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Pay-to-Play – SEC Expands Scope of Rule to CABs

The SEC’s pay-to-play rule has given advisers reason to worry about potential foot faults since its adoption. As we have noted in prior posts, the rule is filled with landmines and is therefore difficult to navigate.  As was evident from the SEC’s announcement of a series of settlements of alleged pay-to-play violations in early 2017, even a small contribution without any intent to influence an election or an official can run afoul of the rule and put two years of fees and carry at risk.

Last week, the SEC issued an order that will expand the scope of the pay-to-play rule.  The SEC approved a FINRA proposal to extend the self-regulatory organization’s Rules 2030 and 4580 (its pay-to-play and associated recordkeeping rules) to a recently established category of FINRA-registered firms known as capital acquisition brokers, or CABs.

CABs are firms that focus on a more limited set of activities than full-service broker-dealers.  Generally, an entity qualifies as a CAB if it engages solely in specific capital raising or corporate advisory activities, including corporate restructurings and acting as a private fund placement agent.  However, CABs are prohibited from maintaining customer funds and cannot trade customer securities.  Firms that carry customer accounts, produce research or chaperone non-U.S. broker-dealers under Rule 15a-6 of the Exchange Act cannot register as CABs.

The SEC order subjects CABs to the pay-to-play restrictions and recordkeeping requirements already applicable to full-service broker-dealers under FINRA CAB Rules 203 and 458.  The pay-to-play rule that applies to CABs is substantially similar to the pay-to-play rule that applies to investment advisers, with minor distinctions.

As a refresher, the SEC’s pay-to-play rule generally prohibits an adviser from providing compensated advisory services to state government or retirement plan investors for two years following an impermissible contribution – in other words, no fees or carry during the two-year “time out” period.  The rule is triggered if the adviser or one of its “covered associates” makes a “contribution” to an “official” of a “government entity” unless the “contribution” falls within one of the narrow exceptions to the rule.  An adviser could also be subject to penalties if the adviser or one of its “covered associates” coordinates or solicits a “contribution” to an “official” or “payment” to a state or local political party.  The use of “quotations” here is intentional – each is a defined term within the rule that requires independent analysis by the adviser.

While the expansion of the FINRA pay-to-play rule is somewhat narrow, it serves as a useful reminder to private fund advisers to review their compliance policies, confirm that applicable recordkeeping requirements are being met, and double-down on ensuring that personnel are well-trained on the potential implications of their political activities.  With the proper procedures in place, the potential for financial and reputational harm resulting from a violation of the pay-to-play rule can be minimized.

As we have said before, a well thought out, robust, and vigilantly enforced pay-to-play policy will pay for itself.

© 2017 Proskauer Rose LLP.

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About this Author

Law Clerk

Lucy Wolf is a law clerk in the Litigation Department and a member of the Private Investment Funds Group.

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Anthony M. Drenzek, Special regulatory Counsel, Proskauer Rose, Attorney, Finance Policy Lawyer
Special Regulatory Counsel

Anthony Drenzek is a special regulatory counsel in the Corporate Department and a member of the Private Investment Funds Group. His background includes more than a decade of comprehensive agency experience in the registration and regulation of securities market participants in coordination with state, federal and self-regulatory organizations nationwide.

Prior to joining Proskauer, Anthony was associate director of the Massachusetts Securities Division, with supervisory responsibility for the Division’s Registration, Inspections, Compliance and Examinations Section, which managed the regulation of broker-dealers, investment advisers and exempt reporting advisers, and which annually audited in excess of $3.2 billion in managed assets. He personally conducted or supervised more than 500 regulatory examinations of registered investment advisers and broker-dealers for compliance with state, federal and self-regulatory organization regulations.  He also authored and amended regulations and policy statements on behalf of the agency in the areas of custody of assets, discretionary authority and disclosure requirements, as well as comment letters to the staff of the U.S. Securities and Exchange Commission in connection with proposed federal rulemaking.

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Michael R. Hackett, Litigation Attorney, Proskauer Law Firm
Associate

Michael R. Hackett is an Associate in the Litigation Department and a member of the Private Investment Funds Disputes practice, resident in the Boston office. His practice encompasses a variety of complex commercial litigation and securities litigation matters for corporate and individual clients, most often in state and federal courts. Mike advises and represents public and private companies in areas including breach of contract, securities, financial services, corporate governance, fiduciary obligations, business torts, fraud and trade secrets, intellectual property,...

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Joshua Newville, Proskauer Rose, regulatory enforcement attorney, industry compliance legal counsel, securities exchange commission lawyer
Partner

Joshua M. Newville is a partner in the Litigation Department in New York. His practice focuses on commercial litigation and regulatory investigations. Mr. Newville advises companies and individuals in securities litigation and compliance matters. He also focuses on internal investigations and enforcement matters. Prior to joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset...

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