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First SEC case on pay-to-play sends a message

Agency flexes muscle to show how serious it is about new rules

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The SEC’s LeeAnn Gaunt: "We are always looking and assessing, and will bring cases when we can."

The first enforcement case brought under the SEC's pay-to-play rules has increased awareness of the extent of the regulations, and their impact on managers and investors.

The case against TL Ventures Inc., “makes it clear that (the SEC is) charting out the broadest possible course of enforcement” for pay-to-play rules, said Stefan Passantino, a partner in the Washington law firm McKenna Long & Aldridge LLP. “It's a really big deal because of the standards they set for themselves to bring this case.”

And more cases are likely.

“We are always looking and assessing, and will bring cases when we can,” said LeeAnn Gaunt, the Boston-based chief of the SEC enforcement division's municipal securities and public pensions unit.

The new rules give the SEC more latitude than some money managers might realize. The agency does not have to prove intent to influence, actual influence of an investment decision, or even an opportunity to influence, Ms. Gaunt said.

On June 20, the Securities and Exchange Commission charged TL Ventures, a Wayne, Pa., private equity firm, with violating the rules that prohibit investment advisers from getting paid for advising public pension funds and other government accounts within two years of making political contributions to people who could influence contracting decisions.

The firm agreed to settle without admitting or denying the charges and to return $256,697 in advisory fees to the $27 billion Pennsylvania State Employees' Retirement System, Harrisburg, and the $4.5 billion Philadelphia Board of Pensions and Retirement, after it was discovered that a TL Ventures affiliate, Penn Mezzanine Partners Management LP, made $4,500 in campaign contributions to candidates for governor and mayor in 2011. The two pension funds had invested $85 million in two TL Ventures funds as early as 1999. The firm, which reported $178 million in venture capital assets under management this year, will also pay $38,197 in penalties and interest.

Even though the client relationship was established well before the contributions were made, it was the connection that mattered.

The pay-to-play rules, which were approved in 2010 and went into effect in 2011, dictate that a firm providing advisory services directly to a government client or through a pooled investment vehicle must forgo compensation for two years, but the rules also prohibit the firm from severing the relationship, which in the case of private equity and other private funds, raises practical and financial concerns for the other investors involved in a particular fund.

There could also be ramifications for the pension fund staff if fee structures and investors' compensation are affected, said Suzanne Dugan, who leads the ethics and fiduciary counseling practice at Cohen Milstein Sellers & Toll PLLC in Washington. “How are they going to sort it out?”

Potential pitfall

One potential pitfall for managers is whether related entities are properly classified. In the TL Ventures case, the SEC also charged the two firms for improperly acting as unregistered investment advisers. Even though the firms claimed exemption from SEC registration, their operations were closely integrated and significantly overlapped, according to the consent order. “That's a very important piece of the enforcement case,” said Ms. Gaunt of the SEC. “When you have closely affiliated advisers, they should look at the relationship status.”

McKenna Long & Aldridge's Mr. Passantino said money managers face more risk than just SEC penalties. “You can't get out and you can't get paid. You get fined and you get publicly branded. It's a very dangerous trap for the unwary,” he said.

SEC officials are turning to a variety of sources to find their next cases, including a robust new whistleblower program, heightened awareness among examiners, and public sources of information like pension fund money manager lists and campaign donation records.

Ms. Dugan noted that while pay-to-play headlines have faded away, potential problems have not. “The lesson here is that there does remain a lot of work to be done. The rules were the beginning of it, not the end of it.” She advises public retirement plan officials to take action along with money managers, and to “have sufficient controls in place to make sure that the managers themselves have controls in place.”

Ms. Gaunt of the SEC echoed that advice. “This rule is really on the investment adviser's obligations. That said, the best practices would be to keep an eye out for potential conflicts, and to have good policies,” she said.

“Clearly the rules are going to be enforced,” said Luke Bierman, dean of the Elon University School of Law, Greensboro, N.C., who served as general counsel of the now-$176.2 billion New York State Common Retirement Fund as officials there sought to recover from placement agent scandals that started in 2006.

That fund, and the $104.3 billion New York State Teachers' Retirement System, both of Albany, banned placement agents in the spring of 2009.

In June, the five pension funds that make up the $150 billion New York City Retirement Systems passed resolutions banning placement agents for all investment classes. Others, including the $300.4 billion California Public Employees' Retirement System, Sacramento, and the $87.4 billion North Carolina Retirement Systems, Raleigh, have added policies following pay-to-play scandals in years past.

“It's still a very real concern,” said Mr. Bierman. “What we're seeing is increased attention to pension funds. It's a lot of money and these have become much higher-profile funds. People taking investment money (from public funds) are going to have to be much more careful.”

This article originally appeared in the July 7, 2014 print issue as, "First SEC case on pay-to-play sends a message".