Pay-to-Play: FINRA Requests SEC Approval of Proposal to Regulate Political Contributions

by Dechert LLP
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The Securities and Exchange Commission (“SEC”) recently published for comments rules proposed by the Financial Industry Regulatory Authority, Inc. (“FINRA”) and the Municipal Securities Rulemaking Board (“MSRB”) to regulate political contributions. FINRA proposed Rule 2030 closely follows Rule 206(4)-5 under the Investment Advisers Act of 1940 and would apply to political contributions by member firms that, for compensation, engage in distribution or solicitation activities with government entities on behalf of certain investment advisers, while FINRA proposed Rule 4580 would impose certain related books and records requirements. See Release No. 34-76767. Revised MSRB Rule G-37 would extend the current Rule G-37 to municipal advisors that are engaged as third-party solicitors or engage in municipal advisory business, while revised Rules G-8 and G-9 would apply current MSRB books and records rules to municipal advisors. See Release No. 34-76763 (December 23, 2015). Comments on proposed Rules 2030 and 4580 and revised Rules G-37, G-8 and G-9 are due on January 20, 2016.

Purpose and Scope

Rule 206(4)-5 was adopted by the SEC in 2010 in the wake of corruption scandals involving public pension plans. This rule prohibits investment advisers from providing advisory services for compensation to a government entity for two years after the adviser or its “covered associate” makes a political contribution to an “official” of the government entity, defined to include “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, if the office” can influence the hiring of an investment adviser. The SEC rule also prohibits investment advisers from coordinating or soliciting third-party contributions to government entity officials and doing anything “indirectly” they could not do “directly.” Rule 206(4)-5 is patterned after the current Rule G-37, adopted in 1994.

Although the SEC first considered banning placement agents from soliciting public pension plans, Rule 206(4)-5 instead prohibits an investment adviser from making payments to a third-party for soliciting government entities unless the third party is subject to a “substantially equivalent” rule regarding political contributions. Recently, the compliance date for this provision was postponed indefinitely pending the adoption of new rules by FINRA (concerning broker-dealers) and the MSRB (concerning municipal advisors).

The long-expected FINRA rule would now expand the scope of current pay-to-play regulation by imposing substantially equivalent restrictions on FINRA member firms that qualify as “covered members.” A covered member is “any member except when that member is engaging in activities that would cause the member to be a municipal advisor”. Proposed Rule 2030 would therefore bar broker-dealers from receiving compensation for distribution and solicitation services from a government entity for two years after a prohibited political contribution to an “official” of such entity, with “official” defined as in the SEC rule, above. In this context, FINRA defines “solicit” as communications for the purpose of obtaining, retaining, or referring a client to an investment adviser. However, FINRA specifically declined to define the meaning of “distribution,” which generally refers to distribution services involving pooled investment vehicles. The SEC recommends that FINRA clarify this term.

In complement, the revisions to MSRB Rule G-37 would impose the substantially equivalent ban on municipal advisors, many of which are also FINRA members. A FINRA member firm “that solicits a government entity for investment advisory services on behalf of an unaffiliated investment adviser may be required to register with the SEC as a municipal advisor as a result of such activity.” Revised Rule G-37 would apply to the unaffiliated broker-dealer. On the other hand, if a FINRA member firm solicits a government entity on behalf of an affiliated investment adviser, such activity would not cause the broker-dealer to have to register as a municipal advisor. That member firm would be a “covered member” subject to the requirements of proposed Rule 2030.

Two-Year Time Out

Proposed Rule 2030 would prohibit FINRA covered members from engaging “in distribution or solicitation activities for compensation with a government entity on behalf of an investment adviser . . . within two years after a contribution to an official of the government entity is made by the covered member or a covered associate.” The proposed rule also prohibits soliciting or coordinating third-party donations to officials and political parties where the FINRA member is engaging in or seeking to engage in distribution or solicitation activities on behalf of an investment adviser.

Similar to the SEC regulation, proposed Rule 2030 defines a “covered associate” as: “a) any general partner, managing member or executive officer, or other individual with a similar status or function; b) any associated person of a covered member who engages in distribution or solicitation activities with a government entity for such covered member; c) any associated person of a covered member who supervises, directly or indirectly, the government entity distribution or solicitation activities of a person in subparagraph (b).”

Revised Rule G-37 would impose substantially the same two-year time out on municipal advisors engaging in “municipal advisory business” with a municipal entity with advisor or dealer selection influence for two years following the making of a political contribution by the advisor or a municipal advisor professional to an official, defined as in Rule 206(5)-4, of the municipal entity.

Look-Back

Consistent with Rule 206(4)-5, proposed Rule 2030 and revised Rule G-37 would each apply a “look back” whereby political contributions made by a person who becomes a covered associate or municipal advisor professional in the two years prior to his obtaining that position are attributed to the member firm or advisor for the purposes of the above time out. However, the look back period under each proposed rule is only six months for certain new associates and professionals who are not directly involved in distribution or solicitation activities or municipal advisory work.

Exceptions

Like the SEC rule, proposed Rule 2030 includes de minimis exceptions for a $350 contribution to any one official for whom the covered associate is entitled to vote and a $150 contribution for any other official, per election cycle.

The MSRB did not, however, propose to raise Rule G-37’s de minimis exception from its current ceiling of $250 to any one official for whom the contributor is entitled to vote, per election cycle.

Exemptions

As proposed, FINRA member firms would be permitted to apply to FINRA for an exemption from the two-year time out if the firm discovers the contribution and seeks to cure the violation if the imposition of the time-out would be unnecessary to achieve the proposed rule’s intended purpose. FINRA would take varying facts and circumstances into account in deciding whether to grant an exemption. The MSRB does not propose to change Rule G-37’s provision regarding exemptions and presumably, FINRA’s exemptive process would follow the same lines as those currently employed by the MSRB.

Disgorgement

As originally proposed, the FINRA rule would have automatically required the disgorgement of fees earned in the two years following a prohibited contribution. As now proposed, disgorgement is not automatic, but remains within FINRA’s authority. Disgorgement coupled with additional fines was the penalty imposed in previous enforcement actions brought pursuant to the SEC and MSRB regulations.

Books and Records

Proposed FINRA Rule 4580 would require FINRA members that engage in distribution or solicitation activities with a government entity on behalf of any investment adviser to maintain records that would allow FINRA to determine compliance with proposed Rule 2030. The proposed requirements for broker-dealers would be substantially similar to the current requirements placed on investment advisers. The MSRB also proposed revising G-8 and G-9, its pay-to-play books and records rules, so that they apply to municipal security advisors.

We recommend that firms consider which of the new rules will apply to their operations and begin preparations in advance of the (as yet unspecified) effective date of the new rules. Dechert has significant experience with the SEC and MSRB as well as state pay-to-play rules and would be happy to provide training on best practices regarding books and records or for associates and professionals.

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