[Federal Register Volume 64, Number 153 (Tuesday, August 10, 1999)]
[Proposed Rules]
[Pages 43556-43568]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-20489]
[[Page 43555]]
_______________________________________________________________________
Part VII
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Part 275
Political Contributions by Certain Investment Advisers; Proposed Rule
Federal Register / Vol. 64, No. 153 / Tuesday, August 10, 1999 /
Proposed Rules
[[Page 43556]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-1812; File No. S7-19-99]
RIN 3235-AH72
Political Contributions by Certain Investment Advisers
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rules.
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SUMMARY: The Commission is publishing for comment a new rule under the
Investment Advisers Act of 1940 that would prohibit an investment
adviser from providing advisory services for compensation to a
government client for two years after the adviser or any of its
partners, executive officers or solicitors make a contribution to
certain elected officials or candidates. The Commission also is
proposing rule amendments that would require a registered adviser that
has government clients to maintain certain records of the political
contributions made by the adviser or any of its partners, executive
officers or solicitors. The new rule and rule amendments would address
``pay to play'' practices in the investment adviser industry.
DATES: Comments must be received on or before November 1, 1999.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549-0609. Comments also may be submitted
electronically at the following E-mail address: rule-comments@sec.gov.
All comment letters should refer to File No. S7-19-99; this file number
should be included on the subject line if E-mail is used. Comment
letters will be available for public inspection and copying in the
Commission's Public Reference Room, 450 Fifth Street, N.W. Washington,
D.C. 20549. Electronically submitted comment letters also will be
posted on the Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Karen L. Goldstein, Attorney,
, or Jeffrey O. Himstreet, Attorney,
, at (202) 942-0716, Task Force on Investment
Adviser Regulation, Division of Investment Management, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-
0506.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed rule 206(4)-5 (17 CFR 275.206(4)-5) and proposed amendments
to rule 204-2 (17 CFR 275.204-2) under the Investment Advisers Act of
1940 (15 U.S.C. 80b) (``Advisers Act'' or ``Act'').
Table of Contents
Executive Summary
I. Background
II. Discussion
A. Rule 206(4)-5
1. ``Pay to Play'' Restrictions
2. Solicitation Restrictions
3. Direct and Indirect Contributions or Solicitations
4. Private Investment Companies
5. Exemptions
B. Recordkeeping
C. Transition Period
D. General Request for Comment
III. Cost/Benefit Analysis
A. Benefits
B. Costs
C. Requests for Comment
IV. Paperwork Reduction Act
V. Summary of Initial Regulatory Flexibility Analysis
VI. Statutory Authority
Text of Proposed Rule and Rule Amendments
Executive Summary
Public pension plan assets are held, administered and managed by
elected officials for the benefit of citizens, retirees, and other
beneficiaries. Elected officials who allow political contributions to
play a role in the management of these assets violate the public trust
by rewarding those who make political contributions. Moreover, they
undermine the fairness of the process by which public contracts are
awarded. Similarly, investment advisers that seek to influence the
award of advisory contracts by public entities, by making or soliciting
political contributions to those officials who are in a position to
influence the awards, compromise their fiduciary obligations to the
plans. These practices--known as ``pay to play''--distort the process
by which investment advisers are selected and can harm plans, which
may, consequently, receive inferior advisory services and/or pay higher
fees. As a result, the millions of retirees and other beneficiaries who
rely on these plans can be harmed.
We believe that advisers' participation in pay to play is
inconsistent with the high standards of ethical conduct required of
them under the Investment Advisers Act. We are therefore proposing a
new rule designed to eliminate an adviser's ability to participate.
Proposed rule 206(4)-5 would prohibit an adviser from providing
advisory services for compensation to a government client for two years
after the adviser, or any of its partners, executive officers or
solicitors, make a contribution to state treasurers or comptrollers or
other elected officials who can influence the selection of the adviser.
The prohibition also would apply to contributions to candidates for
these positions, but would not result from contributions of $250 or
less to elected officials or candidates for whom the person making the
contribution can vote.
Proposed rule 206(4)-5 also would prohibit an adviser from
providing or seeking to provide advisory services for compensation to a
government client while the adviser, or any of its partners, executive
officers or solicitors, solicit contributions for an elected official
or candidate. Finally, we are proposing rule amendments that would
require an adviser registered with us that has government clients to
make and keep certain records regarding the political contributions and
solicitation activities of the adviser, its partners, executive
officers and solicitors.
I. Background
Persons seeking to do business with the governments of some states
and municipalities are increasingly being expected to make political
contributions to elected officials or candidates.\1\ In some cases,
businesses that submit bids for public contracts make political
contributions to elected officials, hoping to influence the selection
process. In other cases, political contributions are solicited from
businesses, or it is simply understood that only contributors will be
considered for selection. Contributions do not typically guarantee an
award of business to the contributor, but the failure to contribute
will guarantee that another is selected. Hence the term ``pay to
play.''
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\1\ See generally Alexander Heard, The Costs of Democracy 142-
145 (1960); Peter M. Manikas, Campaign Finance, Public Contracts and
Equal Protection, 59 Chi.-Kent L. Rev. 817 (1983). Pay to play
practices have been found relating to a variety of government
contracts outside of the financial markets. See, e.g., O'Hare Truck
Service, Inc. v. City of Northlake, 518 U.S. 712 (1996) (independent
towing service contractor).
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Pay to play practices can be viewed as imposing a hidden tax on
persons seeking to do business with governments. They increase the cost
of government services, which is likely to reflect the cost of the
political contribution, and may diminish the quality of services, as
officials may award contracts to less qualified advisory firms. Pay to
play practices are unfair to businesses, particularly smaller
businesses, that cannot afford the required contributions. Pay to play
practices call into question the integrity
[[Page 43557]]
of public officials and the fairness of the government contracting
process.
Pay to play practices have been a significant problem in the
municipal securities market.\2\ Securities firms seeking to underwrite
municipal securities offerings have made political contributions and
other payments to officials who are in a position to influence the
award of underwriting contracts. After studying pay to play practices,
the Commission staff concluded that they harm the municipal securities
markets by increasing underwriting costs, undermining the integrity of
municipal securities underwritings and damaging investor confidence.\3\
We came to the same conclusion in 1994 when we approved Municipal
Securities Rulemaking Board (``MSRB'') rule G-37 to end broker-dealer
participation in pay to play practices.\4\
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\2\ See Murky Depths (Municipal Finance), Economist, Nov. 4,
1995, at 83 (``America's municipal bond market is more rife with
corruption than even its fiercest critics have claimed''); Terence
P. Para, The Big Sleaze in Muni Bonds, Fortune, Aug. 7, 1995, at
113; Leah Nathans Spiro et al., The Trouble with Munis, Bus. Wk.,
Sept. 6, 1993, at 44. See also Lazard Freres & Co., Securities
Exchange Act Release No. 39388 (Dec. 3, 1997) (enforcement action
brought against municipal securities dealer for undisclosed
contributions made by a former partner and officer through a
consultant to obtain municipal securities underwriting business);
SEC v. Rudi, Litigation Release No. 14421 (Feb. 23, 1995) (complaint
alleged that financial advisor received ``kickbacks,'' the amount of
which were to be reduced by campaign contributions).
\3\ See Division of Market Regulation, U.S. Securities and
Exchange Commission, Staff Report on the Municipal Securities
Markets 9-11 (1993).
\4\ See In the Matter of Self-Regulatory Organizations; Order
Approving Proposed Rule Change by the Municipal Securities
Rulemaking Board Relating to Political Contributions and
Prohibitions on Municipal Securities Business and Notice of Filing
and Order Approving on an Accelerated Basis Amendment No. 1 Relating
to the Effective Date and Contribution Date of the Proposed Rule,
Securities Exchange Act Release No. 33868, at sections V.A.1 and 2
(Apr. 7, 1994) (59 FR 17621 (Apr. 13, 1994)) (``Rule G-37 Adopting
Release'') (rule G-37 was adopted ``to establish industry-wide
restrictions and requirements aimed at preventing fraudulent and
manipulative practices''). In approving rule G-37, we also concluded
that pay to play practices may harm the municipal markets by
fostering a selection process that excludes those firms that do not
make contributions, cause less qualified underwriters to be
retained, and undermine equitable practices in the municipal
securities industry. Id. at section V. In 1996, we approved MSRB
rule G-38 to prevent persons from circumventing rule G-37 through
the use of consultants. See Self-Regulatory Organizations; Order
Approving Proposed Rule Change by the Municipal Securities
Rulemaking Board Relating to Consultants, Securities Exchange Act
Release No. 36727 (Jan. 17, 1996) (61 FR 1955 (Jan. 24, 1996)).
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Rule G-37 prohibits broker-dealers from engaging in municipal
securities business with a government issuer for two years after making
a political contribution to an elected official of the issuer who can
influence the selection of the broker-dealer.\5\ The prohibition
applies to contributions made by the firm or any of its ``municipal
finance professionals,'' including certain executive officers.\6\ A
municipal finance professional, however, may make a contribution to a
candidate of up to $250 per election without triggering the prohibition
if he or she can vote for the candidate.\7\ Rule G-37 also prohibits a
broker-dealer from providing or seeking to provide underwriting
services to a government, if the broker-dealer or any of its municipal
finance professionals solicits or coordinates contributions for a
candidate or elected official of the government.\8\ The MSRB requires
broker-dealers to file quarterly reports disclosing the political
contributions made by the firm, its executive officers and municipal
finance professionals,\9\ and to keep accurate records of those
contributions.\10\
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\5\ MSRB rule G-37(b). The prohibition also applies to
successful and unsuccessful candidates for an office that can
influence the selection of the broker-dealer. MSRB rule G-37(g)(vi).
Shortly after rule G-37 became effective, a municipal securities
dealer challenged it as an infringement on the constitutional rights
of municipal securities professionals. A federal appeals court
upheld the constitutionality of rule G-37, finding that the rule
served a compelling government interest in preventing fraudulent and
manipulative acts. Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995),
cert. denied, 517 U.S. 1119 (1996).
\6\ MSRB rule G-37(b). A ``municipal finance professional''
generally is an associated person of a broker-dealer firm who is
``primarily engaged'' in municipal securities activities, solicits
municipal securities business on behalf of a broker-dealer, or a
person who supervises associated persons primarily engaged in
municipal securities activities ``up through and including'' the
chief executive officer of the firm (or person performing similar
functions). MSRB rule G-37(g)(iv).
\7\ MSRB rule G-37(b).
\8\ MSRB rule G-37(c).
\9\ MSRB rule G-37(e). Firms are required to make quarterly
filings with the MSRB on Forms G-37 and G-38. Id. These filings are
made available to the public through its website, at http://
www.msrb.org> (visited July 22, 1999).
\10\ MSRB rule G-8(a)(xvi); Rule G-37 Adopting Release, supra
note 4, at section III.B.2.
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Since the adoption of rule G-37, the Commission has become
concerned about other pay to play practices that are not addressed by
that rule; practices which involve public pension plans and other
funds. We have received reports that the selection of investment
advisers, which we regulate under the Advisers Act, may be influenced
by political contributions,\11\ and as a result, the quality of
management services provided to funds may be affected.\12\ We have
become particularly concerned about the possibility that the adoption
of rule G-37 has resulted in a shift of pay to play practices to this
area as political contributions by broker-dealers are curtailed.\13\ We
therefore have examined the role of investment advisers in the
management of public pension funds and other assets, the role of pay to
play in their selection, and the implications of pay to play practices
on the fiduciary obligations of investment advisers under the federal
securities laws.
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\11\ Letter from Thomas Flanigan (former executive director of
the California State Teachers' Retirement System) to Arthur Levitt,
Chairman, SEC (June 7, 1997), available in File No. S7-19-99 (``(pay
to play) potentially places the credibility of many investment
operations, either through direct or indirect pressure, in
jeopardy''). There also have been numerous press reports of
investment advisers engaging in pay to play practices, some of which
report an adverse impact on plans. See infra note 38.
\12\ Anonymous Letter dated Feb. 5, 1999 to Arthur Levitt,
Chairman, SEC, available in File No. S7-19-99 (marketer for
institutional money manager is ``amazed at how many managers are
awarded contracts by public funds due to the money they have donated
when there were other more qualified managers available''). See,
e.g., Wyatt, Lindsay, Paring the Politics from a Public Plan, Pens.
Mgmt., Nov. 1995, at 12 (Connecticut treasurer quoted as saying that
pay to play ``adversely influenced our treasury''); David A. Vise,
D.C. Pension Plan Mishandled; Too Many Advisers, Poor Financial
Results, Wash. Post, Aug. 15, 1993, at A1.
\13\ See Eric Bailey, Firms with State Pacts Are Fertile Donors
to Fong, L.A. Times, May 25, 1998, at A1 ($400,000 decline in
contributions from underwriting firms attributed to rule G-37); Bill
Krueger, Money Managers Giving to Boyles, News & Observer, May 2,
1996, at A1 (noting that rule G-37 ``dried up'' a contribution
source for a state treasurer, ``so now he is getting campaign
contributions from a group (investment advisers) that is not subject
to (rule G-37)''); Gerri Willis, Filling Carl's War Chest:
Comptroller Getting Thousands From State's Money Managers, Crain's
N.Y. Bus., Sept. 16, 1996, at 1 (securities executive observing that
``(b)ecause of the SEC's crackdown on the pay to play nature of the
muni bond business, the game has shifted to asset management and
brokerage'').
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Investment advisers provide a wide variety of advisory services to
state and local governments.\14\ Advisers manage public monies that
fund pension plans and a number of other important public programs,
including transportation, children's programs, arts programs,
environmental reclamation, and financial aid for education. In
addition, advisers provide risk management,\15\ asset allocation,\16\
financial planning \17\
[[Page 43558]]
and cash management services; \18\ structure bond offerings; \19\ help
state and local governments find and evaluate other advisers that
manage public funds (``pension consultants''); \20\ and provide other
types of services.\21\
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\14\ See Werner Paul Zorn, Public Employee Retirement Systems
and Benefits, in Local Government Finance, Concepts and Practices
376 (John E. Peterson and Dennis R. Strachota, eds., 1st ed. 1991)
(discussing the services investment advisers provide for public
funds).
\15\ See Robert A. Fippinger, The Securities Law of Public
Finance 669 (1997).
\16\ See, e.g., Public Employee Retirement Systems, supra note
14. See also Barry B. Burr, The New $100 Billion Club, Pens. & Inv.,
May 4, 1998, at 1.
\17\ See Cal. Ed. Code Sec. 22303.5 (1999) (requiring teachers'
retirement system to offer retirement planning services to
beneficiaries); CalSTRS Financial Education Program http://
www.calstrs.ca.gov/benefit/defined/mbrinfo/mctbl.html> (visited July
22, 1999). Other funds are also considering whether to offer
financial planning services to their beneficiaries. See, e.g., Steve
Hemmerick, CalPERS Officials Consider `Comprehensive' Financial
Planning for Participants, Pens. & Inv., Feb. 8, 1998, at 3.
\18\ See Government Finance Officers Association, an
Introduction to External Money Management for Public Cash Managers 5
(1991).
\19\ Not all persons who structure bond offerings for state and
local governments are investment advisers subject to regulation
under the Advisers Act. See The Knight Group (pub. avail. Nov. 13,
1991); East Texas Investment Company (pub. avail. Nov. 14, 1975).
But see In re O'Brien Partners, Inc., Investment Advisers Act
Release No. 1772 (Oct. 27, 1998) (financial advisor was subject to
the Advisers Act for rendering advice to municipal securities
issuers ``concerning their investment of bond proceeds in
securities, including (non-government securities), and was
compensated for that advice''). Recently, a group of these firms
agreed to a self-imposed ban on making political contributions to
obtain business. See Financial Advisers Support SEC's `Pay-to-Play'
Rules, WALL. ST. J., Mar. 2, 1999, at A8.
\20\ In addition to assisting the fund in selecting investment
advisers, pension consultants may also provide advice to state and
local governments in designing investment objectives, determining
available funding media, or recommending specific securities or
investments for the fund. Pension consultants are generally
investment advisers subject to the Advisers Act. See Applicability
of Investment Advisers Act to Financial Planners, Pension
Consultants, and Other Persons Who Provide Investment Advisory
Services as a Component of Other Financial Services, Investment
Advisers Act Release. No. 1092 (Oct. 8, 1987) (52 FR 38400, 38401
(Oct. 16, 1987)).
\21\ For example, public funds may retain advisers to perform
custodial services. See, e.g., Public Employee Retirement Systems,
supra note 14, at 376-77.
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Most of the public funds managed by investment advisers fund state
and municipal pension plans. These pension plans have over $2.3
trillion of assets and represent one-third of all U.S. pension
assets.\22\ They are among the largest and most active institutional
investors in the United States.\23\ The management of these funds
significantly affects publicly held companies,\24\ mutual funds \25\
and the securities markets themselves.\26\ But most significantly,
their management affects the taxpayers,\27\ and the millions of state
and municipal retirees who rely on the funds for their pensions and
other benefits.\28\
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\22\ Board of Governors of the Federal Reserve System, Flow of
Funds Accounts of the United States, Flows and Outstandings, First
Quarter 1999 (June 11, 1999) (at tables L.119 and L.120). Since
1994, total financial assets of public pension funds have grown by
almost 45%. Id. at table L.120.
\23\ According to a recent survey, seven of the ten largest
pension funds were sponsored by state and municipal governments (one
was the Federal Retirement Thrift Fund). Top 200 Pension Funds/
Sponsors, Pens. & Inv., Jan. 25, 1999, at 30.
\24\ See Corporate Governance: Funds Flex Their Muscles, Pen. &
Inv., at 109 (Oct. 19, 1998) (``Public funds discover they have the
clout to influence corporate boards they believe are not acting in
the shareholders' best interests.'').
\25\ See Louis Trager, Run on State Money Market Funds; Orange
County Fallout: $1 Billion in Withdrawals, San Francisco Examiner,
Dec. 19, 1994, at B1 (reporting that, shortly after Orange County
filed for bankruptcy, investors withdrew $1.03 billion (nearly 7% of
the funds' assets) from money market funds that held securities
issued by the county). See also Richard Marcis et al., Mutual Fund
Shareholder Response to Market Disruptions, Investment Company
Institute Perspective, at 10 (July 1995) (noting that the Orange
County bankruptcy caused outflows in both tax-exempt bond funds and
money market funds). Public funds are exempt from regulation as
mutual funds under the Investment Company Act of 1940. Sections 2(b)
and 3(c)(11) of the Investment Company Act of 1940 (15 U.S.C. 80a-
2(b) and 3(c)(11)).
\26\ Federal Reserve reports indicate that, of the $2.3 trillion
in non-federal government plans, $1.5 trillion are invested in
corporate equities. Flow of Funds Accounts, supra note 22 (at table
L.120).
\27\ See Paul Zorn, 1997 Survey of State and Local Government
Employee Retirement Systems 61 (1997) (``(t)he investment of plan
assets is an issue of immense consequence to plan participants,
taxpayers, and to the economy as a whole'' as a low rate of return
will require additional funding from the sponsoring government,
which ``can place an additional strain on the sponsoring government
and may require tax increases'').
\28\ The most current census data reports that public pension
funds have 13.6 million beneficiaries. 1992 Census of Governments,
U.S. Bureau of Census, VOL. 4, No. 6, Employee-Retirement Systems of
State and Local Governments, at ii, 19 (1995) (available at http://
www.census.gov/prod/2/gov/gc92-4/gc924-6.pdf> (visited July 22,
1999)).
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Elected officials of state and local governments are involved,
directly or indirectly, in the selection of advisers to manage most
public pension fund assets. In some jurisdictions, one or more elected
officials have sole authority to select advisers.\29\ In others,
elected officials serve as members \30\ or appoint some or all members
\31\ of a governing board that makes selections.\32\ The selection
process typically begins with the issuance of a request for proposals
(``RFP''). The staff of the governing board of the fund receives the
proposals and evaluates the applicants, often with the assistance of a
pension consultant. Specific criteria such as past performance,
experience, management approach, services and fees are established and
used to narrow the list of applicants. Finalists are then interviewed,
and the board selects one or more advisers.\33\ The board may reject
recommendations made by its staff and consultants and, in some
instances, boards have selected advisers that were not among the
``finalists.'' \34\
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\29\ See ``What Are the Comptroller's Responsibilities?''
available at http://www.osc.state.ny.us/divisions/press__office/
response.htm> (visited July 22, 1999) (noting that the placement of
state and local government retirement systems assets is under the
sole custodianship of the New York State Comptroller). See also S.C.
Code Ann. Secs. 9-1-20, 1-11-10 (Law. Co-op. 1998) (five-member
board consisting of five elected officials).
\30\ See, e.g., Cal. Gov't Code Sec. 20090 (Deering 1999) (state
controller, state treasurer); Md. Code Ann., State Pers. & Pens.
Sec. 21-104 (Supp. 1998) (state comptroller, treasurer, secretary of
budget, superintendent of schools, and secretary of the state
police); Miss. Code Ann. Sec. 25-11-15(2) (1998) (state treasurer);
N.C. Gen. Stat. Sec. 135-6 (1999) (state treasurer and state
superintendent of public instruction); R.I. Gen. Laws Sec. 36-8-4
(Supp. 1998) (state treasurer); Utah Code Ann. Sec. 49-1-202 (Supp.
1998) (state treasurer); W. VA. Code Sec. 5-10D-1 (Supp. 1998)
(governor, state treasurer, state auditor, secretary of the
department of administration); Wyo. Stat. Sec. 9-3-404 (Supp. 1998)
(state treasurer).
\31\ See, e.g., Ariz. Rev. Stat. Ann. Sec. 38-713 (1999)
(governor appoints all nine members); CAL. Gov't Code20090 (Deering
1999) (governor appoints three of thirteen members); Hawaii Rev.
Stat.Sec. 88-24 (Supp. 1998) (governor appoints three of eight
members); IDAHO CODE Sec. 59-1304 (Supp. 1998) (governor appoints
all five members); Kan. Stat. Ann. Sec. 74-4905 (Supp. 1997)
(governor appoints four of nine members; speaker of the house and
president of the senate each appoint one member); Me. Rev. Stat.
Ann. tit. 5, Sec. 17102 (Supp. 1997) (governor appoints four of
eight members); Nev. Rev. Stat. Sec. 286.120 (1997) (governor
appoints all seven members); N.H. Rev. Stat. Ann. Sec. 100-A:14(i)
(1998) (governor and council appoint two of thirteen members); VA.
Code Ann. Sec. 51.1-124.20 (Michie 1998) (governor appoints five of
nine members); W. Va. Code Sec. 5-10D-1 (1998) (governor appoints
ten of fourteen members); Wyo. Stat. Sec. 9-3-404 (Supp. 1998)
(governor appoints ten of eleven members (the state treasurer is the
other member)).
\32\ In some cases, state retirement systems have sought to
insulate the selection process from the effects of political
contributions by delegating the selection of investment advisers to
the professional staff of the fund. See, e.g., Missouri State
Employees Retirement System, External Manager Hiring and Termination
Policy (Nov. 13, 1998). See discussion infra at section II.A.1.
\33\ See Stephen A. Berkowitz & Louis D. Finney, the Selection
and Management of Investment Managers for Public Pension Plans 40-45
(1990) (discussing the RFP, selection criteria, performance
measurement, interview process, and elements of a final contract);
Public Cash Managers, supra note 18, at 12-13 (discussing elements
of the RFP and selection process); M. Corrine Larson, an
Introduction to Investment Advisers for State and Local Governments
6 (1996) (discussing the process for drafting the RFP, evaluating
RFP responses, interviewing candidates, and selecting advisers);
Girard Miller et al., Investing Public Funds5 (1998) (discussing
selection criteria, and the use of consultants and an investment
committee to aid in the selection process).
\34\ See, e.g., Josh Kosman, Manager Access to Trustees
Examined, Investment Mgmt. Wkly., Aug. 25, 1997, available in 1997
WL 15447410; Too Many Advisers, Poor Financial Results, supra note
12.
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The absence of a fully objective bidding process makes it possible
for considerations other than merit to intrude into the selection
process.\35\ The
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management of public pension funds is highly lucrative, and there is
keen competition among advisers vying for selection.\36\ The record
suggests strongly that political contributions can play a significant
role in the selection of investment advisers.\37\ Allegations of pay to
play have been reported in at least seventeen states.\38\
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\35\ In approving rule G-37, the MSRB observed, and we agreed,
that in a competitive and objective bidding process, there is ``less
possibility of collusion and political patronage,'' as bidders are
able to publicly compete on price and their willingness to accept
market risk. Rule G-37 Adopting Release, supra note 4, at section
II.A. The prohibition contained in rule G-37 thus applies only to
contracts that were awarded on a basis other than a ``competitive
bid'' (i.e., negotiated offerings). MSRB rule G-37(g)(vii).
Contracts awarded on the basis of a competitive bid remain subject
to the federal securities laws. See In re Stephens, Inc., Securities
Act Release No. 7612 (Nov. 23, 1998) (enforcement action brought
against consultant who authorized undisclosed payments to two public
officials and an outside pension consultant to obtain municipal
finance business that was subject to competitive bidding).
\36\ A recent investment adviser search by CalPERS, for example,
yielded 269 proposals submitted by 189 managers. See Steve
Hemmerick, 58 Managers Make CalPERS' First Cut, PENS. & INV., Aug.
18, 1997, at 6.
\37\ In most cases, these political contributions are lawful.
Thus, we do not suggest that the elected officials, by accepting
these contributions, are acting unlawfully. Also, the Commission has
not investigated and therefore cannot confirm the validity of the
allegations described in the articles cited or referenced in the
footnotes that follow. The Blount court held that allegations of pay
to play were sufficient to support the rulemaking and that ``no
smoking gun is needed where, as here, the conflict of interest is
apparent, the likelihood of stealth great, and the legislative
purpose prophylactic.'' 61 F.3d at 945.
\38\ The articles and other materials describing allegations of
pay to play practices are available in File No. S7-19-99. See, e.g.,
Janet Aschkenasy, Pay-to-Play--Scrutiny of Unethical Practices at
Public Funds Is Intensifying, But Will Self-Policing Efforts
Succeed?, PLAN SPONSOR, Feb. 1998, at 58-60; Charles Gasparino &
Jonathan Axelrod, Political Money May Sway Business of Public
Pensions, Wall St. J., Mar. 24, 1997, at C1; Matt O'Connor, Santos
Done in by Tape; `Time to Belly Up' Remark Called Key to Guilty
Verdict, CHI. TRIB., May 4, 1999, at N1.
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Pay to play practices are rarely explicit: participants do not
typically let it be publicly known that contributions are made or
accepted for the purpose of influencing the selection of an adviser. As
one court noted, ``actors in this field are presumably shrewd enough to
structure their relations rather indirectly.'' \39\ Some elected
officials who are responsible for public pension plans have actively
solicited contributions from advisers that either provide or seek to
provide advisory services to the state or local government.\40\ Several
have received large amounts of money from advisers and contractors to
the pension funds.\41\ Some have participated in the selection of
investment advisers shortly before, or shortly after, receiving
contributions from the adviser.\42\
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\39\ Blount, 61 F.3d at 945.
\40\ See, e.g., Scrutiny of Unethical Practices Intensifying,
supra note 38. Public fund officials also have provided us with
first-hand reports of the solicitation activities of elected
officials. See Letter from Maxie L. Patterson, Executive Director,
Houston Firefighters' Relief and Retirement Fund, to Robert Plaze,
Associate Director, SEC (Feb. 10, 1999), available in File No. S7-
19-99.
\41\ See Houston Firefighters' Fund Letter, supra note 40;
Office of Vermont State Treasurer James H. Douglas, If You Play, You
Pay: New Campaign Finance Legislation Prohibits Contracts for Wall
Street Firms Contributing to State Treasurer Races, a Provision
Pushed by Douglas, available at http://www.state.vt.us/treasurer/
press/pr970616.htm> (visited July 22, 1999); Scrutiny of Unethical
Practices Intensifying, supra note 38.
\42\ For example, a solicitor for an institutional adviser
recently informed us that the solicitor received two invitations
from the same elected official in the same week--one to make a
presentation to the fund's selection committee, the other to attend
a $1,000 fundraising dinner. Anonymous Letter, supra note 12.
Representatives of the selection committee later requested that the
solicitor inform them if a contribution was made ``so they could let
the officials know it came from'' the parties making the
presentation. Anonymous Letter, supra note 12.
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Recently, the nation's largest public pension fund, the California
Public Employees Retirement System (``CalPERS''), sought to end the
participation of its trustees in pay to play practices. The CalPERS
actions and subsequent litigation \43\ provide unusual insights into
how pay to play can work in the selection of investment advisers for
public funds. According to court documents submitted by CalPERS,
elected officials serving as CalPERS trustees solicited campaign
contributions from investment advisers and other fund contractors.\44\
Each raised a considerable amount of money from advisers that are
providing, or are seeking to provide, advisory services to CalPERS.\45\
Failure to contribute reduced the interest of the elected official in
the adviser's role in managing the fund; \46\ contributing a sufficient
amount could lead to the official championing the selection of the
adviser,\47\ which could even result in the fund selecting the adviser
over the recommendation of its professional staff and consultants.\48\
In order to avoid the perception of a conflict, the elected officials
voluntarily would abstain from a vote concerning an adviser that made
contributions,\49\ but the officials could participate in the
discussions that preceded the vote.\50\ CalPERS decided to bar
contractors and prospective contractors from making political
contributions as an effort to end pay to play, which it described as
``an insidious form of corruption'' that ``infects the entire decision-
making process.'' \51\
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\43\ An elected official who is a CalPERS fiduciary sued to
overturn the CalPERS ban on pay to play practices. A California
court invalidated the CalPERS resolutions on procedural grounds.
Kathleen Connell for Controller v. CalPERS, No. 98CS01749 (Cal. Sup.
Ct. Sept. 18, 1998). See also Charles Gasparino, California
Controller's Committee Sues Calpers Over Campaign-Donation Rule,
WALL. ST. J., July 9, 1998, at B7. CalPERS subsequently proposed
similar pay to play prohibitions by regulation. California Public
Employees' Retirement System, Proposed Regulatory Action, Notice
File No. 98-1016-10 (Oct. 30, 1998).
\44\ See Memorandum of Points and Authorities in Opposition to
Petition for Writ of Mandate, Kathleen Connell for Controller v.
CalPERS, No. 98CS01749, at 20 (Cal. Sup. Ct. Sept. 4, 1998) (stating
that ``there was actual evidence of massive contributions solicited
by (the state controller) from CalPERS contractors and other
prospective contractors'') (emphasis in original); Oversight of
Investment Procedures of the Public Employees' Retirement System and
State Teachers' Retirement System, Before the Senate Committee on
Public Employment and Retirement, Calif. Leg. 20-21 (Aug. 25, 1997)
(testimony of James E. Burton, Chief Executive Officer, CalPERS).
\45\ The state controller, for example, raised over $180,000
from 1995 to 1998 from CalPERS contractors. CalPERS Brief, supra
note 44 (declaration of Thomas W. Hiltachk). The state treasurer,
who also is a CalPERS trustee, raised $150,000 from advisers and
other CalPERS contractors in a recent U.S. Senate campaign. See
Firms with State Pacts, supra note 13; Paul Jacobs, Firms Lobby, Woo
State Pension Officials, Win Pacts, L.A. TIMES, Feb. 4, 1998, at A3.
\46\ In connection with the litigation, CalPERS submitted a
declaration in which an adviser stated that, after refusing to make
a political contribution, the elected official's representative
contacted the adviser less frequently about investment matters, and
displayed a ``higher degree of skepticism'' about the adviser's
recommendations. CalPERS Brief, supra note 44 (declaration of Leslie
Brun, Hamilton Lane Advisors, Inc.). See also Paul Jacobs, Donations
to Pension Officials Scrutinized; Politics: Connell, Fong Say They
Are not Influenced by Contributions from Firms Doing Business with
State Systems, L.A. Times, Aug. 21, 1997, at A1; Dan Smith, Connell
Accused of Shunning Non-Donor, Sacramento Bee, Aug. 14, 1998, at A3.
\47\ See Paul Jacobs, Firms Lobby, Woo State Pension Officials,
Win Pacts, L.A. TIMES, Feb. 2, 1998, at A1. Elected officials may
not only champion the selection of contributors, but also may
advocate their retention. See California Pension Fund Weathers
Investment Controversy, Nat'l Mortgage News, June 24, 1996, at 10.
\48\ See Steve Hemmerick, California Funds to Review Voting,
PENS. & INV., Sept. 15, 1997, at 36; Paul Jacobs, Investment Raises
Questions About State Pension Fund Finance, L.A. TIMES, Sept. 16,
1997, at A1; cf. Manager Access to Trustees Examined, supra note 34.
\49\ See Scrutiny of Unethical Practices Intensifying, supra
note 38.
\50\ See CalPERS Brief, supra note 44, at n. 16 (noting that one
trustee who abstained from voting to award contracts to contributors
``has never'' sought recusal from ``participating in the discussions
affecting the contributor''); Donations to Pension Officials, supra
note 46.
\51\ CalPERS Brief, supra note 44, at 8. CalPERS stated that pay
to play negatively affects the decision-making process because ``it
appears that decisions are made, not only by considering who gave a
contribution, but also by considering who did not give a
contribution.'' CalPERS Brief, supra note 44, at 8 (emphasis in
original).
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Two states and some funds have come to similar conclusions
regarding pay to play. Vermont and Connecticut both have recently
enacted statutes prohibiting any person doing business with state funds
from making contributions to the treasurer of either
[[Page 43560]]
state.\52\ The Connecticut Treasurer noted that, before the legislation
was enacted, ``investment managers (were) being chosen more for their
political connections and campaign contributions than for their
performance.'' \53\ Some funds have adopted codes of ethics prohibiting
trustees from accepting contributions.\54\ Some have delegated the
selection of investment advisers to professional staff members, aiming
to insulate the selection process from considerations of campaign
contributions.\55\ Not all efforts to address pay to play have been
effective,\56\ and most jurisdictions and pension plans have not acted
effectively to stop pay to play practices.\57\
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\52\ See CONN. GEN. STAT. Sec. 9-333o (1997); VT. STAT. ANN.
tit. 32, Sec. 109 (1997). Efforts to eliminate pay to play are not
limited to the securities industry. Bar associations also are
considering similar prohibitions to address pay to play practices in
the legal profession. See American Bar Ass'n, Report and
Recommendations of the Task Force on Lawyers' Political
Contributions, Part I (July 1998); Special Committee on Government
Ethics, Association of the Bar of the City of New York, Campaign
Contributions by Lawyers Seeking Government Finance Work (Feb.
1997).
\53\ See Christopher Burnham, Reviving a Pension Plan, AM. City
& County, July 1998.
\54\ See, e.g., Oregon Investment Council, Standard of Ethics,
at 1-2 (July 1998); State of New Hampshire, An Order Enacting a Code
of Ethics for Public Officials and Employees of the Executive Branch
in the Performance of Their Official Duties, Executive Order No. 98-
1, at 2 (May 19, 1998); Fulton County Employees Retirement System
Board, Ethics Policy, at 4-5 (Feb. 11, 1998). Other funds require
disclosure of political contributions. See, e.g., Cal. Gov. Code
Sec. 20152.5 (1999); Texas Permanent School Fund Operating Rules,
Chapter 4, Conduct and Public Relations (Mar. 6, 1998).
\55\ See, e.g., Missouri Investment Adviser Selection Policy,
supra note 32.
\56\ Some public pension plans, for example, prohibit firms that
contract with the plan from making contributions to plan trustees,
but the prohibition does not apply to executives of the firm.
Similarly, several statutory prohibitions apply only to
contributions made to particular officeholders, but not to other
elected officials who are plan trustees, appoint plan trustees, or
otherwise can influence the selection of an investment adviser. Some
codes of ethics can be difficult to enforce when plans are faced
with evidence of pay to play. Also, some advisers have found a way
to circumvent state and plan limitations and disclosure requirements
by making political contributions indirectly, through the use of
third parties such as consultants. See infra notes 92 to 93, and
accompanying text (discussing the use of ``gatekeepers'').
\57\ It is possible that many jurisdictions have found it
difficult to address pay to play practices due to what the Blount
court calls a ``collective action problem (that tends) to make the
misallocation of resources persist.'' Blount, 61 F.3d at 945-46.
Elected officials that accept contributions from state contractors
may believe they have an advantage over their opponents that
forswear the contributions, and firms that do not ``pay'' may fear
they will lose government business to those that do. See id. See
generally Mancur Olson, The Logic of Collective Action; Public Goods
and the Theory of Groups 44 (17th ed. 1998) (group members that seek
to maximize their individual personal welfare will not act to
advance common objectives absent coercion or other incentive). See
also Donations to Public Officials, supra note 46 (fund contractor
quoted as saying, ``(i)f you don't contribute, you're subject to the
concern that others might make contributions'').
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II. Discussion
The Commission regulates investment advisers under the Investment
Advisers Act of 1940. Section 206(1) of the Advisers Act prohibits an
investment adviser from ``employ(ing) any device, scheme, or artifice
to defraud any client or prospective client.'' \58\ Section 206(2)
prohibits advisers from engaging in any act, practice or course of
business which operates as a fraud on a client or prospective
client.\59\ The Supreme Court has construed section 206 as establishing
a federal fiduciary standard governing the conduct of advisers.\60\
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\58\ 15 U.S.C. 80b-6(1).
\59\ 15 U.S.C. 80b-6(2).
\60\ Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11,
17 (1979) (citations omitted); SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180, 191-192 (1963).
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An adviser that participates in pay to play practices undermines
the merit-based selection process established by the public pension
plan.\61\ When an adviser makes political contributions to elected
officials for the purpose of influencing the award of an advisory
contract, the adviser contributes to the risk that the officials may
``award the contracts on the basis of benefit to their campaign chests
rather than to the governmental entity.'' \62\ If pay to play is a
factor in the selection process, the public pension plan can be harmed
in several ways. The most qualified adviser may not be selected,
leading to inferior management, diminished returns or even losses.\63\
The pension plan may pay higher fees because advisers must recoup the
costs of contributions, or because contract negotiations may not occur
on an arm's-length basis.\64\ Moreover, the absence of arm's-length
negotiations may enable advisers to obtain greater ancillary benefits,
such as ``soft dollars,'' from the advisory relationship, which may be
directed for the benefit of the adviser, at the expense of the pension
plan, thereby using a fund asset for its own purposes.
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\61\ See supra notes 29 to 34 and accompanying text.
\62\ Blount, 61 F.3d at 944-45.
\63\ Paring the Politics, supra note 12, at 12 (Connecticut
treasurer quoted as saying that pay to play ``adversely influenced
our treasury''); Too Many Advisers, Poor Financial Results, supra
note 12 (municipal fund awarded contract to an adviser that ``had
the worst performance numbers of all the candidates interviewed'').
\64\ See State Street Effort Fails in Its Lawsuit On
Pennsylvania Pact, Wall. St. J., May 28, 1998, at B17. Firm
executives contributed ``perhaps several thousand dollars'' to the
outgoing treasurer's campaign. Id.
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Because pay to play has the potential to harm advisory clients, we
believe that it is inconsistent with the high standards of ethical
conduct required of fiduciaries under the Advisers Act. We have
authority under section 206(4) of the Act to adopt rules ``reasonably
designed to prevent, such acts, practices, and courses of business as
are fraudulent, deceptive or manipulative.'' \65\ Congress gave us this
authority to prohibit ``specific evils'' that the broad anti-fraud
provisions may be incapable of covering.\66\ The provision thus permits
the Commission to adopt prophylactic rules designed to prevent
fraudulent conduct even if not all of the conduct prohibited is
fraudulent.\67\
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\65\ 15 U.S.C. 80b-6(4).
\66\ S. Rep. No. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The
Commission has used this authority to adopt four rules addressing
abusive advertising practices, custodial arrangements, the use of
solicitors and required disclosures regarding the adviser's
financial condition and disciplinary history. 17 CFR 275.206(4)-1;
275.206(4)-2; 275.206(4)-3; and 275.206(4)-4.
\67\ The Supreme Court, in U.S. v. O'Hagan, 521 U.S. 642 (1997),
interpreted nearly identical language in Section 14(e) of the
Securities Exchange Act of 1934 (``Exchange Act'') (15 U.S.C.
78n(e)) as providing the Commission with authority to adopt rules
that are ``definitional and prophylactic'' and that may prohibit
acts that ``are not themselves fraudulent * * * if the prohibitions
are reasonably designed to prevent acts and practices that are
fraudulent.'' 521 U.S. 667, 673. The language of both section 206(4)
and section 14(e) was taken from section 15(c)(2) of the Exchange
Act (15 U.S.C. 78o(c)(2)). See SEC Legislation, Hearing on S. 1180,
S. 1181 and S. 1182, Before the Senate Committee on Banking and
Currency, Subcommittee on Securities, 86th Cong., 2d Sess. 137
(1959) (testimony of Philip A. Loomis, Director, Division of Trading
and Exchanges, SEC) (``(The language of Section 206(4)) is almost
the identical wording of Section 15(c)(2) of the Securities Exchange
Act in regard to brokers and dealers.'') and S. Rep. No. 1760, 86th
Cong., 2d Sess. 8 (June 28, 1960) (``(The language of section
206(4)) is almost the identical wording of Section 15(c)(2) of the
Securities Exchange Act of 1934 in regard to brokers and
dealers.''). See also H.R. Rep. No. 1655, 91st Cong., 2d Sess. at 4
(Dec. 7, 10, 1970) (the amendment to section 14(e) ``is identical to
that contained in existing section 15(c)(2) of the Exchange Act'').
Congress, in amending section 15(c)(2) to expand the Commission's
authority to prohibit fraud by municipal securities dealers,
described the Commission's rulemaking authority under section
15(c)(2)(D) as including ``the promulgation of prophylactic rules.''
S. Rep. No. 75, 94th Cong., 1st Sess. 228 (Apr. 14, 1975).
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We are proposing new rule 206(4)-5 to prevent advisers from
participating in pay to play practices and protect clients from the
consequences of pay to play. The rule, and related rule amendments that
we are also proposing today, are described below.
A. Rule 206(4)-5
Under proposed rule 206(4)-5, it would be a fraudulent, deceptive,
or
[[Page 43561]]
manipulative act for an investment adviser to provide advisory services
for compensation to a government entity within two years after the
adviser, any of its partners, executive officers or solicitors made a
contribution to an elected official who could influence the selection
of the adviser. The rule would also make it unlawful for an adviser to
solicit contributions for an official of a government client while
providing or seeking to provide the government client advisory
services. Proposed rule 206(4)-5 would not be a ban on political
contributions, but rather a ban, or ``time-out,'' on conducting
advisory business with a government client for two years after a
contribution is made.
Investment advisers subject to the proposed rule would include all
investment advisers that are not prohibited from registering with the
Commission.\68\ As a result, the rule would apply to Commission-
registered advisers and those exempt from registration under section
203 of the Advisers Act, such as those advisers that had fewer than
fifteen clients during the last twelve months.\69\
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\68\ Proposed rule 206(4)-5(a).
\69\ Section 203(b) of the Advisers Act (15 U.S.C. 80b-3(b)).
The Commission is including unregistered advisers within the scope
of the rule principally to make the rule applicable to advisers to
private investment companies. See discussion infra section II.A.4.
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The rule generally would not apply to smaller advisers that are
registered with state securities authorities.\70\ We believe that the
great majority of advisers to public funds are registered with the
Commission. We, therefore, are not proposing to cover state-registered
advisers under the proposed rule. We request comment on our assumption,
and on whether we should extend the scope of the proposed rule to
include state-registered advisers.
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\70\ Amendments to the Advisers Act in 1996 placed regulatory
responsibility for these advisers in the hands of state regulators.
See section 203A of the Advisers Act (15 U.S.C. 80b-3a) enacted as
part of Title III of the National Securities Markets Improvement Act
of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in
scattered sections of the United States Code).
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The Commission modeled proposed rule 206(4)-5 after MSRB rule G-37,
which we believe has successfully addressed pay to play in the
municipal bond market. This approach should minimize the compliance
burdens on firms that would be subject to both rules by allowing them
to adopt common compliance procedures. We have modified the proposed
rule, however, to reflect the different statutory framework under which
the rule would be adopted and the differences between municipal
underwriting and asset management. The differences between proposed
rule 206(4)-5 and rule G-37 are highlighted below. Comment is requested
on whether we should use rule G-37 as a model for proposed rule 206(4)-
5. Are there additional differences in the selection of municipal
underwriters and investment advisers that should be reflected in the
rule?
The Commission considered proposing a different approach to address
pay to play, which would require an adviser to disclose information
concerning its political contributions. Disclosure, however, may not be
effective to protect public pension plan clients. Disclosure to a
pension plan's trustees would be ineffective because, in some cases,
the trustees would have received the contributions. Disclosure to plan
beneficiaries also would be ineffective because they are generally
unable to act on the information by moving their pension assets to a
different plan or reversing adviser hiring decisions.\71\ Moreover,
disclosure requirements have not worked in the past at stopping pay to
play practices and can be circumvented.\72\ We request comment on this
approach.
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\71\ For these reasons, the Commission is not proposing a
reporting requirement for advisers required to keep records of their
political contributions under the proposed amendments to the
recordkeeping rules. See discussion of recordkeeping amendments
infra at Section II.B. MSRB rule G-37, however, does establish a
reporting and disclosure system for broker-dealers subject to that
rule. MSRB rule G-37(e)(ii).
\72\ See discussion of ``gatekeepers'' supra section II.A.2.
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1. ``Pay to Play'' Restrictions
Proposed rule 206(4)-5 would prohibit investment advisers from
providing advice for compensation to a ``government entity'' \73\
within two years after a contribution to an official of the government
entity has been made by (i) the adviser, (ii) any of its partners,
executive officers or solicitors, or (iii) any political action
committee (``PAC'') controlled by the adviser or by any of the
adviser's partners, executive officers or solicitors.\74\ Each element
of the proposed rule and one exception from the prohibition are
discussed below.
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\73\ ``Government entity'' is defined by the proposed rule as
any State or political subdivision of a State, including any agency,
authority, or instrumentality, plan or pool of assets controlled by
the State or political subdivision or any agency, authority or
instrumentality thereof; and officers, agents, or employees of the
State or political subdivision or any agency, authority or
instrumentality thereof, acting in their official capacity. Proposed
rule 206(4)-5(e)(3). In this Release, we use the term government
entity interchangeably with ``government client'' and ``public
pension plan.''
\74\ Proposed rule 206(4)-5(a)(1).
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Investment advisers making contributions covered by the proposed
rule would not be prohibited from providing advisory services to a
government client, but only from receiving compensation from the client
for providing advisory services. This approach is intended to avoid
requiring an adviser to abandon a government client after the adviser
or any of its partners, executive officers or solicitors make a
political contribution covered by the rule. An adviser subject to the
prohibition would likely be obligated to provide (uncompensated)
advisory services until the government client finds a successor.\75\
Alternatively, the rule could establish a time period after the
expiration of which the adviser could no longer provide advisory
services. We request comment on which approach would cause the least
disruption to the government client.
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\75\ An investment adviser that violates the rule may be
required, under its fiduciary duties, to continue providing advisory
services to the public fund, for a reasonable period of time, until
the fund obtains a new adviser. See Temporary Exemption for Certain
Investment Advisers, Investment Advisers Act Release No. 1736 (July
22, 1998) (63 FR 40231, 40232 (July 28, 1998)) (describing an
investment adviser's fiduciary duties to an investment company in
the case of an unforeseeable assignment of the advisory contract).
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The prohibitions in the rule would be triggered by a contribution
to an official of a government entity. Government entities under the
proposed rule include all state and local governments, their agencies
and instrumentalities, and all government pension plans and other
collective government funds.\76\ An official would include an
incumbent, candidate or successful candidate for elective office of a
government entity if the office (or an appointee of the office) is
directly or indirectly responsible for, or can influence the outcome
of, the selection of an investment adviser.\77\ Generally, executive or
legislative officers who hold a position with influence over the
selection of an investment adviser are government officials under the
proposed rule.\78\ These definitions are substantively the same as
those in MSRB rule G-37.\79\
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\76\ Proposed rule 206(4)-5(e)(3).
\77\ Proposed rule 206(4)-5(e)(4).
\78\ The scope of authority of the particular office of an
official, not the individual, would determine whether the official
may have influence over the awarding of an investment advisory
contract. In some cases, authority to select and terminate an
investment adviser is completely delegated to the staff of a public
fund, in which case a government official may not be able to
influence the selection. See supra note 32. Under the proposed rule,
contributions to the official would not trigger the prohibitions of
the rule.
\79\ MSRB rule G-37(g)(ii) and (g)(vi).
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[[Page 43562]]
The proposed rule covers contributions made by an investment
adviser, its partners, executive officers and solicitors; and any PAC
controlled by the adviser or any of its partners, executive officers or
solicitors. The proposed rule uses the same definition of contribution
as MSRB rule G-37.\80\ A contribution would generally be anything of
value made to an official to influence a federal, state or local
election, including any payments for debts incurred in an election, and
transition or inaugural expenses incurred by a successful candidate for
state or local office.\81\
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\80\ MSRB rule G-37(g). Like rule G-37, the proposed rule would
encompass, for federal offices, only those contributions to an
official of a government entity who is seeking election to a federal
office. Proposed rule 206(4)-5(e)(3).
\81\ Proposed rule 206(4)-5(e)(1). Contributions to political
parties would not trigger the proposed rule's prohibitions, unless
the contribution is earmarked or known to be provided to an
official. Contributions to state and local political parties are,
however, subject to the proposed rule's recordkeeping requirements.
See infra section II.B.
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Contributions made to influence the selection process are typically
made not by the firm, but by officers and employees of the firm who
have a direct economic stake in the business relationship with the
government client. This is why the MSRB also applied the prohibitions
of rule G-37 to contributions made by ``municipal finance
professionals'' employed by a broker-dealer. There is no group,
however, within the typical investment advisory firm that corresponds
to municipal finance professionals. In our examination of pay to play
practices involving investment advisers, we found that political
contributions intended to influence the selection of the advisory firm
were typically made by executives of the adviser or persons who solicit
government clients on behalf of the adviser. Therefore, we are
proposing to limit application of the rule to contributions made by the
adviser or its partners, executive officers or solicitors.
Under the proposed rule, the term executive officer includes the
adviser's president, vice-presidents in charge of a business unit or
division of the adviser, and other officers or persons who perform a
policy-making function for the adviser.\82\ A solicitor is any person
who, directly or indirectly, solicits any client for, or refers any
client to, an investment adviser.\83\ Employees who play a role in
obtaining government clients are thus covered by the proposed rule as
are third-party solicitors an investment adviser engages to obtain
clients. Contributions by other employees of the adviser or other
persons (such as spouses, control persons and affiliates) would not
otherwise trigger the rule's prohibitions unless the adviser or any of
its partners, executives or solicitors used the person to indirectly
make a contribution. This could occur, for example, if a firm paid a
non-executive employee a bonus with the expectation or understanding
that the employee would make a political contribution that, if made by
the firm, would trigger the rule's prohibition.\84\
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\82\ Proposed rule 206(4)-5(e)(2). The definition of ``executive
officer'' is the same as that used in Advisers Act rule 205-3. 17
CFR 275.205-3.
\83\ Proposed rule 206(4)-5(e)(6). The definition of
``solicitor'' is the same as that used in Advisers Act rule 206(4)-
3. 17 CFR 275.206(4)-3.
\84\ See discussion of indirect contributions infra section
II.A.3.
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The Commission has drafted the proposed rule so that its
prohibitions are triggered by political contributions by persons we
have found are typically involved in pay to play practices and who, in
the context of an advisory firm, are likely to have an economic
incentive to make contributions to influence the advisory firm's
selection. We are mindful of the burdens the proposed rule would place
on advisory firms and on the ability of persons associated with an
adviser to participate in civic affairs. We thus have narrowly tailored
the rule to achieve our goal of ending adviser participation in pay to
play practices. We request comment on the scope of the rule in its
application to persons associated with an adviser. Are there less
restrictive alternatives that would accomplish our goals?
Proposed rule 206(4)-5 contains a de minimis provision that would
permit a partner, executive officer or solicitor to make contributions
of $250 or less to an elected official or candidate without triggering
the rule's prohibitions if the person making the contribution is
entitled to vote for the official or candidate.\85\ The Commission
assumes that contributions of less than $250 are typically made without
the intent or ability to influence the selection process for investment
advisers and thus do not involve the conflicts of interest the rule is
intended to prevent. Comment is requested on the scope of the
exception. The $250 amount is the same as the de minimis amount
excepted from MSRB rule G-37.\86\ Should the amount be increased or
decreased? Should we provide a de minimis exemption for contributions
of a lesser amount, e.g. $100, to officials for whom an individual is
not entitled to vote?
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\85\ Proposed rule 206(4)-5(b). Under the proposed rule, a
partner, executive officer or solicitor of an investment adviser
could, without triggering the prohibitions of the rule, contribute
up to $250 in both the primary election campaign and the general
election campaign (up to $500) of each official for whom the person
making the contribution would be entitled to vote. For purposes of
this rule, a person would be ``entitled to vote'' for an official if
the person's principal residence is in the locality in which the
official seeks election.
\86\ MSRB rule G-37(b).
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Under the proposed rule, a contribution made by a partner,
executive officer or solicitor of an adviser would also be attributed
to any other adviser that employs or engages the person who made the
contribution within two years after the date the contribution was
made.\87\ As a result, an investment adviser would be required to
``look-back'' in time to determine whether it would be subject to any
business restrictions under the proposed rule when employing or
engaging a partner, executive officer or solicitor. This provision,
which is similar to one in MSRB rule G-37,\88\ would prevent advisers
from circumventing the rule by channeling contributions through
departing employees, or by influencing the selection process by hiring
persons who have made political contributions. Comment is requested on
the look-back requirement. Would a shorter period be sufficient to
prevent circumvention of the rule?
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\87\ Proposed rule 206(4)-5(a)(1)(ii). Persons who are employees
as well as ``independent contractors'' would be covered by the
proposed rule. In no case would the prohibition imposed by the
proposed rule be longer than two years from the date the executive
officer makes a covered contribution. If, for example, an executive
officer becomes employed by an investment adviser one year and six
months after making a contribution, the new employer would be
subject to the proposed rule's prohibition for the remaining six
months of the two-year period. The executive officer's employer at
the time of the contribution would be subject to the proposed rule's
prohibition for the entire two-year period regardless of whether the
executive officer remains employed by the adviser. However, if an
executive officer is not an employee of an adviser, the adviser
would not be responsible for any recordkeeping requirements with
respect to that executive officer. See supra section II.B.
\88\ MSRB rule G-37(g)(iv).
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2. Solicitation Restrictions
Another way an adviser can attempt to influence the selection
process is by soliciting contributions for an elected official.
Therefore, like MSRB rule G-37,\89\ the proposed rule would prohibit an
adviser from providing or seeking to provide advisory services for
compensation while the adviser, or any of its partners, executive
officers or solicitors, solicit any person or PAC to make, or
coordinate, any contribution to an official of a government entity to
which the adviser is providing or seeking to provide investment
advisory
[[Page 43563]]
services.\90\ This provision would also prohibit advisers from seeking
to influence the selection process by, for example, ``bundling'' \91\
contributions from its employees or by making contributions through a
third party, such as a ``gatekeeper.''
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\89\ MSRB rule G-37(c).
\90\ Proposed rule 206(4)-5(a)(2)(i). An investment adviser
would be seeking to provide advisory services to a government entity
when it responds to an RFP, communicates with a government entity
regarding that entity's formal selection process for investment
advisers, or engages in some other solicitation of investment
advisory business with the government entity. A violation of
paragraph (a)(2)(i) of the proposed rule would not trigger a two-
year ban on the provision of investment advisory services for
compensation, but would be a violation of the rule.
\91\ An employee or person acting on an adviser's behalf
``bundles'' contributions by coordinating small contributions from
several employees of the adviser to create one large contribution.
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In a gatekeeper arrangement, political contributions are arranged
by an intermediary, typically a pension consultant, which distributes
or directs contributions to elected officials or candidates. The
gatekeeper ensures that advisers not making a requisite amount of
contributions are not included among the final candidates for advisory
contracts. In addition, the gatekeeper may arrange ``swaps'' of
contributions between elected officials in order to shield the
contributions from public disclosure or to circumvent plan restrictions
on contributions to trustees.\92\ Under the proposed rule, the
gatekeeper in these arrangements would be soliciting political
contributions and, if the gatekeeper is an investment adviser, would
violate the proposed rule.\93\
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\92\ For example, Adviser A advises Plan X, while Adviser B
advises Plan Y. The ``gatekeeper'' may direct a political
contribution from Adviser A to the elected official, who is a
trustee to Plan Y, and from Adviser B to the elected official, who
is a trustee to Plan X, agreeing to place both advisers on each
plan's approved list. Persons reviewing records of the political
contributions would have no way of determining that the
contributions were swapped and that they created conflicts of
interest on the part of the advisers as well as the elected
officials.
\93\ Regardless of whether the gatekeeper is an investment
adviser, a person participating in such a scheme would, if the rule
is adopted, likely be aiding and abetting an adviser's violation of
the rule. See section 209(d) of the Act (15 U.S.C. 80b-9(d))
(authorizing Commission enforcement action for aiding and abetting a
violation of the Advisers Act or any Advisers Act rule).
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3. Direct and Indirect Contributions or Solicitations
The proposed rule would also prohibit acts ``done indirectly,
which, if done directly would be considered a fraudulent, deceptive or
manipulative act under the rule.'' \94\ Thus, an adviser could not
circumvent the rule by directing or funding contributions through third
parties, including, for example, consultants, attorneys, family members
or persons controlling the adviser who have an economic interest in the
adviser being awarded an advisory contract. This provision would also
cover contributions made, directed or funded, with the expectation
that, as a result of the contribution, another contribution would be
made by a third party for the benefit of the adviser. Contributions
made through gatekeepers (described above) thus would be considered
made ``indirectly'' for purposes of the proposed rule.
---------------------------------------------------------------------------
\94\ Proposed rule 206(4)-5(a)(2)(ii). See also section 208(d)
of the Advisers Act (15 U.S.C. 80b-8(d)).
---------------------------------------------------------------------------
4. Private Investment Companies
In some cases, advisers to ``private investment companies,'' \95\
such as hedge funds and venture capital pools, have reportedly made
contributions to elected officials who have influenced the decision of
a government entity to invest in the adviser's company.\96\ The
proposed rule would treat an investment by a government entity in a
private investment company the same as if the government entity entered
into an advisory contract directly with the adviser.\97\ As a result, a
contribution by an adviser, any of its partners, executive officers or
solicitors to an official of a government entity who can influence the
decision to invest in the private fund, would trigger the prohibitions
of the proposed rule. If the government entity was an investor in the
fund at the time of the contribution, the adviser would be required to
cause the private investment company to redeem the investment of the
government entity, or, alternatively, return to the government entity
amounts it received as compensation for managing the assets of the
private investment company attributable to the government entity's
investment. The Commission requests comment on whether additional types
of government investments should be covered by the proposed rule. In
particular, should the rule apply to off-shore funds, which do not fall
within the definition of private investment company, and therefore are
not subject to the proposed rule? \98\
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\95\ The proposed rule defines a private investment company as
an investment company exempt from Commission registration under
section 3(c)(1) or (3)(c)(7) of the Investment Company Act of 1940
(15 U.S.C. 80a-3(c)(1) and 3(c)(7)). Proposed rule 206(4)-5(e)(5).
\96\ The articles describing allegations that advisers to
private investment companies engage in pay to play practices are
available in File No. S7-19-99.
\97\ Proposed rule 206(4)-5(c). The proposed rule would thus
``look through'' the private investment company and treat its
security holders as clients of the adviser. Cf. rule 205-3(b) (17
CFR 275.205-3(b)) (equity owners of private investment companies
treated as clients for purposes of performance fee exemptive rule).
\98\ Off-shore funds are generally not required to register with
the Commission under section 8(a) of the Investment Company Act of
1940 (15 U.S.C. 80a-8(a)).
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5. Exemptions
Under the proposed rule the Commission could, upon application,
exempt advisers from the rule's prohibitions that are triggered by
inadvertent contributions or when imposition of the prohibitions is
inconsistent with the rule's intended purpose. In determining whether
to grant an exemption, we would consider whether (i) the exemption is
in the public interest and consistent with the purposes of the rule,
(ii) the adviser, before the contribution is made, had developed
procedures to ensure compliance with the rule and had no actual
knowledge of the contributions, and (iii) the adviser, after the
contribution was made, took appropriate preventative and remedial
measures, including all available steps to obtain a return of the
contribution.\99\
---------------------------------------------------------------------------
\99\ Proposed rule 206(4)-5(d).
---------------------------------------------------------------------------
These factors are similar to those considered by the NASD and the
appropriate bank regulators in determining whether to grant an
exemption under MSRB rule G-37(i). Under the proposed rule, however,
exemptive authority will be exercised by the Commission.\100\ In
applying the criteria, we expect to take into account, among other
things, the varying facts and circumstances presented by each
application. We would apply these exemptive provisions with sufficient
flexibility to avoid consequences disproportionate to the violation
while accomplishing the remedial purpose of the rule.\101\ We request
comment on the proposed exemptive criteria. Are there additional
criteria the Commission should consider when determining whether to
grant an exemption.
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\100\ The MSRB has provided four ``Questions and Answers''
regarding application of MSRB rule G-37-(i). Question 4, Additional
Rule G-37 Q&As, June 15, 1995, MSRB Rule Book at 196 (1999),
Questions and Answers Regarding Rule G-37(i), June 29, 1998, MSRB
Rule Book at 199 (1999). Denials of an exemption pursuant to MSRB
Rule G-37(i) are not subject to appeal to the Commission. See In re
Morgan Stanley & Co., Securities Exchange Act Release No. 39459
(Dec. 17, 1997).
\101\ Under the proposed rule, an adviser applying for an
exemption, could place advisory fees earned between the date of the
contribution triggering the prohibition and the date on which we
determine whether to grant an exemption in an escrow account. The
escrow account would be payable to the adviser if the Commission
grants the exemption. If the Commission does not grant the
exemption, the fees contained in the account must be returned to the
public fund.
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[[Page 43564]]
B. Recordkeeping
We are also proposing amendments to rule 204-2 to require an
investment adviser that is registered with us and has government
clients to make and keep certain records of contributions made by the
adviser, its partners, executive officers and solicitors.\102\ These
records would be confidential,\103\ and only reviewed by our staff in
the course of an adviser examination. We believe they would be
necessary to allow us to enforce compliance with rule 206(4)-5, if
adopted.
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\102\ 17 CFR 275.204-2.
\103\ Section 210(b) of the Advisers Act (15 U.S.C. 80b-10(b))
prohibits the Commission staff from disclosing to anyone outside the
Commission any information obtained as a result of an examination or
investigation without Commission approval.
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The proposed amendments would require an adviser to make and keep a
list of its partners, executive officers and solicitors, the states in
which the adviser has, or is seeking, government clients, the identity
of those clients, and the contributions made by the firm and its
partners, executive officers and solicitors to government officials and
candidates.\104\ These requirements would be similar to the MSRB
recordkeeping rule for broker-dealers.\105\
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\104\ Proposed rule 204-2(l).
\105\ MSRB rule G-8(a)(xvi). Like rule G-37, the proposed rule
requires an investment adviser to keep, in addition to records of
political contributions, records of any other ``payments'' made to
officials. A payment is defined as any gift, subscription, loan,
advance, or deposit of money or anything of value.
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These new recordkeeping requirements should not be burdensome. As
discussed above, a single contribution could, under the rule, lead to a
two-year suspension of advisory activities for a government client. We
would expect, therefore, that advisers would adopt sufficient internal
procedures to prevent the rule's prohibitions from being triggered. The
records that we propose registered advisers make and keep would be
those an adviser undertaking a serious compliance effort would
ordinarily make, and thus we assume the amendments would involve no
substantial additional burdens. Comment is requested on our assumptions
and on whether our assessment of the burdens is correct. We request
that commenters opposing the new recordkeeping requirements suggest
alternative means we could use to enforce the new rule.
C. Transition Period
The prohibition and recordkeeping requirements under the proposed
rule would arise from contributions made on or after the effective date
of the rule, if adopted. As a result, firms would need to begin
monitoring contributions made by their partners, executive officers and
solicitors on that date. The Commission requests comment on whether
firms would require additional time to develop procedures to comply
with the proposed rule and, if so, how long of a transitional period
following the rule's adoption would be necessary?
D. General Request for Comment
Any interested persons wishing to submit written comments on the
proposed rule and rule amendment that are the subject of this release,
or to suggest additional changes or submit comments on other matters
that might have an effect on the proposals described above, are
requested to do so. Commenters suggesting alternative approaches are
encouraged to submit proposed rule text.
III. Cost/Benefit Analysis
We are sensitive to the costs and benefits imposed by our rules,
and understand that compliance with proposed rule 206(4)-5 and the
proposed amendments to rule 204-2 may impose costs on some advisers.
The proposed rule and rule amendments would apply only to investment
advisers that provide advisory services to government clients and which
make political contributions. In addition, the proposed rule and rule
amendments would only affect the political contributions made by the
adviser, and its partners, executive officers and solicitors. The
majority of advisers and advisory employees thus would be unaffected by
the proposed rule and rule amendments.
A. Benefits
Proposed rule 206(4)-5 would likely yield several important
benefits to investment advisers and state and local governments, both
direct and indirect. The proposed rule would reduce or eliminate the
costs of political contributions incurred by investment advisers
through pay to play practices. While not readily quantifiable, the
record above indicates that advisers, and their partners, executive
officers and solicitors, have made substantial contributions to elected
officials from whom the advisers are seeking business.\106\ We believe
these contributions would decrease substantially if the proposed rule
were adopted. This could result in lower advisory fees being paid by
the state or local government for advisory services, as advisers would
not have to recoup the cost of contributions through fees the advisers
charge the government client.
---------------------------------------------------------------------------
\106\ See supra note 38.
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The proposed rule should also yield several indirect benefits,
including benefits to state and local governments and taxpayers. If
state and local governments select an adviser on the basis of campaign
contributions, the most qualified adviser may not be selected. As
discussed above, awarding advisory contracts to advisers that make
political contributions may lead to inferior management, and diminished
or negative returns.\107\ Similarly, an adviser that is selected on
bases other than merit may obtain soft dollars and other ancillary
benefits at the expense of the government client. Finally, the proposed
rule would level the playing field for advisers to state and local
governments. Campaign contributions create artificial barriers to
competition for firms that cannot or will not make political
contributions. Eradicating pay to play arrangements enables advisory
firms, particularly smaller advisory firms, to compete on the basis of
merit, rather than their ability to make contributions.
---------------------------------------------------------------------------
\107\ See supra note 63 and accompanying text.
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B. Costs
The proposed rule and rule amendments would impose some costs on
advisers that provide advisory services to government clients. The
proposed rule would require an adviser with government clients, and an
adviser which solicits business from government clients, to incur costs
to monitor contributions made by the adviser, and its partners,
executive officers and solicitors, and to establish procedures to
comply with the proposed rule and rule amendments. The initial and
ongoing compliance costs imposed by the proposed rule would vary
significantly among firms, depending on a number of factors. These
include the number of partners, executive officers and solicitors of
the adviser, the degree to which compliance procedures are automated,
and whether the adviser is affiliated with a broker-dealer firm that is
subject to rule G-37. A smaller adviser, for example, would likely have
a small number of partners, executive officers and solicitors, and thus
expend less resources to comply with the proposed rule and rule
amendments than a larger adviser.
As a comparison, Commission staff has been advised that the burden
imposed by rule G-37 on smaller broker-dealer firms is negligible.
Although a large adviser is likely to spend more resources to comply
with
[[Page 43565]]
the rule than a smaller adviser, an adviser with a broker-dealer
affiliate that is required to comply with MSRB rule G-37 could likely
use some or all of the compliance procedures established by the
affiliate. As a result, many advisers with broker-dealer affiliates may
spend few resources to comply with the proposed rule and rule
amendments.
Based on compliance with other recordkeeping rules, Commission
staff anticipates that most advisory firms would develop compliance
procedures to monitor the political contributions made by the adviser
and its partners, executive officers and solicitors. We estimate that
the costs imposed by the proposed rule would be higher initially, as
firms establish and implement procedures to comply with the rule and
rule amendments. If we adopt the proposed rule and rule amendments,
firms with government clients would likely develop and implement
compliance procedures within 60 to 90 days after adoption. It is
anticipated that compliance expenses would then decline to a relatively
constant amount in future years.
The Commission has limited data on the costs that the proposed rule
and rule amendments would impose on investment advisers with government
clients. We estimate that as many as 1,500 investment advisers
registered with the Commission may be affected by the proposed rule and
rule amendments.\108\ Based on registration information filed with the
Commission, we estimate that approximately 450 advisers have fewer than
five partners, executive officers, or solicitors that would be subject
to the proposed rule (``smaller firms''); approximately 825 advisers
have between five and 15 partners, executive officers or solicitors
(``medium firms''); and approximately 225 advisers have more than 15
partners, executive officers, or solicitors that would be subject to
the prohibitions of the proposed rule (``larger firms'').
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\108\ This number was used for purposes of the Paperwork
Reduction Act analysis, infra section IV.
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Advisers that are exempt from registration with the Commission
would be subject to the proposed rule (but not the rule amendments).
The Commission has limited data regarding the number of investment
advisers that are exempt from registration under section 203(b) of the
Advisers Act. Reports indicate that the number of exempt advisers may
exceed 3,000.\109\ While not readily quantifiable, the estimated number
of exempt advisers likely includes advisers to off-shore funds that
would not be subject to the proposed rule. The Commission also has
limited information regarding the number of partners, executive
officers and solicitors of exempt advisers. For purposes of this
analysis, it is anticipated that the number of persons of each exempt
advisory firm that would be subject to the proposed rule are comparable
to the ranges for registered investment advisers, described above.
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\109\ Hal Lux, Hedge Fund? Who Me?, Institutional Investor, Aug.
1998, at 33; Bethany McLean, Everybody's Going Hedge Funds, Fortune,
June 8, 1998, at 180.
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Although the time needed to comply with the proposed rule would
vary significantly from adviser to adviser, the Commission estimates
that firms with government clients would spend between 2.5 hours and
250 hours to establish adequate procedures to comply with the proposed
rule. These estimates are derived in part from conversations with
industry professionals regarding broker-dealer compliance with rule G-
37. Commission staff estimates that ongoing compliance with the
proposed rule would require between 10 and 1,000 hours, annually.
Initial compliance procedures would likely be designed and administered
by compliance professionals and clerical staff. We estimate that the
hourly wage rate for compliance professionals is $114, including
benefits, and for clerical staff, $15 per hour, including benefits. To
establish and implement adequate compliance procedures, the Commission
staff estimates that the proposed rule would impose initial compliance
costs of approximately $285 \110\ per smaller firm, approximately
$13,387.50 \111\ per medium firm, and approximately $22,312.50 \112\
per larger firm. It is estimated that the proposed rule would impose
annual, ongoing compliance expenses of approximately $892.50 \113\ per
smaller firm, $53,550 \114\ per medium firm, and $89,250 \115\ per
larger firm.
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\110\ The per firm cost estimate is based on our estimate that
development of initial compliance procedures for smaller firms would
take 2.5 hours of professional time (at $114 per hour).
\111\ The per firm cost estimate is based on our estimate that
development of initial compliance procedures for medium firms would
take 112.50 hours of professional time (at $114 per hour) and 37.5
hours of clerical time (at $15 per hour).
\112\ The per firm cost estimate is based on our estimate that
development of initial compliance procedures for larger firms would
take 187.50 hours of professional time (at $114 per hour) and 62.5
hours of clerical time (at $15 per hour).
\113\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for smaller firms would take 7.5 hours
of professional time (at $114 per hour) and 2.5 hours of clerical
time (at $15 per hour), per year.
\114\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for medium firms would take 450 hours
of professional time (at $114 per hour) and 150 hours of clerical
time (at $15 per hour), per year.
\115\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for larger firms would take 750 hours
of professional time (at $114 per hour) and 250 hours of clerical
time (at $15 per hour), per year.
---------------------------------------------------------------------------
The prohibitions of the proposed rule may also impose other, less
quantifiable costs on advisers and political officials. An adviser that
becomes subject to the prohibitions of the proposed rule would no
longer be eligible to receive advisory fees from its government client.
The adviser, however, would likely be obligated under its fiduciary
duties to continue providing advisory services to the government client
for a period of time without compensation. An adviser that provides
uncompensated advisory services to a government client may incur
opportunity costs if the adviser is unable to pursue other government
clients. Advisers to government clients, as well as the partners,
executive officers and solicitors of the adviser, also may be less
likely to make political contributions to political officials, possibly
imposing costs on the officials if they are unable to secure alternate
funding.
We anticipate that the proposed rule amendments would impose few,
if any, additional costs. As discussed above, advisers generally would
establish internal compliance procedures to comply with the proposed
rule. Advisers would create and maintain various records, as required
by their own compliance procedures. The proposed rule amendments are
intended to cover those records an adviser typically would maintain in
complying with the proposed rule. Advisers that are exempt from
Commission registration under section 203(b) of the Advisers Act would
be subject to the proposed rule, but not the proposed recordkeeping
amendments. We have requested comment on the scope of the proposed rule
and rule amendments.
C. Requests for Comment
The Commission requests comment on the effects of the proposed rule
and rule amendments on individual investment advisers and on the
advisory profession as a whole. We request data to quantify the costs
and value of the benefits associated with the proposed rule.
Specifically, comment is requested on the costs of establishing
compliance procedures to comply with the proposed rule, both on an
initial and ongoing basis. Comment also is requested on the costs of
using compliance procedures of an affiliated broker-dealer that the
broker-dealer established as a result of rule G-37. In addition, we
request data
[[Page 43566]]
regarding our assumptions about advisers exempt from registration under
section 203(b) of the Act, such as the number of advisers that would be
subject to the proposed rule, and the number of partners, executive
officers and solicitors of these exempt advisers. Commenters should
provide analysis and empirical data to support their views on the costs
and benefits associated with this proposal.
IV. Paperwork Reduction Act
The proposed rule amendments contain a ``collection of
information'' requirement within the meaning of the Paperwork Reduction
Act of 1995,\116\ and the Commission has submitted the amendments to
the Office of Management and Budget (``OMB'') for review in accordance
with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The title for the collection
of information is ``Rule 204-2'' under the Advisers Act. Rule 204-2
contains a currently approved collection of information number under
OMB control number 3235-0278. An agency may not sponsor, conduct, or
require response to an information collection unless a currently valid
OMB number is displayed.
---------------------------------------------------------------------------
\116\ 44 U.S.C. 3501.
---------------------------------------------------------------------------
Section 204 of the Advisers Act provides that investment advisers
required to register with the Commission must make and keep certain
records for prescribed periods, and make and disseminate certain
reports. Rule 204-2 sets forth the requirements for maintaining and
preserving specified books and records. This collection of information
is mandatory. The Commission staff uses this collection of information
in its examination and oversight program, and the information generally
is kept confidential.\117\ The current collection of information for
rule 204-2 is based on average of 235.47 burden hours each year, per
Commission-registered adviser, for a total of 1,483,461 burden hours.
The current total burden is based on 6,300 potential respondents.
---------------------------------------------------------------------------
\117\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------
The proposed amendments to rule 204-2 would require registered
investment advisers that provide advisory services to government
clients to maintain certain records of contributions made by the
adviser or any of its partners, executive officers, or solicitors.
These records would be required to be maintained in the manner, and for
the period of time, as other books and records under rule 204-2(a).
This collection of information would be found at 17 CFR 275.204-2.
Advisers that are exempt from Commission registration under section
203(b) of the Advisers Act would not be subject to the recordkeeping
requirements.
Commission records indicate that there currently are approximately
8,200 potential respondents to the collection of information imposed by
rule 204-2. As a result of the increase in the number of advisers
registered with the Commission, the total burden is being increased by
447,393 hours (1,900 new advisers x 235.47 hours). We estimate that
there may be as many as 1,500 advisers that provide advisory services
to government clients and would thus be affected by the proposed rule
amendments. Under the proposed amendments, each respondent would be
required to retain the records on an ongoing basis. The proposed
amendments to rule 204-2 are estimated to increase the burden by
approximately two hours, to 237.47, per Commission-registered adviser
with government clients. The weighted average burden per Commission-
registered adviser is 235.83. The annual aggregate burden for all
respondents to the recordkeeping requirements under rule 204-2 thus
would be 1,933,854 hours.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to (i) evaluate whether the proposed collections of
information are necessary for the proper performance of the functions
of the agency, including whether the information will have practical
utility; (ii) evaluate the accuracy of the agency's estimate of the
burden of the proposed collection of information; (iii) enhance the
quality, utility, and clarity of the information to be collected; and
(iv) minimize the burden of the collections of information on those who
are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons desiring to submit comments on the collection of
information requirements should direct them to the Office of Management
and Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
D.C. 20503, and also should send a copy of their comments to Jonathan
G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street,
N.W., Washington, D.C. 20549-0609 with reference to File No. S7-19-99.
Requests for materials submitted to OMB by the Commission with regard
to this collection of information should be in writing, refer to File
No. S7-19-99, and be submitted to the Securities and Exchange
Commission, Office of Filings and Information Services. OMB is required
to make a decision concerning the collections of information between 30
and 60 days after publication. A comment to OMB is best assured of
having its full effect if OMB receives it within 30 days of
publication.
V. Summary of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed
rule 206(4)-5 and proposed amendments to rule 204-2, both under the
Advisers Act. The following summarizes the IRFA.
As set forth in greater detail in the IRFA, the proposed rule would
prohibit an investment adviser from providing advisory services for
compensation to a government client for two years after the adviser or
any of its partners, executive officers or solicitors made a
contribution to certain elected officials or candidates. The
prohibition would not result from contributions of up to $250 (per
election) made by a partner, executive officer or solicitor of the
adviser to an elected official or candidate for whom the person making
the contribution can vote. The rule amendments would require a
registered adviser that has government clients and makes political
contributions to maintain certain records of their political
contributions. The IRFA states that the new rule and rule amendments
are designed to prevent advisers from engaging in pay to play
practices, and to protect advisory clients (and their beneficiaries)
from the consequences of pay to play.
The IRFA contains the statutory authority for the proposed rule and
rule amendments. The IRFA also discusses the effect of the proposed
rule and rule amendments on small entities. For purposes of the
Advisers Act and the Regulatory Flexibility Act, an investment adviser
generally is a small entity if (i) it manages assets of less than $25
million reported on its most recent Schedule I to Form ADV (17 CFR
279.1), (ii) it does not have total assets of $5 million or more on the
last day of the most recent fiscal year, and (iii) it is not in a
control relationship with another investment adviser that is not a
small entity.\118\
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\118\ Rule 0-7 (17 CFR 275.0-7).
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The Commission estimates that of the investment advisers subject to
the proposed rule and rule amendments, approximately 1,000 are small
entities. The Commission has no information regarding the number of
small-entity advisers that provide advisory services
[[Page 43567]]
to government clients. Advisers to state and local governments,
however, are unlikely to be small entities. The proposed rule and rule
amendments, therefore, would likely affect few or no small entities.
The IRFA states that the proposed rule and rule amendments would
impose no new reporting requirements. The proposed rule and rule
amendments, however, would create certain new compliance and
recordkeeping requirements. The proposed rule imposes a new compliance
requirement by prohibiting an adviser from providing advisory services
for compensation to government clients for two years after the adviser
or any of its partners, executive officers or solicitors makes a
contribution to certain elected officials or candidates. The proposed
rule amendments would impose new recordkeeping requirements by
requiring an adviser to state and local governments that makes
political contributions to maintain certain records of its
contributions and its advisory clients. An investment adviser that
either does not make political contributions or does not provide
advisory services to a state or local government would be unaffected by
the proposed rule and rule amendments. Moreover, as discussed above,
few or no small entities are likely to be affected by the proposed rule
and rule amendments. There are no rules that duplicate, overlap, or
conflict with, the proposed rule and rule amendments.
The IRFA discusses the various alternatives considered by the
Commission in connection with the proposed rule amendments that might
minimize the effect on small entities, including (a) the establishment
of differing compliance or reporting requirements or timetables that
take into account resources available to small entities; (b) the
clarification, consolidation, or simplification of compliance and
reporting requirements under the proposed rule and rule amendments for
small entities; (c) the use of performance rather than design
standards; and (d) an exemption from coverage of the proposed rule and
rule amendments, or any part thereof, for small entities.
As discussed in more detail in the IRFA, we believe it would be
both unfeasible and unnecessary to exempt small entities from the
proposed rule and rule amendments. After taking into account the
resources available to small entities and the potential burden that
could be placed on small-entity investment advisers, the Commission is
proposing to require small entities to be subject to the proposed rule
and rule amendments. As discussed in more detail in the IRFA, we have
taken steps to minimize the effects on small-entity investment
advisers. We have determined that it does not appear feasible to
establish different reporting or compliance requirements or to further
clarify, consolidate, or simplify the reporting or compliance
requirements.
The IRFA includes information concerning the solicitation of
comments with respect to the IRFA generally, and in particular, the
number of small entities that would be affected by the proposed rule
and rule amendments. A copy of the IRFA may be obtained by contacting
Jeffrey O. Himstreet, Attorney, Securities and Exchange Commission, 450
5th Street, N.W., Washington, DC 20549-0506.
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, the Commission is also requesting information regarding
the potential impact of the proposed rule and rule amendment on the
economy on an annual basis. Commenters should provide empirical data to
support their views.
VI. Statutory Authority
The Commission is proposing new rule 206(4)-5 of the Act pursuant
to the authority set forth in sections 206(4) and 211(a) of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-6(4), 80b-11(a)).
The Commission is proposing amendments to rule 204-2 of the Act
pursuant to the authority set forth in sections 204 and 206(4) of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-4 and 80b-6(4)).
List of Subjects in 17 CFR Part 275
Reporting and recordkeeping requirements, Securities.
Text of Proposed Rule and Rule Amendments
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is proposed to be amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The authority citation for part 275 continues to read in part as
follows:
Authority: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-
6a, 80b-11, unless otherwise noted.
* * * * *
2. Section 275.206(4)-5 is added to read as follows:
Sec. 275.206(4)-5 Political contributions by certain investment
advisers.
(a) Prohibitions. As a means reasonably designed to prevent
fraudulent, deceptive or manipulative acts, practices, or courses of
business within the meaning of section 206(4) of the Act (15 U.S.C.
80b-6(4)), it shall be unlawful:
(1) For any investment adviser not prohibited from registering with
the Commission under section 203A(a) of the Act (15 U.S.C. 80b-3a(a))
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:
(i) The investment adviser;
(ii) Any partner, executive officer or solicitor of the investment
adviser (including a person who becomes a partner, executive officer or
solicitor within two-years after the contribution is made); or
(iii) Any political action committee controlled by the investment
adviser or by any partner, executive officer or solicitor of the
investment adviser; and
(2) For any investment adviser not prohibited from registering with
the Commission under section 203A(a) of the Act (15 U.S.C. 80b-3a(a)),
or any of its partners, executive officers or solicitors:
(i) To solicit any person or political action committee to make, or
coordinate, any contribution to an official of a government entity to
which the investment adviser is providing or seeking to provide
investment advisory services; or
(ii) To do anything indirectly which, if done directly, would
result in a violation of this section.
(b) Exception. Paragraph (a)(1) of this section does not apply to
contributions made by a partner, executive officer or solicitor to
officials for whom the partner, executive officer or solicitor was
entitled to vote at the time of the contributions and which in the
aggregate do not exceed $250 to any one official, per election.
(c) Special rule for private investment companies. For purposes of
this section, an investment adviser to a private investment company in
which a government entity invests provides investment advisory services
to the government entity.
(d) Exemptions. The Commission, upon application, may conditionally
or unconditionally exempt an investment adviser from the prohibition
under paragraph (a)(1) of this section. In determining whether to grant
an exemption, the Commission will consider, among other factors,
whether:
[[Page 43568]]
(1) The exemption is consistent with the purposes of this section;
(2) The investment adviser, before the contribution(s) resulting in
the prohibition was made:
(i) Developed and instituted procedures reasonably designed to
ensure compliance with this section;
(ii) Had no actual knowledge of the contribution(s); and
(3) The investment adviser:
(i) Has taken all available steps to obtain a return of the
contribution(s); and
(ii) Has taken other remedial or preventive measures as may be
appropriate under the circumstances.
(e) Definitions. For purposes of this section:
(1) Contribution means any gift, subscription, loan, advance, or
deposit of money or anything of value made for:
(i) The purpose of influencing any election for federal, state or
local office;
(ii) Payment of debt incurred in connection with any such election;
or
(iii) Transition or inaugural expenses of the successful candidate
for State or local office.
(2) Executive officer means the president, any vice president in
charge of a principal business unit, division or function (such as
sales, administration or finance), any other officer who performs a
policy-making function, or any other person who performs similar
policy-making functions, for the investment adviser.
(3) Government entity means any State or political subdivision of a
State, including
(i) Any agency, authority, or instrumentality of the State or
political subdivision;
(ii) Plan or pools of assets controlled by the State or political
subdivision or any agency, authority or instrumentality thereof; and
(iii) Officers, agents, or employees of the State or political
subdivision or any agency, authority or instrumentality thereof, acting
in their official capacity.
(4) Official means any person (including any election committee for
the person) who was, at the time of the contribution, an incumbent,
candidate or successful candidate:
(i) For an elective office of a government entity, if the office is
directly or indirectly responsible for, or can influence the outcome
of, the use of an investment adviser by a government entity; or
(ii) For any elective office of a government entity, if the office
has authority to appoint any person who is directly or indirectly
responsible for, or can influence the outcome of, the use of an
investment adviser.
(5) A Private investment company is a company that would be an
investment company under section 3(a) of the Investment Company Act of
1940 (15 U.S.C. 80a-3(a)) but for the exceptions to that definition in
sections 3(c)(1) and 3(c)(7) of the Investment Company Act (15 U.S.C.
80a-3(c)(1)).
(6) A Solicitor is any person who, directly or indirectly, solicits
any client for, or refers any client to, an investment adviser.
(f) Effective date. The prohibition on providing investment
advisory services as described in this section arises only from
contributions made on or after (the effective date of this section).
3. Section 275.204-2 is amended by revising paragraphs (e)(1) and
(h)(1) and adding paragraph (l) to read as follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
* * * * *
(e)(1) The following books and records must be maintained and
preserved in an easily accessible place for a period of not less than
five years from the end of the fiscal year during which the last entry
was made on such record, the first two years in an appropriate office
of the investment adviser:
(i) Books and records required to be made under the provisions of
paragraphs (a) to (c)(1) (except for books and records required to be
made under the provisions of paragraphs (a)(11) and (a)(16) of this
section); and
(ii) Books and records required to be made under the provisions of
paragraph (1) of this section.
* * * * *
(h)(1) Any book or other record made, kept, maintained and
preserved in compliance with Secs. 240.17a-3 and 240.17a-4 of this
chapter under the Securities Exchange Act of 1934, or with rules
adopted by the Municipal Securities Rulemaking Board, which is
substantially the same as the book or other record required to be made,
kept, maintained and preserved under this rule, shall be deemed to be
made, kept, maintained and preserved in compliance with this rule.
* * * * *
(l)(1) Every investment adviser registered or required to be
registered under section 203 of the Act (15 U.S.C. 80b-3) that provides
investment advisory services to a government entity, must make and keep
the following records:
(i) The names, titles and business and residence addresses of all
partners, executive officers or solicitors of the investment adviser;
(ii) The States in which the investment adviser or any of its
partners, executive officers, or solicitors is providing or seeking to
provide investment advisory services to a government entity;
(iii) All government entities to which the investment adviser has
provided investment advisory services in the past five years, but not
prior to (insert effective date of rule); and
(iv) All direct or indirect contributions or payments made by the
investment adviser or any of its partners, executive officers, or
solicitors or a political action committee controlled by the investment
adviser or any of its partners, executive officers, or solicitors to an
official, a political party of a State or political subdivision
thereof, or a political action committee.
(2) Records of the contributions and payments must be listed in
chronological order and indicate:
(i) The name and title of each contributor;
(ii) The name and title (including any city/county/state or other
political subdivision) of each recipient of a contribution or payment;
and
(iii) The amount and date of each contribution or payment.
(3) For purposes of this section:
(i) The terms contribution, government entity, official, executive
officer and solicitor have the same meanings as set forth in
Sec. 275.206(4)-5.
(ii) The term payment means any gift, subscription, loan, advance,
or deposit of money or anything of value.
Dated: August 4, 1999.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-20489 Filed 8-9-99; 8:45 am]
BILLING CODE 8010-01-P
