Educate why Pay to Play prohibitions can lead to SEC charges for illegal donations.
My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation. I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company. I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania.
Having worked as the CCO for RIAs, I have been through numerous regulatory audits and examinations. Experience gives me insight into how the SEC conducts investigations and attempts to obtain enforcement actions.
After completing this case study, the participants will be able to:
Define political contributions.
Define “pay -to-play.”
Understand why certain political contributions can cause a conflict of interest.
Understand what prompts the SEC to bring enforcement actions against RIAs concerning “pay-to-play.”
Identify political contribution best practices.
Political Contribution, “Pay-to-Play”, Covered Associates, Recordkeeping, Government Influence
The “pay-to-play” rule, officially Rule 206(4)-5 under the Investment Advisers Act of 1940, can be triggered when a firm or covered associate donates money to a government official who has control over assigning an investment manager, or allocating money, for public investment funds. The goal of the “pay-to-play” rule is to eliminate any air of impropriety, based on the assumption that people inherently cannot make unbiased decisions after receiving gifts or donations.
RIAs are subject to a two-year timeout from “providing compensatory advisory services either directly to a government client or through a pooled investment vehicle after political contributions are made to a candidate who could influence the investment advisor selection process for a public pension fund or appoint someone with such influence.”
The SEC has fined several firms for violating the two-year timeout by accepting fees from city or state pension funds after their associates made campaign contributions to elected officials or political candidates with the potential to wield government influence over those pension funds.
The two-year timeout is intended to discourage “pay-to-play” practices in the investment of public money, including public pension funds. RIAs must be mindful of the restrictions that can arise from campaign contributions made by their associates.
More donations in high-stakes election years means more chances that the SEC will pursue investigations related to its often abused “pay-to-play” rule. The SEC will be focusing on this projected uptick in “pay-to-play” violations as the basis for many upcoming enforcement actions.
The SEC brought an enforcement action against an RIA, Ancora Advisors (“Ancora”), for violating the “pay-to-play” rule. Covered associates of Ancora 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.
Covered associates of Ancora make campaign contributions to candidates for elected offices have influence over selecting investment advisers for a public pension system in Ohio and a public university in Ohio. Within two years after these contributions, Ancora is given a contract to provide advisory services to both the public pension system and public university. Providing advisory services under that contract within two years after the contributions, Ancora violates Section 206(4) of the Advisers Act and Rule 206(4)-5.
The noted definition of covered associates includes: “(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.”
The offices of Governor and Treasurer of Ohio had the ability to influence the selection of investment advisers for the Public Pension System. Specifically, the Governor and Treasurer of Ohio each appoint at least one member of the board of the Public Pension System, which has influence over selecting investment advisers for the Public Pension System.
The office of Governor of Ohio also had the ability to influence the selection of investment advisers for the Public University. Specifically, the Governor of Ohio appoints all members of the Public University’s Board of Trustees, which has the ability to influence the selection of investment advisers for the Public University.
During a period within two years after covered associates have made a total of over $25,000 in campaign contributions to the Governor of Ohio, Ancora proceeds in providing those investment advisory services to the aforementioned public pension system within the State of Ohio (the “Public Pension System”). The Public Pension System is a unit or instrumentality of the State of Ohio. Ancora also provides investment advisory services to the aforementioned public university within the State of Ohio (the “Public University”). The Public University is also a unit or instrumentality of the State of Ohio.
Advisers Act Rule 206(4)-5(a)(1) prohibits any RIA from providing investment advisory services for compensation to a government entity within two years after a contribution to an official of a government entity made by the investment adviser or any covered associate of the investment adviser. Importantly, Advisers Act Rule 206(4)-5 does not require a showing of quid pro quo or actual intent to influence an elected official or candidate. The mere act of the contribution itself creates the obligation to comply with the Rules. This compliance also places the impetus on the RIA to know whether its employees who qualify as covered associates have made such contributions.
Under the Rules, Ancora, therefore, willfully violates Section 206(4) of the Advisers Act and Rule 206(4)-5, which makes it unlawful for any investment adviser registered (or required to be registered) with the SEC to provide investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.
The SEC orders Ancora to cease and desist from committing or causing any current or future violations. The SEC also censures Ancora and fines the company $100,000, payable to the SEC.
The Office of Compliance Inspections and Examinations issues a Risk Alert that SEC examiners have observed practices raising concerns about various firms’ compliance with their obligations under “pay-to-play” rules. These concerns include:
- “Compliance with the rule’s ban on doing business with a municipal issuer within two years of a political contribution to officials of the issuer by any of the firm’s municipal finance professionals.
- Possible recordkeeping violations.
- Failure to file accurate and complete required forms with regulators regarding political contributions.
- Inadequate supervision.”
The Risk Alert identifies practices examiners have seen certain firms use to comply with applicable federal, state, and local rules on contributions. These practices include training programs for finance professionals, self-certification of compliance with restrictions on political contributions, surveillance for unreported political contributions, and preclearance or restrictions on political contributions when permitted by state or local law.
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 hiring personnel who might conceivably fall within the definition of “covered associate.” The RIAs might just be inviting “pay-to-play” rule problems if that person has made recent donations.