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Regulatory Update, December 2009

I'm pleased to provide ICSGroup's latest regulatory update. In this issue we cover several hot topics in the investment industry that could potentially impact private equity and hedge funds. As always, feel free to call or e-mail me if you ever have a question about anything covered in this update.
In This Issue
ICSGroup Offers Pay-to-Play/Politcal Contributions Solution
The SEC Reviews Process for Selecting Investment Advisors for Examination
ICSGroup Offers A Solution for Political Contributions

The SEC's proposed rule governing "pay-to-play" practices defines "pay-to-play" activity as:

        making a contribution to certain elected officials or candidates;

        soliciting from others, or coordinating, contributions to certain elected officials, candidates or political parties where the advisor is providing or seeking government business

Note: The rule also prohibits fund advisors from paying third-party placement agents, solicitors, finders or similar parties to solicit a governmental agency but that topic will not be the focus of this article.

Investment advisors who "pay-to-play", either directly or indirectly, are prohibited from receiving compensation for their advisory services for that governmental entity for a period of two years after the advisor or its "covered associates" make such a payment.

The Devil is in the Definitions
Three definitions are key to understanding the breadth and depth of the Proposed Rule: "Contribution", "Covered Associate" and "Official". A close look at how these terms are defined reveals the complexity hidden within the Proposed Rules.

A "contribution" is any gift, subscription, loan, advance, or deposit of money or anything of value made for: (1) the purpose of influencing any election for federal, state or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office. "Contribution" includes coordinating events or fundraisers or soliciting contributions or payments from others on behalf of a state or local political candidate, a governmental official or a political party.

The Proposed Rule includes two exceptions for contributions of $250 or less. First, there is an exception for contributions of $250 or less made to the official for whom the contributor is entitled to vote. Second, the Proposed Rule also provides a less helpful exception with respect to contributions made by a covered associate to officials other than those for whom the covered associate was entitled to vote. There are several conditions to this exception which are quite onerous, including: (1) the contributions by the covered associate must be $250 or less in the aggregate; (2) the adviser must have discovered the contribution by the covered associate within four months of the date of the contribution; and (3) the adviser must cause the contribution to be returned to the covered associate within 60 days of learning of the contribution.

"Covered Associate" is defined to include the following persons (or a PAC controlled by them): The adviser's general partners or managing members, the president and any vice president in charge of a principal business unit, division or function; any executive officer who in connection with his or her regular duties performs, or supervises any person who performs, investment advisory services; any executive officer who in connection with his or her regular duties solicits, or supervises any person who solicits, investment advisory business; and any employee who solicits a state or local government. While the SEC stated in the proposing release that this definition would not include a comptroller, head of human resources or director of information services, it would include, for example, an executive officer who performs advisory services for one fund and contributes to an official of a government entity invested in another fund managed by the investment adviser.
Contributions by third parties including attorneys, family members, or companies affiliated with the adviser are not specifically included in the definition of "covered associate" but would also trigger the Two-Year Bar if they are really indirect donations by a "covered associate."  Other challenges exist with this definition. Consider that an employee who is not a "covered associate" makes a contribution and is subsequently promoted to a position in which he or she is a covered associate -does the political contribution trigger the Two-Year Bar?  The Proposed Rule makes clear that it would.  Furthermore, the Two-Year Bar would continue even if a covered associate who made a donation leaves the firm or moves to another position where he or she is not a covered associate.
"official" is any person who is (or who has the authority to appoint any person who is) directly or indirectly responsible for the selection of an adviser or who can influence the outcome of the selection process.  This definition poses many questions because the term is not limited to incumbents, nor is it limited to candidates for the office that selects investment advisors.  A Governor who normally would not select investment advisors, would nonetheless be an "official" if he or she is currently in a position to influence the selection of investment advisers.  All would agree that a Governor would be able to influence such a decision however, what about governmental officials whose influence is less clear.  Equally burdensome is the fact that contributions to a candidate who does not get elected and therefore would not be involved, either directly or indirectly in the selection process, would still trigger the Two-Year Bar.
By this Proposed Rule, the SEC is attempting to curtail payments that might induce investments by public pension funds.  According to the SEC, making investment decisions based on the payment of political contributions can distort the process by which investment advisors are selected.  Such "induced" investments may not be in the best interest of the plan or its beneficiaries as they may receive inferior advisory services and pay higher fees which implicates the fiduciary duty that plans have to their beneficiaries. 

Compliance Won't Be a Walk in the Park
The rule applies to both registered investment advisors as well as those that are exempt from registration under section 203(b)(3) of the Investment Advisors Act.  Unregistered firms will not get a pass on this one.
The two-year bar would also apply to new hires that are "covered associates" who have made political contributions prior to joining the firm.  Making a hiring decision based on a representation as to whether political contributions were made up to two years in the past may prove to be a source of anxiety for the new hire as well as the firm.  Potential new hires may be effectively disqualified from consideration due to their prior political contributions, even though those contributions were perfectly legal when made.  Covered Associates' political contributions must continue to be tracked even after that covered associate leaves the firm.
What's a Fund To Do??
Given the complexities of the Proposed Rule, as well as the state rules governing pay-to-play, there may be a natural inclination for a fund manager to impose a blanket policy prohibiting employees from making political contributions to candidates for state and local office altogether.  Unfortunately, such a policy may not be sufficient, since, for example, a contribution to a candidate for federal office may trigger the Two-Year Bar if the candidate is currently a state or local "official."  We urge fund managers not to wait until after the Proposed Rule is finalized to address their fund's policies and procedures relating to political contributions.  Some states and localities have already adopted anti-pay to play rules that may or may not mirror the SEC approach.
ICSGroup Has a Solution
Because of the significant potential impact making a political contribution can have on a firm's ability to be compensated for its advisory services, ICSGroup is now offering its clients a solution. ICSGroup's state-by-state pay-to-play rules paired with its political contributions tracking and approval tool provides an effective means to ensure compliance with state rules as well as the much anticipated SEC rule.  Our software enables employees to request approval electronically prior to making a political contribution.  For those states in which the advisor does or is soliciting business, the request will be automatically disapproved.  All other requests will be routed to an approver who will review the municipality or state in which the contribution is to be made to determine if the contribution will impact the advisor's business opportunities.  All requests, whether approved or not, are archived in a database and the information is easily accessible for many years into the future.  


Contact us to learn more about this state of the art resource. Info@i-c-solutions.net
Integrated Compliance Solutions Group LLC ("ICSGroup") is a regulatory compliance consulting firm specializing in providing '33 Act, '34 Act, Investment Advisor's Act and industry best practice compliance support to the investment management industry. 
Our target clients include: registered investment advisers, private equity funds, hedge funds, mutual funds, broker-dealers and pension funds.  We are a high quality, cost-effective outsourced compliance solution to complement in-house compliance staff.  ICSGroup is minority owned and managed.
Visit us at www.i-c-solutions.net to learn more.
ICSGroup Highlights
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