The SEC’s Rule 206(4)-5 under the Investment Advisers Act of 1940 (Advisers Act), aka the Pay-to-Play Rule, was partially delayed until recently, when FINRA adopted a complementary Rule. Broker-dealers that engage in distribution or solicitation activities with a government entity on behalf of any investment adviser need to pay close attention to the rule changes. I have outlined the rules, penalties and new FINRA rule below.
Serious Consequences, Even for Modest Sums
In 2010, the SEC adopted Rule 206(4)-5 under the Investment Advisers Act of 1940 (Advisers Act) addressing pay-to-play practices by investment advisers (the SEC Pay-to-Play Rule), which in part prohibited SEC-registered investment advisers (and exempt reporting advisers) and their covered associates from providing, or agreeing to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of the investment adviser unless the “person” is a defined “regulated person” (such as FINRA member broker-dealer entity). Rule 206(4)-5 has a de minimis exception that permits covered associates to make aggregate contributions of up to $350 per election (primary and general elections are counted separately) to an elected official or candidate for whom the covered associate is entitled to vote, and up to $150 per election to an elected official or candidate for whom the covered associate is not entitled to vote. For investment advisers, failure to comply with the terms of the SEC Pay-to-Play Rule can have very serious consequences, including fines and, more importantly, being unable to receive advisory fees from applicable clients for periods of up to two years from the date of a triggering political contribution (and potentially having to return applicable advisory money received since the date of the political contribution in question). A number of firms have faced regulatory action in the last year for what might otherwise be fairly modest (often in the range of $500) and routine political contributions by members of their staffs, including some contributions made to unsuccessful candidates for office (for purposes of the SEC Pay-to-Play Rule and the new FINRA rules, it is the office being sought or held that is important, not whether a candidate is successful in the election).
FINRA’s Comparable Rules
On August 20, 2017, rules that are highly similar and complementary to the SEC Pay-to-Play Rule became effective for most FINRA member broker-dealers: FINRA Rules 2030 (Engaging in Distribution and Solicitation Activities with Government Entities) and 4580 (Books and Records Requirements for Government Distribution and Solicitation Activities). On September 29, 2017, the SEC issued an order to clarify that the same standards also apply to so-called FINRA-registered “Capital Acquisition Brokers.”
Rule 2030(a) prohibits a covered member from engaging in distribution or solicitation activities for compensation with a “government entity” on behalf of an investment adviser that provides or is seeking to provide investment advisory services to such government entity within two years after a contribution[i] to an official of the government entity is made by a covered FINRA member (if made or reimbursed directly by the FINRA member, there is no de minimis dollar threshold) or a covered associate (including a person who becomes a covered associate within two years[ii] after the contribution is made). An “official of a government entity” includes an incumbent, candidate or successful candidate for elective office of a state or local government entity[iii] if the office is directly or indirectly responsible for, or can potentially influence the outcome of, the hiring of an investment adviser or has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser (such as the ability of, say a governor of a state, to appoint a member of a pension board that may then, in turn, be solicited to make an investment in a private fund managed by one of the broker-dealer’s clients).
Rule 2030(b) prohibits a covered member or covered associate from soliciting or coordinating (say by “bundling” the contributions of others into a single envelope to mail as one) any person or political action committee (PAC) to make any contribution to an official of a government entity in respect of which the covered member is engaging in, or seeking to engage in, distribution or solicitation activities on behalf of an investment adviser; or payment to a political party of a state or locality of a government entity with which the covered member is engaging in, or seeking to engage in, distribution or solicitation activities on behalf of an investment adviser. Further, covered members and their covered associates are explicitly prohibited from doing anything indirectly that, if done directly, would result in a violation of the rule – for example, intentionally funneling payments through consultants, family members or affiliates.
Takeaway
Any broker-dealer that has not done so already is highly advised to, on an expedited basis, adjust its Written Supervisory Procedures to account for the rule changes and, if it engages in distribution or solicitation activities with a government entity on behalf of any investment adviser that provides or is seeking to provide investment advisory services to such government entity, implement procedures to ensure internal collection of appropriate data (under new Rule 4580) from its associated persons.
[i] See Rule 2030(g)(1) for definition. FINRA does not consider a donation of time by an individual to be a contribution, provided the FINRA member has not solicited the individual’s efforts and the FINRA member’s resources, such as office space and telephones, are not used. Similarly, FINRA would not consider a charitable donation made by a FINRA member to an organization that qualifies for an exemption from federal taxation under the Internal Revenue Code, at the request of an official of a government entity, to be a counted “contribution.” There are also certain allowances for smaller political contributions that are promptly returned/refunded.
[ii] The “look back” applies to any person who becomes a covered associate, including a current employee who has been transferred or promoted to a position covered by the rule. A person becomes a “covered associate” for purposes of the rule’s “look back” provision at the time he or she is hired or promoted to a position that meets the definition of a “covered associate.” The two-year period is reduced to six months in the case of natural persons who made an applicable political contribution prior to becoming a FINRA member covered associate if, after becoming a covered associate, the natural person does not engage in, or seek to engage in, distribution or solicitation activities with a government entity on behalf of the FINRA member. The prohibitions and “look back” will not be triggered by contributions made prior to August 20, 2017.
[iii] If the individual is a state or local official at the time a contribution is made, but is running for federal office (i.e. U.S. Senate or president), the limitations of the rule would also still apply.