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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Pay-To-Play and
Public Pension Plans

Remarks of

Robert E. Plaze

Associate Director, Division of Investment Management,
U. S. Securities and Exchange Commission

At the Annual Joint Legislative Meeting of
The National Association of State Retirement Administrators,
National Conference on Public Employee Retirement Systems and
The National Council on Teacher Retirement, Washington, D.C.

January 26, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission.

Thank you for inviting me to address this meeting of the group of state pension administrators. My father was a state retiree and lived on his pension for a number of years. I know how the importance the security of a pension plan is to millions of persons like my Dad, and how important your jobs are.

I am a member of the staff of the Commission. But my remarks this afternoon are my own, and I am not speaking for the Commission or my colleagues on the staff.

When Arthur Levitt became Chairman almost six years ago, among his goals was the reform of the municipal securities markets. Since then, a series of initiatives have improved investor disclosure in the municipal securities markets. A second area of reform – and one most relevant to why you have invited me here today – has been the curbing of pay-to-play practices.

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don't give, you don't get business.

Chairman Levitt, and several SEC officials have been involved in the municipal securities markets. They knew that pay-to-play practices had been pervasive and corrupting to the market for municipal securities. And if you ask them, they will tell you stories about checks left on the table at a dinner. They may even know the minimum required contributions in a particular jurisdiction to be eligible for public contracts.

Pay-to-play creates the impression that contracts for professional services are awarded on the basis of political influence rather than professional competence. It harms the citizens of the municipality and the investing public asked to purchase the securities. It brings discredit on the businesses and professionals who participate in the practice.

In 1993, the first in a series of steps to end pay-to-play practices began when a group of investment banks voluntarily agreed to swear off making contributions for the purpose of obtaining municipal business. In 1994, the SEC approved MSRB rule G-37 – which is known as the pay-to-play rule.1

G-37 prohibits municipal securities dealers from engaging in the municipal securities business with an issuer two years after contributions are made to an official of an issuer by the dealer or its employees engaged in municipal finance business. The prohibition applies equally to officials who are incumbents and those who are candidates. There is a de minimis exception, which permits contribution of up to $250 to candidates for whom they can vote.

The rule was met with howls of protest from some state and municipal officials. Some argued that it violated their First Amendment rights to make and solicit political contributions. These claims were soon tested in the federal courts, and in an important decision, a federal court of appeals held that G-37 was a constitutionally permissible restraint on free speech – because it serves a compelling governmental interest of rooting out corruption in the market for municipal securities.2

As we meet this afternoon, the American Bar Association is considering proposals to bar the practice of lawyers obtaining business through political contributions. Deans of 47 law schools across the country have joined Chairman Levitt in calling for an end to what the San Francisco Chronicle called "a sleazy practice that costs taxpayers." 3 We hope that my profession will adopt a strong and effective ban.

Bringing an end to pay-to-play practices thus has been a step-by-step process.

Recently, Chairman Levitt has asked my Division to look into the question of whether the Commission needed to address pay-to-play in the public pension area. We are now in the fact-gathering stage of this project, which could very well lead to a rule proposal.

What have we found? So far, we see strong indicators that pay-to-play can be a powerful force in the selection of money managers of public pension plans. There are public reports of pay-to-pay problems with the management of public money in 12 states – and many of these are the largest states.

  • In one small state a former state treasurer raised over $73,000 in campaign contributions, virtually all from contractors for the state retirement system 4

  • The controller of a large state has raised $1.8 million from pension fund contractors, many of which are out-of-state 5

  • In another state, a former state treasurer raised contributions from contractors, one of whom received a five-fold increase in the custody fees it charged. The treasurer's candidate lost and the contract was terminated by the new treasurer.6

  • The Executive Director of the MSRB has been quoted in the Wall Street Journal as saying that "the conflicts of interest in the [public pension business] are as bad as anything we've seen in the muni-bond market.7

  • An elected state official has told me that she thought that G-37 has resulted in the movement of some pay-to-play activity over to the public pension area. Phone calls from some advisers have confirmed this.

Claims that pay-to-play really isn't a problem are refuted by the findings of states and plans that have taken on the issue. Vermont and Connecticut have enacted legislation.8 Both were concerned that awards of advisory contracts were being made on the basis of political favoritism rather than expertise. They concluded that even where no actual corruption occurred, the appearance of impropriety was intolerable.

CalPERS has acted in California, and the records of its rulemaking proceeding and subsequent litigation are particularly instructive about how pay-to-play works and its insidiousness.

It is heartening to see some of the plans and jurisdictions putting an end to the culture of pay-to-play. As you know, it takes two to tango, and it takes two to participate in these practices – the payer and the payee. Our concern is with the activities of the payers – investment advisers, whom we regulate under the Investment Advisers Act of 1940.9

The Advisers Act imposes a federal fiduciary duty on advisers with respect to their clients and prospective clients.10

  • When the process of the selection of an investment adviser is corrupted, the duties of an adviser to his client are compromised.

  • When the selection process is corrupted and advisers are selected based not on their merit but on the amount or their political contributions, the ultimate clients of advisers – the pension pools they manage – are harmed and the benefits of retirees threatened.

A similar harm occurs when advisers are not chosen because they have not made the requisite amount of contributions.

We at the Commission believe that G-37 is working pretty well. And I have to believe, based on the evidence we have collected so far, that the burden will fall on those who argue that the Commission should not apply the core principles of G-37 to investment advisers and the public pension plan area.

We have spoken with your representatives from NASRA, and we have discussed the matter with some of your colleagues. They have described the difficult position in which a professional manager is placed when it becomes apparent that the decision-making process is being skewed by considerations of political contributions. You have a unique perspective from which to help us understand the issues.

I look forward to further discussions with you and look forward to hearing your views.

Thank you.

1 Self-Regulatory Organizations; Municipal Securities Rulemaking Board, Securities Exchange Act Release No. 34-33868 (Apr. 7, 1994).

2Blount v. SEC , 61 F.3d 938 (1995), cert. denied , 517 U.S. 1119 (1996).

3A Sleazy Practice That Costs Taxpayers , San Francisco Chron., Aug. 1, 1997, at A26.

4See Office of Vermont State Treasurer James H. Douglas, If You Play, You Pay: New Campaign Finance Legislation Prohibits Contracts for Wall Street Firms Contributing to State Treasurer Races, a Provision Pushed by Douglas (06/16/97) http://www.state.vt.us/treasurer/press/pr970616.htm.

5 Clifford J. Leavy, Firms Handling N.Y. Pension Fund Are Donors to Comptroller , N.Y. Times, Oct. 3, 1998, at A16)

6See Steve Hemmerick, See You in Court,' Bank Tells Its Client: State Street Sues over Custody Contract, Pens. & Inv., Feb. 23, 1998, at 2.

7 Charles Gasparino and Jonathan Axelrod, Political Money May Sway Business of Public Pensions , Wall St. J., Mar. 24, 1997, at C1.

8 Conn. Gen. Stat. § 9-333 o (1997); Vt. Stat. Ann. tit. 32, § 109 (1997).

9 15 U.S.C. 80b.

10SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963).