The 2020 U.S. election is officially underway. While that’s great for democracy, it can be hard on financial services organizations due to increased political contributions and political activities by employees—contributions or activities that have the potential to violate pay-to-play rules and generate fines or even prohibit future business. As a result, investment management firms should ensure they have adequate policies and procedures in place to monitor their employees’ political contributions and government relationships to prevent potential conflicts of interest that put the firm at risk.
Pay-to-Play and Political Contribution Regulations
Pay-to-play rules, such as the U.S. Securities and Exchange Commission's (“SEC”) pay-to-play rule 206(4)-5, may be triggered when a firm or firm employee donates, either directly or indirectly, to a government official with the ability to manage or allocate money for a government entity client. Such a donation could result in a quid pro quo and create a conflict of interest, but could still be problematic even if there is no actual quid pro quo or conflict present.
The government entities in question can be anything from a large state pension plan to a university endowment. Violation of pay-to-play rules can result not only in fines but also in being locked out for two years from receiving compensation from the client in question, so it’s a situation that financial services firms that solicit government entity clients should avoid.
Firms also need to keep in mind that the amount of money that can trigger a violation of the SEC’s pay-to-play rule isn’t much—it starts at $150 in some instances and $350 in others. State or local rules may be even more strict.
Why it Matters Now
With a highly charged political climate, this election cycle could generate more political activity from employees. As a result, firms need to proactively ensure they are—and will remain—in compliance with relevant pay-to-play regulations.
If your firm has clients or prospective clients that are government entities or government-associated entities, they need to be tracked and monitored. You should pay attention to your firm's employees that interact with government entities.
Pay-to-play compliance can be tricky. One special area to watch out for is incumbent candidates, as contributions to such candidates may inadvertently violate pay-to-play rules. For example, it is important to track any contributions to candidates for Vice President of the United States if that candidate was already a government official, such as a state governor.
While the SEC certainly has plenty of responsibilities on its plate, based on precedent it is likely that the regulator will step up enforcement and investigation of potential play-to-play situations in an election year. And even if your firm makes it through the election cycle without a knock on the door from the SEC, this doesn’t mean you’re in the clear. The SEC will be on the lookout for violations during lookback periods after 2020.
Recent administrative proceedings by the SEC against both registered investment advisers and exempt reporting advisers should serve as a stark reminder of the importance of actively monitoring for risks that exposure to government entity clients or political parties may present. In December 2018 the SEC fined an investment adviser $100,000 for violating the SEC’s pay-to-play rule because two of the adviser’s covered associated made multiple contributions to Ohio gubernatorial candidates in excess of de minimis amounts*.
What’s Involved in Risk and Compliance Oversight for Political Contributions and Government Relationships
Pay-to-play rules encourage more than just the oversight of financial contributions. Organizations may also need to track political activities such as volunteering or use of property where an employee may allow a political campaign to use office resources or locations.
While organizations should certainly consider educating all employees about pay-to-play rules, covered associates are the biggest risk and where they should focus their efforts. Covered associates for SEC pay-to-play regulations generally include officers, directors, general partners, and any employees who are soliciting (or who will be soliciting) government entity clients. Covered associates also include political action committees controlled by the advisor or covered associates of the advisor. State or municipal pay-to-play rules may define covered associates differently.
Best Practices for Monitoring Political Contributions and Government Relationships
- Be aware and understand relevant pay-to-play rules. The first step to ensuring compliance with pay-to-play rules is to be aware of them and understand which ones apply to your firm. In addition to federal rules like 206(4)-5, there may be local, municipal, and state rules that are relevant.
- Make sure your policies adhere to the relevant pay-to-play rules. At a minimum, your firm’s policies need to be in line with relevant pay-to-play rules. Many firms have policies that are stricter than the letter of the law to err on the side of caution. For example, figure 1 shows the results of a recent ACA webcast poll in which 16% of respondents said they prohibit all political contributions. How strict your firm needs to be depends on the risk area and whether or not your firm has, or plans to have, government entity clients.
- Communicate your firm’s pay-to-play policies to your employees. A critical step in enforcing pay-to-play policies is making sure your employees are aware of them. The policies should be highlighted during a new employee’s onboarding process, but many firms also require additional yearly attestations and compliance training for existing employees. Explain that financial contributions or political activities can cause conflicts of interest that put your firm at risk and give employees the tools to ensure they can be in compliance. Be aware that due to lookback periods, your firm should also ask new employees about prior political contributions for relevant time periods.
- Implement technology that can automate pay-to-play monitoring. Managing all the policies, paperwork, and testing around pay-to-play compliance can be time-consuming and inefficient. Automated systems can assist with communicating the policies, managing the submission of employee’s preclearance request, tracking where employees are requesting to make a political contribution, and testing. According to a recent ACA webcast poll, 86% of respondents use technology to support their code of ethics compliance efforts (figure 2).
Your firm may also want to consider implementing technology that allows covered associates to periodically certify that they have not made political contributions, or that all contributions have been appropriately reported and disclosed. These systems allow for approval workflows that make the tracking and documentation of political contributions easier and more efficient.
- Test for compliance. Testing usually consists of checking a variety of political donation databases and specific state-level databases against employee names to verify contributions (or lack thereof). A recent ACA webcast poll showed that 62% of respondents conduct periodic reviews of publicly available information for compliance checking (figure 3). The amount of testing depends on the size the company, the number of employees subjected to pay-to-play rules, and the risk level. For example, annual or semi-annual testing may be appropriate if your firm isn’t particularly high risk, while other firms may have a need for quarterly or monthly testing. A best practice is to test more frequently than just once a year and identify potential issues sooner rather than later.
How Do You Measure Up? Download the Infographic
An election year coupled with one of the strictest penalties under the Investment Advisers Act of 1940 means there has never been a more important time for firms to review their compliance with the SEC’s pay-to-play rule. According to a recent poll conducted by ACA, some firms may need to review and refresh their firm’s policies and procedures regarding political contributions. Download our infographic to learn more see how your peers are handling pay-to-play compliance, and for steps you can take now to ensure compliance with the rules that are relevant to your firm.
How We Help
It is important for investment advisers to establish policies, procedures, and effective testing strategies for monitoring the risk that political contributions and government relationships may present. If you are interested in learning more about how ACA helps firms in mitigating these risks through compliance advisory and managed services and regulatory technology, please contact your ACA consultant or Sean McKeveny at email@example.com.
About the Author
Elaine Vincent is a Principal Consultant at ACA and oversees the Forensic Testing and Filings and Outsourced Marketing Review teams at ACA’s Analysis and Review Center (“ARC”) in Pittsburgh, PA. She joined ACA in September 2014 as a member of the electronic communications surveillance team. She spent time in the field conducting SEC mock audits, focused reviews, gap analyses, and other regulatory compliance work, and she also assisted with the initial launch of the ARC’s outsourced marketing review team. In her current role, Elaine supervises ARC teams focused on managed services including marketing reviews, anti-money laundering, regulatory filings and related consulting, and various other forensic testing and managed services. Prior to joining ACA, Elaine spent several years practicing law at a Pittsburgh area law firm, with a focus on civil and administrative litigation. Elaine earned her Juris Doctor from the University of Pittsburgh School of Law and her Bachelors of Arts in Philosophy and Italian from the University of Pittsburgh, graduating Magna Cum Laude.