Recent Exemptions From Rule 206(4)-5 Demonstrate the Importance of Strong Compliance Policies and Quick Corrective Action

Recent Exemptions From Rule 206(4)-5 Demonstrate the Importance of Strong Compliance Policies and Quick Corrective Action

Client Alert


Recently, the Securities and Exchange Commission (SEC) has demonstrated its willingness to largely forgo the strict consequences of Investment Advisers Act Rule 206(4)-5 (the “Pay-to-Play Rule”) in circumstances where investment advisers can demonstrate that they have effective compliance policies and took action when confronted with a potential violation. These recent exemptive orders are the first such orders since 2020.

The Pay-to-Play Rule is intended to deter investment advisers, and their covered associates, from using campaign contributions to exert improper influence over existing or prospective investments by public sector clients. Violations of the Pay-to-Play Rule can lead to fines and prohibitions on investment advisers receiving any compensation from a government entity for two years following the date of the violative contribution.1

The SEC issued two exemptive orders that imposed limited conditions on the investment adviser:

  • AEW Capital Management, L.P.2 – An individual who did not work for AEW at the time made a $1,000 campaign contribution to a Boston city council member who was serving as acting mayor of Boston and was a candidate for re-election as mayor. Investment decisions for City of Boston public investment pools, including the hiring of an investment adviser, are overseen by a five-member board that includes two mayoral appointments. The individual was subsequently hired by AEW and became a covered associate six months after having made the contribution. In the course of the hiring process, AEW learned of the contribution, and the individual sought and received a refund from the campaign. Thereafter, AEW walled off the individual from all activities involving the City of Boston, and the individual generally has not solicited any government entities upon joining even though the role into which she was hired would ordinarily be involved in such activities.
  • J.P. Morgan Investment Management Inc.3 – An individual who did not work for J.P. Morgan at the time made a $1,000 contribution to the mayor of Tallahassee, who was running for reelection. Investment decisions for City of Tallahassee public investment pools, including the hiring of an investment adviser, are overseen by a six-member board, on which the mayor serves in an ex-officio capacity. The individual was subsequently hired by J.P. Morgan and became a covered associate. In the course of the hiring process, J.P. Morgan learned of the contribution, and the individual sought and received a refund from the campaign. Thereafter, J.P. Morgan walled off the individual from all activities involving the City of Tallahassee.

In both of these cases, the SEC highlighted in its notice of application for an exemptive order the vetting process and the compliance policies and procedures the investment advisers had in place. The SEC also highlighted the investment advisers’ explanations that they took all available steps to obtain a return of the contributions and informed the individuals that they could have no contact with any representative of the clients at issue. The SEC noted the potentially significant consequences, explaining that causing the investment advisers to serve without compensation for the remainder of the two-year periods could result in financial losses that would be hundreds of times the amount of the contribution. Given the circumstances, the SEC issued exemptive orders and included conditions only that: (1) the individuals are prohibited from discussing any business with the relevant government entities until the two-year period following the contributions lapses; (2) the individuals will receive written notification of that prohibition and will provide a quarterly certification of compliance; and (3) the investment advisers will conduct testing to prevent violations of that prohibition. These limited conditions are consistent with other similar applications where the order is issued before two years have passed since the triggering contribution. 

By contrast, the SEC recently issued a third exemptive order that imposed more onerous conditions:

  • Calmwater Asset Management, LLC4 – A covered associate made a $250 campaign contribution to an unsuccessful candidate for Colorado state treasurer. The treasurer is an ex officio voting member of the board of trustees for the state of Colorado’s pension fund, which has the authority to select the investment adviser. The covered associate attempted to pre-clear the contribution, but due to an oversight, the compliance personnel did not analyze the contribution and approve or deny it, and the covered associate incorrectly thought he had received oral approval. The covered associate did not complete pre-clearance through Calmwater’s compliance software tool. A compliance consultant discovered the contribution during an annual review, and the covered associate then sought and received a return of the contribution.

Even though Calmwater explained that it took remedial measures—including replacing its chief compliance officer, updating its pre-authorization policy for contributions, adding quarterly certifications for employees, installing an upgraded version of its compliance software tool, and amending its compliance manual—the SEC still imposed a condition that Calmwater must appoint an independent compliance consultant to annually review and test its compliance program and compliance systems. Though not nearly as severe as it could have been, this is likely more of a burden (and more expensive) than the limited conditions imposed on AEW and J.P. Morgan.

While all three of these investment advisers emerged relatively unscathed by seeking exemptive orders in advance of potential enforcement investigations, these cases demonstrate how easy it is to run afoul of the Pay-to-Play Rule. For AEW and J.P. Morgan, the “look-back” provision of the Pay-to-Play Rule brought in contributions made by individuals who, although they were not covered associates at the time of the contribution, were hired shortly thereafter and became covered associates. For Calmwater, the investment adviser’s compliance operation simply dropped the ball, and though significant reforms were made after the fact, the SEC still required independent compliance oversight going forward. Also, in that case, the contribution was made to an unsuccessful candidate who never held office and was never in a position to actually influence anything. But that makes no difference under the Pay-to-Play Rule.

Based on these recent actions, the SEC appears ready to issue exemptive orders with limited conditions to investment advisers with 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 in the routine hiring process, advisers want to demonstrate in an exemptive application that they have robust compliance operations and took steps to remediate the situation quickly.

As off-year elections across the country heat up and the 2024 presidential race gains entrants, it may be worth evaluating current policies. Pre-clearance requirements for political contributions are an effective way for compliance to review and confirm that each planned contribution is acceptable while preserving the ability of covered individuals to participate in the electoral process. Additionally, periodic compliance checks of public campaign contribution databases for donations are prudent. Finally, it is always worth considering supplemental training and compliance certifications 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 and navigating compliance with the Pay-to-Play Rule.



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