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 adviser’s
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 adviser’s
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 adviser’s relationship is
continuous. As a result of this continuous relationship, an adviser
develops a thorough knowledge of a client’s 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
Commission’s 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
person’s 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 adviser’s "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 term’s
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 adviser’s 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 rule’s
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 Rule’s
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 entity’s 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 fund’s
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 entity’s
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
Commission’s 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
Commission’s 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 agency’s 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 SEC’s 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
Commission’s goal can be fully achieved by (i) eliminating the automatic
two-year prohibition, and instead, relying on the Commission’s 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. O’Malley
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 Commission’s 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).