unit for examining federally registered investment advisers which include separate account managers, as well as hedge fund and private equity managers. Additionally, the OCIE examines and inspects investment companies, broker-dealers, transfer agents, clearing agencies, private fund advisers, national securities exchanges, and municipal advisors.

The 2017 priorities also reflect a continuing focus on protecting retail investors, including individuals investing for their retirement, and assessing systemic macro risks posed by products and or business practices. In the words of outgoing Chair Mary Jo White: “These priorities make clear we are continuing to focus on a wide range of issues impacting our markets, from traditional areas such as market-wide risks to new forms of technology including automated investment advice. Whether it is protecting our most vulnerable senior investors or those investing in the trillion-dollar money market fund industry, OCIE continues its efficient and effective risk-based approach to ensure compliance with our nation’s securities laws.” Read More

August 25, 2016:  The SEC adopted amendments to several Investment Advisers Act rules and the investment adviser registration and reporting form to enhance the disclosure of information by investment advisers. These changes include reporting of social media sites, Regulatory Assets under Management (RAUM) by client category, SMA AUM by custodian, outsourced CCO information, use of derivatives, and retention of performance advertising records, among others.

The rule takes effect 10/31/16, with a compliance date of 10/01/17. Any adviser filing an initial Form ADV or an amendment to an existing Form ADV on or after 10/01/17 will be required to provide responses to the form revisions. For advisers with a 12/31 year-end, the real impact will come in the first quarter of 2018. Amendments to Books and Records Rule 275.204-2 will apply to communications circulated or distributed after 10/01/17. Details of new and amended sections of Form ADV and record retention rules are outlined below. Access the final rule here: https://www.sec.gov/rules/final/2016/ia-4509.pdf.  Read More

June 28, 2016:  The U.S. Securities and Exchange Commission (“SEC”) announced a proposed new rule to require advisers to formally develop business continuity and transition plans.  Proposed Rule 206(4)-4 under the Investment Advisers Act and amendments to Rule 204-2 under the Act are now under consideration during the registrant comment period. Under the proposed rule, it would be unlawful for an SEC-registered investment adviser to provide investment advice unless the adviser adopts and implements a written business continuity and transition plan and reviews that plan at least annually. Read More