November 1, 1999
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Proposed Rule 206(4)-5 -- File No. S7-19-99
Dear Mr. Katz:
Morgan Stanley Dean Witter Investment Management Inc. ("MSDWIM"), on its own behalf and on behalf of its affiliated investment advisers,1 is submitting this letter to comment on Rule 206(4)-5 (the "Rule") which was proposed by the Securities and Exchange Commission (the "SEC") on August 4, 1999. The Rule is modeled after the Municipal Securities Rulemaking Board's (the "MSRB's") Rule G-37 and was proposed to eliminate alleged pay-to-play in the investment adviser industry. MSDWIM enthusiastically supports this purpose behind the Rule. Consistent with that support, the following comments describe ways in which we believe the Rule can be improved and tailored to address the pay-to-play practice that may exist, taking into account certain practical considerations in the investment adviser industry.
I. The Two Year Ban on Compensation Should Be Eliminated or an Automatic Exemption Should be Granted if a Contribution is Refunded in a Timely Manner
Rule 206(4)-5 imposes a two year ban on receiving compensation for investment advisory services provided to a governmental entity if a covered contribu tion is made. The Rule, however, permits the SEC to grant exemptions from this two year ban after considering certain factors, such as the impact on the public interest of granting an exemption.
MSDWIM believes that the Rule's two year ban on compensation should be eliminated because of its severity and inflexibility, i.e., it punishes innocent and inadvertent contributions in the same way that it punishes contributions made with corrupt intent. Rather, pay-to-play can be better addressed by creating a rule that prohibits a covered contribution and by treating a violation of such prohibi tion like any other violation of SEC rules (i.e., alleged violators are referred to the SEC enforcement process and administrative fines and other sanctions may be imposed commensurate with the violation). Indeed, this will permit the SEC to tailor its penalties to the severity of a particular violation.
In the alternative, a provision should be added to the Rule allowing for an automatic exemption from the two year ban on compensation if an investment adviser causes a covered contribution to be refunded by a candidate's campaign within a reasonable time (e.g., thirty (30) days) after the adviser discovers the contribution, provided that the adviser has adopted and maintained procedures reasonably designed to prevent and discover contributions in a timely fashion (e.g., on a quarterly basis). A contribution which is refunded by a candidate in a timely fashion has little or no chance of influencing that candidate. Also, the possibility of an automatic exemption will create an additional incentive on the part of an adviser to enforce its compliance procedures diligently and ferret out covered contributions on its own initiative.
Given the Rule's breadth and its potential to capture innocent and inadvertent contributions, MSDWIM believes that the Rule, in its current form, will generate numerous exemption requests which will create a burden on the SEC staff. By adding a provision for an automatic exemption, as described above, the exemp tion process will be streamlined and this burden on the SEC staff will be significantly reduced.
Also, such a bright line standard for granting exemptions will ensure that a repeat of what happened under Rule G-37's exemption provision does not occur in the context of this Rule. In particular, at the prompting of the SEC and the MSRB, the National Association of Securities Dealers ("NASD"), which administers Rule G-37's exemption process, has only been granting exemptions under three very narrow circumstances -- (1) where the contribution was intentionally made by a disgruntled employee to sabotage his or her employer; (2) where small incremental contributions made to a particular candidate aggregate over the $250 de minimis exemption (e.g., $255); and (3) where a ban is triggered because a person who made a contribution becomes a covered Municipal Finance Professional as a result of a merger or acquisition.2 59 Fed. Reg. 30376 (June 13, 1994); MSRB Q&A #4 (June 15, 1995); MSRB Q&A #3 (June 29, 1998). Please note that there has been no instance of a Rule G-37 ban being triggered because of a contribution made by a disgruntled employee or because of incremental contributions aggregating over $250. Also, in the cases involving mergers and acquisitions, the NASD has only granted conditional exemptions. Thus, the NASD has, as a general matter, been automati cally denying exemption applications. By requiring an automatic exemption in thecase of a refund, Rule 206(4)-5 will ensure that exemptions will be granted and permit the exemption provision to achieve its purpose, which is "to avoid conse quences disproportionate to the violation." See Notice, Discussion Section, Item #5.
II. The Scope of the Definition of Solicitor Is Too Broad
The Rule is triggered if an individual who meets the definition of a "solicitor" makes a contribution to a covered government official. The Rule defines "solicitor" as any person who solicits any client for, or refers any client to, an investment adviser. Given that this definition includes the referral of "any client" and does not specify the type of business that must be referred, it could include persons who solicit private clients for business other than investment advisory business. This is unduly broad in that the definition captures those who have no interest in a firm's investment advisory business with governmental entities. Thus, the definition of "solicitor" should be changed to cover only persons who solicit governmental entities for investment advisory business. Moreover, to further eliminate those persons who have no economic interest in investment advisory business with governmental entities, the definition of "solicitor" should extend only to those who receive compensation for their solicitation activity.
The notice of proposed rulemaking (the "Notice") also states that the term "solicitor" includes outside persons (i.e., non-employees) who solicit or refer clients to an investment adviser. Such outside persons should not be included in the definition of solicitor because it imposes an unfair and unrealistic burden on an investment adviser to control and monitor outside persons to the same degree that it controls and monitors its employees. This is particularly unreasonable given that even an inadvertent or innocent contribution by an outside solicitor would trigger a two year ban on compensation. Also, outside solicitors usually represent more than one firm, thus making it difficult to know on whose behalf the solicitor makes agiven contribution. Please note that because of these reasons, the MSRB drafted Rule G-37 so that a contribution made by an outside consultant would not trigger a two year ban on municipal securities business.
If the SEC decides that outside solicitors should be included in the definition of solicitor, it should, at the very least, limit the application of the Rule so that it only applies to contributions which are made to officials of the governmental entities being solicited by that outside solicitor. Indeed, this approach was taken in the proposed amendment to MSRB Rule G-38, which requires a broker dealer to report certain contributions made by its outside consultants. In particular, a broker dealer would be required, under this proposed amendment, to report the contributions made by its outside consultants to officials of the issuers with whom the consultant has communicated to solicit municipal securities business. See MSRB, Request for Comment (April 19, 1999).
III. Two-Year Look Back Should Be Eliminated or Reduced
The Rule has a two year look back feature -- i.e., a contribution made by an individual two years prior to qualifying or being retained as an executive officer or solicitor would trigger the two year ban for his or her investment adviser. We believe that this feature should be eliminated from the Rule.
The purpose of this two year look back is to prevent an investment adviser from indirectly circumventing the Rule by using past contributions of executive officers or solicitors to influence a public fund's selection of an adviser. However, the Rule already has a provision prohibiting an indirect violation of the Rule. Also, the two year look back creates unfair results. For example, an individual who contributed to a candidate for purely personal reasons while at another firm or ina different industry may not be hired by an adviser for fear of triggering the Rule's ban.
Even if the look back is not eliminated altogether, the look back period should be reduced to sixty (60) days. Going back two years is excessive and unwarranted. It is highly unlikely that a contribution made that long ago would serve to influence a public fund's selection of an adviser. Reducing the look back period to sixty (60) days is a more reasonable and realistic approach to address these concerns regarding prior contributions.
Also, for individuals who are newly hired as executive officers or solicitors, it is unreasonable for the investment adviser to be strictly liable for the contributions that such outside person may have made during the look back period while at another firm or in another profession. Thus, if the look back feature of the Rule is retained, the Rule should permit an investment adviser to rely on the written representation of a newly hired employee stating the contributions that he or she made during the look back period.
IV. The Rule Should Clarify What It Means by Compensation
If a covered contribution is made, the Rule imposes a two year ban on receiving compensation for providing investment advisory services to a governmen tal entity. The Notice states that an investment adviser "would not be prohibited from providing advisory services to a government client, but only from receiving compensation from the client for advisory services."
Although MSDWIM believes that this two year ban should be eliminated, as described above, it agrees with the Rule to the extent that if the ban is retained, it should prohibit compensation rather than the actual provision of invest ment advisory services. This is especially the case for investment advisers to private investment companies in which a governmental entity invests alongside other non-governmental entities. In such situations, it would be unfair to the other investors in the private investment company to be denied the services of an investment adviser because the adviser has to withdraw (e.g., as general partner of a venture capital fund, thus causing a dissolution of the fund) or because the private investment company's advisory contract has to be transferred to another adviser to comply with a ban on engaging in advisory business.
Rather, the Notice gives an investment adviser to such private investment company the choice of (1) causing the private investment company to redeem the investment of the governmental entity, or (2) returning to the governmen tal entity compensation attributable to the governmental entity's investment. Re deeming a governmental entity's investment is, in most cases, not viable because (1) the governing agreements do not generally provide for such redemption; (2) such redemption causes other investors to have a greater share of the risks and expenses related to the fund than they had expected at the time of their investment; and (3) the assets of private investment companies may be illiquid, non-transferable securities which can neither be distributed pro rata to the governmental entity nor readily sold for the cash equivalent of the investment's potential value. Indeed, the illiquid nature of these investments may also preclude accurately calculating the fair market value of the governmental entity's investment in the pooled vehicle.
Thus, if the Rule's ban on compensation is retained, it is imperative that the Rule provide a clear methodology by which an investment adviser to a private investment company can accurately determine the amount of compensation that must be returned to or forgone in connection with a governmental entity. This may not be clear depending upon the fee arrangement for a particular fund. For example, certain private funds have incentive fee arrangements under which anadviser is compensated at the time of disposition of an investment, a point which may take well over two years to reach. In determining the compensation that must be returned to or forgone in connection with a governmental entity under such circumstances, an adviser should be permitted to take the compensation attributable to the governmental entity's investment and use the pro-rata share which was earned during the two year ban. For example, if the compensation attributable to a govern mental entity's investment is $100,000 and the investment was held for eight years, an adviser who was subject to the two year ban during that period would have to return $25,000 of that compensation (i.e., the pro-rata share that was earned during the two year ban).
V. The $250 Exemption Should Be Increased to $1,000
Rule 206(4)-5 exempts contributions by an individual solicitor or executive officer which do not exceed $250 per election and is made to a candidate for whom the contributor is entitled to vote. We agree that this exemption should only be available for contributions made to a candidate for whom the contributor is entitled to vote. However, we believe that the de minimis threshold should be increased from $250 to $1,000. This more accurately reflects an amount under which corrupt influence is unlikely. In fact, Congress created the $1,000 per election limit under the Federal Election Campaign Act of 1971, as amended, ("FECA") because contributions under that amount were not deemed to result in corrupt influence. See Buckley v. Valeo, 424 U.S. 1, 29 (1976). This change would also do away with the unfair discrepancy created between federal candidates who are state or local officials (and thus subject to Rule 206(4)-5's $250 de minimis exemption) and those who are not (and thus only subject to FECA's $1,000 limit).
VI. The Rule Should Clarify the Term Investment Advisory Services
The Rule applies to the provision of investment advisory services for compensation to a governmental entity. However, it does not define the term "investment advisory services." Thus, the Rule should be changed to clearly define this term. Given that the Rule is being promulgated pursuant to the Investment Advisers Act of 1940 ("Act"), "investment advisory services" should be defined as those activities listed under the Act for purposes of defining "investment adviser." Act, § 202(11). Please note that this would exempt services which are incidental to providing broker dealer services. See id. Thus, a broker dealer providing advisory services in connection with a brokerage account would not fall under the Rule.
VII. Advisers to Off-Shore Funds Should Be Included
The Notice states that advisers to off-shore funds are not covered under the Rule because off-shore funds do not fall within the definition of private investment company. MSDWIM believes, however, that the Rule should extend to advisers to off-shore funds. Indeed, off-shore funds in which U.S. persons invest, including governmental entities, qualify as private investment companies. A private investment company for purposes of the Rule means an investment company exempt from SEC registration under Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 ("the '40 Act"). See Notice, FN 95. Because Section 7(d) of the '40 Act prohibits off-shore funds from registering with the SEC and publicly offering its securities in the U.S., they must offer securities within the exemptions under Section 3(c)(1) or 3(c)(7) of the '40 Act. Thus, under the '40 Act, an off-shore fund offering its securities in the U.S. must do so as a private investment company. Moreover, as a practical matter, off-shore funds must be included under the Rule to even the playing field between advisers to off-shore funds and other private investment companies.
While we support the purpose of the Rule, we believe that certain aspects of the Rule are overbroad and have a significant chance of capturing inadver tent or innocent contributions. These comments provide an unambiguous and tailored approach to pay-to-play, which will, among other things, protect against harm to the industry and the public funds. Thus, MSDWIM hopes that the SEC will consider and implement the comments.
Harold J. Schaaff
Morgan Stanley Dean Witter Investment Management Inc.
cc: Robert E. Plaze
1 Morgan Stanley Dean Witter Investment Management Inc. is a wholly-owned subsidiary of Morgan Stanley Dean Witter & Co., and is one of a number of affiliated investment managers that manage the assets of public funds.
2 In a Q&A issued on June 29, 1998, the MSRB attempted to clarify that these circumstances should not be the only ones under which exemptions are granted. MSRB, Q&A #2 (June 29, 1998). However, the NASD has not changed its practice of limiting exemptions to these three circumstances.