Tag Archives: third party marketer

Investment Adviser Pay to Play Rules

SEC Proposal Would Ban Third Party Solicitors from Seeking Public Monies

Back in July there was much discussion about new “pay to play” rules proposed by the SEC.  The proposed “pay to play” rules would limit the ability of investment managers (including hedge fund managers) to make political contributions and would also limit the ability of third party marketers to raise capital for managers from state and federal pension plans.

There have been many interesting comments on these proposed rules so far, and, as some have noted, it seems to me that these rules may hinder the first-amendment rights of these money managers.  The comment period ends October 6, 2009 and the SEC may choose to vote on the rule thereafter, but I would not expect for any rule to be finalized before the end of this year.  However, hedge fund managers may want to review their investment advisory compliance manual to make sure they have discussed this issue.  Hedge fund managers who are not yet registered with the SEC as investment advisers will likely deal with this issue when they register.

I have included below (i) a definition of pay to play below, (ii) the SEC press release announcing the proposal, and (iii) a discussion of pay to play from 1999, the last time the SEC had a proposal to regulate these activities.

Mallon P.C. will be commenting on the proposal so please let us know your opinions below.


Pay to Play Definition (see old SEC release, reprinted below)

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.


SEC Proposes Measures to Curtail “Pay to Play” Practices


Washington, D.C., July 22, 2009 — The Securities and Exchange Commission today voted unanimously to propose measures intended to curtail “pay to play” practices by investment advisers that seek to manage money for state and local governments. The measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.

The proposals relate to money managed by state and local governments under important public programs. Such programs include public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for their retirement, and 529 plans that allow families to invest money for college.

To help manage this money, state and local governments often hire outside investment advisers who may directly manage this money and provide advice about which investments they should make. In return for their advice, the investment advisers typically charge fees that come out of the assets of the pension funds for which the advice is provided. If the advisers manage mutual funds or other investments that are options in a plan, the advisers receive fees from the money in those investments.

Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.

The selection process also can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term “pay to play.” Advisers and government officials who engage in pay to play practices may try to hide the true purpose of contributions or payments.

“Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices,” said SEC Chairman Mary Schapiro. “Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “Pay to play serves the interests of advisers to public pension plans rather than the interests of the millions of pension plan beneficiaries who rely on their advice. The rule we are proposing today would help ensure that advisory contracts are awarded on professional competence, not political influence.”

The rule being proposed for public comment by the SEC includes prohibitions intended to capture not only direct political contributions by advisers, but other ways advisers may engage in pay to play arrangements.

Restricting Political Contributions

Under the proposed rule, an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The rule would apply to the investment adviser as well as certain executives and employees of the adviser. Additionally, the rule would apply to political incumbents as well as candidates for a position that can influence the selection of an adviser.

There is a de minimis provision that permits an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:
1. Make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser.
2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

Banning Third-Party Solicitors

The proposed rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser.

Restricting Indirect Contributions and Solicitations

Finally, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.

* * *

Public comments on today’s proposed rule must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule will be posted to the SEC Web site as soon as possible.
# # #


U.S. Securities and Exchange Commission

Speech by SEC Staff:
Pay-To-Play and
Public Pension Plans
Remarks of
Robert E. Plaze
Associate Director, Division of Investment Management,
U. S. Securities and Exchange Commission

At the Annual Joint Legislative Meeting of
The National Association of State Retirement Administrators,
National Conference on Public Employee Retirement Systems and
The National Council on Teacher Retirement, Washington, D.C.

January 26, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Thank you for inviting me to address this meeting of the group of state pension administrators. My father was a state retiree and lived on his pension for a number of years. I know how the importance the security of a pension plan is to millions of persons like my Dad, and how important your jobs are.

I am a member of the staff of the Commission. But my remarks this afternoon are my own, and I am not speaking for the Commission or my colleagues on the staff.

When Arthur Levitt became Chairman almost six years ago, among his goals was the reform of the municipal securities markets. Since then, a series of initiatives have improved investor disclosure in the municipal securities markets. A second area of reform – and one most relevant to why you have invited me here today – has been the curbing of pay-to-play practices.

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.

Chairman Levitt, and several SEC officials have been involved in the municipal securities markets. They knew that pay-to-play practices had been pervasive and corrupting to the market for municipal securities. And if you ask them, they will tell you stories about checks left on the table at a dinner. They may even know the minimum required contributions in a particular jurisdiction to be eligible for public contracts.

Pay-to-play creates the impression that contracts for professional services are awarded on the basis of political influence rather than professional competence. It harms the citizens of the municipality and the investing public asked to purchase the securities. It brings discredit on the businesses and professionals who participate in the practice.

In 1993, the first in a series of steps to end pay-to-play practices began when a group of investment banks voluntarily agreed to swear off making contributions for the purpose of obtaining municipal business. In 1994, the SEC approved MSRB rule G-37 – which is known as the pay-to-play rule.1

G-37 prohibits municipal securities dealers from engaging in the municipal securities business with an issuer two years after contributions are made to an official of an issuer by the dealer or its employees engaged in municipal finance business. The prohibition applies equally to officials who are incumbents and those who are candidates. There is a de minimis exception, which permits contribution of up to $250 to candidates for whom they can vote.

The rule was met with howls of protest from some state and municipal officials. Some argued that it violated their First Amendment rights to make and solicit political contributions. These claims were soon tested in the federal courts, and in an important decision, a federal court of appeals held that G-37 was a constitutionally permissible restraint on free speech – because it serves a compelling governmental interest of rooting out corruption in the market for municipal securities.2

As we meet this afternoon, the American Bar Association is considering proposals to bar the practice of lawyers obtaining business through political contributions. Deans of 47 law schools across the country have joined Chairman Levitt in calling for an end to what the San Francisco Chronicle called “a sleazy practice that costs taxpayers.” 3 We hope that my profession will adopt a strong and effective ban.

Bringing an end to pay-to-play practices thus has been a step-by-step process.

Recently, Chairman Levitt has asked my Division to look into the question of whether the Commission needed to address pay-to-play in the public pension area. We are now in the fact-gathering stage of this project, which could very well lead to a rule proposal.

What have we found? So far, we see strong indicators that pay-to-play can be a powerful force in the selection of money managers of public pension plans. There are public reports of pay-to-pay problems with the management of public money in 12 states – and many of these are the largest states.

* In one small state a former state treasurer raised over $73,000 in campaign contributions, virtually all from contractors for the state retirement system 4

* The controller of a large state has raised $1.8 million from pension fund contractors, many of which are out-of-state 5

* In another state, a former state treasurer raised contributions from contractors, one of whom received a five-fold increase in the custody fees it charged. The treasurer’s candidate lost and the contract was terminated by the new treasurer.6

* The Executive Director of the MSRB has been quoted in the Wall Street Journal as saying that “the conflicts of interest in the [public pension business] are as bad as anything we’ve seen in the muni-bond market.7

* An elected state official has told me that she thought that G-37 has resulted in the movement of some pay-to-play activity over to the public pension area. Phone calls from some advisers have confirmed this.

Claims that pay-to-play really isn’t a problem are refuted by the findings of states and plans that have taken on the issue. Vermont and Connecticut have enacted legislation.8 Both were concerned that awards of advisory contracts were being made on the basis of political favoritism rather than expertise. They concluded that even where no actual corruption occurred, the appearance of impropriety was intolerable.

CalPERS has acted in California, and the records of its rulemaking proceeding and subsequent litigation are particularly instructive about how pay-to-play works and its insidiousness.

It is heartening to see some of the plans and jurisdictions putting an end to the culture of pay-to-play. As you know, it takes two to tango, and it takes two to participate in these practices – the payer and the payee. Our concern is with the activities of the payers – investment advisers, whom we regulate under the Investment Advisers Act of 1940.9

The Advisers Act imposes a federal fiduciary duty on advisers with respect to their clients and prospective clients.10

* When the process of the selection of an investment adviser is corrupted, the duties of an adviser to his client are compromised.

* When the selection process is corrupted and advisers are selected based not on their merit but on the amount or their political contributions, the ultimate clients of advisers – the pension pools they manage – are harmed and the benefits of retirees threatened.

A similar harm occurs when advisers are not chosen because they have not made the requisite amount of contributions.

We at the Commission believe that G-37 is working pretty well. And I have to believe, based on the evidence we have collected so far, that the burden will fall on those who argue that the Commission should not apply the core principles of G-37 to investment advisers and the public pension plan area.

We have spoken with your representatives from NASRA, and we have discussed the matter with some of your colleagues. They have described the difficult position in which a professional manager is placed when it becomes apparent that the decision-making process is being skewed by considerations of political contributions. You have a unique perspective from which to help us understand the issues.

I look forward to further discussions with you and look forward to hearing your views.

Thank you.

1 Self-Regulatory Organizations; Municipal Securities Rulemaking Board, Securities Exchange Act Release No. 34-33868 (Apr. 7, 1994).

2Blount v. SEC , 61 F.3d 938 (1995), cert. denied , 517 U.S. 1119 (1996).

3A Sleazy Practice That Costs Taxpayers , San Francisco Chron., Aug. 1, 1997, at A26.

4See Office of Vermont State Treasurer James H. Douglas, If You Play, You Pay: New Campaign Finance Legislation Prohibits Contracts for Wall Street Firms Contributing to State Treasurer Races, a Provision Pushed by Douglas (06/16/97) http://www.state.vt.us/treasurer/press/pr970616.htm.

5 Clifford J. Leavy, Firms Handling N.Y. Pension Fund Are Donors to Comptroller , N.Y. Times, Oct. 3, 1998, at A16)

6See Steve Hemmerick, See You in Court,’ Bank Tells Its Client: State Street Sues over Custody Contract, Pens. & Inv., Feb. 23, 1998, at 2.

7 Charles Gasparino and Jonathan Axelrod, Political Money May Sway Business of Public Pensions , Wall St. J., Mar. 24, 1997, at C1.

8 Conn. Gen. Stat. § 9-333 o (1997); Vt. Stat. Ann. tit. 32, § 109 (1997).

9 15 U.S.C. 80b.

10SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963).



Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Job Opportunity – Marketer Wanted

I received an inquiry from a recruiter who is looking for a hedge fund marketer.  Here it is:

I am a recruiter that usually doesn’t enter into this area of expertise.  However, I do have a very hot opportunity for a Hedge Fund Marketer in the South West.  Would love to hear from anyone qualified, licensed but just downsized or looking for expanding his/her portfolio.

If you would like more information on this opportunity, I would be happy to pass along the information.

How to grow your hedge fund

There are several effective ways to grow your hedge fund. Many of those methods will be discussed and evaluated here. Obviously superior performance among investors with comparable risk is a great way to grow your fund. This section will delve into how investment teams can derive the superior performance that all funds strive for.

Character of the Management Team

There are certain key characteristics of successful investors that generally indicate whether the management team will be successful. A concentration on the business processes of the fund and consistent learning rather than daily results will generally lead to a knowledgeable management team. Most successful money managers understand that markets tend to be fickle and daily results are not always a good barometer of achievement. Hubris has the potential to plague intelligent investors; however, humility tends to lead to personal improvement and less risky investment strategies.

Investment managers should focus on their love for their work. Investors like to invest with people they can trust and those that exude a love for their work. A common trait amongst successful investors is a deep understanding of how investing induces the progress of our society. If investors have a sense that they are actually doing good for society, they tend to be more enthusiastic about their work which encourages investment. Investors should focus on the value that they provide to society. Many sophisticated investors want to believe in positive effects of their investments in addition to creation of wealth.

In addition, managers should focus on their skills rather than attempting to predict general macroeconomic trends. Successful managers know that there are always excellent opportunities in the markets to exploit. There are many trading strategies that successful investors can employ but the management team should focus on their abilities. Good management teams are patient. They fully understand their methodology. They rarely look for shortcuts or the easy way out.


Investment professionals aspiring to become masters will strive for understanding and be consistent in their philosophy. Novices tend to look for an easy way to succeed. New investors will extrapolate previously successful investment models in books and project future gains. Inexperience leads investors to search for immediate profits rather than the consistent model of return that successful long term managers achieve. Thus, patience and consistency is a virtue.

Understanding and Application of Economics

A superior understanding of market forces can lead to growth of a fund. Investors that align their investment strategies with the overall economic and liquidity environment tend to be more successful and are able to maximize profit in nearly all environments. An intrinsic understanding of the drivers of market prices and examples of investment success guides successful funds. In addition, staying dynamic and perceptive of changing market trends is vital to maintaining the edge that superior economic knowledge grants.

Being able to time the liquidity cycle of the market should be a determinant in how a fund allocates capital. It has been found that 97% of equities fall in a period of tightening while 90% of equities rise in a steep yield curve environment. In addition, liquidity cycles can be utilized to determine the attractiveness of foreign markets that actively trade stocks and bonds. In an increasingly flat economic environment understanding global liquidity and economic indicators is essential to most funds.

Asset Allocation

Large cash positions provide low returns but good investors should be patient within their preferred asset class. Thus, investors looking to grow their funds should seek out other asset classes in which to allocate capital. While investors should find asset classes that best match their portfolio, it has been found that allocating 10 to 25 percent of assets to actively managed futures can increase long term returns and decrease long term risk. Many studies have found that adding actively managed futures to a portfolio of stocks/bonds can decrease volatility and increase gains.

In addition, investors should understand the almost universally recognized truth that joining several risky investments into one portfolio decreases risk and raises return. Mixing together uncorrelated assets should smooth out long term performance and increase fund size as the investments will react to different market forces.

Effective Marketing

In today’s increasingly competitive market for the capital of sophisticated investors, hedge fund managers need to market their fund properly in order to encourage large infusions of capital. A hedge fund manager may not solicit investment into the fund through any “general solicitation” or “general advertisement” per SEC regulations and thus funds rely upon advisory services to raise capital. Hedge funds used to rely on networks of advisors and their high net worth clientele; however, with the increasingly flat investment world, hedge fund consultants can be easily contact via the internet. Hedge fund advisors utilizing the internet are subject to the same SEC regulations as traditional advisors. Operational websites must adhere to the following regulations: the site is password protected, there are no references to a specific fund on the home page, the internal contents of the website are only available to qualified clients, and prospective investors are required to wait thirty days before investing.

In addition, a hedge fund administrator may be helpful in marketing and managing the fund. A hedge fund administrator provides valuable third party resources that: reduce expenses of the fund, validate performance results to investors, increase the managers’ time available to focus on investing, and provide access to accounting and finance professionals.

Hedge funds can benefit from using banks as a prime broker as it provides many resources and most importantly a centralized clearing house for transactions. Prime brokerages also provide value-added services of: capital introduction, risk management advisory services, and consulting services. Outsourcing non-investment activities to another firm decreases distractions, allowing the managers to focus on investing.

Transparency and Simplicity

Hedge funds trying to grow should encourage capital infusion by being somewhat transparent and simple. Typically hedge funds want to be relatively opaque; however, increasing investors are requesting more information and a minimum level of transparency for effective due diligence in now usually required. A level of transparency can be accomplished with an operational website that complies with all regulations. Many investors may not seriously consider investment in a fund without a website. In addition, managers should list performance on hedge fund databases. Acknowledgment of outperforming associated risk benchmarks on a hedge fund database will typically induce some investors to choose your fund over another.

Should a start-up hedge fund have an audit?

Question: Should a start-up hedge fund have an audit?

Answer: This is a question which we will get very often for funds that aim to launch on July 1 or later.  While there is generally no legal requirement for a hedge fund to have their performance results audited, a vast majority of hedge funds have their returns audited because it will aid in the marketing efforts by lending credibility to performance results.

With regard to this question, and as with most business-issue oriented hedge fund questions, the answer is going to depend on the manager’s program and what the manager plans to accomplish during the first 6, 12 and 18 months of operations.

Generally, first year hedge fund manager’s are going to need to focus on costs. Not only from a cash flow perspective, but also from a return perspective. Any costs (which the fund bears) affect performance. Accordingly, many start-up hedge fund managers may forgo an audit of the fund’s track record during the first year. The manager then may have the fund audited after the end of the fund’s second year. A manager might consider doing this in a couple of situations. The first situation is when the fund starts trading during mid-year or later. In this instance it will probably not make a lot of sense to have an audit for fund operations of less than one year. An exception to this generality is if you have a decent amount of AUM and you are looking to begin courting institutional investors. If this is the case, then it will generally be a good idea to have an audit.

The second situation when a start-up hedge fund manager might not choose to have an audit after the first year is if the manager has a longer term hedge fund incubation program. This might be the case if the hedge fund manager has a longer term trading strategy (buy and hold) or when the manager does not plan to seek institutional money during the second year. Many managers will go with this slow and steady approach to asset raising in order to understand the back end operations of their fund. As noted in numerous places, one of the main reasons why hedge funds fail is inadequate back office operations.

If a start-up hedge fund manager plans to start with a larger asset base, say $10 million or more, and plans to aggressively court the institutional market during the first half of the coming year, then it might be wise to think about an audit. While the decision to forgo a first year audit is strictly a business decision, it is recommended that you discuss this decision with both your legal team and your potential auditor.  Additionally, if you will be using the services of a third party marketer, you will want to discuss this decision with the third party marketer.