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The SEC Has Been Busy With Pay-to-Play Compliance and Expects You To Be As Well

The Securities and Exchange Commission (SEC) has given notice that it intends to take a very active role with respect to pay-to-play issues in the securities markets and has put the regulated community on notice that it expects private corporate compliance training to be well under way as well.

As we have recently reported, the SEC has announced its intentions to take a significantly more aggressive regulatory posture with regard to the confluence of campaign contributions and public investing. Just last week, the House Financial Services Committee saw to it that the SEC has the tools for the job when it voted to double the SEC’s budget and awarded the Commission significantly greater regulatory powers.

The Municipal Securities Rulemaking Board (“MSRB”) has also gotten into the act by recently announcing plans to file a rule change with the SEC to revise Rule G-37 to prohibit dealers from engaging in municipal securities business with issuers for two years if they make certain contributions to the political campaigns of officials of issuers. The proposed revision to Rule G-37 would require municipal securities dealers, their muni professionals, and political action committees to disclose the political contributions they make to bond ballot election campaigns.

Meanwhile, in a case which should get the attention of compliance officers everywhere, the SEC has recently notified Southwest Securities Inc. that it plans to recommend “administrative and cease-and-desist proceedings” against the company based, in part, on the company’s failure to conduct compliance training for its financial services staff. In that case, the SEC initiated the action as a result of the company’s alleged use of political donations to win municipal bank work. Southwest’s (now former) employee at the center of the allegations maintained that he only unintentionally exceeded the MSRB cap of $250 donation per election and that the SEC was “more concerned about Southwest Securities and their lack of compliance training of their bankers.” According to FINRA records, Southwest said the employee had failed to report political contributions as required by MSRB and the employee, in turn, faulted the company for failing to adequately inform him of the MSRB rules.

In another, very significant action, the SEC announced last week that banking powerhouse JPMorgan has entered into a multi-million dollar settlement with the agency over allegations that company employees made unlawful payments to friends of county officials. Under the settlement JPMorgan agreed to cancel interest-rate swap contracts between it and Jefferson County, Alabama, pay $75 million in civil fines and payments, and forfeit $647 million in claimed termination fees under the swap contracts.

The allegations giving rise to liabilities in excess of $722 million for JP Morgan ultimately arose from allegations concerning the actions of just two (now former) managing directors of JPMorgan. “The transactions were complex but the scheme was simple,” SEC Enforcement Director Robert Khuzami said in a statement. “Senior JP Morgan bankers made unlawful payments to win business and earn fees.”

These federal enforcement developments highlight the importance of instituting a proper compliance training program. Firms should review and revise policies, practices, and procedures to stay current on the most recent versions of the rules and regulations promulgated by the SEC and MSRB. The SEC has put the regulated community on notice that failure to implement proper compliance policies and train employees adequately can have significant negative consequences. By undertaking the effort to develop a comprehensive compliance program before problems arise, companies can better protect themselves from potential liability and its related, potentially catastrophic, costs and expenses.

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The SEC Has Been Busy With Pay-to-Play Compliance and Expects You To Be As Well

New Mexico Chief Investment Officer Resigns after Investigation

The pay-to-play probe related to U.S. public pension systems led by New York Attorney General Andrew Cuomo, the U.S. Securities and Exchange Commission and the Justice Department has claimed another victim. Bloomberg reports today that New Mexico’s chief investment officer has resigned after being drawn into the nationwide investigation.

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New Mexico Chief Investment Officer Resigns after Investigation

Blue Ribbon Panel Proposal

Amid the continued debate over the SEC’s proposed pay-to-play rules there are some proponents who argue that oversight of pay-to-play practices must reach beyond the agency’s current recommendations. So even while many commentators oppose the rules on grounds that they sweep too broadly and impair competition, (click here to read comment letters) the former head of the SEC, Arthur Levitt, has declared that President Barack Obama should empower a “blue ribbon” panel to investigate pay-to-play practices of public pension funds.

The call for a probe into the public pension fund practices comes at a time when certain pension funds are examining their own investment processes and making positive changes, such as the California Public Employees’ Retirement System. However, the general concern among regulators and funds is that choices about who should invest public monies are influenced by factors like money and politics rather than an investment manager’s merits and cannot be subject to self-regulation. Levitt said in an interview on Bloomberg Television that public pension fund boards should not make investment decisions, but should cede such power to a professional staff.

The SEC’s proposed rules are meant to address those concerns. The SEC proposal is modeled on the rules proposed by the agency in 1999, when Levitt was chairman. Levitt has explained, “We had a lot of pressure [against the proposal in 1999].” The pressure came from Congress, Levitt said. “When you talk about campaign contributions, Congress gets very sensitive. They feel that’s one step away from their own activities.” Levitt’s panel would go beyond the SEC proposal and would investigate the public officials who sit on boards of state pension funds, highlight conflicts and recommend “best practices.”

Blue Ribbon Panel Proposal

SEC Bans Third Party Solicitation of Municipal Investors

While most agree the SEC’s proposed new pay-to-play rules are a necessary development, there has been controversy around a proposal that would ban placement agents from representing clients before state and local persons. Unlike the MSRB pay-to-play rules, the SEC would prohibit investment advisers from using any third party intermediary, including placement agents registered as broker-dealers with the SEC, to solicit municipal investors on their behalf. In several comment letters filed with the SEC, participants in the private equity and venture capital industry argue that the SEC’s proposal to ban investment advisers’ use of third-party placement agents is overreaching and will put small and new funds out of business. London-based private equity research firm Preqin said in a comment letter that 85% of public pension funds and other institutions handling public money felt larger managers would be the main beneficiaries of the proposed ban.

Industry leaders such as Blackstone (which has a proprietary placement agent) have been urging the SEC to reconsider its proposed outright ban because they believe that third-party placement agents play a vital role for investment advisers. Blackstone’s Chief Executive Officer, Stephen Schwartzman, said in a comment letter that he agrees with getting rid of political fixers, but taking the “drastic step” of eliminating the function of legitimate placement agents would unfairly burden firms just starting out. For many first-time funds, a placement agent is often utilized to introduce the general partner to potential investors, including large institutional investors such as public pension funds. The ban on using placement agents is seen as harmful to an emerging industry just at the time the agent business is growing; Preqin reported that of the private equity firms that raised funds in 2008, 54 percent used a placement agent, up from 45 percent in 2007 and 40 percent in 2006.

The ban on placement agents has been compared to steroid usage in Major League Baseball. As Schwartzman wrote in his comment letter: “Recently, there have been reports of a few high profile baseball players using illegal steroids to unfairly enhance their performance. Their illegal and unethical behavior has unquestionably challenged professional baseball and yet no one is suggesting banning baseball.” In contrast, others support the ban. For example, one private equity executive said the danger of corruption is a big issue that needs to be regulated. “How do you decide who is legitimate and who isn’t?” the person asked.

As opposed to an outright ban of placement agents, smaller funds are asking the SEC to consider alternative approaches, such as implementing more stringent licensing, oversight and disclosure regulations equally on all participants in the investment process. The California Public Employees’ Retirement System (Calpers), the biggest U.S. public pension fund, said in May it adopted a new policy requiring external managers to disclose fees about placement agents they hire to seek Calpers business.

Given the controversy over this issue, the SEC has a challenging task at hand.

SEC Bans Third Party Solicitation of Municipal Investors

SEC Boots Kickbacks at Federal Level

Amid the storm of pay-to-play scandals and as pay-to-play has become an increasingly hot-button state issue, the Securities Exchange Commission (the “SEC”) stepped in on August 3, 2009 to propose measures at the federal level intended to eliminate or at least curtail “pay-to-play” practices. The measures are aimed to regulate the practice of money managers making political contributions or hidden payments in hopes of winning business from government officials and conversely government officials soliciting political contributions by guaranteeing an award of business. Although the SEC has initiated fraud cases in the past related to kickbacks in pay-to-play schemes, the proposed rules seek to comprehensively address the growth of the government pension plan market and the alleged evils related to its expansion.

According to SEC Chairman Mary Schapiro, “Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices. Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices.” As one commentator has stated “so Shapiro is trying to be proactive, reducing…the near occasions of sin.” The rule is intended to help ensure advisory contracts are awarded on professional competence and not political influence. However, as SEC Commissioner Luis Aguilar has cautioned, pay-to-play conduct “is incredibly hard to police.”

The new rule, which revisits a 1999 SEC proposal that was not finalized in part due to monitoring concerns, would prohibit an investment adviser from providing advisory services for compensation to a government client for two years after the adviser makes a contribution to certain elected officials or candidates. Like the 1999 SEC proposal, the proposed rule is modeled on rules G-37 and G-38 of the Municipal Securities Rulemaking Board (“MSRB”), which address pay to play practices in the municipal securities markets. The SEC has couched the rule as a two-year “time out” on conducting compensated advisory business with a government client after a contribution is made and not as a limitation or outright ban of political contributions.

The proposal would also forbid an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser. Additionally, it would prevent an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is seeking government business. New recordkeeping requirements that would require a registered adviser to maintain certain records of the political contributions made by the adviser are also proposed.

The implications of the proposed measures could be wide ranging. For example, the new recordkeeping rules may have the unintended effect of causing non-U.S. advisers to private pools not to accept investments from U.S. government entities in order to avoid onerous record keeping requirements. In addition, commentators have speculated that the proposed ban on the use of third parties (like placement agents) would make it difficult for smaller and newer funds to develop business because such funds would not have existing contacts with the managers of public pools of capital. The uneven playing field for small funds in turn could limit the investment choices of pension plan officials, who may not have the time and resources to evaluate potential investment opportunities. The SEC seeks comments to address these and other possible pitfalls associated with its proposal.

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SEC Boots Kickbacks at Federal Level