Two RIAs Pay The Price For Violating The Pay-To-Play Rule

Even if they are disinterested in politics, registered investment advisers (“RIA”) must be aware of the Pay-to-Play Rule if they market their services to government clients. A failure to comply with this rule can lead to serious compliance problems.

Rule 206(4)-5 under the Investment Advisers Act, better known as the Pay-to-Play Rule, is designed to prevent the improper use of campaign contributions to government officials who are in a position to choose firms to manage the assets of government clients, such as public pension funds. The rule is intended to prevent RIAs, or their covered associates, from using contributions in an attempt to win government contracts. The rule puts RIAs on equal footing in the bidding process.

Nuts and bolts of the Pay-to-Play Rule

The Pay-to-Play Rule bars RIAs from providing advisory services for compensation to a government entity client for two years after the RIA or its covered associates makes a campaign contribution to elected officials or candidates who may be in a position to influence the hiring of an RIA to manage that government entity’s assets. Pursuant to the rule, these contributions trigger a two-year time out from providing advisory services to the government entity.

A “government entity” includes a state or a political subdivision of a state, as well as any agency, authority or instrumentality of the state or political subdivision.

The definition of “covered associates” encompasses:

• any general partner, managing member or executive officer, or some other individual with a similar function or status;
• any employee who solicits a government entity for the investment adviser and any person who supervises this employee, either directly or indirectly; and
• any political action committee controlled by the investment adviser or by any of its covered associates.

“Official” includes any person who, at the time of the contribution, was an incumbent, candidate, or successful candidate for elective office of a government entity. The elective office must be directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser. It can also be an official who has the authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the government entity’s hiring of an investment adviser.

The Pay-to-Play Rule does not require proof of a quid pro quo or actual intent to influence an elected official or candidate. The rule applies even if the candidate does not win the election.

Smaller contributions will not trigger the two-year time out. It is not a violation of the rule if a covered associate contributes $350 or less, per election, to an elected official or candidate for whom the covered associate is entitled to vote. If the covered associate is not entitled to vote for the elected official or candidate, the individual may only contribute up to $150, per election, to such elected official or candidate.

SEC plays hard ball with Pay-to-Play Rule violations

On December 18, 2018, the SEC brought an enforcement action against an RIA for violating the Pay-to-Play Rule. Between January 2013 and June 2017, two covered associates of an Ohio-based RIA made campaign contributions to candidates for elected office in Ohio. Those particular elected offices had influence over selecting investment advisers for a public pension system and a public university in Ohio. One covered associate made thousands of dollars in campaign contributions to the governor and the treasurer of Ohio. The other also contributed to the governor of Ohio. The governor and treasurer each appoint at least one member of the board of the public pension system. The governor also appoints all of the members of the public university’s board of trustees.

Within two years after these contributions were made, the RIA received payment to provide advisory services to the public pension system and public university. By doing so, the firm violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-5 thereunder.

The SEC ordered the RIA to cease and desist from committing or causing any current or future violations. The RIA was also censured. In addition, the RIA was ordered to pay a civil money penalty in the amount of $100,000 to the SEC. The enforcement action can be found at https://www.sec.gov/litigation/admin/2018/ia-5077.pdf.

Another recent action for violations of the Pay-to-Play Rule

On July 10, 2018, the SEC settled an enforcement action against a Los Angeles-based RIA, which violated the Pay-to-Play Rule. The action resulted from campaign contributions made by three covered associates to candidates for elected office in California and Rhode Island. The elected office had influence over selecting investment advisers for public pension plans in those states. Within a two-year timeframe after those contributions occurred, the RIA was compensated to provide advisory services to the states’ public pension plans and violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-5 thereunder.

The SEC ordered the RIA to cease and desist from committing or causing any violations, as well as future violations of Section 206(4) of the Investment Advisers Act and Rule 206(4)-5. In addition, the RIA was censured and ordered to pay a civil money penalty of $100,000. The enforcement action can be viewed at www.sec.gov/litigation/admin/2018/ia-4960.pdf.

That same day, the SEC settled two other enforcement cases involving the Pay-to-Play Rule. Those enforcement actions can be found at https://www.sec.gov/litigation/admin/2018/ia-4958.pdf and https://www.sec.gov/litigation/admin/2018/ia-4959.pdf. There were also a number of Pay-to-Play Rule enforcement actions in 2017. Several of these enforcement actions were brought against exempt reporting advisers.

Conclusion

No matter which side of the aisle you sit on, RIAs that hope to win government contracts must strictly adhere to the Pay-to-Play Rule. Failing to do so can lead to serious compliance problems.

Investment advisers seeking government contracts should adopt robust policies and procedures designed to detect and prevent political contributions which could influence the selection of the firm by a government entity. For example, an investment adviser might implement a policy requiring covered associates to pre-clear their political contributions through the RIA’s Chief Compliance Officer or a designee. These policies and procedures should also promote educational efforts regarding pay-to-play issues and require supervisory review to detect potential violations. In addition, investment advisers should address potential pay-to-play issues in the firm’s Code of Ethics.

RIAs should also be careful when they hire personnel who might conceivably fall within the definition of “covered associate.” They might be inviting Pay-to-Play Rule problems if that person has made recent donations.

And finally, as the next election cycle heats up, the SEC may be ready to bring additional enforcement actions to send the message that RIAs and other firms must comply fully with the Pay-to-Play Rule.

This article is not a solicitation of any investment product or service to any person or entity. The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.