its oversight of brokers and dealers and enforcement of its own
rules). In fact, such advisers are subject neither to our oversight
nor to the recordkeeping rules we are adopting today.
    \326\ Importantly, a person that is registered under the
Exchange Act as a broker-dealer and under the Advisers Act as an
investment adviser could potentially be a ``regulated person'' under
the rule if it met the conditions for either prong of the
definition. Such a regulated person should follow the rules that
apply to the services it is performing, rather than complying with
both investment adviser and broker-dealer pay to play requirements.
The Exchange Act generally requires brokers and dealers to register
with the Commission and become members of at least one self-
regulatory organization. Exchange Act sections 15(a), 15(b)(8) [15
U.S.C. 78o(a), (b)(8)]. Section 3(a)(4)(A) of the Exchange Act
generally defines a ``broker'' as any person engaged in the business
of effecting transactions in securities for the account of others
[15 U.S.C. 78c(a)(4)(A)]. See, e.g., Definition of Terms in and
Specific Exemptions for Banks, Savings Associations, and Savings
Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange
Act of 1934, Exchange Act Release No. 44291, at n.124 (May 11, 2001)
[66 FR 27759 (May 18, 2001)] (``Solicitation is one of the most
relevant factors in determining whether a person is effecting
transactions.''); Strengthening the Commission's Requirements
Regarding Auditor Independence, Exchange Act Release No. 47265, at
n.82 (Jan. 28, 2003) [68 FR 6006 (Feb. 5, 2003)] (noting that a
person may be ``engaged in the business,'' among other ways, by
receiving compensation tied to the successful completion of a
securities transaction). See also Persons Deemed Not to Be Brokers,
Exchange Act Release No. 22172, at sec. II.A (Jun. 27, 1985) [50 FR
27940 (Jul. 9, 1985)] (noting that attorneys, accountants, insurance
brokers, financial service organizations and financial consultants
are engaged in the business of effecting transactions in securities
for the account of others if they are retained by an issuer
specifically for the purpose of selling securities to the public and
receive transaction based-compensation for their services).

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

    Advisers compensating other advisers that qualify as ``regulated
persons'' for soliciting government entities must adopt policies and
procedures reasonably designed to prevent a violation of the rule.\327\
Such policies and procedures should include, among other things, a
careful vetting of candidates and ongoing review of ``regulated
person'' investment advisers acting as solicitors currently being used.
Such review would need to determine whether the adviser (and its
covered persons) acting as a solicitor has made political contributions
or otherwise engaged in conduct that would disqualify it from the
definition of ``regulated person'' and thereby preclude the hiring
adviser from paying it for the solicitation activity.
---------------------------------------------------------------------------

    \327\ See Advisers Act rule 206(4)-7 [17 CFR 275.206(4)-7]
(requiring advisers to adopt and implement compliance policies and
procedures).
---------------------------------------------------------------------------

(c) Restrictions on Soliciting and Coordinating Contributions and
Payments
    Rule 206(4)-5 prohibits advisers and covered persons from
coordinating or soliciting \328\ any person or PAC to make (i) any
contribution \329\ to an official of a government entity to which the
adviser is providing or seeking to provide investment advisory
services,\330\ or (ii) any payment \331\ 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.\332\
These restrictions are intended to prevent advisers from circumventing
the rule's prohibition on direct contributions to certain elected
officials such as by ``bundling'' a large number of small employee
contributions to influence an election, or making contributions (or
payments) indirectly through a State or local political party.\333\
---------------------------------------------------------------------------

    \328\ Rule 206(4)-5(f)(10)(ii) (defining ``solicit,'' with
respect to a contribution or payment, as communicating, directly or
indirectly, for the purpose of obtaining or arranging a contribution
or payment). Some commenters requested that we provide guidance
regarding when an adviser would be deemed to be soliciting
contributions for purposes of the rule. See, e.g., Caplin & Drysdale
Letter. An adviser that consents to the use of its name on
fundraising literature for a candidate would be soliciting
contributions for that candidate. Similarly, an adviser that
sponsors a meeting or conference which features a government
official as an attendee or guest speaker and which involves
fundraising for the government official would be soliciting
contributions for that government official. Whether a particular
activity involves a solicitation or coordination of a contribution
or payment for purposes of the rule will depend on the facts and
circumstances, thus we have not attempted to draw a bright line. The
MSRB takes a similar approach. See MSRB, Solicitation of
Contributions, MSRB Interpretive Letter (May 21, 1999), available at
http://msrb.org/msrb1/rules/interpg37.htm (determination of whether
activity constitutes ``soliciting'' under rule G-37 is a facts and
circumstances analysis). See also supra note 255.
    \329\ In the case of the fundraising meeting or conference
described as an example in note 328, expenses incurred by the
adviser for hosting the event would be a contribution by the
adviser, thereby triggering the two-year ban on the adviser
receiving compensation for providing advisory services to the
government entity over which that official has influence. See
section II.B.2(a) of this Release. Such expenses may include, but
are not limited to, the cost of the facility, the cost of
refreshments, any expenses paid for administrative staff, and the
payment or reimbursement of any of the government official's
expenses for the event. The de minimis exception under rule 206(4)-
5(b)(1) would not be available with respect to these expenses
because they would have been incurred by the firm, not by a natural
person. See MSRB, Supervision When Sponsoring Meetings and
Conferences Involving Issuer Officials, MSRB Rule G-37 Interpretive
Notice (Mar. 26, 2007), available at http://www.msrb.org/msrb1/
rules/notg37.htm (rather than addressing meetings and conferences in
its rules directly, the MSRB applies a facts and circumstances test
on a case-by-case basis).
    \330\ Rule 206(4)-5(a)(2)(ii). An investment adviser would be
seeking to provide advisory services to a government entity when it
responds to a request for proposal, communicates with a government
entity regarding that entity's formal selection process for
investment advisers, or engages in some other solicitation of
investment advisory business of the government entity. A violation
of paragraph (a)(2)(ii) of the rule would not trigger a two-year ban
on the provision of investment advisory services for compensation,
but would be a violation of the rule.
    \331\ A payment is defined as any gift, subscription, loan,
advance, or deposit of money or anything of value. Rule 206(4)-
5(f)(7). This definition is similar to the definition of
``contribution,'' but broader, in the sense that it does not include
limitations on the purposes for which such money is given (e.g., it
does not have to be made for the purpose of influencing an
election). We are including the broader term ``payments,'' as
opposed to ``contributions,'' here to deter an adviser from
circumventing the rule's prohibitions by coordinating indirect
contributions to government officials by making payments to
political parties.
    \332\ Rule 206(4)-5(a)(2)(ii). This provision prohibits, for
example, an adviser from soliciting a payment to the political party
of a State if the adviser is providing or seeking to provide
advisory services to the State, but would not preclude that adviser
from soliciting a payment to a local political party (as long as the
adviser is not also providing or seeking to provide advisory
services to a government entity in that locality). In these
circumstances, the rule would, however, prohibit an adviser from
soliciting the payment to a local political party as a means to
indirectly make payments to the State party. See rule 206(4)-5(d).
    \333\ We note that this provision is not limited to the bundling
of employee contributions. Another example of conduct that would be
prohibited by this section would be an adviser or its covered
associates soliciting contributions from professional service
providers.
---------------------------------------------------------------------------

    We received only a few comments on this provision. One supporter of
our proposal asserted that it ``would close an important gap in which
contributions might be made indirectly to government officials for the
purpose of influencing their choice of investment advisers.'' \334\
Most commenters that addressed the provision focused on the prohibition
relating to contributions and payments to State and local political
parties where the adviser is providing, or seeking to provide, advisory
services. One State official suggested that this prohibition would
unfairly affect states with strict limitations on individual
contributions to candidates as they are now more reliant on party money
for campaigns.\335\ Another State official, however, explained the
importance of the provision by pointing out that it is often difficult
or impossible to differentiate between individuals seeking an office
and the political party, which often merely passes contributions it
receives on to the candidate, and may direct successful candidates to
place pension business with contributors.\336\
---------------------------------------------------------------------------

    \334\ Cornell Law Letter.
    \335\ CT Treasurer Letter. In upholding restrictions targeted at
a particular industry, courts have found that the loss of
contributions from a small segment of the electorate ``would not
significantly diminish the universe of funds available to a
candidate to a non-viable level.'' Green Party of Conn. v. Garfield,
590 F. Supp. 2d 288, 316 (D. Conn. 2008); see also Preston v. Leake,
629 F. Supp. 2d 517, 524 (E.D.N.C. 2009) (differentiating the
``broad sweep of the Vermont statute'' that ``restricted essentially
any potential campaign contribution'' from a statute that ``only
applies to lobbyists''); In re Earle Asphalt Co., 950 A.2d 918, 927
(N.J. Super. Ct. App. Div. 2008), aff'd 957 A.2d 1173 (N.J. 2008)
(holding that a limitation on campaign contributions by government
contractors and their principals did not have the same capacity to
prevent candidates from amassing the resources necessary for
effective campaigning as the statute in Randall). See supra note 68.
    \336\ Reilly Letter.
---------------------------------------------------------------------------

    We are adopting this provision, as proposed. These restrictions on
soliciting and coordinating

contributions and payments close what would otherwise be a potential
gap in the rule as advisers could circumvent its limitations on direct
contributions through soliciting and coordinating others to make
contributions to influence an election or a government official's
investment adviser selection process.\337\ We disagree that this
prohibition would unfairly affect candidates in states that limit
individual contributions, because the rule is non-discriminatory and
would affect contributions (and payments) to all candidates equally
that were being bundled or made through a gatekeeper for the benefit of
an investment adviser seeking or doing business with the State or local
government.
---------------------------------------------------------------------------

    \337\ We note that a direct contribution to a political party by
an adviser or its covered associates would not violate the rule,
unless the contribution was a means for the adviser to do indirectly
what the rule would prohibit if done directly (for example, if the
contribution was earmarked or known to be provided for the benefit
of a particular government official). See section II.B.2(d) of this
Release. The MSRB amended rule G-37 in 2005 to expand its
prohibition on soliciting others to make, and on coordinating,
payments to State and local political parties to close what the MSRB
identified as a gap in which contributions were being made
indirectly to officials through payments to political parties for
the purposes of influencing their choice of municipal securities
dealers. The MSRB had not previously been able to deter this
misconduct, despite issuing informal guidance in both 1996 and 2003.
See Rule G-37: Request for Comments on Draft Amendments to Rule G-
37(c), Relating to Prohibiting Solicitation and Coordination of
Payments to Political Parties, and Draft Question and Answer
Guidance Concerning Indirect Rule Violations, MSRB Notice 2005-11
(Feb. 15, 2005), available at http://www.msrb.org/msrb1/archive/
2005/2005-11.asp (``Both the 1996 Q&A guidance and the 2003 Notice
were intended to alert dealers and [municipal finance professionals]
to the realities of political fundraising and guide them toward
developing procedures that would lead to compliance with both the
letter and the spirit of the rule. The MSRB continues to be
concerned, however, that dealer, [municipal finance professional],
and affiliated persons' payments to political parties, including
``housekeeping'', ``conference'' or ``overhead'' type accounts, and
PACs give rise to at least the appearance that dealers may be
circumventing the intent of Rule G-37.''); Self-Regulatory
Organizations; Municipal Securities Rulemaking Board; Order
Approving Proposed Rule Change Concerning Solicitation and
Coordination of Payments to Political Parties and Question and
Answer Guidance on Supervisory Procedures Related to Rule G-37(d) on
Indirect Violations, Exchange Act Release No. 52496 (Sept. 22, 2005)
(SEC order approving change to MSRB G-37 to prohibit soliciting or
coordinating payments to political parties).
---------------------------------------------------------------------------

(d) Direct and Indirect Contributions or Solicitations
    Rule 206(4)-5(d) prohibits acts done indirectly, which, if done
directly, would violate the rule.\338\ As a result, an adviser and its
covered associates could not funnel payments through third parties,
including, for example, consultants, attorneys, family members, friends
or companies affiliated with the adviser as a means to circumvent the
rule.\339\ We emphasize, however, that contributions by these other
persons would not otherwise trigger the rule's two-year time out.\340\
We received no comments on this aspect of the proposed rule and are
adopting it as proposed.
---------------------------------------------------------------------------

    \338\ Paragraph (d) of the rule is substantially similar to
section 208(d) of the Advisers Act [15 U.S.C. 80b-8(d)], which
states, ``It shall be unlawful for any person indirectly, or through
or by any other person, to do any act or thing which it would be
unlawful for such person to do directly under the provisions of this
title or any rule or regulation thereunder.'' MSRB rule G-37
contains a similar provision. See MSRB rule G-37(d).
    \339\ This provision would also cover, for example, situations
in which contributions by an adviser are made, directed or funded
through a third party with an expectation that, as a result of the
contributions, another contribution is likely to be made by a third
party to an ``official of the government entity,'' for the benefit
of the adviser. Contributions made through gatekeepers thus would be
considered to be made ``indirectly'' for purposes of the rule. In
approving MSRB rule G-37, the Commission stated: ``[rule G-37(d)] is
intended to prevent dealers from funneling funds or payments through
other persons or entities to circumvent the [rule]'s requirements.
For example, a dealer would violate the [rule] if it does business
with an issuer after contributions were made to an issuer official
from or by associated persons, family members of associated persons,
consultants, lobbyists, attorneys, other dealer affiliates, their
employees or PACs, or other persons or entities as a means to
circumvent the rule. A dealer also would violate the rule by doing
business with an issuer after providing money to any person or
entity when the dealer knows that the money will be given to an
official of an issuer who could not receive the contribution
directly from the dealer without triggering the rule's prohibition
on business.'' Self-Regulatory Organizations; Order Approving
Proposed Rule Change by the Municipal Securities Rulemaking Board
Relating to Political Contributions and Prohibitions on Municipal
Securities Business and Notice of Filing and Order Approving on an
Accelerated Basis Amendment No. 1 Relating to the Effective Date and
Contribution Date of the Proposed Rule, Exchange Act Release No.
33868 (Apr. 7, 1994) [59 FR 17621 (Apr. 13, 1994)].
    \340\ Like MSRB rule G-37(d), rule 206(4)-5(d) requires a
showing of intent to circumvent the rule in order for such persons
to trigger the time out. See Blount, 61 F.3d at 948 (``In short,
according to the SEC, the rule restricts such gifts and
contributions only when they are intended as end-runs around the
direct contribution limitations.'').
---------------------------------------------------------------------------

(e) Covered Investment Pools
    Rule 206(4)-5 includes a provision that applies each of the
prohibitions of rule 206(4)-5 to an investment adviser that manages
assets of a government entity through a hedge fund or other type of
pooled investment vehicle (``covered investment pool'').\341\ For
example, a political contribution to a government official that would,
under the rule, trigger the two-year time out from providing advice for
compensation to the government entity would also trigger a two-year
time out from the receipt of compensation for the management of those
assets through a covered investment pool. This provision extends the
protection of the rule to public pension plans that increasingly access
the services of investment advisers through hedge funds and other types
of pooled investment vehicles they sponsor or advise.
---------------------------------------------------------------------------

    \341\ See rule 206(4)-5(c). We discuss the types of pooled
investment vehicles that are ``covered investment pools'' below at
section II.B.2.(e)(1) of this release.
---------------------------------------------------------------------------

    This provision will generally affect two common types of
arrangements in which a government official is in a position to
influence investment of funds in pooled investment vehicles. The first
is the investment of public funds in a hedge fund or other type of
pooled investment vehicle. The other is the selection of a pooled
investment vehicle sponsored or advised by an investment adviser as a
funding vehicle or investment option in a government-sponsored plan,
such as a ``529 plan.'' \342\
---------------------------------------------------------------------------

    \342\ We note that if an adviser is selected by a government
entity to advise a government-sponsored plan (regardless of whether
the plan selects one of the pools the adviser offers or manages as
an option available under its plan), the prohibitions of the rule
directly apply. See rule 206(4)-5(a)(1) and (a)(2).
---------------------------------------------------------------------------

    An adviser that makes political contributions to steer assets to a
pooled investment vehicle it manages facilitates fraud by implementing
a government official's quid pro quo scheme.\343\ Public pension plan
beneficiaries are harmed when a government official violates the public
trust, for example, by failing to disclose that the government official
has directed the investment of the plan's assets in a pooled investment
vehicle not because of the vehicle's financial merits but rather
because the official has received a political contribution.\344\ By
engaging in such conduct, the adviser engages in a scheme to defraud
the beneficiaries of the government plan or program.\345\ Additionally,
an investment adviser to a pooled investment vehicle that is an
investment option in a government plan or program may prepare
information about the pooled investment vehicle that may be used by
plan officials to evaluate the vehicle and by pension plan
beneficiaries to decide whether to allocate assets to the vehicle. Such
an adviser engages in or facilitates an act, practice, or course of
business which is fraudulent, deceptive, or manipulative when the
adviser does not disclose that it made a contribution for the purpose
of inducing an investment by the government officials and that the

government officials sponsoring the plan chose the vehicle as an
investment option for beneficiaries not solely on the basis of its
merits, but rather as the consequence of improper quid pro quo
payments.\346\ The rule also operates to prevent an adviser from
engaging in pay to play practices indirectly through an investment pool
that it would not be permitted to do if it directly managed (or sought
to directly manage) the assets of a government entity.\347\
---------------------------------------------------------------------------

    \343\ SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009).
    \344\ Id. at 566.
    \345\ See id. at 568-69; section 206(4) of the Advisers Act. See
also Exchange Act rule 10b-5 [17 CFR 240.10b-5].
    \346\ See, e.g., Oran v. Stafford, 226 F.3d 275, 285-86 (3d Cir.
2000) (``a duty to disclose may arise when there is * * * an
inaccurate, incomplete or misleading prior disclosure''); Glazer v.
Formica Corp., 964 F.2d 149, 157 (2d Cir. 1992) (``when a
corporation does make a disclosure--whether it be voluntary or
required--there is a duty to make it complete and accurate'')
(quoting Roeder v. Alpha Industries, Inc., 814 F.2d 22, 26 (1st Cir.
1987). See also Exchange Act Rule 10b-5(b).
    \347\ See rule 206(4)-5(d). See also section 208(d) of the Act.
---------------------------------------------------------------------------

    Although a few commenters asserted that the rule or parts of it
should not apply to pooled investment vehicles,\348\ none made a
persuasive argument that the problems the rule is designed to address
are not present in the management of public pension plan and other
public monies invested in pooled investment vehicles. As we discussed
in the Proposing Release,\349\ when a decision to invest public funds
in a pooled investment vehicle is based on campaign contributions, the
public pension plan may make inferior investment choices and may pay
higher fees. And such pension plans may invest in pooled investment
vehicles that pay substantially higher advisory fees and assume
significantly greater risks than other investment alternatives.\350\
---------------------------------------------------------------------------

    \348\ See, e.g., Comment Letter of Abbott Capital Management,
LLC (Oct. 6, 2009) (``Abbott Letter''); ICI Letter; NY City Bar
Letter; SIFMA Letter; Skadden Letter; Sutherland Letter.
    \349\ See Proposing Release, at section II.A.3.(e)(2).
    \350\ See, e.g., Nanette Burns, Can Retirees Afford This Much
Risk? Business Week (Sept. 17, 2007), available at http://
www.businessweek.com/magazine/content/07_38/b4050048.htm (asserting
that public pension plan assets are increasingly being invested in
higher risk alternative investments, including hedge funds); Hannah
M. Terhune, Accounts Training, Money Science (Dec. 11, 2006),
available at http://www.moneyscience.com/Hedge_Fund_Tutorials/
Hedge_Fund_Management_and_Performance_Fees.html (noting an
``enormous difference in rewards for the managers of hedge funds
versus those of mutual funds'' because hedge fund managers are
entitled to performance fees).
---------------------------------------------------------------------------

    We find nothing in the structure of pooled investment vehicles or
the variety of investment strategies they employ that suggests a reason
for treating advisers to pooled investment vehicles differently from
advisers to separately managed advisory accounts, except, as we discuss
below, registered investment companies to which we apply a more limited
version of the rule. That an investment in a pooled investment vehicle
may not involve a direct advisory relationship with a government
sponsored plan does not change the nature of the fraud or the harm that
may be inflicted as a consequence of the adviser's pay to play
activity.
    Indeed, many of our recent enforcement cases alleged political
contributions or kickbacks designed to induce public officials to
invest public pension plan assets in pooled investment vehicles.\351\
We are concerned that our failure to apply the rule to advisers who
manage assets through these vehicles would ignore an area where there
has been considerable growth, both in the amount of public assets
invested in such pooled investment vehicles and allegations of pay to
play activity involving public pension plans.\352\ We believe a failure
to apply the rule in this area could, in some cases, even encourage the
use of covered investment pools as a means of avoiding application of
the rule.
---------------------------------------------------------------------------

    \351\ See, e.g., SEC v. Paul J. Silvester, et al., Litigation
Release No. 16759, Civil Action No. 3:00-CV-19411 DJS (D. Conn.)
(Oct. 10, 2000) (action in which investment adviser allegedly paid
third-party solicitors who kicked back a portion of the money to the
former Connecticut State Treasurer in order to obtain public pension
fund investments in a hedge fund managed by the adviser); SEC v.
William A. DiBella, et al., Litigation Release No. 20498, Civil
Action No. 3:04 CV 1342 (EBB) (D. Conn.) (Mar. 14, 2008) (consultant
was found to have aided and abetted the former Connecticut State
Treasurer in a pay to play scheme involving an investment adviser to
a private equity fund who had paid third-party solicitors to obtain
public pension fund investments in the fund). There are examples of
pay to play activity in the context of pooled investment vehicles in
other jurisdictions as well. See, e.g., supra note 18 (listing
various actions relating to the recent pay to play allegations
surrounding the New York Common Retirement Fund). See also Guilty
Plea in Fraud Case Tied to New York Pension, Associated Press (Dec.
4, 2009), available at hhttp://www.nytimes.com/2009/12/04/nyregion/
04pension.html (describing the guilty plea of an adviser to a
venture capital fund to charges that he helped his company land a
lucrative deal with New York's public pension fund by giving nearly
$1 million worth of illegal gifts to State officials).
    \352\ See, e.g., Investment Company Institute, 529 Plan Program
Statistics, Mar. 2009 (Feb. 5, 2010), available at http://
www.ici.org/research/stats/529s/529s_03-09 (indicating that 529
plan assets have increased from $8.6 billion in 2000 to $100.3
billion in the first quarter of 2009, and that 529 plan accounts
have increased from 1.3 million in 2000 to 11.2 million in the first
quarter of 2009); Investment Company Institute, The U.S. Retirement
Market, 2008, 18 Research Fundamentals, No. 5 (June 2009), available
at http://www.ici.org/pdf/fm-v18n5.pdf (indicating that 403(b) plan
and 457 plan assets have increased from $627 billion in 2000 to $712
billion in the fourth quarter of 2008); SEI, Collective Investment
Trusts: The New Wave in Retirement Investing (May 2008), available
at https://longjump.com/networking/
RepositoryPublicDocDownload?id=80031025axe139509557&docname=SEI%20CIT
%20White%20Paper%205.08.pdf&cid=80031025&encode=application/pdf
(citing Morningstar data indicating that collective investment trust
assets nearly tripled from 2004 to 2007 and grew by more than 150
percent between 2005 and 2007 alone). See also Michael Marois,
CalPERS, Blackstone Clash over Placement Agent `Jackpot' Fees,
Bloomberg (Apr. 7, 2010), available at http://www.bloomberg.com/
apps/news?pid=newsarchive&sid=acPNrTn1q7pw (noting that placement
agents working for private equity, hedge funds, venture capital and
real estate firms typically earn the equivalent of 0.5 percent to 3
percent of the money they place under the management of their
client, quoting California State Treasurer Bill Lockyer, a member of
the CalPERS board, ``[t]he contingency fees are too much of a
jackpot for the placement agents * * * [they] invite corrupt
practices'').
---------------------------------------------------------------------------

    Nonetheless, as described in more detail below, we have made
several changes from the proposal to more narrowly tailor the
applicability of the rule to pooled investment vehicles in order to
achieve our regulatory purpose while reducing compliance burdens that
commenters brought to our attention. In addition, we have made certain
clarifying changes to the rule, as described below.
(1) Definition of ``Covered Investment Pool''
    Under the rule, a ``covered investment pool'' \353\ includes: (i)
Any investment company registered under the Investment Company Act of
1940 that is an investment option of a plan or program of a government
entity; or (ii) any company that would be an investment company under
section 3(a) of that Act but for the exclusion provided from that
definition by section 3(c)(1), section 3(c)(7) or section 3(c)(11) of
that Act.\354\ Accordingly, it includes such unregistered pooled
investment vehicles as hedge funds, private equity funds, venture
capital funds and collective investment trusts.\355\ It also

includes registered pooled investment vehicles, such as mutual funds,
but only if those registered pools are an investment option of a
participant-directed plan or program of a government entity.\356\ These
plans or programs may include college savings plans like ``529 plans''
\357\ and retirement plans like ``403(b) plans'' \358\ and ``457
plans'' \359\ that typically allow participants to select among pre-
established investment ``options,'' or particular investment pools
(often invested in registered investment companies or funds of funds,
such as target date funds), that a government official has directly or
indirectly selected to include as investment choices for
participants.\360\
---------------------------------------------------------------------------

    \353\ Rule 206(4)-5(f)(3).
    \354\ 15 U.S.C. 80a-3(c)(1), (7) or (11). We note that a bank
maintaining a collective investment trust would not be subject to
the rule if the bank falls within the exclusion from the definition
of ``investment adviser'' in section 202(a)(11)(A) of the Advisers
Act [15 U.S.C. 80b-2(a)(11)(A)]. A non-bank adviser that provides
advisory services with respect to a collective investment trust in
which a government entity invests, however, would be subject to the
rule's prohibitions with respect to all of its government entity
clients, including the collective investment trust in which a
government entity invests, unless another exemption is available.
    \355\ One commenter questioned the Commission's authority to
apply the rule in the context of covered investment pools in light
of the opinion of the Court of Appeals for the District of Columbia
Circuit in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
Sutherland Letter. That case created some uncertainty regarding the
application of sections 206(1) and 206(2) of the Advisers Act in
certain cases where investors in a pool are defrauded by an
investment adviser to that pool. See Prohibition of Fraud by
Advisers to Certain Pooled Investment Vehicles, Investment Advisers
Act Release No. 2628 (Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)],
(adopting rule 206(4)-8 [17 CFR 275.206(4)-8]). In addressing the
scope of the exemption from registration in section 203(b)(3) of the
Advisers Act and the meaning of ``client'' as used in that section,
the Court of Appeals expressed the view that, for purposes of
sections 206(1) and (2), the ``client'' of an investment adviser
managing a pool is the pool itself, not an investor in the pool. In
its opinion, the Court of Appeals distinguished sections 206(1) and
(2) from section 206(4) of the Advisers Act, which applies to
persons other than clients. Id. at n.6. See also United States v.
Elliott, 62 F.3d 1304, 1311 (11th Cir. 1995). Section 206(4) permits
us to adopt rules proscribing fraudulent conduct that is potentially
harmful to investors in pooled investment vehicles. We are adopting
rule 206(4)-5 under this authority.
    \356\ Rule 206(4)-5(f)(8).
    \357\ A 529 plan is a ``qualified tuition plan'' established
under section 529 of the Internal Revenue Code of 1986 [26 U.S.C.
529]. States generally establish 529 plans as State trusts which are
considered instrumentalities of States for Federal securities law
purposes. As a result, the plans themselves are generally not
regulated under the Federal securities laws and many of the
protections of the Federal securities laws do not apply to investors
in them. See section 2(b) of the Investment Company Act [15 U.S.C.
80a-2(b)] and section 202(b) of the Advisers Act [15 U.S.C. 80b-
2(b)] (exempting State-owned entities from those statutes). However,
the Federal securities laws do generally apply to, and the
Commission does generally regulate, the brokers, dealers, and
municipal securities dealers that effect transactions in interests
in 529 plans. See generally sections 15(a)(1) and 15B of the
Exchange Act [15 U.S.C. 78a-15(a)(1) and 15B]. A bank effecting
transactions in 529 plan interests may be exempt from the definition
of ``broker'' or ``municipal securities dealer'' under the Exchange
Act if it can rely on an exception from the definition of broker in
the Exchange Act. In addition, State sponsors of 529 plans may hire
third-party investment advisers either to manage 529 plan assets on
their behalf or to act as investment consultants to the agency
responsible for managing plan assets. These investment advisers,
unless they qualify for a specific exemption from registration under
the Advisers Act, are generally required to be registered with the
Commission as investment advisers and would therefore be subject to
our rule.
    \358\ A 403(b) plan is a tax-deferred employee benefit
retirement plan established under section 403(b) of the Internal
Revenue Code of 1986 [26 U.S.C. 403(b)].
    \359\ A 457 plan is a tax-deferred employee benefit retirement
plan established under section 457 of the Internal Revenue Code of
1986 [26 U.S.C. 457].
    \360\ We would consider a registered investment company to be an
investment option of a plan or program of a government entity where
the participant selects a model fund or portfolio (such as an age-
based investment option of a 529 plan) and the government entity
selects the specific underlying registered investment company or
companies in which the portfolio's assets are invested.
---------------------------------------------------------------------------

    We proposed to include in the definition of ``covered investment
pool'' the types of pooled investment vehicles that are likely to be
used as funding vehicles for, or investments of, government-sponsored
savings and retirement plans. We explained that we included registered
investment companies because of the significant growth in government-
sponsored savings plans in recent years, which increasingly use these
funds as investment options,\361\ and the increased competition among
advisers for selection of their fund as an investment option for these
plans.\362\ We were concerned that advisers to pooled investment
vehicles, including registered investment companies, may make political
contributions to influence the decision by government officials to
include their funds as options in such plans.
---------------------------------------------------------------------------

    \361\ See supra note 352 and accompanying text.
    \362\ See, e.g., Charles Paikert, TIAA-CREF Stages Comeback in
College Savings Plans, Crain's New York Bus., Apr. 23, 2007
(depicting TIAA-CREF's struggle to remain a major player in managing
State 529 plans because of increasing competition from the
industry's heavyweights); Beth Healy, Investment Giants Battle for
Share of Exploding College-Savings Market, Boston Globe, Oct. 29,
2000, at F1 (describing the increasing competition between
investment firms for State 529 plans and increasing competition to
market their plans nationally). See also AnnaMaria Andriotis, 529
Plan Fees are Dropping, SmartMoney, Dec. 16, 2009, available at
http://www.smartmoney.com/personal-finance/college-planning/529-
plan-fees-are-dropping-but-for-how-long/?hpadref=1 (``Costs on these
plans are falling for a few reasons, and the biggest one has little
to do with the State of the economy: The nature of their contracts
creates competition. When a contract for a State 529 plan expires,
program managers compete against each other and may lower their fees
to try to secure the new contract.'').
---------------------------------------------------------------------------

    We recognized in our proposal, however, that an adviser to a
registered investment company might have difficulty in identifying when
or if a government investor was a fund shareholder for purposes of
preventing the adviser (or its covered associates) from making
contributions that would trigger a two-year time out.\363\ Therefore,
we proposed to only include publicly offered registered investment
companies in the definition of covered investment pool for purposes of
the two-year time out provision to the extent they were investments or
investment options of a plan or program of a government entity.\364\
---------------------------------------------------------------------------

    \363\ See Proposing Release, at nn. 185-87 and accompanying
text.
    \364\ See proposed rule 206(4)-5(f)(3) (``Covered investment
pool means any investment company, as defined in section 3(a) of the
Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) * * * except
that for purposes of paragraph (a)(1) of this section, an investment
company registered under the Investment Company Act of 1940 (15
U.S.C. 80a), the shares of which are registered under the Securities
Act of 1933 (15 U.S.C. 77a), shall be a covered investment pool only
if it is an investment or an investment option of a plan or program
of a government entity.'').
---------------------------------------------------------------------------

    Several commenters asserted that an adviser to a publicly offered
investment company would have similar difficulties in identifying
government investors in registered investment companies for purposes of
complying with other provisions of the rule.\365\ One opposed
application of the rule to registered investment companies ``even if
the [company] is not included in a plan or program of a government
entity,'' \366\ although several generally urged us to exclude
registered investment companies from the rule altogether.\367\ Another
commenter urged us to apply the rule's recordkeeping requirements
(discussed below) prospectively and after a period of time that would
be adequate to enable funds to redesign their processes and systems to
capture information about whether an investor is a ``government
entity,'' which would be necessary to comply with the rule and our
proposed amendment to the Act's recordkeeping rule.\368\ Some noted
that identifying government investors would be particularly challenging
when shares were held through an intermediary.\369\
---------------------------------------------------------------------------

    \365\ See Davis Polk Letter; Fidelity Letter; ICI Letter; NSCP
Letter; Comment Letter of Standard & Poor's Investment Advisory
Services LLC and Standard & Poor's Securities Evaluations, Inc.
(Oct. 5, 2009) (``S&P Letter''); SIFMA Letter; T. Rowe Price Letter.
    \366\ T. Rowe Price Letter.
    \367\ Fidelity Letter; ICI Letter; NSCP Letter; SIFMA Letter. We
disagree that registered investment companies should be excluded
from our rule. Pay to play activity is fraudulent, regardless of
whether it occurs in the context of a pooled investment vehicle or a
separately managed account. One commenter asserted that the
existence of a regulatory regime applicable to investment companies
precludes the need for pay to play prohibitions with respect to
these pools. See ICI Letter. However, existing laws and regulations
applicable to investment companies do not specifically address pay
to play practices.
    \368\ ICI Letter. See also section II.D of this Release.
    \369\ See T. Rowe Price Letter; ICI Letter, Fidelity Letter.
---------------------------------------------------------------------------

    We continue to believe for the reasons discussed above \370\ and in
the Proposing Release, that advisers to registered investment companies
should be subject to the rule. In response to comments, we have
modified our

proposal to include a registered investment company in the definition
of covered investment pool, for purposes of all three of the rule's pay
to play prohibitions, but only if it is an investment option of a plan
or program of a government entity.\371\ We believe this approach
strikes the right balance between applying the rule in those contexts,
discussed in the Proposing Release,\372\ in which advisers to
registered investment companies may be more likely to engage in pay to
play conduct, while recognizing the compliance challenges relating to
identifying government investors in registered investment companies
\373\ that may result from a broader application of the rule. When an
adviser's investment company is an investment option in a participant-
directed government plan or program, we believe it is reasonable to
expect the adviser will know (or can reasonably be expected to acquire
information about) the identity of the government plan.\374\ We
recognize that when shares are held through an intermediary, an adviser
may have to take additional steps to identify a government entity.\375\
Therefore, we have provided advisers to registered investment companies
with additional time to modify current systems and processes.\376\
---------------------------------------------------------------------------

    \370\ See supra notes 361-362 and accompanying text.
    \371\ Rule 206(4)-5(f)(3).
    \372\ Proposing Release, at nn.185-87 and accompanying text. See
also supra notes 352 and 362 and accompanying text (describing the
growth in government-sponsored savings plans in recent years and the
increased competition for an adviser's fund to be selected as an
investment option of such a plan).
    \373\ Identifying government investors in other types of covered
investment pools does not generally present similar compliance
challenges. See, e.g., rule 2(a)(51) under the Investment Company
Act [17 CFR 270.2(a)(51)] (defining ``qualified purchaser,'' as that
term is used in section 3(c)(7) of that Act); Rule 501(a) of
Regulation D under the Securities Act of 1933 (``Securities Act'')
[17 CFR 230.501(a)] (defining ``accredited investor'' for purposes
of limited offerings without registration under the Securities Act
of 1933); and Advisers Act rule 205-3 (creating an exception from
the prohibition against an adviser receiving performance-based
compensation from clients that are not ``qualified clients,'' and
which is relied on by many advisers to funds that are exempt from
Investment Company Act registration under section 3(c)(1) of that
Act).
    \374\ With respect to a 529 plan, for example, an adviser would
know that its investment company is an investment option of the plan
and will know the identity of the government entity investor because
a 529 plan can only be established by a State, which generally
establishes a trust to serve as the direct investor in the
investment company, while plan participants invest in various
options offered by the 529 trust. The rule does not require an
adviser to identify plan participants, only the government plan or
program. See rule 206(4)-5(f)(5)(iii) (defining a ``government
entity'' to include a plan or program of a government entity. The
definition does not include the participants in those plans or
programs).
    \375\ For example, while 403(b) plans and 457 plans are
generally associated with retirement plans for government employees,
they are not used exclusively for this purpose. For instance,
certain non-profit or tax-exempt entities can establish these types
of plans. We also understand that it is not uncommon for
contributions of 403(b) and 457 plans to be commingled into an
omnibus position that is forwarded to the fund, making it more
challenging for an adviser to distinguish government entity
investors from others.
    \376\ See section III.D of this Release. We received several
letters addressing this concern. ICI Letter; T. Rowe Price Letter;
Fidelity Letter.
---------------------------------------------------------------------------

    We have also made several minor changes from our proposal intended
to clarify and simplify application of the rule. First, at the
suggestion of commenters,\377\ we are clarifying that an adviser to a
registered investment company is only subject to the rule--i.e., the
investment company is only considered a covered investment pool--if the
investment company is an investment option of a plan or program of a
government entity that is participant-directed.\378\ This change
reflects our intent, as demonstrated by the examples we give in the
definition (i.e., 529 plans, 403(b) plans, and 457 plans) that the
definition is intended to encompass those covered investment pools that
have been pre-selected by the government sponsoring or establishing the
plan or program as part of a limited menu of investment options from
which participants in the plan or program may allocate their account.
We have also added, as additional examples to the definition of
``government entity,'' a defined benefit plan and a State general fund
to better distinguish these pools of assets from a plan or program of a
government entity.\379\ We have also made minor organizational changes
within the definition of government entity from our proposal to make
clear that such pools are not ``plans or programs of a government
entity.''
---------------------------------------------------------------------------

    \377\ See, e.g., ICI Letter; Davis Polk Letter; SIFMA Letter.
    \378\ Rule 206(4)-5(f)(8).
    \379\ Rule 206(4)-5(f)(5).
---------------------------------------------------------------------------

    Finally, we have simplified the definition of ``covered investment
pool'' as it applies to registered investment companies. The definition
as adopted includes investment companies registered under the
Investment Company Act that are an option of a plan or program of a
government entity, regardless of whether, as proposed, their shares are
registered under the Securities Act of 1933 (``1933 Act''). As
discussed above, under the rule as adopted an adviser to a registered
investment company is only subject to the rule if the company is an
investment option of a plan or program. As a result, we believe it is
unnecessary to distinguish between registered investment companies
based on whether their shares are registered under the 1933 Act,
although we understand that those shares will typically be registered
where the fund is an option in a plan or program of a government
entity.
(2) Application of the Rule
    Under rule 206(4)-5 (and as proposed) an investment adviser is
subject to the two-year time out if it manages a covered investment
pool in which the assets of a government entity are invested.\380\ The
rule does not require a government entity's withdrawal of its
investment or cancellation of any commitment it has made. Indeed, the
rule prohibits advisers not from providing advice subsequent to a
triggering political contribution, but rather from receiving
compensation for providing advice. If a government entity is an
investor in a covered investment pool at the time a contribution
triggering a two-year ``time out'' is made, the adviser must forgo any
compensation related to the assets invested or committed by that
government entity.\381\
---------------------------------------------------------------------------

    \380\ Rule 206(4)-5(c).
    \381\ As we noted above and in the Proposing Release, the phrase
``for compensation'' includes both profits and the recouping of
costs, so an adviser is not permitted to continue to manage assets
at cost after a disqualifying contribution is made. Proposing
Release, at n.191. See also supra note 137 and accompanying text. As
we discussed above in section II.B.2(a)(1) of this Release, we are
not persuaded by commenters who suggested permitting the adviser to
be compensated at cost following payment of a triggering
contribution or payment. See, e.g., Dechert Letter; NY City Bar
Letter. In our judgment, the potential loss of profits from the
government client alone may be insufficient to deter pay to play
activities. However, costs specifically attributable to the covered
investment pool and not normally incurred in connection with a
separately managed account, such as costs attributable to an annual
audit of the pool's assets and delivery of its audited financial
statements, would not be considered compensation to the adviser for
these purposes.
---------------------------------------------------------------------------

    Application of the two-year time out may present different issues
for covered investment pools than for separately managed accounts due
to various structural and legal differences. Having made a contribution
triggering the two-year time out, the adviser may have multiple options
available to comply with the rule in light of its fiduciary obligations
and the disclosure it has made to investors. For instance, in the case
of a private pool, the adviser could seek to cause the pool to redeem
the investment of the government entity.\382\

Such redemptions may be relatively simple matters in the case of, for
example, a highly liquid private pool.\383\ Commenters pointed out to
us that, for some private pools, such as venture capital and private
equity funds, a government entity's withdrawal of its capital or
cancellation of its commitment may have adverse implications for other
investors in the fund.\384\ In such cases, 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 assets
of the government client.\385\
---------------------------------------------------------------------------

    \382\ To the extent the adviser may seek to cause the private
pool to redeem the investment of a government entity investor under
these circumstances, it should consider disclosing this as an
investment risk in a private placement memorandum, prospectus or
other disclosure document to current and prospective investors in
such a fund. See, e.g., Rule 502 of Regulation D under the
Securities Act [17 CFR 230.502] (addressing disclosure obligations
for non-accredited investors who purchase securities in a limited
offering pursuant to rules 505 or 506 of Regulation D under the
Securities Act [17 CFR 230.505 or 17 CFR 230.506].
    \383\ We understand that other types of pooled investment
vehicles, including private equity and venture capital funds,
already have special withdrawal and transfer provisions related to
the regulatory and tax considerations applicable to certain types of
investors, such as those regulated by the Employee Retirement Income
Security Act of 1974 (``ERISA'') [29 U.S.C. 18]. See generally James
M. Schell, Private Equity Funds--Business Structure and Operations
(Law Journal Press 2000) (2010).
    \384\ See Abbott Letter; ICI Letter; NY City Bar Letter.
    \385\ As we noted in the Proposing Release, some commenters to
our 1999 Proposal asserted that a performance fee waiver raises
various calculation issues. See Proposing Release, at n.192. An
adviser making a disqualifying contribution could comply with rule
206(4)-5 by waiving a performance fee or carried interest determined
on the same basis as the fee or carried interest is normally
calculated--e.g., on a mark-to-market basis. For arrangements like
those typically found in private equity and venture capital funds
where the fee or carry is calculated based on realized gains and
losses and mark-to-market calculations are not feasible, advisers
could use a straight-line method of calculation which assumes that
the realized gains and losses were earned over the life of the
investment.
---------------------------------------------------------------------------

    For registered investment companies, the options for restricting
compensation involving government investors are more limited, due to
both Investment Company Act provisions and potential tax
consequences.\386\ In our proposal, we suggested one approach that
would meet the requirements of the rule--an adviser of a registered
investment company could waive its advisory fee for the fund as a whole
in an amount approximately equal to fees attributable to the government
entity.\387\ One commenter agreed with our approach,\388\ while another
commenter suggested we could, alternatively, permit the government
entity to continue to pay its portion of the advisory fee, but require
the adviser to rebate that portion of the fee to the fund as a
whole.\389\ We believe either approach would meet the requirements of
the rule we are adopting today.
---------------------------------------------------------------------------

    \386\ See Proposing Release, at n.193 and accompanying text.
See, e.g., rule 18f-3 under the Investment Company Act [17 CFR
270.18f-3]. Moreover, other regulatory considerations, such as those
under ERISA, may impact these arrangements with respect to
collective investment trusts.
    \387\ This may also be done at the class level or series level
for private funds organized as corporations.
    \388\ ICI Letter.
    \389\ NY City Bar Letter.
---------------------------------------------------------------------------

(3) Subadvisory Arrangements
    A number of commenters urged that we exclude from the rule
subadvisers to covered investment pools because, being in a subordinate
role to the adviser, they may have no involvement in the adviser's
solicitation activities including no ability to identify government
entities being solicited, and therefore should not be held accountable
for the adviser's actions.\390\ None of these commenters, however,
indicated that a subadviser could not obtain from the adviser the
information necessary to comply with the rule. Additionally, no
commenter provided us with a basis to distinguish advisers from
subadvisers that would be adequate to avoid undermining the
prophylactic nature of our rule. ``Subadviser'' is not defined under
the Act,\391\ and significant variation exists in subadvisory
relationships.\392\ There is no readily available way to draw
meaningful distinctions between advisers and subadvisers by, for
example, looking at who controls marketing and solicitation
activities,\393\ who has an advisory contract directly with the
government client,\394\ or other factors. In addition, subadvisers
generally have the same economic incentives as advisers to obtain new
business and increase assets under management. We are concerned that
under the approaches suggested by commenters, an adviser that sought to
avoid compliance with the prophylactic provisions of our rule and
engage in pay to play could organize itself to operate as a subadviser
in such an arrangement. We therefore believe it is not appropriate to
exclude subadvisers from the rule.
---------------------------------------------------------------------------

    \390\ See, e.g., IAA Letter; S&P Letter; Skadden Letter; Davis
Polk Letter.
    \391\ ``Subadviser'' also is not defined under the Investment
Company Act, which requires that both advisory and subadvisory
contracts (``which contract, whether with such registered company or
with an investment adviser of such registered company * * * '') be
approved by a vote of a majority of the outstanding voting
securities of the registered investment company. See section 15(a)
of the Investment Company Act [15 U.S.C. 80a-15(a)].
    \392\ See, e.g., Investment Company Institute, Board Oversight
of Subadvisers (Jan. 2010), available at http://www.ici.org/pdf/
idc_10_subadvisers.pdf (providing guidance to mutual fund boards
of directors with respect to overseeing subadvisory arrangements and
recognizing that ``there is no one `correct' approach to effective
subadvisory oversight by fund boards'' because there are a wide
variety of potential subadvisory arrangements).
    \393\ See, e.g., Davis Polk Letter (suggesting that we limit the
application of the prohibitions to a subadviser to a covered
investment pool that has the ability to control the soliciting,
marketing or acceptance of government clients); S&P Letter
(suggesting that we limit the application of the prohibitions to a
subadviser to a covered investment pool that: (1) Has the ability to
control the soliciting, marketing or acceptance of government
clients; and (2) is not a related person of the investment adviser
or distributor or other investment pool).
    \394\ See, e.g., IAA Letter; Skadden Letter. See also sections
2(a)(20) and 15(a) of the Investment Company Act (treating a
subadviser as an adviser to a registered investment company even in
the absence of a direct contractual relationship with the investment
company).
---------------------------------------------------------------------------

    We are, however, providing some guidance that may assist advisers
in subadvisory and fund of funds arrangements in complying with the
rule.\395\ First, by the terms of the rule, if an adviser or subadviser
makes a contribution that triggers the two-year time out from receiving
compensation, the subadviser or adviser, as applicable, that did not
make the triggering contribution could continue to receive compensation
from the government entity,\396\ unless the arrangement were a means to
do indirectly what the adviser or subadviser could not do directly
under the rule.\397\ Second, advisers to underlying funds in a fund of
funds arrangement are not required to look through the investing fund
to determine whether a government entity is an investor in the
investing fund unless the investment were made in that manner as a
means for the adviser to do indirectly

what it could not do directly under the rule.\398\
---------------------------------------------------------------------------

    \395\ See, e.g., IAA Letter (requesting clarification as to how
the rule would apply when an adviser becomes subject to the
compensation ban after hiring a subadviser or vice versa). See also
Fidelity Letter; MFA Letter; SIFMA Letter (each expressing concern
about how the rule would apply in the fund of funds context).
    \396\ We understand that, under some advisory arrangements, the
government entity has a contract only with the adviser and not the
subadviser. Under those circumstances, it would be consistent with
the rule for an adviser that has triggered the two-year time out to
pass through to the subadviser that portion of the fee to which the
subadviser is entitled, as long as the adviser retains no
compensation from the government entity and the subadviser (and its
own covered associates) has not triggered a time out as well.
    \397\ See Rule 206(4)-5(d). For instance, an adviser that hires
an affiliated subadviser to manage a covered investment pool in
which a government entity invests so that the adviser could make
contributions to that government entity would be doing indirectly
what it would be prohibited from doing directly under the rule. A
subadviser would be providing ``investment advisory services for
compensation to a government entity'' regardless of whether the
subadviser is paid directly by the government entity or by the
adviser.
    \398\ See rule 206(4)-5(d).
---------------------------------------------------------------------------

    (f) Exemptions
    An adviser may apply to the Commission for an order exempting it
from the two-year compensation ban.\399\ Under this provision, which we
are adopting as proposed, we can exempt advisers from the rule's time
out requirement where the adviser discovers contributions that trigger
the compensation ban only after they have been made, and when
imposition of the prohibition is unnecessary to achieve the rule's
intended purpose. This provision will provide advisers with an
additional avenue by which to seek to cure the consequences of an
inadvertent violation by the adviser that falls outside the limits of
the rule's de minimis exception and exception for returned
contributions,\400\ such as when a disgruntled employee makes a greater
than $350 contribution as he or she exits the firm. In determining
whether to grant an exemption, we will take into account the varying
facts and circumstances that each application presents. Among other
factors, we will consider: (i) whether the exemption is necessary or
appropriate in the public interest and consistent with the protection
of investors and the purposes fairly intended by the policy and
provisions of the Advisers Act; (ii) whether the investment adviser,
(A) before the contribution resulting in the prohibition was made,
adopted and implemented policies and procedures reasonably designed to
prevent violations of rule 206(4)-5; (B) prior to or at the time the
contribution which resulted in such prohibition was made, had no actual
knowledge of the contribution; and (C) after learning of the
contribution, (1) has taken all available steps to cause the
contributor involved in making the contribution which resulted in such
prohibition to obtain a return of the contribution; and (2) has taken
such other remedial or preventive measures as may be appropriate under
the circumstances; (iii) whether, at the time of the contribution, the
contributor was a covered associate or otherwise an employee of the
investment adviser, or was seeking such employment; (iv) the timing and
amount of the contribution which resulted in the prohibition; (v) the
nature of the election (e.g., Federal, State or local); and (vi) the
contributor's apparent intent or motive in making the contribution
which resulted in the prohibition, as evidenced by the facts and
circumstances surrounding such contribution.\401\ We intend to apply
these factors with sufficient flexibility to avoid consequences
disproportionate to the violation, while effecting the policies
underlying the rule.
---------------------------------------------------------------------------

    \399\ Rules 0-4, 0-5, and 0-6 under the Advisers Act [17 CFR
275.0-4, 0-5, and 0-6] provide procedures for filing applications
under the Act, including applications under the rule 206(4)-5.
    \400\ See sections II.B.2(a)(6) and (7) of this Release,
describing exceptions to the two-year time out prohibition of the
rule.
    \401\ See Rule 206(4)-5(e). These factors are similar to those
considered by FINRA and the appropriate bank regulators in
determining whether to grant an exemption under MSRB rule G-37(i).
---------------------------------------------------------------------------

    We received limited comment on this provision. A few commenters
suggested that the operation of the rule should toll until a decision
is made about an applicant's request.\402\ We are concerned that such
an approach could encourage frivolous applications and encourage
applicants to delay the disposition of their applications. As we
explained in the Proposing Release, an adviser seeking an exemption
could place into an escrow account any advisory fees earned between the
date of the contribution triggering the prohibition and the date on
which we determine whether to grant an exemption.\403\ Some commenters
recommended the rule build in a specified length of time for the
Commission to respond to requests for relief.\404\ We recognize that
applications for an exemptive order will be time-sensitive and will
consider such applications expeditiously. We note that the escrow
arrangements discussed above may lessen the hardship on advisers.
---------------------------------------------------------------------------

    \402\ ICI Letter; Skadden Letter.
    \403\ See Proposing Release, at n.199. The escrow account would
be payable to the adviser if the Commission grants the exemption. If
the Commission does not grant the exemption, the fees contained in
the account would be returned to the government entity client. In
contrast, MSRB rule G-37, on which rule 206(4)-5 is based, does not
permit a municipal securities dealer to continue to engage in
municipal securities business with an issuer while an application is
pending. See MSRB Rule G-37 Q&A, Question V.1.
    \404\ IAA Letter; ICI Letter; NASP Letter (each suggesting all
applications be granted if they are not acted upon in 30 days);
Skadden Letter (suggesting a 45-day deadline).
---------------------------------------------------------------------------

D. Recordkeeping

    We are adopting amendments to rule 204-2 to require registered
investment advisers that have government clients, or that provide
investment advisory services to a covered investment pool in which a
government entity investor invests, to make and keep certain records
that will allow us to examine for compliance with new rule 206(4)-
5.\405\ The rule amendments reflect several changes from our proposal,
which are discussed below. These requirements are similar to the MSRB
recordkeeping requirements for brokers, dealers and municipal
securities dealers.\406\
---------------------------------------------------------------------------

    \405\ Rule 204-2(a)(18) and (h)(1). An adviser is required to
make and keep these records only if it provides investment advisory
services to a government entity or if a government entity is an
investor in any covered investment pool to which the investment
adviser provides investment advisory services. Advisers that solicit
government clients on behalf of other advisers are also subject to
the amended recordkeeping requirements. Advisers that are exempt
from Commission registration under section 203(b)(3) of the Advisers
Act, however, are not subject to the recordkeeping requirements
under amended 204-2 unless they do register with us, although as
discussed earlier, supra note 92 and accompanying text, they are
subject to rule 206(4)-5. Advisers keeping substantially the same
records under rules adopted by the MSRB are not required to keep
duplicate records. Rule 204-2(h)(1).
    \406\ MSRB rule G-8(a)(xvi). The MSRB also requires certain
records to be made and kept in accordance with disclosure
requirements that our rule does not contain.
---------------------------------------------------------------------------

    Amended rule 204-2 requires registered advisers that provide
investment advisory services to a government entity, or to a covered
investment pool in which a government entity is an investor, to make
and keep records of contributions made by the adviser and covered
associates to government officials (including candidates), and of
payments to State or local political parties and PACs.\407\ The
adviser's records of contributions and payments must be listed in
chronological order identifying each contributor and recipient, the
amounts and dates of each contribution or payment and whether a
contribution was subject to rule 206(4)-5's exception for certain
returned contributions.\408\ The rule also requires an adviser that has
government clients to make and keep a list of its covered
associates,\409\ and the government entities to which the adviser has
provided advisory services in the past five years.\410\ Similarly,
advisers to covered investment pools must make and keep a list of
government entities that invest, or have invested in the past five
years, in a covered investment pool, including any government entity
that selects a covered investment pool to be an option of a plan or
program of a government entity, such as a 529, 457 or 403(b)

plan.\411\ An investment adviser, regardless of whether it currently
has a government client, must also keep a list of the names and
business addresses of each regulated person to whom the adviser
provides or agrees to provide, directly or indirectly, payment to
solicit a government entity on its behalf.\412\ The amended rule
reflects several changes from our proposal, which we describe below.
---------------------------------------------------------------------------

    \407\ Contributions and payments by PACs controlled by the
adviser or a covered associate would also have to be recorded as
these PACs are ``covered associates'' under the rule. Rule 206(4)-
5(f)(2)(iii). See section II.B.2(a)(4) of this Release.
    \408\ Rule 204-2(a)(18)(ii).
    \409\ The adviser must record the name, title(s), and business
and residence addresses of each covered associate. Rule 204-
2(a)(18)(i)(A).
    \410\ Advisers do not have to maintain a record of government
entities that were clients before the effective date. For additional
information regarding the implementation of rule 206(4)-5, see
section III of this Release.
    \411\ Amended rule 204-2 does not require an adviser to a
covered investment pool that is an option of a government plan or
program to make and keep records of participants in the plan or
program, but only the government entity. See supra note 374.
Consistent with changes we have made to the definition of covered
investment pool, we note that an adviser's recordkeeping obligations
with respect to a registered investment company apply only if such
an investment company is an option of a plan or program of a
government entity. See section II.B.2(e) of this Release.
    \412\ Rule 204-2(a)(18)(i)(D).
---------------------------------------------------------------------------

    First, in response to comments,\413\ we have limited the rule to
provide that only records of contributions,\414\ not payments,\415\ to
government officials and candidates are required to be kept under the
rule.\416\ We have made this change because, unlike contributions,
which are one type of payment, all payments do not trigger the two-year
time out. As a result of this change, the recordkeeping obligations
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.
Commenters also argued that we should not require, as proposed,
advisers to maintain records of payments to PACs.\417\ Although those
payments do not trigger application of the two-year time out, payments
to PACs can be a means for an adviser or covered associate to funnel
contributions to a government official without directly contributing.
We are, therefore, adopting the amendment to require advisers to keep
records of payments to PACs as these records will allow our staff to
identify situations that might suggest an intent to circumvent the
rule.\418\
---------------------------------------------------------------------------

    \413\ Fidelity Letter; IAA Letter; SIFMA Letter.
    \414\ See supra note 153 and accompanying text (defining
``contribution'').
    \415\ See supra note 331 (defining ``payment'').
    \416\ Rule 204-2(a)(18)(i)(C).
    \417\ See, e.g., IAA Letter; SIFMA Letter.
    \418\ Accordingly, as part of a strong compliance program, an
adviser or covered associate that receives a general solicitation to
make a contribution to a PAC should consider inquiring about how the
collected funds would be used to determine whether the PAC is
closely associated with a government official to whom a direct
contribution would subject the adviser to the two-year time out. See
section II.B.2(d) of this Release and rule 206(4)-5(d). The MSRB
takes a similar approach regarding whether a payment to a PAC is an
indirect contribution to a government official. See MSRB Rule G-37
Q&A, Questions III.4 and III.5.
---------------------------------------------------------------------------

    Second, an investment adviser to a registered investment company
must maintain records identifying government entity investors only if
the investments are made as part of a plan or program of a government
entity or provide participants in the plan or program with the option
of investing in the fund.\419\ This change would narrow the records
required to those necessary to support the rule as modified from our
proposal, and we believe addresses commenters' concerns regarding the
ability of advisers to registered investment companies to identify
government entity investors.\420\ As discussed above, we believe it is
reasonable to expect advisers to know the identity of the government
entity when a registered fund they advise is part of a plan or program.
In addition, as commenters suggested, we are providing a substantial
transition period for advisers to registered investment companies that
should allow these advisers to make the necessary changes to account
documents and systems to allow them to identify government entities
that provide one or more of the investment companies they advise as an
investment option.\421\
---------------------------------------------------------------------------

    \419\ Rule 204-2(a)(18)(i)(B). Amended rule 204-2 does not
require an adviser to a covered investment pool that is an option of
a government plan or program to make and keep records of
participants in the plan or program, but only the government entity.
For a discussion of the application of the rule to a covered
investment pool that is an option of a government plan or program,
see supra note 371 and accompanying text. Consistent with changes we
have made to the definition of covered investment pool, we note that
an adviser's recordkeeping obligations with respect to a registered
investment company apply only if such an investment company is an
option of a plan or program of a government entity. See section
II.B.2(e) of this Release.
    \420\ Advisers to covered investment pools that are relying on
Investment Company Act exclusions in sections 3(c)(1), 3(c)(7) and
3(c)(11) must identify government entity investors regardless of
whether they are an investment option of a plan or program of a
government entity. Rule 204-2(a)(18)(i)(B).
    \421\ See section III of this Release.
---------------------------------------------------------------------------

    Third, the amended rule requires an adviser to maintain a list of
only those government entities to which it provides, or has provided in
the past five years, investment advisory services.\422\ We are not
requiring, as proposed, a list of government entities the adviser
solicited for advisory business.\423\ Some commenters expressed
concerns about the potential scope of this requirement and noted that
solicitation does not trigger rule 206(4)-5's two-year time out, rather
it is providing advice for compensation that does so.\424\ In light of
these concerns, and the record before us today, we are not requiring
advisers to maintain lists of government entities solicited that do not
become clients.
---------------------------------------------------------------------------

    \422\ See rule 204-2(a)(18)(i)(B).
    \423\ See proposed rule 204-2(a)(18)(i)(B).
    \424\ Dechert Letter; SIFMA Letter; Skadden Letter.
---------------------------------------------------------------------------

    Fourth, as discussed above, rule 206(4)-5 permits an adviser to use
certain third parties to solicit on its behalf. We are, therefore,
requiring that advisers that provide or agree to provide, directly or
indirectly, payment to advisers or broker-dealers registered with the
Commission that act as regulated persons under rule 206(4)-5 to
maintain a list of the names and business addresses of each such
regulated person.\425\ These records will enable the Commission's staff
to review and compare the regulated person's records to those of the
adviser that hired the regulated person.
---------------------------------------------------------------------------

    \425\ Rule 204-2(a)(18)(i)(D). If an adviser does not specify
which types of clients the regulated person should solicit on its
behalf (e.g., that it should only solicit government entities), the
adviser could satisfy this requirement by maintaining a list of all
of its regulated person solicitors. Supra note 412.
---------------------------------------------------------------------------

    Finally, the amendments require advisers to make and keep records
of their covered associates, and their own and their covered
associates' contributions, only if they provide advisory services to a
government client.\426\ Commenters had expressed concerns that
requiring advisers with no government business to make and keep these
records could be unnecessarily intrusive to employees and burdensome on
advisers.\427\ In light of those concerns, and the record before us
today, we are not requiring advisers with no government business to
make and keep these records.\428\ As a consequence, an adviser with no
government clients would not have to require employees to report their
political contributions.
---------------------------------------------------------------------------

    \426\ Rule 204-2(a)(18)(iii).
    \427\ IAA Letter; Dechert Letter; SIFMA Letter.
    \428\ Although advisers that do not have government entity
clients are not required to maintain records under the amendments,
the look-back requirements of rule 206(4)-5 continue to apply. As a
result, an adviser that has not maintained records of the firm's and
its covered associates' contributions would have to determine
whether any contributions by the adviser, its covered associates,
and any former covered associates would subject the firm to the two-
year time out prior to accepting compensation from a new government
entity client. The same applies to newly-formed advisers. The
records an adviser develops during this determination process, would
fall under the adviser's obligation to maintain records of all
direct or indirect contributions made by the investment adviser or
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. Rule 204-
2(a)(18)(i)(C).
---------------------------------------------------------------------------

E. Amendment to Cash Solicitation Rule

    We are adopting, as proposed, a technical amendment to rule 206(4)-
3 under the Advisers Act, the ``cash solicitation rule.'' That rule
makes it

unlawful, except under specified circumstances and subject to certain
conditions, for an investment adviser to make a cash payment to a
person who directly or indirectly solicits any client for, or refers
any client to, an investment adviser.\429\
---------------------------------------------------------------------------

    \429\ 17 CFR 275.206(4)-3.
---------------------------------------------------------------------------

    Paragraph (iii) of the cash solicitation rule contains general
restrictions on third-party solicitors that cover solicitation
activities directed at any client, regardless of whether it is a
government entity client. New paragraph (e) to rule 206(4)-3 alerts
advisers and others that special prohibitions apply to solicitation
activities involving government entity clients under rule 206(4)-
5.\430\
---------------------------------------------------------------------------

    \430\ Rule 206(4)-3(e). We received no comments on this proposed
amendment.
---------------------------------------------------------------------------

III. Effective and Compliance Dates

    Rule 206(4)-5 and the amendments to rules 204-2 and 206(4)-3 are
effective on September 13, 2010. Investment advisers subject to rule
206(4)-5 must be in compliance with the rule on March 14, 2011.
Investment advisers may no longer use third parties to solicit
government business except in compliance with the rule on September 13,
2011.\431\ Advisers to registered investment companies that are covered
investment pools must comply with the rule by September 13, 2011.\432\
Advisers subject to rule 204-2 must comply with amended rule 204-2 on
March 14, 2011. However, if they advise registered investment companies
that are covered investment pools, they have until September 13, 2011
to comply with the amended recordkeeping rule with respect to those
registered investment companies.
---------------------------------------------------------------------------

    \431\ Rule 206(4)-5(a)(2).
    \432\ Rule 206(4)-5(f)(3).
---------------------------------------------------------------------------

A. Two-Year Time Out and Prohibition on Soliciting or Coordinating
Contributions

    We are providing advisers with a six month transition period to
give them time to identify their covered associates and current
government entity clients and to modify their compliance programs to
address new compliance obligations under the rule.\433\ Accordingly,
rule 206(4)-5's prohibition on providing advisory services for
compensation within two years of a contribution will not apply to, and
the rule's prohibition on soliciting or coordinating contributions will
not be triggered by contributions made before March 14, 2011.\434\ We
believe that the length of the transition period should address
commenters' concerns that advisers have sufficient time to implement
policies and procedures regarding contributions to avoid violations of
the rule and that the rule not affect the 2010 elections for which some
advisory personnel may already have committed to make political
contributions.\435\
---------------------------------------------------------------------------

    \433\ Section III.D of this Release addresses when advisers to
``covered investment pools'' that are registered investment
companies must comply with the rule; section III.E of this Release
addresses transition considerations specific to certain other pooled
investment vehicles.
    \434\ Likewise, these prohibitions do not apply to contributions
made before March 14, 2011 by new covered associates to which the
look back applies. See section II.B.2(a)(5) of this Release for a
discussion of the rule's look-back provision. For example, if an
individual who becomes a covered associate of an adviser on or after
March 14, 2011 made a contribution before March 14, 2011, that new
covered associate's contribution would not trigger the two-year time
out for the adviser. On the other hand, if an individual who later
becomes a covered associate made the contribution on or after March
14, 2011, the contribution would trigger the two-year time out for
the adviser if it were made less than, as applicable, six months or
two years before the individual became a covered associate.
    \435\ Commenters recommended that we provide advisers with six
months to one year as a transition for rule 206(4)-5. See Davis Polk
Letter; MFA Letter; ICI Letter; IAA Letter; NASP Letter; Skadden
Letter.
---------------------------------------------------------------------------

B. Prohibition on Using Third Parties To Solicit Government Business
and Cash Solicitation Rule Amendment

    Advisers must comply with the new rule's prohibition on making
payments to third parties to solicit government entities for investment
advisory services on September 13, 2011.\436\ Before this compliance
date, advisers are not prohibited by the rule from making payments to
third-party solicitors regardless of whether they are registered as
broker-dealers or investment advisers.\437\
---------------------------------------------------------------------------

    \436\ Rule 206(4)-5(a)(2).
    \437\ We note, however, that the antifraud provisions of the
Federal securities laws continue to apply during the transition
period.
---------------------------------------------------------------------------

    We have provided an extended transition period to provide advisers
and third-party solicitors with sufficient time to conform their
business practices to the new rule, and to revise their compliance
policies and procedures to prevent violation of the new rule. In
addition, the transition period will provide an opportunity for a
registered national securities association to propose a rule that would
meet the requirements of rule 206(4)-5(f)(9)(ii)(B) and for the
Commission to consider such a rule. If, after one year, a registered
national securities association has not adopted such rules, advisers
would be prohibited from making payments to broker-dealers for
distribution or solicitation activities with respect to government
entities, but would be permitted to make payments to registered
investment advisers that meet the definition of ``regulated person''
under the rule.\438\ We understand from our staff, however, that FINRA
plans to act within the timeframe; if they do not, we will consider
whether we should take further action.
---------------------------------------------------------------------------

    \438\ See rule 206(4)-5(f)(9)(i).
---------------------------------------------------------------------------

    Finally, the compliance date for the technical amendment to the
cash solicitation rule, rule 206(4)-3, which is intended to alert
advisers that rule 206(4)-5 is applicable to solicitations of a
government entity, is one year from the effective date, as the
amendment to the cash solicitation rule need only be operative when
rule 206(4)-5's third-party solicitor provisions are in effect.

C. Recordkeeping

    As discussed above, the amendments to rule 204-2 apply only to
investment advisers with clients who are government entities. Such
advisers must comply with the amended rule on March 14, 2011 except as
noted below. By March 14, 2011, these advisers must begin to maintain
records of all persons who are covered associates under the rule and
keep records of political contributions they make on and after that
date. Advisers must also make and keep a record of all government
entities that they provide advisory services to on and after March 14,
2011. Advisers are not, however, required to look back for the five
years prior to the effective date to identify former government
clients. Advisers that pay regulated persons to solicit government
entities for advisory services on their behalf must make and keep a
list of those persons beginning on and after September 13, 2011.\439\
---------------------------------------------------------------------------

    \439\ Rule 204-2(a)(18)(i)(D).
---------------------------------------------------------------------------

D. Registered Investment Companies

    Advisers to registered investment companies that are ``covered
investment pools'' under the rule \440\ must comply with rule 205(4)-5
with respect to those covered pools September 13, 2011. During the
transition period, contributions by the adviser or its employees to
government entity clients that have selected an adviser's registered
investment company as an investment option of a plan or program will
not trigger the prohibitions of rule 206(4)-5.\441\
---------------------------------------------------------------------------

    \440\ A registered investment company is only a covered
investment pool if it is an investment option of a plan or program
of a government entity, such as a 529 plan, 403(b) plan or 457 plan.
See rule 206(4)-5(f)(3).
    \441\ Advisers to covered investment pools other than registered
investment companies--i.e., companies that would be investment
companies under section 3(a) of the Investment Company Act but for
the exclusion provided from that definition by either section
3(c)(1), section 3(c)(7) or section 3(c)(11)--are subject to the
six-month transition period. We believe advisers to these types of
funds, because the interests in them are typically held in the name
of the investor, should be able to identify government entities
without significant difficulty.

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

    We have provided for an extended compliance date to respond to
concerns expressed by commenters that an adviser to a registered
investment company may require additional time to identify government
entities that have selected that registered investment company as an
investment option when shares of the fund are held through omnibus
arrangements such that the identity of the fund investor is not readily
available to the adviser.\442\ The changes we have made to the proposed
rule that limit the application of the two-year time out with respect
to registered investment companies to those that are options in a plan
or program of a government entity,\443\ together with this extended
compliance date should provide advisers to registered investment
companies sufficient time to put into place those system enhancements
or business arrangements, such as those with intermediaries, that may
be necessary to identify those government plans or programs in which
the funds serve as investment options.\444\
---------------------------------------------------------------------------

    \442\ See ICI Letter; T. Rowe Price Letter.
    \443\ See section II.B.2(a) of this Release.
    \444\ A few commenters recommended that the rule apply only to
new government investors in registered investment companies after
the effective date of the rule. See ICI Letter; T. Rowe Price
Letter. We do not believe this would be appropriate because pay to
play can be just as troubling in the context of an adviser renewing
an advisory contract (or including a registered investment company
as an investment option in a plan or program) as one that is
endeavoring to obtain business for the first time.
---------------------------------------------------------------------------

    As noted above, we are providing for an extended compliance date
for advisers that manage registered investment companies that are
covered investment pools under the rule, which we are applying, for the
same reasons, to recordkeeping obligations that arise as a result of
those covered investment pools. Thus, advisers to these covered
investment pools must make and keep a record of all government entity
investors on and after September 13, 2011.\445\
---------------------------------------------------------------------------

    \445\ Amended rule 204-2 does not require an adviser to a
covered investment pool that is an option of a government plan or
program to make and keep records of participants in the plan or
program, but only the government entity. See supra note 411.
---------------------------------------------------------------------------

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits imposed by our rules,
and understand that there will be costs associated with compliance with
rule 206(4)-5 and the amendments to rule 204-2.\446\ We recognize that
the rule and amendments will place burdens on advisers that provide or
seek to provide advisory services to government entities, and that
advisers may in turn choose to limit the ability of certain persons
associated with an adviser to make contributions to candidates for
certain offices and to solicit contributions for certain candidates and
payments to political parties. We believe there are practical, cost-
effective means to comply with the rule without an adviser imposing a
blanket ban on political contributions by its covered associates. We
have closely drawn the rule, and modified it based on comments
received, to achieve our goal of addressing adviser participation in
pay to play practices, while seeking to limit the burdens imposed by
the rule.
---------------------------------------------------------------------------

    \446\ As proposed, we are also making a conforming technical
amendment to rule 206(4)-3 to address potential areas of conflict
with proposed rule 206(4)-5. We do not believe that this technical
amendment affects the costs associated with the rulemaking. It will
benefit advisers because it provides clarity about the application
of our rules when they potentially overlap.
---------------------------------------------------------------------------

    The rule and rule amendments are designed to address pay to play
practices by investment advisers that provide advisory services to
government entity clients and to certain covered investment pools in
which a government entity invests. The rule prohibits an investment
adviser from providing advisory services for compensation to a
government client for two years after the adviser or certain of its
executives or employees make a contribution to certain elected
officials or candidates. The rule also prohibits an adviser from
providing or agreeing to provide, directly or indirectly, payment to
any third party that is not a ``regulated person'' for a solicitation
of advisory business from any government entity, or for a solicitation
of a government entity to invest in certain covered investment pools,
on behalf of such adviser. Additionally, the rule prevents an adviser
from coordinating or soliciting from others contributions to certain
elected officials or candidates or payments to certain political
parties. The rule applies both to advisers registered with us (or
required to be registered) and those 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)). Our amendment to rule 204-2 requires a
registered adviser to maintain certain records of the political
contributions made by the adviser or certain of its executives or
employees, as well as records of the regulated persons the adviser pays
or agrees to pay to solicit government entities on the adviser's
behalf.
    In the Proposing Release, we requested comment on the effects of
the proposed rule and rule amendments on pension plan beneficiaries,
participants in government plans or programs, investors in pooled
investment vehicles, investment advisers, the advisory profession as a
whole, government entities, third party solicitors, and political
action committees.\447\ We requested that commenters provide analysis
and empirical data to support their views on the costs and benefits
associated with the proposal. For example, we requested comment on the
costs of establishing compliance procedures to comply with the proposed
rule, both on an initial and ongoing basis and on the costs of using
compliance procedures of an affiliated broker-dealer that the broker-
dealer established as a result of MSRB rules G-37 and G-38. In
addition, we requested data regarding our assumptions about the number
of unregistered advisers that would be subject to the proposed rule,
and the number of covered associates of these exempt advisers. Finally,
in the context of the objectives of this rulemaking, we sought comments
that address whether these rules will promote efficiency, competition
and capital formation, and what effect the rule would have on the
market for investment advisory services and third-party solicitation
services.
---------------------------------------------------------------------------

    \447\ Proposing Release, at section III.C.
---------------------------------------------------------------------------

    We received approximately 250 comment letters on the proposal.
Almost all of the commenters agreed that pay to play is a serious issue
that should be addressed. One commenter stated that ``the benefits
derived from the application of pay to play limitations to public
sector advisory services will far outweigh any temporary dislocations
that may occur as private and public sector professionals make the
necessary adjustments to their activities to transition to the
Commission's new standards.'' \448\ Many, however, expressed concern
about costs,\449\ particularly those related to the proposed ban on
payments to third parties. Some suggested that the

Commission underestimated the costs of compliance with the rule and
rule amendments.\450\ As discussed below, many of the commenters that
did comment specifically on the costs and benefits of the proposal did
not provide empirical data to support their views.
---------------------------------------------------------------------------

    \448\ MSRB Letter. See also Thompson Letter; Common Cause
Letter; Fund Democracy/Consumer Federation Letter (each identifying
benefits of the rule).
    \449\ See, e.g., Davis Polk Letter (generally commenting that
any benefits of the proposed rule were outweighed by its likely
costs). See also ICI Letter; Monument Group Letter.
    \450\ See, e.g., SIFMA Letter (``While SIFMA believes that
addressing practices that potentially undermine the merit-based
selection of investment advisers is an important and laudable
effort, the SEC appears to have underestimated the compliance costs
the Proposed Rule will impose on covered parties.''); 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.''); Davis
Polk Letter (``We believe that the Commission may have substantially
underestimated the number of investment advisers that will be
affected by the Proposed Rule and its costs and market effects in
concluding that many of the aspects of the Rule would impose only
minimal additional costs and burdens on investors and investment
advisers.''). The commenters who addressed our estimates, however,
did so in general terms and did not provide specific suggestions as
to how they should be modified. See the discussion below regarding
changes from the proposed rule that we believe mitigate some of the
costs.
---------------------------------------------------------------------------

A. Benefits

    As we discuss extensively throughout this Release, we expect that
rule 206(4)-5 will yield several important direct and indirect
benefits. Overall, the rule is intended to address pay to play
relationships that interfere with the legitimate process by which
advisers are chosen based on the merits rather than on their
contributions to political officials. The potential for fraud to invade
the various, intertwined relationships created by pay to play
arrangements is without question. We believe that rule 206(4)-5 will
reduce the occurrence of fraudulent conduct resulting from pay to play
and thus will achieve its goals of protecting public pension plans,
beneficiaries, and other investors from the resulting harms. One
commenter who agreed with us commended the proposed rule as a ``strong
start in controlling corruption, balancing the rights of the advisors
and their executives with the very real detriment to the public which
the numerous cases of pay-to-play involving public pension funds and
other public entities have caused.'' \451\
---------------------------------------------------------------------------

    \451\ Common Cause Letter.
---------------------------------------------------------------------------

    Addressing pay to play practices will help protect public pension
plans and investments of the public in government-sponsored savings and
retirement plans and programs by addressing situations in which a more
qualified adviser may not be selected, potentially leading to inferior
management, diminished returns or greater losses. One commenter who
agreed, observed, ``[w]hen lucrative investment contracts are awarded
to those who pay to play, public pension funds may end up receiving
substandard services and higher fees, resulting in lower earnings.''
\452\ One public official commenter detailed the role of pay to play
arrangements in the selection of public pension fund managers and the
harm it can inflict on the affected plans,\453\ while other officials
wrote to us explicitly expressing support for a Commission rule.\454\
By addressing pay to play practices, we will help level the playing
field so that the advisers selected to manage retirement funds and
other investments for the public are more likely to be selected based
on the quality of their advisory services. These benefits, although
difficult to quantify, could result in substantial savings and better
performance for the public pension plans, their beneficiaries, and
participants.\455\ Two commenters noted that the rule would promote the
interests of plan beneficiaries.\456\
---------------------------------------------------------------------------

    \452\ Bloomberg Letter.
    \453\ Weber Letter (``I have seen money managers awarded
contracts with our fund which involved payments to individuals who
served as middlemen, creating needless expense for the fund. These
middlemen were political contributors to the campaigns of board
members who voted to contract for money management services with the
companies who paid them as middlemen.''). See also Pohndorf Letter
(noting that when the sole trustee of a major pension fund changed
several years ago, a firm managing some of the fund's assets ``began
to receive invitations to fundraising events for the new trustee
with suggested donation amounts''); Tobe Letter (suggesting the
negative effects of pay to play activities on the Kentucky
Retirement System's investment performance).
    \454\ See, e.g., DiNapoli Letter; Bloomberg Letter.
    \455\ According to the most recently available US census data,
as of 2008, there are 2,550 State and local government employee
retirement systems. http://www.census.gov/govs/retire/. See also
Fund Democracy/Consumer Federation Letter (``These practices
adversely affect the economic interests of millions of America's
public servants.'').
    \456\ Comment Letter of John C. Emmel (Sept. 18, 2009) (``one
more step to foster a level playing field for investors * * * where
advisors' priorities trump those of the investing public''); Comment
Letter of George E. Kozel (Aug. 31, 2009) (``Kozel Letter'')
(``Their interests lie in obtaining the highest fees not in
producing benefits for the pensioners. * * *'').
---------------------------------------------------------------------------

    By leveling the playing field among advisers competing for State
and local government business, the rule will help minimize or eliminate
manipulation of the market for advisory services provided to State and
local governments.\457\ For example, direct political contributions or
payments made to third-party solicitors as part of pay to play
practices create artificial barriers to competition for firms that
cannot, or will not, make those contributions or payments.\458\ They
also increase costs for firms that may feel they have no alternative
but to pay to play. The rule addresses a collective action problem
created by this dynamic analogous to the one identified in the Blount
opinion.\459\ One commenter emphasized the importance of restoring
public confidence in the investment activities of all public pension
funds.\460\ Indeed, at its core, the rulemaking addresses practices
that undermine the integrity of the market for advisory services, as
underscored by another commenter.\461\
---------------------------------------------------------------------------

    \457\ See DiNapoli Letter (advocating for a ``level playing
field for investors and investment advisers that protects the
integrity of the decision-making process [for hiring an investment
adviser]''); Bloomberg Letter (``Pay to play practices clearly
undermine the open competitive process by which government contracts
are to be awarded.'').
    \458\ See supra note 453.
    \459\ See Blount, 61 F.3d at 945-46 (discussing the harms of pay
to play: ``Moreover, there appears to be a collective action problem
tending to make the misallocation of resources persist.''). See also
text accompanying notes 291-294 of this release. Collective action
problems are a class of market failures calling for a regulatory
response, and exist, for example, where participants may prefer to
abstain from an unsavory practice (such as pay to play), but
nonetheless participate out of concern that, even if they abstain,
their competitors will continue to engage in the practice profitably
and without adverse consequences.
    \460\ Thompson Letter. See also Bloomberg Letter.
    \461\ Common Cause Letter (``Pay-to-play has not only the
potential to compromise an investment adviser's ethical and legal
duties under the Investment Advisers Act of 1940, but in several
high profile cases across the nation, has already done so,
negatively impacting the public perception of government decision
making and, in some cases, costing the taxpayer millions of dollars
and placing billions of dollars in pension funds at risk.''). See
also Dempsey Letter (noting applause for efforts ``to stop the `pay-
to-play' practice which only serves to undermine public trust in
investment advisors and regulators'').
---------------------------------------------------------------------------

    Allocative efficiency is enhanced when government clients award
advisory business to advisers that compete based on price, performance
and service and not the influence of pay to play, which in turn enables
advisory firms, particularly smaller advisory firms, to compete on
merit, rather than their ability or willingness to make
contributions.\462\ In addition, taking into account the effects of
analogous practices in the underwriting of municipal securities prior
to MSRB rule G-37,\463\ we believe a merit-based competitive process
may result in the allocation of public pension monies to different
advisers who may well deliver better investment performance and lower
advisory fees than those advisers

whose selection was influenced by pay to play.
---------------------------------------------------------------------------

    \462\ See Comment Letter of Budge Collins (Sept. 30, 2009) (the
rule would ``level the playing field for the rest of us who have
never made contributions to elected officials who sit on investment
management committees'').
    \463\ One commenter cited a study containing evidence that
before rule G-37 was adopted, underwriters' pay to play practices
distorted underwriting fees as well as which firms were hired by
government issuers. See Butler Letter.
---------------------------------------------------------------------------

    As adopted, the rule contains a prohibition against advisers
directly or indirectly compensating a third party to solicit government
entities on its behalf, unless the third-party solicitor is a
``regulated person'' subject to pay to play restrictions. This
exception enables advisers and pension plans (and their beneficiaries)
to continue to benefit from the services of third-party solicitors,
such as the placement of interests in private funds, while at the same
time benefitting from a Commission rule that prohibits pay to play
practices.\464\
---------------------------------------------------------------------------

    \464\ Commenters, both on the Proposing Release and our 1999
proposal, argued that treating third-party solicitors as covered
associates would create significant compliance challenges because
these solicitors were not controlled by advisers. See supra note 264
and accompanying text.
---------------------------------------------------------------------------

    Our rule may also benefit pension plans by preventing harms that
can result when an adviser is not negotiating at arm's length with a
government official. For example, as a result of pay to play, an
adviser may obtain greater ancillary benefits, such as ``soft
dollars,'' from the advisory relationship, which may be directed for
the benefit of the adviser, potentially at the expense of the pension
plan, thereby using a pension plan asset for the adviser's own
purposes.\465\ Additionally, taxpayers may benefit from our rule
because they might otherwise bear the financial burden of bailing out a
government pension fund that has ended up with a shortfall due to poor
performance or excessive fees that might result from pay to play.\466\
---------------------------------------------------------------------------

    \465\ See supra note 55 and accompanying text.
    \466\ See Kozel Letter (supporting the Commission's proposal and
asserting that the persons who engage in pay to play practices know
that any shortfalls would be covered by taxpayers); Bloomberg Letter
(``Because the City is legally obligated to make up any short fall
in the pension system assets to ensure full payment of pension
benefits, pay to play practices can potentially harm all New
Yorkers.''). See also Common Cause Letter; 1997 Survey, supra note 8
(``[t]he investment of plan assets is an issue of immense
consequence to plan participants, taxpayers, and to the economy as a
whole'' as a low rate of return will require additional funding from
the sponsoring government, which ``can place an additional strain on
the sponsoring government and may require tax increases'').
---------------------------------------------------------------------------

    In addition to the general benefits of addressing pay to play
practices by investment advisers noted above, we believe the specific
provisions of the rule, including the two-year time out, the ban on
using third parties to solicit government business, and the
restrictions on soliciting and coordinating contributions and payments
will likely result in similar benefits to those that have resulted from
MSRB rules G-37 and G-38, on which our rule is closely modeled. The
MSRB rules have prohibited municipal securities dealers from
participating in pay to play practices since 1994.\467\ As we have
stated previously, we believe these rules have significantly curbed pay
to play practices in the municipal securities market, and are likely to
be similarly effective in deterring pay to play activities by
investment advisers.\468\
---------------------------------------------------------------------------

    \467\ MSRB rule G-37 was approved by the Commission and adopted
by the MSRB in 1994. See supra note 66.
    \468\ See supra notes 101-107 and accompanying text.
---------------------------------------------------------------------------

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

B. Costs

    We acknowledge that the rule and rule amendments will impose costs
on advisers that provide or seek to provide advisory services to
government clients directly, or indirectly through pooled investment
vehicles. We discuss these costs below, along with a number of
modifications we have made to the proposed rule and proposed amendments
that will reduce costs.
1. Compliance Costs Related to Rule 206(4)-5
    Rule 206(4)-5 requires an adviser with government clients to incur
costs to monitor contributions made by the adviser and its covered
associates and to establish procedures to comply with the rule. The
initial and ongoing compliance costs imposed by the rule will vary
significantly among firms, depending on a number of factors. Our
estimated compliance costs, discussed below, take into account
different ways a firm might comply with the rule. These factors include
the number of covered associates of the adviser, the degree to which
compliance procedures are automated (including policies and procedures
that could require pre-clearance), the extent to which an adviser has a
pre-existing policy under its code of ethics or compliance
program,\469\ and whether the adviser is affiliated with a broker-
dealer firm that is subject to MSRB rules G-37 and G-38. A smaller
adviser, for example, will likely have a small number of covered
associates, and thus expend less resources to comply with the rule and
rule amendments than a larger adviser.
---------------------------------------------------------------------------

    \469\ One commenter stated that many investment advisers already
have pay to play policies and procedures in place within the
framework of their codes of ethics. See IAA Letter (advocating for
regulation that would address pay to play practices through an
adviser's code of ethics, as an alternative to the approach taken in
proposed rule 206(4)-5).
---------------------------------------------------------------------------

    Although a larger adviser is likely to spend more resources to
comply with the rule, based on staff observations, a larger adviser is
more likely to have an affiliated broker-dealer that is required to
comply with MSRB rules G-37 and G-38.\470\ As we learned from a broker-

dealer with an investment adviser affiliate that commented on our 1999
proposal, ``the more the Rule mirrors G-37, the more firms can borrow
from or build upon compliance procedures already in place. * * *''\471\
Accordingly, we believe some advisers with broker-dealer affiliates may
spend fewer resources to comply with the rule and rule amendments. We
recognize, as some commenters pointed out, that MSRB rules G-37 and G-
38 compliance systems may not be easily extensible in all cases, and we
acknowledge that the range of efficiencies created in these
circumstances will vary.\472\ A prominent concern of these commenters
related to a proposed recordkeeping amendment which would have required
advisers to keep records of solicitations-- something that is not
required under MSRB recordkeeping rule G-8. As previously discussed, we
are not adopting that proposed amendment, which may address the concern
noted by commenters.
---------------------------------------------------------------------------

    \470\ According to registration information available from
Investment Adviser Registration Depository (``IARD'') as of April 1,
2010, there are 1,332 SEC-registered investment advisers (or 11.48%
of the total 11,607 registered advisers) that indicate in Item
5.D.(9) of Form ADV that they have State or municipal government
clients. Of those 1,332 advisers, 113 (or 85.0%) of the largest 10%
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. 204 of the largest 20% (or 76.7%)
have one or more affiliated broker-dealers or are, themselves, also
registered as a broker-dealer. Conversely, only 40 (or 30.1%) of the
smallest 10% have one or more affiliated broker-dealers or are,
themselves, also registered as a broker-dealer; and only 67 of the
smallest 20% (or 25.2%) have one or more affiliated broker-dealers
or are, themselves, also registered as a broker-dealer. With respect
to broker-dealer affiliates, however, we note that our IARD data
does not indicate whether the affiliated broker-dealer is a
municipal securities dealer subject to MSRB rules G-37 and G-38.
Also, as one commenter asserted, private fund managers may be among
the larger advisers, based on assets under management, but they are
unlikely to have an affiliated broker-dealer that has already
adopted similar procedures to comply with MSRB rules G-37 and G-38
because most private fund managers are not involved in municipal
underwriting. MFA Letter. We acknowledge that a private fund manager
generally would be less likely to have an affiliated broker-dealer
from which it can borrow or build upon compliance procedures;
however, we also expect that a private fund manager would use less
resources than other large registered advisers to comply with the
rule because a private fund manager is not subject to rule 206(4)-7,
the Advisers Act compliance rule, and would likely have fewer
employees and covered associates than a larger organization.
    \471\ Comment Letter of US Bancorp Piper Jaffray Inc. (now,
``Piper Jaffray & Co.'') (Nov. 15, 1999).
    \472\ SIFMA Letter. See also ICI Letter.
---------------------------------------------------------------------------

    We anticipate that advisory firms subject to rule 206(4)-5 will
develop compliance procedures to monitor the political contributions
made by the adviser and its covered associates.\473\ We estimate that
the costs imposed by the rule will be higher initially, as firms
establish and implement procedures and systems to comply with the rule
and rule amendments. We expect that compliance expenses would then
decline to a relatively constant amount in future years, and annual
expenses are likely to be lower for small advisers as the systems and
processes should be less complex than for a large adviser.
---------------------------------------------------------------------------

    \473\ Investment advisers registered with the Commission are
required to adopt and implement policies and procedures reasonably
designed to prevent violation by the adviser or its supervised
persons of the Advisers Act and the rules the Commission has adopted
thereunder. See rule 206(4)-7.
---------------------------------------------------------------------------

    We estimate that approximately 1,697 investment advisers registered
with the Commission may be affected by the rule and rule
amendments.\474\ Of the 1,697 advisers, we estimate that approximately
1,271 advisers have fewer than five covered associates that would be
subject to the rule (each, a ``smaller firm''); approximately 304
advisers have between five and 15 covered associates (each, a ``medium
firm''); and approximately 122 advisers have more than 15 covered
associates that would be subject to the prohibitions of the rule (each,
a ``larger firm'').\475\
---------------------------------------------------------------------------

    \474\ 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. Additionally, some advisers
that do not currently have government clients may seek to obtain
them in the future. In doing so, they likely would conduct due
diligence to confirm they would not be prohibited from receiving
compensation for providing investment advisory services to the
government client.
    \475\ 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.
---------------------------------------------------------------------------

    One commenter disagreed with us basing our cost estimates on an
assumption that most registered advisers would have fewer than five
covered associates because the commenter expects most advisers to
require all or most of their employees to receive approval prior to
making any political contributions in order to avoid inadvertently
triggering the rule.\476\ Although the rule does not require this
approach and the changes we have made to the rule (e.g., modified
definition of covered associate) should help address the concerns of
this commenter that led to the assertion, we recognize that some
advisers may voluntarily restrict all of their employees' political
contributions in such a manner. This type of pre-screening process
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. We also received a comment
that our estimates should take into account turnover of personnel.\477\
Our cost estimate assumes a certain level of turnover; although these
categories are based on an adviser's number of covered associates, we
have not calculated per-covered associate costs associated with this
rulemaking. The categories of smaller, medium and larger advisers are
based on an estimated number of covered associates, but are not
intended to represent a static population of covered associates within
each category. For instance, in estimating the ongoing burdens on
advisers to comply with the rule, we implicitly incorporated a greater
degree of turnover at larger advisers in estimating that they would
incur 1,000 hours annually as compared to the estimated 10 hours for a
small adviser.
---------------------------------------------------------------------------

    \476\ See MFA Letter.
    \477\ ICI Letter.
---------------------------------------------------------------------------

    Advisers that are unregistered in reliance on the exemption
available under section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-
3(b)(3)] would be subject to rule 206(4)-5.\478\ 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).\479\ 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