Pay-To-Play Lessons From This Week's SEC Settlements - Law360

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1 Page 1 of 5 Portfolio Media. Inc. 111 West 19th Street, 5th floor New York, NY Phone: Fax: customerservice@law360.com Pay-To-Play Lessons From This Week's SEC Settlements By attorneys with Allen & Overy LLP Law360, New York (January 18, 2017, 4:05 PM EST) -- On Jan. 17, 2017, the U.S. Securities and Exchange Commission announced 10 separate settlements with investment advisory firms relating to violations of SEC Rule 206(4)-5, the SEC s payto-play rule for investment advisers and exempt reporting advisers. Although none of the 10 cases involved a major penalty (the largest fine was $100,000), they collectively demonstrate the SEC s continued focus on pay-to-play enforcement cases and the extent to which pay-to-play enforcement represents an important priority of the Enforcement Division s new Public Finance Abuse Unit. As Andrew Ceresney, the then-head of the SEC s Enforcement Division, noted in 2016 when discussing the unit s work, there will be continued activity in public finance enforcement, and thus these settlements may be a preview of things to come. And because the firms involved are banned from receiving compensation from affected public sector investors, the real economic cost of the violations is likely to be much higher. The settlements also serve as a timely reminder that exempt reporting advisers, while exempt from registration and some aspects of SEC regulation, are subject to a number of compliance and anti-fraud provisions that apply regardless of registration status. Venture capital firms and mid-sized advisers that claim exempt reporting adviser status should ensure that they are aware of their compliance obligations, and have policies and procedures in place to avoid inadvertent violations. Charles Borden William E. White Overview of the SEC Rule 206(4)-5 and the Two-Year Ban As with other federal pay-to-play rules (there are also current or pending pay-to-play rules for municipal securities dealers, municipal advisers, swap dealers, security-based swap dealers and placement agents), the core of SEC Rule 206(4)-5 is the two-year ban, which contains three principal elements: Claire Rajan 1. A covered donor (a covered adviser; an employee of the adviser who either solicits state or local government entities for advisory business or supervises someone who solicits such business; senior executives of the adviser or other individuals who set policy for the adviser; and any political action committee controlled or directed by either the adviser or a covered employee) 2. Makes a contribution (contributions include monetary contributions and in-kind contributions, such as hosting a fundraiser and paying related expenses out of pocket)

2 Page 2 of 5 3. To a covered official (any candidate who holds or seeks a state or local elective office that possesses the authority to influence the selection of investment advisers by certain state or local public-sector entities, either directly or through the appointment of someone who can exercise such selection authority). If these three components are satisfied, an adviser is prohibited from receiving compensation for providing investment advisory services to any entity in the relevant jurisdiction for which the recipient of the contribution is a covered official. This may result in a moratorium on soliciting new business and unwinding of existing arrangements. Even where a government entity invests in an investment pool and the adviser advises the pool, rather than the government entity directly, such a relationship is covered by the rule. The two-year ban contains limited exceptions, including an exception for de minimis contributions of up to $350 per election to a candidate for whom he or she is entitled to vote and up to $150 per election to a candidate for whom he or she is not entitled to vote. Where the three elements above are met and an exception does not apply, the only way to avoid the two-year ban is to obtain discretionary exemptive relief from the SEC. In the past two years, the SEC has only granted such relief seven times. In addition to the two-year ban, the rule also prohibits covered donors from soliciting contributions for a covered official. In addition to directly asking others to make contributions, this includes being listed as a co-host of a campaign fundraiser. Case Study of Lime Rock Management LP There are common facts and themes in each of the 10 settlements. In most of these cases, the contributions were relatively small, the contributor obtained a refund of the contribution, and the investments were closed-end funds in which the public entity had invested years prior to the contribution being made. The settlement with Lime Rock Management LP exemplifies these common threads. Lime Rock agreed to pay a $75,000 penalty as a result of an employee making a $1,000 contribution to Ohio Gov. John Kasich s presidential campaign in October The governor appoints one of the 11 board members to the Ohio State Teachers Retirement System. The system had collectively invested $148 million starting in 2004 in various funds advised by Lime Rock. The last investment was made in 2008, a full seven years prior to the date of the contribution, and all of the funds were closed-end funds from which investors were generally prohibited from withdrawing their investment. The contributor voluntarily disclosed the contribution a month later in a training session. The next day, the contributor sought a refund of the contribution, which was received. In addition, Lime Rock established an escrow account and deposited all fees into that account (a total of $1.3 million in two years). In July 2016, Lime Rock sought exemptive relief from the SEC in connection with this contribution, which was ultimately unsuccessful. These facts are similar to the first Rule 206(4)-5 enforcement matter that the SEC brought, which was against TL Ventures Inc. in In that proceeding, TL Ventures sought exemptive relief for two contributions made to the governor of Pennsylvania and a Philadelphia mayoral candidate in 2011, as the Pennsylvania state retirement system and the Philadelphia pension system had previously invested in a TL Venturesadvised closed-end fund more than a decade earlier. At the time of the contributions, TL Ventures was in the process of winding down and had not issued any new funds since TL Ventures did not receive exemptive relief and was required to disgorge all $300,000 in compensation earned during the two-year ban. Pay-to-Play Lessons Learned Based on our review of the 10 settled cases, we have identified the following key

3 Page 3 of 5 takeaways: Exempt reporting advisers are not exempt from SEC enforcement. While they are not subject to registration or regular compliance examinations, exempt reporting advisers are subject to a range of anti-fraud and other compliance requirements, including Rule 206(4)-5. The settlements demonstrate the SEC s intent to enforce these requirements, even when violations are relatively technical. Exempt reporting advisers must ensure that they have the compliance infrastructure in place to avoid violations of the Advisers Act and associated SEC rules. While exempt reporting advisers are not required to adopt a compliance manual, doing so may help to avoid becoming a target of SEC enforcement. Relatively small contributions made by employees may result in significant business losses. Alta Communications, for example, is subject to the ban for two years as a result of a $500 contribution to a state treasurer, in addition to the cost and disruption of the SEC enforcement action and cease-anddesist order. Similarly, the Cypress Advisors matter resulted from a $400 contribution to a New York City mayoral candidate and prevents the receipt of fees from some of the country s largest pension funds. Although Rule 206(4)-5 permits investment advisers to seek discretionary exemptive relief from the SEC, the process is timeconsuming and relief is far from certain. As described above, in Lime Rock, there was virtually no indication that the contribution could influence an investment decision and yet the exemptive relief application was unsuccessful. Pershing Square Capital Management LP had also sought exemptive relief for a $500 contribution made to a candidate for governor of Massachusetts, which was made based on the employee s longtime friendship with the candidate s sister, and still received a penalty. Contributions to state and local officeholders federal campaigns can trigger liability under Rule 206(4)-5. The contributor in Lime Rock misunderstood the firm s political contribution policies and thought he did not have to pre-clear a contribution to Kasich s federal campaign, even though Kasich was a sitting governor. This is a common misunderstanding, as sitting state governors and treasurers are usually covered under the SEC s pay-to-play rule and regularly run for federal office for Congress, president or vice president, as we saw in the 2016 election with Indiana Gov. Mike Pence s vice presidential candidacy. Pay-to-play violations do not require evidence of quid pro quo or even any attempt to influence a business decision. Even where there are no further investment decisions to be made and the funds are closed, a contribution may result in a ban on receiving compensation for investment advisory services and a civil fine. For example, in one of the cases recently settled, Cypress Advisors Inc. agreed to a settlement on the basis of a $400 contribution to a mayoral candidate made in 2013, where various New York City retirement funds had invested in Cypress fund in 1999 and the fund had been closed in Similarly, the Banc Funds Co. LLC was subject to a fine and a cease-and-desist order for a $1,000 contribution to a candidate for governor of Illinois in 2013 because of investments a state retirement system had made in closed-end funds in 2002 and 2005.

4 Page 4 of 5 Obtaining a refund of the contribution, even within 24 hours of making it, is not sufficient to unwind the two-year ban on business. In more than half of the 10 settled cases, the contribution was refunded. With these settlements, the SEC is sending the signal that exemptive relief requires more than basic remediation after discovering a violation it also requires that the adviser have in place an adequate compliance framework well in advance. Rule 206(4)-5 regulates more than the making of monetary contributions. In the settlement with Commonwealth Venture Management Corp., one of the employees co-hosted a fundraising event for a candidate, which violates Rule 206(4)-5 s solicitation ban. In addition, attending a campaign event often requires buying of a ticket, and the payment for an event ticket is considered a campaign contribution under campaign finance laws. Tips for Avoiding Pay-to-Play Enforcement The following four tips for compliance can help an adviser steer clear of pay-to-play violations and avoid the consequence of lost public-entity business: Prevention is the best way to avoid being subject to a two-year ban. Most investment advisers including exempt reporting advisers should implement a political contribution pre-clearance system by which covered donors are required to pre-clear certain contributions. If such a system can prevent a problematic contribution from being made in the first place, a lot of heartache can be avoided. Ensure covered donors are aware of the pre-clearance policies through notifications, trainings and certifications of compliance. Relatedly, it is important that the compliance function maintains an accurate list of covered donors to ensure that all the necessary employees and senior executives are covered by the policies. A robust compliance program includes monitoring and testing functions to ensure that inadvertent contributions have not been made. Consider undertaking a review of your existing pay-to-play compliance program to ensure it is tailored to your needs. Charles Borden is a partner in the Washington, D.C., office of Allen & Overy LLP and leads the firm's political law practice. He is a visiting fellow at the Centre for Analysis of Risk and Regulation at the London School of Economics, which focuses on cross-border regulatory analysis, including with respect to the regulation of public corruption and political activities. He also co-teaches a course titled Government Ethics: Scandal and Reform at Harvard Law School, where he is a visiting lecturer in law. Chris Salter is a partner in Allen & Overy's Washington office. He previously worked at the SEC as an attorney in the Division of Market Regulation. William E. White is also a partner in the firm's Washington office. He spent eight years in the SEC Enforcement Division, serving as a staff attorney, branch chief and senior

5 Page 5 of 5 trial counsel. Samuel Brown and Claire Rajan are associates in Allen & Overy's Washington office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. All Content , Portfolio Media, Inc.