Commentary: How best to avoid pay-to-play pitfalls

Although the 2020 presidential vote is still many months away, the election cycle is in full swing. As media coverage increases with each primary debate and voters begin to coalesce around preferred candidates, we can expect to see a sharp increase in political contributions by fund managers and their employees — to down-ballot campaigns as well as the race for the White House — which may lead to intensified scrutiny of those contributions by financial regulators and clients.

In fact, political contributions by fund managers are already on the rise. The last midterm cycle witnessed the highest level of donations ever in a midterm year from fund managers, according to the Center for Responsive Politics. The hedge fund industry alone contributed $101 million to federal candidates, political action committees and outside spending groups during the 2018 election cycle.

During a presidential election year, contributions go up not only for federal candidates, but also state and local races because of higher interest in the political process. However, such civic engagement creates unique challenges for the financial sector. Fund managers and advisers need to be aware of the risks of violating "pay-to-play" rules that regulate and limit political contributions to any official who may have a role in awarding investment mandates. Effective compliance policies and processes can protect funds from the risks of monetary penalties, lost fees and reputational damage.

The Securities and Exchange Commission's record of stringent enforcement of the pay-to-play rule should give pause to any fund employee who is thinking of writing a check or hosting a cocktail party for a political candidate. Simply stated, Rule 206(4)-5 of the Investment Advisers Act of 1940 prohibits financial advisers from accepting compensation during a two-year window following a political contribution to an official who is in a position to influence the awarding of investment mandates.

In 2017, the commission announced that 10 investment advisory firms agreed to pay penalties ranging from $35,000 to $100,000 to settle charges that they violated the investment adviser pay-to-play rule. The SEC found that the firms violated the two-year "timeout" by accepting fees from city or state pension funds after their associates made campaign contributions to elected officials or political candidates who hold the potential to wield influence over those pension funds.

More recently, in 2018 the SEC fined an investment adviser and two exempt reporting advisers for Rule 206(4)-5 violations. In all three cases, one or more public plans had significant investments in funds managed by the respondents before the disqualifying campaign contributions. The campaigns included those for governor, state attorney general, state treasurer and superintendent of public instruction. In other cases, the SEC fined a global investment bank for allowing a senior employee to leverage firm resources to support the campaign of the Massachusetts treasurer, and also brought charges against private equity firms and several wealth management firms for alleged violations of the rule.

The pay-to-play prohibition is a strict liability rule, leaving little room to argue that the disqualifying contribution was unintentional or merely a regulatory foot fault. It does not matter whether a donation was made with intent to influence an official's actions, if contributions were returned, or even whether a fund employee made a contribution while at a former employer within the two-year "look back" period. It also doesn't matter if the investments preceded the contributions. The rule also applies to non-monetary or "in-kind" contributions, including working for a campaign. Exempt reporting advisers are also subject to the pay-to-play rule.

If a firm discovers that a disqualifying contribution was made, the only way to avoid SEC enforcement action is to forgo fees on the investment for two years. If a firm does become subject to an enforcement action, it will not only face monetary penalties, but also will be publicly censured and thus incur reputational damage.

It is therefore important to design and manage a fund's compliance policies and procedures to protect against the risk of pay-to-play violations. For example, as part of the annual compliance reviews that our firm conducts on behalf of clients, we ask questions to determine whether the employees are politically active. A chief compliance officer also can use the OpenSecrets website provided by the aforementioned Center for Responsive Politics to search public records and identify individual donations to federal candidates, outside spending groups (including super PACs), and political parties. However, that information does not extend to all state and local office holders or candidates who may have the ability to influence investment mandates.

Given the broad applicability and strict enforcement of the pay-to-play rule, and the challenges of effective compliance monitoring, we recommend that firms consider a blanket prohibition against political contributions by their employees. Firms must weigh the benefits of contributing to state and local campaigns against the potential costs of violating the very technical requirements of the rule. It would also reduce monitoring costs to prohibit all contributions. Additionally, as a side benefit, firms can cite their compliance policies to fend off campaign solicitations without telegraphing political preferences. One thing both Republicans and Democrats should be able to agree on is that the monetary penalties of pay-to-play violations — and particularly the reputational risks — are considerable and should be scrupulously avoided. And in this contentious political environment, it may be better to steer your business completely clear of any political entanglements.

Todd Cipperman is founding principal of Cipperman Compliance Services LLC, Wayne, Pa. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.