# Political Contributions by Certain Investment Advisers > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2010-16559 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** July 14, 2010 - **Citation:** 75 FR 41018 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 275 [Release No. IA-3043; File No. S7-18-09] RIN 3235-AK39 Political Contributions by Certain Investment Advisers AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The new rule also prohibits an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers. DATES: Effective Date: September 13, 2010. Compliance Dates: Investment advisers subject to rule 206(4)-5 must be in compliance with the rule on March 14, 2011. Investment advisers may no longer use third parties to solicit government business except in compliance with the rule on September 13, 2011. Advisers to registered investment companies that are covered investment pools must comply with the rule by September 13, 2011. Advisers subject to rule 204-2 must comply with amended rule 204-2 on March 14, 2011. However, if they advise registered investment companies that are covered investment pools, they have until September 13, 2011 to comply with the amended recordkeeping rule with respect to those registered investment companies. See section III of this Release for further discussion of compliance dates. FOR FURTHER INFORMATION CONTACT: Melissa A. Roverts, Senior Counsel, Matthew N. Goldin, Branch Chief, Daniel S. Kahl, Branch Chief, or Sarah A. Bessin, Assistant Director, at (202) 551-6787 or IArules@sec.gov, Office of Investment Adviser Regulation, Division of Investment Management, U.S. Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549. SUPPLEMENTARY INFORMATION: The Commission is adopting rule 206(4)-5 [17 CFR 275.206(4)-5] and amendments to rules 204-2 [17 CFR 275.204-2] and 206(4)-3 [17 CFR 275.206(4)-3] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (“Advisers Act” or “Act”). 1 1 15 U.S.C. 80b. Unless otherwise noted, when we refer to the Advisers Act, or any paragraph of the Advisers Act, we are referring to 15 U.S.C. 80b of the United States Code, at which the Advisers Act is codified, and when we refer to rule 206(4)-5, rule 204-2, rule 204A-1, rule 206(4)-3, or any paragraph of these rules, we are referring to 17 CFR 275.206(4)-5, 17 CFR 275.204-2, 17 CFR 275.204A-1 and 17 CFR 275.206(4)-3, respectively, of the Code of Federal Regulations, in which these rules are published. Table of Contents I. Background II. Discussion A. First Amendment Considerations B. Rule 206(4)-5 1. Advisers Subject to the Rule 2. Pay to Play Restrictions (a) Two-Year “Time Out” for Contributions (1) Prohibition on Compensation (2) Officials of a Government Entity (3) Contributions (4) Covered Associates (5) “Look Back” (6) Exceptions for De Minimis Contributions (7) Exception for Certain Returned Contributions (b) Ban on Using Third Parties to Solicit Government Business (1) Registered Broker-Dealers (2) Registered Investment Advisers (c) Restrictions on Soliciting and Coordinating Contributions and Payments (d) Direct and Indirect Contributions or Solicitations (e) Covered Investment Pools (1) Definition of “Covered Investment Pool” (2) Application of the Rule (3) Subadvisory Arrangements (f) Exemptions D. Recordkeeping E. Amendment to Cash Solicitation Rule III. Effective and Compliance Dates A. Two-Year Time Out and Prohibition on Soliciting or Coordinating Contributions B. Prohibition on Using Third Parties to Solicit Government Business and Cash Solicitation Rule Amendment C. Recordkeeping D. Registered Investment Companies IV. Cost-Benefit Analysis A. Benefits B. Costs 1. Compliance Costs Related to Rule 206(4)-5 2. Other Costs Related to Rule 206(4)-5 (a) Two-Year Time Out (b) Third-Party Solicitor Ban 3. Costs Related to the Amendments to Rule 204-2 V. Paperwork Reduction Act A. Rule 204-2 B. Rule 206(4)-3 C. Rule 206(4)-7 D. Rule 0-4 VI. Final Regulatory Flexibility Analysis A. Need for the Rule B. Significant Issues Raised by Public Comment C. Small Entities Subject to Rule D. Projected Reporting, Recordkeeping, and Other Compliance Requirements E. Agency Action to Minimize Effect on Small Entities VII. Effects on Competition, Efficiency and Capital Formation VIII. Statutory Authority I. Background Investment advisers provide a wide variety of advisory services to State and local governments, 2 including managing their public pension plans. 3 These pension plans have over $2.6 trillion of assets and represent one-third of all U.S. pension assets. 4 They are among the largest and most active institutional investors in the United States; 5 the management of these funds affects publicly held companies 6 and the securities markets. 7 But most significantly, their management affects taxpayers and the beneficiaries of these funds, including the millions of present and future State and municipal retirees 8 who rely on the funds for their pensions and other benefits. 9 Public pension plan assets are held, administered and managed by government officials who often are responsible for selecting investment advisers to manage the funds they oversee. 2 See Sofia Anastopoulos, An Introduction to Investment Advisers for State and Local Governments (2d ed. 2007); Werner Paul Zorn, Public Employee Retirement Systems and Benefits, Local Government Finance, Concepts and Practices 376 (John E. Peterson & Dennis R. Strachota eds., 1st ed. 1991) (discussing the services investment advisers provide for public funds). 3 To simplify the discussion, we use the term “public pension plan” interchangeably with “government client” and “government entity” in this Release. However, our rule applies broadly to investment advisory activities for government clients, such as those mentioned here in this Section of the Release, regardless of whether they are retirement funds. For a discussion of how the proposed rule would apply with respect to investment programs or plans sponsored or established by government entities, such as “qualified tuition plans” authorized by section 529 of the Internal Revenue Code [26 U.S.C. 529] and retirement plans authorized by section 403(b) or 457 of the Internal Revenue Code [26 U.S.C. 403(b) or 457], see section II.B.2(e) of this Release. 4 Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States, Flows and Outstandings, Fourth Quarter 2009 78 tbl.L.119 (Mar. 11, 2010). Since 2002, total financial assets of public pension funds have grown by 28%. Id. 5 According to a recent survey, seven of the ten largest pension funds were sponsored by State and municipal governments. The Top 200 Pension Funds/Sponsors, Pens. & Inv. (Sept. 30, 2008), available at http://www.pionline.com/article/20090126/CHART/901209995. 6 See Stephen J. Choi & Jill E. Fisch, On Beyond CalPERS: Survey Evidence on the Developing Role of Public Pension Funds in Corporate Governance, 61 Vand. L. Rev. 315 (2008) (“Collectively, public pension funds have the potential to be a powerful shareholder force, and the example of CalPERS and its activities have spurred many to advocate greater institutional activism.”). 7 Federal Reserve reports indicate that, of the $2.6 trillion in non-Federal government plans, $1.5 trillion is invested in corporate equities. Board of Governors of the Federal Reserve System, supra note 4, at 78 tbl.L.119. 8 See Paul Zorn, 1997 Survey of State and Local Government Employee Retirement Systems 61 (1997) (hereinafter “1997 Survey”) (“[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”). 9 The most current census data reports that public pension funds have 18.6 million beneficiaries. 2007 Census of Governments, U.S. Bureau of Census, Number and Membership of State and Local Government Employee-Retirement Systems by State: 2006-2007 (2007) (at Table 5), available at http://www.census.gov/govs/retire/2007ret05.html. Elected officials who allow political contributions to play a role in the management of these assets and who use these assets to reward contributors violate the public trust. Moreover, they undermine the fairness of the process by which public contracts are awarded. Similarly, investment advisers that seek to influence government officials' awards of advisory contracts by making or soliciting political contributions to those officials compromise their fiduciary duties to the pension plans they advise and defraud prospective clients. These practices, known as “pay to play,” distort the process by which advisers are selected. 10 They can harm pension plans that may subsequently receive inferior advisory services and pay higher fees. Ultimately, these violations of trust can harm the millions of retirees that rely on the plan or the taxpayers of the State and municipal governments that must honor those obligations. 11 10 Among other things, pay to play practices may manipulate the market for advisory services by creating an uneven playing field among investment advisers. These practices also may hurt smaller advisers that cannot afford the required contributions. 11 See 1997 Survey, supra note 8. Pay to play practices are rarely explicit: participants do not typically let it be publicly known that contributions or payments are made or accepted for the purpose of influencing the selection of an adviser. As one court noted, “[w]hile the risk of corruption is obvious and substantial, actors in this field are presumably shrewd enough to structure their relations rather indirectly.” 12 Pay to play practices may take a variety of forms, including an adviser's direct contributions to government officials, an adviser's solicitation of third parties to make contributions or payments to government officials or political parties in the State or locality where the adviser seeks to provide services, or an adviser's payments to third parties to solicit (or as a condition of obtaining) government business. As a result, the full extent of pay to play practice remains hidden and is often hard to prove. 12 Blount v. SEC, 61 F.3d 938, 945 (D.C. Cir. 1995), cert. denied, 517 U.S. 1119 (1996). Public pension plans are particularly vulnerable to pay to play practices. Management decisions over these investment pools, some of which are quite large, are typically made by one or more trustees who are (or are appointed by) elected officials. And the elected officials or appointed trustees that govern the funds are also often involved, directly or indirectly, in selecting advisers to manage the public pension funds' assets. These officials may have the sole authority to select advisers, 13 may be members of a governing board that selects advisers, 14 or may appoint some or all of the board members who make the selection. 15 13 See, e.g., 2 N.Y. Comp. Codes R. & Regs. tit. 2 § 320.2 (2009) (placement of State and local government retirement systems assets (valued at $109 billion as of March 2009) is under the sole custodianship of the New York State Comptroller). 14 See, e.g., S.C. Code Ann. §§ 9-1-20, 1-11-10 (2008) (board consists of all elected officials); Cal. Gov't Code § 20090 (Deering 2008) (board consists of some elected officials, some appointed members, and some representatives of interest groups chosen by the members of those groups); Md. Code Ann., State Pers. & Pens. § 21-104 (2008) (pension board consists of some elected officials, some appointed members, and some representatives of interest groups chosen by the members of those groups). 15 See, e.g., Ariz. Rev. Stat. Ann. § 38-713 (2008) (governor appoints all nine members); Hawaii Rev. Stat. § 88-24 (2008) (governor appoints three of eight members); Idaho Code Ann. § 59-1304 (2008) (governor appoints all five members). Numerous developments in recent years have led us to conclude that the selection of advisers, whom we regulate under the Investment Advisers Act, has been influenced by political contributions and that, as a result, the quality of management service provided to public funds may be negatively affected. We have been particularly concerned that these contributions have been funneled through “solicitors” and “placement agents” that advisers engage (or believe they must engage) in order to secure a client relationship with a public pension plan or an investment from one. 16 As we will discuss in more detail below, in such an arrangement the contribution may be made in the form of a substantial fee for what may constitute no more than an introduction service by a “well connected” individual who may use the proceeds of the fee to make (or reimburse himself for having made) political contributions or provide some form of a “kickback” to an official or his or her family or friends. 17 16 For example, in one recent action we alleged that, in connection with a pay to play scheme in New York State, investment advisers paid sham “placement agent” fees, portions of which were funneled to public officials, as a means of obtaining public pension fund investments in the funds those advisers managed and that participants, in some instances, concealed the third-party solicitor's role in transactions from the investment management firms that paid fees to the solicitor by making misrepresentations about the solicitor's involvement and covertly using one of the solicitor's legal entities as an intermediary to funnel payments to the solicitor. SEC v. Henry Morris, et al., Litigation Release No. 20963 (Mar. 19, 2009). 17 See id. (along with the Commission's complaint in the action, available by way of a hyperlink from the litigation release) . See also, e.g., In the Matter of Quadrangle Group LLC, AGNY Investigation No. 2010-044 (Apr. 15, 2010) (finding that “private equity firms and hedge funds frequently use placement agents, finders, lobbyists, and other intermediaries * * * to obtain investments from public pension funds * * *, that these placement agents are frequently politically connected individuals selling access to public money* * *”); Complaint, Cal. v . Villalobos, et al., No. SC107850 (Cal. Super. Ct., W. Dist. of L.A. County, May 5, 2010), available at http://ag.ca.gov/cms_attachments/press/pdfs/n1915_filed_complaint_for_civil_penalties.pdf (alleging, inter alia, that a top executive and a board member at CalPERS accepted various gifts from a former CalPERS board member, “known among private equity firms as a person who attempts to exert pressure on CalPERS' representatives,” who was acting as a placement agent trying to secure investments from the California public pension fund). The details of pay to play arrangements have been widely reported as a consequence of the growing number of actions that we and State authorities have brought involving investment advisers seeking to manage the considerable assets of the New York State Common Retirement Fund. 18 In addition, we have brought enforcement actions against the former treasurer of the State of Connecticut and other parties in which we alleged that the former treasurer awarded State pension fund investments to private equity fund managers in exchange for payments, including political contributions, funneled through the former treasurer's friends and political associates. 19 Criminal authorities have in recent years brought cases in New York, 20 New Mexico, 21 Illinois, 22 Ohio, 23 Connecticut, 24 and Florida, 25 charging defendants with the same or similar conduct. 18 See SEC v. Henry Morris, et al., Litigation Release No. 21036 (May 12, 2009); In the Matter of Quadrangle Group LLC, AGNY Investigation No. 2010-044 (Apr. 15, 2010); In the Matter of GKM Newport Generation Capital Servs., LLC, AGNY Investigation No. 2010-017 (Apr. 14, 2010); In the Matter of Kevin McCabe, AGNY Investigation No. 2009-152 (Apr. 14, 2010); In the Matter of Darius Anderson Platinum Advisors LLC, AGNY Investigation No. 2009-153 (Apr. 14, 2010); In the Matter of Global Strategy Group, AGNY Investigation No. 2009-161 (Apr. 14, 2010); In the Matter of Freeman Spogli & Co., AGNY Investigation No. 2009-174 (Feb. 1, 2010); In the Matter of Falconhead Capital, LLC, AGNY Investigation No. 2009-125 (Sept. 17, 2009); In the Matter of HM Capital Partners I, LP, AGNY Investigation No. 2009-117 (Sept. 17, 2009); In the Matter of Ares Management LLC, AGNY Investigation No. 2009-173 (Feb. 17, 2010); In the Matter of Levine Leichtman Capital Partners, AGNY Investigation No. 2009-124 (Sept. 17, 2009); In the Matter of Access Capital Partners, AGNY Investigation No. 09-135 (Sept. 17, 2009); In the Matter of The Markstone Group, AGNY Investigation No. 10-012 (Feb. 28, 2010); In the Matter of Wetherly Capital Group, LLC and DAV/Wetherly Financial, L.P., AGNY Investigation No. 2009-172 (Feb. 8, 2010) (in each case, banning the use of third-party placement agents pursuant to a “Pension Reform Code of Conduct”). 19 See SEC v. Paul J. Silvester, et al., Litigation Release No. 16759 (Oct. 10, 2000); Litigation Release No. 20027 (Mar. 2, 2007); Litigation Release No. 19583 (Mar. 1, 2006); Litigation Release No. 18461 (Nov. 17, 2003); Litigation Release No. 16834 (Dec. 19, 2000); SEC v. William A. DiBella et al., Litigation Release No. 20498 (Mar. 14, 2008) (2007 U.S. Dist. LEXIS 73850 (D. Conn., May 8, 2007), aff'd 587 F.3d 553 (2nd Cir. 2009)). See also U.S. v. Ben F. Andrews, Litigation Release No. 19566 (Feb. 15, 2006); In the Matter of Thayer Capital Partners, TC Equity Partners IV, L.L.C., TC Management Partners IV, L.L.C., and Frederick V. Malek, Investment Advisers Act Release No. 2276 (Aug. 12, 2004); In the Matter of Frederick W. McCarthy, Investment Advisers Act Release No. 2218 (Mar. 5, 2004); In the Matter of Lisa A. Thiesfield, Investment Advisers Act Release No. 2186 (Oct. 29, 2003). 20 See New York v. Henry “Hank” Morris and David Loglisci, Indictment No. 25/2009 (NY Mar. 19, 2009) (alleging that the deputy comptroller and a “placement agent” engaged in enterprise corruption and State securities fraud for selling access to management of public funds in return for kickbacks and other payments for personal and political gain). 21 See U.S. v. Montoya, Criminal No. 05-2050 JP (D.N.M. Nov. 8, 2005) (the former treasurer of New Mexico pleaded guilty); U.S. v. Kent Nelson, Criminal Information No. 05-2021 JP, (D.N.M. 2007) (defendant pleaded guilty to one count of mail fraud); U.S. v. Vigil, 523 F.3d 1258 (10th Cir. 2008) (affirming the conviction for attempted extortion of the former treasurer of New Mexico for requiring that a friend be hired by an investment manager at a high salary in return for the former treasurer's willingness to accept a proposal from the manager for government business). 22 See Jeff Coen, et al., State's Ultimate Insider Indicted, Chi. Trib., Oct. 31, 2008, available at http://www.chicagotribune.com/news/local/chi-cellini-31-oct31,0,6465036.story (describing the thirteenth indictment in an Illinois pay to play probe); Ellen Almer, Oct. 27, 2000, available at http://www.chicagobusiness.com/cgi-bin/news.pl?id=775 (discussing the guilty plea of Miriam Santos, the former treasurer of the City of Chicago, who told representatives of financial services firms seeking city business that they were required to raise specified campaign contributions for her and personally make up any shortfall in the amounts they raised). See also SEC v. Miriam Santos, et al., Litigation Release No. 17839 (Nov. 14, 2002); Litigation Release No. 19269 (June 14, 2005) (355 F. Supp. 2d 917 (N.D. Ill. 2003)). 23 See Reginald Fields, Four More Convicted in Pension Case: Ex-Board Members Took Gifts from Firm, Cleveland Plain Dealer, Sept. 20, 2006 (addressing pay to play activities of members of the Ohio Teachers Retirement System). 24 See U.S. v. Joseph P. Ganim, 2007 U.S. App. LEXIS 29367 (2d Cir. 2007) (affirming the district court's decision to uphold an indictment of the former mayor of Bridgeport, Connecticut, in connection with his conviction for, among other things, requiring payment from an investment adviser in return for city business); U.S. v. Triumph Capital Group, et al., No. 300CR217 JBA (D. Conn. 2000) (the former treasurer, along with certain others, pleaded guilty—while others were ultimately convicted). One of the defendants, who had been convicted at trial, recently won a new trial. U.S. v. Triumph Capital Group, et al., 544 F.3d 149 (2d Cir. 2008). 25 United States v. Poirier, 321 F.3d 1024 (11th Cir.), cert. denied sub nom. deVegter v. United States, 540 U.S. 874 (2003) (partner at Lazard Freres & Co., a municipal services firm, was convicted for conspiracy and wire fraud for fraudulently paying $40,000 through an intermediary to Fulton County's independent financial adviser to secure an assurance that Lazard would be selected for the Fulton County underwriting contract). Allegations of pay to play activity involving State and municipal pension plans in other jurisdictions continue to be reported. 26 In the course of this rulemaking we received a letter from one public official detailing the role of pay to play arrangements in the selection of public pension fund managers and the harms it can inflict on the affected plans. 27 In addition, other public officials wrote to express support for a Commission rule to prohibit investment advisers from participating in pay to play arrangements. 28 26 See, e.g., Aaron Lester, et al., Cahill Taps Firms Tied to State Pension Investor, Boston.com, Mar. 21, 2010 (suggesting that an investment adviser may have bundled out-of-State donations to the Massachusetts State Treasurer's campaign in return for a State pension fund investment management contract); Kevin McCoy, Do Campaign Contributions Help Win Pension Fund Deals, USA Today, Aug. 28, 2009; Ted Sherman, Pay to Play Alive and Well in New Jersey, NJ.com, Nov. 28, 2009 (noting more generally that pay to play continues to occur with government contracts of all kinds in New Jersey); Imogen Rose-Smith and Ed Leefeldt, Pension Pay to Play Casts Shadow Nationwide, Institutional Investor, Oct. 1, 2009 (suggesting connections between a private equity fund principal's fundraising activities and pension investments in the fund). See also sources cited supra note 17. 27 Comment Letter of Suzanne R. Weber, Erie County Controller (Oct. 6, 2009) (“Weber Letter”) (“I have seen money managers awarded contracts with our fund which involved payments to individuals who served as middlemen, creating needless expense for the fund. These middlemen were political contributors to the campaigns of board members who voted to contract for money management services with the companies who paid them as middlemen.”). See also Comment Letter of David R. Pohndorf (Aug. 4, 2009) (“Pohndorf Letter”) (noting that when the sole trustee of a major pension fund changed several years ago, a firm managing some of the fund's assets “began to receive invitations to fundraising events for the new trustee with suggested donation amounts.”). 28 See, e.g., Comment Letter of New York State Comptroller Thomas P. DiNapoli (Oct. 2, 2009) (“DiNapoli Letter”); Comment Letter of New York City Mayor Michael R. Bloomberg (Sept. 9, 2009) (“Bloomberg Letter”). See also Comment Letter of Kentucky Retirement Systems Trustee Chris Tobe (Sept. 18, 2009) (“Tobe Letter”) (suggesting the negative effects of pay to play activities on the Kentucky Retirement System's investment performance). On August 3, 2009, we proposed a new antifraud rule under the Advisers Act designed to prevent investment advisers from obtaining business from government entities in return for political contributions or fund raising— i.e., from participating in pay to play practices. 29 We modeled our proposed rule on those adopted by the Municipal Securities Rulemaking Board, or MSRB, which since 1994 has prohibited municipal securities dealers from participating in pay to play practices. 30 We believe these rules have significantly curbed pay to play practices in the municipal securities market. 31 29 Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. 2910 (Aug. 3, 2009) [74 FR 39840 (Aug. 7, 2009)] (the “Proposing Release”). 30 MSRB rule G-37 was approved by the Commission and adopted in 1994. 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, Exchange Act Release No. 33868 (Apr. 7, 1994) [59 FR 17621 (Apr. 13, 1994)]. The MSRB's pay to play rules include MSRB rules G-37 and G-38. They are available on the MSRB's Web site at http://www.msrb.org/msrb1/rules/ruleg37.htm and http://www.msrb.org/msrb1/rules/ruleg38.htm, respectively. 31 See Proposing Release, at n.23. See also infra note 101; Comment Letter of the Municipal Securities Rulemaking Board (Oct. 23, 2009) (“MSRB Letter”); Comment Letter of Common Cause (Oct. 6, 2009) (“Common Cause Letter”). Along the lines of MSRB rule G-37, 32 our proposed rule would have prohibited an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. 33 It also would have prohibited an adviser and certain of its executives and employees from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. 34 In addition, similar to MSRB rule G-38, 35 our proposed rule would have prohibited the use of third parties to solicit government business. 36 We also proposed amendments to rule 204-2 under the Advisers Act that would have required registered advisers to maintain certain records regarding political contributions and government clients. As discussed in more detail below, our proposed rule departed in some respects from the MSRB rules to reflect differences between advisers and broker-dealers and the scope of the statutory authority we have sought to exercise. 32 See MSRB rule G-37(b). Our proposal, like MSRB rule G-37, was designed to address our concern that pay to play activities were “undermining the integrity” of the relevant market, in particular the market for the provision of investment advisory services to government entity clients. See Blount, 61 F.3d at 939 (referring to the MSRB's concerns that pay to play practices were “undermining the integrity of the $250 billion municipal securities market” as its motivation for proposing MSRB rule G-37). 33 Proposed rule 206(4)-5(a)(1). See also MSRB rule G-37(b). 34 Proposed rule 206(4)-5(a)(2)(ii). See also MSRB rule G-37(c). 35 See MSRB rule G-38(a). 36 Proposed rule 206(4)-5(a)(2)(i). We received some 250 comment letters on our proposal, many of which were from advisers, third-party solicitors, placement agents, and their representatives. 37 Public pension plans and their officials were divided—some embraced the rule, including one that stated that the rule is an important means to “increase transparency and public confidence in the investment activities of all public pension funds,” 38 while others were critical, arguing, for example, that our proposal “may result in unintended hardships being placed upon public pension funds.” 39 We received no letters from plan beneficiaries whom we sought to protect with the proposed rule, 40 although two public interest groups supported it strongly. 41 Advisers, third-party solicitors and placement agents, fund sponsors, and others whose business arrangements could be affected by the rule generally supported our goal of eliminating advisers' participation in pay to play practices involving public plans. 42 Nonetheless, most of them objected to our adoption under the Advisers Act of a rule similar to MSRB rules G-37 and G-38. 43 Most particularly opposed the proposed prohibition on payments to third parties for soliciting or marketing to government entities modeled on MSRB rule G-38. 44 Several urged that, if we were to adopt a rule based on the approach taken in our proposal, we should broaden exceptions and exemptions under the rule to accommodate certain business arrangements. 45 We respond to these comments below. 46 37 Other commenters included pension plans and their officials, trade associations, law firms, and public interest groups. Comments letters submitted in File No. S7-25-06 are available on the Commission's Web site at: http://www.sec.gov/comments/s7-18-09/s71809.shtml. 38 Comment Letter of New York City Comptroller William C. Thompson, Jr. (Oct. 6, 2009) (“Thompson Letter”). 39 Comment Letter of Executive Director and Secretary to the Board of Trustees of the State Retirement and Pension System of Maryland R. Dean Kenderdine (Oct. 5, 2009). 40 We note, however, that subsequent to our proposal, AFSCME, which represents 1.6 million State and local employees and retirees, issued a report that strongly endorses sanctions to prevent pay to play activities. AFSCME, Enhancing Public Retiree Pension Plan Security: Best Practice Policies for Trustees and Pension Systems (2010), available at http://www.afscme.org/docs/AFSCME-report-pension-best-practices.pdf. 41 See, e.g., Common Cause Letter; Comment Letter of Fund Democracy/Consumer Federation of America (Oct. 6, 2009) (“Fund Democracy/Consumer Federation Letter”). 42 See, e.g., Comment Letter of the Investment Adviser Association (Oct. 5, 2009) (“IAA Letter”) (noting “support [for] measures to combat pay to play activities, i.e., the practice of investment advisers or their employees making political contributions intended to influence the selection or retention of advisers by government entities. Pay to play practices undermine the principle that advisers are selected on the basis of competence, qualifications, expertise, and experience. The practice is unethical and undermines the integrity of the public pension plan system and the process of selecting investment advisers.”); Comment Letter of John R. Dempsey (Aug. 8, 2009) (“Dempsey Letter”) (noting applause for efforts “to stop the `pay-to-play' practice which only serves to undermine public trust in investment advisors and regulators.”); Comment Letter of Barry M. Gleicher (Sept. 7, 2009) (noting strong support for the proposal “with no modifications. * * * The Rule is necessary to curb elaborated practices that would deprive taxpayers and beneficiaries of cost effective and honest administration of pension funds”); Tobe Letter. 43 See, e.g., IAA Letter (“We respectfully submit, however, that the structure of the MSRB rules is not appropriately tailored to the investment advisory business. * * * We believe the Commission should make significant changes to the Proposal, which would permit it to accomplish its important goals.”); Comment Letter of Wesley Ogburn (Aug. 4, 2009) (“Ogburn Letter”); Comment Letter of the Third Party Marketers Association (Aug. 27, 2009) (“3PM Letter”); Comment Letter of Preqin (Aug. 28, 2009) (“Preqin Letter I”) (suggesting that institutional private equity investors polled favored a private equity specific proposal rather than relying on the framework from the municipal securities industry); Comment Letter of Dechert LLP (Oct. 22, 2009) (“Dechert Letter”); Comment Letter of the Committee on Federal Regulation of Securities of the Section of Business Law of the American Bar Association (Oct. 13, 2009) (“ABA Letter”); Comment Letter of Fidelity Investments (Oct. 7, 2009) (“Fidelity Letter”); Comment Letter of Sutherland Asbill & Brennan LLP (Oct. 6, 2009) (“Sutherland Letter”); Comment Letter of the Investment Company Institute (Oct. 6, 2009) (“ICI Letter”); Comment Letter of the Massachusetts Mutual Life Insurance Company (Oct. 6, 2009) (“MassMutual Letter”); Comment Letter of Skadden, Arps, Slate, Meagher & Flom LLP (Oct. 6, 2009) (“Skadden Letter”); Comment Letter of the Managed Funds Association (Oct. 6, 2009) (“MFA Letter”). 44 See, e.g., Comment Letter of Ounavarra Capital, LLC (Aug. 28, 2009) (“Ounavarra Letter”) (noting that banning third-party marketers in the municipal securities industry did not adversely affect most bankers' ability to conduct basic marketing whereas banning third-party marketers for small advisers could have a stronger impact on advisers that have either no or very limited marketing capability of their own); Comment Letter of MVision Private Equity Advisers USA LLC (Sept. 2, 2009) (“MVision Letter”) (arguing that, whereas placement agents for municipal bond offerings are usually regulated entities, the restrictions in the municipal securities arena were targeted at consultants who offer only their contacts and influence with government officials and provided no valuable services to the financial services industry or investors); Comment Letter of Kalorama Capital (Sept. 8, 2009) (arguing that a better analogy, at least with respect to the operation of third-party marketers, is to the licensed professional presenting an IPO to a pension fund). For further discussion of these comments, see section II.B.2(b) of this Release. 45 See, e.g., Comment Letter of the Committee on Investment Management Regulation and the Committee on Private Investment Funds of the Association of the Bar of the City of New York (Oct. 26, 2009) (“NY City Bar Letter”) (arguing that broker-dealer rules have sufficient safeguards and that adopting the proposed pay to play rule will interfere with traditional distribution arrangements); Dechert Letter; Sutherland Letter; MFA Letter. 46 Particular comments on the various aspects of our proposal are summarized in the corresponding sub-sections of section II of this Release. II. Discussion As discussed in more detail below, we have decided to adopt rule 206(4)-5, which we have revised to reflect comments we received. For the reasons we discuss above and in the Proposing Release, we believe rule 206(4)-5 is a proper exercise of our rulemaking authority under the Advisers Act to prevent fraudulent and manipulative conduct. 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.” 47 Section 206(2) prohibits an investment adviser from engaging in “any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” 48 The Supreme Court has construed section 206 as establishing a Federal fiduciary standard governing the conduct of advisers. 49 47 15 U.S.C. 80b-6(1). 48 15 U.S.C. 80b-6(2). 49 Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-192 (1963). We believe that pay to play 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.” 50 Congress gave us this authority to prohibit “specific evils” that the broad antifraud provisions may be incapable of covering. 51 The provision thus permits the Commission to adopt prophylactic rules that may prohibit acts that are not themselves fraudulent. 52 50 15 U.S.C. 80b-6(4). 51 S. Rep. No. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The Commission has used this authority to adopt seven rules addressing abusive advertising practices, custodial arrangements, the use of solicitors, required disclosures regarding advisers' financial conditions and disciplinary histories, proxy voting, compliance procedures and practices, and deterring fraud with respect to pooled investment vehicles. 17 CFR 275.206(4)-1; 275.206(4)-2; 275.206(4)-3; 275.206(4)-4; 275.206(4)-6; 275.206(4)-7; and 275.206(4)-8. 52 Section 206(4) was added to the Advisers Act in Public Law 86-750, 74 Stat. 885, at sec. 9 (1960). See H.R. Rep. No. 2197, 86th Cong., 2d Sess., at 7-8 (1960) (“Because of the general language of section 206 and the absence of express rulemaking power in that section, there has always been a question as to the scope of the fraudulent and deceptive activities which are prohibited and the extent to which the Commission is limited in this area by common law concepts of fraud and deceit . . . [Section 206(4)] would empower the Commission, by rules and regulations to define, and prescribe means reasonably designed to prevent, acts, practices, and courses of business which are fraudulent, deceptive, or manipulative. This is comparable to Section 15(c)(2) of the Securities Exchange Act [15 U.S.C. 78o(c)(2)] which applies to brokers and dealers.”). See also S. Rep. No. 1760, 86th Cong., 2d Sess., at 8 (1960) (“This [section 206(4) language] is almost the identical wording of section 15(c)(2) of the Securities Exchange Act of 1934 in regard to brokers and dealers.”). The Supreme Court, in United States v. O'Hagan, interpreted nearly identical language in section 14(e) of the Securities 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 prohibition is `reasonably designed to prevent * * * acts and practices [that] are fraudulent.’ ” United States v. O'Hagan, 521 U.S. 642, 667, 673 (1997). The wording of the rulemaking authority in section 206(4) remains substantially similar to that of section 14(e) and section 15(c)(2) of the Securities Exchange Act. See also Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Advisers Act Release No. 2628 (Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)] (stating, in connection with the suggestion by commenters that section 206(4) provides us authority only to adopt prophylactic rules that explicitly identify conduct that would be fraudulent under a particular rule, “We believe our authority is broader. We do not believe that the commenters' suggested approach would be consistent with the purposes of the Advisers Act or the protection of investors.”). Investment advisers that seek to influence the award of advisory contracts by public pension plans, by making political contributions to, or soliciting them for, those officials who are in a position to influence the awards, compromise their fiduciary obligations to the public pension plans they advise and defraud prospective clients. 53 In making such contributions, the adviser hopes to benefit from officials who “award the contracts on the basis of benefit to their campaign chests rather than to the governmental entity” 54 or by retaining a contract that might otherwise not be renewed. If pay to play is a factor in the selection or retention process, the public pension plan can be harmed in several ways. The most qualified adviser may not be selected or retained, potentially leading to inferior management or performance. The pension plan may pay higher fees because advisers must recoup the contributions, or because contract negotiations may not occur on an arm's-length basis. The absence of arm's-length negotiations may enable advisers to obtain greater ancillary benefits, such as “soft dollars,” from the advisory relationship, which might be used for the benefit of the adviser, potentially at the expense of the pension plan, thereby using the pension plan's assets for the adviser's own purposes. 55 53 See Proposing Release, at section I; Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. 1812 (Aug. 4, 1999) [64 FR 43556 (Aug. 10, 1999)] (“1999 Proposing Release”). As a fiduciary, an adviser has a duty to deal fairly with clients and prospective clients, and must make full disclosure of any material conflict or potential conflict. See, e.g., Capital Gains Research Bureau, 375 U.S. at 189, 191-92; Applicability of the Investment Advisers Act of 1940 to Financial Planners, Pension Consultants, and Other Persons Who Provide Others with Investment Advice as a Component of Other Financial Services, Investment Advisers Act Release No. 1092 (Oct. 8, 1987) [52 FR 38400 (Oct. 16, 1987)]. Most public pension plans establish procedures for hiring investment advisers, the purpose of which is to obtain the best possible management services. When an adviser makes political contributions for the purpose of influencing the selection of the adviser to advise a public pension plan, the adviser seeks to interfere with the merit-based selection process established by its prospective clients—the public pension plan. The contribution creates a conflict of interest between the adviser (whose interest is in being selected) and its prospective client (whose interest is in obtaining the best possible management services). 54 See Blount, 61 F.3d at 944-45. 55 Cf. In re Performance Analytics, et al., Investment Advisers Act Release No. 2036 (June 17, 2002) (settled enforcement action in which an investment consultant for a union pension fund entered into a $100,000 brokerage arrangement with a soft dollar component in which the investment consultant would continue to recommend the investment adviser to the pension fund as long as the investment adviser sent its trades to one particular broker-dealer). As we discuss above, pay to play practices are rarely explicit and often hard to prove. 56 In particular, when pay to play involves granting of government advisory business in exchange for political contributions, it may be difficult to prove that an adviser (or one of its executives or employees) made political contributions for the purpose of obtaining the government business, or that it engaged a solicitor for his or her political influence rather than substantive expertise. 57 Pay to play practices by advisers to public pension plans, which may generate significant contributions for elected officials and yield lucrative management contracts for advisers, will not stop through voluntary efforts. This is, in part, because these activities create a “collective action” problem in two respects. 58 First, government officials who participate may have an incentive to continue to accept contributions to support their campaigns for fear of being disadvantaged relative to their opponents. Second, advisers may have an incentive to participate out of concern that they may be overlooked if they fail to make contributions. 59 Both the stealth in which these practices occur and the inability of markets to properly address them argue strongly for the need for us to adopt the type of prophylactic rule that section 206(4) of the Advisers Act authorizes. 56 Cf. Blount, 61 F.3d at 945 (“no smoking gun is needed where, as here, the conflict of interest is apparent, the likelihood of stealth great, and the legislative purpose prophylactic”). 57 See id. at 944 (“actors in this field are presumably shrewd enough to structure their relations rather indirectly”). 58 Collective action problems exist, for example, where participants may prefer to abstain from an unsavory practice (such as pay to play), but nonetheless participate out of concern that, even if they abstain, their competitors will continue to engage in the practice profitably and without adverse consequences. As a result, collective action problems, such as those raised by pay to play practices, call for a regulatory response. For further discussion, see infra note 459 and accompanying text. 59 In our view, the collective action problem we are trying to address is analogous to the one noted in the case upholding MSRB rule G-37. See Blount, 61 F.3d at 945 (“Moreover, there appears to be a collective action problem tending to make the misallocation of resources persist”). For a discussion of concerns raised regarding our proposed rule that are similar to those raised regarding MSRB rule G-37, see section II.A of this Release. A. First Amendment Considerations The Commission believes that rule 206(4)-5 is a necessary and appropriate measure to prevent fraudulent acts and practices in the market for the provision of investment advisory services to government entities by prohibiting investment advisers from engaging in pay to play practices. We have examined a range of alternatives to our proposal, carefully considered some 250 comments we received on the proposal and made revisions to the proposed rule where we concluded it was appropriate. We believe the rule represents a balanced response to the developments we discuss above regarding pay to play activities occurring in the market for government investment advisory services. The rule provides specific prohibitions to help ensure that adviser selection is based on the merits, not on the amount of money given to a particular candidate for office, while respecting the rights of industry participants to participate in the political process. The rule is not unique; Congress, for instance, has barred Federal contractors from making contributions to public officials. 60 60 2 U.S.C. 441c. Before we address particular aspects of the rule, we would like to respond to commenters' assertions that the fact that the rule's limitations on compensation are triggered by political contributions represents an infringement on the First Amendment guarantees of freedom of speech and association. 61 These commenters acknowledge that selection of an investment adviser by a government entity should not be a “pay back” for political contributions, but argue that the rule impermissibly restricts the ability of advisers and certain of their employees to demonstrate support for State and local officials. 61 See, e.g., Comment Letter of W. Hardy Callcott (Aug. 3, 2009) (“Callcott Letter I”); Comment Letter of W. Hardy Callcott (Jan. 21, 2010) (“Callcott Letter II”); Comment Letter of the National Association of Securities Professionals, Inc. (Oct. 6, 2009) (“NASP Letter”); Comment Letter of Caplin & Drysdale, Chartered (Oct. 6, 2009) (“Caplin & Drysdale Letter”); Comment Letter of the Securities Industry and Financial Markets Association (Oct. 5, 2009) (“SIFMA Letter”); ABA Letter; Sutherland Letter; Comment Letter of IM Compliance LLC (Oct. 6, 2009) (“IM Compliance Letter”); Comment Letter of the American Bankers Association (Oct. 6, 2009) (“American Bankers Letter”). The Commission is sensitive to, and has carefully considered, these constitutional concerns in adopting the rule. Though it is not a ban on political contributions or an attempt to regulate State and local elections, we acknowledge that the two-year time out provision may affect the propensity of investment advisers to make political contributions. Although political contributions involve both speech and associational rights protected by the First Amendment, a “limitation upon the amount that any one person or group may contribute to a candidate or political committee entails only a marginal restriction upon the contributor's ability to engage in free communication.” 62 Limitations on contributions are permissible if justified by a sufficiently important government interest that is closely drawn to avoid unnecessary abridgment of protected rights. 63 62 Buckley v. Valeo, 424 U.S. 1, 20 (1976). See also SpeechNow.org, et al. v. FEC, 599 F.3d 686 (D.C. Cir. 2010); McConnell v. FEC, 540 U.S. 93, 135-36 (2003). 63 Buckley, 424 U.S. at 25. See also FEC v. Wisconsin Right to Life, Inc., 551 U.S. 449 (2007); Republican Nat'l Comm. v. FEC, No. 08-1953, 2010 U.S. Dist. LEXIS 29163 (D.D.C. Mar. 26, 2010) (three judge panel). This standard is lower than the strict scrutiny standard employed in reviewing such forms of expression as independent expenditures. Under the higher level of scrutiny, a restriction must be narrowly tailored to serve a compelling governmental interest. Blount, 61 F.3d at 943. See also Citizens United v. FEC, 130 S. Ct. 876 (2010) (distinguishing restrictions on “independent expenditures” from restrictions on “direct contributions” and leaving restrictions on direct contributions untouched while striking down a restriction on independent expenditures as unconstitutional). We note that in Blount, 61 F.3d at 949, the court upheld MSRB rule G-37 even assuming that strict scrutiny applied. For the reasons stated by the court in that decision, we believe that Rule 206(4)-5 would be upheld under a strict scrutiny standard as well as under the standard the Supreme Court has applied to contribution restrictions. Prevention of fraud is a sufficiently important government interest. 64 We believe that payments to State officials as a quid pro quo for obtaining advisory business as well as other forms of “pay to play” violate the antifraud provisions of section 206 of the Advisers Act. As discussed in our Proposing Release, “pay to play” arrangements are inconsistent with an adviser's fiduciary obligations, distort the process by which investment advisers are selected, can harm advisers' public pension plan clients and the beneficiaries of those plans, and can have detrimental effects on the market for investment advisory services. 65 The restrictions inherent in rule 206(4)-5 are in the nature of conflict of interest limitations which are particularly appropriate in cases of government contracting and highly regulated industries. 66 Pursuant to our authority under section 206(4) of the Advisers Act, which we discuss above, we may adopt rules that are reasonably designed to prevent such acts, practices and courses of business. 64 Blount, 61 F.3d at 944. 65 See Proposing Release, at section I. The prohibitions on solicitation and coordination of campaign contributions are justified by the same overriding purposes which support the two-year time out provisions. The provisions are intended to prevent circumvention of the time out provisions in cases where an investment adviser has or is seeking to establish a business relationship with a government entity. Absent these restrictions, solicitation and coordination of contributions could be used as effectively as political contributions to distort the adviser selection process. The solicitation and coordination restrictions relate only to fundraising activities and would not prevent advisers and their covered employees from expressing support for candidates in other ways, such as volunteering their time. 66 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, Exchange Act Release No. 33868 (Apr. 7, 1994) [59 FR 17621 (Apr. 13, 1994)] (noting, in connection with the Commission's approval of MSRB rule G-37, that the restrictions inherent in that pay to play rule “are in the nature of conflict of interest limitations which are particularly appropriate in cases of government contracting and highly regulated industries.”). As detailed in the following pages, we have closely drawn rule 206(4)-5 to accomplish its goal of preventing quid pro quo arrangements while avoiding unnecessary burdens on the protected speech and associational rights of investment advisers and their covered employees. The rule is therefore closely drawn in terms of the conduct it prohibits, the persons who are subject to its restrictions, and the circumstances in which it is triggered. The United States Court of Appeals for the District of Columbia Circuit upheld the similarly designed MSRB rule G-37 in Blount v. SEC. 67 Indeed, the Blount opinion has served as an important guidepost in helping us shape our rule. 68 67 61 F.3d at 947-48. 68 Notwithstanding the Blount decision, some commenters asserted that subsequent Supreme Court jurisprudence, including Randall v. Sorrell, 548 U.S. 230 (2006), and Citizens United, 130 S. Ct. 876 (decided following the closing of the comment period for rule 206(4)-5), would result in the proposed rule being found unconstitutional because it is not narrowly tailored to advance the Commission's interests in addressing pay to play by investment advisers. See, e.g., Callcott Letter I; Callcott Letter II; NASP Letter; American Bankers Letter. We disagree. The cases cited by commenters are distinguishable. Citizens United deals with certain independent expenditures (rather than contributions to candidates), which are not implicated by our rule. Randall involved a generally applicable State campaign finance law limiting overall contributions (and expenditures), which the Court feared would disrupt the electoral process by limiting a candidate's ability to amass sufficient resources and mount a successful campaign. Randall, 548 U.S. at 248-49. By contrast, our rule is not a general prohibition or limitation, but rather is a focused effort to combat quid pro quo payments by investment advisers seeking governmental business. Comparable restrictions targeted at a particular industry have been upheld under Randall because the loss of contributions from such a small segment of the electorate “would not significantly diminish the universe of funds available to a candidate to a non-viable level.” Green Party of Conn. v. Garfield, 590 F. Supp. 2d 288, 316 (D. Conn. 2008). See also Preston v. Leake, 629 F. Supp. 2d 517, 524 (E.D.N.C. 2009) (differentiating the “broad sweep of the Vermont statute” that “restricted essentially any potential campaign contribution” from a statute that “only applies to lobbyists”); In re Earle Asphalt Co., 950 A.2d 918, 927 (N.J. Super. Ct. App. Div. 2008), aff'd 957 A.2d 1173 (N.J. 2008) (holding that a limitation on campaign contributions by government contractors and their principals did not have the same capacity to prevent candidates from amassing the resources necessary for effective campaigning as the statute in Randall ). One commenter expressly dismissed arguments that Randall would have implications for the Commission's proposed rule. Fund Democracy/Consumer Federation Letter. First, the rule is limited to contributions to officials of government entities who can influence the hiring of an investment adviser in connection with money management mandates. 69 These restrictions are triggered only in situations where a business relationship exists or will be established in the near future between the investment adviser and a government entity. 70 69 See section II.B.2(a)(2) of this Release (discussing the definition of “official” of a government entity for purposes of rule 206(4)-5). 70 See section II.B.2(a)(1) of this Release (discussing the prohibition on compensation for providing advisory services to the client during rule 206(4)-5's two-year time out). Second, the rule does not in any way impinge on a wide range of expressive conduct in connection with elections. For example, the rule imposes no restrictions on activities such as making independent expenditures to express support for candidates, volunteering, making speeches, and other conduct. 71 71 See Citizens United, 130 S. Ct. at 908-09 (noting that a government interest cannot be sufficiently compelling to limit independent expenditures by corporate entities). See also SpeechNow.org, 599 F.3d at 692 (spelling out the different standards of constitutional review established by the Supreme Court for restrictions on independent expenditures and direct contributions). Some commenters expressed concern, for example, that rule 206(4)-5 may quell volunteer activities, deter employees of investment advisers from running for office, or chill charitable contributions. See, e.g., Caplin & Drysdale Letter; NASP Letter. We have expressly clarified that volunteer activities and charitable contributions generally would not trigger the rule's time out provision and that employees running for office would not be subject to the contribution limitation. See infra notes 157 and 139, respectively. Third, it does not prevent anyone from making a contribution to any candidate, as covered employees may contribute $350 to candidates for whom they may vote, and $150 to other candidates. A limitation on the amount of a contribution involves little direct restraint on political communication, because a person may still engage in the symbolic expression of support evidenced by a contribution. 72 Furthermore, the rule takes the form of a restriction on providing compensated advisory business following the making of contributions rather than a prohibition on making contributions in excess of the relevant ceilings. 73 72 Buckley, 424 U.S. at 21. See also section II.B.2(a)(6) of this Release (discussing the de minimis exceptions to covered associates' contributions triggering the two-year time out). Some commenters raised constitutional concerns regarding the levels of the de minimis exception in our proposal. See, e.g., Callcott Letter I; Callcott Letter II; Caplin & Drysdale Letter; IM Compliance Letter; Sutherland Letter. As discussed below, we have both raised the amount of the de minimis exception in line with inflation and added an additional exception. 73 See section II.B.2(a)(1) of this Release (discussing the two-year time out on receiving compensation for advisory services). Fourth, the rule only applies to investment advisers that are registered with us, 74 or unregistered in reliance on section 203(b)(3) of the Advisers Act, that have (or that are seeking) government clients. 75 It applies only to the subset of the significantly broader set of advisers over which we have antifraud authority that we believe are most likely to be engaged by government clients to manage public assets either directly or though investment pools. 76 74 Unless indicated expressly otherwise, each time we refer to a “registered” investment adviser in this Release, we mean an adviser registered with the Commission. 75 See section II.B.1 of this Release (discussing advisers covered by the rule). One commenter raised constitutional concerns by arguing that the rule would apply beyond the advisory business of an adviser that solicits government clients, no matter how separate the other product or service offerings of the adviser are from the governmental business. ABA Letter. But we believe we have made clear that the rule's time out provisions, which are designed to eliminate quid pro quo arrangements and ameliorate market distortions, apply only with respect to the provision of advisory services to government clients, which is consistent with our authority under the Advisers Act. See section II.B.2(a)(1) of this Release. 76 See section II.B.1 of this Release. Finally, the rule is not a restriction on contributions that is applicable to the public and is not intended to eliminate corruption in the electoral process. Rather, it is focused exclusively on conduct by professionals subject to fiduciary duties, seeking profitable business from governmental entities. The rule is targeted at those employees of an adviser whose contributions raise the greatest danger of quid pro quo exchanges, 77 and it covers only contributions to those governmental officials who would be the most likely targets of pay to play arrangements because of their authority to influence the award of advisory business. 78 77 See section II.B.2(a)(4) of this Release (discussing the definition of “covered associates,” whose contributions could trigger the two-year time out). 78 See section II.B.2(a)(2) of this Release (discussing the definition of “official” of a government entity for purposes of the rule 206(4)-(5)). Some commenters argued that the definition of “official” we included in our proposal was ambiguous. See, e.g., Caplin & Drysdale Letter. In response, we have provided additional guidance. See section II.B.2(a)(2) of this Release. B. Rule 206(4)-5 We are today adopting new rule 206(4)-5 under the Advisers Act that is designed to protect public pension plans and other government investors from the consequences of pay to play practices by deterring advisers' participation in such practices. 79 As we noted in the Proposing Release, advisers and government officials might, in order to circumvent our rule, attempt to structure their transactions in a manner intended to hide the true purpose of a contribution or payment. 80 Therefore, our pay to play restrictions are intended to capture not only direct political contributions by advisers, but also other ways that advisers may engage in pay to play arrangements. Rule 206(4)-5 prohibits several principal avenues for pay to play activities. 79 Rule 206(4)-5 is targeted to a concrete business relationship between contributors and candidates' governmental entities. It is not intended to restrict the voices of persons and interest groups, reduce the overall scope of election campaigns, or equalize the relative ability of all votes to affect electoral outcomes. Indeed, if investment advisers do not seek government business from those to whom they and their covered associates make contributions or for whom they solicit contributions, the rule's limitations will not be triggered. Rather, the rule is intended to prevent direct quid pro quo arrangements, fraudulent and manipulative acts and practices, and improve the mechanism of a free and open market for investment advisory services for government entity clients. With pay to play activities, the conflict of interest is apparent, the likelihood of stealth in the arrangements is great, and our regulatory purpose is prophylactic. See Blount, 61 F.3d at 945 (describing the court's similar characterization of MSRB rule G-37). 80 Proposing Release, at section II.A. First, the rule makes it unlawful for an adviser to receive compensation for providing advisory services to a government entity for a two-year period after the adviser or any of its covered associates makes a political contribution to a public official of a government entity or candidate for such office who is or will be in a position to influence the award of advisory business. 81 Importantly, as we noted in the Proposing Release, rule 206(4)-5 would not ban or limit the amount of political contributions an adviser or its covered associates could make; rather, it would impose a two-year time out on conducting compensated advisory business with a government client after a contribution is made. 82 This first prohibition is substantially similar to our proposal. However, as discussed below, we have made certain modifications to some of the definitions of terms in this prohibition. 83 81 Rule 206(4)-5(a)(1) makes it unlawful for any investment adviser covered by the rule to provide investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate, as defined in the rule, of the investment adviser (including a person who becomes a covered associate within two years after the contribution is made). As noted below, an “official” includes an incumbent, candidate or successful candidate for elective office of a government entity if the office is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser or has the authority to appoint any person who is directly or indirectly responsible for or can influence the outcome of the hiring of an investment adviser. See section II.B.2(a)(2) of this Release. 82 Proposing Release, at section II.A. 83 See generally section II.B.2(a) of this Release. Second, the rule generally prohibits advisers from paying third parties to solicit government entities for advisory business unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. 84 That is, an adviser is prohibited from providing or agreeing to provide, directly or indirectly, payment to any person for solicitation of government advisory business on behalf of such adviser unless that person is registered with us and subject to pay to play restrictions either under our rule or the rules of a registered national securities association. 85 This represents a modification from our proposal, which included a flat ban without an exception for any brokers or investment advisers. 86 As discussed below, commenters persuaded us that the objective of the rule in eliminating pay to play activities of advisers could be preserved if the third parties they hire are themselves registered investment advisers subject to Commission oversight or are broker-dealers subject to pay to play restrictions imposed by a registered national securities association that the Commission must approve. 84 Rule 206(4)-5(a)(2)(i) makes it unlawful for any investment adviser covered by the rule and its covered associates (as defined in the rule) to provide or agree to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of such investment adviser unless such person is a regulated person or is an executive officer, general partner, managing member (or, in each case, a person with a similar status or function), or employee of the investment adviser. “Regulated person” is defined in rule 206(4)-5(f)(9). See section II.B.2(b) of this Release for a discussion of this definition. 85 See section II.B.2(b) of this Release. While our rule would apply to any registered national securities association, the Financial Industry Regulatory Authority, or FINRA, is currently the only registered national securities association under section 19(a) of the Exchange Act [15 U.S.C. 78s(b)]. As such, for convenience, we will refer directly to FINRA in this Release when describing the exception for certain broker-dealers from the rule's ban on advisers paying third parties to solicit government business on their behalf. The Commission's authority to consider rules proposed by a registered national securities association is governed by section 19(b) of the Exchange Act [15 U.S.C. 78s(b)] (“No proposed rule change shall take effect unless approved by the Commission or otherwise permitted in accordance with the provisions of this subsection.”). 86 See Proposing Release, at section II.A.3(b). Third, the rule makes it unlawful for an adviser itself or any of its covered associates to solicit or to coordinate: (i) Contributions to an official of a government entity to which the investment adviser is seeking to provide investment advisory services; or (ii) payments to a political party of a State or locality where the investment adviser is providing or seeking to provide investment advisory services to a government entity. 87 We are adopting this aspect of the rule as proposed. 87 Rule 206(4)-5(a)(2)(ii) makes it unlawful for any investment adviser covered by the rule and its covered associates to coordinate, or to solicit any person [including a political action committee] to make, any: (A) contribution to an official of a government entity to which the investment adviser is providing or seeking to provide investment advisory services; or (B) payment to a political party of a State or locality where the investment adviser is providing or seeking to provide investment advisory services to a government entity. See section II.A.2.(c) of this Release. Fourth, as it is not possible for us to anticipate all of the ways advisers and government officials may structure pay to play arrangements to attempt to evade the prohibitions of our rule, the rule includes a provision that makes it unlawful for an adviser or any of its covered associates to do anything indirectly which, if done directly, would result in a violation of the rule. 88 This provision in the rule we are adopting today is identical to our proposal. 89 88 Rule 206(4)-5(d) makes it unlawful for any investment adviser covered by the rule and its covered associates to do anything indirectly which, if done directly, would result in a violation of this section. See section II.B.2(d) of this Release. 89 See Proposing Release, at section II.A.3(d). Finally, for purposes of our rule, an investment adviser to certain pooled investment vehicles in which a government entity invests or is solicited to invest will be treated as though the adviser were providing or seeking to provide investment advisory services directly to the government entity. 90 This provision is substantially similar to our proposal, although we have made certain modifications described below. 91 90 Rule 206(4)-5(c) states that, for purposes of rule 206(4)-5, an investment adviser to a covered investment pool in which a government entity invests or is solicited to invest, shall be treated as though that investment adviser were providing or seeking to provide investment advisory services directly to the government entity. See section II.B.2(e) of this Release. 91 See section II.B.2(e) of this Release. 1. Advisers Subject to the Rule Rule 206(4)-5 applies to registered investment advisers and certain advisers exempt from registration. In particular, it applies to any investment adviser registered (or required to be registered) with the Commission, or unregistered in reliance on the exemption available under section 203(b)(3) of the Advisers Act (15 U.S.C. 80b-3(b)(3)). 92 The rule would not, however, apply to most small advisers that are registered with State securities authorities instead of the Commission, 93 or advisers that are unregistered in reliance on exemptions other than section 203(b)(3) of the Advisers Act. 94 92 Rule 206(4)-5(a)(1) and (2). Section 203(b)(3) [15 U.S.C. 80b-3(b)(3)] exempts from registration any investment adviser that is not holding itself out to the public as an investment adviser and had fewer than 15 clients during the last 12 months. We are including this category of exempt advisers within the scope of the rule in order to make the rule applicable to the many advisers to private investment companies that are not registered under the Advisers Act. 93 Advisers with less than $25 million of assets under management are prohibited from registering with the Commission by section 203A of the Advisers Act [15 U.S.C. 80b-3A]. 94 The rule would also not apply to certain other advisers that are exempt from registration with the Commission. See, e.g., section 203(b)(1) of the Advisers Act [15 U.S.C. 8b-3(b)(1)] (exempting from registration intrastate investment advisers). As explained in the Proposing Release, we believe these advisers are unlikely to advise public pension plans. See Proposing Release, at n.64 and accompanying text. The rule would also not apply to persons who are excepted from the definition of investment adviser under section 202(a)(11) of the Advisers Act [15 U.S.C. 80b-2(a)(11)]. For a discussion, in particular, of the exclusion of banks and bank holding companies which are not investment companies from the Advisers Act's definition of “investment adviser,” see infra note 274. We received limited comment on this aspect of the rule. One commenter explicitly agreed with the scope of our proposed rule, noting that it would capture most, if not all, advisers that provide discretionary management with respect to public pension fund assets, regardless of whether they are registered. 95 Other commenters recommended that the rule apply more broadly to all advisers that may manage assets of government entities. 96 The primary effect of such an expansion of the rule would be to apply it to smaller firms, the regulatory responsibility for which Congress has previously allocated to the State securities authorities. 97 It is our understanding that few of these firms manage public pension plans or other public funds. 98 Accordingly, we have decided to adopt this provision as proposed. 95 Comment Letter of the California Public Employees' Retirement System (Oct. 6, 2009) (“CalPERS Letter”) (“CalPERS agrees that the scope of the proposed rule would capture most if not all external managers who have discretion over the investment of public pension fund assets, including hedge fund managers, real estate managers, private equity managers, traditional long-only managers, money managers, and others, regardless of whether the managers are registered investment advisors. CalPERS supports application of the rule to investment advisers, as defined in the proposed rule.”). 96 These suggestions included applying the rule to all registered (including SEC-registered and State-registered) and unregistered advisers ( see, e.g., 3PM Letter (arguing that selective application of the rule could lead to convoluted organizational structures designed to bypass its reach and that the proposal represents the kind of patchwork regulation that will lead to the kind of inconsistency the Commission is seeking to correct), and extending the rule to State-registered advisers ( see, e.g., Comment Letter of the Cornell Securities Law Clinic (Oct. 6, 2009) (“Cornell Law Letter”)). 97 Amendments to the Advisers Act in 1996 placed the 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, Public Law 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States Code). 98 See Proposing Release, at n.64. We did not receive any comment challenging our understanding. 2. Pay to Play Restrictions (a) Two-Year “Time Out” for Contributions Rule 206(4)-5(a)(1) prohibits investment advisers from receiving compensation for providing advice to a “government entity” within two years after a “contribution” to an “official” of the government entity has been made by the investment adviser or by any of its “covered associates.” 99 The rule does not ban political contributions and does not limit the amount of any political contribution. Instead, the rule imposes a ban—a “time out”—on receiving compensation for conducting advisory business with a government client for two years after certain contributions are made. The two-year time out is intended to discourage advisers from participating in pay to play practices by requiring a “cooling-off period” during which the effects of a political contribution on the selection process can be expected to dissipate. 99 Rule 206(4)-5(a)(1). Rule 206(4)-5(a)(1) is based largely on MSRB rule G-37 under which a broker-dealer is prohibited from engaging in the municipal securities business for two years after making a political contribution. 100 As noted above and as explained in the Proposing Release, we modeled the rule on the MSRB rules because we believe that they have significantly curbed pay to play practices in the municipal securities market. 101 We also pointed out that our approach would minimize the compliance burdens on firms that would be subject to both rule regimes. But we requested comment on our proposed approach and whether alternative models might be appropriate. 100 Proposing Release, at section II.A.2. 101 See id. at n.23 (citing others, including the MSRB, who agree that the MSRB rules have been effective: MSRB, MSRB Notice 2009-62, Amendments Filed to Rule G-37 Regarding Contributions to Bond Ballot Campaigns (Dec. 4, 2009), available at http://msrb.org/msrb1/archive/2009/2009-62.asp (“Rule G-37, in effect since 1994, has provided substantial benefits to the industry and the investing public by greatly reducing the direct connection between political contributions given to issuer officials and the awarding of municipal securities business to brokers, dealers and municipal securities dealers (“dealers”), thereby effectively assisting with eliminating pay-to-play practices in the new issue municipal securities market.”); MSRB, MSRB Notice 2009-35, Request for Comment: Rule G-37 on Political Contributions and Prohibitions on Municipal Securities Business—Bond Ballot Campaign Committee Contributions (June 22, 2009) (“The MSRB believes the rule has provided substantial benefits to the industry and the investing public by greatly reducing the direct connection between political contributions given to issuer officials and the awarding of municipal securities business to dealers, thereby effectively eliminating pay-to-play practices in the new issue municipal securities market.” [footnote omitted]); MSRB, MSRB Notice 2003-32, Notice Concerning Indirect Rule Violations: Rules G-37 and G-38 (Aug. 6, 2003) (“The impact of Rules G-37 and G-38 has been very positive. The rules have altered the political contribution practices of municipal securities dealers and opened discussion about the political contribution practices of the entire municipal industry.”); Letter from Darrick L. Hills and Linda L. Rittenhouse of the CFA Institute to Jill C. Finder, Asst. Gen. Counsel of the MSRB (Oct. 19, 2001), available at http://www.cfainstitute.org/Comment%20Letters/20011019.pdf (stating, “We generally believe that the existing [MSRB] pay-to-play prohibitions have been effective in stemming practices that compromise the integrity of the [municipal securities] market by using political contributions to curry favor with politicians in positions of influence.”); Comm. on Capital Mkts. Regulation, Interim Report of the Committee on Capital Markets Regulation (Nov. 30, 2006), available at http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf (stating, upon describing MSRB Rule G-37 and the 2005 amendments to MSRB Rule G-38, “Taken together, the MSRB's rules have largely put an end to the old “pay to play” practices in municipal underwriting.”)). See also Comment letter of Professors Alexander W. Butler, Larry Fauver and Sandra Mortal (Sept. 30, 2009) (“Butler Letter”) (citing Alexander W. Butler, Larry Fauver & Sandra Mortal , Corruption, Political Integrity, and Municipal Finance, 22 R. of Fin. Stud. 2673-705 (2009)). Several commenters supporting the rule explicitly addressed the appropriateness of the MSRB approach. One, for example, asserted that the proposed rule “appropriately expands upon MSRB G-37 and G-38.” 102 Another agreed that the MSRB rules “provide an appropriate regulatory analogy for addressing [pay to play] issues.” 103 Many other commenters, however, sought to distinguish advisers and municipal securities dealers, and asserted that, because of the differences between the two, MSRB rule G-37 is an inappropriate model on which to base an investment adviser pay to play rule. 104 Some argued that the long-term nature of advisory relationships is fundamentally different from discrete municipal underwriting transactions, and consequently, the two-year time out is more disruptive and severe for advisers and the governments that retain them than for municipal securities dealers who are simply banned from obtaining “new” business as opposed to terminating a long-term relationship. 105 Some commenters asserted that the relationships are different because advisers provide ongoing and continuous advice as a fiduciary, rather than a one-time transaction such as an underwriting, and that advisory services are typically subject to an open competitive bid process instead of through negotiated transactions that are typical of municipal underwritings. 106 102 Common Cause Letter. 103 Comment Letter of Credit Suisse Securities (USA) LLC (Sept. 14, 2009) (“Credit Suisse Letter”). 104 See, e.g., IAA Letter; ICI Letter; SIFMA Letter; ABA Letter; Dechert Letter; Skadden Letter; Comment Letter of Jones Day (Oct. 5, 2009) (“Jones Day Letter”); Comment Letter of Simpson Thacher & Bartlett LLP on behalf of Park Hill Group LLC and its affiliates (Sept. 21, 2009) (“Park Hill Letter”); Comment Letter of Monument Group, Inc. (Sept. 18, 2009) (“Monument Group Letter”). One commenter suggested, in particular, that the rule's two-year time out provision is outside of our authority because it imposes an “automatic penalty, subject only to discretionary post facto review.” Comment Letter of Edwin C. Laurenson (Dec. 31, 2009). We disagree. The two-year time out is not a penalty. Rather, it is a “cooling-off period” to dissipate any effects of a quid pro quo. A violation of the provision would result from receiving, or continuing to receive, payment after making the contribution, not from the making of the contribution itself. 105 See, e.g., IAA Letter; ABA Letter; Dechert Letter; Skadden Letter; Jones Day Letter; Park Hill Letter; Monument Group Letter. But see Credit Suisse Letter (“G-37 and G-38 provide an appropriate regulatory analogy”); Butler Letter (“This practice [municipal underwriting pay to play] was analogous to the type of pay to play currently under consideration by the Commission”). 106 See, e.g., IAA Letter; ICI Letter; SIFMA Letter; ABA Letter; Dechert Letter; Skadden Letter; Jones Day Letter; Park Hill Letter; Monument Group Letter. We disagree that the differences between municipal securities underwriting and money management are sufficient to warrant an alternative approach. Commenters are correct that municipal securities underwriters provide episodic services rather than ongoing services often provided by money managers. But underwriters seek to provide repeated, if not ongoing, services, and the imposition of a two-year time out can have considerable competitive consequences to a broker-dealer whose government client must employ the services of a competitor whose services it may continue to employ after MSRB rule G-37's two-year time out has run its course. That advisers are in a fiduciary relationship with their public pension plan clients argues for at least as significant consequences for participation in pay to play practices that can harm these clients. Our decision to adopt a rule based on the MSRB model is influenced primarily by our judgment that the MSRB rules have significantly curbed pay to play practices in the municipal securities market 107 and that alternative approaches, including those suggested by commenters, would fail to provide an adequate deterrent to pay to play activities. We considered each of the principal suggestions offered by commenters. 107 See supra notes 31 and 101 and accompanying text. Some commenters suggested requiring advisers to disclose their contributions to State and local officials. 108 Statutes requiring disclosure of political contributions are, in part, designed to inform voters about a candidate's financial supporters; an informed electorate can then use the information to vote for or against a candidate. 109 But voters' possible reactions, if any, to such disclosure would not necessarily resolve the concerns we are trying to address in this rulemaking. Our concern is protecting advisory clients and investors whom we have the responsibility to protect under the Advisers Act—namely, the public pension plans and their beneficiaries who are affected by pay to play practices. 110 Disclosure to a plan's trustees might be insufficient where the trustee (particularly a sole trustee) has received the contributions and is presumably well aware of the conflicts involved. Moreover, and as we pointed out in the Proposing Release, requiring advisers to disclose political contributions to beneficiaries would be unlikely to protect them since most cannot act on the information by moving their pension assets to a different plan or by reversing the plan trustees' adviser hiring decisions. 111 Not all beneficiaries may be entitled to vote (or withhold their vote) for the official to whom a contribution was made, and those that are may need to wait a substantial period of time until a future election to exercise their vote. Further, as beneficiaries may constitute only a small proportion of the electorate, they may not be able to influence an election; therefore, reliance on the electoral process may be insufficient to protect government plans and their beneficiaries from pay to play. In addition, even if the fact of a contribution is disclosed (which is required in many states), the contribution's true purpose is unlikely to be disclosed. 108 See, e.g., SIFMA Letter; Preqin Letter I; Comment Letter of Triton Pacific Capital, LLC (Sept. 1, 2009) (“Triton Pacific Letter”); Comment Letter of the State Association of County Retirement Systems (Sept. 8, 2009); Comment Letter of CapLink Partners (Sept. 9, 2009) (“CapLink Letter”); Comment Letter of Parenteau Associates, LLC (Aug. 7, 2009) (“Parenteau Letter”). 109 See Buckley, 424 U.S. at 67 (1976) (noting that campaign financing disclosure requirements “deter actual corruption and avoid the appearance of corruption by exposing large contributions and expenditures to the light of publicity”). 110 As discussed above, our purposes in this rulemaking are preventing fraud, protecting investors and maintaining the integrity of the adviser selection process, not campaign finance reform. See section I of this Release. 111 See Proposing Release, at section II.A.2. Some commenters made the same points. See, e.g., NY City Bar Letter; Cornell Law Letter; 3PM Letter. See also Blount, 61 F.3d at 947 (explaining, in the context of the municipal securities industry, the potential inadequacy of disclosure to address pay to play concerns, that “disclosure would not likely cause market forces to erode `pay to play * * *'” because the “* * * purpose of protecting the integrity of the market [would] * * * `be achieved less effectively.'”). Several commenters suggested that the Commission adopt a requirement that an adviser include in its code of ethics 112 a policy that prohibits contributions made for the purpose of influencing the selection of the adviser. 113 Several commenters recommended, similarly, that we require advisers to adopt policies and procedures 114 reasonably designed to prevent and detect contributions designed to influence the selection of an adviser. 115 Many of these commenters suggested that preclearance of employee contributions could be required under an adviser's code of ethics or compliance policies and procedures. 116 One commenter asserted that an advantage of this approach is that it would allow an adviser to customize sanctions based on the severity of the violation. 117 112 Registered investment advisers are required to have codes of ethics under the Advisers Act. See Advisers Act rule 204A-1. 113 See, e.g., IAA Letter; ABA Letter; Comment letter of the National Society of Compliance Professionals, Inc. (Oct. 6, 2009) (“NSCP Letter”); NY City Bar Letter; Fidelity Letter. 114 Registered investment advisers are required to adopt and implement policies and procedures reasonably designed to prevent violation by the adviser or its supervised persons of the Advisers Act and the rules the Commission has adopted thereunder. See Advisers Act rule 206(4)-7. 115 See, e.g., ABA Letter; NY City Bar Letter; IAA Letter; ICI Letter; NSCP Letter. 116 See, e.g., IAA Letter; NY City Bar Letter; ABA Letter. 117 ABA Letter. We do not, however, believe that codes of ethics or compliance procedures alone would be adequate to stop pay to play practices, particularly when the adviser or senior officers of the adviser are involved either directly or indirectly. First, it is those senior officers who, as noted below, have the greatest incentives to engage in pay to play and therefore are most likely to make contributions, who would themselves ultimately be responsible for enforcing their own compliance with the firm's ethics code or compliance procedures. Second, violations of codes of ethics or compliance procedures do not themselves establish violations of the Federal securities laws. Moreover, the comments suggesting these alternatives would have us require the codes or procedures be designed to prevent or detect contributions intended to influence the selection of the adviser by a government entity. As discussed extensively above and in our Proposing Release, pay to play is an area in which intent is often very difficult to prove, and is often hidden in the guise of legitimate conduct. 118 Political contributions are made ostensibly to support a candidate; the burden on a regulator or prosecutor of proving a different intent presents substantial challenges absent unusual evidence. Commenters would thus have us give the adviser, which stands to benefit from the contribution, the discretion to determine whether contributions were intended to influence its selection by the government entity. We do not believe codes of ethics or policies and procedures alone, without a rule providing for specific, prophylactic prohibitions, are adequate to address this type of conduct. 119 118 See, e.g., Proposing Release, at n.16 and accompanying text. 119 We note that, under our rules, an adviser's code of ethics must require compliance with the rule we are today adopting (rule 204A-1(a)(2)) and the adviser must adopt policies and procedures designed to prevent violation of the rule (rule 206(4)-7(a)). On balance, we believe that adopting a two-year time out for investment advisers similar to the two-year time out applicable to broker-dealers underwriting municipal securities is appropriate. Our years of experience with MSRB rule G-37 suggests that the “strong medicine” provided by that rule has both significantly curbed participation in pay to play and provides a reasonable cooling-off period to mitigate the effect of a political contribution. We are sensitive about potential implications of the operation of the rule on public pension funds, which could lose the services of an investment adviser subject to a time out. While we have designed the rule to reduce its impact, 120 investment advisers are best positioned to protect these clients by developing and enforcing robust compliance programs designed to prevent contributions from triggering the two-year time out. 120 See, e.g., section II.B.2(a)(6) of this Release (discussing the de minimis exceptions to the two-year time out); section II.B.2(f) of this Release (discussing the rule's exemptive provision). (1) Prohibition on Compensation As noted above, investment advisers subject to new rule 206(4)-5 are not prohibited from providing advisory services to a government client, even after triggering the two-year time out. Instead, an adviser is prohibited from receiving compensation for providing advisory services to the government client during the time out. 121 We have taken this approach to enable an adviser to act consistently with its fiduciary obligations so it will not have to abandon a government client after making a triggering contribution, but rather may provide uncompensated advisory services for a reasonable period of time to allow the government client to replace the adviser. 122 We are adopting this element of the rule as proposed. 121 Rule 206(4)-5(a)(1) makes it unlawful for investment advisers covered by the rule to provide investment advisory services for compensation to a government entity within two years after a triggering contribution. Under the rule, the two-year time out begins to run once the contribution is made and not when the contribution is discovered either by our examination staff or by the adviser. The adviser, therefore, should return all such compensation promptly upon discovering the triggering contribution. For the application of the rule to investments by government entities in pooled investment vehicles, see section II.B.2(e) of this Release. 122 Proposing Release, at section II.A.3(a)(1). An investment adviser's fiduciary duties may require it to continue providing advisory services for a reasonable period of time under these circumstances. For another instance in which an adviser's fiduciary duties may require its continued provision of services, 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 assignment of the advisory contract). One commenter supported the prohibition on compensation as the least disruptive option to government clients, 123 while others argued that the prohibition on compensation was unreasonable and, in some cases, difficult or near impossible to implement. 124 A coalition of commenters representing State and local governments asserted that, due to restrictions on accepting uncompensated services under State and local law, it was unlikely that government entities would accept uncompensated services even if an adviser were willing or required to provide them. 125 Commenters representing advisers took the opposite view, expressing concern that they would be locked into providing uncompensated services for extended periods of time as a result, and wanted the Commission to provide guidelines as to what a reasonable amount of time is for a government client to claim or move its assets. 126 One asserted that it would be unreasonable to require advisers to provide uncompensated services altogether. 127 123 Cornell Law Letter. 124 See, e.g., ICI Letter; Jones Day Letter. Some commenters argued for more flexibility in sanctions (Skadden Letter; ABA Letter; Fidelity Letter; ICI Letter; MassMutual Letter; Comment Letter of Wells Fargo Advisors (Oct. 6, 2009) (“Wells Fargo Letter”); IAA Letter). 125 Comment Letter of the National Conference of State Legislatures, National Association of Counties, National League of Cities, International City/County Management Association, National Association of State Auditors, Comptrollers and Treasurers, Government Finance Officers Association, National Association of State Retirement Administrators, National Conference on Public Employee Retirement Systems, and National Council on Teacher Retirement (Oct. 6, 2009) (“National Organizations Letter”). With respect to direct advisory relationships, because restrictions on governments receiving services without payment would be a function of particular State or local laws, we believe government entities and their advisers are in the best position to work out arrangements that are consistent with both State and local law and the compensation prohibition of our rule. With respect to investments by government entities in pooled investment vehicles, in particular, such restrictions could be avoided. See section II.B.2(e)(2) of this Release (describing possible arrangements for continued payment to investment pools even after a time out is triggered). 126 See, e.g., Comment Letter of Davis Polk & Wardwell LLP (Oct. 6, 2009) (“Davis Polk Letter”) (recommending that three months would be reasonable); ICI Letter (suggesting 30 days). Other commenters raised concern regarding the potential harm of a time out to government investors for whom identifying new managers may be a lengthy process. See, e.g., NASP Letter. We believe, however, that, on balance, pension funds and their beneficiaries are best served by the rule's deterrent effect against engaging in pay to play activities. An adviser's fiduciary obligations to continue to provide services for a reasonable amount of time, combined with the extended compliance dates described in section III of this Release which should afford the ability of market participants to organize themselves in a way to adapt to the rule's requirements, should be sufficient to minimize the impact on pension plans to the extent they need to prepare to transition to a new money manager after a two-year time out is triggered. 127 Jones Day Letter. Other commenters argued that the specter of a two-year time out might cause some firms to ban or require pre-clearance of all employees' contributions. See, e.g., Caplin & Drysdale Letter. Although the rule does not require this approach, as a result of commenters' assertions, we address this possibility in our cost-benefit analysis. See section IV of this Release. Few of the commenters who opposed this provision appeared to favor its elimination, which would require the adviser to immediately cease providing advisory services upon making a triggering contribution. 128 Rather, they appeared to oppose the two-year time out more generally. 129 128 See, e.g., Davis Polk Letter; ICI Letter. 129 See, e.g., National Organizations Letter; ICI Letter; Jones Day Letter; Dechert Letter. We are not persuaded by their arguments. We believe the prohibition on compensation is both appropriate and administrable. The incentives to engage in pay to play may be significant, precisely because of the long-term nature of many advisory relationships from which the adviser could benefit for several years. As a result, the consequences of engaging in pay to play need to be commensurate with these incentives for the prophylactic rule to have a meaningful deterrent effect. 130 We acknowledge that the rule will involve compliance costs and could adversely affect an adviser's business. 131 On the other hand, a political contribution would not affect the ability of an adviser to provide compensated services to other clients, including other government clients. Moreover, the fiduciary obligations of an adviser would not require it to provide uncompensated advice indefinitely—rather, the adviser may need to continue to provide advice for only a reasonable period of time during which its client can seek to obtain advisory services from others. 132 130 This deterrent effect is the basis for our view that the two-year time out should not apply only to “new business” and that advisers should not be able to “negotiate” for lesser consequences. See supra note 124 (pointing to commenters who called for more flexibility regarding the two-year time out). As we point out above, our concerns extend to contributions designed to enable advisers to retain contracts that might not otherwise be renewed. 131 For a discussion of costs and other burdens that may be imposed by our rule, see generally sections IV-V of this Release. 132 See supra note 122 and accompanying text. The amount of time a client might need in good faith to find and engage a successor to the adviser would, in our view, be the primary consideration of the length of a reasonable period, which may depend in part on such matters as applicable law, the client's customary process of finding and engaging advisers and the types of assets managed by the adviser that is subject to the time out. In some cases, a client may be able to quickly engage a “transition adviser” to manage its assets until a permanent successor is found. See, e.g., Illinois State Board Sets Transition Manager RFP, Pensions & Investments, Feb. 8, 2010 available at http://www.pionline.com/article/20100208/PRINTSUB/302089976. In other cases, the client may be required by the law under which it operates to undertake a specified process to obtain a new manager, such as a solicitation for proposals from potential managers. Some commenters urged us to permit advisers to continue to receive compensation during the two-year time out for services provided pursuant to an existing management contract, 133 without distinguishing whether the contract was acquired as a result of political contributions. One commenter further suggested specifically that we permit advisory services to continue to be provided by the adviser at cost during the time out to remove the profit motive of pay to play. 134 We are also not persuaded by their suggestions. Allowing contracts acquired as a result of political contributions to continue uninterrupted would eviscerate the rule. Were a “free pass” available for contracts merely because they were entered into prior to discovery of a contribution, advisers would be strongly incentivized against “discovering” contributions. 135 Because no new business from a government client may even be available to the adviser until the two-year period has run its course, advisers whose contributions succeeded in acquiring a management contract for two years or more could escape any consequences under such an exception. 136 Further, in our judgment, the potential loss of profits will not operate as an adequate deterrent. It is our understanding that being selected to manage public pension plan assets has a reputational value that itself contributes to advisory profits by attracting additional assets under management regardless of the profits derived directly from the management of government client assets. 137 133 See, e.g., Dechert Letter; Fidelity Letter; ICI Letter; Jones Day Letter (in some instances, pointing to the MSRB's approach of not necessarily applying MSRB rule G-37's two-year time out when a contribution is made after a business contract is signed). See MSRB, Interpretation on the Effect of a Ban on Municipal Securities Business under Rule G-37 Arising During a Pre-Existing Engagement Related to Municipal Fund Securities, MSRB Rule G-37 Interpretive Notice (April 2, 2002), available at http://msrb.org/msrb1/archive/ContributionsNotice.htm ). As we explain above, due to the long-term nature of typical advisory contracts and our belief that the consequences of giving a contribution need to be commensurate with the potential benefits obtained, we are not taking this approach. 134 Dechert Letter. 135 An approach that applied the two-year time out only to new business would preclude the adviser from receiving compensation only from additional contracts that might be awarded by the government entity during the two-year period. In our judgment, the risk of the potential loss of additional advisory contracts for a two-year period would provide an inadequate deterrent to contributions designed to influence the award of such additional advisory contracts. 136 We are concerned that limiting application of the rule to new business could invite abuse. For example, pension officials seeking contributions after a contract has been awarded could attempt to offer an adviser additional assets to manage under the existing contract with the condition that the adviser subsequently make political contributions. 137 See, e.g., Kevin McCoy, Do Campaign Contributions Help Win Pension Fund Deals, USA Today, Aug. 28, 2009, available at http://www.usatoday.com/money/perfi/funds/2009-08-26-pension-fund-political-donations_N.htm (referring to advisory firms winning management mandates from pension funds, stating: “The awards generate lucrative fees and lend prestige that could help lure new clients.”); Louise Story, Quadrangle Facing Questions Over Pension Funds, N.Y. Times, Apr. 21, 2009, available at http://www.nytimes.com/2009/04/22/business/22quadrangle.html (highlighting an indirect benefit of a pension fund investment, stating: “the prestige associated with it helped the firm lure other big investors.”). (2) Officials of a Government Entity The rule's two-year time out is triggered by a contribution to an “official” of a “government entity.” 138 An official includes an incumbent, candidate or successful candidate for elective office of a government entity if the office is directly or indirectly responsible for, or can 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. 139 Government entities include all State and local governments, their agencies and instrumentalities, and all public pension plans and other collective government funds, including participant-directed plans such as 403(b), 457, and 529 plans. 140 138 Rule 206(4)-5(a)(1) makes it unlawful for covered investment advisers to provide investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any of its covered associates. 139 Rule 206(4)-5(f)(6). For purposes of the rule, we would not interpret the definition of “official” as covering an individual who is also a “covered associate” of the adviser. Accordingly, under the rule, a covered associate who is an incumbent or candidate for office is not limited to contributing the de minimis amount to his or her own campaign. The MSRB takes a similar view with respect to its rule G-37. MSRB, Questions and Answers Concerning Political Contributions and Prohibitions on Municipal Securities Business: Rule G-37, MSRB rule G-37 Interpretive Notice, available at http://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/Rule-G37-Frequently-Asked-Questions.aspx (“MSRB Rule G-37 Q&A”), Question II.10 (May 24, 1994). 140 Rule 206(4)-5(f)(5). The two-year time out is thus triggered by contributions, not only to elected officials who have legal authority to hire the adviser, but also to elected officials (such as persons with appointment authority) who can influence the hiring of the adviser. We have not modified this approach from our proposal. 141 As we noted in the Proposing Release, a person appointed by an elected official is likely to be subject to that official's influences and recommendations. 142 It is the scope of authority of the particular office of an official, not the influence actually exercised by the individual, that would determine whether the individual has influence over the awarding of an investment advisory contract under the definition. 143 We are adopting these provisions as proposed. 144 141 See Proposing Release, at section II.A.3(a)(2). 142 Id. 143 As such, executive officers or legislators whose official position gives them the authority to influence the hiring of an investment adviser generally would be “government officials” under the rule. For example, a State may have a pension fund whose board of directors, which has authority to hire an investment adviser, is constituted, at least in part, by appointees of the governor and members of the State legislature. See, e.g., The Commonwealth of Pennsylvania Public School Employees' Retirement Board, Statement of Organization, By-Laws and Other Procedures (rev. Jun. 11, 2009), art. II, sec. 2.1, available at http://www.psers.state.pa.us/org/board/policies/201001_bylaws.pdf (noting that the board shall be composed of, inter alia, two persons appointed by the Pennsylvania State Governor, two Pennsylvania State senators and two members of the Pennsylvania State house of representatives). In such circumstances, the governor and the members of the State legislature serving on the board would be officials of the government entity. Conversely, a public official who is tasked with performing an audit of the selection process but has no influence over hiring outcomes would not be an official of a government entity for purposes of the rule. 144 These definitions and their application are substantively the same as those in MSRB rule G-37. See MSRB rule G-37(g)(ii) and (g)(vi). Some commenters asserted that the rule should be more specific as to which public officials to whom a contribution is made would trigger application of the rule in order to reduce uncertainty and compliance burdens. 145 But State and municipal statutes vary substantially with respect to whom they entrust with the management of public funds, and any effort we make in a rule of general application to identify specific officials who are in a position to influence the selection of an adviser would certainly be over-inclusive in some circumstances and under-inclusive in others. 146 Others urged that triggering contributions should be limited to contributions to officials directly responsible for the selection of advisers. 147 Excluding from the application of the rule contributions to those who are in a position to indirectly influence the selection of an investment adviser could simply lead officials to re-structure their relationships to avoid application of the rule to advisers that may contribute to those officials. 145 See, e.g., IAA Letter; NSCP Letter; Comment Letter of T. Rowe Price Associates, Inc. (Oct. 6, 2009) (“T. Rowe Letter”); MFA Letter; Davis Polk Letter. For a discussion of the potential costs involved in identifying officials to whom contributions could trigger the rule's prohibitions, see section IV of this Release (presenting our cost-benefit analysis). Another commenter suggested that advisers should be able to rely on certifications from candidates and officials regarding whether their office would render them an “official” for purposes of the rule— i.e., identifying the range, if any, of public investment vehicles over which the relevant office directly or indirectly influences the selection of investment advisers or appoints individuals who do). Caplin & Drysdale Letter. We are concerned that such a safe harbor would undercut the purposes of the rule, not least because officials will be incentivized to offer such certifications liberally (and will presumably sometimes do so inappropriately) to encourage contributions. 146 Like us, the MSRB does not specify which officials have the authority to influence the granting of government business for purposes of its rule G-37. See MSRB, Campaign for Federal Office, MSRB Rule G-37 Interpretive Notice (May 31, 1995), available at http://msrb.org/msrb1/rules/interpg37.htm (“The Board does not make determinations concerning whether a particular individual meets the definition of “official of an issuer.”). 147 See, e.g., IAA Letter; NASP Letter; NY City Bar Letter; Davis Polk Letter. Two commenters argued that the rule should not cover contributions to candidates for Federal office, 148 while another contended that it should. 149 Under our rule, as proposed, a candidate for Federal office could be an “official” under the rule not because of the office he or she is running for, but as a result of an office he or she currently holds. 150 So long as an official has influence over the hiring of investment advisers as a function of his or her current office, contributions by an adviser could have the same effect, regardless to which of the official's campaigns the adviser contributes. For that reason, we are not persuaded that an incumbent State or local official should be excluded from the definition solely because he or she is running for Federal office. 151 148 See, e.g., NSCP Letter; Dechert Letter. 149 Fund Democracy/Consumer Federation Letter. 150 As a result, if a State or municipal official were, for example, a candidate for the U.S. Senate, House of Representatives, or presidency, an adviser's contributions to that official would be covered by the rule. MSRB rule G-37's time out provision is also triggered by contributions to State and local officials running for Federal office. See MSRB Rule G-37 Q&A, Questions IV.2-3. 151 Under certain circumstances, a State or municipal official running for Federal office could remove herself from being an “official” for purposes of rule 206(4)-5 by eliminating her ability to influence the outcome of the hiring of an investment adviser. This might occur, for example, if she were to: (i) Formally withdraw from participation in or influencing adviser hiring decisions; (ii) be leaving office, so that he or she could not participate in subsequent decision-making; and (iii) have held direct influence over the adviser hiring process (as opposed to, for example, having designated an appointee with such influence who would remain in a position to influence such hiring). (3) Contributions The rule's time out provisions are triggered by contributions made by an adviser or any of its covered associates. 152 A contribution is defined to include a gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing an election for a Federal, State or local office, including any payments for debts incurred in such an election. 153 It also includes transition or inaugural expenses incurred by a successful candidate for State or local office. 154 The definition is the same as we proposed and as the one used in MSRB rule G-37. 155 152 Rule 206(4)-5(a)(1) makes it unlawful for covered investment advisers to provide investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any of its covered associates. As suggested above, we are concerned that contributions may be used “as the cover for what is much like a bribe: a payment that accrues to the private advantage of the official and is intended to induce him to exercise his discretion in the donor's favor, potentially at the expense of the polity he serves.” Blount, 61 F.3d at 942 (describing the Commission's approval of MSRB rule G-37 as based on a wish to curtail this function). 153 Rule 206(4)-5(f)(1). 154 MSRB rule G-37 also covers payment of transition or inaugural expenses as contributions for purposes of its time out provision. See MSRB Rule G-37 Q&A, Question II.6. However, under neither rule does a contribution include the transition or inaugural expenses of a successful candidate for Federal office. Contributions to political parties are not specifically covered by the definition and thus would not trigger the rule's two-year time out unless they are a means to do indirectly what the rule prohibits if done directly (for example, the contributions are earmarked or known to be provided for the benefit of a particular political official). We also note that “contributions” are not intended to include independent “expenditures,” as that term is defined in 2 U.S.C. 431 & 441b (the Federal statutory provisions limiting contributions and expenditures by national banks, corporations, or labor organizations invalidated by Citizens United v. Federal Election Commission, 130 S. Ct. 876 (2010) (holding that corporate funding of independent political broadcasts in candidate elections cannot be limited under the First Amendment)). Indeed, it is our intent that, under the rule, advisers and their covered associates “are not in any way restricted from engaging in the vast majority of political activities, including making direct expenditures for the expression of their views, giving speeches, soliciting votes, writing books, or appearing at fundraising events.” Blount, 61 F.3d at 948. 155 MSRB rule G-37(g)(i). We received requests that we clarify the application of the rule to some common circumstances that may arise in the course of an adviser's relationship with a government client. 156 We would not consider a donation of time by an individual to be a contribution, provided the adviser has not solicited the individual's efforts and the adviser's resources, such as office space and telephones, are not used. 157 Similarly, we would not consider a charitable donation made by an investment adviser to an organization that qualifies for an exemption from Federal taxation under the Internal Revenue Code, 158 or its equivalent in a foreign jurisdiction, at the request of an official of a government entity to be a contribution for purposes of rule 206(4)-5. 159 156 See, e.g., Caplin & Drysdale Letter; Callcott Letter I (volunteer activities); NASP Letter (charitable contributions); Sutherland Letter; IAA Letter (entertainment expenses and conference expenses). We address entertainment and conference expenses in section II.B.2(c) of this Release (which discusses the prohibition on soliciting or coordinating contributions from others). 157 See Proposing Release, at n.91. A covered associate's donation of his or her time generally would not be viewed as a contribution if such volunteering were to occur during non-work hours, if the covered associate were using vacation time, or if the adviser is not otherwise paying the employee's salary ( e.g., an unpaid leave of absence). But see rule 206(4)-5(d) (prohibiting an adviser from doing indirectly what the rule would prohibit if done directly). The MSRB deals similarly with this issue. See MSRB Rule G-37 Q&A, Question II.19. 158 Section 501(c)(3) of the Internal Revenue Code (26 U.S.C. 501(c)(3)) contains a list of charitable organizations that are exempt from Federal income taxation. 159 The MSRB deals similarly with this issue. See MSRB Rule G-37 Q&A, Question II.18. But see rule 206(4)-5(d) (prohibiting an adviser from doing indirectly what the rule would prohibit if done directly). The few commenters that addressed the definition of “contribution” generally urged us to adopt a narrower version. Some, for example, recommended that contributions be expressly limited to political contributions and more explicitly exclude expenditures not clearly made for the purpose of influencing an election. 160 We are not narrowing our definition. We are instead adopting our definition as proposed due to our concern that “contributions” may also take the form of payment of election-related debts and transition or inaugural expenses. Further, our definition of “contribution” already requires that the payment be made for the purpose of influencing an election for a Federal, State or local office. 161 We believe that the scope of our proposed definition is appropriate in light of the conduct we are seeking to address. 160 See, e.g., National Organizations Letter; NASP Letter. 161 Rule 206(4)-5(f)(1). Commenters were divided as to whether contributions to PACs or local political parties should trigger the two-year time out. 162 Such contributions were not explicitly covered by the proposed rule and do not necessarily trigger the two-year time out in MSRB rule G-37. 163 In some cases, such contributions may effectively operate as a funnel to the campaigns of the government officials. 164 In other cases, however, they may fund general party political activities or the campaig [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2010-16559. Public record. Not legal advice.