The Staff of the Securities and Exchange Commission's (SEC) Division of Investment Management (the Division) recently issued responses to several questions it has received regarding Rule 206(4)-5 of the Investment Advisers Act of 1940, better known as the pay-to-play rule (the SEC rule).
The Staff's response addresses an ambiguous regulatory area created in recent years as both the SEC and registered national securities associations worked toward creating and implementing their respective pay-to-play rules. The SEC's response provides assurance to investment advisers that they will not face an enforcement action as a result of this disparity, pending its remediation.
"Pay to play" describes the practice of investment advisers and other individuals making campaign contributions and related payments to elected officials and political candidates in the hopes of influencing how and where management contracts for public pension plan assets and similar government investment accounts are awarded. Adopted in 2010, the SEC rule includes prohibitions designed to preclude not only direct political contributions by investment advisers, but also other ways that advisers may engage in pay-to-play arrangements.
The Staff response covers a range of topics, including questions related to compliance dates; the definitions of a covered associate, government entity and official; third-party solicitors; and others. Most significantly, the response included new guidance regarding the compliance date for the pending ban on third-party solicitation for capital acquisition brokers (CABs).
Capital Acquisition Brokers
CABs are registered broker-dealers engaging in a limited range of activities including distribution and solicitation activities with government entities on behalf of investment advisers. The guidance addresses inquiries regarding the SEC rule's prohibition on covered investment advisers paying third parties in order to solicit government business on their behalf, although the SEC rule does permit payments to a third party that is a "regulated person," which is defined, in part, to include a registered broker or dealer that is itself subject to pay-to-play rules adopted by a registered national securities association.
This ban on third-party solicitation was originally set to come into effect on July 31, 2015. However, because both the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) had not yet established their own pay-to-play rules at that time, the Division indicated it would not recommend enforcement action for such third-party transactions until those rules were established. Subsequently, FINRA rules 2030 and 4580 – establishing rules covering the activities of member firms engaged in the distribution or solicitation activities with government entities on behalf of investment advisers – were approved in 2016 and became effective on Aug. 20, 2017 (the FINRA pay-to-play rules). As a result, the SEC's relief regarding such activities expired as the FINRA rules were in place.
Also in 2016, the SEC approved FINRA regulations that apply exclusively to firms that both meet the definition of a CAB and elect to be governed under these rules (collectively, the CAB rules). Under the CAB rules, CABs are subject to certain FINRA rules, but are not explicitly covered by the FINRA pay-to-play rules. Although FINRA filed a proposed rule change with the SEC on Aug. 18 to adopt CAB rules 203 and 458, which would apply the established FINRA pay-to-play rules to CABs, until any such amendments take effect CABs would remain outside the definition of a "regulated person." As a result, an investment adviser and its covered associates would remain prohibited from providing payments to any CAB in order to solicit a government entity for investment advisory services. Therefore, the Staff was asked if it would recommend enforcement action to the SEC against an investment adviser or its covered associates under rule 206(4)-5(a)(2)(i) for the payment to any person that is a CAB to solicit a government entity for investment advisory services. In response, the Staff stated that the Division would not recommend enforcement action to the SEC "against an investment adviser or its covered associates under rule 206(4)-5(a)(2)(i) for payment to any person that is a CAB to solicit a government entity for investment advisory services on behalf of the investment adviser or its covered associates" until any rules subjecting CABs to the FINRA pay-to-play rules come into effect.
Originally published November 1, 2017
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