By Ari Berman and Nikolay Vydashenko

Yesterday, the U.S. Securities and Exchange Commission (SEC) published its new rules to curb the abuses of “pay-to-play” practices involving investment advisers who manage assets of government entities — most often, state or municipal public pension funds.

The SEC’s new “pay-to-play” rules contain three key components.

First, the rules bar, with certain limited exceptions, an investment adviser from providing government entities with investment advice for two years if the adviser (or certain of its employees defined in the rule as “covered associates”) makes a campaign contribution to an elected official or candidate who is in a position to influence the selection of the adviser.

• The investment adviser and covered associates are prohibited from directing third parties to make contributions that would otherwise trigger the bar if made by the adviser or covered associates
• The investment adviser and covered associates may not, without triggering the two-year bar, solicit another person or a political action committee to (1) make a contribution to an elected official or candidate who can influence the selection of the adviser; and (2) make a payment to a political party of the state or locality where the adviser is seeking to provide investment advisory services to the government entity.

Second, the rules impose limits on paying third-party placement agents to solicit a government entity on behalf of the investment adviser. Specifically, an investment adviser is prohibited from paying a third party, such as a placement agent, to solicit a government entity on behalf of the investment adviser, unless the placement agent is a SEC-registered investment adviser or broker-dealer subject to similar pay-to-play restrictions. Notably, the SEC’s initial proposed draft of these rules sought to prohibit investment advisers from using placement agents entirely. Private equity firms and hedge funds, along with placement agents, strongly opposed this proposal, and the SEC indicated it was persuaded by some of the arguments in their comment letters. Compliance with these limitations will be required within one year of the rules' effective date, which is 60 days after the rules’ publication in the Federal Register.

Third, the rules create a new books and records provision that obligates investment advisers to maintain records related to (1) government entities to which the investment adviser provides or has provided investment advice; (2) political contributions made by the investment adviser and covered associates; and (3) third-party placement agents used by the investment adviser to solicit business from a government entity.

The SEC’s new rules follow in the wake of the New York Attorney General’s well-publicized investigation into misconduct involving “pay-to-play” practices at New York Common Retirement Fund and the SEC’s parallel investigation of the same conduct. 

In light of these developments, private equity firms and hedge funds may want to consider taking the following actions:

• Review and enhance compliance materials and fundraising guidelines to guard against even the appearance of impropriety in connection with fundraising from public sources (including regulating employees’ and their immediate families’ political contributions)
• Increase diligence efforts with respect to placement agents, such as engaging outside providers to conduct background checks on potential placement agents and to ensure proper registration of placement agents and their representatives
• Revisit engagement letters with placement agents to ensure comfort with representations made by placement agents
• Ensure proper disclosures to public pension funds or others regarding retention and payment of placement agents.

For more information, please contact Vinson & Elkins lawyers Cliff Thau, Ari Berman, or Nikolay Vydashenko. Visit our website to learn more about V&E's Securities Litigation and Enforcement practice,  or e-mail one of the practice contacts.