A Closer Look at the new SEC Rule 206(4)-5 on Pay to Play

Over the weekend, the Securities and Exchange Commission released the full text of Rule 206(4)-5 in Release No. IA-3043. I made few notes during the broadcast of the open meeting, but there were lots of unanswered questions.

Rule 206(4)-5 is only 12 pages long, but Release IA-3043 also includes another 190 pages of commentary and discussion.

Summary (from the SEC):

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.

Limitations on Political Contributions

It is unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

  1. directly or indirectly influence the hiring of an investment adviser, or
  2. has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

A primary election is separate election from the general election. [Release page 63]

Those are increases from the proposed rule.

Who is a Covered Associate?

  1. Any general partner, managing member or executive officer, or other individual with a similar status or function;
  2. Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
  3. Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Placement Agent Ban

The rule retreated from the complete ban on placement agents that was in the draft rule. The SEC seems willing to put a ban in place. For now, the rule allows you to use a placement agent provided that they are either an SEC registered investment adviser or a SEC registered broker dealer. The extra limit on the broker dealer is that they have be subject to a an equivalent restriction on political contributions. Something that  is not yet place. Apparently, FINRA is working on pay-to-play regulations for broker-dealers.

Does Rule 206(4)-5 Apply to Private Funds?

Rule 206 (4)-5 will apply to registered investment advisers and unregistered investment advisers who are relying on the small adviser exception to registration. (Of course, that exception is scheduled to be eliminated shortly as part of the financial reform legislation.)

Also, the rule deems the adviser to a “covered investment pool” to be providing investment advisory services directly to the investor in the pool.

Therefore, private equity fund managers and their employees will be subject to this rule. Even venture capital fund managers who managed to keep a registration exemption in the financial reform bill will need comply with this new rule.

The financial reform bill is bumping the SEC registration up to $100 million from $25 million. That means a bunch of advisers and small funds will fall out from having to comply with this rule since it does not apply to state-registered advisers.


The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

  1. its covered associates
  2. all government entities that are investors
  3. all contributions made to an “official of a government entity”
  4. all contributions made to a political party
  5. all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

What’s a Contribution?

“[A]ny gift, subscription, loan, advance, or deposit of money or anything of value made for:

(i) The purpose of influencing any election for federal, state or local office;
(ii) Payment of debt incurred in connection with any such election; or
(iii) Transition or inaugural expenses of the successful candidate for state or local office.”

Cash donations are clearly contributions. The release says that volunteer activity is not a contribution.[Release Page 23]

Effective Date

The rule has not made its way into the federal register, but will be effective 60 days after publication.

The limitations on political contributions and the record-keeping requirments have a compliance deadline of six months after the effective date. That means you need to get ready by the end of this calendar year, with the actual deadline likely to be in early March.

The limitation on the use of third parties to solicit government business has a compliance deadline one year after the effective date. That will likely be sometime during the summer of 2011.

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4 Responses to A Closer Look at the new SEC Rule 206(4)-5 on Pay to Play

  1. Brian July 16, 2010 at 5:23 pm #

    I am still unclear about whether the new rule includes officials of a retirement system who are elected by active employees and/or retirees. Given the SEC commentary, I am leaning toward thinking it is included.

    Doug, what are your thoughts?

    • Doug Cornelius July 20, 2010 at 10:03 am #

      Brian –

      Probably not unless the retirement system is a government entity.

      “Official” means any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity ….

      “Government entity” means any state or political subdivision of a state, including:
      (i) Any agency, authority, or instrumentality of the state or political subdivision;
      (ii) A pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to a “defined benefit plan” as defined in section 414(j) of the Internal Revenue Code (26 U.S.C. 414(j)), or a state general fund;
      (iii) A plan or program of a government entity; and
      (iv) Officers, agents, or employees of the state or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity.

      If it’s a privately sponsored and governed retirement system, then no. If it’s a government sponsored retirement system, then it would, even though the election is not a public election.


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