With the 2024 elections fast approaching, investment advisers must continue to be mindful of political contributions by their personnel if they manage or intend to manage public pension plan¹ assets, among other compliance considerations. In particular, Rule 206(4)-5 under the Investment Advisers Act of 1940 (Pay-to-Play Rule) presents unique compliance challenges and imposes severe consequences for missteps, even in the absence of any quid pro quo arrangement.² As current state and local officials continue to declare their candidacies for various elective offices, advisers must be mindful of the offices that these candidates seek, as well as the offices that these candidates currently hold. Consider these potential candidacies:

• The current Governors of the States of California and Florida declare their candidacies for the President of the United States.
• The current Governor of West Virginia declares his candidacy to represent West Virginia in the U.S. Senate.

In each of these examples, a political contribution could trigger the application of the Pay-to-Play Rule because, at the time of the contribution, the recipient would hold an elective office that has influence over the selection of advisers that manage the assets of their state public pension plans, including the California Public Employees’ Retirement System (CalPERS) and the Florida Retirement System (FRS) Pension Plan. Non-de minimis contributions could preclude an adviser from collecting fees for managing public pension plan assets for two years.

Although the Pay-to-Play Rule frequently receives the most attention from compliance professionals, advisers will also need to navigate intermingling state and local laws, agency or public pension plan-specific policies and contractual obligations regarding political contributions and gifts, as well as procurement lobbyist registration requirements that may apply to an adviser and its personnel (e.g., sales and marketing personnel) and its placement agents. It is important that advisers investigate and understand these requirements in advance of communicating with public officials or their agents because, for example, registration as a procurement lobbyist may be required prior to contacting an official. Conversely, advisers that do business with a public pension plan may become subject to certain registration or reporting requirements with the applicable state, city or county or subject themselves to gift or other requirements. It is important that advisers be mindful of the possibility that they may be subject to such requirements as well.

This OnPoint provides a summary of considerations related to the Pay-to-Play Rule, lobbyist registration, gifts and use of placement agents, as well as additional disclosure requirements that may apply when an adviser manages public pension plan assets.

Pay-to-Play Considerations

The Pay-to-Play Rule prohibits an adviser from providing investment advisory services for compensation to a state or local public pension plan or other “government entity” for two years if the adviser or its “covered associates” make political contributions³ over a de minimis threshold to certain officials with authority over the government entity or officials who may appoint or influence such officials. This provision of the rule applies to an adviser that provides advisory services directly to a government entity (e.g., through a separately managed account) as well as indirectly through “covered investment pools.”⁴ The two-year prohibition on receiving compensation – colloquially known as a “time out” – also has an anti-circumvention provision such that the adviser and its covered associates are prohibited from doing anything indirectly that would be prohibited if done directly (e.g., directing a spouse or domestic/civil union partner to contribute to an official to avoid directly violating the Pay-to-Play Rule).⁵ The Pay-to-Play Rule imposes strict liability – that is, a non-de minimis contribution could trigger an automatic time out, even in the absence of any quid pro quo arrangement, although there is an exemption process if an adviser discovers a violation after it has already occurred.

The Pay-to-Play Rule is intended to apply to those categories of executives and employees that have an economic incentive to make contributions to influence an advisory firm’s selection.  For these reasons, the term “covered associate” is broadly defined and includes certain executive officers and employees of an adviser that solicit government entities as well as their supervisors, even if the supervisor formally resides within the adviser’s parent company or affiliate. A covered associate also includes a political action committee that is controlled by an adviser or its covered associates. Although the rule provides exceptions for de minimis political contributions, the de minimis thresholds are low and only apply to natural person covered associates.⁶

Importantly, the Pay-to-Play Rule attributes to an adviser the contributions made by a person within two years of becoming a covered associate of the adviser, regardless of whether the person was a covered associate, or even an associated person of the adviser, at the time the contribution was made.⁷ Accordingly, when an employee becomes a covered associate, including through outside hire, internal promotion or merger, the adviser must “look back” to that employee’s contributions to determine whether the adviser is subject to a time out. If the employee made a contribution less than two years before becoming a covered associate, the adviser is subject to a time out for the remainder of the two-year period. Advisers must also “look forward” with respect to covered associates who cease to qualify as covered associates or leave the firm. Accordingly, dismissing a covered associate that made the triggering contribution does not relieve the adviser from the two-year time out.

The Pay-to-Play Rule also prohibits advisers and their covered associates from:

• Soliciting from others (including political action committees) or coordinating:

1. contributions to an official of a state or local public pension plan or other government entity to which the adviser is providing or seeking to provide investment advisory services; and
2. payments to political parties in the state or municipality where the adviser is providing or seeking to provide investment advisory services; and

• Paying a third party (including an affiliate), such as a solicitor, finder or placement agent, to solicit a state or local public pension plan or other government entity on behalf of the adviser, unless that third party is a “regulated person” (generally, an SEC-registered investment adviser, municipal advisor or broker-dealer subject to similar pay-to-play restrictions).

The SEC staff has pursued enforcement actions under the Pay-to-Play Rule for contributions that were only marginally above the de minimis thresholds or were immediately returned following discovery. SEC Commissioner Hester Peirce recently criticized the Pay-to-Play Rule as “an exceedingly blunt instrument” that “does not require any evidence of an actual quid pro quo, or even evidence that the adviser was seeking a quid pro quo,” and noted that the rule “does not require any assessment of whether the official receiving the contribution realistically could influence the decision to hire an investment adviser, or whether the contribution itself reasonably could be expected to influence the official.”⁸

In light of the severe consequences for non-compliance and the strict liability attributes of the Pay-to-Play Rule, advisers should review their compliance policies and procedures and consider the following measures, among others:

• Identify who would be considered a “covered associate” under various pay-to-play laws, including the Pay-to-Play Rule, as well as other personnel whose activities the adviser may voluntarily wish to cover (e.g., individuals likely to be promoted to a position that would cause them to be a covered associate in the near future).
• Develop an in-take process for new employees that could be considered a “covered associate” to screen their political contributions during the prior two years (or six months, as appropriate).
• Identify and maintain a list of the current investors/clients and potential investors/clients of the adviser that may be “government entities.”
• Identify and maintain a list of public “officials” associated with these government entities that can influence, or appoint an individual who can influence, the decision to hire an adviser.
• Determine whether mandatory employee training and/or training materials regarding the Pay-to-Play Rule would be beneficial to all or some of the adviser’s personnel (e.g., politically active personnel), particularly during election seasons.
• Ensure that the existing policies and procedures are adequate for the scope of the adviser’s current and future operations, which may include a pre-clearance process to track and approve contributions, fundraising events and membership or leadership positions on any political action committee or other organization that makes political contributions.

Procurement Lobbyist Registration Considerations

Traditionally, lobbyists are known to seek to influence lawmakers or other policymakers within the legislative or executive branches of government, such as a state senator, treasurer or comptroller. In contrast, “procurement” lobbyists seek to influence the purchase of goods or services, which may include the contract for a public pension plan to invest in a pooled investment vehicle or a separate account. A public pension plan may be considered a government entity, which could make efforts to influence the plan’s procurement decisions subject to that jurisdiction’s procurement lobbying law. A procurement lobbyist could be internal personnel, the adviser itself or a traditional third-party placement agent. Procurement lobbying restrictions vary across states, counties, cities and the public pension plans themselves.

In analyzing the applications of a lobbying law to the adviser and its personnel, the questions that should be considered include:

• Is procurement lobbying covered by the applicable lobbying law, and if so, does it apply to public pension plans in that jurisdiction?
• Are there any relevant exceptions, such as competing in a competitive bidding process or providing information at the request of a public official?
• What are the minimum contact, contract value, contribution or expenditure thresholds that would trigger registration?
• Who is required to register, the employee, the firm or both?
• What is the timing of initial registration, for example, prior to contacting the public pension plan or within a certain amount of time after first contact, such as within five days of contact?
• If lobbyist registration is required, how is the registration submitted?
• Are there any periodic reporting or other requirements that are applicable to registered lobbyists?
• Are lobbyists prohibited from receiving compensation that is contingent on the success or outcome of the solicitation of a public pension plan?⁹

To comply with applicable lobbying laws, firms generally track their governmental clients and prospective clients, and either internally develop analysis, or purchase analysis from a law firm or other vendor, analyzing these lobbying questions discussed above. Dechert’s World Compass Procurement Lobbying Module is one such tool that provides this analysis, and is regularly updated to ensure that firms have the most up-to-date analysis in an easy to use format.

Gifts Considerations

Many states and localities have adopted laws that restrict the amount of “gifts” that may be given to a government employee or official and these restrictions would apply to an adviser and its personnel. These laws vary in scope – from an absolute prohibition to permitting a de minimis amount – and what is defined as a gift – from anything of value to specific items such as a sit-down meal. In addition to state laws, city or county public pension plans may be subject to city or county laws, as applicable, that have additional restrictions on gifts beyond those included in state law. Moreover, state and local government agencies and public pension plans may have adopted their own policies regarding gifts that may be more restrictive than the applicable laws. Individuals that are registered as procurement lobbyists may also be subject to more restrictive requirements. Regardless of legal requirements, advisers should be mindful of the potential impact to their reputation or public perception that gifts to government employees by their personnel may create.

Placement Agents

Several public pension plans have adopted forms that require disclosure of “placement agents” that have been used in connection with the plan’s investment. A “placement agent” may be defined broadly to include internal personnel of the adviser who engage in marketing activities. Some plans may also ban the use of third-party placement agents or restrict the payment of contingent compensation as a result of the plan’s investment. Accordingly, it is important to understand these requirements in advance of using a third-party placement agent to solicit new public pension plans.

Other Considerations

Advisers should also be mindful that public pension plans may have additional requirements that apply at the time a contract is entered into, such as registration with a particular state agency as a vendor of the jurisdiction of the plan, as well as ongoing disclosure requirements. For example, some plans may require annual disclosure of certain types of assets that individuals associated with the adviser own that are located within the jurisdiction of the public pension plan. Often, these requirements are subject to interpretation and can be difficult to navigate.

In addition, advisers should be mindful that any such disclosures and other information given to a public pension plan may be subject to public disclosure requirements.

Conclusion

The requirements applicable to a particular public pension plan often vary between plans. Navigating these requirements can be challenging and time consuming. Moreover, as the 2024 election cycle ramps up, political contributions to certain candidates may require special attention by advisers to ensure they remain compliant with all applicable rules.

Footnotes

1) References to public pension plans throughout this OnPoint refer generally to state and local public pension plans and other governmental entities in the United States.

2) Registered broker-dealers, municipal broker-dealers, municipal advisors and swap dealers are subject to similar pay-to-play restrictions under the federal securities laws. This OnPoint primarily focuses on the SEC’s pay-to-play rule – Rule 206(4)-5 under the Investment Advisers Act – that applies to SEC-registered investment advisers, exempt reporting advisers and foreign private advisers. For additional information, please see Dechert OnPoint, SEC Adopts “Pay-to-Play” Rule for Investment Advisers.

3) A contribution may include money or anything of value, including an “in-kind” contribution (e.g., providing one’s home to be used for a fundraiser). However, volunteer work would generally not constitute a contribution (and thus would not trigger a time out on the receipt of compensation under the Pay-to-Play Rule), provided: (1) the adviser did not solicit the volunteer’s efforts; (2) none of the adviser’s resources (e.g., office space and telephones) were used; and (3) the volunteer work occurred during non-work hours, the volunteer was using vacation time or the adviser did not otherwise pay the volunteer’s salary (e.g., the volunteer work occurred during an unpaid leave of absence).

4) The term “covered investment pool” generally includes hedge funds, private equity funds, venture capital funds and collective investment trusts, as well as registered investment companies (e.g., mutual funds) that are investment options of a participant-directed plan or program of a government entity (e.g., “529 plans”).

5) Political contributions to political parties, political action committees and similar committees and organizations raise unique considerations.

6) Each natural person covered associate can make a de minimis contribution of $350 or less to someone for whom the covered associate is entitled to vote at the time of the contribution, or $150 or less to someone for whom they are not entitled to vote, in each case, per official, per election. For purposes of the Pay-to-Play Rule, a primary election campaign and general election campaign are separate elections, and thus a covered associate may contribute up to the maximum permitted amount in each of such elections without triggering the rule’s time out provision.

7) The look back period is reduced to six months for covered associates who are not involved in the solicitation of clients.

8) SEC Commissioner Hester M. Peirce, Laudable Ends, Poorly Pursued: Statement Regarding Recent Pay-to-Play Rule Settlements (Sept. 15, 2022).

9) A number of jurisdictions prohibit the payment and/or receipt of compensation that is contingent on the outcome of the solicitation. This type of prohibition is generally inconsistent with many historical compensation practices involving internal and external sales and marketing personnel.