August 2009
Authors:
Mark D. Perlow mark.perlow@klgates.com
+1.415.249.1070
Alan P. Goldberg alan.goldberg@klgates.com
+1.
312.807.4227
Thomas A. Hickey III thomas.hickey@klgates.com
+1.617.261.3208
Michael D. Ricciuti michael.ricciuti@klgates.com
+1.617.951.9094
A. Michael Primo michael.primo@klgates.com
+1.617.261.3273
K&L Gates is a global law firm with lawyers in 33 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities.
For more information, visit www.klgates.com.
The Securities and Exchange Commission (the “SEC” or “Commission”) recently released proposed Rule 206(4)-5 (the “Proposed Rule”) under the Investment
Advisers Act of 1940 (the “Advisers Act”) to address perceived “pay-to-play” practices by certain investment advisers providing advisory services to state, county and municipal public employee retirement plans or other government programs, such as transportation, children’s services, arts and environmental reclamation programs.
The Proposed Rule is modeled on, and draws on the SEC’s experience regarding,
MSRB Rules G-37 and G-38, which are intended to prevent “pay-to-play” practices among municipal securities dealers. The Proposed Rule is similar to the SEC’s 1999 proposal to address advisers’ “pay-to-play” practices, with certain changes that the
SEC abandoned in the face of widespread opposition by public officials and the advisory industry.
In the proposing release, the SEC cites a number of recent enforcement actions brought by the SEC and criminal authorities related to “pay-to-play” practices, and the SEC argues that these practices have the potential to compromise the adviser selection processes of government clients as well as investment advisers’ fiduciary standards. The SEC also points out that it is hard to prove that a contribution has been made expressly to influence the selection process, as a way to justify the broad prophylactic prohibitions of the Proposed Rule.
The Proposed Rule seeks to protect government clients by preventing certain investment advisers from making contributions or payments to public officials responsible for overseeing those government assets as a “quid pro quo” for directing business to the adviser. The Proposed Rule would apply to all investment advisers registered with the SEC, as well as all investment advisers excepted from such registration by Section 203(b)(3) of the Advisers Act, the “private adviser”
1
exception.
The Proposed Rule also would apply to investment advisers to “covered investment pools,” which includes registered investment companies (such as mutual funds) as well as certain private funds. Specifically, the Proposed Rule would:
The Proposed Rule would prohibit investment advisers from receiving compensation for providing advisory services to a government entity for two years after the investment adviser or a
“covered associate”
2
has made a political contribution (or provided a gift, loan or anything of value) to an official of a government entity that is in a position to influence the decision to award the investment adviser business or that has the authority to appoint an official in such a position. A “government entity” would include any public pension plans or collective government funds, and an “official” would include incumbents and candidates for office; these definitions largely track the existing MSRB rules. The two-year time out would continue in effect after the covered associate who made the contribution left the firm, and a contribution made by a covered associate would be attributed to any investment adviser that

subsequently engaged the contributor; these provisions are intended to prevent firms from channeling contributions through departing employees and from influencing officials by hiring persons who have contributed to these officials.
There would be two exceptions from the two-year time out requirement. First, there would be a de minimis exception of up to $250 per election for candidates for whom an individual is entitled to vote. Second, there would an exception for inadvertent triggering contributions – where a covered associate makes a contribution of up to
$250 to a candidate for whom the associate is not entitled to vote. An investment adviser could “cure” such an inadvertent contribution if it is discovered within four months of the date of the contribution and if the adviser causes the contribution to be returned within sixty days of the date of discovery.
An adviser could rely on this exception only no more than twice per twelve-month period and no more than once for any covered associate irrespective of time period.
The SEC points out in the proposing release that the
Rule would not prohibit an adviser that has triggered the two-year time out from providing services to a government client, because the SEC does not want an adviser to abandon the government client after making a covered contribution. The SEC also points out the clear implication of this aspect of the Rule, namely that such an adviser would have to continue to provide advisory services to the government client without compensation for a “reasonable” period of time, until the client could replace the adviser.
The Proposed Rule also would bar investment advisers and their covered associates from making payments (or providing gifts, loans or anything of value), directly or indirectly, to unrelated third parties for the purpose of soliciting government entities for advisory business on behalf of the investment adviser. This prohibition would not apply to persons who are employees of the adviser or under common control with the adviser.
Such third parties are often known as “finders,”
“solicitors,” “placement agents,” or “pension consultants.” “Soliciting” would include direct and indirect communications made for the purpose of:
(i) obtaining, retaining or referring a client; or
(ii) obtaining or arranging a contribution or payment. The SEC also proposed technical amendments to Rule 206(4)-3, which regulates the payment by advisers to solicitors, to alert advisers and others that special prohibitions apply to solicitation activities involving government clients.
The SEC states that it believes that the prohibition on payments to third-party solicitors is necessary to prevent advisers from circumventing the Proposed
Rule, based on the MSRB’s experience: the MSRB first adopted Rule G-37, which imposes a two-year time out for contributors, but observed that municipal securities dealers sought to circumvent
(in its view) the Rule by hiring third-party solicitors.
In response, the MSRB adopted a version of Rule
G-38, which required public disclosure of the terms of dealers’ agreements with solicitors. However, the MSRB later concluded that disclosure alone was inadequate to prevent circumvention of the Rule and thus amended Rule G-38 to impose a complete ban on the use of third-party solicitors.
The Proposed Rule would prohibit investment advisers and their covered associates from coordinating or soliciting a person or political action committee to make contributions to officials of government entities to which the investment adviser provides or seeks to provide advisory services. The Proposed Rule also attempts to eliminate indirect contributions to officials by prohibiting the coordinating of payments to state or local political parties. “Coordination” of contributions would include bundling small contributions by an investment adviser’s employees to create one large contribution. The SEC states that it believes that this aspect of the Proposed Rule also is necessary to prevent investment advisers from circumventing the Rule, also based on the
MSRB’s experience.
The Proposed Rule includes a “catchall” provision prohibiting acts which, if done directly, would result in a violation of the Proposed
Rule. This provision would prevent investment advisers from circumventing the Proposed Rule by, for example, directing contributions through attorneys, family members or friends. It also would prohibit the coordination of “swaps” of
August 2009 2

contributions between elected officials in order to obscure them.
The Proposed Rule would apply to investment advisers to “covered investment pools,” which includes registered investment companies
(such as mutual funds), as well as private funds that rely on the exceptions from registration under sections 3(c)(1), 3(c)(7) and 3(c)(11) of the
Investment Company Act of 1940. The former two sections would encompass managers of hedge funds and private equity funds, and the latter would encompass managers of collective trust funds: as the
SEC points out, each of these types of pools is a significant investment or funding vehicle of a variety of government-sponsored savings and retirement plans, including 529 college savings plans and
403(b) and 457 retirement plans. The SEC states that it is concerned that fund advisers might make political contributions to influence the decision to include their funds as options in these plans.
Specifically, each of the Rule’s prohibitions would apply to an investment adviser that manages assets of a government entity through the entity’s investment in a covered investment pool managed by that adviser. There would be one important exception: in the case of an adviser to a publiclyoffered registered investment company, the Rule would apply the two-year time out provision only when the investment company is included as an option for participants in a plan or program of a government entity ( e.g.
, a 529 plan), and not just because a plan or program has decided itself to invest in such a fund. The SEC recognizes in the proposing release that publicly offered funds can have many investors, and it would create substantial compliance challenges for advisers to have to monitor all of their shareholders to determine whether any were government plans or programs.
However, if a covered associate of the adviser to a covered investment pool were to make a triggering contribution relating to a government entity that has invested directly in the pool, the adviser would have to forgo any compensation related to the assets invested or committed by that entity. For private funds, this would involve waiving the related fees and performance allocations. However, since waiving fees for an investor in a registered investment company would raise senior security and preferential dividend issues, the SEC suggests that the adviser could waive its fees for the fund as a whole in an amount equal to the fees attributable to the government entity’s investment.
The Proposed Rule also would require registered investment advisers to maintain records of: (i) all covered associates of the investment adviser; (ii) all government entity clients or prospective clients; (iii) all government entity clients in the past five (5) years; and (iv) all direct or indirect payments made by the adviser and its covered associates to government officials, state or local political parties, and political action committees.
3
The SEC makes clear in the proposing release that it believes that keeping these records is a prerequisite to a serious effort to comply with the Proposed Rule. In addition, the
Commission proposes to permit an adviser to request an exemption from the Rule’s “time out” requirement based upon the adviser’s facts and circumstances, relying on factors similar to those used by FINRA and the bank regulators in granting exemptions under Rule G-37. A key factor would be whether the adviser had implemented reasonably designed policies and procedures to comply with the
Proposed Rule.
The Proposed Rule is partly a response to highly publicized criminal and later SEC investigations into alleged improper influence on state, county, and municipal employees and elected officials who manage public pension plans and who are involved in the selection of investment advisers. In particular, in March, 2009, the New York Attorney
General and the SEC brought parallel criminal and civil fraud cases alleging fraud in connection with placement agents used to place investments of New
York’s Common Retirement Fund (“CRF”), the
New York state public employees’ retirement fund.
The actions allege that CRF’s Comptroller and
Chief Investment Officer and others participated in fraudulent schemes involving multiple investment transactions in which placement agents were
August 2009 3

permitted to invest CRF funds in exchange for illicit payments made to public officials and others.
In addition, there have been a series of government probes regarding placement agents’ involvement with public plans. The SEC, the Department of
Justice and numerous state attorneys general have opened investigations into these practices. The combined effect of these law enforcement activities is to create a public atmosphere that will give momentum to the SEC’s efforts to adopt the
Proposed Rule.
The Proposed Rule, if adopted, would have broad implications for investment advisers. Based on the
SEC’s and the MSRB’s experience with Rules G-37 and G-38, the Rule would likely significantly curtail political contributions by investment advisers and their covered associates to state and local officials, as well as advisers’ use of third-party solicitors. The
Rule would particularly impact advisers with substantial investments from government clients.
However, the Rule would affect all covered investment advisers, since it contemplates significantly expanded recordkeeping requirements and new compliance measures, especially to monitor and record covered associates’ political contributions. Implementing these requirements might require administrative efforts and intrusion into the personal lives of covered associates to the same degree as the Advisers Act code of ethics rule.
Comments on the Proposed Rule are due on October
6, 2009. The SEC specifically requested comment on whether investment advisers would need a transition period beyond the effective date of the
Rule (when adopted) in order to develop compliance procedures, and if so, how long the transition period should be (
six months). e.g., 90 days or
Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London
Los Angeles Miami Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park
San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Washington, D.C.
K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous
GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.
K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in
Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), and in Singapore; a limited liability partnership (also named K&L
Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in
Taipei; and a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
©2009 K&L Gates LLP. All Rights Reserved. would not, however, include services rendered prior to the effective date of the Proposed Rule.
1
Section 203(b)(3) excepts from SEC registration “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any [registered] investment company.”
2
A “covered associate” includes the investment adviser’s general partner, managing member, executive officers, any employee with a similar status or function, any employee who solicits a government entity for the adviser, and any political action committee controlled by the adviser or any of the foregoing persons.
3
The recordkeeping requirements would include investments made by government entities in covered investment pools. The five-year recordkeeping requirement
August 2009 4