Pay to Play. The LAW REPORT. Develop a Good Understanding of Core Terms of the Rule. Overview of an Effective Compliance Program

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1 Hedge The Fund LAW REPORT hedge fund law and regulation Pay to Play Key Elements of a Pay-to-Play Compliance Program for Managers By Edward L. Pittman, Dechert LLP New limits on political contributions and other political activity by advisers to hedge funds with public pension plan investors will become effective on March 14, Many of the concepts in Rule 206(4)-5 ( Rule ) under the Investment Advisers Act of 1940 ( Advisers Act ) are grounded in campaign finance law, rather than the securities laws. For this reason, compliance with the Rule may present challenges to many advisers. At the same time, however, the penalties for failing to adhere to the strict requirements of the Rule will be severe including a two-year ban on business, loss of revenues, and possible sanctions by regulators. This article is designed to provide a practical overview of a compliance program for hedge fund advisers. Overview of an Effective Compliance Program In most cases, political activity addressed by the Rule will not be motivated by an improper purpose and, in fact, generally is encouraged as part of the democratic process. Regardless of motive, however, there may be little room for forgiveness once the activity has occurred. For this reason, the support of senior management which in some cases may include those located in a parent or affiliates may be crucial to conveying the importance of careful compliance with policies on political activity. Some of the basic elements of a compliance program in this area are outlined below. Implementation of policies will vary greatly from manager to manager. In general, however, creation of the program will involve developing an understanding of key provisions of the Rule, drafting policies and procedures, and preparing relevant forms and templates for records. In addition, a critical requirement of the compliance program must involve education and training. Develop a Good Understanding of Core Terms of the Rule The Rule has a number of important definitional terms and concepts that are necessary to understand. Some of the requirements of the Rule are straightforward. However, difficult interpretive issues may arise particularly regarding the definitions of covered associate ( CA ), contribution, and solicitation. In many cases, the answers may not be intuitive. Those in compliance, however, must be very familiar with the key concepts and terms in order to identify potential issues. Identify Persons Covered by the Rule In smaller advisers, determining who will be subject to the limitations of the Rule may not be difficult. However, in larger organizations, or those with affiliates or external partners, it can be one of the greatest initial and ongoing challenges. The definition of a CA under the Rule is broad and includes individuals who engage in sales activity (often by participating in presentations with public fund clients) as well as their direct and indirect supervisors. In addition, the term encompasses those who are partners or officers; who head an office or function within the adviser; or, who whether or not part of the adviser are responsible for

2 policy making decisions that affect the adviser. [1] A review of organizational structure, direct and indirect reporting lines, and functions may be necessary in many cases to make determinations about who is covered by the Rule. In designating persons as CAs for recordkeeping purposes, it is important not to be overly inclusive, since once designated their political contributions or activities may cause violations of the Rule. If not clear, compliance officers may decide to treat any designations as potential until given further review, including an assessment of any prior contributions they may have made. In some cases, policies will call for the individuals that fall within the definition of a CA to be given written notice and asked to sign an acknowledgement that they are aware of the firm s policies and the limitations on their political activity. Records should reflect when new CAs are added to the list. Identify Additional Persons Who May be Affected by the Rule, or Whose Assistance May be Necessary to Assure Compliance with the Rule A broader group of persons not directly covered by the Rule may be designated for additional training or subject to heightened compliance requirements. Because of the twoyear lookback, this group may include those who might be prevented from receiving a promotion in the future because of their political activity. It also may include persons whose activities (particularly with respect to sales efforts) could cause them to inadvertently fall within the definition of a CA. In addition, personnel in human resources, accounting, audit, as well as senior officers in the holding company, and risk officers, should have an awareness of the Rule and the adviser s policies on political activities. Among other things, their assistance may be important in assuring that campaignrelated expenses are not reimbursed, that consideration of the Rule is made in connection with mergers or changes in reporting lines, or that potential associates who may be CAs receive and complete a political contribution disclosure form prior to being hired. Develop Relevant Compliance Policies and Supervisory Procedures General Policies New policies and procedures may need to be developed for different areas of the adviser and its affiliates. For a broader audience they may be very general. They may address general limits on political activity and contributions, including the use of office space and firm resources for political activities, attendance at presentations, participation in fundraising events and other campaign related functions, permissible referral activity, expense reimbursements, hiring of new employees, and pre-clearance of promotions within the organization. Because of the complexity of the issues, policies should encourage persons both to contact the compliance office with questions, and to immediately report any activity that might have violated the adviser s policies. In some cases, prompt notice of a potential violation may allow the firm to take action to avoid any sanctions. Written Procedures Written procedures may be separate from the general policies. Because of the complexity of some of the issues and processes, this may be necessary to avoid confusing a more general audience. Procedures generally will allocate specific responsibilities and contain specificity regarding steps, including reviews that must be undertaken to assure compliance, as well as any recordkeeping requirements.

3 Establish Pre-Clearance Policies and Procedures Compliance policies and procedures may emphasize preclearance of several different types of activity. Pre-clearance of contributions, new hires and promotions, as well as marketing and sales efforts all may be a necessary part of the compliance program for the Rule. Implementation of the procedures may require drafting new forms or, for larger advisers, developing new systems. Pre-Clearance of Political Contributions Compliance policies frequently will call for pre-clearance of political contributions or certain political activity to avoid inadvertent violations of the Rule. Among other things, review of contribution requests may focus on: dollar amounts of the contributions; whether or not the person is entitled to vote for the candidate; and whether or not the firm has any business interest that could be affected by a contribution to a particular candidate. Contributions to state and local parties or PACs also should be reviewed to make sure that they are not used as an indirect means of making a political contribution designated for a particular candidate. In some cases, pre-clearance forms will also include an attestation that the contribution was not solicited by anyone in the organization. Checklists may be used by compliance to assure that relevant factors are considered and each necessary step is taken as part of the review. Once made, contributions by CAs must be reflected on the firm s records. Pre-Clearance of Potential Associates and Promotions Pre-clearance of persons who are potential CAs may be part of the hiring process. Persons who are being considered for a position in which they would have to be designated as a CA will be asked to complete a contribution disclosure form that lists any political contributions, including to federal campaigns and political parties, over the prior two years. In some cases, compliance may extend this process to potential business partners. Attestations may not always be sufficient. It may be prudent to conduct some due diligence by sampling relevant donor databases. [2] Pre-Clearance of New Investors Another area where pre-clearance or reviews may be called for is in connection with solicitations of new business from public pension funds or as part of the client intake process. Public fund clients also will need to be reflected on the firm s records. Prior to solicitations or acceptance of public funds as investors, some advisers may wish to review records of political contributions by CAs and to survey donor databases to make certain that no disqualifying contributions already have been made which would prevent the adviser from being compensated by the new client. At the same time, specific state or local laws or fund policies regarding contributions may be noted in order to prevent potential problems. Pre-Clearance of New Marketing Relationships Placement agent agreements and other sales and marketing relationships should be reviewed to assure that these organizations are (or will be) registered with the SEC as advisers or brokers, and that appropriate representations and warranties are present. With placement agents, this may include warranties relating to compliance with any forthcoming FINRA rules on pay-to-play activity. In some cases, the adviser also may request disclosure of contributions by a placement agent, and sample donor databases to determine whether any potential problems may arise under

4 current laws or policies applicable to a particular public fund. Placement agent agreements also may address issues that could arise if the agent is not permitted to receive compensation as a result of violating the Rule, or any FINRA rule that might be adopted, or cannot solicit a particular public fund because it has violated state or local laws or public fund policies. For example, a disqualifying contribution by the placement agent to the Governor of California may prevent it from soliciting some public funds in that state. Conduct Periodic Surveys and Assessments Periodic surveys and reviews of political contributions generally on a quarterly basis are advisable. These surveys provide a regular reminder of the firm s political contributions policies, and also may unearth contributions that were not reported for pre-clearance and are not properly reflected on the adviser s records. Quarterly surveys also are recommended because, under the Rule, an exception is provided for certain inadvertent contributions between $150 and $350 that are discovered by the adviser within four months after being made, and subsequently returned by the candidate. In connection with quarterly surveys, procedures may provide for a re-assessment of the compliance program in this area. Among other things, a scheduled assessment can provide an opportunity to consider whether any new guidance has been issued by the SEC, and whether any promotions, hires, departures, investments, or changes in the organizational structure have occurred that require adding or removing persons to the CA list. A snapshot of the CA list at this time might be taken as a backup to roughly reflect when persons were added or removed from the list. Create Forms and Records Part of the compliance process will involve the preparation of forms and templates for records. As suggested above, the forms often used are: contribution pre-clearance; contribution disclosure for potential CAs; and quarterly contribution survey forms. Records that must be maintained under the Rule are: list of CAs; list of political contributions by the adviser and CAs; list of public fund clients; and list of third party marketers or placement agents. Construct an Education and Training Program Because participation in the electoral process is regarded favorably in our society, it is important to develop an education and training program to prevent innocent political contributions or activity that may inadvertently result in a violation of the Rule, or that may require the organization to forgo revenue opportunities. Education and training programs may be varied depending on the target audience. As suggested above, separate audiences may include both those whose activity is clearly covered by the Rule, and those whose activity may not be covered by the Rule, but who interact regularly with public funds or elected officials. Distinctions also may be drawn between those newly hired or promoted, and those who have already received training. One of the primary goals is to impart an understanding of the many types of political activity that may be problematic under the Rule, including in-kind contributions and coordinating or soliciting contributions. Equally important, in some cases, will be instructing individuals within the adviser about which activities, particularly with respect to sales efforts, could cause a person whose political contributions have not been reviewed to fall within the definition of a CA.

5 Conclusion The issues presented by the new Rule come mainly from the realm of campaign finance law rather than the Advisers Act. In addition to mastering new terms and concepts, compliance officers and senior management will need to determine what policies and procedures make sense in their particular organizations. Implementation of a compliance program for the SEC s new Rule may be either a very simple task (for relatively smaller advisers) or a very complex task (for larger advisers with greater numbers of employees or affiliates, advisers for whom public pension funds are an important component of the business and advisers with politically active partners or associates). It may be difficult in many cases to achieve the right balance between compliance with the Rule and allowing persons to participate in the political process. Because of the consequences for failure, however, all stakeholders must be involved and must appreciate the importance of compliance. enforcement proceedings involving public integrity issues and improper political contributions. Mr. Pittman s clients have included some of the financial services industry s largest clearing firms and global transfer agents, as well as national securities exchanges, ECNs, algorithmic trading firms, investment banks, large soft dollar brokers, exchange specialists, market makers, advisors, boutique merger and acquisition firms, and banks. Mr. Pittman previously served on the Executive Staff of the SEC and as assistant/deputy chief counsel for the Division of Trading and Markets. In addition to practicing law, he has been CEO and President of a mutual fund group with domestic and foreign funds, and independent chairman of another mutual fund group. He formerly was a member of the ICI s Independent Directors Council and its task force on derivative investments. [1] The breadth of persons that might be subject to the Rule, Edward L. Pittman is Counsel in the Washington, D.C. office of Dechert LLP. He advises broker-dealers and money managers in a broad range of matters, including capital market structure, operations, pay-to-play and ethics-related corporate issues, and the creation of internal compliance procedures. Among other assignments, he has represented a pension consulting firm in an SEC inquiry and has served as an SEC or state-mandated Independent Consultant following in the context of holding companies, is illustrated in an SEC report regarding MSRB Rule G-37 published earlier this year. Securities Exchange Act Release No (March 18, 2010), available at: investreport/ htm. [2] Examples of donor databases include: and