With Election Season Upon Us, Ethics Counsel Should Remain Vigilant About the SEC’s Pay-to-Play Rules

Shareholder Advocate Spring 2024

May 2, 2024

With the 2024 general election only eight months away, now is a good time for ethics and compliance counsel of public pension funds to refresh their understanding of the Securities and Exchange Commission’s (“SEC”) Rule 206-4(5) under the Investment Advisers Act of 1940. It’s also a good time to remain vigilant about this so-called “Pay-to-Play Rule” and its implications.

Enacted in 2010, the SEC’s Pay-to-Play Rule limits investment advisors from making political contributions to certain state and local government officials and candidates who possess the authority to influence the selection of an investment manager for public pension funds. It should be noted that the Pay-to-Play Rule does not extend to federal officials and candidates. There is an exception to this rule when a certain state or local official is running for federal office. For example, if the Governor of California decides to run for the President of the United States, they would be limited from receiving political contributions from investment advisors because the governor has appointment authority over the California Public Employees’ Retirement System. In fact, this scenario played out in the 2012 presidential election. According to Washington Post columnist Dan Balz, Republican presidential nominee Mitt Romney eliminated Governor Chris Christie of New Jersey from his vice-presidential short list because Governor Christie would be prohibited from raising money from financial institutions under the Pay-to-Play Rule (Romney also asked Christie to resign as governor, but he refused to do so).

The Pay-to-Play Rule does not extend to every investment advisor. Specifically, the rule applies to political contributions by “covered associates,” who may be defined in two ways: (1) general partners, managing members, or executive officers of an investment advisor; and (2) employees who solicit a government entity such as a public pension fund for the advisor, directly or indirectly. The application of the rule may be tricky because it requires determining what investment advisor directly or indirectly supervises a covered associate. On its face, independent contractors may appear outside of the rule; however, an investment advisor may also indirectly supervise them, thus falling under the rule.

The Pay-to-Play Rule also puts in place a two-year “cooling off” period during which an advisor is prohibited from receiving compensation from a public pension fund for two years after an advisor or “covered associate” makes a political contribution. Again, there is an exception: the rule allows an advisor or “covered associate” to make de minimis contributions: (1) $350 per election cycle for candidates running for offices that the advisor can vote for; and (2) $150 for other candidates.

Here again, the rule can be tricky to apply because the rule extends to an individual who is not a covered associate at the time of the contribution but then becomes a covered associate during the two-year time period. For example, in 2022, the SEC fined the Asset Management Group of Bank of Hawaii where a similar set of facts occurred. According to the SEC’s administrative proceedings, in July 2018, an officer of the Bank of Hawaii, as a noncovered associate, made a $1,000 contribution to the then[1]governor of Hawaii. Three months later, the officer became an indirect supervisor of the bank’s Asset Group, which provided investment advisory services. This change in role converted the officer from a non-covered associate to a covered associate. The SEC determined that the Asset Group of Bank of Hawaii violated the Pay-to-Play Rule because the now covered associate or former bank officer made a political contribution to the governor of Hawaii during the “cooling off” period. The governor of Hawaii possesses the authority to influence the investment advisory services for the University of Hawaii, a client of the investment manager. As a result, the SEC prohibited the investment management firm from receiving advisory fees from the University of Hawaii.

Therefore, ethics and compliance counsel of public pension funds should take three steps going into the election season. First, ethics counsel should proactively communicate with investment managers about the Pay-to-Play Rule, encouraging such managers to identify “covered associates,” adopt preclearance policies, and carry out period compliance checks about campaign contributions to certain state and local officials. Second, ethics counsel should identify a list of local and state elected officials or candidates that possess authority to appoint or influence their pension fund. Finally, ethics counsel should consider reviewing and updating placement agent forms, including disclosures of political contributions under the Pay-to-Play Rule. A “placement agent” may be defined as an internal or external employee to an investment advisor that does marketing on behalf of the investment manager. In some instances, this may not apply since certain states and pension funds have banned the use of placement agents. Taking these proactive steps will provide public pension funds with assurances that there are no compliance concerns.