Coming on the heels of a spate of state and SEC suits alleging investment adviser pay to play violations, and with the agency having proposed (but never finalised) similar rules in 1999 (see Political Contributions by Certain Investment Advisers, Investment Advisers Act Release No. 1812 (4 August 1999)) neither the fact of the new SEC proposals nor their general contours come as a surprise. The proposed rules follow closely the 1999 proposal. They proposed rules also are explicitly modelled on Municipal Securities Rulemaking Board Rules (MSRB rules) G-37 and G-38, parallel regulations applicable to broker-dealers in the municipal securities business.

There are three reasons for that, each of which is acknowledged more or less explicitly in the SEC's rule release:

Proposed rule 206(4)-5(a)(1) under the Investment Advisers Act would prohibit advisers from providing advisory services "for compensation," to a government entity (broadly defined to include all state and local – but not federal – government and government-sponsored agencies, instrumentalities, plans, programs, pools of assets, and so on) for a period of two years after the adviser or any of its "covered associates" makes a "contribution" to an "official" of the government entity.

The terms in quotation marks have the following meanings:

One effect of the proposed rules will be a new degree of caution when hiring personnel who may qualify as "covered associates" - likely resulting in pre-hire questionnaires around the topic of political contributions and political activity. This is because the proposal includes a "look back" provision that subjects the adviser to the two-year ban even if a covered associate of the adviser made the triggering contribution prior to employment with the adviser. Additionally, the two-year ban continues to apply to an adviser if the covered associate who made the contribution while with the adviser then leaves the firm. The two-year ban applies only as to government entities to whose officials contributions have been made. At least under these rules, an adviser would not be restricted, for example, in providing advisory services to a public pension plan in New York after the adviser's president made a contribution to a California official with influence over the selection of advisers for a California pension plan. (This assumes of course that no such contributions were made to New York officials.)

The proposed rules absolutely prohibit advisers and their covered associates from making or agreeing to make payments to unaffiliated third parties (such as placement agents or pension consultants) to solicit government business. "Solicit" is defined broadly to include any direct or indirect communication for the purpose of obtaining a client for or referring a client to an adviser.

This prohibition would not apply to solicitations by covered associates or personnel of the adviser itself or certain affiliates of the adviser or their employees, such that an adviser could pay a sister company under common control with the adviser to solicit government business.

Some states, including New York, have recently addressed the use by investment advisers of placement agents and other third party solicitors in seeking government advisory business. The New York Attorney General, for example, published a Public Pension Fund Reform Code of Conduct banning the use of placement agents, which was adopted by several advisers as part of out-of-court settlements in pay to play investigations (see, for example, Cuomo Secures Agreement with Leading Pension Fund Advisor Pacific Corporate Group Holdings to Adopt Code of Conduct and Eliminate Pay-to-Play in Pension Funds Nationwide, where the adviser is providing or seeking to provide advisory services.)

Both the proposed SEC rules in this area and the New York Attorney General's code of conduct leave a number of ambiguities, not least that the New York code of conduct prohibits the use of "placement agents" without defining the term. Those ambiguities and the fact that intermediaries serve an important market function for both advisers and their potential clients that is not readily severed suggest that the solicitor ban – although it probably will generate less near-term attention than the political contribution rules – will take longer for the industry to both make sense of and ultimately come to terms with.

The proposed rules also prohibit advisers and their covered associates from soliciting or co-ordinating contributions to an official or payments to a political party of a state or locality.

This prohibition would restrict an adviser from, for example, "bundling" de minimis contributions of its covered associates. Like payments to third party solicitors, such adviser solicitation and co-ordination is completely banned under the proposed rules (meaning that more is at stake than a two-year ban).

The SEC would require registered advisers to invest to maintain certain new records if they:

(Unregistered advisers get a pass on this aspect of the proposal, but presumably are expected to keep similar records as a basic compliance practice.)

The new required records would include:

There are a number of exceptions:

Discussion of the proposed rules is likely to revive issues and concerns that were raised by the SEC's earlier 1999 rule-making. It therefore is useful to go back to that record and review the comment files generated then. In summarising those comments, the SEC says the following:

Our own review of the 1999 comment record turns up some interesting themes:

Letters from advisers objected to, among other things, the length of the ban, the "look back" provision in which contributions made by an individual at a prior employer carry over to taint the current employer, and the limited size and scope of the de minimis exception.

The prospect of a hard ban on using third party solicitors drew repeated comment (with an outsize impact on smaller investment advisers especially feared) (for example, Wesley Ogburn, Portfolio Manager, Stanford Management Company (Stanford University Endowment), Menlo Park, California, 4 August 2009 (noting a possible disproportionate effect on smaller investment advisers that often rely on third party solicitors and cannot afford an extensive internal marketing and sales staff)).

One letter, in particular, stands out for the size of the organisation and the compliance approach the firm said it would have to adopt. The firm argued that distinguishing who is and is not a covered person from day to day and which donations do and do not qualify for exceptions was sufficiently complex, and the penalty for a misjudgment (that is, the two-year ban) so harsh, that its response would have been a flat prohibition on every employee from making any political contributions or engaging in volunteer political activity (comment letter from Andrew J. Bowden, Deputy General Counsel and Vice President, Legg Mason, Inc., 1 November 1999).

The Federal Election Commission also weighed in. While the rules generally are not applicable to federal officials, state officials running for federal office would be covered, causing members of the FEC to comment that application of pay to play rules to federal campaigns impermissibly encroaches on the exclusive domain of the Federal Election Campaign Act of 1971 (comment letter from Darryl R. Wold, Vice Chairman, Lee Ann Elliott, Commissioner and David M. Mason Commissioner, Federal Election Commission, 1 November 1999).

Again, the public comment period ends 6 October 2009. Meanwhile Shearman & Sterling will continue to monitor and report on the rule proposal. For further information, click here.