Source: Google Gemini

In 2010 the Securities and Exchange Commission adopted a rule aimed at stopping pay to play political contributions by investment advisors that sought to do business with governments.  Rule 206(4)-5 followed 10 years of SEC investigations and enforcement actions in a number of states where advisors or third party placement agents sought to influence hiring by making political contributions to elected officials.

Before the SEC action there was an undercurrent of pay to play in the public funds investment industry.  Some investment advisors sought favor by making political contributions, others hired third party placement agents to gain introductions/access to public sector decision makers and some candidates for political office solicited contributions from investment advisors or broker/dealers.

No doubt some business was facilitated by payments and political-based access and some firms/individuals prospered using this business model.  Others sought to limit their marketing activities to comply with anti-fraud and fiduciary responsibility laws. Elected officials or candidates for public office might solicit advisors and broker/dealers—they were perceived as having deep pockets—and it was challenging to say “no.” Try to explain the intricacies of anti-fraud rules to someone who is fund raising for a mayor or governor.

As a practical matter before the rule was adopted there was a kind of sorting: some public agencies were characterized as places where political access could get you business.  Some firms played for this business.  Other firms did not compete for business at places that they deemed “political.”

Rule 206(4)-5 changed this.  It banned contributions by investment advisors and their employees to elected state and local government officials with some exceptions for contributions not exceeding $350 per election for whom an advisor representative was entitled to vote and $150 per election for other candidates.  It also provided for a two-year time-out for an advisor receiving compensation from a government entity after a non-compliant contribution is made and banned advisors and covered employees from soliciting or coordinating political contributions for covered officials or payments to state/local political parties. The rule also prohibited an advisor from paying   solicitors or placement agents unless they were regulated by the rule. A parallel rule enacted by FINRA applied to broker/dealer representatives.

The rules altered industry practices, particularly the involvement of elected officials in decisions related to investments.  Some participants in the public funds investment business observed that the rules reduced the influence of politics in their activities.  Some officials, particularly those who managed retirement funds, complained that the ban on unregulated placement agents reduced their access to certain types of investments, while representatives of the investment industry complained that the rules infringed on their rights and had significant compliance costs.

Rescinding the Rule

The SEC acted on September 3 to rescind the rule.  The proposal is subject to a 60 day public comment period after which the Commission will take final action.

Rolling back regulations is a strong Washington theme these days.  The SEC action aligns with the Trump administration’s push to roll back regulations generally and was supported by the three Republican SEC commissioners. (There are also two vacancies on the Commission that cannot be filled by Republicans.)     The Commission also has scaled back enforcement actions affecting the financial services industry, as has the Commodity  Futures Trading Commission.

The Rationale: Other Rules Are Sufficient to Limit Abuse

The SEC chair’s statement supporting the proposed recission called out other rules that he said were sufficient to limit abuse.  He noted that the SEC is not charged with regulating elections, that advisors are subject to anti-fraud and fiduciary standards and that there are parallel rules that apply to municipal securities professionals and broker dealers.  The reference to these parallel rules is odd because they do not apply to investment advisors.   

The chair also cited “unintended consequences” of the rule as the rationale for repeal. These consequences included limitations on First Amendment free speech—the rule led some firms to prohibit all political contributions by employee and in all events the amounts were limited—and operational challenges that were costly to advisor firms and led some firms to ban all contributions.  An economic analysis estimated the annual cost of the rule to be more than $400 million.  Eliminating this cost could lead advisors to charge less for their services.  The release supporting recission also posited that the rule might have led to some firms avoiding doing business with municipalities, thus limiting municipality access to advisors.

These arguments for repeal turned on their head the explanation made in favor of the rule in 2009 when it was proposed. At the time the SEC said “Pay to play practices could, for example, lead a political official to choose an investment adviser with higher fees or inferior investment performance because the adviser contributed funds to the official’s election campaign. Choosing an adviser with higher fees or weaker performance could harm retirees who rely on public pension plans.”

Some commentators have speculated that Rule G-37 of the Municipal Securities Rulemaking Board might be next on the chopping block because it contains substantially the same limits and mechanisms as Rule 206(4)-5, but there is no sign that the MSRB is considering this.  Moreover, in a bit of a head-turner the SEC noted that the continuation of G-37 and the similar FINRA rule  will limit pay to play if Rule 206(4)-5 is rescinded. (Put aside the pesky detail that it is an almost identical rule in a closely-related business.)

Bottom Line

The Commission is proposing to replace a bright line (a specific prohibition and specific de minimis exceptions that apply to mostly candidates for whom an advisor representative can vote) with a set of principles (“advisors are fiduciaries and must not commit fraud”).  Principles based regulation requires a financial firm to develop and apply limits tailored to the nature to its business.  These are contained in codes of ethics and compliance policies unique to each firm.  This may appear to ease the burden on firms, but the irony of this approach is that it may encourage the Commission staff to pursue what some call “regulation by enforcement.”  That’s a claim that some observers made about the efforts under the prior administration to pursue enforcement actions aggressively, pushing administrative settlements at or beyond the boundaries of regulations.   That is not likely under the current administration, but it could well become a reality in a future administration.

Some states and municipalities have similar rules limiting political contributions, requiring that they be reported, or requiring that potential contractors make certifications related to the use of consultants, involvement of officials who are outside of the normal contracting/procurement chain, etc.  Repeal of Rule 206(4)-5 could lead to added actions at the state and local level to deal with the issue or could lead to industry pressure to repeal these local bans.

In all events without the federal ban some advisors and their employees could engage in expanded political activities and elected officials may take a more direct interest in the hiring and management of advisors.   In a few words the work of investing public funds may be less insulated from politics.

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The proposal is subject to a  60 day comment period before the Commission takes final action.  Expect that industry representatives, some municipal agencies and associations representing state and local government will comment.  You can file comments or review those received  here.