It’s election season in America – and for investment advisers (registered or exempt), that means a renewed focus on Rule 206(4)-5, the political contributions rule, commonly known as the “pay-to-play rule.”
The rule, adopted under the U.S. Investment Advisers Act of 1940 (as amended, the Advisers Act) broadly prohibits many investment advisers from providing 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 adviser or any of its “covered associates.” The prohibition applies not only to registered investment advisers (RIAs) but also exempt reporting advisers (ERAs), relying on the venture capital fund adviser exemption (the VC Exemption) and/or the private fund adviser exemption (the PF Exemption), as well as foreign private advisers.
Given the broad reach of the rule, many advisers (and most larger financial services firms) have adopted strict policies both to (i) monitor political contributions among their personnel and (ii) prohibit altogether or limit political contributions to the applicable de minimis threshold.
This note highlights the basic features of the pay-to-play rule as political activity gathers momentum through the November 5th general election, including the applicability of the rule to the Harris-Walz presidential campaign in light of the rule’s reach to federal elections where state or local incumbent official are candidates.
2024 election considerations
While the rule relates to contributions to state and local officials (and not federal officials), the rule’s coverage extends to incumbent state and local officials running for federal offices. In the 2024 presidential election, therefore, the rule covers Minnesota governor Tim Walz, who is running as the Democratic Party’s nominee for vice president. Accordingly, all donations to Kamala Harris’s presidential bid (i.e. the Harris-Walz ticket) are covered under the rule. The pay-to-play rule also prohibits contributions for House and Senate races where state or local officials are running, such as, for example, West Virginia governor Jim Justice in his Senate race.
The pay-to-play rule allows for a de minimis exception of $350 per official, per election, for natural persons to contribute to officials for whom the person is entitled to vote at the time of the contributions, with a reduced de minimis exception of $150 (per official per election) if the person is not entitled to vote for such official at the time of the contributions. The primary election and the general election for a given office are treated as separate elections for purposes of the foregoing limits. There is no limit to the number of officials who can be supported under the de minimis exception. For purposes of the rule, a person would be “entitled to vote” for an official if the person’s principal residence is in the locality in which the official seeks election.
Background
Adopted by the U.S. Securities and Exchange Commission in 2010 as a result of scandals involving kickbacks from fund sponsors to officials who worked for state and local pension plans, the pay-to-play rule is designed to remove the connection between political contributions and officials who may be able to influence investment decisions by state and local governments and public pensions.
In addition to the two-year limit on receipt of investment advisory compensation described above, the rule contains two other important prohibitions:
- no investment adviser may directly or indirectly make a payment to any person to solicit a government entity for investment advisory services on behalf of such adviser unless such person is (a) a regulated person (such as another registered investment adviser, a registered broker-dealer or a registered municipal advisor) or (b) an executive officer, general partner, managing member or employee of the investment adviser, with state and local plans often having adopted even more conservative rules or procurement policies that prohibit payments to placement agents and/or finders in all circumstances; and
- no investment adviser may coordinate, or to solicit any person or 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.
The rule broadly defines many of its key terms:
- “contribution” means not only cash, but gifts, loans or anything of value (including, potentially, volunteer labor for a campaign);
- “official” means any 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” 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 by a government entity;
- “government entity” means any U.S. state or political subdivision of a US state (such as a city or county), including (among other things) any agency, authority, or instrumentality of the state, city or county, a pool of assets sponsored or established of the state, city or county, any plan or program of a government entity; and officers, agents, or employees of the state, city or county; and
- “solicit” means, (a) with respect to investment advisory services, to communicate (directly or indirectly) for the purpose of obtaining or retaining an advisory client or referring an advisory client and (b) with respect to a contribution or payment, to communicate (directly or indirectly) for the purpose of obtaining or arranging a contribution or payment.
Applicability and compliance with the rule
The pay-to-play rule applies to all “covered associates” of an investment adviser, which includes (i) any general partner, managing member or executive officer, or other individual with a similar status or function; (ii) any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and (iii) any PAC controlled by the investment adviser or by any person described above.
While affiliated entities may not technically be covered under the definition of “covered associate,” any entity (affiliated or third-party) that solicits government entities on behalf of an adviser for compensation would trigger the rule’s restrictions. In addition, the rule and the Advisers Act generally prohibit an adviser and its covered associates from doing anything indirectly which if done directly would result in the rule’s violation.
As noted above, while many SEC rules apply only to registered investment advisers (RIAs), the pay-to-play rule covers RIAs as well as (i) exempt reporting advisers relying on either the VC Exemption or the PF Exemption and (ii) foreign private advisers. RIAs, however, are also required to keep detailed records of all contributions made by the RIA or its covered associates under the books-and-records rule.
Given the potentially adverse financial consequences of political contributions to all advisers, especially those who solicit public pension plans, state university endowments and other state and local government entities as part of their investor base, and the additional recordkeeping requirements for RIAs, most advisers will adopt a relatively conservative policy for compliance with the pay-to-play rule, often requiring pre-clearance of all political contributions or prohibiting all political contributions without the express prior consent of the RIA’s compliance officer. Covered associates of investment advisers, including employees, should familiarize themselves with and comply with the policies and procedures of their organization regarding the pay-to-play rule.
Conclusion
As election day draws near, it is natural that many investment advisory businesses will review their existing policies and procedures relating to political contributions and, in many cases, refresh or review those policies and procedures with their personnel to avoid violations. This is especially true in light of Walz’s nomination for vice president in 2024, and it may be worth highlighting the pay-to-play rule’s additional applicability during the 2024 presidential campaign to avoid any unintended consequences.
We are happy to discuss the pay-to-play rule and its consequences for all types of investment advisers and welcome any questions you may have about the rule, compliance with your policies and procedures, and/or any other applicable rules under the Advisers Act.
The full text of the rule is available here.
Similar prohibitions apply to political action committees (“PACs”), so that no subject advisers or their covered persons may coordinate, or solicit any person or PAC to make (i) any contribution to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services; or (ii) payment to a political party of a state or locality where the adviser is providing or seeking to provide investment advisory services to a government entity.
As Minnesota governor, Walz serves as ex officio chair of the Minnesota State Board of Investment and may influence appointments and decisions of the Minnesota State Retirement System and the Minnesota Public Employees Retirement Association.
A six-month look-back provision applies to new hires (or promotions to roles with “covered associate” status), such that prior political contributions of any new covered associate will trigger the rule’s provisions; a full two-year look-back provision will apply if the new covered associate will solicit clients on behalf of the investment adviser.
Rule 206(4)-5(a)(2)(i).
Rule 206(4)-5(d); Section 208(d) of the Advisers Act.
Rule 204-2(a)(18).
