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News March 28, 2011 Issue

SEC Posts FAQs On Pay-To-Play Rule

Guidance is good.

And the SEC has been serving up lots of it lately.

With all the newly adopted rules out there, advisers have been scrambling to comply and the SEC has been deluged with questions. As the SEC staff processes all of the inquiries, it is also publishing its responses.

First came the updated custody rule FAQs one year ago just before amendments to the rule went into effect. Then on March 18 of this year, the SEC posted FAQs to help advisers preparing their new Form ADV Part 2 brochures and brochure supplements. The SEC got its hat trick last week as once again it posted a series of responses to frequently asked questions, this time regarding the pay-to-play rule.

As with the other FAQs, the SEC pledged that as appropriate, it will update, add to, or modify the pay-to-play rule FAQs going forward.

Here are a few highlights from the pay-to-play FAQs:

Advisers subject to the pay-to-play rule have recordkeeping obligations that begin this year. March 14 was the commencement date (generally) for recordkeeping pursuant to Rule 204-2(a)(18), the subparagraph of the books and records rule applicable to the pay-to-play prohibitions. If the adviserís client is a mutual fund that is a plan investment option with government entity investors, the adviser has until September 13 to begin recordkeeping. (Question I.1)

Recordkeeping is on a going-forward basis only. Records are required to be kept for a five-year period from the date of initial obligation under the rule. Even though the rule says "but not prior to September 13, 2010," the FAQs clarify that recordkeeping need not extend back to that date. "An adviser must begin to create and maintain a list of current government clients (if it has any) on March 14, 2011, except clients that are registered investment companies with respect to which it must begin to create and maintain such list on September 13, 2011." (Question I.2)

"Covered associates" are only natural persons (no companies) and political action committees controlled by such persons. If an adviserís covered associate is supervised by someone at the adviserís parent company, the parent company is not also a covered associate. (Question II.1)

Where a company is the managing member of an adviser, that companyís PAC isnít a covered associate either. Only if the adviser or any of its associates has the ability to "direct or cause the direction of the governance or the operations of the managing memberís PAC" would the PAC then be considered a covered associate. (Question II.2)

Affiliates of the adviser and the affiliateís personnel are not covered associates. Donít start thinking "creative," however. The SEC cautioned (and reminded) that doing anything indirectly that would be prohibited directly is a violation of the rule. "If an affiliated company receives payment from the adviser to solicit government entities on the adviserís behalf, the affiliated company must be a regulated person under the pay to play rule." (Question II.3)

MSRB guidance under its similar rule 37 is not authoritative, but in the absence of guidance from the SEC on a particular point, it "may be useful to consider." (Questions II.4 and V.2)

Direct contributions and contributions to a PAC will not make a PAC a covered associate. "However, a chain of contributions through PACs made for the purpose of avoiding the pay to play rule, would violate the ruleís Ögeneral prohibitions against doing anything indirectly which would be prohibited of done directly." (Question II.5)

Family members arenít covered by the pay to play rule, but donít try to funnel additional contributions through them. (Question II.6)

An adviserís independent contractor "acting on behalf of an investment adviser" is treated like an employee for purposes of the pay to play rule. (Question II.7)

Any employee of a dual registrant that solicits a government entity for advisory services is a covered associate. (Question II.8)

An adviserís affiliated broker-dealer that receives compensation for soliciting government entities is a "regulated person." (Question IV.2)

Foreign governments are not government entities for purposes of the pay-to-play rule.

If an elected official can influence the hiring of an adviser, it doesnít have to be a politically elected official. Participant-elected board members also trigger the pay-to-play rule prohibitions. (Question III.2)

Solicitors receiving continuing compensation ("trailing payments") based on clients introduced prior to the pay-to-play rule can continue to receive such payments "so long as the solicitor does not solicit the government entity client after the compliance date." (Question IV.1)

The exception for returned contributions is "one per employer." If an adviserís employee (availing itself of the exception) becomes employed by another firm, the new firm would not be prohibited from relying on the exception with respect to another contribution of the employee. (Question IV.3)

The SECís pay-to-play rule doesnít pre-empt state or local laws. (Question V.1)

Contributions by an adviser or its covered associate to a PAC wonít trigger the two-year "time out." However, if the adviser uses the PAC as part of an effort to "coordinate and solicit" payments to a state or local political party where the adviser is providing or seeking to provide advisory services to a government entity, that could create problems. (Question V.3)