subject to the rule.\480\ For purposes of this analysis, it is assumed
that each unregistered advisory firm that would be subject to the rule
would either be a smaller firm or a medium firm in terms of number of
covered associates because it is unlikely that an adviser that operates
outside of public view and is limited to fewer than 15 clients \481\
would have a large number of advisory personnel that would be covered
associates. One commenter agreed that most of these unregistered
advisers would be small, although the commenter based its assessment on
assets under management, not on the adviser's likely number of covered
associates.\482\
---------------------------------------------------------------------------

    \478\ The amendments to rules 204-2 and 206(4)-3, however, only
apply to advisers that are registered, or required to be registered,
with the Commission.
    \479\ This number is based on our review of registration
information on IARD as of April 1, 2010, 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.
    \480\ 11.48% of 2000 is 230. See supra note 474.
    \481\ See section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)] (advisers who rely on this exception from registration must
have fewer than 15 clients in a 12-month period) .
    \482\ 3PM Letter.
---------------------------------------------------------------------------

    Some commenters asserted that our estimated number of advisers
subject to the proposed rule was too low.\483\ One claimed that the
number of advisory firms exempted from registration in reliance on
Section 203(b)(3) may be ``over two times our estimate,'' but provided
statistics about the number of unregistered pooled investment vehicles,
not the number of advisers to those pools.\484\ Other commenters did
not provide empirical data or suggest alternative formulas by which to
recalculate our estimate. Additionally, another seemed to misunderstand
our estimates.\485\
---------------------------------------------------------------------------

    \483\ See Davis Polk Letter; MFA Letter; 3PM Letter.
    \484\ 3PM Letter. See also Davis Polk Letter (citing to 3PM
Letter on this proposition).
    \485\ Davis Polk Letter (suggesting that we failed to take into
account the costs likely to be borne by unregistered investment
advisers). See supra notes 479 and 480 and accompanying text;
Proposing Release, nn.219-20 and accompanying text (providing an
estimate of the number of unregistered advisers we expect to be
subject to this rule, and that must develop compliance systems).
---------------------------------------------------------------------------

    As we stated in the Proposing Release,\486\ although the time
needed to comply with the rule will vary significantly from adviser to
adviser, as discussed in detail below, the Commission staff estimates
that firms with government clients will spend between 8 hours and 250
hours to establish policies and procedures to comply with the rule.
Commission staff further estimates that ongoing compliance with the
rule will require between 10 and 1,000 hours annually. In addition,
advisory firms may incur one-time costs to establish or enhance current
systems to assist in their compliance with the 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.
---------------------------------------------------------------------------

    \486\ See Proposing Release, at section III.B.
---------------------------------------------------------------------------

    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 $294, including benefits, and for compliance clerks, $59 per hour,
including benefits.\487\ To establish and implement adequate compliance
procedures, we estimate that the rule would impose initial compliance
costs of approximately $2,352 per smaller firm,\488\ approximately
$29,407 per medium firm,\489\ and approximately $58,813 per larger
firm.\490\ It is estimated that the rule would impose annual, ongoing
compliance expenses of approximately $2,940 per smaller firm,\491\
$117,625 per medium firm,\492\ and $235,250 per larger firm.\493\
---------------------------------------------------------------------------

    \487\ 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 2009, modified by Commission staff to
account for an 1800-hour work-year and multiplied by 5.35 (in the
case of compliance managers) or 2.93 (in the case of compliance
clerks) to account for bonuses, firm size, employee benefits and
overhead. The calculations discussed in this release are updated
from those included in the Proposing Release to incorporate data
from the most recently updated version of this publication.
    \488\ 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 $294 per hour).
Accordingly, the per firm cost estimate is $2,352 (8 x $294).
    \489\ With respect to our estimated range of 8-250 hours, we
assume a medium 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 or 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 $294 per hour (or $27,563), and
31.25 hours of clerical time, at $59 per hour (or $1,844), for a
total estimated cost of $29,407.
    \490\ 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 $294 per hour (or $55,125), and
62.5 hours of clerical time, at $59 per hour (or $3,688), for a
total estimated cost of $58,813.
    \491\ 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 $294 per hour, for a total estimated
cost of $2,940 per year.
    \492\ 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 $294 per hour (or $110,250), and 125
hours of clerical time, at $59 per hour (or $7,375), for a total
estimated cost of $117,625 per year.
    \493\ 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 $294 per hour (or $220,500) and 250
hours of clerical time, at $59 per hour (or $14,750), for a total
cost of $235,250 per year.
---------------------------------------------------------------------------

    In establishing these estimates, which are calculated in the same
manner as those we included in the Proposing Release, we took into
consideration comments in 1999 that suggested our cost estimates were
too low.\494\ Our staff, in developing the estimates contained in the
Proposing Release, also engaged in conversations with industry
professionals regarding broker-dealer compliance with rules G-37 and G-
38 and representatives of investment advisers that have pay to play
policies in place.\495\ We significantly increased our cost estimates
from the 1999 proposal as a result. Some commenters on the proposed
rule asserted that our projected costs are too low, but did not provide
empirical data or formulas for us to review.\496\ One commenter
indicated that, ``as a practical matter, although there may be
significant differences in the number of hours dedicated to ongoing
annual compliance between firms of different sizes, the estimated
number of hours needed to develop initial compliance procedures will be
similar for all firms, regardless of size. The initial effort of
designing and implementing new policies and procedures and educating
personnel will require similar effort and upfront fixed costs.'' \497\
We disagree. Although there are some aspects of implementing

a compliance program that would be similar among all firms regardless
of their number of covered associates, we expect most costs will vary
significantly among firms of different sizes as they engage in such
activities as developing and monitoring reporting mechanisms to track
covered associate contributions, revising their codes of ethics,
training their employees, and performing routine quality control tests.
---------------------------------------------------------------------------

    \494\ See Proposing Release, at n.226 and accompanying text.
    \495\ Id. at section III.B.
    \496\ See, e.g., ICI Letter; MFA Letter; SIFMA Letter.
    \497\ See Davis Polk Letter.
---------------------------------------------------------------------------

    In the Proposing Release, we estimated that 75% of larger advisory
firms, 50% of medium firms, and 25% of smaller firms that are subject
to the rule may also engage outside legal services to assist in
drafting policies and procedures, based on staff observations. In
addition, we also estimated 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 larger firm. One commenter suggested that we had underestimated both
the percentage of advisers that would engage outside counsel and the
number of hours that outside counsel would spend lending their
assistance, but did not provide alternative estimates.\498\ Based on
our staff's experience administering the compliance program rule, we
continue to believe that our estimates for the number of firms that
will retain outside counsel for review of policies and procedures are
appropriate. Based on this comment, however, we have revisited the
number of hours we estimated outside counsel would spend reviewing
policies and procedures and have increased these estimates. We now
estimate the cost associated with such an engagement would include fees
for approximately eight hours of outside legal review for a smaller
firm, 16 hours for a medium firm, and 40 hours for a larger firm, at a
rate of $400 per hour.\499\ Consequently, for a smaller firm we
estimate a total of $3,200 in outside legal fees for each of the
estimated 318 advisers that would seek assistance, for a medium firm we
estimate a total of $6,400 for the estimated 152 advisers that would
seek assistance, and for each of the 92 larger firms we estimate a
total of $16,000. Thus, we estimate that approximately 562 investment
advisers will incur these additional costs, for a total cost of
$3,462,400 \500\ among advisers affected by the rule amendments.\501\
---------------------------------------------------------------------------

    \498\ Id.
    \499\ In the Proposing Release we estimated the hourly cost of
outside counsel to be $400 based on our consultation with advisers
and law firms who regularly assist them in compliance matters. We
did not receive comment on this estimate and continue to believe
that it is an accurate estimate.
    \500\ (318 x $3,200 = $1,017,600) + (152 x $6,400 = $972,800) +
(92 x $16,000 = $1,472,000) = $3,462,400.
    \501\ One commenter asserted that a greater number of firms
would seek assistance of counsel, regardless of size, but did not
provide data to support its assertion. Davis Polk Letter.
---------------------------------------------------------------------------

    One commenter suggested that, due to the complexity of, and
variation among, State and local laws, it might be more difficult than
we had accounted for in the proposal for an adviser to determine with
certainty who could be a covered official, and as a result, a greater
number of advisers would seek the help of outside counsel to make this
determination than we estimated.\502\ Although the commenter did not
provide an estimate of how many firms might seek such assistance, we
believe that the additional guidance we have provided in the discussion
of officials will address this commenter's concerns and result in fewer
consultations with outside counsel than anticipated. In addition, it is
our understanding from discussions with those involved in advising on
compliance with MSRB rules G-37 and G-38 that a small percentage of
persons subject to the rule seek legal assistance to make these
determinations. Our rule uses substantially similar definitions of
``official'' of a ``government entity'' to those used in the MSRB
rules; therefore we expect that the percentage of advisory firms that
would retain legal counsel to make these determinations would be
similarly small. Moreover, we anticipate that the advisers that are
most likely to need assistance identifying officials of government
entities are larger advisers, whose businesses tend to be national in
scope and whose clients are located throughout the country. If all 122
of the larger advisory firms we estimate are subject to the rule retain
legal counsel at a rate of $400 per hour, for approximately 20 hours
per year, those advisers would incur an estimated total of $976,000 in
legal fees.\503\
---------------------------------------------------------------------------

    \502\ Caplin & Drysdale Letter. See also IAA Letter; MFA Letter.
    \503\ $400 x 20 = $8,000, and $8,000 x 122 = $976,000.
---------------------------------------------------------------------------

    In the Proposing Release, we estimated that approximately five
advisers annually would apply to the Commission for an exemption from
the rule, based on staff discussions with the FINRA staff responsible
for reviewing exemptive applications submitted under MSRB rule G-37,
and that outside counsel would spend 16 hours preparing and submitting
an application. We received criticism that these approximations were
too low.\504\ Given that the advisory industry is much larger than the
municipal securities industry, and in light of the number of comment
letters we received that expressed concern about inadvertent violations
of the rule that would not qualify for the exception for returned
contributions, our staff estimates that approximately seven advisers
annually would apply to the Commission for an exemption from the rule.
Although we may initially receive more than seven applications a year
for an exemption, over time, we expect the number of applications we
receive will significantly decline to an average of approximately seven
annually. We continue to believe that a firm that applies for an
exemption will hire outside counsel to prepare an exemptive request,
but based on commenters concerns have raised the number of hours
counsel will spend preparing and submitting an application from 16
hours to 32 hours, at a rate of $400 per hour.\505\ As a result, each
application will cost approximately $12,800, and the total estimated
cost for seven applications annually will be $89,600.
---------------------------------------------------------------------------

    \504\ See Davis Polk Letter; ICI Letter.
    \505\ The hourly cost estimate of $400 is based on our
consultation with advisers and law firms who regularly assist them
in compliance matters.
---------------------------------------------------------------------------

2. Other Costs Related to Rule 206(4)-5
    The prohibitions of the rule may also impose other costs on
advisers, covered associates, third-party solicitors, and political
officials.
(a) Two-Year Time Out
    An adviser that becomes subject to the prohibitions of the rule
would no longer be eligible to receive advisory fees from its
government client. This would result in a direct loss to the adviser of
revenues and profits relating to that government client, although
another adviser that the government client subsequently chose to retain
would see an increase in revenues and profits. The two-year time out
could also limit the number of advisers able to provide services to
potential government entity clients. An adviser that triggers the two-
year time out 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,
at a minimum, 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 contributions to
government officials, including candidates, potentially resulting in
less funding for these officials. Under the rule, advisers and covered
associates will be subject to new limitations on the amounts and to
whom they can contribute without triggering the rule's time out
provision. In addition, these same persons will be prohibited from
soliciting others to contribute or from coordinating contributions to
government officials, including candidates, or payments to political
parties in certain circumstances. These limitations and prohibitions,
including if a firm chooses to adopt policies or procedures that are
more restrictive than the 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.\506\ In addition to these costs, the rule's impact on
advisers' and employees' contributions will introduce some inefficiency
into the allocation of contributions to candidates and officials as the
rule impacts contributions regardless of whether they are being made
for the purpose of engaging in pay to play.
---------------------------------------------------------------------------

    \506\ One commenter suggested that the proposed rule would
inhibit individuals who work for an investment adviser from running
for office because, if they were successful, it may cost their
former employer business. Caplin & Drysdale Letter. We have
addressed this comment by making it clear that an individual can
contribute to his or her own campaign without triggering the rule.
See supra note 139.
---------------------------------------------------------------------------

    We have made several modifications to the rule from the proposal
that will reduce these costs or burdens. We are creating a new
exception to the two-year time out for contributions made by a natural
person more than six months prior to becoming a covered associate
unless he or she, after becoming a covered associate, solicits clients
on behalf of the investment adviser.\507\ This modification will
decrease the burdens on both employees and employers in terms of
tracking and limiting employee contributions prior to becoming employed
or promoted by an investment adviser. In terms of narrowing the scope
of ``covered investment pools,'' we included a registered investment
company in the definition of covered investment pool, for purposes of
all three of the rule's pay to play prohibitions, only if it is an
investment option of a plan or program of a government entity.\508\ As
noted above, we believe this approach strikes the right balance between
applying the rule in those contexts in which advisers to registered
investment companies are more likely to engage in pay to play conduct
while recognizing the compliance challenges and costs that may result
from a broader application of the rule. We are also broadening the
exception to the rule's time out provision in several respects that
should further decrease the compliance costs associated with the two-
year time out and will lower any perceived costs on covered associates'
ability to express their support for candidates. We are increasing the
aggregate contribution amount eligible for the exception for certain
returned contributions from $250 to $350 to any one official per
election,\509\ and we are increasing the number of times an adviser is
permitted to rely on the returned contributions exception from two to
three per calendar year for advisers with more than 50 employees.\510\
Furthermore, we are making the same adjustment from $250 to $350 for
contributions eligible for the de minimis exception,\511\ and we are
adopting a de minimis exception for contributions not exceeding $150
made by individuals who are not entitled to vote for the
candidate.\512\
---------------------------------------------------------------------------

    \507\ Rule 206(4)-5(b)(2).
    \508\ Rule 206(4)-5(f)(3) and (f)(8).
    \509\ Rule 206(4)-5(b)(3).
    \510\ Id.
    \511\ Rule 206(4)-5(b)(1).
    \512\ See id.
---------------------------------------------------------------------------

    Several commenters highlighted the costs of the two-year time out
to the adviser and government entity client, as well as pension fund
beneficiaries, stating that the time out could force termination of
long-standing relationships and may result in a permanent termination
of the advisory relationship.\513\ We acknowledge that advisers subject
to the time out may lose a government client's business beyond the two-
year period and are sensitive to the concerns of commenters regarding
the operation of the rule on public pension funds, including the
burdens they may face in replacing managers and the possibility that
some managers may no longer seek to manage public plan assets as a
result of the rule. We believe that these costs are necessary to
accomplish our goal of addressing pay to play and are justified by the
benefits of rule 206(4)-5. As discussed above, rule 206(4)-5 is modeled
on the pay to play rules adopted by the MSRB, which have significantly
curbed pay to play practices in the municipal securities market. We
believe that adopting a two-year time out similar to the time out
applicable under the MSRB rules is appropriate, and that the fiduciary
relationship advisers have with public pension plans argues for a
strong prophylactic rule. Finally, while we have designed the rule to
reduce its impact,\514\ investment advisers are best positioned to
protect government clients by developing and enforcing robust
compliance programs designed to prevent contributions from triggering
the two-year time out.
---------------------------------------------------------------------------

    \513\ See, e.g., ICI Letter (``[E]xisting State and local
government clients may be harmed by the forced termination of a
mutually beneficial business relationship, despite receiving free
services for a period of time, because the government client is
subject to the costs associated with selecting a new adviser, and
plan beneficiaries are subject to the costs associated with
portfolio commissions and other restructuring costs. Consequently,
our members believe that the two-year ban will operate as a
permanent ban because a government entity will be unlikely to go
through the process of identifying and hiring a replacement adviser,
and then return to the original adviser after the ban ends.''). See
also IAA Letter; NASP Letter; SIFMA Letter.
    \514\ See, e.g., section II.B.2(a)(6) of this Release
(discussing the de minimis exceptions to the two-year time out);
section II.B.2(f) of this Release (discussing the rule's exemptive
provision).
---------------------------------------------------------------------------

    Commenters also noted, particularly, the potential harm of the two-
year time out to government clients and to other investors in a fund
that holds illiquid securities when a government investor redeems its
interests in the fund as a result of the fund adviser's triggering
contribution.\515\ As we note above, however, our rule does not require
an adviser that has triggered the time out to redeem the interests of a
government investor or cancel its commitment. The adviser may have
multiple options available from which to select to comply with the rule
in light of its fiduciary obligations and the disclosure it has made to
investors. The adviser could instead comply with the rule by waiving or
rebating the portion of its fees or any performance allocation or
carried interest attributable to the government client.\516\
---------------------------------------------------------------------------

    \515\ CT Treasurer Letter; NY City Bar Letter.
    \516\ See supra note 385 and accompanying text.
---------------------------------------------------------------------------

    Most of the comments we received about the costs of this aspect of
the proposed rule, however, focused on the costs of an inadvertent
violation.\517\ We understand that there will be costs, sometimes quite
significant, as a result

of inadvertent violations. However, with these potential costs in mind,
we have taken additional steps to decrease the likelihood of
inadvertent violations of the rule. First, as discussed above, we
shortened the look back with respect to most covered associates. We
expect this new exception will provide an additional mechanism for
advisers to avoid the cost of a time out as a result of an inadvertent
violation and will largely address commenters' concerns about the
screening burdens for new or promoted employees that this aspect of the
proposal would have imposed on advisers.\518\ Second, as discussed
above, we are increasing to $350 the amount eligible for an exception
for certain returned contributions from what we had proposed, we are
increasing the number of times an adviser is permitted to rely on the
returned contributions exception, and we are also adopting an
additional de minimis exception for certain contributions not exceeding
$150. Last, we note that an adviser's implementation of a strong
compliance program will reduce the likelihood, and therefore costs, of
inadvertent violations.
---------------------------------------------------------------------------

    \517\ See, e.g., IAA Letter (``We are concerned that the
Commission has not considered the significance of the sanctions
imposed as a result of an adviser's inadvertent violation of the
rule.'').
    \518\ IAA Letter (``Under the Proposal, investment advisers
would be required to screen for and eliminate potential employment
candidates based upon contributions made for a period of up to
twenty-four months before the person would begin employment with the
adviser. This requirement * * * would be extremely costly and
burdensome to implement.''); Wells Fargo Letter (``The ``look back''
provision is too draconian. * * * [A] compliance system [will be]
costly to develop and arduous to implement * * * [and] it would also
impose severe limitations on the career opportunities of those newly
entering the investment advisory world who are weighed down by
political contributions that were completely innocuous when
made.'').
---------------------------------------------------------------------------

    One commenter asserted that the proposed rule would put advisers at
a competitive disadvantage to other providers of advisory services to
government plans that would not be subject to it, such as banks and
insurance companies.\519\ As we stated earlier, we believe that the
concerns that we are trying to address with the rule justify its
adoption, notwithstanding the potential competitive effects that
advisers may face as a result of the limits on our jurisdiction. We
also do not view competition by means of engaging in practices such as
pay to play as an interest that we need to protect.
---------------------------------------------------------------------------

    \519\ NY City Bar Letter.
---------------------------------------------------------------------------

(b) Third-Party Solicitor Ban
    Under our proposal, advisers would have been prohibited from
compensating any third party to solicit government entities for
advisory services, other than ``related persons.'' \520\ As a result,
advisers that rely on third-party solicitors to obtain government
clients would have had to bear the expense of hiring and training in-
house staff in order to continue their solicitation activities,\521\ a
result that commenters said would be particularly costly for small and
new investment advisers.\522\ In addition, third-party solicitors might
also have experienced substantial negative consequences under the
proposed rule.\523\ We heard from many commenters on this issue,
offering various perspectives on how the costs would outweigh the
benefits of the proposed prohibition.\524\ A few commenters asserted
that this proposal would have a significant adverse effect on efficient
capital formation in that it would make it more difficult for private
equity and venture capital managers to obtain funding that they in turn
can invest in portfolio companies.\525\ As other commenters pointed
out, this aspect of our proposed rule might also have placed a
significant burden on public pension plans,\526\ particularly smaller
plans because third-party solicitors provide services that plans may
value, including serving as placement agent for alternative investments
and serving a screening function with respect to those investments
presented to the pension plan.\527\
---------------------------------------------------------------------------

    \520\ Proposed rule 206(4)-5(a)(2)(i)(a).
    \521\ See, e.g., Comment Letter of Greenhill & Co., LLC (Oct. 2,
2009) (``The elimination of placement agents would add a significant
administrative and cost burden to fund sponsors seeking
investors.''). See also Alta Letter; Atlantic-Pacific Letter;
Braxton Letter; Benedetto Letter; CA Assoc. of County Retirement
Letter; Capstone Letter; EVCA Letter; GA Firefighters Letter;
Glovista Letter; IL Fund Association Letter; MN Board Letter; Myers
Letter; NCPERS Letter; NYC Teachers Letter; PA Public School
Retirement Letter; Reed Letter; Myers Letter; TX Public Retirement
Letter; WI Board Letter; Credit Suisse Letter (``Moreover, by
performing these functions, placement agents enable investment
advisers to focus on their core expertise, investment management,
and to avoid the necessity of developing the costly in-house
resources necessary to raise capital directly.'').
    \522\ See, e.g., MFA Letter (``[M]anagers that engage placement
agents, particularly small and offshore managers, would lose the
ability to market their services to government clients or incur
significantly higher costs to hire internal marketing personnel; and
managers that hire internal personnel could spend substantial
amounts to register as a broker-dealer.''). See also SIFMA Letter;
IAA Letter; Seward & Kissel Letter; Sadis & Goldberg Letter; WI
Board Letter; GA Firefighters Letter; MN Board Letter; IL Fund
Association Letter; NYC Teachers Letter; TX Public Retirement
Letter; PA Public School Retirement Letter; Ehrmann Letter; Finn
Letter; Savanna Letter; Atlantic-Pacific Letter; Peterson Letter;
Devon Letter; Chaldon Letter; Meridian Letter; Benedetto Letter;
Capstone Letter; Braxton Letter; Littlejohn Letter; Alta Letter;
Charles River Letter; Reed Letter; Glovista Letter; Blackstone
Letter; Park Hill Letter.
    \523\ Proposing Release, at 89. See also Thomas Letter (``The
ban would very likely cripple many legitimate placement agents--most
of whom are currently regulated by the SEC and FINRA--as the public
pension plans are the largest source of capital for alternative
investments.''); Comment Letter of the Managing Partner of Bridge 1
Advisors, LLC Robert G. McGroarty (Sept. 24, 2009) (``Bridge 1
Letter''); SIFMA Letter.
    \524\ See, e.g., Davis Polk Letter (``While we strongly support
the underlying purpose of the Proposed Rule, we believe that this
ban on all third-party solicitors is overly expansive and the costs
inflicted on both investment advisers and government clients from
lack of access to the valuable services provided by most third-party
solicitors outweigh any expected benefits to be gained from its
adoption.''); Capstone Letter (suggesting that many placement agent
firms are small businesses helping investment managers that are,
themselves, minority- or women-owned small businesses, and that,
together, they are creating jobs and helping other businesses by
efficiently directing capital); Monument Letter (making a similar
comment regarding the minority and female ownership of placement
agents); Glantz Letter; Comment Letter of Indian Harbor Partner
Robert W. Stone (Aug. 13, 2009) (``Indian Harbor Letter'');
Kurmanaliyeva Letter; M Advisory Letter (adding that the investment
management industry as a whole will incur ``dramatic job losses'');
Parenteau Letter.
    \525\ Alta Letter; Benedetto Letter; Comment Letter of Berkshire
Property Advisors, LLC (Sept. 29, 2009) (``Berkshire Letter'');
Bridge 1 Letter; Comment Letter of Hampshire Real Estate Companies
(Sept. 29, 2009); Comment Letter of Thomas J. Mizo on behalf of HFF
Securities L.P. (Sept. 24, 2009); M Advisory Letter; Monument Group
Letter; Comment Letter of Psilos Group Managers, LLC (Sept. 28,
2009).
    \526\ See, e.g., Park Hill Letter (``The Commission has
commented that if the Placement Agent Ban is adopted, Public Pension
Investors can seek to engage placement agents themselves in order to
continue to have access to their services in helping to find the
best Fund Sponsors. However, that would impose costs on Public
Pension Investors that they do not currently incur. Moreover, as the
Commission has acknowledged in its cost-benefit analysis, if the
Placement Agent Ban were adopted, Fund Sponsors who do not have in-
house marketing staffs would be disproportionately disadvantaged
relative to larger firms that have those internal resources in the
competition for obtaining access to Public Pension Investors and
other institutional investors.''); Thomas Letter (``A ban on
placement agents would have significant unintended consequences for
public pension plans. * * * [For instance, the] incremental effort
by investment staffs to perform due diligence on promising but
possibly ill-prepared investment managers will raise the cost and
lessen the overall pension fund portfolio performance.''); Comment
Letter of Austin F. Whitman (Sept. 21, 2009) (``Without access to
placement agents, government pensions would be significantly
disadvantaged relative to their private sector peers, with limited
access (and benefit from) the services described above.''); ABA
Letter. But see Fund Democracy/Consumer Federation Letter (``The
proposed ban would simply replace the indirect cost of placement
agents incurred by pension plan sponsors with the direct cost of
hiring their own placement agents--without the conflict of interest
and potential for abuse that relying on advisers' placement agents
creates.'').
    \527\ See, e.g., Ogburn Letter; Schmitz Letter (highlighting the
valuable ``pre-vetting'' function of placement agents, especially in
light of pension funds' budgetary pressures and lean staffs);
Savanna Letter (discussing the ``pre-screening'' effect that
reputable placement agent client selection provides for pension
professionals); Atlantic-Pacific Letter; Indian Harbor Letter;
Peterson Letter; Rubenstein Letter; Comment Letter of R[eacute]al
Desrochers (Aug. 20, 2009) (noting that from the perspective of a
former pension fund investment officer, ``[t]he skill sets of
certain placement agents streamlined what they brought to our
attention and made our internal process much more efficient.'');
Devon Letter; Thomas Letter; Myers Letter; PRIM Board Letter
(``[T]he Commission should strongly resist the politically expedient
suggestion that an outright ban on the use of placement agents is
somehow good for plan sponsors; nothing could be further than the
truth.''); Meridian Letter; Comment Letter of Norman G. Benedict
(Sept. 30, 2009) (indicating that, from the perspective of a retired
public pension chief investment officer, placement agents provide an
essential and invaluable service, particularly with providing access
to private equity fund investments, which often yielded higher
returns than more traditional, publicly traded securities);
Berkshire Letter; Comment Letter of The British Private Equity and
Venture Capital Association (Sept. 18, 2009) (``BVCA Letter'')
(``Placement agents are not just a crude middleman in the
fundraising process''); CT Treasurer Letter; Credit Suisse Letter
(describing four key functions its placement agent group performs);
Portfolio Advisors Letter (noting that among the valuable services
provided are: ``(1) Helping new fund sponsors to become more
established among the institutional investor community; (ii) helping
sponsors to complete RFPs, provide information and respond to
questions, which, in turn, gives the public pension plans and other
investors a broader pool of investment options; and (iii) serving as
intermediaries in uniting capital with fund sponsors who can put the
money to work by investing in businesses and creating value'');
George Letter; Comment Letter of Rahul Mehta (Sept. 11, 2009);
Touchstone Letter; SIFMA Letter.

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

    Others argued, for similar reasons as those expressed above, that
it would also harm public pension plans to ban payments to third
parties because it would decrease competition by reducing the number of
advisers competing for government business \528\ and limit the universe
of investment opportunities presented to public pension funds.\529\
---------------------------------------------------------------------------

    \528\ See, e.g., Seward & Kissel Letter; Meridian Letter; SIFMA
Letter; Comment Letter of Oakpoint Advisors (Aug. 26, 2009); Comment
Letter of SeaCrest Investment Management, LLC (Sept. 25, 2009).
    \529\ See, e.g., Braxton Letter (stressing not only the
increased costs that public pension funds will likely face, but also
the likely reduction in creative investment strategies and
opportunities available as a result of smaller and emerging funds
being forced out of the market); BVCA Letter; CT Treasurer Letter;
SIFMA Letter; IAA Letter; Strategic Capital Letter; Alta Letter;
Benedetto Letter; Glantz Letter; Kurmanaliyeva Letter; Park Hill
Letter.
---------------------------------------------------------------------------

    We believe our decision to modify the proposed rule to permit
advisers to make payments to certain ``regulated persons'' to solicit
government clients on their behalf,\530\ as described in more detail
above, should alleviate many of these concerns, including those from
private equity and venture capital managers on capital formation.\531\
In particular, we believe the concerns expressed by private equity and
venture capital managers regarding the effects of the rule on capital
formation have been substantially addressed by the modification for
payments to ``regulated persons.'' We expect advisers that engage the
services of regulated person solicitors will incur limited costs to
initially confirm and subsequently monitor the solicitor's eligibility
to be a ``regulated person.'' Nevertheless, we expect this exception to
the third-party solicitor ban will substantially reduce the costs
commenters associated with this aspect of the proposal.
---------------------------------------------------------------------------

    \530\ See Rule 206(4)-5(a)(2)(i).
    \531\ Our decision not to adopt the ``related person'' exception
contained in the proposed rule does not diminish our belief. As we
noted above, we believe our modification of the ban to allow
advisers to pay ``regulated persons'' to solicit government entities
on their behalf will still allow advisers to use employees of
certain related companies--i.e., of those related companies that
qualify as ``regulated persons''--as solicitors.
---------------------------------------------------------------------------

    We acknowledge, however, that the third-party solicitor ban will
nonetheless have a substantial negative impact on persons who provide
third-party solicitation services that are not regulated persons,
including State-registered advisers.\532\ If their businesses consist
solely of soliciting government entities on behalf of investment
advisers, the rule could result in these persons instead being employed
directly by regulated persons, shifting the focus of their solicitation
activities, seeking to change their business model to shift their
source of payment from investment advisers to pension plans, or going
out of business.\533\ In addition, we acknowledge that the third-party
solicitor ban may adversely affect both competition and allocative
efficiency in the market for advisory services where third-party
solicitors that are not regulated persons participate. We have
carefully considered these effects. As discussed above, however, we do
not have regulatory authority to oversee the activities of State-
registered advisers through examination and our recordkeeping rules.
Nor do we have authority over the states to oversee their enforcement
of their rules, as we do with FINRA. As a result, we have not included
State-registered advisers in the definition of regulated person.\534\
---------------------------------------------------------------------------

    \532\ As we note above, State-registered advisers are subject
neither to our oversight nor to the recordkeeping rules we are
adopting today.
    \533\ See supra note 523.
    \534\ See supra note 325 and accompanying text.
---------------------------------------------------------------------------

    In addition, some commenters suggested that the third-party
prohibition could have a negative impact on the efficient allocation of
capital for government plans, particularly small ones, and advisers
that seek to manage these assets directly (not through a covered
investment pool).\535\These small government plans may, as a result of
the rule's ban on payments to third parties, have fewer managers to
select from to the extent that larger advisers choose not to
participate in this market. In addition, both government plans and
advisers that seek these government clients may have to hire internal
staff, respectively, to identify potential advisers and potential
government clients to the extent these functions are not internalized.
However, these commenters did not discuss the potentially significant
costs that exist today of hiring third-party solicitors, and that
eliminating the cost of pay to play may, in fact, provide greater
access to pension plans by those advisers that are currently unable to
afford the costs of direct or indirect political contributions or
third-party solicitor fees.\536\ We expect that prohibiting pay to play
will reduce the costs to plans and their beneficiaries that may result
when adviser selection is based on political contributions rather than
investment considerations.\537\
---------------------------------------------------------------------------

    \535\ See, e.g., 3PM Letter; Bryant Law Letter.
    \536\ At least one commenter agreed. See Butler Letter (``[W]e
find some evidence that the pay to play practices by underwriters
[before rule G-37 was adopted] distorted not only the fees, but
which firms were allocated business. The current proposal mentions
that pay to play practices may create an uneven playing field among
investment advisers by hurting smaller advisers that cannot afford
to make political contributions. We find evidence that is consistent
with this view [in our research on pay to play by municipal
underwriters]. During the pay to play era, municipal bonds were
underwritten by investment banks with larger underwriting market
shares compared to afterward. One interpretation of this result is
that smaller underwriters were passed over in favor of larger
underwriters (who presumably had deeper pockets for political
contributions).'').
    \537\ See supra notes 452 & 453 and accompanying text
(describing commenters' observations about some of the pay to play
costs to plans and their beneficiaries).
---------------------------------------------------------------------------

3. Costs Related to the Amendments to Rule 204-2
    The amendments to rule 204-2 require SEC-registered advisers with
government clients to maintain certain records of campaign
contributions by certain advisory personnel and records of the
regulated persons the adviser pays or agrees to pay to solicit
government entities on its behalf.\538\ Records are a critical
complement to rule 206(4)-5. In particular, such records are necessary
for examiners to inspect advisers for compliance with the terms of the
rule.
---------------------------------------------------------------------------

    \538\ Unregistered advisers that would be subject to rule
206(4)-5 would not be subject to the amendments to rule 204-2.
---------------------------------------------------------------------------

    As described below, for purposes of the Paperwork Reduction Act of
1995 (``PRA''),\539\ we have estimated that Commission-registered
advisers would incur approximately 3,394 additional hours annually to
comply with the

amendments to rule 204-2.\540\ Based on this estimate, we anticipate
that advisers would incur an aggregate cost of approximately $200,246
per year for the total hours advisory personnel would spend in
complying with the recordkeeping requirements.\541\ In addition, we
expect advisory firms may incur one-time costs to establish or enhance
current systems to assist in their compliance with the amendments to
rule 204-2. For purposes of the PRA, we have estimated that some small
and medium firms will incur start-up costs, on average, of $10,000, and
larger firms will incur, on average, $100,000. As a result, the
amendments to rule 204-2 are estimated to increase the PRA non-labor
cost burden by $20,080,000.\542\
---------------------------------------------------------------------------

    \539\ 44 U.S.C. 3501.
    \540\ See infra note 559 and accompanying text.
    \541\ We expect that the function of recording and maintaining
records of political contributions would be performed by a
compliance clerk at a cost of $59 per hour. See supra note 487.
Therefore, the total costs would be $200,246 (3,394 hours x $59 per/
hour).
    \542\ ($10,000 x 788) + ($100,000 x 122) = $7,880,000 +
$12,200,000 = $20,080,000.
---------------------------------------------------------------------------

    We received a number of specific comments on this aspect of the
proposal, many of which included assertions about cost burdens
associated with maintaining records related to unsuccessful
solicitations, and urged us to reconsider the benefits to be gained
from such a requirement in light of the costs.\543\ We were persuaded
by these commenters to eliminate provisions of the proposed amendments
to the recordkeeping rule that would have required advisers to maintain
a list of government entities that the adviser solicits.\544\ Instead,
an adviser must only retain records of existing government entity
clients and investors as well as records of regulated persons that the
adviser pays or agrees to pay to solicit government entities on its
behalf for a five-year period. Additionally, we have narrowed the scope
of the amended rule to apply only to advisers with government entity
clients; an adviser is only required to make and keep these records if
it provides investment advisory services to a government entity or a
government entity is an investor in any covered investment pool to
which the investment adviser provides investment advisory
services.\545\ We have also limited the rule to provide that only
records of contributions, not payments, to government officials and
candidates are required to be kept under the rule. Additionally,
because rule 206(4)-5 applies to an adviser to a registered investment
company only if it is an investment option of a participant-directed
plan or program of a government entity,\546\ such investment advisers
will only have to identify government entities that provide plan or
program participants the option of investing in the fund, which
addresses many commenters' concerns about recordkeeping burdens that
would have been imposed on advisers to registered investment companies
under the proposed rule.\547\
---------------------------------------------------------------------------

    \543\ MassMutual Letter (``[T]he requirement to maintain records
of each governmental entity being solicited would require a diverse
financial services company like MassMutual to undertake significant
legacy software system modifications or build an entirely new system
to track each instance of a ``solicitation,'' which could include
phone calls, meetings, or responses to governmental requests. This
system would then need to aggregate data across multiple business
lines, many with existing systems that may not have the ability to
share this data in a useful format. All of these are costly and time
consuming activities to meet a requirement that appears to add
little value to the Commission's efforts to ensure compliance with
the Proposed Rule.''). See also Davis Polk Letter; Dechert Letter;
Holl Letter; SIFMA Letter; Skadden Letter.
    \544\ See proposed rule 204-2(a)(18)(i)(B).
    \545\ Rule 204-2(a)(18)(iii). See NASP Letter (``Many advisers
do not have governmental clients but will still have to collect the
information or attestations which would increase compliance costs
while providing no public benefit at all.'')
    \546\ See supra note 353 and accompanying text.
    \547\ See, e.g., ICI Letter.
---------------------------------------------------------------------------

    We anticipate that commenters' general concerns that we may have
underestimated the burdens we presented in our proposal will be offset
by what we believe will be a reduction in burdens as a result of the
various modifications from our proposal described above. In addition,
we have revised the rule to require advisers to maintain a list of
regulated persons that solicit on an adviser's behalf, but expect
advisers to already have this information in the normal course of
business, including in some instances, to comply with existing
requirements of rule 206(4)-3.

V. Paperwork Reduction Act

A. Rule 204-2

    The amendment to rule 204-2 contains a ``collection of
information'' requirement within the meaning of the PRA. In the
Proposing Release, the Commission solicited comment on the proposed
amendment to the collection of information requirement.\548\ The
Commission also submitted the proposed amendment's collection of
information requirement to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11 under control number 3235-0278. The title for the collection of
information is ``Rule 204-2 under the Investment 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 sponsor, or conduct, and a person is not required to respond to, a
collection of information unless it displays a currently valid OMB
control number.
---------------------------------------------------------------------------

    \548\ See Proposing Release, at section IV.
---------------------------------------------------------------------------

    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 collection of information under rule
204-2 is necessary for the Commission staff to use in its examination
and oversight program, and the information generally is kept
confidential.\549\ The respondents are investment advisers registered
or required to be registered with us.
---------------------------------------------------------------------------

    \549\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
---------------------------------------------------------------------------

    Today's amendments to rule 204-2 require every investment adviser
registered or required to be registered that provides advisory services
to (or pays or agrees to pay regulated persons to solicit) government
entities to maintain certain records of contributions made by the
adviser or any of its covered associates and regarding regulated
persons the adviser pays or agrees to pay for soliciting government
entities on its behalf. The amendments require such 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 to which the investment adviser
provides or has provided investment advisory services, or which are or
were investors in any covered investment pool to which the investment
adviser provides or has provided investment advisory services, as
applicable, in the past five years, but not prior to the effective date
of the rule; (iii) all direct or indirect contributions made by the
investment adviser or any of its covered associates to an official of a
government entity, or payments to a political party of a State or
political subdivision thereof, or to a political action committee; and
(iv) the name and business address of each regulated person to whom the
investment adviser provides or agrees to provide, directly or
indirectly, payment to solicit a government entity for investment
advisory services on its behalf, in accordance with rule 206(4)-
5(a)(2)(i).
    The adviser's records of contributions and payments are 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 rule 206(4)-5(b)(2). An investment
adviser is only required to make and keep current the records referred
to in (i) and (iii) above if it provides investment advisory services
to a government entity or a government entity is an investor in any
covered investment pool to which the adviser provides investment
advisory services. The records required by amended rule 204-2 are
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 will be found at 17 CFR 275.204-2. Advisers
that are exempt from Commission registration under section 203(b)(3) of
the Advisers Act are not subject to the recordkeeping requirements.
    The amendments to rule 204-2 that we are adopting today differ from
our proposed amendments in several respects. We have tailored certain
of the requirements from our proposal. First, we have limited the rule
to provide that only records of contributions, not payments, to
government officials, including candidates, are required to be kept
under the rule. Second, investment advisers to registered investment
companies only have to identify--and keep records regarding--government
entities that invest in a fund as part of a plan or program of a
government entity, including any government entity that selects the
fund as an investment option for participants in the plan or
program.\550\ Third, we are not adopting provisions of the proposed
amendments to the recordkeeping rule that would have required advisers
to maintain a list of all government entities that they have solicited.
In addition, we have revised the rule so that only those advisers that
have government entity clients must make and keep certain required
records, unlike the proposal, which would have required all registered
advisers to maintain records of contributions and covered associates.
We are also adopting a requirement that advisers maintain records of
regulated persons they pay to solicit government entities on their
behalf, to reflect that rule 206(4)-5 permits advisers to compensate
these solicitors.
---------------------------------------------------------------------------

    \550\ Under our proposal, investment advisers to registered
investment companies would have had to identify and keep records
regarding government entities that invest in the funds regardless of
whether they were part of a plan or program of a government entity.
For a discussion of this modification, see section II.B. of this
Release.
---------------------------------------------------------------------------

    As noted above, we requested comment on the PRA analysis contained
in the Proposing Release. Although a few commenters expressed general
concerns that the paperwork burdens associated with our proposed
amendments to rule 204-2 might be understated, commenters representing
advisers to registered investment companies suggested that the proposal
significantly underestimated the burden attributed to these covered
investment pools.\551\ With respect to registered investment companies,
commenters noted that the proposed recordkeeping requirements required
advisers to identify government investors in registered investment
companies regardless of whether the fund was part of a plan or program
of a government entity, and as a result the proposed amendments to the
recordkeeping rule would have been difficult to comply with as fund
shareholder records do not necessarily identify government investors.
---------------------------------------------------------------------------

    \551\ See ICI Letter (``[I]n relying on the estimates for
compliance with the MSRB rules, the Commission significantly
underestimates the compliance and recordkeeping burdens associated
with the proposed rule.'').
---------------------------------------------------------------------------

    As a result of these comments, we recognize that we may have
underestimated the recordkeeping burden for advisers to registered
investment companies that would have been subject to proposed rule
206(4)-5. However, we believe that our change to the definition of
``covered investment pool'' from the proposal to only include those
registered investment companies that are an investment option of a plan
or program of a government entity addresses the recordkeeping concerns
commenters expressed regarding these covered investment pools and
lowers recordkeeping burdens by limiting the records relating to
registered investment companies that an investment adviser must keep
under the rule.\552\ In addition, the other changes we highlight
above--other than the requirement to keep records regarding regulated
persons--would lessen the recordkeeping requirements relative to our
proposal and thereby diminish our burden estimates. We anticipate that
commenters' general concerns that we may have underestimated the
burdens we presented in our proposal, as well as the burden associated
with the additional requirement to maintain a list of regulated persons
that solicit on an adviser's behalf, will be offset by what we believe
will be a reduction in burdens as a result of the various modifications
from proposed amendments to the recordkeeping rule, as described above.
Moreover, notwithstanding the fact that the amendments we are adopting
reduce advisers' recordkeeping obligations relative to our proposal, we
are increasing our estimates to address the additional investment
advisers who have registered with us since our proposal was issued.
---------------------------------------------------------------------------

    \552\ See Rule 204-2(a)(18)(i)(B).
---------------------------------------------------------------------------

    Prior to today's amendments, the approved collection of information
for rule 204-2, set to expire on March 31, 2011, was based on an
average of 181.15 burden hours each year, per Commission-registered
adviser, for a total of 1,954,109 burden hours. In addition, the
currently-approved collection of information for Rule 204-2 includes a
non-labor cost estimate of $13,551,390. The total burden is based on an
estimate of 10,787 registered advisers.
    Commission records indicate that currently there are approximately
11,607 registered investment advisers subject to the collection of
information imposed by rule 204-2.\553\ 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 148,543
hours.\554\ In addition, the total non-labor cost burden has increased
to $14,581,509 as a result of this increase in the number of registered
advisers.\555\
---------------------------------------------------------------------------

    \553\ This figure is based on registration information from IARD
as of April 1, 2010. The figures we relied on in our Proposing
Release were based on registration information from IARD as of July
1, 2009. See Proposing Release, at section IV.
    \554\ 11,607 - 10,787 = 820. 820 additional advisers x 181.15
hours = 148,543 hours.
    \555\ We estimate that non-labor costs attributed to rule 204-2
will increase in the same proportion as the increase in the
estimated hour burden for the rule. (2,102,652 hours/1,954,109
hours) x $13,551,390 currently approved non-labor cost estimate =
$14,581,509.
---------------------------------------------------------------------------

    In our Proposing Release, we estimated 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 rule amendments.\556\ One commenter argued that this
estimate was too low because it underestimates the number of investment
advisers unregistered in reliance on Section 203(b)(3) of the Advisers
Act and estimated to be subject to the Proposed Rule.\557\ Unregistered

advisers are not subject to rule 204-2's recordkeeping requirements. As
a result, they are not included in our estimates for purposes of this
analysis. We continue to believe our estimates are appropriate,
although we have revised this number for purposes of both our cost-
benefit analysis above and our PRA analysis to reflect both an increase
in the number of registered advisers since the proposal and the
modification from our proposal to not require records of unsuccessful
solicitations. We now estimate that approximately 1,697 registered
advisers provide advisory services to government clients and to certain
pooled investment vehicles in which government entities invest, and
would thus be affected by the rule amendments.\558\
---------------------------------------------------------------------------

    \556\ See Proposing Release, at section IV.
    \557\ Davis Polk Letter (``The cost benefit analysis is based
solely on an estimated 1,764 registered investment advisers and does
not account for the costs and burdens of compliance attributable to
investment advisers exempt from registration. The estimated number
of investment advisers unregistered in reliance on section 203(b)(3)
of the Advisers Act (2,000) and estimated to be subject to the
Proposed Rule (231), appears to be low. In its comment letter, the
Third Party Marketers Association notes that the number of advisory
firms exempted from registration may be `over two times the estimate
of the Commission. * * *''' (citations omitted)). The Davis Polk
Letter does not offer any of its own estimates for the number of
unregistered advisers, and the 3PM Letter references statistics
regarding the number of funds, not the number of advisers.
    \558\ This estimate is based on registration information from
IARD as of April 1, 2010, applying the same methodology as in the
Proposing Release. As previously noted, according to responses to
Item 5.D(9) of Part 1 of Form ADV, 1,332 advisers have clients that
are State or municipal government entities, which represents 11.48%
of all advisers registered with us. 10,275 advisers have not
responded that they have clients that are State or municipal
government entities. Of those, however, responses to Item 5.D(6) of
Part 1 of Form ADV indicate that 2,486 advisers have some clients
that are other pooled investment vehicles. Estimating that the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 285 of these advisers would be subject to the rule
(2,486 x 11.48% = 285). Out of the 10,275 that have not responded
that they have clients that are State or municipal government
entities, after backing out the 2,486 which have clients that are
other pooled investment vehicles, responses to Item 5.D(4) of Part 1
of Form ADV indicate that 699 advisers have some clients that are
registered investment companies. Estimating that roughly the same
percentage of these advisers advise pools with government entity
investors as advisers that have direct government entity clients--
i.e.,11.48%. 80 of these advisers would be subject to the rule (699
x 11.48% = 80). Although we limited the application of rule 206(4)-5
with respect to registered investment companies to those that are
investment options of a plan or program of a government entity, we
continue to estimate that 80 advisers would have to comply with the
recordkeeping provisions because of the difficulty in further
delineating this estimated number. Therefore, we estimate that the
total number of advisers subject to the rule would be: 1,332
advisers with State or municipal clients + 285 advisers with other
pooled investment vehicle clients + 80 advisers with registered
investment company clients = 1,697 advisers subject to rule. We
expect certain additional advisers may incur compliance costs
associated with rule 206(4)-5. We anticipate some advisers may be
subject to the rule because they solicit government entities on
behalf of other investment advisers. In the Proposing Release, our
estimates included an estimated burden attributable to advisers that
do not currently have government clients but that may begin to seek
them. The revision to the recordkeeping rule that eliminated the
requirement to maintain records of government entities that an
adviser solicits has eliminated the need for this additional burden
estimate.
---------------------------------------------------------------------------

    Under the amendments, each respondent is required to retain the
records in the same manner and for the same period of time as currently
required under rule 204-2. The amendments to rule 204-2 are estimated
to increase the burden by approximately 2 hours per Commission-
registered adviser with government clients annually for a total
increase of 3,394 hours.\559\ The revised annual aggregate burden for
all respondents to the recordkeeping requirements under rule 204-2 thus
would be 2,106,046 hours.\560\ The revised average burden per
Commission-registered adviser would be 181.45 hours.\561\
---------------------------------------------------------------------------

    \559\ 2 x 1,697 = 3,394.
    \560\ 1,954,109 (current approved burden) + 148,543 (burden for
additional registrants) + 3,394 (burden for proposed amendments) =
2,106,046 hours.
    \561\ 2,106,046 (revised annual aggregate burden) divided by
11,607 (total number of registrants) = 181.45.
---------------------------------------------------------------------------

    Additionally, as we noted in the Proposing Release and reiterate
above, we expect advisory firms may incur one-time costs to establish
or enhance current systems to assist in their compliance with the
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.
    As a result of these one-time costs, we estimate that there will be
an increase to the total non-labor cost burden. We estimated above that
the non-labor cost burden has increased to $14,581,509 as a result of
the increase in the number of registered advisers since the collection
was last approved.\562\ We believe the one-time costs could vary
substantially among smaller, medium, and larger firms as smaller and
medium firms may be able to use non-specialized software, such as a
spreadsheet, or off-the-shelf compliance software to keep track of the
information required by the rule while larger firms are more likely to
have proprietary systems. Based on IARD data we estimate that there are
approximately 1,271 smaller firms, 304 medium firms, and 122 larger
firms.\563\ We estimate that one half of the smaller and medium firms
will not incur these one-time start up costs because they will use
existing tools for compliance. We expect the other half of smaller and
medium firms will incur one-time start up costs on average of $10,000,
in the event they have a greater number of employees and government
clients, and larger firms, that likely have the most employees and
government clients, will incur one-time start up costs on average of
$100,000. As a result, the amendments to rule 204-2 are estimated to
increase the non-labor cost burden by $20,080,000.\564\ Due to this
increase, we now estimate the revised total non-labor cost burden for
rule 204-2 to be $34,661,509.
---------------------------------------------------------------------------

    \562\ See supra note 555.
    \563\ This estimate is based on registration information from
IARD as of April 1, 2010. These estimates are based on IARD data,
specifically the responses to Item 5.B.(1) of Form ADV, that 997 (or
74.9%) of the 1,332 registered investment advisers that have
government clients have fewer than five employees who perform
investment advisory functions, 239 (or 17.9%) have five to 15 such
employees, and 96 (or 7.2%) have more than 15 such employees. We
then applied those percentages to the 1,697 advisers we believe will
be subject to the proposed rule for a total of 1,271 smaller, 304
medium and 122 larger firms.
    \564\ [$10,000 x 788] + [$100,000 x 122] = $7,880,000 +
$12,200,000 = $20,080,000.
---------------------------------------------------------------------------

B. Rule 206(4)-3

    The amendment to rule 206(4)-3 contains a revised collection of
information requirement within the meaning of the PRA. In the Proposing
Release, the Commission published notice soliciting comment on the
collection of information requirement.\565\ The Commission submitted
the revised collection of information requirement to OMB for review in
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. Rule 206(4)-3
contains a currently approved collection of information under OMB
control number 3235-0242. The title for the collection of information
is ``Rule 206(4)-3--Cash Payments for Client Solicitations.'' As noted
above, an agency may not sponsor, or conduct, and a person is not
required to respond to, a collection of information unless it displays
a currently valid OMB control number.
---------------------------------------------------------------------------

    \565\ See Proposing Release, at section IV.
---------------------------------------------------------------------------

    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.\566\
---------------------------------------------------------------------------

    \566\ Section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].
---------------------------------------------------------------------------

    The Commission is adopting amendments to rule 206(4)-3 under the
Advisers Act. The amendments to rule 206(4)-3, which are identical to
our proposed amendments, 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 rule
206(4)-5. This collection of information is 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.
    We requested comment on the PRA analysis contained in Proposing
Release. We received no comment on this portion of our analysis. In
addition, we have not modified our amendments to rule 206(4)-3 relative
to our proposal.
    The current approved collection of information for rule 206(4)-3,
set to expire on March 31, 2011, is based on an estimate that 20
percent 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).
    Commission records indicate that currently there are approximately
11,607 registered investment advisers,\567\ 20 percent of which (or
2,321) 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 1,112.32 hours (158
additional advisers \568\ x 7.04 hours). We estimate that approximately
20 percent of the Commission-registered advisers that use rule 206(4)-3
(or 464 advisers) \569\ provide, or seek to provide, advisory services
to government clients.\570\ Under the amendments, each respondent would
be prohibited from certain solicitation activities, subject to the
exception for ``regulated persons,'' with respect to government
clients, activities that otherwise would have been covered by rule
206(4)-3.\571\ Thus, they would not need to enter into and retain the
written agreement required under rule 206(4)-3 with respect to those
third parties they are prohibited from paying to solicit government
entities.
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    \567\ This figure is based on registration information from IARD
as of April 1, 2010. The figures we relied on in our Proposing
Release were based on registration information from IARD as of July
1, 2009.
    \568\ 2,321 (20% of current registered investment advisers)--
2,163 (20% of registered investment advisers when burden estimate
was last approved by OMB) = 158.
    \569\ 2,321 x 20 percent = 464.
    \570\ In light of the 11.48% 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 558.
    \571\ Rule 206(4)-3(a).
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    In the Proposing Release, we estimated a decrease to the burden due
to the prohibition on paying third party solicitors to be 20% of the
annual burden. As a result of the revised ban on using third parties,
we now estimate that the amendments to rule 206(4)-3 will only decrease
the burden by 15 percent,\572\ or approximately 1.06 hour,\573\ per
Commission-registered adviser that uses the rule and has or is seeking
government clients annually, for a total decrease of 491.84 hours.\574\
The revised annual aggregate burden for all respondents to the
recordkeeping requirements under rule 206(4)-3 thus would be 15,848.48
hours.\575\ The revised average burden per Commission-registered
adviser would be 6.83 hours.\576\
---------------------------------------------------------------------------

    \572\ In our proposal, which would have banned the use of third-
party solicitors altogether, we estimated a 20 percent decrease in
the burden under rule 206(4)-3. But, to account for the regulated
persons exception to the third-party solicitor ban in adopted rule
206(4)-5, we have modified our estimate to only a 15 percent
decrease. That is because our staff estimates that one quarter (or 5
percent) of the proposal's estimated burden reduction relating to
entering into and retaining the written agreement required under
rule 206(4)-3 will be retained as investment advisers engage third
parties that are regulated persons to solicit on their behalf.
    \573\ 7.04 x 15 percent = 1.06.
    \574\ 464 x 1.06 = 491.84.
    \575\ 15,228 (current approved burden) + 1,112.32 (burden for
additional registrants)--491.84 (reduction in burden for amendments)
= 15,848.48 hours.
    \576\ 15,848.48 (revised annual aggregate burden) divided by
2,321 (total number of registrants who rely on rule) = 6.83.
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C. Rule 206(4)-7

    As a result of the adoption of rule 206(4)-5, rule 206(4)-7
contains a revised collection of information requirement within the
meaning of the PRA. In the Proposing Release, the Commission estimated
that registered advisers would spend between 8 hours and 250 hours to
establish policies and procedures to comply with rule 206(4)-5.\577\
Rule 206(4)-7 contains a currently approved collection of information
under OMB control number 3235-0585. The title for the collection of
information is ``Investment Advisers Act Rule 206(4)-7, Compliance
procedures and practices.'' As noted above, an agency may not sponsor,
or conduct, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
---------------------------------------------------------------------------

    \577\ See Proposing Release, at section III.B.
---------------------------------------------------------------------------

    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)-7, in part, requires registered investment advisers to
adopt and implement written policies and procedures reasonably designed
to prevent violation of the Federal securities laws. This collection of
information is mandatory. The purpose of the information collection
requirement is to ensure that registered advisers maintain
comprehensive, written internal compliance programs. It also assists
the Commission's staff in its examination and oversight program.
Information obtained in our examination and oversight program generally
is kept confidential.\578\
---------------------------------------------------------------------------

    \578\ Section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].
---------------------------------------------------------------------------

    As we previously noted, we expect that registered investment
advisers subject to rule 206(4)-5 will modify their compliance programs
to address new obligations under that rule. The current approved
collection of information for rule 206(4)-7, set to expire on March 31,
2011, is based on 10,817 registered advisers that were subject to the
rule at an average burden of 80 hours each year per respondent for a
total of 865,360 burden hours.
    Commission records indicate that currently there are approximately
11,607 registered investment advisers.\579\ 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
63,200 hours (790 x 80 hours). In addition, although the time needed to
comply with rule 206(4)-5 will vary significantly from adviser to
adviser, as discussed in detail below, the Commission staff estimates
that firms with government clients will spend between 8 hours and 250
hours to implement policies and procedures to comply with the rule,
depending on the

firm's number of covered associates.\580\ Of the 1,697 registered
advisers that we estimate may be affected by rule 206(4)-5,\581\ we
estimate that approximately 1,271 are smaller firms, 304 are medium
firms, and 122 are larger firms.\582\ We anticipate that smaller firms
will spend 8 hours, medium firms will spend 125 hours, and larger firms
will spend 250 hours,\583\ for a total of 78,668 hours,\584\ to
implement policies and procedures. Our estimates take into account our
staff's observation that some registered advisers have established
policies regarding political contributions, which can be revised to
reflect the new requirements. The revised annual aggregate burden for
all respondents to comply with rule 206(4)-7 thus would be 1,007,228
hours.\585\
---------------------------------------------------------------------------

    \579\ This figure is based on registration information from IARD
as of April 1, 2010.
    \580\ See section IV.B.1. of this Release (describing the cost
estimates associated with compliance with rule 206(4)-5).
    \581\ See supra note 558. 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)] are not subject to rule 206(4)-
7 and, therefore, are not reflected in this burden estimate pursuant
to the PRA.
    \582\ See supra note 475.
    \583\ See supra notes 489-491.
    \584\ (1,271 x 8 = 10,168) + (304 x 125 = 38,000) + (122 x 250 =
30,500) = 78,668.
    \585\ 865,360 (current approved burden) + 63,200 (burden for
additional registrants) + 78,668 (burden attributable to rule
206(4)-5) = 1,007,228 hours.
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D. Rule 0-4

    Rule 0-4 under the Advisers Act,\586\ entitled ``General
Requirements of Papers and Applications,'' prescribes general
instructions for filing an application seeking exemptive relief with
the Commission. The requirements of rule 0-4 are designed to provide
the Commission with the necessary information to assess whether
granting the orders of exemption is necessary and appropriate, in the
public interest and consistent with the protection of investors and the
intended purposes of the Act. In light of the adoption of rule 206(4)-
5, which contains a provision for seeking an exemptive order from the
Commission, we are revising the collection of information requirement
for rule 0-4. Rule 0-4 contains a currently approved collection of
information under OMB control number 3235-0633. As noted above, an
agency may not sponsor, or conduct, and a person is not required to
respond to, a collection of information unless it displays a currently
valid OMB control number.
---------------------------------------------------------------------------

    \586\ 17 CFR 275.0-4.
---------------------------------------------------------------------------

    The current approved collection of information contains an
estimated total annual hour burden of one hour for administrative
purposes because most of the work of preparing an application is
performed by outside counsel and, therefore, imposes minimal, if any,
hourly burden on respondents. Because we expect that all, or
substantially all, of the work of preparing an application for an
exemptive order under rule 206(4)-5 will also be performed by outside
counsel, we continue to believe that the current estimate of one hour,
in the unlikely event the adviser does perform an administrative role,
is sufficient. As a result, we are not increasing our estimated hourly
burden in connection with the adoption of rule 206(4)-5.
    The current approved collection of information also contains an
estimated total annual cost burden of $355,000, which is attributed to
outside counsel legal fees. In the Proposing Release, we estimated that
approximately five advisers annually would apply to the Commission for
an exemption from rule 206(4)-5.\587\ We also estimated that an
advisory firm that applies for an exemption would hire outside counsel
to prepare their exemptive requests, and that counsel would spend 16
hours preparing and submitting an application for review at a rate of
$400 per hour, for a per application cost of $6,400 and a total
estimated cost for five applications annually of $32,000.
---------------------------------------------------------------------------

    \587\ See Proposing Release, at Section III.B.
---------------------------------------------------------------------------

    The Commission requested public comment on these estimates in the
Proposing Release, and we received comments indicating that our
estimate of five exemptive application submissions per year is too
low.\588\ We did not receive comments on our cost estimates. Given that
the advisory industry is much larger than the municipal securities
industry, and in light of the number of comment letters we received
that expressed concern about inadvertent violations of the rule that
would not qualify for the exception for returned contributions, our
staff estimates that approximately seven advisers annually would apply
to the Commission for an exemption from the rule. Although we may
initially receive more than seven applications a year for an exemption,
over time, we expect the number of applications we receive will
significantly decline to an average of approximately seven annually. We
continue to believe that a firm that applies for an exemption will hire
outside counsel to prepare an exemptive request, but based on
commenters' concerns have raised the number of hours counsel will spend
preparing and submitting an application from 16 hours to 32 hours, at a
rate of $400 per hour.\589\ As a result, each application will cost
approximately $12,800, and the total estimated cost for seven
applications annually will be $89,600. The total estimated annual cost
burden to applicants of filing all applications has therefore increased
to $444,600.\590\
---------------------------------------------------------------------------

    \588\ See Davis Polk Letter; ICI Letter.
    \589\ The hourly cost estimate of $400 is based on our
consultation with advisers and law firms who regularly assist them
in compliance matters.
    \590\ $355,000 + $89,600 = $444,600.
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VI. Final Regulatory Flexibility Analysis

    The Commission has prepared the following Final Regulatory
Flexibility Analysis regarding 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.\591\ We prepared an Initial Regulatory
Flexibility Analysis (``IRFA'') in conjunction with the Proposing
Release in August 2009.\592\ The Proposing Release included, and
solicited comment, on the IRFA.
---------------------------------------------------------------------------

    \591\ 5 U.S.C. 604(b).
    \592\ See Proposing Release, at section V.
---------------------------------------------------------------------------

A. Need for the Rule

    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.\593\
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 rule and rule amendments
we are adopting today are designed to prevent fraud, deception, and
manipulation by reducing or eliminating adviser participation in pay to
play practices.
---------------------------------------------------------------------------

    \593\ See section I of this Release, for more information about
the need for the Commission to take action to prevent pay to play
practices.
---------------------------------------------------------------------------

    Rule 206(4)-5, the ``pay to play'' rule, prohibits an 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, from providing
advisory services for compensation to a government client for two years
after the adviser, or any of its covered associates, makes 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.\594\ In addition, the
rule we are adopting prohibits an adviser and 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,\595\ and from providing or agreeing to provide, directly or
indirectly, payment to any third party, other than a ``regulated
person,'' engaged to solicit advisory business from any government
entity on behalf of the adviser.\596\ Further, the prohibitions in the
rule also apply to advisers to certain investment pools in which a
government entity invests or that are investment options of a plan or
program of a government entity.\597\ The amendment we are adopting to
rule 204-2 is designed to provide Commission staff with records to
review compliance with rule 206(4)-5, and the amendment to rule 206(4)-
3 clarifies the application of the cash solicitation rule as a result
of the adoption of rule 206(4)-5.\598\
---------------------------------------------------------------------------

    \594\ Rule 206(4)-5(a)(1).
    \595\ Rule 206(4)-5(a)(2)(ii).
    \596\ Rule 206(4)-5(a)(2)(i). ``Regulated person'' is defined in
rule 206(4)-5(f)(9).
    \597\ Rule 206(4)-5(c).
    \598\ For a more detailed discussion of the prohibitions
contained in rule 206(4)-5, see section II.B.2 of this Release. For
a more detailed discussion of the amendments to rules 204-2 and
206(4)-3, see sections II.D and II.E, respectively, of this Release.
---------------------------------------------------------------------------

B. Significant Issues Raised by Public Comment

    In the Proposing Release, we requested comment on the IRFA, in
particular, on the number of small entities, particularly small
advisers, to which the rule and rule amendments would apply and the
effect on those entities, including whether the effects would be
economically significant; and how to quantify the number of small
advisers, including those that are unregistered, that would be subject
to the proposed rule and rule amendments. We received a number of
comments related to the impact of our proposal on small advisers. The
commenters argued that the proposed rule, particularly the provision
that would have prohibited advisers from directly or indirectly
compensating any third party to solicit government business on its
behalf, would be disproportionately expensive for, and would impose an
undue regulatory burden on, smaller firms.\599\
---------------------------------------------------------------------------

    \599\ See supra note 522.
---------------------------------------------------------------------------

C. Small Entities Subject to Rule

    Under Commission rules, for the purposes of the Advisers Act and
the Regulatory Flexibility Act, an investment adviser generally is a
small entity if it: (i) Has assets under management having a total
value of less than $25 million; (ii) did not have total assets of $5
million or more on the last day of its most recent fiscal year; and
(iii) does not control, is not controlled by, and is not under common
control with another investment adviser that has assets under
management of $25 million or more, or any person (other than a natural
person) that had $5 million or more on the last day of its most recent
fiscal year.\600\
---------------------------------------------------------------------------

    \600\ 17 CFR 275.0-7(a).
---------------------------------------------------------------------------

    The Commission estimates that as of April 2010 there are
approximately 708 small SEC-registered investment advisers.\601\ Of
these 708 advisers, 61 indicate on Form ADV that they have State or
local government clients, and would, therefore, be affected by the
rule.\602\ The rule also applies to those advisers that are exempt from
registration with the Commission in reliance on section 203(b)(3) of
the Advisers Act. As noted above, 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).\603\ Applying the same principles we
used with respect to registered investment advisers, we estimate that
230 of those advisers manage pooled investment vehicles in which
government client assets are invested and would therefore be subject to
the rule.\604\ Based on the current number of registered advisers
subject to the rule that are small entities, we estimate that
approximately 4 percent of unregistered advisers,\605\ or nine, would
be subject to the rule are small entities.\606\
---------------------------------------------------------------------------

    \601\ This estimate is based on registration information from
IARD as of April 1, 2010. We have estimated the number of small
advisers by reference to advisers' responses to Item 12.A, B and C
of Part 1 of Form ADV.
    \602\ This estimate is based on registration information from
IARD as of April 1, 2010. We have estimated the number of small
advisers with State or local government clients by reference to
advisers' responses to Item 5.D(9) of Part 1 of Form ADV.
    \603\ This number is based on our review of registration
information on IARD as of April 1, 2010, 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.
    \604\ 11.48% of 2000 is 230. See supra note 474.
    \605\ 61 registered small entities subject to the rule/1,697
registered advisers subject to the rule = 3.6%.
    \606\ 230 x 4% = 9.2. Because these advisers are not registered
with us, we do not have more precise data about them, and we are not
aware of any databases that compile information regarding how many
advisers that are exempt from registration with the Commission in
reliance on section 203(b)(3) of the Advisers Act have State or
local government clients, and how many of these advisers would be
small entities for purposes of this analysis. We sought comments on
this issue, but none of the comments we received provided any
estimates or empirical data. However, we address above commenters
who generally questioned our estimates. See supra notes 482-484 and
accompanying text. We expect certain additional advisers may incur
compliance costs associated with rule 206(4)-5. Some advisers may be
subject to the rule because they solicit government entities on
behalf of other investment advisers.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements

    The rule imposes certain reporting, recordkeeping and compliance
requirements on advisers, including small advisers. The rule imposes a
new compliance requirement by: (i) Prohibiting an adviser from
providing investment advisory services for compensation to government
clients for two years after the adviser or any of its covered
associates makes a contribution to certain elected officials or
candidates; (ii) prohibiting an adviser from providing or agreeing to
provide, directly or indirectly, payment to any third party, other than
a ``regulated person,'' engaged to solicit advisory business from any
government entity on behalf of the adviser; and (iii) prohibiting 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.
    The rule amendments impose new recordkeeping requirements by
requiring an adviser to maintain certain records about its covered
associates, its advisory clients, government entities invested in
certain pooled investment vehicles managed by the adviser, its
solicitors, and its political contributions, as well as the political
contributions of its covered associates.\607\ An investment adviser
that does not provide or seek to provide advisory services to a
government entity, or to a covered investment pool

in which a government entity invests, is not subject to rule 206(4)-5
and certain recordkeeping requirements under amended rule 204-2.
---------------------------------------------------------------------------

    \607\ See supra notes 559-564 and accompanying text (providing
the revised estimated hour burden and non-labor cost burden to
comply with amended rule 204-2, for purposes of the PRA).
---------------------------------------------------------------------------

    As noted above, we believe that a limited number of small advisers
\608\ will have to comply with rule 206(4)-5 and the amendments to
rules 204-2 and 206(4)-3. To the extent small advisers tend to have
fewer clients and fewer employees that would be covered associates for
purposes of the rule, the rule should impose lower costs on small
advisers as compared to large advisers because variable costs, such as
the requirement to make and keep records relating to contributions,
should be lower due to the likelihood that there would be fewer records
to make and keep.\609\ Moreover, as discussed above, the rule and
amendments were modified from what we had proposed in several ways that
we expect will substantially minimize compliance burdens on small
advisers.
---------------------------------------------------------------------------

    \608\ See section VI.C of this Release.
    \609\ However, as noted above, many larger advisers with broker-
dealer affiliates may spend fewer resources to comply with the
proposed rule and rule amendments because they may be able to rely
on compliance procedures and systems that the broker-dealer already
has in place to comply with MSRB rules G-37 and G-38. See supra
section IV.B.
---------------------------------------------------------------------------

E. Agency Action To Minimize Effect on Small Entities

    The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant impact on small entities.\610\ In
considering whether to adopt rule 206(4)-5 and the amendments to rules
204-2 and 206(4)-3, the Commission considered the following
alternatives: (i) The establishment of differing compliance or
reporting requirements or timetables that take into account the
resources available to small entities; (ii) the clarification,
consolidation, or simplification of compliance and reporting
requirements under the rule and rule amendments for such small
entities; (iii) the use of performance rather than design standards;
and (iv) an exemption from coverage of the rule and rule amendments, or
any part thereof, for such small entities.
---------------------------------------------------------------------------

    \610\ As noted above, we considered two alternatives to certain
aspects of proposed rule 206(4)-5: A disclosure obligation and a
two-year time out for third-party solicitors. We do not believe
either alternative would accomplish our stated objective of
curtailing pay to play activities and thereby address potential
harms from those activities. See Proposing Release, at section
II.A.2, including nn.133 and 134 and accompanying text.
---------------------------------------------------------------------------

    Regarding the first alternative, the Commission is not adopting
different compliance or reporting requirements for small advisers as it
may be inappropriate to do so under the circumstances. The proposal is
designed to reduce or eliminate adviser participation in pay to play, a
practice that can distort the process by which investment advisers are
selected to manage public pension plans that can harm public pension
plan clients and cause advisers to violate their fiduciary obligations.
To establish different requirements for small advisers could diminish
the protections the rule and rule amendments would provide to public
pension plan clients and their beneficiaries.
    Regarding the second alternative, we considered whether further
clarification, consolidation, or simplification of the compliance
requirements would be feasible or necessary, and would reduce
compliance requirements. As a result, we have simplified the compliance
requirements by limiting the recordkeeping obligations to better
reflect the activities of an adviser or a covered associate that could
result in the adviser being subject to the two-year time out, including
not requiring advisers to maintain records of unsuccessful
solicitations of government entities and payments (as opposed to
contributions) by advisers or covered associates to government
officials.\611\ Moreover, we are amending rule 206(4)-3, the cash
solicitation rule, to clarify that the requirements of new rule 206(4)-
5 apply to solicitation activities involving government clients.\612\
---------------------------------------------------------------------------

    \611\ See supra note 423 and accompanying text.
    \612\ See section II.D. of this Release.
---------------------------------------------------------------------------

    Regarding the third alternative, we considered using performance
rather than design standards with respect to pay to play practices of
investment advisers to be neither consistent with the objectives for
this rulemaking nor sufficient to protect investors in accordance with
our statutory mandate of investor protection. Design standards, which
we have employed, provide a baseline for advisory conduct as it relates
to contributions and other pay to play activities, which is consistent
with a rule designed to prohibit pay to play. The use of design
standards also is important to ensure consistent application of the
rule among investment advisers to which the rule and rule amendments
will apply.
    Regarding the fourth alternative, exempting small entities could
compromise the overall effectiveness of the rule and related rule
amendments. Banning pay to play practices benefits clients of both
small and large advisers, and it would be inconsistent to specify
different requirements for small advisers.
    As discussed above, several commenters suggested alternative
approaches to our rule.\613\ Such alternatives include, for example:
(i) That we require advisers to disclose their contributions to State
and local officials; (ii) that we require advisers to include in their
codes of ethics a policy that prohibits contributions made for the
purpose of influencing the selection of the adviser; (iii) that we
require advisers to adopt policies and procedures reasonably designed
to prevent and detect contributions designed to influence the selection
of an adviser; (iv) that we mandate preclearance of employee
contributions; and (v) that we allow an adviser to customize sanctions
based on the severity of the violation.\614\ While it may be true that
some of these approaches could diminish the compliance burdens on
advisers, including small advisers, as we explain above, we considered
these alternative approaches and do not believe they would
appropriately address the kind of conduct at which our rule is
directed.\615\
---------------------------------------------------------------------------

    \613\ See generally section II.B.2(a) of this Release.
    \614\ See id.
    \615\ See id.
---------------------------------------------------------------------------

    We are sensitive to the burdens our rule amendments will have on
small advisers. We believe that the rule we are adopting today contains
a number of modifications from what we had proposed that will alleviate
many of the commenters' concerns regarding small advisers. Most
notably, as described above, we have created an exception to the third-
party solicitor ban for ``regulated persons,'' which will, for
instance, allow advisers to continue to use third party placement
agents to sell interests in covered investment pools they manage
instead of incurring additional costs to hire internal marketing staff,
a result that could have disproportionally affected small
advisers.\616\ Moreover, as discussed above, we have modified the
exceptions to the rule's two-year time out provisions in certain
respects to reduce the likelihood of an inadvertent or minor violation
of the rule, including a shortened look back of six months for certain
new covered associates whose contributions are less likely to involve
pay to play and a new de minimis exception for contributions to
officials for whom a covered associate is not entitled to vote.\617\ We
have also limited certain recordkeeping requirements we had proposed in
order to achieve our

goals in a way that balances the costs and benefits of the rule,
including not requiring records of unsuccessful solicitations or
payments (that are not contributions) by advisers or covered associates
to government officials.\618\
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    \616\ See section II.B.2(b) of this Release.
    \617\ See sections II.B.2(a)(5) and (6) of this Release.
    \618\ See sections II.D and III.B.3. of this Release.
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VII. Effects on Competition, Efficiency and Capital Formation

    We are adopting amendments to rule 204-2 pursuant to our authority
under sections 204 and 211. Section 204 requires the Commission, when
engaging in rulemaking pursuant to that authority, to consider whether
the rule is ``necessary or appropriate in the public interest or for
the protection of investors.'' \619\ Section 202(c) of the Advisers Act
requires the Commission, when engaging in rulemaking that requires it
to consider or determine whether an action is necessary or appropriate
in the public interest, to consider, in addition to the protection of
investors, whether the action will promote efficiency, competition, and
capital formation.\620\
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    \619\ 15 U.S.C. 80b-4.
    \620\ 15 U.S.C. 80b-2(c). In contrast, we are adopting rule
206(4)-5 and amendments to rule 206(4)-3 pursuant to our authority
set forth in sections 206(4) and 211. For a discussion of the
effects of these amendments on competition, efficiency and capital
formation, see sections IV, V, and VI of this Release.
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    In the Proposing Release, we solicited comment on whether, if
adopted, the proposed amendments to rule 204-2 would promote
efficiency, competition and capital formation. We further encouraged
commenters to provide empirical data to support their views on any
burdens on efficiency, competition or capital formation that might
result from adoption of the proposed amendments. We did not receive any
empirical data in this regard concerning the proposed amendments. We
received some general comments, addressed below, asserting that the
proposed amendments to require registered advisers to maintain books
and records relating to investment advisory services they provide to
government entities would have an adverse impact on competition.
    We are amending rule 204-2 to require a registered adviser to make
and keep a list of its covered associates, the government entities to
which the adviser directly or indirectly provides advisory services,
the ``regulated person'' solicitors the adviser retains, and the
contributions made by the firm and its covered associates, as
applicable, to government officials and candidates.\621\ The amendments
are designed to provide our examiners important information about the
adviser and its covered associates' contributions to government
officials, the government entities to which the adviser directly or
indirectly provides advisory services, and the solicitors it retains.
These amendments may also benefit advisers as records required under
the amended rule will assist the Commission in enforcing the rule
against, for example, an adviser whose pay to play activities, if not
uncovered, could adversely affect the competitive position of a
compliant adviser.
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    \621\ Rule 204-2(a)(18)(i).
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    Although we believe that the amendments to the Advisers Act
recordkeeping rule will require advisers to incur both one-time costs
to establish and enhance current systems to assist in their compliance
with the amendments and ongoing costs to maintain records, these costs
will be borne by all registered advisers that have government entity
clients or that pay regulated entities to solicit government clients on
their behalf. As the amendments to the recordkeeping rule do not
disproportionally affect any particular group of advisers with
government entity clients and do not materially increase the compliance
burden on advisers under rule 204-2, we do not believe that they will
affect competition across registered investment advisers. Some
commenters asserted that certain asset managers that provide advice to
government entities but are not subject to the Advisers Act
recordkeeping rule, such as banks and advisers that are exempt from
registration under the Act, may be at a competitive advantage to
registered advisers that must incur the costs of keeping records under
the rule.\622\ While we acknowledge these entities could potentially
obtain a competitive advantage for this reason, we do not believe the
costs attributable to the amendments to rule 204-2 will have a
significant impact on registered advisers such that the advantage
gained by asset managers not subject to the Advisers Act recordkeeping
rule will be substantial.\623\ Moreover, exempt advisers or persons
that do not meet the definition of investment adviser are not subject
to rule 204-2.\624\ Finally, we also note that banks may be subject to
laws and rules that do not apply to registered advisers.
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    \622\ SIFMA Letter (``The books and records requirement under
the Proposed Rule are under inclusive. * * * As an initial matter,
the books and records requirements apply only to some of the
advisers covered by the Proposed Rule--although the Proposed Rule
applies to a substantial number of entities who are exempt from
registration under the Advisers Act, the Proposed Rule's additional
books and records only modify the rules that apply to registered
investment advisers.'').
    \623\ In addition, we note that advisers not subject to the
amendments to rule 204-2 may nonetheless maintain some of the
required records as part of a strong compliance program.
    \624\ See section 204 of the Advisers Act, 15 U.S.C. 80b-4 (that
provides the Commission authority to prescribe recordkeeping for
advisers, other than those specifically exempted from registration).
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    We believe that the amendments to rule 204-2 may, to a limited
extent, affect efficiency and capital formation with respect to the
allocation of public pension plan assets. The amendments to rule 204-2
will allow our staff to examine for compliance with rule 206(4)-5.
Authority to examine records may improve registered investment
advisers' compliance with rule 206(4)-5, which may reduce the adverse
effects of political contributions on the selection of investment
advisers. While the amendments to the rule will not affect the
aggregate amount of pension fund assets available for investment,
limiting the effects of political contributions on the investment
adviser selection process should improve the mechanism by which capital
is formed and allocated to investment opportunities.

VIII. Statutory Authority

    The Commission is adopting new rule 206(4)-5 and amending rule
206(4)-3 of the Advisers Act pursuant to the authority set forth in
sections 206(4) and 211(a) of the Investment Advisers Act of 1940 [15
U.S.C. 80b-6(4), 80b-11(a)].
    The Commission is amending rule 204-2 of the Advisers Act pursuant
to the authority set forth in sections 204 and 211(a) of the Advisers
Act [15 U.S.C. 80b-4 and 80b-11(a)].

List of Subjects in 17 CFR Part 275

    Reporting and recordkeeping requirements; Securities.

0
For the reasons set out in the preamble, Title 17 Chapter II of the
Code of Federal Regulations is amended as follows.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
1. The authority citation for Part 275 continues to read in part as
follows:

    Authority:  15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.
* * * * *

0
2. Section 275.204-2 is amended by adding paragraph (a)(18) and by
revising paragraph (h)(1) to read as follows:

Sec.  275.204-2  Books and records to be maintained by investment
advisers.

    (a) * * *
    (18)(i) Books and records that pertain to Sec.  275.206(4)-5
containing a list or other record of:
    (A) The names, titles and business and residence addresses of all
covered associates of the investment adviser;
    (B) All government entities to which the investment adviser
provides or has provided investment advisory services, or which are or
were investors in any covered investment pool to which the investment
adviser provides or has provided investment advisory services, as
applicable, in the past five years, but not prior to September 13,
2010;
    (C) All direct or indirect contributions made by the investment
adviser or any of its covered associates to an official of a government
entity, or direct or indirect payments to a political party of a State
or political subdivision thereof, or to a political action committee;
and
    (D) The name and business address of each regulated person to whom
the investment adviser provides or agrees to provide, directly or
indirectly, payment to solicit a government entity for investment
advisory services on its behalf, in accordance with Sec.  275.206(4)-
5(a)(2).
    (ii) Records relating to the contributions and payments referred to
in paragraph (a)(18)(i)(C) of this section must be listed in
chronological order and indicate:
    (A) The name and title of each contributor;
    (B) The name and title (including any city/county/State or other
political subdivision) of each recipient of a contribution or payment;
    (C) The amount and date of each contribution or payment; and
    (D) Whether any such contribution was the subject of the exception
for certain returned contributions pursuant to Sec.  275.206(4)-
5(b)(2).
    (iii) An investment adviser is only required to make and keep
current the records referred to in paragraphs (a)(18)(i)(A) and (C) of
this section if it provides investment advisory services to a
government entity or a government entity is an investor in any covered
investment pool to which the investment adviser provides investment
advisory services.
    (iv) For purposes of this section, the terms ``contribution,''
``covered associate,'' ``covered investment pool,'' ``government
entity,'' ``official,'' ``payment,'' ``regulated person,'' and
``solicit'' have the same meanings as set forth in Sec.  275.206(4)-5.
* * * * *
    (h)(1) Any book or other record made, kept, maintained and
preserved in compliance with Sec. Sec.  240.17a-3 and 240.17a-4 of this
chapter under the Securities Exchange Act of 1934, or with rules
adopted by the Municipal Securities Rulemaking Board, which is
substantially the same as the book or other record required to be made,
kept, maintained and preserved under this section, shall be deemed to
be made, kept, maintained and preserved in compliance with this
section.
* * * * *

0
3. Section 275.206(4)-3 is amended by adding paragraph (e) and removing
the authority citation at the end of the section to read as follows:

Sec.  275.206(4)-3  Cash payments for client solicitations.

* * * * *
    (e) Special rule for solicitation of government entity clients.
Solicitation activities involving a government entity, as defined in
Sec.  275.206(4)-5, shall be subject to the additional limitations set
forth in that section.

0
4. Section 275.206(4)-5 is added to read as follows:

Sec.  275.206(4)-5  Political contributions by certain investment
advisers.

    (a) Prohibitions. As a means reasonably designed to prevent
fraudulent, deceptive or manipulative acts, practices, or courses of
business within the meaning of section 206(4) of the Act (15 U.S.C.
80b-6(4)), it shall be unlawful:
    (1) 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)) to provide investment advisory services for
compensation to a government entity within two years after a
contribution to an official of the government entity is made by the
investment adviser or any covered associate of the investment adviser
(including a person who becomes a covered associate within two years
after the contribution is made); and
    (2) 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 the investment adviser's covered
associates:
    (i) To provide or agree to provide, directly or indirectly, payment
to any person to solicit a government entity for investment advisory
services on behalf of such investment adviser unless such person is a
regulated person or is an executive officer, general partner, managing
member (or, in each case, a person with a similar status or function),
or employee of the investment adviser; and
    (ii) To coordinate, or to solicit any person or political action
committee to make, any:
    (A) Contribution to an official of a government entity to which the
investment adviser is providing or seeking to provide investment
advisory services; or
    (B) Payment 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.
    (b) Exceptions.
    (1) De minimis exception. Paragraph (a)(1) of this section does not
apply to contributions made by a covered associate, if a natural
person, to officials for whom the covered associate was entitled to
vote at the time of the contributions and which in the aggregate do not
exceed $350 to any one official, per election, or to officials for whom
the covered associate was not entitled to vote at the time of the
contributions and which in the aggregate do not exceed $150 to any one
official, per election.
    (2) Exception for certain new covered associates. The prohibitions
of paragraph (a)(1) of this section shall not apply to an investment
adviser as a result of a contribution made by a natural person more
than six months prior to becoming a covered associate of the investment
adviser unless such person, after becoming a covered associate,
solicits clients on behalf of the investment adviser.
    (3) Exception for certain returned contributions.
    (i) An investment adviser that is prohibited from providing
investment advisory services for compensation pursuant to paragraph
(a)(1) of this section as a result of a contribution made by a covered
associate of the investment adviser is excepted from such prohibition,
subject to paragraphs (b)(3)(ii) and (b)(3)(iii) of this section, upon
satisfaction of the following requirements:
    (A) The investment adviser must have discovered the contribution
which resulted in the prohibition within four months of the date of
such contribution;
    (B) Such contribution must not have exceeded $350; and
    (C) The contributor must obtain a return of the contribution within
60 calendar days of the date of discovery of such contribution by the
investment adviser.

    (ii) In any calendar year, an investment adviser that has reported
on its annual updating amendment to Form ADV (17 CFR 279.1) that it has
more than 50 employees is entitled to no more than three exceptions
pursuant to paragraph (b)(3)(i) of this section, and an investment
adviser that has reported on its annual updating amendment to Form ADV
that it has 50 or fewer employees is entitled to no more than two
exceptions pursuant to paragraph (b)(3)(i) of this section.
    (iii) An investment adviser may not rely on the exception provided
in paragraph (b)(3)(i) of this section more than once with respect to
contributions by the same covered associate of the investment adviser
regardless of the time period.
    (c) Prohibitions as applied to covered investment pools. For
purposes of this section, an investment adviser to a covered investment
pool in which a government entity invests or is solicited to invest
shall be treated as though that investment adviser were providing or
seeking to provide investment advisory services directly to the
government entity.
    (d) Further prohibition. As a means reasonably designed to prevent
fraudulent, deceptive or manipulative acts, practices, or courses of
business within the meaning of section 206(4) of Advisers Act (15
U.S.C. 80b-6(4)), it shall be 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 the
investment adviser's covered associates to do anything indirectly
which, if done directly, would result in a violation of this section.
    (e) Exemptions. The Commission, upon application, may conditionally
or unconditionally exempt an investment adviser from the prohibition
under paragraph (a)(1) of this section. In determining whether to grant
an exemption, the Commission will consider, among other factors:
    (1) 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 (15 U.S.C. 80b);
    (2) Whether the investment adviser:
    (i) Before the contribution resulting in the prohibition was made,
adopted and implemented policies and procedures reasonably designed to
prevent violations of this section; and
    (ii) Prior to or at the time the contribution which resulted in
such prohibition was made, had no actual knowledge of the contribution;
and
    (iii) After learning of the contribution: