The SEC Proposes To Rescind Pay-To-Play Rule

The SEC proposed to rescind the “pay-to-play” rule, Advisers Act Rule 206(4)-5 (the “Rule”), that prohibits registered and exempt investment advisers from providing compensated investment advisory services to a government client for two years following even a small political contribution to certain elected officials or candidates.[1]The SEC also proposed to rescind a related Books and Records Rule provision, paragraph (a)(18) of Rule 204-2. We do not expect many advisers would miss the Rule.

Advisers Act Remains Intact

Otherwise, the Advisers Act and associated rules, including broad prohibitions on fraud, fiduciary duty requirements, the compliance rule[2], and the code of ethics rule[3], would continue to apply and would likely be sufficient to deter activity the Rule was intended to address.

Pay-To-Play: Unintended Consequences

The Commission determined that the Rule, adopted in 2010, led to significant unintended consequences, such as prohibitions by some advisers on political contributions at the state and local level. Advisers found the Rule operationally challenging; they also found that it created a de facto strict liability standard, where small donations or “foot faults” triggered substantial prohibitions and fines.

The Commissioners Concur

“After more than 15 years of experience administering the ‘pay-to-play’ rule, it is clear that it is overly prescriptive and has produced a host of unintended consequences. Beyond operational implementation challenges, it has imposed serious penalties for small, often impulsive donations to candidates in both parties, and routinely punishes and handicaps advisory firms for an employee making a donation even before joining the business. Furthermore, advisers’ implementation of the rule has effectively resulted in the suppression of political speech,” said SEC Chairman Paul S. Atkins in a statement. “Ultimately, matters involving political contributions are more properly governed by local ordinances, state laws, and federal election regulations—not by the SEC.” Statements by Commissioners Peirce and Uyeda similarly advocate for full rescission of the Rule.

Traditional SEC Tools Are Sufficient

Importantly, fraudulent pay-to-play practices such as quid pro quo payments and kickbacks were unlawful under the Advisers Act and other State and Federal laws before the Rule was adopted and would remain unlawful following its rescission.[4] Registered investment advisers would continue to be required to maintain policies and procedures reasonably designed to prevent fraudulent pay-to-play practices, to satisfy their fiduciary obligations to assess and mitigate pay-to-play risks, to adopt codes of ethics reflecting those obligations, and to reasonably supervise persons under their supervision with a view to preventing violations.

State And Local Law Remains

Independent of the Rule, many States and municipalities have pay-to-play and related laws: For example, New York State Common Retirement Fund (“CRF”) may not allocate to an investment manager that uses the services of a placement agent or other intermediary to assist the manager in obtaining an allocation from CRF.[5]The Release also cites applicable statutes in Connecticut[6], Maryland, New Jersey, Rhode Island[7], South Carolina and Philadelphia.Individual pension plans may have policies and procedures that are similar to the requirements of State or municipal legal requirements.

Dual Registrants Have Similar Prohibitions

Other sources of pay-to-play legal requirements apply to managers that are dually registered.Exchange Act rule 15Fh-6, for example, imposes political contribution restrictions on security-based swap dealers that are similar to the Rule. Under the MSRB Political Contribution Rule (rule G-37), brokers, dealers, municipal securities dealers, and municipal advisors are subject to a two-year prohibition on engaging in municipal securities business or municipal advisory business, if they made certain contributions to officials of municipal entities within the preceding two-year period, with a shorter six-month lookback period for certain personnel, and an exception for de minimis contributions. MSRB rule G-38 prohibits brokers, dealers, and municipal securities dealers from paying persons who are not affiliated persons for solicitation of municipal securities business on their behalf. The Rule was modeled on MSRB rules G-37 and G-38.FINRA adopted “substantially equivalent” rule 2030 and a related recordkeeping rule, rule 4580, to enable its member firms to continue to engage in distribution and solicitation activities for compensation with government entities on behalf of investment advisers following the adoption of the Rule.Commodities based swap dealers are also subject to CFTC’s Rule 23.451.

Pay-To-Play Policies And Procedures Revisited

If the Rule is rescinded, advisers who provide or seek to provide investment advisory services to State or local governments should tailor their compliance policies and procedures and the standard of business conduct contained in their code of ethics to address their particular pay-to-play risks. The compliance rule does not enumerate specific elements that an adviser must include in its policies and procedures.Rather, it provides an adviser with flexibility to apply the rule in a manner best suited to its organization. In designing its policies and procedures, an adviser should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations, and then design policies and procedures that address those risks. Some advisers who provide or seek to provide investment advisory services to State or local governments may replace policies and procedures established pursuant to the Rule with policies and procedures tailored to address their pay-to-play risks. Others may determine, after assessing their pay-to-play risks, to maintain policies and procedures established pursuant to the Rule. Following rescission of the Rule, to the extent an adviser provides or seeks to provide investment advisory services to State or local governments and determines to update its compliance policies and procedures, identifying factors creating pay-to play risk exposure particular to the adviser and its clients in light of its particular business needs, organizational structure, and the nature of its business, would be relevant to making this update. Below are several factors to consider:

• Compliance with applicable law. The adviser’s policies and procedures need to address pay-to-play practices that violate the Advisers Act. For purposes of efficiency and cohesiveness of internal policies, the adviser could leverage these policies and procedures to address its compliance with political donation and other relevant anti-corruption laws and regulations (including any State or local laws and regulations or other applicable Federal laws) governing the adviser’s existing or prospective public pension plan clients.

• Risk identification. The adviser’s policies and procedures need to identify and assess the risk of adviser personnel engaging in pay-to-play practices (including by making contributions to government officials, political parties and political action committees) that violate the Advisers Act, and may consider identifying and assessing those risks that violate other applicable laws in connection with an award or retention of investment advisory services (including through an investment in the adviser’s advised funds). Pay-to-play risks vary substantially across different types of advisers and the adviser’s policies and procedures need to take into account these risks (such as the size of the adviser’s investment and business development teams; indirect conduct such as structuring transactions intended to hide the true purpose of a contribution or payment using third-parties, such as consultants, attorneys or friends, to hide the true source of the donation). Factors that might affect an adviser’s risk assessment include:

• Governmental relationships. Whether the adviser has an existing relationship with one or more government entities or officials or whether the adviser is seeking to provide investment advisory services to such entities and, if so, whether any contributions or related activities should be analyzed to assess the adviser’s risk.

• Personnel. The nature of the position of any personnel making a contribution (advisory, senior level decision makers, or business development personnel versus back-office or clerical employees) and the associated risk and whether any personnel carry heightened pay-to-play risks for other reasons (including their history of contributions).

• Pre-clearance. Pre-clearance of contributions may be advisable. The adviser could consider whether to maintain reports documenting contributions by personnel to help identify pay-to-play risk depending on the nature of its business. A small adviser could determine it does not need a pre-clearance program. Alternatively, a large adviser with multiple advisory contracts with public pension plans could determine it is appropriate to have a pre-clearance system for contributions similar to pre-clearing personal securities transactions.

• Risk mitigators. After identifying conflicts and other compliance factors creating pay-to play risk, the adviser needs to design policies and procedures to address those risks. Perhaps an adviser’s personnel could make contributions during a particular low risk window. Or perhaps the policies and procedures could set forth contribution thresholds, including where contributions falling under such a threshold would not be subject to all or certain elements of the adviser’s policies and procedures such as a preclearance requirement.

• Third-party solicitors. To the extent an adviser uses third-party solicitors, the adviser needs to address pay-to-play risks associated with such practices. Perhaps such engagements should be approved by the adviser’s CCO. Perhaps any third-party solicitating government business on behalf of the adviser should be a registered investment adviser, registered broker-dealer, security-based swap dealer, or registered municipal adviser who has not made a political contribution to the government entity it is soliciting.

• Periodic monitoring. Periodic monitoring of compliance with and the effectiveness of any elements an adviser has included with respect to pay-to-play conduct, could be part of the adviser’s overall review of the effectiveness of the implementation of its policies and procedures under the compliance rule.Periodic monitoring could include periodic audits of pre-clearance requests against a report documenting contributions by personnel to ensure compliance with its pre-clearance process, or other required protocols.

• Remedial steps. The adviser needs to include in its policies and procedures steps to address contributions that are inconsistent with its policy. The policies could require seeking the return of contributions within a specific timeframe or potential disciplinary actions against employees that violate the policies. The code of ethics rule does not require an adviser to adopt a particular standard of business conduct. Rather, it requires that the standard an adviser chooses reflect its fiduciary obligations and require compliance with the Federal securities laws. An adviser that provides or seeks to provide investment advisory services to State or local governments needs to review and adjust its code of ethics to include a standard of business conduct that aligns with any policies and procedures the adviser adopts under the compliance rule in the context of its pay-to-play risks.

Conclusion

State and local government employee retirement funds have nearly $10 trillion in financial assets and Federal government employee retirement funds have close to an additional $5 trillion in assets.[8] Few investment advisers would not want the opportunity to manage a portion of those assets.In a post Advisers Act Pay-To-Play Rule world, to be eligible to do so, advisers must be aware of and avoid running afoul of individual pension plan policies as well as State, local and other applicable Federal laws.Tailored compliance policies and procedures combined with vigilant monitoring will remain the best path forward.

The public comment period on the proposal is open until November 9, 2026. The link to provide a comment is here.

This article is provided for general informational purposes and does not constitute legal advice. Please contact us to discuss how these developments may apply to your business.

[1] See Investment Advisers Act Release No. 6994 (the “Release”).

[2] Rule 206(4)-7.The compliance rule requires, among other things, that registered investment advisers have written policies and procedures reasonably designed to prevent violations of the Advisers Act and that are reviewed at least annually.

[3] Rule 204A-1. The code of ethics rule requires, among other things, that a registered investment adviser maintain a written standard of business conduct that reflects the adviser’s fiduciary obligations and requires that supervised persons comply with applicable Federal securities laws.

[4] See, for example, SEC v. Paul J. Silvester, et al., Lit. Rel. No. 16759 (Oct. 10, 2000) and SEC v. Henry Morris et al., Lit. Rel. No. 21036 (May 12, 2009).See Release footnote 15 for additional SEC enforcement actions.

[5] See Release footnote 115.

[6] See Release footnotes 112-115.

[7] See Release footnotes 48-50.

[8] See Release footnote 123.