D
450 Lexington Avenue
New York, NY  10017


November 1, 1999


Re: Proposed Rule 206(4)-5 -- File No. S7-19-99

Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Dear Mr. Katz:

     We appreciate the opportunity to comment on proposed rule 206(4)-5 (the "Proposed Rule") under the Investment Advisers Act of 1940 ("Advisers Act"), which the Securities and Exchange Commission ("Commission") proposed on August 4, 1999, and we support the efforts of the Commission in addressing pay-to-play practices.  Our clients believe that the selection of an investment adviser by public officials should be based on qualitative factors, including an adviserís investment experience, commitment to client service and past performance.  We note at the outset, however, that our clients have not encountered systemic abuses in this area and that incidents of pay-to-play are isolated.  Accordingly, we suggest less onerous alternative approaches to those contained in the Proposed Rule, including the adoption of more flexible sanctions and the reformulation of the exemptive provision as a safe harbor.  We believe these alternatives address pay-to-play abuses consistent with other measures under the Advisers Act and more proportionately to the potential for abuse.

I.   Use of the MSRB Model and the Two-Year Prohibition

     The Proposed Rule essentially would prohibit an investment adviser from providing advice for compensation to a government entity for two years after the adviser, or certain of its associated persons, made a contribution to an official of the government entity.  The framework for the Proposed Rule, including the two-year prohibition, is based on Municipal Securities Rulemaking Board ("MSRB") rule G-37.1  The proposing release requests comment on whether the Commission should use MSRB rule G-37 as the model for the Proposed Rule.

     We believe that significant differences exist between investment advisers and municipal underwriters and as a result MSRB rule G-37, and particularly its two-year prohibition, is not a fully appropriate model for the Proposed Rule.  We note from the outset that an investment adviser is already governed by the Advisers Act, which provides the Commission with an existing array of enforcement tools, including fines and sanctions.2 

     Moreover, an adviserís relationship with its clients differs substantially from that of a municipal underwriter.  While a municipal underwriter provides services to a government entity on a sporadic basis, an investment adviserís relationship is continuous.  As a result of this continuous relationship, an adviser develops a thorough knowledge of a clientís investment needs and objectives and its portfolio composition.  In addition, an adviser may offer a particular investment expertise or service that is not readily replaced or available elsewhere.  Thus, any requirement that an adviser sever an existing relationship with a client could cause significant harm to the client.  Finally, an adviser with an existing government client would seem to face significantly less pressure to engage in pay-to-play practices to retain the client than a municipal underwriter who generally must compete to underwrite each new municipal offering. 

     We also note that a two-year prohibition may have far greater consequences for an investment adviser than for a municipal underwriter.  A  government entity may make numerous securities offerings each year.  Following a two-year prohibition, a municipal underwriter could compete for each new offering.  By contrast, advisory contracts tend to be long-term in nature and are infrequently put up for rebidding.  Thus, the automatic prohibition for advisers could effectively last far longer than two years and may become permanent.  Under the Proposed Rule, an adviser could continue to provide its services to a client without compensation.  However, MSRB rule G-37 does not similarly place municipal underwriters in the position of losing a client permanently or providing free underwriting services.

     Based on the differences in regulatory schemes, relationships and types of services offered between an investment adviser and a municipal underwriter, we submit that MSRB rule G-37 is not a fully appropriate model for the Proposed Rule.  In particular, we believe that the two-year prohibition would be unduly disruptive and is not necessary for the protection of investors.  Rather, we believe that a rule which simply prohibits pay-to-play practices, combined with (i) the new recordkeeping requirements contained in the Proposed Rule and (ii) the Commissionís existing remedies under the Advisers Act, should prevent the types of abuses that the Proposed Rule seeks to address.

II.  The Exemptive Provision  

     The Proposed Rule contains a provision whereby advisers can apply for an exemption from the two-year prohibition on providing advisory services if in general (i) the exemption is consistent with purposes of the proposed rule, (ii) the adviser, before the impermissible contribution was made, developed and instituted procedures reasonably designed to ensure compliance with the rule and had no actual knowledge of the covered contribution and (iii) the adviser took all available steps to obtain a return of the contribution and any other measures appropriate under the circumstances.  We would suggest that the exemptive provision be reformulated as a safe harbor.

     We note several practical concerns if the Proposed Rule, including the exemptive provision, is adopted in its current form.  In the first instance, industry experience suggests that the exemptive process typically requires the expenditure of substantial time and effort by both petitioners and the staff - e.g., applications under Section 9 of the Investment Company Act.  In addition, an adviser applying for an exemption would presumably continue to provide advisory services to its government client while the application remained before the Commission.  Unless the Commission was prepared to act quickly on these applications, an adviser could amass significant fees that would need to be held in escrow, collected and refunded to the client or addressed in some other acceptable manner.  Finally, the standards contained in the exemption are vague, particularly the requirement that an adviser take "other remedial or preventive measures as may be appropriate under the circumstances."  We believe more specific criteria would need to be provided. 

III. Two-Year Look Back Provision

     The Proposed Rule contains a look-back provision, which would subject an adviser to the two-year prohibition on providing advisory services for compensation if the adviser hires or otherwise has a new partner, executive officer or solicitor who within the previous two years made a covered political contribution.  We believe that this look-back provision creates significant practical difficulties in application.  For instance, it would impose on an adviser strict liability for the actions of persons who were not previously under its control.  This standard would require an adviser to undertake exhaustive background checks and make hiring decisions based in part on its evaluation of a potential new personís good word and memory.  The look-back provision only remotely address the pay-to-play issue.  It seems unlikely that a government official would choose an adviser because a new partner, executive officer or solicitor, while employed or working elsewhere (possibly in a completely different industry), made a contribution to the official.  Thus, we believe that the look-back provision should be eliminated or, alternatively, it should contain a specific due diligence standard, such as a signed representation from the potential new person, and be limited in time to no longer than one calendar month.

IV.  Executive Officers 

     The Proposed Rule would apply to contributions by an adviserís "executive officers," which are defined generally to include the president, any vice-president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a "policy-making function" or any other person who performs similar "policy-making functions" for the adviser.  We believe that certain clarifications to this definition are necessary.  First, the definition should specify the scope of the termís application so as not to include executive officers of holding companies or affiliated entities.  These persons, absent direct compensation from the adviser, would have far less incentive to engage in pay-to-play practices.  Including these persons substantially increases compliance burdens and the potential for inadvertent violations of the Proposed Rule.

     Second, the definition should clarify the meaning of "policy-making function."  We find this term to be vague and believe that it should exclude all but the most senior officers of an adviser.  Again, if not limited in scope, an adviser will need to track the activities of a significantly greater number of associated persons.

     Finally, the Proposed Rule includes a provision prohibiting an adviser from indirectly engaging in prohibited actions.  All employees could be considered capable of facilitating indirect violations of the Proposed Rule through personal political contributions.  Accordingly, the definition of executive officers should contain a presumption that contributions by non-executive officers do not constitute a violation of the Proposed Rule absent evidence to the contrary.  

V.   Solicitors

     The Proposed Rule would also apply to contributions made by an adviserís solicitors.  The term "solicitor" is defined to include any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.  We believe that the definition as proposed is overly broad and creates significant compliance monitoring difficulties.

     The definition of "solicitor" could include any employee of an adviser or its affiliates - potentially thousands of persons for a full service financial firm.  The proposing release attempts to limit this application by noting that the ruleís prohibitions would not be triggered by contributions from employees of the adviser or from other persons (such as spouses, control persons and affiliates) who do not play a role in obtaining government clients, provided the adviser or certain of its associated persons do not use these employees or other persons to indirectly make contributions.  We believe that this limitation should be incorporated into the definition.  Moreover, we believe that the role played in obtaining government clients must be substantial in order to avoid application of the rule to persons who only play an occasional role and whose contributions are not likely to be motivated by an intent to obtain government clients. 

     In addition, we note that the limitation contained in the proposing release would not alleviate compliance monitoring burdens because an adviser would need to track every employee (as well as spouses, control persons and affiliates) to determine (i) whether they have made contributions and, if so, (ii) the purpose behind the contributions.  Thus, we believe that, for employees and other persons who do not play a substantial role in obtaining government clients, advisers should be entitled to rely on written representations.  The written representations could state that the employee or other person has not made a political contribution for the purpose of obtaining government clients for the adviser.

     Finally, the definition of solicitor also includes third parties.  We note that advisers have far less ability to monitor the activities of third parties.  In addition, third parties may work for several advisers simultaneously.  Thus, a contribution made by a third-party solicitor, although triggering the Proposed Ruleís prohibitions, may have been for the benefit of some other adviser or for an entity unrelated to the advisory industry.  Accordingly, we propose that the definition of solicitor either (i) exclude third parties or (ii) allow advisers to rely on written representations from third party solicitors.

VI.  Covered Officials 

     The Proposed Rule would apply to contributions made to an official of a government entity.  An "official" is defined generally to include an incumbent, candidate or successful candidate for elective office of a government entity if the office (or an appointee of the office) is directly or indirectly responsible for, "or can influence the outcome of," the selection of an investment adviser.  We believe that the existing definition is vague and needs clarification.  As currently written, almost any office could be viewed as having indirect responsibility for influencing the selection of an investment adviser.  We believe that the definition should contain more explicit guidelines as to which types of offices are considered responsible for the selection of an adviser, including for example, legislative and executive offices and treasury offices.  Otherwise, an adviser would be required to extensively investigate and constantly monitor state and local government offices to determine whether a specific individual in a particular jurisdiction held an office covered by the Proposed Rule.  

VII. Private Investment Funds 

     The Proposed Rule would treat an investment by a government entity in a private investment fund as if the government entity entered into an advisory contract directly with the adviser.  Thus, if the prohibitions of the rule were triggered by a covered contribution, and a government entity was an investor in a private fund at the time of the contribution, the adviser would be required to (i) cause the private fund to redeem the investment of the government entity, or (ii) return to the government entity the amounts the adviser received as compensation for managing the assets of the private fund attributable to the government entityís investment.

     We note that private investment funds frequently are established for the purpose of making long-term investments in illiquid securities or other illiquid assets (e.g., private equity, venture capital and certain real estate funds).  Private funds investing in illiquid assets cannot and do not control the timing of "liquidity events," and therefore may not be able to redeem investments for several years.  In addition, attempts to provide a redemption to a single client prematurely would likely jeopardize the position of the private fundís remaining investors.   Thus, under the Proposed Rule, an adviser would be forced to follow the alternative of returning to the government entity compensation received for assets attributed to the government entityís investment.

     Returning compensation to a government entity raises at least two specific concerns.  First, because public pension funds frequently make very large investments in private funds (in some cases $100 million or more), management fees to be refunded could easily reach $1 million or more per year (which is consistent with rates charged to non-government clients), leaving a government entity with a substantial windfall.  We believe this windfall would be disproportionate to a potential violation involving as little a few dollars.  Moreover, the Commissionís existing enforcement tools allow it to impose fines and take other measures it deems appropriate.  Second, fee arrangements in private funds vary and are not always calculated as an annual asset based fee.  For example, certain private investment funds have incentive fee arrangements that provide for the adviser to be compensated at the time of disposition of an investment, a point which may take well over two years to reach.  The portion of the fee attributable to a two-year prohibition period may not be easily calculated.  Accordingly, the Proposed Rule would need to provide some guidance on the proper method for calculating fees deemed to be received during the two-year prohibition period.

     Due to the redemption characteristics of private funds and inherent difficulties in returning fees to government agencies, we strongly reiterate our recommendation and request that the automatic two-year prohibition be dropped from the Proposed Rule.  Alternatively, any prohibition involving private funds should be limited to future rather than existing investments.

VIII.     Recordkeeping 

     The Commission has proposed an amendment to rule 204-2 requiring registered advisers to make and keep additional records, including a list of the states in which the adviser is providing "or seeking to provide" investment advisory services to a government client.  We note that most advisers are constantly "seeking" new clients and that many investment advisers operate a national business.  Thus, absent further clarification of the term "seeking," many advisers will be required to maintain a list containing the name of every state.  We are not certain that this approach will be helpful to advisers in establishing a compliance system or to the Commissionís staff who may rely on these lists during examinations.  Rather, we suggest that the term "seeking" be clarified to incorporate some type of bright-line test.  For example, "seeking" could be restated to require an affirmative step such as the receipt or completion by an adviser of a government agencyís request for a proposal.

IX.  Effective Date

     A key provision of the Proposed Rule calls for advisers to implement a system of procedures to ensure compliance with the rule.  Advisers most likely will attempt to satisfy this provision by creating an automated compliance system, which may require major reprogramming of existing systems.  Consistent with the SECís policy statement calling for a moratorium on the implementation of new Commission rules requiring major reprogramming, any adoption of a pay-to-play rule should not be made effective prior to March 31, 2000.3

     In addition, establishing compliance with any new pay-to-play rule will require a reasonable amount of time regardless of when any final rule is adopted.  Our clients estimate that the steps necessary to effectively meet the requirements of a new rule - including the implementation of computer systems, the development of additional compliance procedures, revisions to codes of ethics and the communication to employees of any new restrictions - will take at least 90 days.  Thus, we submit that any final rule should not be effective until the latter of March 31, 2000 or 90 days after its adoption.

Conclusion

     As noted, we and our investment management clients support the efforts of the Commission to ensure a level playing field with respect to obtaining government clients.  Our clients believe that the decision of government officials should be based on the ability of an adviser to deliver quality services.  However, we submit that the Commissionís goal can be fully achieved by (i) eliminating the automatic two-year prohibition, and instead, relying on the Commissionís existing enforcement tools and (ii) clarifying the scope of certain key terms and concepts in the Proposed Rule.  We hope that the Commission will carefully consider these comments prior to adopting any final rule.

                         Very truly yours,

                         Pierre de Saint Phalle
                         Nora M. Jordan
                         Terrance J. OíMalley


cc:  Paul F. Roye
          Robert E. Plaze



Footnotes


1.        References made in the proposing release to rule G-37 provide only limited assistance in understanding the contemplated application of the Proposed Rule.  In addition, the Proposed Rule contains certain imbedded assumptions based on rule G-37 that are not immediately apparent to persons lacking daily experience interpreting and applying the rule.

2.        We note that other prohibitions in the Advisers Act, including, for example, prohibitions on principal transactions and various types of misleading advertising, are enforced through the Commissionís existing enforcement tools.  While violations of these prohibitions seem equally as harmful to clients and the industry as pay-to-play practices, the relevant regulations and rules do not proscribe specific remedies.

3.        See Policy Statement: Regulatory Moratorium to Facilitate the Year 2000 Conversion, Investment Advisers Act Release No. 1749 (Aug. 27, 1998).