The Federal Securities Pay-to-Play Regulatory Framework is Complete - A Primer for Financial Services Firms

By Ernesto A. Lanza / Sep 29, 2016

On September 20, 2016, the Securities and Exchange Commission ("SEC") issued two orders effectively completing the federal pay-to-play regulatory framework for investment advisers, municipal advisors, underwriters of municipal securities, other broker-dealers, municipal advisors and dealers in derivatives doing business with state and local governments ("governmental entities") under rules of the SEC, Commodity Futures Trading Commission ("CFTC"), Financial Industry Regulatory Authority ("FINRA") and Municipal Securities Rulemaking Board ("MSRB").

The SEC orders, based on the August approval of new FINRA Rule 2030 on broker-dealers engaged in distribution and solicitation activities with governmental entities and the extension of MSRB Rule G-37 to include municipal advisors in addition to underwriters, declared that the prerequisites had been met to trigger the third-party solicitor provisions of SEC Rule 206(4)-5 on pay-to-play activities by SEC-registered investment advisers. The investment adviser third-party solicitation restrictions, which had been held in abeyance pending MSRB and FINRA rulemaking, are slated to become effective simultaneously with FINRA Rule 2030 in 2017.

While recent press reports on pay-to-play restrictions have focused on the implications of Indiana Governor Mike Pence's nomination as the Republican Vice Presidential candidate, that race is just one of thousands of situations at the local, state, and federal level where financial services firms face risks every election cycle to their business activities from wayward actions of their professionals or from lax compliance processes.

This Alert provides a brief high-level primer on the federal securities pay-to-play regulatory framework, while future Alerts will focus on specific aspects of these federal rules as applicable implementation dates approach or as events may warrant from time to time.

CORE PAY-TO PLAY RESTRICTIONS AND REQUIREMENTS 

Although each rule shares a common backbone, each also is targeted at a particular category of market participant engaged in a specific type of business with governmental entities - such as investment advisory services, underwriting and other broker-dealer activities, derivatives transactions, and municipal advisory activities. Each rule also includes unique aspects not seen in other rules. Many firms are subject to more than one rule and different personnel within such firms can be subject to the provisions of different rules. Compliance with a single pay-to-play rule can be extremely complex, such complexity quickly escalating if multiple rules apply to the same firm and to different but potentially overlapping groups within the firm. Since each rule has its variations, the description below is general in nature, and reference to specific rule language is required to determine the precise reach and operation of each particular rule.

Ban on Business and Types of Contributions Covered. The federal pay-to-play rules do not directly prohibit or limit political contributions. Instead, they prohibit firms from engaging in, or receiving compensation for, specified business activities with governmental entities if the firms or their relevant personnel, or political action committees ("PACs") controlled by either, make contributions to an incumbent or candidate for elective office with authority to hire such firms (or to appoint officials with such authority), with limited de minimis exceptions. This ban on business, sometimes referred to as a "time out," typically extends for two years after a triggering contribution, but can be longer.

The types of recipients of contributions typically covered by the rules include governors, state treasurers, mayors, county commissioners, city or town council members, school board members, and many other types of elected public officials involved in the process of selecting firms to engage in financial services business with governmental entities. Ultimately, the determination of whether a contribution is covered by the rules depends on the specific legal authority of a particular officeholder under state or local law.

Contributions to political parties or other political organizations do not result in a ban on business unless used as a conduit for making a contribution to one or a limited number of elected officials. Contributors may be able to obtain assurances from such parties or other organizations that contributions are not being earmarked for particular officials.

Prohibition on Solicitation and Bundling Contributions. The rules prohibit firms or their relevant personnel from soliciting others to contribute to, or from bundling contributions of others for, elected officials of governmental entities with which the firm is undertaking or seeking to undertake business. Unlike the ban on business, the prohibition on solicitation or bundling also covers contributions to political parties of the state or locality in which such business is sought or undertaken.

Restrictions on Solicitation of Business for Third-Parties. If any person or entity is paid to solicit governmental entities to hire firms subject to pay-to-play restrictions, such solicitor itself also is subject to pay-to-play restrictions.

Procedural Requirements. Each rule requires establishment of detailed supervisory and recordkeeping procedures that are subject to examination by the enforcement agencies.

Exemptions from Bans on Business. The rules provide processes for seeking from the regulators exemptions from bans on business triggered by a contribution. Historically, depending on the specific rule, some firms have been successful in obtaining exemptions, but this process is typically quite arduous and requires a clear articulation of supporting facts and circumstances and of effective remedial actions taken or to be taken by the firm.

Disclosures for Municipal Underwriters and Advisors. Underwriters of municipal securities and municipal advisors, but not other types of firms, must make quarterly public disclosures of covered contributions (including contributions to bond ballot campaigns) and business activities undertaken by the firm and its relevant personnel.

BUSINESS ACTIVITIES TRIGGERING THE RULES

The financial services firms and their activities covered by the rules include:

Municipal advisors:

  • Providing investment advice on the investment of municipal bond proceeds ("bond proceeds advice") [MSRB Rule G-37]
  • Providing advice on whether and how to issue municipal securities, or the structure, timing, and terms of an issuance of municipal securities (including issuances under plans or programs such as 529 college savings plans, local government investment pools and ABLE Act programs, known as "municipal fund securities" programs) and other similar matters ("offering advice") [MSRB Rule G-37]
  • Providing advice on swaps or other derivatives entered into with governmental entities [MSRB Rule G-37]
  • Soliciting, for compensation, governmental entities to hire an unaffiliated investment adviser (whether registered with the SEC or a state) to provide investment advisory services, an unaffiliated broker-dealer to underwrite municipal securities, or an unaffiliated municipal advisor to provide municipal advisory services [MSRB Rule G-37] (these categories are collectively referred to as "municipal advisory services")

SEC-registered investment advisers:

  • Providing investment advice (whether or not relating to municipal bond proceeds), including pools of assets (e.g., retirement plans) and other plans or programs (e.g., municipal fund securities programs) of governmental entities ("general investment advice") [SEC Rule 206(4)-5]
  • Providing municipal advisory services [MSRB Rule G-37], except that bond proceeds advice is included within general investment advice covered by SEC Rule 206(4)-5
  • Soliciting, for compensation, governmental entities to hire an affiliated SEC-registered investment adviser to provide investment advisory services [SEC Rule 206(4)-5]

State-registered investment advisers:

  • Providing municipal advisory services [MSRB Rule G-37]

Broker-dealers:

  • Underwriting municipal bonds and notes, or serving as distributor for municipal fund securities programs ("underwriting activities") [MSRB Rule G-37]
  • Providing municipal advisory services [MSRB Rule G-37], except that offering advice that consists of advice on structure, timing, and terms of an issuance of municipal securities and other similar matters when acting as underwriter is included within underwriting activities covered by MSRB Rule G-37
  • Engaging in distribution activities for compensation with a governmental entity on behalf of an investment adviser providing investment advisory services to such governmental entity [FINRA Rule 2030 (not yet effective)]
  • Soliciting, for compensation, governmental entities to hire an affiliated SEC-registered investment adviser to provide investment advisory services [FINRA Rule 2030 (not yet effective)]

Swap dealers:

  • Entering into swaps with governmental entities [CFTC Rule 23.451]
  • Providing municipal advisory services [MSRB Rule G-37]

Security-based swap dealers:

  • Entering into security-based swaps with governmental entities [SEC Rule 15Fh-6 (compliance date to be established in the future to coincide with applicable security-based swap dealer registration requirements)]
  • Providing municipal advisory services [MSRB Rule G-37]

WHAT FINANCIAL SERVICES FIRMS SHOULD DO

Firms first becoming subject to any of these pay-to-play restrictions must understand how these complex rules likely will require changes to existing practices as well as the establishment and enforcement of detailed policies, procedures and processes. Firms already subject to any of the existing rules will need to review and potentially revise their policies, procedures and processes in light of these changes to the current framework. The consequences of a rule violation can be extremely severe, including not only the ban on future business but also disgorgement of prior fees, significant civil fines, and potential bars of individuals from working in the securities industry.

COLLATERAL EFFECTS ON ELECTED OFFICIALS AND POLITICAL ORGANIZATIONS

The pay-to-play rules do not apply to elected officials, candidates for public office, political parties or other political organizations, other than PACs controlled by financial services firms or their relevant personnel. That is, the receipt of a contribution that could cause a violation for the financial services firm does not result in a violation by the recipient. Nonetheless, the rules have had a considerable impact on the ability of such individuals or organizations to raise funds from the financial services industry. The impact of pay-to-play restrictions on candidates for public office or political organizations will be explored in future Alerts.

If you have any questions regarding this Alert, please contact Ernesto A. Lanza at (202) 572-8672 | elanza@clarkhill.com, Charles R. Spies at (202) 572-8663 | cspies@clarkhill.com or another member of Clark Hill's Political Law Team, or Lisa A. Chiesa at (412) 394-2454 | lchiesa@clarkhill.com or another member of Clark Hill's Public Finance Team.