things, requires an adviser that engages a third-party solicitor for
clients: (i) to make a bona fide effort to ascertain whether the
solicitor has complied with the adviser's agreement with the
solicitor; and (ii) to have a reasonable basis for believing that
the solicitor has so complied. Advisers Act rule 206(4)-
3(a)(2)(iii)(C) [17 CFR 275.206(4)-3(a)(2)(iii)(C)].
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    In light of these considerations, including the apparent
difficulties for advisers to monitor the activities of their third-
party solicitors, we are proposing to prohibit investment advisers from
using third-party solicitors to obtain government clients.\135\
Proposed rule 206(4)-5 would make it unlawful for any investment
adviser registered (or required to be registered) with the Commission,
or unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act [15 U.S.C. 80b-3(b)(3)], or any of its
covered associates, to provide or agree to provide, directly or
indirectly, ``payment'' to any person to solicit a government entity
for investment advisory services unless such person is: (i) A ``related
person'' of the investment adviser or, if the related person is a
company, an employee of that related person; or (ii) any of the
adviser's employees, general partners, LLC managing members, executive
officers (or other person with a similar status or function, as
applicable).\136\ The rule's prohibition on an adviser's payments to
third-party solicitors may apply to persons commonly called
``finders,'' ``solicitors,'' ``placement agents,'' or ``pension
consultants.'' \137\
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    \135\ Although rule 206(4)-3 under the Advisers Act (the ``Cash
Solicitation Rule'') contemplates that certain client solicitation
activities of third parties can be undertaken where certain
conditions are met and the adviser both ``makes a bona fide effort
to ascertain whether'' and ``has a reasonable basis for believing
that'' the solicitor has complied with certain aspects of the rule
(Advisers Act rule 206(4)-3(a)(2)(iii)(C) [17 CFR 275.206(4)-
3(a)(2)(iii)(C)]), commenters' concerns about the inability of
advisers to control the political contribution activity of their
solicitors (which is not restricted under the Cash Solicitation
Rule) persuade us that a different approach is appropriate for
solicitation of government clients.
    \136\ Proposed rule 206(4)-5(a)(2)(i). Advisers making payments
to solicitors must comply with the cash solicitation rule under the
Advisers Act. If this component of proposed rule 206(4)-5 is adopted
as proposed, investment advisers registered or required to be
registered with us would no longer be able to rely on the cash
solicitation rule to pay third-party solicitors to obtain government
clients. For a discussion of proposed amendments to the cash
solicitation rule, see infra section II.C.
    \137\ Pension consultants provide advice to pension plans
(public or private) and their trustees with respect to their
investments, selection of money managers and other service
providers, and other investment-related matters. Many pension plans
rely heavily on the expertise and guidance of their pension
consultant in helping them to manage pension plan assets. Pension
consultants may act as third-party solicitors. Others may act as
investment advisers subject to our rule. In 2005, our Office of
Compliance Inspections and Examinations published a report
highlighting concerns relating to the Advisers Act stemming from
examinations of 24 pension consultant firms, including conflicts of
interest that arise with respect to pension consultants that provide
products and services to both pension plan advisory clients and
money managers and mutual funds on an ongoing basis. Office of
Compliance Inspections and Examinations, U.S. Securities and
Exchange Commission, Staff Report Concerning Examinations of Select
Pension Consultants (May 16, 2005), available at http://www.sec.gov/
news/studies/pensionexamstudy.pdf. Commission staff also published
on the Commission's Web site, in cooperation with the U.S.
Department of Labor, tips to assist fiduciaries of employee benefit
plans in reviewing conflicts of interest of pension consultants.
Selecting and Monitoring Pension Consultants: Tips for Plan
Fiduciaries (June 1, 2005), available at http://www.sec.gov/
investor/pubs/sponsortips.htm.
    Although the terms are sometimes used interchangeably,
``finders'' typically locate buyers and/or sellers for a security on
behalf of a broker-dealer, ``solicitors'' typically locate
investment advisory clients on behalf of an investment adviser, and
``placement agents'' typically specialize in finding investors
(often institutional investors or high net worth investors) that are
willing and able to invest in a private offering of securities on
behalf of the issuer of such privately offered securities.

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    The proposed rule would only apply to ``third-party'' solicitors
who solicit government entities for investment advisory services.\138\
The prohibition on payments to third-party solicitors would not cover
solicitations on behalf of an investment adviser by a person who is a
``related person'' of the adviser, any of the related person's
employees if the related person is a company,\139\ or any executive
officer or partner of the adviser.\140\ A contribution to a government
official by certain of these persons would instead trigger the two-year
``time out'' under paragraph (a) of the proposed rule, during which the
investment adviser could not provide investment advisory services for
compensation to the government entity whose selection of an adviser
that official could influence.\141\ We have proposed to include related
persons and their employees (if the related persons are companies) in
order to enable advisers to compensate parent companies and other
owners, subsidiaries and sister companies--as well as employees of
related companies--for government entity solicitation activities
because we recognize that there may be efficiencies in allowing
advisers to rely on these particular types of persons to assist them in
seeking clients.\142\ We request comment on whether we should include
employees of an adviser's related persons that are companies within the
group of persons not subject to the ban on payments to third parties.
Should we include only employees of certain related persons of the
adviser? If so, how should we make that determination? We also request
comment on whether there are other types of persons associated with an
investment adviser who should not be subject to the ban on payments to
third parties. We would define ``payment'' as any gift, subscription,
loan, advance or deposit of money or anything of value.\143\ We are
proposing this definition to cover the various means by which an
adviser and its covered associates may seek to compensate a third-party
solicitor.\144\ A ``finder's fee'' paid for a third-party solicitation
would be an example of a prohibited payment. It could also include
payments made to pension consultants for performing various services,
such as attending or sponsoring conferences, if those services are
intended to obtain government clients.\145\ Are there other types of
payments we should explicitly include in the definition? Are there
others that we should exclude, and, if so, why?
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    \138\ Proposed rule 206(4)-5(a)(2)(i).
    \139\ We would define ``related person'' as any person, directly
or indirectly, controlling or controlled by the investment adviser,
and any person that is under common control with the investment
adviser. Proposed rule 206(4)-5(f)(9). The term ``company'' is
defined in the Advisers Act, in relevant part, as ``a corporation, a
partnership, an association, a `joint-stock' company, a trust, or
any organized group of persons, whether incorporated or not.'' 15
U.S.C. 80b-2(a)(5).
    \140\ More specifically, we do not include any of the following
within the prohibition on payments for solicitation of government
clients: executive officers, general partners, managing members (or,
in each case, persons with similar status or function), employees,
or ``related persons'' of the investment adviser. Proposed rule
206(4)-5(a)(2)(i). We make this distinction because related person
solicitors are subject to an adviser's (or its affiliates') control
and thus should not present the compliance challenges that advisers
pointed to with respect to third-party solicitors. See supra note
134 and accompanying text. MSRB rule G-38's exclusions are based on
two similar definitions--of ``affiliated person of the broker,
dealer or municipal securities dealer'' and of ``affiliated company
of the broker, dealer or municipal securities dealer.'' MSRB rule G-
38(b)(i) and (b)(ii).
    \141\ Pursuant to proposed rule 206(4)-5(a)(1), certain
contributions by the investment adviser and its covered associates
would trigger the two-year time out. For a discussion of the two
year ``time out'' provision of the proposed rule, see supra section
II.A.3(a). We are not proposing that contributions by ``related
persons'' and their employees would trigger the two-year time out,
although we request comment on whether to include in the definition
of ``covered associate'' an employee of a related person who
solicits a government entity for the adviser. See discussion at
section II.A.3(a)(4), supra. See also proposed rule 206(4)-5(d).
    \142\ For example, if an adviser's sister company has an office
in a given location, the adviser might seek the assistance of a
sister company's employee at that location to solicit local
government business on its behalf rather than relying on its own
personnel who might be located a significant distance away.
    \143\ Proposed rule 206(4)-5(f)(7). MSRB rule G-38 incorporates
the definition of ``payment,'' as well as the definitions of
``issuer'' and ``municipal securities business'' from MSRB rule G-
37(g).
    \144\ As well as the various means by which an adviser and its
covered associates may seek to solicit other persons or coordinate
donations to political parties. See infra section II.A.3(d).
    \145\ The proposed rule's prohibition on making payments to
third-party solicitors of government clients would apply expressly
only to investment advisers and their covered associates. But see
proposed rule 206(4)-5(d) (the proposed rule's prohibitions on an
adviser and its covered associates doing indirectly what cannot be
done directly). For a discussion of this provision, see infra
section II.A.3.(d) of this Release. The proposed rule would not
prohibit government entities from retaining ``pension consultants''
(or other third-parties) and paying them to recommend particular
investment advisers for the management of public funds.
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    We would broadly define ``solicit'' to mean: (i) With respect to
investment advisory services, to communicate, directly or indirectly,
for the purpose of obtaining or retaining a client for, or referring a
client to, an investment adviser; and (ii) with respect to a
contribution or payment, to communicate, directly or indirectly, for
the purpose of obtaining or arranging a contribution or payment. We are
proposing this definition to capture the types of communications in
which an investment adviser might engage that we believe should trigger
application of the rule's prohibitions--communications for the purpose
of obtaining or retaining a client or a contribution.\146\ Whether a
particular communication constitutes a ``solicitation,'' therefore,
depends on the specific facts and circumstances relating to the
communication. The nature of information conveyed in any communication
and the manner in which it is presented would be relevant factors to
consider. Does our proposed definition effectively capture the
appropriate scope of communications? If not, what types of
communications should we exclude, and why?
---------------------------------------------------------------------------

    \146\ See proposed rule 206(4)-5(f)(10). MSRB rule G-38 contains
a similar definition. See MSRB rule G-38(b)(i).
---------------------------------------------------------------------------

    We request comment on our proposal to prohibit the use of third-
party solicitors of government business. Is our proposed prohibition on
the use of third-party solicitors an appropriate means to deter pay to
play practices? We propose to prohibit only third-party solicitors as
likely posing a significant threat to investor protection; certain
related-party solicitors would, instead, be subject to the time out
limitations of proposed rule 206(4)-5(a)(1). Is this differentiation
appropriate? If not, should we instead subject advisers to the two-year
time out for contributions made by their third party solicitors
although, as noted above, commenters in 1999 indicated that such a
requirement may impose significant compliance challenges? \147\ If the
differentiation is appropriate, should we also have a two-year look
back restriction for any contributions made by the third party? Is
there a different approach that would be effective at eliminating
circumvention of the rule through the use of third parties? For
example, should we consider narrowing the prohibition to accommodate
government solicitation activities by third parties if such third
parties (and

their related persons) commit not to contribute to (or solicit
contributions for) officials of any government entity from which any
adviser that hires them is seeking business? To what extent might the
proposed ban on using third parties to solicit government business
disproportionately impact the ability of certain investment advisers,
such as those that are smaller and less established, to compete in the
market to provide advisory services to government clients? Conversely,
to what extent might the proposed ban benefit smaller or less
established advisers who are currently unable or unwilling to engage in
pay to play practices to compete for government business?
---------------------------------------------------------------------------

    \147\ See supra note 134.
---------------------------------------------------------------------------

(c) Restrictions on Soliciting and Coordinating Contributions and
Payments
    Another way an adviser can attempt to influence the selection
process is by coordinating contributions for an elected official or
payments to a political party, or by soliciting others to make
contributions to an elected official or payments to a political
party.\148\ Therefore, proposed rule 206(4)-5(a)(2)(ii) would prohibit
an adviser and its covered associates from soliciting any person or PAC
to make, or from coordinating, any contribution to an official of a
government entity to which the adviser is providing or seeking to
provide investment advisory services, or any payment \149\ to a
political party of a State or locality where the investment adviser is
providing or seeking to provide investment advisory services to a
government entity.\150\ Our proposed restrictions on soliciting and
coordinating contributions and payments generally track MSRB rule G-
37.\151\ The MSRB amended its rule in 2005, with Commission approval,
to expand its prohibition on soliciting others to make, and on
coordinating, payments to State and local political parties to close
what the MSRB identified as a gap in which contributions were being
made indirectly to officials through payments to political parties for
the purposes of influencing their choice of municipal securities
dealers.\152\ The MSRB had not previously been able to deter this
misconduct, despite issuing informal guidance in both 1996 and in
2003.\153\ We are proposing a similar prohibition on soliciting or
coordinating payments to political parties in States or localities
where the investment adviser is providing or seeking to provide
investment advisory services to a government entity because we are
concerned that our adoption of a rule that only prohibits advisers from
soliciting others to make, or coordinating, contributions to officials
would lead to the development of a similar gap in which advisers could
circumvent the rule by making payments to political parties to
influence an official.\154\
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    \148\ For examples of solicitation or coordination of
contributions in the municipal securities dealer context, see In the
Matter of Pryor, McClendon, Counts & Co., Inc. et al., Exchange Act
Release No. 48095 (June 26, 2003) (Commission alleged that a broker-
dealer violated rule G-37(c) because its president delivered three
$250 money orders (in other people's names) in addition to his own
personal check for $250 to the campaign of a New York City mayoral
candidate during a period when the firm was engaged in municipal
securities business with New York City); In the Matter of FAIC
Securities, Inc., Exchange Act Release No. 36937 (Mar. 7, 1996)
(Commission alleged that the broker-dealer willfully violated G-
37(c) because the firm's municipal finance professionals approved
its affiliated companies' political contributions to candidates for
office who could influence the awarding of municipal securities
business by the State of Florida and by Dade County, Florida, and
during the two-year period following those contributions, the firm
continued to seek, and was selected, to participate in negotiated
underwritings of certain municipal securities by both Dade County
and a State agency).
    \149\ See supra note 143 and accompanying text for the
definition of ``payment.'' This definition is derived from the
definition of ``contribution,'' but does not include the limits on
the purposes for which such money is given, as currently set forth
in the proposed definition of contribution. We are including
``payments,'' as opposed to ``contributions,'' here to deter an
adviser from circumventing the rule's prohibitions by coordinating
indirect contributions to government officials through payments to
political parties. We noted similar concerns in the context of MSRB
Rule G-37 when we approved a recordkeeping provision in rule G-8 to
require persons subject to that rule to keep records relating to
political party payments. See SEC Order Approving Proposed Rule
Change by the Municipal Securities Rulemaking Board Relating to Rule
G-37 on Political Contributions and Prohibitions on Municipal
Securities Business, and Rule G-8, on Recordkeeping, Exchange Act
Release No. 35446 (Mar. 6, 1995) (``[S]ome [industry participants]
currently are urging dealers to make payments to political parties
earmarked for expenses other than political contributions (such as
administrative expenses or voter registration drives). Since these
payments would not constitute ``contributions'' under the rule, the
recordkeeping and reporting provisions would not apply. The MSRB is
concerned, based upon this information, that the same pay-to-play
pressures that motivated the MSRB to adopt rule G-37 may be emerging
in connection with the fundraising practices of certain political
parties described above.'').
    \150\ Proposed rule 206(4)-5(a)(2)(ii). An investment adviser
would be seeking to provide advisory services to a government entity
when it responds to a request for proposal, communicates with a
government entity regarding that entity's formal selection process
for investment advisers, or engages in some other solicitation of
investment advisory business of the government entity. A violation
of paragraph (a)(2)(ii) of the proposed rule would not trigger a
two-year ban on the provision of investment advisory services for
compensation, but would be a violation of the rule. This provision
would prohibit, for example, an adviser's solicitation of a payment
to the political party of the State in which the adviser was seeking
to provide advisory services to a government entity of the State,
but would not preclude that adviser from soliciting a payment to a
local political party, unless the adviser was doing so as a means to
do indirectly what the adviser could not do directly under the
proposed rule (for example, if the adviser was soliciting the
payment as a means to funnel payments to an official of the
government entity from which the adviser was seeking business). See
proposed rule 206(4)-5(d).
    \151\ See MSRB rule G-37(c). We note, however, that G-37 did not
contain a prohibition on soliciting or coordinating payments to
political parties in 1999, and our 1999 proposal did not contain
such a provision. 1999 Proposing Release, supra note 17.
    \152\ See Rule G-37: Request for Comments on Draft Amendments to
Rule G-37(c), Relating to Prohibiting Solicitation and Coordination
of Payments to Political Parties, and Draft Question and Answer
Guidance Concerning Indirect Rule Violations, MSRB Notice 2005-11
(Feb. 15, 2005), available at http://www.msrb.org/msrb1/archive/
2005/2005-11.asp (``G-37(c) Notice'') (``[T]he MSRB is especially
troubled by the emergence of recent media and other reports that
issuer agents have informed dealers and [municipal finance
professionals] that, if they are prohibited from contributing
directly to an issuer official's campaign, they should contribute to
the affiliated party's ``housekeeping'' account. The MSRB is
concerned that dealers or [municipal finance professionals] who make
such payments may be doing so in an effort to avoid the political
contribution limitations embodied in Rule G-37.''); Self-Regulatory
Organizations; Municipal Securities Rulemaking Board; Order
Approving Proposed Rule Change Concerning Solicitation and
Coordination of Payments to Political Parties and Question and
Answer Guidance on Supervisory Procedures Related to Rule G-37(d) on
Indirect Violations, Exchange Act Release No. 52496 (Sept. 22, 2005)
(SEC order approving change to MSRB G-37 to prohibit soliciting or
coordinating payments to political parties).
    \153\ See G-37(c) Notice, supra note 152. (``Both the 1996 Q&A
guidance and the 2003 Notice were intended to alert dealers and
[municipal finance professionals] to the realities of political
fundraising and guide them toward developing procedures that would
lead to compliance with both the letter and the spirit of the Rule.
The MSRB continues to be concerned, however, that dealer, [municipal
finance professional], and affiliated persons' payments to political
parties, including ``housekeeping,'' ``conference'' or ``overhead''
type accounts, and PACs give rise to at least the appearance that
dealers may be circumventing the intent of Rule G-37.'').
    \154\ We note that a direct contribution to a political party by
an adviser or its covered associates would not trigger the two-year
time out provision of the proposed rule (although we request comment
on our proposed definition of ``contribution''), unless the
contribution was a means for the adviser to do indirectly what the
proposed rule would prohibit if done directly (for example, if the
contribution was earmarked or known to be provided for the benefit
of a particular government official). See supra note 93. We are
proposing, however, that an adviser be prohibited from soliciting
others to make, or coordinating, payments to political parties
because, as the MSRB's experience has shown, advisers could
otherwise use such means to circumvent the proposed rule's
limitations on direct contributions to government officials.
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    Proposed rule 206(4)-5(a)(2)(ii) would also prohibit advisers from
seeking to influence the selection process by, for example,
``bundling'' \155\ contributions

or payments from its employees or others or by making or coordinating
contributions or payments through a third party, such as a
``gatekeeper.'' \156\ In a gatekeeper arrangement, political
contributions or payments are arranged by an intermediary, typically a
pension consultant, which distributes or directs contributions or
payments to elected officials or candidates.\157\ The gatekeeper
ensures that advisers not making a requisite amount of contributions or
payments are not included among the final candidates for advisory
contracts. In addition, a gatekeeper could arrange ``swaps'' of
contributions or payments between elected officials in order to obscure
the significance of the contributions or payments from public
disclosure or to circumvent plan restrictions on contributions to
trustees.\158\ Under the proposed rule, the gatekeeper in these
arrangements would be coordinating political contributions or payments
and, if the gatekeeper is an investment adviser, would itself violate
the proposed rule's restrictions on coordinating contributions or
payments.\159\ The adviser would also violate the proposed rule if it
paid the third-party solicitor to coordinate political contributions or
payments in order to obtain business.
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    \155\ An employee or person acting on an adviser's behalf
``bundles'' contributions or payments by coordinating small
contributions or payments from several employees of the adviser or
others to create one large contribution or payment. For an example
of this in the context of the municipal securities industry, see In
the Matter of Pryor, McClendon, Counts & Co., Inc. et al.,
Securities Act Release No. 48095 (June 26, 2003) (``Counts[, the
president of the broker-dealer firm,] gave his administrative
assistant $750 in cash, told her to purchase three separate money
orders, and told her to make them payable for $250 each to the
candidate's campaign. Counts instructed his assistant to make out
one of the money orders as if it were from the assistant herself,
and to make out the other two as if they were from the wife of a
[firm] employee and a friend of Counts', respectively. Counts then
caused those money orders to be delivered to the candidate's
campaign together with Counts' own personal check for $250. [When
two of the three money orders were subsequently returned,] Counts
instructed his assistant to deposit the returned $500 into [the
firm]'s bank account, which she did.'').
    \156\ We are proposing that solicitation of contributions of
others for an official of a government entity to which an adviser is
providing or seeking to provide investment advisory services by an
adviser or its covered associates be subject to a flat prohibition
under the rule, rather than trigger a two-year ``time out,'' because
we recognize it may be more difficult for an adviser to monitor
solicitation activities (as opposed to direct contribution
activity). For a discussion of an adviser's obligation to adopt
policies and procedures reasonably designed to prevent violations of
the Advisers Act pursuant to our ``compliance rule,'' see infra note
207 and accompanying text.
    \157\ See, e.g., SEC v. Morris et al., Litigation Release No.
21001 (Apr. 15, 2009) (the Commission's complaint alleges that
placement agents acted as gatekeepers by directing investment
management firms to funnel kickbacks through various entities); In
the Matter of Kent D. Nelson, Initial Decision Release No. 371 (Feb.
24, 2009) (an administrative law judge found that an investment
adviser funneled payments through a third party to the New Mexico
State treasurer, acting as gatekeeper by extracting $4.4 million in
finder's fees from broker-dealers and siphoning $2.9 million to the
State treasurer's office to influence the office's discretionary
commitment of funds, in exchange for being retained as an adviser by
the State treasurer's office); (Investment Advisers Act Release No.
2868 (Apr. 17, 2009). Similar types of arrangements exist outside of
the context of government investments, such as in the area of union
pension funds. See, e.g., In the Matter of Duff & Phelps Investment
Management Co., Inc., Investment Advisers Act Release No. 1984
(Sept. 28, 2001) and related case In re Performance Analytics, et
al., Investment Advisers Act Release No. 2036 (June 17, 2002) (in a
settled action, the Commission alleged that an investment adviser
entered into an arrangement with gatekeeper broker-dealer in which
the adviser would direct its trades to broker-dealer if the broker-
dealer would continue to recommend the adviser to the union pension
fund board, and the broker-dealer allegedly funneled payments to
certain trustees on the pension fund board to preserve its role as
gatekeeper and to preserve the adviser's role as adviser to the
fund).
    \158\ For example, Adviser A advises Plan X, while Adviser B
advises Plan Y. The ``gatekeeper'' may direct a political
contribution from Adviser A to the elected official, who is a
trustee to Plan Y, and from Adviser B to the elected official, who
is a trustee to Plan X, agreeing to place both advisers on each
plan's approved list. Persons reviewing records of the political
contributions would have no way of determining that the
contributions were swapped and that they created conflicts of
interest on the part of the advisers as well as the elected
officials.
    \159\ Regardless of whether the gatekeeper is an investment
adviser, a person participating in such a scheme could, if the rule
is adopted, be considered to be aiding and abetting an adviser's
violation of the rule. See section 209(d) of the Act [15 U.S.C. 80b-
9(d)] (authorizing Commission enforcement action for aiding and
abetting a violation of the Advisers Act or any Advisers Act rule).
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    We request comment on this aspect of the proposed rule, including
our proposed definitions. Is it appropriate to differentiate between
``contributions'' to officials and ``payments'' to political parties?
Are there alternative approaches that would effectively deter these
types of indirect pay to play arrangements? Do commenters believe that
our proposed inclusion of payments to State and local political parties
closes an important gap in which contributions might be made indirectly
to officials for the purposes of influencing their choice of investment
advisers? Alternatively, do commenters believe that our proposed
inclusion of political parties is unnecessary?
(d) Direct and Indirect Contributions or Solicitations
    Rule 206(4)-5(d) would also prohibit acts done indirectly, which,
if done directly, would result in a violation of the rule.\160\ Thus,
an adviser and its covered associates could not circumvent the rule by
directing or funding contributions through third parties, including,
for example, consultants, attorneys, family members, friends or
companies affiliated with the adviser. This provision would also cover,
for example, situations in which contributions by an adviser are made,
directed or funded through a third party with an expectation that, as a
result of the contribution, another contribution is likely to be made
by a third party to an ``official of the government entity,'' for the
benefit of the adviser. Contributions made through gatekeepers
(described above) thus would be considered made ``indirectly'' for
purposes of the proposed rule. We request comment on this aspect of the
proposed rule.
---------------------------------------------------------------------------

    \160\ Proposed rule 206(4)-5(d). See also section 208(d) of the
Advisers Act [15 U.S.C. 80b-8(d)]; MSRB rule G-37(d).
---------------------------------------------------------------------------

(e) Investment Pools
(1) Application of the Rule to Pooled Investment Vehicles
    Pay to play activities in the context of investment pools \161\
also raise concerns about the potential for fraud.\162\ The fraud that
may result from pay to play practices can occur in a number of
circumstances involving the government official and the pooled
investment vehicle. The following are examples of pay to play
relationships involving

investment pools that implicate the concerns underlying this
rulemaking:
---------------------------------------------------------------------------

    \161\ Investment pools may include, but are not limited to:
mutual funds, hedge funds, private equity funds, and venture capital
funds.
    \162\ See, e.g., SEC v. Paul J. Silvester et al., Litigation
Release No. 16759 (Oct. 10, 2000) (action in which investment
adviser allegedly paid third party solicitors who kicked back a
portion of the money to the former Connecticut State Treasurer in
order to obtain public pension fund investments in a hedge fund
managed by the adviser); SEC v. William A. DiBella et al.,
Litigation Release No. 20498 (Mar. 14, 2008) (consultant was found
to have aided and abetted the former Connecticut State Treasurer in
a pay to play scheme involving an investment adviser to a private
equity fund who had paid third-party solicitors to obtain public
pension fund investments in the fund); In the Matter of the Carlyle
Group, AGNY Investigation No. 2009-071, Assurance of Discontinuance
Pursuant to Executive Law Sec.  63(15) (May 14, 2009), available at
http://www.oag.state.ny.us/media_center/2009/may/pdfs/
Carlyle%20AOD.pdf; In the Matter of Riverstone Holdings, LLC, AGNY
Investigation No. 2009-091, Assurance of Discontinuance Pursuant to
Executive Law Sec.  63(15) (June 11, 2009), available at http://
www.oag.state.ny.us/media_center/2009/june/pdfs/
Riverstone%20AOD%20FINAL%20EXECUTED.pdf; and In the Matter of PCG
Corporate Partners Advisors II, LLC, AGNY Investigation No. 2009-
101, Assurance of Discontinuance Pursuant to Executive Law Sec.
63(15) (July 1, 2009), available at http://www.oag.state.ny.us/
media_center/2009/july/pdfs/PCG%20AOD%20FINAL%20EXECUTED.pdf (three
settled actions brought by New York Attorney General in which
advisers allegedly paid third-party solicitors who kicked back a
portion of the money to the former New York Deputy State Treasurer
in order to obtain public pension investments in private equity
funds managed by the advisers).
---------------------------------------------------------------------------

     When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and the government
official directs that public monies (e.g., pension plan assets) be
invested in that adviser's pooled investment vehicle;
     When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and that government
official chooses that investment adviser to be an adviser to a
government sponsored plan, such as a ``529 plan;'' \163\ and
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    \163\ This practice would be covered under (a)(1) of the
proposed rule. See supra section II.A.3.(a) of this release. For a
specific discussion of the application to ``529 plans,'' see
discussion below at footnotes 176-189 and related text.
---------------------------------------------------------------------------

     When an investment adviser to a pooled investment vehicle
makes a contribution to a government official and that government
official chooses that adviser's pooled investment vehicle as an
investment option in a government sponsored plan, such as a ``529
plan,'' \164\ regardless of whether the adviser is also chosen to be
the adviser to the plan.
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    \164\ See Elliot Blair Smith, Fund Scandal Worries Tuition Plan
Investors, USA Today (Nov. 19, 2003), at B1 (reporting that the
former governor of Wisconsin received campaign contributions from
the founder of a mutual fund company, and subsequently the then-
governor's staff created a panel of four State employees that
selected the founder's firm to manage the State's 529 plan and
provide the plan's investment options).
---------------------------------------------------------------------------

    Pay to play activities can harm public pension plans and their
beneficiaries. Such activities can cause competition in the market for
investments to be manipulated, which can distort the process by which
investment decisions regarding public investments are made, and can
result in public pension plans making inferior investments. In
addition, the pension plan may pay higher fees because advisers must
recoup the contributions, or because the contract negotiations are not
handled on an arm's-length basis.
    An adviser's participation in pay to play activities may also
defraud other investors in a pooled investment vehicle. For example, in
a pay to play kickback scheme, the government investor in the pooled
vehicle would receive a kickback payment from the adviser while other
investors in the pool may pay higher advisory fees as a result of the
adviser trying to recoup the cost of the kickback. As another example,
a government investor that has engaged in a pay to play scheme with an
investment adviser may leverage the fact of the adviser's payment to
obtain additional benefits for itself that may operate as a fraud on
other investors in the pooled vehicle.
    Therefore, the proposed prophylactic rule seeks to address pay to
play practices by advisers managing pooled investment vehicles.\165\
The proposed rule would subject an adviser to a covered investment pool
to the prohibitions of proposed rule 206(4)-5 \166\ so that the
government entities, the pooled investment vehicles, and the other
investors in that vehicle are also protected against the harms that may
result when advisers engage in pay to play practices.
---------------------------------------------------------------------------

    \165\ See proposed rule 206(4)-5(c).
    \166\ Id.
---------------------------------------------------------------------------

(2) Covered Investment Pools
    The proposed rule's prohibitions would be applicable only with
respect to an adviser that manages a covered investment pool.\167\ The
proposed rule would generally define ``covered investment pool'' \168\
as: (i) Any investment company as defined in section 3(a) of the
Investment Company Act of 1940 (``Investment Company Act''); \169\ or
(ii) any company that would be an investment company under section 3(a)
of that Act but for the exclusion provided from that definition by
section 3(c)(1), section 3(c)(7) or section 3(c)(11) of that Act.\170\
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    \167\ See proposed rule 206(4)-5(c). As described below,
proposed rule 206(4)-5 narrows this definition to exclude certain
investment companies for the purposes of paragraph (a)(1) of the
proposed rule.
    \168\ Proposed rule 206(4)-5(f)(3).
    \169\ 15 U.S.C. 80a-3(a).
    \170\ 15 U.S.C. 80a-3(c)(1), (7) or (11).
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    Our 1999 proposal would have applied the rule only to advisers
managing private funds, such as hedge funds and private equity
funds,\171\ that are typically excepted from the definition of
investment company by either section 3(c)(1) or 3(c)(7) of the
Investment Company Act.\172\ We have expanded upon that proposal to
include advisers managing investment companies \173\ (which are
registered under the Investment Company Act \174\) as well as
collective investment trusts (which are excepted from the definition of
investment company by section 3(c)(11)).\175\ Both of these types of
collective investment pools today are used as either funding vehicles
for, or investments of, government-sponsored savings and retirement
plans. These plans include, for example, college savings plans (such as
``529 plans'' \176\) and retirement plans (such as ``403(b) plans''
\177\ and ``457 plans'' \178\). They typically allow participants to
select among pre-established investment ``options,'' or particular
investment pools (often invested in registered investment companies or
funds of funds, such as target date funds), that a government official
has directly or indirectly selected to include as investment choices
for participants.\179\
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    \171\ See 1999 Proposing Release, supra note 17, at section
II.A.4.
    \172\ 15 U.S.C. 80a-3(c)(1) and (7).
    \173\ 15 U.S.C. 80a-3(a).
    \174\ 15 U.S.C. 80a-8.
    \175\ 15 U.S.C. 80a-3(c)(11). We note that a bank maintaining a
collective investment trust would not be subject to the proposed
rule if the bank falls within the exclusion from the definition of
``investment adviser'' in Section 202(a)(11)(A) of the Advisers Act
[15 U.S.C. 80b-2(a)(11)(A)]. A person who falls within the
definition of an investment adviser that provides advisory services
with respect to a collective investment trust in which a government
entity invests, however, would be subject to the rule's
prohibitions.
    \176\ A 529 plan is a ``qualified tuition plan'' established
under Section 529 of the Internal Revenue Code of 1986 [26 U.S.C.
529]. States generally establish 529 plans as State trusts which are
considered instrumentalities of States for Federal securities law
purposes. As a result, the plans themselves are generally not
regulated under the Federal securities laws and many of the
protections of the Federal securities laws do not apply to investors
in them. See Section 2(b) of the Investment Company Act [15 U.S.C.
80a-2(b) and Section 202(b) of the Advisers Act [15 U.S.C. 80b-2(b)
(exempting State-owned entities from those statutes). However, the
Federal securities laws do generally apply to, and the Commission
does generally regulate, the brokers, dealers, and municipal
securities dealers that effect transactions in interests in 529
plans. See generally Sections 15(a)(1) and 15B of the Securities
Exchange Act of 1934 [15 U.S.C. 78a-15(a)(1) and 15B] (``Exchange
Act''). A bank effecting transactions in 529 plan interests may be
exempt from the definition of ``broker'' or ``municipal securities
dealer'' under the Exchange Act if it can rely on an exception from
the definition of broker in the Exchange Act. In addition, State
sponsors of 529 plans may hire third-party investment advisers
either to manage 529 plan assets on their behalf or to act as
investment consultants to the agency responsible for managing plan
assets. These investment advisers, unless they qualify for a
specific exemption from registration under the Advisers Act, are
generally required to be registered with the Commission and would
therefore be subject to our proposed rule.
    \177\ A 403(b) plan is a tax-deferred employee benefit
retirement plan established under Section 403(b) of the Internal
Revenue Code of 1986 [26 U.S.C. 403(b)].
    \178\ A 457 plan is a tax-deferred employee benefit retirement
plan established under Section 457 of the Internal Revenue Code of
1986 [26 U.S.C. 457].
    \179\ For example, many 529 plans allow plan participants to
select among various underlying investment options to direct the
investment of their contributions. The participants' contributions
are then invested in options of the 529 plan and the plan, in turn,
invests its assets in the investment companies or other investments
on which the plan options are based. The Internal Revenue Code
requires that in order to set up a 529 plan investor contributions
must be held in a qualified trust. See 26 U.S.C. 529(b). Often, the
adviser to the 529 plan also advises the registered investment
companies that serve as the underlying investment options for the
plan. Sometimes, however, registered investment companies advised by
investment advisers that do not provide advisory services directly
to the government entity may serve as the underlying investment
options for the plan.

---------------------------------------------------------------------------

    Government-sponsored savings plans have grown enormously in recent
years.\180\ Competition for an adviser's fund to be selected as an
investment option in government-sponsored savings plans is keen,\181\
and we are concerned that advisers to pooled investment vehicles are
making political contributions to influence the decision by government
entities of the funds to be included as options in such plans. Of
course, as discussed above,\182\ proving such a direct quid pro quo or
intent to influence in a specific case often will not be possible. As
previously stated, it is precisely because of that difficulty that a
prophylactic rule is needed.\183\ We are concerned about the harmful
effects pay to play activities may have in this context on these
government-sponsored plans and their beneficiaries. Plans and their
beneficiaries may be harmed, for example, if because of an adviser's
political contributions, a government official causes a government-
sponsored plan to invest in a fund managed by that adviser that charges
higher fees or is less well managed than a fund that may have been
chosen on the basis of pure merit. In addition, pay to play practices
could be particularly damaging in the 529 context if a State offers
only one, or very few, investment options to its participants.\184\
Accordingly, we are proposing to include these other pooled investment
vehicles often managed by investment advisers.
---------------------------------------------------------------------------

    \180\ See Investment Company Institute, 529 Plan Program
Statistics, Dec. 2008 (May 22, 2009), available at http://
www.ici.org/research/stats/529s/529s_12-08 (indicating that 529
plan assets have increased from $8.6 billion in 2000 to $104.9
billion in the fourth quarter of 2008, and that 529 plan
participants have increased from 1.3 million in 2000 to 11.2 million
in the fourth quarter of 2008); Investment Company Institute, The
U.S. Retirement Market, 2008, 18 Research Fundamentals, No. 5 (June
2009), available at http://www.ici.org/pdf/fm-v18n5.pdf (indicating
that 403(b) plan and 457 plan assets have increased from $627
billion in 2000 to $712 billion in the fourth quarter of 2008); SEI,
Collective Investment Trusts: The New Wave in Retirement Investing
(May 2008), available at https://longjump.com/networking/
RepositoryPublicDocDownload?id=80031025axe139509557&docname=SEI%20CIT
%20White%20Paper%205.08.pdf&cid=80031025&encode=application/pdf
(citing Morningstar data indicating that collective investment trust
assets nearly tripled from 2004 to 2007 and grew by more than 150
percent between 2005 and 2007 alone).
    \181\ See, e.g., Charles Paikert, TIAA-CREF Stages Comeback in
College Savings Plans, Crain's New York Business (Apr. 23, 2007)
(depicting TIAA-CREF's struggle to remain a major player in managing
State 529 plans because of increasing competition from the
industry's heavyweights); Beth Healy, Investment Giants Battle for
Share of Exploding College-Savings Market, Boston Globe (Oct. 29,
2000), at F1 (describing the increasing competition between
investment firms for State 529 plans and increasing competition to
market their plans nationally).
    \182\ See supra notes 16 and 55 and accompanying text.
    \183\ See, e.g. Blount, supra note 16, at 945.
    \184\ See, e.g., Restrictions Lessen Benefits of State College
Savings Plans, USA Today (Dec. 1, 2003), at A20 (``[M]any States
offer only a few investment options * * * [and] limit investors to a
single fund company. * * * While plans vary, States typically have
negotiated an exclusive deal with one fund company.'').
---------------------------------------------------------------------------

    Under the rule, each of the pay to play prohibitions (with one
exception discussed below) would be equally applicable to an investment
adviser that manages assets of a government entity through the entity's
investment in a covered investment pool managed by that adviser. For
example, if an investment adviser subject to our rule makes a campaign
contribution to an official of a government entity in a position to
influence the decision to invest government assets in a private equity
fund managed by that adviser, the investment adviser would be
prohibited from receiving compensation with respect to the government
entity's investment in the private equity fund.
    In the case of an adviser to a publicly-offered registered
investment company, however, we propose to apply the two-year ``time
out'' provision only when the investment company is included in a plan
or program of a government entity (e.g., a 529 plan).\185\ When a
government entity invests in publicly-offered securities of a
registered investment company, we are generally less concerned that the
investment company's adviser would be motivated by pay to play
considerations if, for example, the adviser has not bid for, or
solicited, the government entity's business. Moreover, in many
circumstances in which a government entity determines to make an
investment in an investment company for cash management or other
purposes, the adviser may not even be aware that a government entity
has made an investment.\186\ We are mindful that subjecting advisers
and their covered associates to the two-year ``time out'' in these
situations could create substantial compliance challenges because the
adviser would have to monitor investments by these government entities
in its investment companies to ensure that a contribution by the
adviser or its covered associates did not trigger a time out. In
contrast, we have included an exception that would subject to the two-
year time out provision an adviser to a publicly offered registered
investment company that is included in a plan or program of a
government entity because we believe pay to play concerns are more
likely to be present in that situation, and advisers will clearly know
that the government entity is a client or investor in the adviser's
investment company. As noted above, significant competition exists
among advisers to have their funds selected as investment options in
government-sponsored savings plans, which we believe may contribute to
the risk of pay to play.\187\
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    \185\ Proposed rule 206(4)-5(c), (f)(3). Accordingly, the time
out provision would be applicable, for example, if a particular
mutual fund is selected to be an investment option for participants
in a 529 plan; the time out provision would not be applicable if a
State government invested its pension fund assets in that same
mutual fund. We define a ``plan or program of a government entity''
in the proposed rule as any investment program or plan sponsored or
established by a government entity, including, but not limited to, a
``qualified tuition plan,'' such as a 529 plan, a retirement plan,
such as a 403(b) plan or 457 plan, or any similar program or plan.
Proposed rule 206(4)-5(f)(8).
    \186\ In contrast, where securities are privately placed, such
as securities of a private fund, the adviser (and through its
compliance program, its personnel) should be aware that an
investment from a government entity is being solicited and should
therefore be in a position to refrain from making contributions that
would trigger a ``time out'' with respect to receiving compensation
from that government entity.
    \187\ See supra note 180 and accompanying text.
---------------------------------------------------------------------------

    We believe it is appropriate, however, to apply the other two
substantive prohibitions of the proposed rule \188\ to advisers to
pooled investment vehicles regardless of whether it is included in a
plan or program of a government entity. We believe the same concerns
regarding pay to play are raised under those prohibitions whether the
adviser is managing the government entities' assets directly or through
a pooled investment vehicle.
---------------------------------------------------------------------------

    \188\ Proposed rule 206(4)-5(a)(2)(i) and (ii).
---------------------------------------------------------------------------

    For example, an investment adviser subject to our proposed rule
that manages a registered investment company would be prohibited from
compensating a third party to solicit an investment by a government
entity in the fund or soliciting others to make contributions to
officials of a government entity that the adviser seeks to have invest
in the fund. For purposes of the two-year time out, however, a mutual
fund adviser would not need to screen for investments from government
entities to determine if a disqualifying campaign contribution has been
made if the fund is used for investment of a State government's general
assets or for investment by the State's pension fund. If the registered
investment company is to be included in that State's 529 plan, however,
the investment adviser would be subject to the two-year time out on
contributions.\189\
---------------------------------------------------------------------------

    \189\ The proposed rule would prohibit the receipt of
compensation from the investment company by the investment adviser,
not the inclusion of the investment company in the 529 plan, and
would also prohibit the receipt of any advisory fee to which the
adviser is entitled if it is also a direct adviser to the 529 plan.
     We note that a firm retained by a government entity to
distribute interests in a 529 plan (i.e., municipal fund securities)
may be subject to MSRB rules. See Municipal Securities Rulemaking
Board, Interpretive Notice: Rule D-12: Interpretation Relating to
Sales of Municipal Fund Securities in the Primary Market (Jan. 18,
2001), available at http://www.msrb.org/msrb1/rules/NewRuleD-
12Interpretation.htm. Such a distributor may have an affiliated
investment adviser that is retained by the government entity to
provide investment advice to the 529 plan. Thus, the distributor
could be subject to MSRB rules G-37 and G-38, while the affiliated
investment adviser could be subject to our proposed rule, if
adopted. As we note above, the investment adviser's fiduciary
obligations could require it to continue to provide investment
advice without compensation after it or a covered associate gives a
contribution that triggers our proposed rule's two-year ``time out''
while MSRB rule G-37 typically would ban a firm from continuing to
engage in municipal securities business for two years after a
triggering contribution is made. See supra note 80. However, the
MSRB has provided additional flexibility in the context of contracts
to distribute securities such as interests in 529 plans. See
Municipal Securities Rulemaking Board, Interpretation on the Effect
of a Ban on Municipal Securities Business under Rule G-37 Arising
During a Pre-Existing Engagement Relating to Municipal Fund
Securities (Apr. 2, 2002), available at http://www.msrb.org/msrb1/
rules/notg37.htm (allowing a dealer that has become subject to G-
37's ban on new municipal securities business to continue receiving
compensation throughout the duration of the ban if certain
conditions are met). We are not proposing a similar approach under
our rule because it would undermine the deterrent effect of having a
two-year time out.

---------------------------------------------------------------------------

    We request comment on the definition of covered investment pool
under the proposed rule. Should we also apply the rule in the context
of government investments in structured finance vehicles in which
public funds may invest? \190\ Should we, alternatively or in addition,
limit the applicability of the proposed rule's prohibitions in the
context of registered investment companies to circumstances under which
the government entity's investment is of a sufficiently large size such
that the fund adviser is more likely to have an incentive to attempt to
influence the government entity's decision-making process? If so, how
should we define that threshold? Should we, for example, base it on the
amount of assets in the fund, such as 5 percent of the fund's assets?
Should we treat differently under the rule advisers to funds in plans
where the adviser is not the sole or primary adviser to the plan or
where a different adviser's funds are included as investment options
under the plan? For example, are there sub-advisory arrangements in
which a sub-adviser would not know or be able to influence whether, or
which, government entities are being solicited for a covered investment
pool? If so, how should we define those sub-advisers? Should we
circumscribe the rule's applicability so it is not triggered in the
context of government entity investments in particular types of funds,
such as money market funds, where the ability of the adviser to profit
might be attenuated because, for example, those particular types of
funds tend to generate lower margin or investments tend to be for
relatively short terms? Should we provide exceptions to the provision
subjecting an adviser to a two-year ``time out'' from receiving
compensation in the context of specific types of government entity
investments (such as short-term investments for cash management)?
---------------------------------------------------------------------------

    \190\ These might include, for example, pools exempt from the
definition of ``investment company'' under Section 3(c)(5) or (6) of
the Investment Company Act [15 U.S.C. 80a-3(c)(5) and (6)] and pools
relying on rule 3a-7 under the Investment Company Act. [17 CFR
270.3a-7]. Pursuant to our proposed definition of ``covered
investment pool,'' the rule would apply to an investment by a
government entity in a structured finance vehicle that relies on
Section 3(c)(1) or 3(c)(7) of the Investment Company Act [15 U.S.C.
80a-3(c)(1) and (7)]. See proposed rule 206(4)-5(f)(3).
---------------------------------------------------------------------------

(3) Applying the Compensation Limit to Covered Investment Pools
    If a government entity is an investor in a covered investment pool
at the time the contribution triggering a two-year ``time out'' is
made, the proposed rule would require the adviser to forgo any
compensation related to the assets invested or committed by that
government entity.\191\ We recognize the provisions of the proposed
rule that would require the adviser to either waive its fee or
terminate the relationship raise different issues for investment pools
than for separately managed accounts due to various structural and
legal differences.
---------------------------------------------------------------------------

    \191\ See discussion at Section II.A.3.(a)(1), supra. We note
that the phrase ``for compensation'' includes both profits and the
recouping of costs, so the proposed rule would not permit an adviser
to continue to manage assets at cost after a disqualifying
contribution is made.
---------------------------------------------------------------------------

    In the case of a private fund, the adviser typically could waive or
rebate the related fees and any performance allocation or carried
interest.\192\ The adviser may also seek to cause the pooled investment
vehicle to redeem the investment of the government entity. For many
private funds, such as venture capital and private equity funds, it may
not be possible for a government entity to withdraw its capital or
cancel its commitment without harm to the other investors. We request
comment on ways to prevent advisers to these funds from benefitting
from contributions covered by the two-year time out, while protecting
other investors in the funds.
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    \192\ Some commenters on our 1999 Proposal noted that a
performance fee waiver raises various calculation issues. An adviser
making a disqualifying contribution could comply with the proposed
rule by waiving a performance fee or carried interest determined on
the same basis as the fee or carried interest is normally
calculated, e.g., on a mark-to-market basis. For arrangements like
those typically found in private equity and venture capital funds
where the fee or carry is calculated based on realized gains and
losses and mark-to-market calculations are not feasible, advisers
could use a straight line method of calculation which assumes that
the realized gains and losses were earned over the life of the
investment.
---------------------------------------------------------------------------

    The options for restricting compensation involving government
investors in registered investment companies are more limited, due to
both Investment Company Act provisions and potential tax
consequences.\193\ One approach that would meet the requirements of the
proposed rule would be for the adviser of a registered investment
company to waive its advisory fee for the fund as a whole in an amount
approximately equal to fees attributable to the government entity.\194\
We request comment on other options that may be available, including
alternatives that might require us to revise the proposed rule.
---------------------------------------------------------------------------

    \193\ See, e.g., Rule 18f-3 under the Investment Company Act.
Moreover, other regulatory considerations, such as the Employee
Retirement Income Security Act of 1974 [29 U.S.C. 18] (``ERISA''),
may impact these arrangements with respect to collective investment
trusts.
    \194\ This may also be done at the class level or series level
for private funds organized as corporations.
---------------------------------------------------------------------------

    An adviser to a covered investment pool that serves as an
investment option in a government program such as a 529 plan might seek
to eliminate its investment pool as an option in order to comply with
or mitigate costs arising from the rule's two-year ``time out.'' As a
result, plan investors may be denied an appropriate investment
alternative. Would elimination of the option be an inappropriate
consequence we should seek to prevent? Have we appropriately applied
the rule to curb pay to play activities (that may be effectuated, for
example, through revenue sharing arrangements) while still permitting
funds to be marketed and distributed to government entities in the
ordinary course of business through compensated third parties, such as
registered broker-dealers?
(f) Exemptions
    We are proposing a provision under which an adviser may apply to us
for an order exempting it from the two-year compensation ban.\195\
Under the proposed rule, the Commission could

exempt advisers from the rule's ``time out'' requirement where the
adviser discovers contributions that trigger the compensation ban only
after they have been made or when imposition of the prohibitions is
unnecessary to achieve the rule's intended purpose.\196\
---------------------------------------------------------------------------

    \195\ Rules 0-4, 0-5, and 0-6 under the Advisers Act [17 CFR
275.0-4, 0-5, and 0-6] provide procedures for filing applications
under the Act, including applications under the proposed rule.
    \196\ This provision is similar to our 1999 proposal.
---------------------------------------------------------------------------

    In determining whether to grant an exemption from the two-year
compensation ban, we would take into account the varying facts and
circumstances that each application presents. Further, we would
consider: (i) Whether the exemption is necessary or appropriate in the
public interest and consistent with the protection of investors and the
purposes fairly intended by the policy and provisions of the Advisers
Act; (ii) whether the investment adviser, (A) before the contribution
resulting in the prohibition was made, adopted and implemented policies
and procedures reasonably designed to prevent violations of this
section; (B) prior to or at the time the contribution which resulted in
such prohibition was made, had no actual knowledge of the contribution;
and (C) after learning of the contribution, (1) has taken all available
steps to cause the contributor involved in making the contribution
which resulted in such prohibition to obtain a return of the
contribution; and (2) has taken such other remedial or preventive
measures as may be appropriate under the circumstances; (iii) whether,
at the time of the contribution, the contributor was a covered
associate or otherwise an employee of the investment adviser, or was
seeking such employment; (iv) the timing and amount of the contribution
which resulted in the prohibition; (v) the nature of the election
(e.g., Federal, State or local); and (vi) the contributor's apparent
intent or motive in making the contribution which resulted in the
prohibition, as evidenced by the facts and circumstances surrounding
such contribution.\197\
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    \197\ Proposed rule 206(4)-5(e). If the proposed rule is
adopted, we would grant such exemptions pursuant to our authority
under Section 206A of the Advisers Act [15 U.S.C. 80b-6a].
---------------------------------------------------------------------------

    These factors are similar to those considered by FINRA and the
appropriate bank regulators in determining whether to grant an
exemption under MSRB rule G-37(i).\198\ As suggested above, when
applying the criteria, we expect to take into account, among other
things, the varying facts and circumstances presented by each
application. The factors are intended to assist us in determining
whether granting relief is appropriate. For example, one factor relates
to whether the adviser had and implemented reasonably designed policies
and procedures. Several other factors relate to the adviser's knowledge
of the contribution and its conduct after the contribution was
discovered. The remaining factors largely relate to the particular
facts surrounding the contribution that may affect whether it is
appropriate for us to grant relief in that situation. For example, the
same amount of money contributed in a local election may have a much
greater impact than in a Federal election. Facts regarding the timing
and amount of the contribution, the contributor's employment status at
the time of the contribution, as well as the contributor's apparent
intent or motive may suggest whether the contribution was made to
influence the selection of the adviser. We would apply these exemptive
provisions with sufficient flexibility to avoid consequences
disproportionate to the situation, while effecting the policies
underlying the rule.\199\ Should we provide for additional exemptions
from the proposed rule? We request comment on the proposed criteria for
exemptions by application. Are there additional criteria the Commission
should explicitly consider when determining whether to grant an
exemption?
---------------------------------------------------------------------------

    \198\ See MSRB rule G-37(i).
    \199\ An adviser applying for an exemption could place advisory
fees earned between the date of the contribution triggering the
prohibition and the date on which we determine whether to grant an
exemption in an escrow account. The escrow account would be payable
to the adviser if the Commission grants the exemption. If the
Commission does not grant the exemption, the fees contained in the
account must be returned to the public fund.
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B. Recordkeeping

    We are also proposing amendments to rule 204-2 \200\ to require an
investment adviser that is registered or required to be registered with
us and (i) has or seeks government clients or (ii) provides investment
advisory services to a covered investment pool in which a government
entity investor invests or is solicited to invest, to make and keep
certain records of contributions made by the adviser and its covered
associates. We believe these records would be necessary to allow us to
examine for compliance with rule 206(4)-5, if adopted.
---------------------------------------------------------------------------

    \200\ 17 CFR 275.204-2.
---------------------------------------------------------------------------

    The proposed amendments would require an adviser to make and keep
the following records: (i) The names, titles and business and residence
addresses of all covered associates of the investment adviser; (ii) all
government entities for which the investment adviser or any of its
covered associates is providing or seeking to provide investment
advisory services, or which are investors or are solicited to invest in
any covered investment pool to which the investment adviser provides
investment advisory services, as applicable; \201\ (iii) all government
entities to which the investment adviser has provided investment
advisory services, along with any related covered investment pool(s) to
which the investment adviser has provided investment advisory services
and in which the government entity has invested, as applicable, in the
past five years, but not prior to the effective date of the proposed
rule; \202\ and (iv) all direct or indirect contributions or payments
made by the investment adviser or any of its covered associates to an
official of a government entity, a political party of a State or
political subdivision thereof, or a PAC.\203\ The adviser's records of
contributions and payments would be required to be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether such
contribution or payment was subject to the exception for certain
returned contributions pursuant to proposed rule 206(4)-5(b)(2).\204\
These requirements are generally consistent with the MSRB recordkeeping
rule for broker-dealers.\205\
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    \201\ We note that an adviser may identify its clients on its
books through the use of codes. See Advisers Act rule 204-2(d) [17
CFR 275.204-2(d)].
    \202\ See id.
    \203\ Proposed rule 204-2(a)(18)(i). We note that this provision
is intended to include records of direct contributions an adviser or
its covered associates makes under proposed rule 206(4)-5(a)(1), as
well as records of contributions or payments an adviser or its
covered associates coordinates or solicits another person or PAC to
make under proposed rule 206(4)-5(a)(2)(ii), which would be
considered indirect contributions or payments.
    \204\ Proposed rule 204-2(a)(18)(ii).
    \205\ MSRB rule G-8(a)(xvi). Like rule G-37, the proposed rule
requires an investment adviser to keep, in addition to records of
political contributions, records of any other ``payments'' made to
officials, political parties or PACs. See proposed amendment to rule
204-2(a)(18)(i)(D). See also supra note 149 and accompanying text
for an explanation of how the rule distinguishes between
contributions and payments. The MSRB also requires certain records
to be made and kept in accordance with disclosure requirements that
our proposed rule does not contain.
---------------------------------------------------------------------------

    Should we exclude de minimis contributions from the recordkeeping
requirement? Should we expand our recordkeeping requirements to cover
records of contributions or payments not just to government officials
and political parties, but also persons associated with officials of
government entities, regardless of whether contributions or payments to
these individuals trigger the prohibitions

contained in our proposed pay to play rule? \206\
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    \206\ See supra note 89 and accompanying text.
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    To manage compliance with the proposed rule effectively, we would
expect that the adviser would adopt sufficient internal procedures--
which would include keeping certain records--to prevent the rule's
prohibitions from being triggered.\207\ As discussed above, a single
contribution could, under the rule, lead to a two-year suspension of
compensated advisory activities for a government client. Therefore, we
anticipate that many, if not all, of the records that we propose to
require registered advisers make and keep under our proposed amendments
would be those an adviser undertaking a serious compliance effort would
ordinarily make and keep. We request that commenters opposing the new
recordkeeping requirements suggest alternative means that would be
sufficient to aid examinations for compliance with the proposed rule.
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    \207\ See Advisers Act rule 206(4)-7 [17 CFR 275.206(4)-7]
(setting forth guidelines for advisers' compliance policies and
procedures).
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C. Amendment to Cash Solicitation Rule

    We are also proposing a technical amendment to rule 206(4)-3 under
the Advisers Act, the ``cash solicitation rule.'' That rule makes it
unlawful, except under specified circumstances and subject to certain
conditions, for an investment adviser to make a cash payment to a
person who directly or indirectly solicits any client for, or refers
any client to, an investment adviser.\208\
---------------------------------------------------------------------------

    \208\ 17 CFR 275.206(4)-3.
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    Because paragraph (iii) of rule 206(4)-3 contains provisions
regarding more general restrictions on third-party solicitors that
would cover solicitation activities directed at any client--whether a
government entity client or not--our proposed technical amendment would
be designed to note the specialized provisions prohibiting payments by
an adviser to third-party solicitors of government clients that are
contained in proposed rule 206(4)-5. Specifically, we propose to add a
new paragraph (e) to rule 206(4)-3 to alert advisers and others that
special prohibitions apply to solicitation activities involving
government entity clients under our proposed pay to play rule.\209\
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    \209\ Proposed rule 206(4)-3(e).
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D. Transition Period

    The prohibition and recordkeeping requirements under the proposed
rule would arise from contributions made on or after the effective date
of the rule, if adopted. As a result, firms would need to have
developed and adopted appropriate procedures to track contributions and
would need to begin monitoring contributions made by their covered
associates on that date. The Commission requests comment on whether
firms would require additional time to develop procedures to comply
with the proposed rule and, if so, how long of a transition period
following the rule's adoption would be necessary? For example, if a
transition period is necessary, would 90 days be an appropriate amount
of time? Would longer be necessary, e.g., six months, and if so, why?

E. General Request for Comment

    Any interested persons wishing to submit written comments on the
proposed rule and rule amendment that are the subject of this Release,
or to suggest additional changes or submit comments on other matters
that might have an effect on the proposals described above, are
requested to do so. Commenters suggesting alternative approaches are
encouraged to submit proposed rule text.

III. Cost/Benefit Analysis

    We are sensitive to the costs and benefits imposed by our rules,
and understand that there would be compliance costs with proposed rule
206(4)-5 and the proposed amendment to rule 204-2.\210\ We are mindful
of the burdens the proposed rule would place on advisory firms and
limitations it would place on the ability of certain persons associated
with an adviser to make contributions to candidates for certain offices
and to solicit contributions for certain candidates and payments to
political parties. We thus have narrowly tailored the rule to achieve
our goal of ending adviser participation in pay to play practices,
while seeking to limit these burdens.
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    \210\ We are also proposing to make a conforming technical
amendment to rule 206(4)-3 to address potential areas of conflict
with proposed rule 206(4)-5. We do not expect that this technical
amendment will affect the costs associated with the rulemaking.
---------------------------------------------------------------------------

    The proposed rule and rule amendments would address ``pay to play''
practices by investment advisers that provide, or are seeking to
provide, advisory services to government entity clients and to certain
covered investment pools in which a government entity invests. The
proposed rule would prohibit an investment adviser from providing
advisory services for compensation to a government client for two years
after the adviser or certain of its executives or employees make a
contribution to certain elected officials or candidates. The proposed
rule would also prohibit an adviser from providing or agreeing to
provide, directly or indirectly, payment to any third party for a
solicitation of advisory business from any government entity, or for a
solicitation of a government entity to invest in certain covered
investment pools, on behalf of such adviser. Additionally, the proposed
rule would prevent an adviser from coordinating or soliciting from
others contributions to certain elected officials or candidates or
payments to certain political parties. Our proposed amendment to rule
204-2 would require a registered adviser (or adviser required to be
registered) to maintain certain records of the political contributions
made by the adviser or certain of its executive or employees.

A. Benefits

    As discussed extensively throughout this release, we expect that
proposed rule 206(4)-5 would yield several important direct and
indirect benefits. At its core, the rulemaking addresses practices that
undermine the integrity of our markets. Overall, the proposed rule is
intended to address pay to play relationships that interfere with the
legitimate process by which advisers are chosen based on the merits
rather than on their contributions to political officials. The
potential for fraud to invade the various, intertwined relationships
created by pay to play arrangements is without question. Accordingly,
we believe that the proposed rule will achieve its goals of protecting
public pension plans, beneficiaries, and other investors from the
resulting harms.
    Curtailing pay to play practices will help protect public pension
plans and investments of the public in government-sponsored savings and
retirement plans and programs by addressing situations in which a more
qualified adviser may not be selected, potentially leading to inferior
management, diminished returns or greater losses. By addressing pay to
play practices, we would be leveling the playing field so that the
advisers selected to manage retirement funds and other investments for
the public are more likely to be selected based on their skills and the
quality of their advisory services. These benefits could result in
substantial savings and better performance for the public pension

plans, their beneficiaries, and participants.\211\
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    \211\ According to U.S. census data as of 2007, there are 2,547
State and local government employee retirement systems.
---------------------------------------------------------------------------

    By leveling the playing field among advisers competing for State
and local government business, the proposed rule could also eliminate
or minimize manipulation of the market for advisory services provided
to State and local governments. Payments made to third-party solicitors
as part of pay to play practices create artificial barriers to
competition for firms that cannot, or will not, make those
contributions or payments. They also create increased costs for firms
that may feel they have no alternative but to pay to play.
Additionally, pay to play practices potentially expose an adviser to
other costs, such as liability, defense costs and distraction from its
duties. Curtailing pay to play arrangements enables advisory firms,
particularly smaller advisory firms, to compete on merit, rather than
their ability or willingness to make contributions.
    Moreover, the absence of arm's-length negotiations may enable
advisers to obtain greater ancillary benefits, such as ``soft
dollars,'' from the advisory relationship, which may be directed for
the benefit of the adviser, potentially at the expense of the pension
plan, thereby using a pension plan asset for the adviser's own
purposes.\212\ Additionally, taxpayers could benefit because they might
otherwise bear the financial burden of bailing out a government pension
fund that has ended up with a shortfall due to poor performance or
excessive fees that might result from pay to play.
---------------------------------------------------------------------------

    \212\ See supra note 51.
---------------------------------------------------------------------------

    Applying the proposed rule to government entity investments in
certain pooled investment vehicles or where a pooled investment vehicle
is an investment option in a government-sponsored plan or program would
extend the same benefits regardless of whether an adviser subject to
the proposed rule is providing advice directly to the government entity
or is managing assets for the government entity indirectly through a
pooled investment vehicle. By addressing distortions in the process by
which investment decisions are made regarding public investments, we
will provide important protections to public pension plans and their
beneficiaries, as well as participants in other important plans or
programs sponsored by government entities. Other investors in a pooled
investment vehicle also will be better protected from, among other
things, the effects of fraud that may result from an adviser's
participation in pay to play activities, such as higher advisory fees.
    Finally, the proposed amendments to rule 204-2 would benefit the
public plans and their beneficiaries and participants in State plans or
programs as well as investment advisers that keep the required records.
The public pension plans, beneficiaries, and participants would benefit
from these amendments because the records required to be kept would
provide Commission staff with information to review an adviser's
compliance with proposed rule 206(4)-5 and thereby may promote improved
compliance. Advisers would benefit from the proposed amendments to the
recordkeeping rule as these records would assist the Commission in
enforcing the rule against, for example, competitors whose pay to play
activities, if not uncovered, could adversely affect the competitive
position of a compliant adviser.

B. Costs

    The proposed rule and rule amendments would impose costs on
advisers that provide advisory services to government clients, though
we have tried to minimize the costs associated with an inadvertent
violation of proposed rule 206(4)-5 by including an exception for
certain returned contributions. The proposed rule would require an
adviser with government clients, and an adviser that solicits business
from government clients, to incur costs to monitor contributions made
by the adviser and its covered associates, and to establish procedures
to comply with the proposed rule and rule amendments. The initial and
ongoing compliance costs imposed by the proposed rule would vary
significantly among firms, depending on a number of factors. These
include the number of covered associates of the adviser, the degree to
which compliance procedures are automated, the extent to which an
adviser has a pre-existing policy under its code of ethics or
compliance program,\213\ and whether the adviser is affiliated with a
broker-dealer firm that is subject to rules G-37 and G-38. A smaller
adviser, for example, would likely have a small number of covered
associates, and thus expend less resources to comply with the proposed
rule and rule amendments than a larger adviser.
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    \213\ See Investment Counsel Association of America Comment
Letter (May 15, 2000) (``May ICAA Comment Letter'') (``According to
our members, many investment advisers already have policies and
procedures in place to report contributions under State and local
law and to avoid pay to play issues.'').
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    A large adviser is likely to spend more resources to comply with
the rule than a smaller adviser. However, based on staff observations,
a large adviser is more likely to have an affiliated broker-dealer that
is required to comply with MSRB rules G-37 and G-38.\214\ Such a large
adviser could likely use some or all of the compliance procedures
established by its broker-dealer affiliate to facilitate its compliance
with proposed rule 206(4)-5. As a result, many advisers with broker-
dealer affiliates may spend less resources to comply with the proposed
rule and rule amendments.\215\
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    \214\ According to registration information available from
Investment Adviser Registration Depository (``IARD'') as of July 1,
2009, there are 1,312 SEC-registered investment advisers (or 11.57%
of the total 11,340 registered advisers) that indicate in Item
5.D.(9) of Form ADV that they have State or municipal government
clients. Of those 1,312 advisers, 108 (or 82.4%) of the largest 10%
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer; and 202 of the largest 20% (or 87.1%)
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. Conversely, only 46 (or 35.1%) of the
smallest 10% have one or more affiliated broker-dealers or are,
themselves, also registered as a broker-dealer; and only 72 of the
smallest 20% (or 31.0%) have one or more affiliated broker-dealers
or are, themselves, also registered as a broker-dealer. With respect
to broker-dealer affiliates, however, we note that our IARD data
does not indicate whether the affiliated broker-dealer is a
municipal securities dealer subject to MSRB rules G-37 and G-38.
    \215\ Cf. Comment Letter of US Bancorp Piper Jaffray (Nov. 15,
1999) (``U.S. Bancorp Letter'') (``[T]he more the Rule mirrors G-37,
the more firms can borrow from or build upon compliance procedures
already in place. * * * [H]owever, [there are] many differences
between the rules that would result in significant new burdens.'').
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    We anticipate that advisory firms subject to proposed rule 206(4)-5
would develop compliance procedures to monitor the political
contributions made by the adviser and its covered associates. We
estimate that the costs imposed by the proposed rule would be higher
initially, as firms establish and implement procedures and systems to
comply with the rule and rule amendments. It is anticipated that
compliance expenses would then decline to a relatively constant amount
in future years, and annual expenses are likely to be lower for small
advisers as the systems and processes should be less complex than for a
large adviser.
    We estimate that approximately 1,764 investment advisers registered
with the Commission may be affected by the proposed rule and rule
amendments.\216\

Of the 1,764 advisers, we estimate that approximately 1,300 advisers
have fewer than five covered associates that would be subject to the
proposed rule each, a ``smaller firm''; approximately 328 advisers have
between five and 15 covered associates each, a ``medium firm''; and
approximately 136 advisers have more than 15 covered associates that
would be subject to the prohibitions of the proposed rule each, a
``larger firm'' \217\.
---------------------------------------------------------------------------

    \216\ This number is based on registration information available
from IARD as of July 1, 2009. As noted previously, there are 1,312
SEC-registered investment advisers (or 11.57% of the total 11,340
registered advisers) that indicate in Item 5.D.(9) of Form ADV that
they have State or municipal government clients. Based on this data
point and other responses to Item 5.D., we further estimate that 289
(or 11.57%) of the 2,502 registered investment advisers that manage
``other pooled investment vehicles'' (and do not also indicate that
they have State or municipal government clients) are advising pooled
investment vehicles in which government clients invest, and we
estimate that 79 (or 11.57%) of the 679 registered investment
advisers that manage registered investment companies (and do not
also indicate that they have State or municipal government clients)
are advising registered investment companies that are available as
an investment option in a government plan or program. The sum of
1,312, 289 and 79 is 1,680. The proposed rule also applies to those
advisers that seek to obtain government clients, and we do not know
the precise number of such advisers. We believe, however, that the
percentage of advisers is likely not great because, according to
IARD data, there has not been any appreciable growth or shrinkage
over the past five years in the percentage of SEC-registered
advisers who have State or municipal government clients; the
percentage has been almost unchanged. Accordingly, we estimate that
an additional 5% (or 84) of SEC-registered advisers are seeking
government clients, for a total of 1,764 (1,680 + 84) registered
advisers subject to the proposed rule.
    \217\ These estimates are based on IARD data, specifically the
responses to Item 5.B.(1) of Form ADV, that 967 (or 73.7%) of the
1,312 registered investment advisers that have government clients
have fewer than five employees who perform investment advisory
functions related to those government clients, 244 (or 18.6%) have
five to 15 such employees, and 101 (or 7.7%) have more than 15 such
employees. We then applied those percentages to the 1,764 advisers
we believe will be subject to the proposed rule for a total of 1,300
smaller, 328 medium and 136 larger firms.
---------------------------------------------------------------------------

    Advisers that are unregistered in reliance on the exemption
available under section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)] would be subject to proposed rule 206(4)-5.\218\ Based on our
review of registration information on IARD and outside sources and
reports, we estimate that there are approximately 2,000 advisers that
are unregistered in reliance on section 203(b)(3).\219\ Applying the
same principles we used with respect to registered investment advisers,
we estimate that 231 of those advisers manage pooled investment
vehicles in which government client assets are invested and would
therefore be subject to the proposed rule.\220\
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    \218\ The proposed amendments to rules 204-2 and 206(4)-3 would
apply only to advisers that are registered, or required to be
registered, with the Commission.
    \219\ This number is based on our review of registration
information on IARD as of July 1, 2009, IARD data from the peak of
hedge fund adviser registration in 2005, and a distillation of
numerous third-party sources including news organizations and
industry trade groups.
    \220\ 11.57% of 2000 is 231.4. See supra note 216.
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    For purposes of this analysis, it is assumed that each exempt
advisory firm that would be subject to the proposed rule would likely
either be smaller firms or medium firms, in terms of number of covered
associates because it is unlikely that an adviser that is limited to
fewer than 15 clients would have a large number of advisory personnel
that would be covered associates.\221\
---------------------------------------------------------------------------

    \221\ See section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)].
---------------------------------------------------------------------------

    Although the time needed to comply with the proposed rule would
vary significantly from adviser to adviser, the Commission staff
estimates that firms with government clients would spend between 8
hours and 250 hours to establish policies and procedures to comply with
the proposed rule. Commission staff further estimates that ongoing
compliance with the proposed rule would require between 10 and 1,000
hours, annually. These estimates are derived in part from conversations
with industry professionals regarding broker-dealer compliance with
rule G-37 and G-38 and representatives of investment advisers that have
pay to play policies in place. In addition, advisory firms may incur
one-time costs to establish or enhance current systems to assist in
their compliance with the proposed rule. These costs would vary widely
among firms. Small advisers may not incur any system costs if they
determine a system is unnecessary due to the limited number of
employees they have or the limited number of government entity clients
they have. Large firms likely already have devoted significant
resources into automating compliance and reporting and the new rule
could result in enhancements to these existing systems. We believe such
system costs could range from the tens of thousands of dollars for
simple reporting systems, to hundreds of thousands of dollars for
complex systems used by the large advisers. As we noted previously,
large advisers are more likely to have broker-dealer affiliates that
may already have compliance systems in place for MSRB rules G-37 and G-
38 that could be used by an adviser.
    Initial compliance procedures would likely be designed, and ongoing
administration of them performed, by compliance managers and compliance
clerks. We estimate that the hourly wage rate for compliance managers
is $258, including benefits, and for compliance clerks, $63 per hour,
including benefits.\222\ To establish and implement adequate compliance
procedures, we estimate that the proposed rule would impose initial
compliance costs of approximately $2,064 \223\ per smaller firm,
approximately $26,156 \224\ per medium firm, and approximately $52,313
\225\ per larger firm.\226\ It is estimated that the proposed rule
would impose annual, ongoing compliance

expenses of approximately $2,580 \227\ per smaller firm, $104,625 \228\
per medium firm, and $209,250 \229\ per larger firm.
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    \222\ Our hourly wage rate estimate for a compliance manager and
compliance clerk is based on data from the Securities Industry
Financial Markets Association's Management & Professional Earnings
in the Securities Industry 2008, modified by Commission staff to
account for an 1800-hour work-year and multiplied by 2.93 to account
for bonuses, firm size, employee benefits and overhead.
    \223\ The per firm cost estimate is based on our estimate that
development of initial compliance procedures for smaller firms would
take 8 hours of compliance manager time (at $258 per hour).
    \224\ With respect to our estimated range of 8-250 hours, we
assume a medium-sized firm would take 125 hours to develop initial
compliance procedures, and such a firm would likely have support
staff. We also anticipate that a compliance manager would do
approximately 75% of the work because he/she is responsible for
implementing the policy for the entire firm. Accordingly, the per
firm cost estimate is based on our estimate that development of
initial compliance procedures for medium firms would take 93.75
hours of compliance manager time (at $258 per hour) and 31.25 hours
of clerical time (at $63 per hour).
    \225\ With respect to our estimated range of 8-250 hours, we
assume a larger firm would take 250 hours to develop initial
compliance procedures, and such a firm would likely have support
staff. We also anticipate that a compliance manager would do
approximately 75% of the work because he/she is responsible for
implementing the policy for the entire firm. Accordingly, the per
firm cost estimate is based on our estimate that development of
initial compliance procedures for larger firms would take 187.50
hours of compliance manager time (at $258 per hour) and 62.5 hours
of clerical time (at $63 per hour).
    \226\ Some commenters in 1999 suggested that our cost estimates,
then, were too low. See U.S. Bancorp Letter (``[W]e believe the
initial compliance cost estimates in the [1999] Release of $285 for
a small firm, $13,387.50 for a medium firm and $22,312.50 for a
large firm underestimate by orders of magnitude the initial costs of
compliance.''); Comment Letter of American Council of Life Insurance
(Nov. 1, 1999) (``Many of our member companies have observed that
the proposal's compliance cost projections are speculative and
unrealistic, especially when applied to large diversified financial
institutions like life insurers. * * * Moreover, the cost estimates
are greatly understated when the proposed rule is applied to large
diversified life insurers offering investment advice as one of
several products and services. * * * One of our larger diversified
member companies has estimated that it would cost approximately
$200,000 per year to administer compliance with the proposed rule
for the approximately 200-300 people the rule would encompass. The
company developing these estimates based its estimate of hours and
labor costs on its actual compliance with Rule G-37.''). We have
significantly increased our cost estimates from our 1999 proposal.
We also note that the scope of persons covered under the current
rule proposal is narrower than the scope of persons proposed to be
covered in 1999. See supra note 98 and accompanying text.
    \227\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for smaller firms would take 10 hours
of compliance manager time (at $258 per hour) per year.
    \228\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for medium firms would take 375 hours
of compliance manager time (at $258 per hour) and 125 hours of
clerical time (at $63 per hour), per year.
    \229\ The per firm cost estimate is based on our estimate that
ongoing compliance procedures for larger firms would take 750 hours
of compliance manager time (at $258 per hour) and 250 hours of
clerical time (at $63 per hour), per year.
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    We further anticipate that approximately one-third of advisers that
we estimate would be subject to the rule may also engage outside legal
services to assist in drafting policies and procedures.\230\ We
estimate the cost associated with such an engagement would include fees
for approximately three hours of outside legal review for a smaller
firm, 10 hours for a medium firm, and 30 hours for a large firm, at a
rate of $400 per hour. For a smaller firm we estimate a total of $1,200
in outside legal fees for each of the estimated 325 advisers that would
seek assistance, for a medium firm we estimate a total of $4,000 for
the estimated 164 advisers that would seek assistance, and for each of
the 102 larger firms we estimate a total of $12,000.\231\ Thus, we
estimate that approximately 591 investment advisers will incur these
additional costs, for a total cost of $2,270,000 among advisers
affected by the proposed rule amendments.
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    \230\ Based on staff observations, we estimate 75% of larger
firms, 50% of medium firms, and 25% of smaller firms would seek to
outsource all or a portion of this type of legal work.
    \231\ As noted above, we estimate 75% of larger firms, 50% of
medium firms, and 25% of smaller firms would seek the assistance of
outside counsel.
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    Additionally, we expect that on average approximately five advisers
annually will apply to the Commission for an exemption from the
proposed rule.\232\ We estimate that a firm that applies for an
exemption will hire outside counsel to prepare an exemptive request,
and that counsel will spend 16 hours preparing and submitting an
application for review at a rate of $400 per hour. As a result, each
application will cost approximately $6,400, and the total estimated
cost for five applications annually will be $32,000.
---------------------------------------------------------------------------

    \232\ This estimate is based on staff discussions with Financial
Industry Regulatory Authority staff responsible for reviewing
exemptive applications submitted under MSRB rule G-37.
---------------------------------------------------------------------------

    The prohibitions of the proposed rule may also impose other costs
on advisers, covered associates, third-party solicitors, and political
officials. An adviser that becomes subject to the prohibitions of the
proposed rule would no longer be eligible to receive advisory fees from
its government client. This could limit the number of advisers able to
provide services to potential government entity clients. The adviser,
however, may be obligated to provide (uncompensated) advisory services
for a reasonable period of time until the government client finds a
successor to ensure its withdrawal did not harm the client, or the
contractual arrangement between the adviser and the government client
might obligate the adviser to continue to perform under the contract at
no fee. An adviser that provides uncompensated advisory services to a
government client would incur the direct cost of providing
uncompensated services, and may incur opportunity costs if the adviser
is unable to pursue other business opportunities for a period of time.
Advisers to government clients, as well as covered associates of the
adviser, also may be less likely to make political contributions to
political officials, possibly imposing costs on the officials if they
are unable to secure alternate funding. Under the proposed rule,
covered associates and executives may face new limitations on the
amounts and to whom they can contribute. In addition, these same
individuals could be prohibited from soliciting others to contribute or
from coordinating contributions to government officials or political
parties in certain circumstances. These limitations and prohibitions,
including if a firm chose to adopt policies or procedures that are more
restrictive than the proposed rule, could be perceived by the
individuals subject to them as costs imposed on their ability to
express their support for certain candidates for elected office and
government officials.
    Because the proposed rule would prohibit advisers from compensating
third parties to solicit government entities for advisory services,
advisers that currently rely on third-party solicitors to obtain
government clients may have to bear the expense of hiring and training
in-house staff in order to continue their solicitation activities.
While third-party solicitors are not subject to the proposed rule, the
proposed ban on advisers' use of third-party solicitors may have a
substantial negative impact on persons who provide third-party
solicitation services, and if their businesses consists solely of
soliciting government entities on behalf of investment advisers, the
proposed rule could result in these persons instead being employed
directly by advisers or shifting the focus of their solicitation
activities. In addition, small investment advisers and new investment
advisers that do not have the capital to hire employees to obtain
government clients may find it difficult to enter the market to provide
advisory services to government pension plans or to obtain additional
government clients.
    We also anticipate that the proposed amendment to rule 204-2 would
impose additional costs. The proposed amendments to rule 204-2 would
require that SEC-registered advisers maintain certain records of
campaign contributions by certain advisory personnel.\233\ For purposes
of the Paperwork Reduction Act, we have estimated that Commission-
registered advisers would incur approximately 3,528 additional hours
annually to comply with the proposed amendments to rule 204-2.\234\
Based on this estimate, we anticipate that advisers would incur an
aggregate cost of approximately $222,264 per year for the total hours
advisory personnel would spend in complying with the proposed
recordkeeping requirements.\235\ Unregistered advisers that would be
subject to proposed rule 206(4)-5 would not be subject to the proposed
amendments to rules 204-2 and 206(4)-3.
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    \233\ One commenter in 1999 expressed the view that our proposed
amendments to the recordkeeping rule would be burdensome. See Nov.
ICAA Comment Letter (``The proposed rule, in effect, requires firms
to keep an ongoing, continuously updated list of prospective
government clients. * * * [I]t is logistically unclear how a firm
should compile this list. * * * [T]he burden of continuously
compiling this list would be significant.'') We have increased our
burden estimate from our 1999 proposal. We note that records are a
critical component of proposed rule 206(4)-5. In particular, such
records are necessary for examiners to inspect advisers for
compliance with the terms of the proposed rule. We also note that it
is typical for advisers seeking business from government entities to
do so through a request for proposal or similar process, which would
typically generate a record.
    \234\ See infra note 242.
    \235\ We expect that the function of recording and maintaining
records of political contributions would be performed by a
compliance clerk at a cost of $63 per hour. See supra note 222.
Therefore the total costs would be $222,264 (3,528 hours x $63 per/
hour).
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C. Request for Comment

    The Commission requests comment on the effects of the proposed rule
and rule amendments on pension plan beneficiaries, participants in
government plans or programs, investors in pooled investment vehicles,
investment advisers, the advisory profession as a whole, government
entities, third party solicitors, and political action committees. We
request data to quantify the costs and value of the benefits associated
with the

proposed rule. Specifically, comment is requested on the costs of
establishing compliance procedures to comply with the proposed rule,
both on an initial and ongoing basis. Comment also is requested on the
costs of using compliance procedures of an affiliated broker-dealer
that the broker-dealer established as a result of rule G-37 and G-
38.\236\ In addition, we request data regarding our assumptions about
the number of unregistered advisers that would be subject to the
proposed rule, and the number of covered associates of these exempt
advisers. As discussed below, section 202(c)(1) of the Advisers Act
does not apply to proposed new rule 206(4)-5 or the proposed amendments
to rule 206(4)-3. Nonetheless, in the context of the objectives of this
rulemaking, we are interested in comments that address whether these
proposed rules will promote efficiency, competition and capital
formation. We solicit comment on the effect the proposed rule would
have on the market for investment advisory services and third-party
solicitation services. Commenters should provide analysis and empirical
data to support their views on the costs and benefits associated with
this proposal.
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    \236\ See ABA Comment Letter (``Any cost-benefit analysis of the
Rule logically should begin, by analogy, with an analysis of the
costs that have been borne by Municipal Securities Professionals in
complying with MSRB Rule G-37, bearing in mind that the proposed
Rule contains no reporting requirements.'').
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IV. Paperwork Reduction Act

A. Rule 204-2

    The proposed amendment to rule 204-2 contains a new ``collection of
information'' requirement within the meaning of the PRA, and the
Commission has submitted the proposed amendment to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. The title for the collection of information
is ``Rule 204-2 under the Advisers Act of 1940.'' Rule 204-2 contains a
currently approved collection of information number under OMB control
number 3235-0278. An agency may not conduct or sponsor, and a person is
not required to respond to a collection of information unless it
displays a currently valid control number.
    Section 204 of the Advisers Act provides that investment advisers
registered or required to be registered with the Commission must make
and keep certain records for prescribed periods, and make and
disseminate certain reports. Rule 204-2 sets forth the requirements for
maintaining and preserving specified books and records. This collection
of information is mandatory. The Commission staff uses this collection
of information in its examination and oversight program, and the
information generally is kept confidential.\237\
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    \237\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
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    The current approved collection of information for rule 204-2 is
based on an average of 181.15 burden hours each year, per Commission-
registered adviser, for a total of 1,954,109 burden hours. The current
total burden is based on an estimate of 10,787 registered advisers.
    The proposed amendments to rule 204-2 would require every
investment adviser registered or required to be registered that
provides or seeks to provide advisory services to government entities
to maintain certain records of contributions made by the adviser or any
of its covered associates. The proposed amendments would require an
adviser to make and keep the following records: (i) The names, titles
and business and residence addresses of all covered associates of the
investment adviser; (ii) all government entities for which the
investment adviser or any of its covered associates is providing or
seeking to provide investment advisory services, or which are investors
or are solicited to invest in any covered investment pool to which the
investment adviser provides investment advisory services, as
applicable; (iii) all government entities to which the investment
adviser has provided investment advisory services, along with any
related covered investment pool(s) to which the investment adviser has
provided investment advisory services and in which the government
entity has invested, as applicable, in the past five years, but not
prior to the effective date of the proposed rule; and (iv) all direct
or indirect contributions or payments made by the investment adviser or
any of its covered associates to an official of a government entity, a
political party of a State or political subdivision thereof, or a PAC.
An adviser to a covered investment pool in which a government entity
invests or is solicited to invest would be treated as though that
investment adviser were providing or seeking to provide investment
advisory services directly to the government client. The adviser's
records of contributions and payments would be required to be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether such
contribution or payment was subject to the exception for certain
returned contributions pursuant to proposed rule 206(4)-5(b)(2). These
records would be required to be maintained in the same manner, and for
the same period of time, as other books and records under rule 204-
2(a). This collection of information would be found at 17 CFR 275.204-
2. Advisers that are exempt from Commission registration under section
203(b)(3) of the Advisers Act would not be subject to the recordkeeping
requirements.
    Commission records indicate that currently there are approximately
11,340 registered investment advisers subject to the collection of
information imposed by rule 204-2.\238\ As a result of the increase in
the number of advisers registered with the Commission since the current
total burden was approved, the total burden has increased by 100,176
hours (553 additional advisers \239\ x 181.15 hours). We estimate that
approximately 1,764 Commission-registered advisers provide, or seek to
provide, advisory services to government clients and to certain pooled
investment vehicles in which government entities invest, and would thus
be affected by the proposed rule amendments.\240\ Under the proposed
amendments, each respondent would be required to retain the records in
the same manner and for the same period of time as currently required
under rule 204-2. The proposed amendments to rule 204-2 are estimated
to increase the burden by approximately two hours per Commission-
registered adviser with government clients annually for a total
increase of 3,528 hours.\241\ The revised annual aggregate burden for
all respondents to the recordkeeping requirements under rule 204-2 thus
would be 2,057,813 hours.\242\ The revised weighted average burden per
Commission-registered adviser would be 181.46 hours.\243\
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    \238\ This figure is based on registration information from IARD
as of July 1, 2009.
    \239\ 11,340-10,787 = 553.
    \240\ See supra note 216.
    \241\ This increased burden relates only to the recordkeeping
requirements we are proposing to amend. See supra section III.B. of
this release for an explanation of other estimated costs associated
with complying with the proposed rule and rule amendments.
    \242\ 1,954,109 (current approved burden) + 100,176 (burden for
additional registrants) + 3,528 (burden for proposed amendments) =
2,057,813 hours.
    \243\ 2,057,813 (revised annual aggregate burden) divided by
11,340 (total number of registrants) = 181.46.
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    Additionally, we expect advisory firms may incur one-time costs to
establish or enhance current systems to

assist in their compliance with the proposed amendments to rule 204-2.
These costs would vary widely among firms. Small advisers may not incur
any system costs if they determine a system is unnecessary due to the
limited number of employees they have or the limited number of
government entity clients they have. Large firms likely already have
devoted significant resources into automating compliance and reporting
and the new rule could result in enhancements to these existing
systems. We believe they could range from the tens of thousands of
dollars for simple reporting systems, to hundreds of thousands of
dollars for complex systems used by the large advisers.

B. Rule 206(4)-3

    The proposed amendment to rule 206(4)-3 contains a revised
``collection of information'' requirement within the meaning of the
PRA, and the Commission has submitted the proposed amendment to the OMB
for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The
title for the collection of information is ``Rule 206(4)-3--Cash
Payments for Client Solicitations.'' Rule 206(4)-3 contains a currently
approved collection of information number under OMB control number
3235-0242.
    Section 206(4) of the Advisers Act provides that it shall be
unlawful for any investment adviser to engage in any act, practice, or
course of business which is fraudulent, deceptive, or manipulative.
Rule 206(4)-3 generally prohibits investment advisers from paying cash
fees to solicitors for client referrals unless certain conditions are
met. The rule requires that an adviser pay all solicitors' fees
pursuant to a written agreement that the adviser is required to retain.
This collection of information is mandatory. The Commission staff uses
this collection of information in its examination and oversight
program, and the information generally is kept confidential.\244\
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    \244\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
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    The current approved collection of information for rule 206(4)-3 is
based on an estimate that 20% of the 10,817 Commission-registered
advisers (or 2,163 advisers) rely on the rule, at an average of 7.04
burden hours each year, per respondent, for a total of 15,228 burden
hours (7.04 x 2,163).
    The proposed amendments to rule 206(4)-3 would require every
investment adviser that relies on the rule and that provides or seeks
to provide advisory services to government entities to also abide by
the limitations provided in proposed rule 206(4)-5. This collection of
information would be found at 17 CFR 275.206(4)-3. Advisers that are
exempt from Commission registration under section 203(b)(3) of the
Advisers Act would not be subject to rule 206(4)-3.
    Commission records indicate that currently there are approximately
11,340 registered investment advisers,\245\ 20% of which (or 2,268) are
likely subject to the collection of information imposed by rule 206(4)-
3. As a result of the increase in the number of advisers registered
with the Commission since the current total burden was approved, the
total burden has increased by 739.2 hours (105 additional advisers
\246\ x 7.04 hours). We assume that approximately 20% of the
Commission-registered advisers that use rule 206(4)-3 (or 454 advisers)
provide, or seek to provide, advisory services to government clients
and would thus be affected by the proposed rule amendments.\247\ Under
the proposed amendments, each respondent would be prohibited from
certain solicitation activities with respect to government
clients,\248\ which would eliminate the need to enter into and retain
the written agreement required under rule 206(4)-3 with respect to
those clients. Accordingly, the proposed amendments to rule 206(4)-3
are estimated to decrease the burden by 20%, or approximately 1.4
hours, per Commission-registered adviser that uses the rule and has or
is seeking government clients annually, for a total decrease of 635.6
hours. The revised annual aggregate burden for all respondents to the
recordkeeping requirements under rule 206(4)-3 thus would be 15,331.6
hours.\249\ The revised weighted average burden per Commission-
registered adviser would be 6.76 hours.\250\
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    \245\ This figure is based on registration information from IARD
as of July 1, 2009.
    \246\ 2,268 (20% of current registered investment advisers) -
2,163 (20% of registered investment advisers when burden estimate
was last approved by OMB) = 105.
    \247\ In light of the 11.57% of registered investment advisers
that indicate they have State or municipal government clients, we
conservatively estimate that 20% of the advisers who rely on rule
206(4)-3 are soliciting government entities to be advisory clients
or to invest in covered investment pools those advisers manage. See
supra note 214.
    \248\ See proposed rule 206(4)-3(a).
    \249\ 15,228 (current approved burden) + 739.2 (burden for
additional registrants) -635.6 (reduction in burden for proposed
amendments) = 15,331.6 hours.
    \250\ 15,331.6 (revised annual aggregate burden) divided by
2,268 (total number of registrants who rely on rule) = 6.76.
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C. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed amendments to the
collection of information are necessary for the proper performance of
the functions of the Commission, including whether the information will
have practical utility; (ii) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collection of information; (iii)
determine whether there are ways to enhance the quality, utility, and
clarity of the information to be collected; and (iv) determine whether
there are ways to minimize the burden of the collection of information
on those who are to respond, including through the use of automated
collection techniques or other forms of information technology.
    Persons desiring to submit comments on the collection of
information requirements should direct them to the Office of Management
and Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Room 3208,
Washington, DC 20503, and also should send a copy of their comments to
Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100
F Street, NE., Washington, DC 20549-1090 with reference to File No. S7-
18-09. Requests for materials submitted to OMB by the Commission with
regard to this collection of information should be in writing, refer to
File No. S7-18-09, and be submitted to the Securities and Exchange
Commission, Office of Investor Education and Advocacy, 100 F Street,
NE., Washington, DC 20549-0213. OMB is required to make a decision
concerning the collections of information between 30 and 60 days after
publication. A comment to OMB is best assured of having its full effect
if OMB receives it within 30 days after publication of this release.

V. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory
Flexibility Analysis (``IRFA'') regarding proposed rule 206(4)-5 and
the amendments to rules 204-2 and 206(4)-3 in accordance with section
3(a) of the Regulatory Flexibility Act.\251\
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    \251\ 5 U.S.C. 603(a).
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A. Reasons for Proposed Action

    Investment advisers that seek to influence the award of advisory
contracts by government entities, by making or soliciting political

contributions to those officials who are in a position to influence the
awards violate their fiduciary obligations. These practices--known as
``pay to play''--distort the process by which investment advisers are
selected and, as discussed in greater detail above, can harm advisers'
public pension plan clients, and thereby beneficiaries of those plans,
which may receive inferior advisory services and pay higher fees. In
addition, the most qualified adviser may not be selected, potentially
leading to inferior management, diminished returns or greater losses
for the public pension plan. Pay to play is a significant problem in
the management of public funds by investment advisers. Moreover, we
believe that advisers' participation in pay to play is inconsistent
with the high standards of ethical conduct required of them under the
Advisers Act. The proposed rule and rule amendments are designed to
prevent fraud, deception and manipulation by reducing or eliminating
adviser participation in pay to play practices.

B. Objectives and Legal Basis

    Proposed rule 206(4)-5, the ``pay to play'' rule, would prohibit an
adviser registered (or required to be registered) with the Commission,
or unregistered in reliance on the exemption available under section
203(b)(3) of the Advisers Act, from providing advisory services for
compensation to a government client for two years after the adviser, or
any of its covered associates, make a contribution to public officials
(and candidates) such as State treasurers, comptrollers or other
elected executives or administrators who can influence the selection of
the adviser.\252\ In addition, we are proposing to prohibit an adviser
or any of its covered associates from soliciting contributions for an
elected official or candidate or payments to a political party of a
State or locality where the adviser is providing or seeking to provide
advisory services to a government entity,\253\ and from providing or
agreeing to provide, directly or indirectly, payment to any third party
engaged to solicit advisory business from any government entity on
behalf of the adviser.\254\ Further, the prohibitions in the proposed
rule also would apply to advisers to certain investment pools in which
a government entity invests.\255\ The proposed rule amendment to rule
204-2 is designed to provide Commission staff with records to review
compliance with proposed rule 206(4)-5, and the proposed amendment to
rule 206(4)-3 would clarify the application of the cash solicitation
rule as a result of proposed rule 206(4)-5.
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    \252\ Proposed rule 206(4)-5(a)(1).