New ‘National Examination Risk Alert’ Issued by the SEC Re: Compliance with Political Contribution ‘Pay-to-Play’ Rules in Municipal Securities

On August 31, the U.S. Securities and Exchange Commission (SEC)’s Office of Compliance Inspections and Examinations issued a National Examination Risk Alert¹ directed to improve compliance with Municipal Securities Rulemaking Board (MSRB) Rule G-37 and G-38, rules concerned with restricting the political contributions of underwriters and other professionals in the municipal bond market to officials of issuers (i.e., a municipality that issues bonds) with whom they are doing or seeking to do business (i.e., “pay-to-play” issues).

Rule G-37 generally prohibits MSRB-registered brokers, dealers or municipal securities dealer firms from engaging in “municipal securities business” with an issuer for two years² after any contributions have been made to an official of such issuer by the firm, a “municipal finance professional” (MFP)³ associated with the firm, or a political action committee controlled by the firm or MFP (a “controlled PAC”). There is an exception from this prohibition for contributions of $250 or less (per election) made by an MFP to an official of an issuer for whom the MFP was entitled to vote (generally referred to as a “de minimis contribution”). MSRB Rule G-38 prohibits a regulated firm from making any payment, directly or indirectly, to any person who is not an affiliated person of the firm to solicit municipal securities business (as defined in Rule G-37) on behalf of such firm.

Concerns expressed due to the observations of SEC examiners include:

• compliance failures relating to not observing Rule G-37’s ban on doing business with a municipal issuer within two years of a political contribution to officials of the issuer by firm MFPs
• recordkeeping violations, including failures to maintain accurate and complete lists of MFPs and non-MFP executive officers as required by MSRB Rule G-8
• reporting failures, including failures to file full and complete Form G-37s that identify all municipal securities businesses in which a firm is engaged and the political contributions made to issuer officials by MFP and non-MFP executive officers, and
• inadequate supervision (including failures by firms to follow the procedures designed internally to help ensure such firms’ compliance with pay-to-play rules).

SEC staff “observations” (which may be seen as potential suggestions, despite a disclaimer in the alert that they are noted for informational purposes only and not intended as an endorsement of any particular practice) of steps taken by certain firms with respect to pay-to-play prohibitions under MSRB rules as well as other applicable legal requirements include:

• Training to MFPs. Many firms provide and document regular training for MFPs on the requirements of MSRB Rules G-37 and G-38. Training can be an important supplement to surveillance, especially during years in which political contributions are likely to be higher, such as presidential election years.
• Self-certification. Some firms also require MFPs, non-MFP executive officers and employees who could become MFPs (as a result of a potential promotion, contemplated adjustment to their role within the company, etc.) to certify on an annual or other periodic basis that they understand and are abiding with firm political contribution policies.
• Surveillance. Some firms independently search public records (e.g., http://www.fec.gov/ and a number of non-governmental sites) to ensure that their personnel are accurately reporting their political contributions. Some firms may also screen e-mails and other communications to check for evidence of unreported contributions.
• Two-Year Look-back. Some firms have procedures that subject select non-MFPs (who may later become a MFP) to full firm requirements – something that can help to mitigate the impact of “look-back” issues.
• Separation of Functions. Some firms provide separation between, on the one hand, functions such as pre-clearance, look-backs, or surveillance, and on the other hand, functions that could influence an employee’s terms of employment, such as management and human resources. This separation may help avoid the possibility that an adverse action could be taken based on the employee’s political preferences.
• Pre-Clearance. Many firms require pre-clearance of political contributions by MFPs, a process that may involve approval from a firm’s compliance department or similar group. Some firms require some level of pre-clearance of political contributions beyond just MFPs, sometimes with different thresholds for employee pre-clearance based on factors such as the employee’s status and the particular functions or activities for which the employee is responsible. At higher risk levels, a firm may require pre-clearance of all political contributions, including federal ones, since a federal official may be running for a state office, while at lower risk levels a firm may only require pre-clearance of contributions in connection with local political races. Some firms apply a similar risk analysis to determine whether to require pre-clearance of political contributions by immediate household members of certain employees.
• Restrictions on Political Contributions. As an alternative or complement to pre-clearance, and while not required by MSRB rules, some firms have chosen to prohibit any non-de minimis political contributions by MFPs or prospective MFPs as a condition of employment, to the extent permitted by state or local law. Not all jurisdictions may allow such a blanket limitation.

Pepper Point: SEC Rule 206(4)-5 under the Investment Advisers Act of 1940 was closely modeled on Rule G-37 and G-38 (although the “third-party solicitor”-related portion of the SEC rule is still in a degree of flux, in part due to issues of who may be required to register as a “Municipal Advisor”). Rule 206(4)-5 is applicable to all SEC registered and many legally unregistered investment advisers. A major motivation in analyzing the G-37 and G-38 practices and failures of MSRB-registered firms is likely the goal of providing guidance to investment advisors as to how to effectively comply with Rule 206(4)-5.

¹ The alert, available at http://www.sec.gov/about/offices/ocie/riskalert-munipaytoplay.pdf, is the fourth this year and the sixth in a continuing series of Risk Alerts that the SEC’s examination staff began issuing in 2011.

² Rule G-37 contains “look-forward” and “look-back” provisions. The basic look-back period is two years. This period starts to run from the making of a non-de minimis contribution to an official of the issuer by the firm, by an MFP primarily engaged in municipal securities representative activities or solicitation activities associated with the firm, or by a controlled PAC. During this two-year period there is a ban on engaging in municipal securities business with that issuer under MSRB Rule G-37(b)(i). The look-forward period is one year. During this period, which starts to run with the last activity or position that created MFP status for an individual, that person retains his or her status as an MFP. For persons who are MFPs solely by virtue of their supervisory or management-level activities, the look-back is shortened to six months under MSRB Rule G-37(b)(iii) and the look-forward is one year. For someone who is an MFP solely because of solicitation activities, MSRB Rule G-37(b)(ii) provides that the only contributions made by him or her to officials of an issuer during the two-year look-back period prior to becoming an MFP that would result in a ban on business would be those non-de minimis contributions made to an official of an issuer from whom such person has solicited business.

³ An MFP is generally defined to include:
-any associated person of a firm that primarily engages in municipal securities representative activities
-any associated person who solicits municipal securities business
-any associated person who is both a municipal securities principal or a municipal securities sales principal and a supervisor of any of the persons described in the two bullets above
-certain supervisors, up to and including the CEO or similarly situated official or the officer(s) of a bank designated by the board of directors of the bank as responsible for the day-to-day conduct of the bank’s municipal securities dealer activities, and
-any associated person who is a member of the firm’s executive or management committee or similarly situated officials, if any.