Initial Disclaimer: I have never written about politics before in my life, so I’m not entirely sure how to go about it. But I was specifically requested to say something about this particular piece of sausage and, well, I can never resist an appeal to my vanity, so I went and did it.
Last summer, the Securities and Exchange Commission passed Rule 206(4)-5, and amended a few other Rules under the Investment Advisers Act of 1940. If you read the adopting release, and you believe everything you read, this bit of legislation is intended to preserve “the public trust” from abuse at the hands of elected officials who are taking campaign contributions and kicking it back to Wall Street by directing business to financial firms.
Why this stuff matters
Many investment firms, particularly in what’s known as the “alternative asset” space, an abstract term for, generally, hedge funds and private equity funds, earn two sets of fees, only one of which is tied to performance returns. The other is based on the amount of assets the fund has to invest, contributed by investors and added to by performance growth. Managers and employees earn their compensation from the fees paid – asset fees tend to go to expenses which includes base salaries and bonus compensation for non-partner employees – managers who have ownership in their firms earn the performance based fees directly. For most funds, the higher fee is tied to performance – which is why Madoff inflated his returns, rather than his asset size – but asset growth can still make a substantial impact on a firm’s bottom line, and excess in asset-based revenues over expenses can mean profit for managers.
Cases of kickbacks, or “pay to play”, have come up with what seems increasing frequency in news reports – a good recent (and local) example is Alan Hevesi, the NYS comptroller who recently pled guilty to directing state pension funds to certain investment firms in return for gifts.
So there’s no denying that this is an actual issue, and I suppose the Commission – at the explicit behest of Congress, mind you, who gets the PR credit here – gets a hats-off for addressing an issue that exists, rather than one invented to inflame public fears which they can then take credit for calming.
Why this is the wrong solution
However, I think you’d be hard-pressed to say they got it right on this one.
What the law actually says is this:
1– An investment advisor (regardless of whether it’s an entity registered with the SEC, a state, or nothing at all) may not receive compensation from a “government entity” where the advisor or its “covered associates” have made a contribution to a state or local government “official” of that public entity within the past two years (above a de minimis amount – $150 for an official someone can’t vote for, and $350 for an official one can vote for).
A key takeaway here is that the rule applies only to state and local officials – which includes state and local officeholders (of any variety, potentially) who are running for Federal office or Federal officeholders running for state positions. It doesn’t touch current Federal folk who are running for re-election or new Federal office.
The devil is in the details here, and the definitions of those terms in quotes matter. A “public entity” covers what you would think of, in terms of recent news as well as common sense: public pension funds, 529 plans (education savings), and other state and locally funded pools of cash. This would seem easy enough to comply with, if we stopped there, and perhaps a facially fair rule. However, the definition doesn’t stop there: it also includes any pool of money, whether publicly affiliated or not, for which a state or local government official has the ability to make investment decisions or to appoint someone to make investment decisions. So, if the principal of your local public school serves on the Board of Directors for a charitable entity that makes investments – that situation is covered, too.
For investment firms, keeping tabs on which of your clients is a public entity has now gotten a lot harder. Firms are required to “Know Your Customer” to comply with applicable anti-money-laundering laws – but the kinds of documentation requested usually do not require a full history of the Board of Directors for the past two years, say. Or the chairman of an investment committee who left six months ago and held no other position in the entity that would make him noteworthy. This contributes to putting advisors in a bind with respect to compliance.
“Congress shall make no law. . .”
To the best of my knowledge, Congresscritters and SEC employees are still groups with disparate elements; there’s no direct benefit to the Commission’s employees here and they don’t have a direct motive for taking such a step. However, this rule was passed amid a flurry of Congressional interest in pay-to-play, and the Rule intersects with provisions of Dodd-Frank. At the very least, Congress was fully aware of the potential windfalls here (discussed below in conspiracy-laden detail) by the time the notice and comment period rolled around.
In the adopting release, the SEC pats itself on the back for dancing carefully around the First Amendment – we’re not restricting speech, they say, we are restricting compensation – and they’re not wrong about that with the first prong of the law. However, the effect of prohibiting the receipt of compensation is to restrict speech – legal guidance around compliance with these rules essentially says, look, it’s impossible with these definitions to keep track of which prospective clients can be tainted by contributions, unless you want to provide each of your investors a list of everyone your staff has made donations to and have them certify that none of those people have been in a position to direct your investment activities and you won’t hire any of them, either. That would not be a questionnaire designed to attract clients. So firms are essentially saying, you have to notify us about all of your state and local donations in advance, and we reserve the right to tell you you can’t make them. “[W]e acknowledge”, the Commission apologizes, “that the two-year time out provision may affect the propensity of investment advisers to make political contributions” – but they still get to make this rule, because it balances out OK in the end (see below).
I’m no constitutional law scholar, and this Rule may technically be constitutionally acceptable – they are, in fact, not making a law restricting speech; they are only making a law whose impact is to restrict speech, and there are theoretical ways to comply with that law which do not restrict speech. I would think, particularly in the wake of Citizens United, we are all in agreeance on political contributions and speech. The adopting release acknowledges that protected rights are involved here, and provides the balancing act rationale: “Limitations on contributions are permissible if justified by a sufficiently important government interest that is closely drawn to avoid unnecessary abridgment of protected
rights”
Those devious feds
This compliance issue, to me, is an example of impressive cleverness and deviousness on the part of your federal officials. I go on to outline the rest of the rule below, if you’re interested (and hey, who isn’t interested in the regulation of investment firms! Let me hear you, crickets!) – but this first prong is the part I am most impressed with.
As outlined above, investment firms which solicit any non-individual investors have no practical compliance choice that will allow them to continue to conduct their business except to require pre-approval and the ability to deny state and local political contributions. (To be fair, some firms simply restrict employee state and local donations to a particular state and then decide not to seek clients from that state, and that should be low-risk. But this is not something most firms are willing to do – the competition for investors is fierce, and most firms will take good money wherever they can get it.)
The beauty of these definitions is that, like the definition of “government entity”, the definition of state or local official is pretty broad. It covers anyone serving in or running for a state or local office who would have the ability to direct investment activities or could hire or appoint someone with the ability to direct investment activities.
As written, and explicitly acknowledged in the release, this includes state or local officials (or someone serving in state or local government on the Board of Directors, as above) who is running for federal office. So Congress has effectively reduced funding for the campaigns of state and local officials from some of the wealthiest individuals – investment folks, who have the money to spend on politics and who might well be interested in doing so.
Candy from a baby: Fattening the Feds
This has two potential boons for Congress (outside of chest-beating regarding pay-to-play itself): one is that great candidates who start out in state or local offices and build political careers from there will have higher financial hurdles to overcome. I am not a student of electoral history, but I’m willing to bet at least some Congressfolk come up through the ranks this way. The second is that Congress whoops, the Commission has effectively deprived challengers who come from nonfederal offices of an important source of funding. Wall Street can fund Gillibrand, that is, but not Ford(Apologies for the correction – here’s an actual example or two.).
I’m no conspiracy theorist. And despite being a Democrat, I often think it’s better to leave certain things unregulated, because the law is poorly written and makes a lot of things worse – even when you need to regulate something, it’s an arms race between the drafters and the lawyers hired to get around them. So I don’t think that the SEC’s primary reason for passing this law was to make it harder for “Washington outsiders” to make it into office.
Regardless of whether the bill was intended to benefit Federal incumbents, I think you’d be hard pressed to say it won’t have that effect. You all know a lot more than I do about contributions and political donations – maybe I underestimate how much of that funding is coming from investment professionals. But I’d be surprised if they weren’t a significant source of revenue, whether for the side of right or wrong. And I’ll be very curious to see if the wise analysts of the SSP notice any differences in the funding of state-level challengers to federal office.
If you’re interested, the other main points of the rule are:
2– The advisor and its covered associates cannot solicit or coordinate contributions either to an official of a public entity which is a prospective client or to a state or local political party (italics mine) in a location where the advisor is looking for prospective clients. So, thankfully(sarcasm), you can still give to the D-Trip , but you’d better stay away from state and local parties anywhere you might want to conduct business.
This one is a strict prohibition. I think that we pass Constitutional muster here (for those who think we do) by the narrowness of the scope: The Commission finds this only a “marginal limitation” in the adopting release. But it still reads, initially, as a somewhat ballsy move, particularly if you give any weight to my feelings above that Congress has a lot to be thankful for in respect of this piece of drafting.
Finally, the third major prong is:
3– The advisor and its covered associates may not pay third parties to solicit public entities as clients unless those third parties are also subject to pay to play rules.
In the article I linked to above, this requirement caused placement agents to fall all over themselves trying to get registered before they went out of business – and this is the most visible intersection with Dodd-Frank.