Recent Pay-to-Play Settlement: Notwithstanding a Strong Dissent Over 206(4)-5 Overbreadth, the Need for Strong Compliance Policies Persists

Recent Pay-to-Play Settlement: Notwithstanding a Strong Dissent Over 206(4)-5 Overbreadth, the Need for Strong Compliance Policies Persists

Client Alert


With political campaign activity ramping up as the fall elections approach, the Securities and Exchange Commission (SEC) has indicated it will continue stringent enforcement of Investment Advisers Act Rule 206(4)-5 (the Pay-to-Play Rule or Rule). Over a forceful dissent from Commissioner Hester Peirce, the SEC recently instituted and settled an administrative proceeding against Wayzata Investment Partners LLC for a violation of the Rule, which is intended to deter investment advisers from using campaign contributions to exert improper influence over existing or prospective investments by public sector clients. As this action demonstrates, even tenuous connections between a donation and an investment decision are enough to lead to serious consequences, and advisers would be prudent to review their policies and procedures to ensure they do not find themselves on the wrong side of this Rule.

On April 15, 2024, the SEC settled an administrative proceeding and ordered Wayzata to pay a $60,000 penalty and cease and desist from any future violations of the Pay-to-Play Rule. In April 2022, a covered associate of Wayzata had made a $4,000 campaign contribution to a candidate for elected office in Minnesota, which office had influence over selecting investment advisers for a state investment board in Minnesota.1 As the SEC’s order noted, the state investment board had already invested in funds advised by Wayzata prior to the contribution. But that did not matter, as the Rule does not require a showing of quid pro quo or actual intent to influence an elected official or candidate. All that is required for a violation is that the contribution was made and investment advisory services were provided within two years.

SEC Commissioner Peirce’s dissent, titled “There’s Got to Be a Better Way,” built on her prior 206(4)-5 dissents, which highlighted the “sweeping” and “blunt” nature of the Pay-to-Play Rule. She noted that the SEC’s order “does not allege any link between the donation and the investments,” as the state investment board “had invested in closed-end funds advised by Respondent several years prior to the contribution,” and Wayzata simply “continued to provide advisory services for compensation in connection with the board’s longstanding closed-end fund investments.” 

Criticism of the Pay-to-Play Rule is not new, but legal challenges to the Rule have thus far been unsuccessful. In 1994, the Municipal Securities Rulemaking Board adopted a similar pay-to-play rule, which restricted broker-dealers from making certain political contributions. The U.S. Court of Appeals for the D.C. Circuit rejected a challenge to the rule, finding that regulating pay-to-play practices in the municipal bond market is within the authority of the SEC to reduce distortion in financial markets and the rule did not violate the First Amendment. Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995), cert. denied, 517 U.S. 1119 (1996). In 2015, the D.C. Circuit rejected another challenge to the SEC’s pay-to-play authority on procedural grounds. New York Republican State Comm. v. SEC, 799 F.3d 1126 (D.C. Cir. 2015). And in 2019, the D.C. Circuit dismissed a challenge brought by the New York Republican State Committee and the Tennessee Republican Party to a rule nearly identical to the Pay-to-Play Rule, holding that the SEC had authority to enact the rule, doing so was not arbitrary and capricious, and the rule did not violate the First Amendment. New York Republican State Comm. v. SEC, 927 F.3d 499 (D.C. Cir. 2019). In 2020, the Supreme Court denied certiorari, leaving intact the SEC’s authority to enforce the Rule.

Given evolving judicial views regarding campaign contribution limits over time, additional challenges to the Rule could be possible in the future.2 In the meantime, investment advisers should pay close attention to their policies and procedures to ensure that contributions to campaigns are highlighted as a fraught activity. Despite the impact on participation in the political process, the severe consequences of a violation—not only significant fines, but also potential prohibition on the investment adviser from receiving any compensation from a government investment entity for two years—cannot be ignored. Some advisers implement preclearance for all political contributions so that compliance can review and confirm that each planned contribution is acceptable. Additionally, periodic compliance checks of public campaign contribution databases for donations (or the use of a vendor to conduct such periodic checks) would be prudent in order to (1) assess the effectiveness of the adviser’s policies and (2) be aware of issues promptly if a contribution is made. It is also worth considering supplemental training, compliance attestations, and/or compliance alerts for personnel in order to highlight this issue.

Our team has experience designing and working with clients to implement effective pay-to-play policies and procedures focused on meeting the expectations of regulators, as well as seeking exemptions in the event of violations and defending conduct before relevant SEC personnel. With campaign contributions poised to set new records, the 2024 election season poses significant risks for investment advisers. State and local pension funds hold over $5 trillion in assets, much of which is managed by investment advisers. Any investment adviser that manages such assets is at risk of violating the Pay-to-Play Rule. Based on its recent activity, the SEC appears ready to issue exemptive orders or reach settlements with limited conditions when investment advisers have strong compliance policies and procedures in place to promptly address contributions made in violation of the Pay-to-Play Rule. In the event something unexpected occurs or a contribution is discovered, advisers want to demonstrate in an exemptive application that they have robust compliance operations and quickly took steps to remediate the situation.



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