A core part of running an advisory business is ensuring that your practice complies with regulatory guidelines set by the Securities and Exchange Commission (SEC). One such guideline, Rule 206(4)-5 or the SEC pay-to-play rule, governs what advisors can and can’t do when making contributions to political campaigns. Advisors who violate this rule could find themselves facing potentially steep civil penalties.
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What Is the SEC Pay to Play Rule?
Adopted in 2010, Advisers Act Rule 206(4)-5 is a regulatory guideline that applies to selected financial professionals, including SEC-registered investment advisors (RIAs) and advisors who are exempt from SEC registration but provide investment advisory services or intend to do so. The pay-to-play rule imposes “a limited ‘time-out’ on conducting advisory business for compensation with a government client after a contribution is made.”
In terms of its significance, the rule is designed to prevent advisors from engaging in activities that would allow them to secure contracts based on financial incentives, rather than merit. In passing the rule, the SEC asserted that pay-to-play arrangements have the potential to result in fraudulent conduct that could prove harmful to the beneficiaries of public pension plans.
The SEC gives an example of how this could play out. Say that an investment advisor makes a sizable campaign contribution to an elected official. The official then “rewards” the advisor with a contract to manage a public pension plan. However, the official bases their decision on the campaign contribution, completely overlooking the fact that the advisor charges higher than average fees while demonstrating a less than stellar track record of managing pension plan assets.
In this instance, the advisor benefits as does the official. However, the employees participating in the pension plan may suffer if the advisor mismanages plan assets or charges exorbitant fees which detract from earnings.
How SEC Rule 206(4)-5 Works
The SEC is clear about what type of activity is prohibited for advisors regarding campaign contributions. There are three specific directives laid out in the rule stating that investment advisors cannot:
- Provide advisory services in exchange for compensation to a government entity, directly or through a pooled investment vehicle, for two years after making political donations to an elected official or candidate for office if that individual or their office is capable of influencing the selection of said advisor to oversee government pension funds or investment accounts.
- Pay or agree to pay a third-party placement agent to solicit business from a government entity unless the third party is a registered broker-dealer or SEC-registered investment advisor who is subject to pay-to-play restrictions.
- Solicit or coordinate contributions from others to a political official, candidate or political party in a state or locality where they offer or plan to offer advisory services.
The rule specifies that advisors, their employees and covered associates can’t do anything directly or indirectly that would result in a violation. Advisors who are subject to the rule can, however, apply for an exemption. The SEC also imposes recordkeeping requirements on RIAs who are covered by the rule.
It’s important to note that the rule doesn’t ban political contributions made by advisors entirely, nor does it specify a limit on the dollar amount of contributions an advisor or covered associates can make. Instead, the first provision of the rule imposes a time limit on when an advisory can engage in business with a government client after making political contributions.
In terms of who the rule applies to on the receiving end of contributions, it’s aimed at state and local government officials, including those elected to office and those running for office. The SEC pay-to-play rule doesn’t apply to federal officials or candidates for the most part unless the candidate holds a position in state or local government at the time a contribution is received.
Penalties for Violating the SEC’s Pay-to-Play Rule
Running afoul of the SEC can be costly, as advisors who violate the pay-to-play rule can be subjected to fines. Fines can easily run into tens of thousands of dollars. The SEC can impose fines even in instances where the advisor or covered associate who contributes attempts to have it refunded after the fact.
In addition to civil fines, which can be costly, the SEC can require advisors who violate the rule to be subject to ongoing cease and desist orders. Advisors are also required to disclose violations of the rule in their regulatory filings, including Form ADV.
That could be damaging to your business’s long-term growth, potentially even more so than a civil fine. Prospective clients may be wary of working with an advisor who has a noted SEC rule violation on their record.
Maintaining Compliance With the Pay-to-Play Rule
Implementing a sound compliance policy is a safe way to stay on the right side of the SEC’s rules, including pay-to-play guidelines. Here are some tips to consider if you or your firm makes political campaign contributions.
- Pre-screen. Introducing a pre-screening process that requires compliance officers to review campaign contributions before they’re made can make it easier to spot potential rule violations. Applying pre-screening to all contributions, regardless of the amount or to whom they’re made, can ensure that nothing slips through the cracks.
- Report. The SEC requires advisors to maintain records of political contributions. Developing a standard reporting system that all advisors, executives and covered associates must adhere to can ensure compliance with this part of the pay-to-play rule.
- Train. Once you’ve created compliance guidelines regarding the pay-to-play rule, the next step is ensuring that all current employees are trained in how to follow them. The same applies to new hires joining the firm.
- Track. Tracking political contributions can get tricky if you have a larger firm, but it’s important to know who’s making campaign donations and where they’re making them. Employees should be encouraged to self-report both direct and indirect donations.
What happens if you implement compliance practices, but a violation occurs?
The first step is addressing the practices that lead to the violation and correcting them, so they’re not repeated. Your next step may be attempting to “cure” the contribution by seeking a refund of it. However, that’s not a guarantee that you can avoid coming under the scrutiny of the SEC, as there are limits on when you can do this. For that reason, it’s in your firm’s best interest to ensure that you’re following compliance practices accordingly at all times.
Frequently Asked Questions
What Is the Pay-to-Play Rule for Political Donations?
The SEC pay-to-play prevents investment advisors from offering their services in exchange for a fee to elected officials or political candidates within two years of making a campaign contribution. The rule is intended to prohibit advisors who make political donations from receiving preferential treatment in the awarding of government contracts.
Who Is a Covered Associate for Pay-to-Play Rules?
The pay-to-play rule applies to both investment advisors and their covered associates. Under SEC rules, a covered associate is defined as:
- Any general partner, managing member or executive officer
- Other individuals with a similar status or function
- Any employee who solicits a government entity on behalf of an investment adviser
- Any person who supervises any such employee, either directly or indirectly
The SEC interprets the term “employee” to include independent contractors acting on behalf of an investment advisor. Political donations made by the family members of an employee or covered associate are not specifically covered by these guidelines, but the rule does prohibit doing anything indirectly that would otherwise be a violation if done directly.
Are Foreign Governments Covered by SEC Pay-to-Play Rules?
No, the SEC rules do not apply to foreign governments. The rules are designed to primarily target political donations made at the state and local levels. Donations made to candidates for federal office can be covered if the candidate holds a state or local government position at the time campaign contributions are made.
Bottom Line
The SEC’s pay-to-play rule is meant to restrict advisors from engaging in unethical behavior with elected officials and those running for office at the state and local government levels. Firms that engage in making political donations should be aware of what can trigger a violation and the consequences that may follow.
Tips for Growing Your Advisory Business
- Gaining more clients is central to your success. If you’re looking for a way to grow your client base, you may consider working with an online lead-generation platform. SmartAsset AMP (Advisor Marketing Platform) is our holistic marketing service that financial advisors can use for client lead generation and automated marketing. Sign up for a free demo to explore how SmartAsset AMP can help you expand your practice’s marketing operation. Get started today.
- The SEC has strict rules regarding compliance that extend beyond the pay-to-play rule. If you’re a registered investment advisor or are thinking of starting an RIA firm, it’s to your advantage to fully understand the scope of what’s expected concerning compliance and the penalties for failing to observe regulatory guidelines.
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