New York Attorney General and SEC Seek to Curb Pay-to-Play Practices

Article

Corporate & Finance Alert

October 6, 2009

The New York Attorney General has reached settlements with seven private equity firms in the Attorney General’s investigation of pay-to-play practices involving the New York State Common Retirement Fund. As part of the settlements, the private equity firms agreed to adopt the Public Pension Fund Reform Code of Conduct (the “Code of Conduct”). The private equity firms are the Carlyle Group, River Stone Holdings, Pacific Corporate Group Holdings, HM Capital Partners, Levine Leichtman Capital Partners, Access Capital Partners, and Falconhead Capital.

On August 3, 2009, the United States Securities and Exchange Commission (the “SEC”) proposed a new rule under the Investment Advisers Act of 1940, as amended, that reflects similar policies as the Code of Conduct. The public comment period on the proposed rule ends on October 6, 2009.

On September 23, 2009, the New York State Comptroller issued an executive order prohibiting an investment advisory firm from doing business with the New York State Common Retirement Fund for two years from the date that the investment advisory firm or a covered associate makes a contribution to the comptroller, or a candidate for the office of comptroller. The executive order will expire on the effective date of the final SEC rule.

This article will discuss the key provisions of the Code of Conduct and the proposed SEC rule.

The Code of Conduct focuses on the following areas: placement agents, campaign contributions, disclosure, quid pro quo employment arrangements, gifts, and conflicts of interest. The Code of Conduct applies not only to New York public pension funds, but also to any retirement plan for employees of the United States government, the government of any state or political subdivision thereof, or the agencies of these government entities.

The Code of Conduct prohibits investment management firms from using third-party intermediaries, or placement agents, to influence the investment decision making process at public pension funds. It contains exceptions for employees acting within the scope of their professional duties; service providers whose sole basis of compensation is the provision of legal, accounting, engineering, real estate, or other professional services unrelated to soliciting business for the investment management firm; and lobbying administrative agencies and legislatures on issues unrelated to public pension fund investment decisions. Thus, investment management firms now have to conduct their marketing through their own investor relations and marketing personnel.

The Code of Conduct prohibits investment management firms from taking investments from, or providing services to, public pension funds for two years after the investment management firm makes campaign contributions to officials who are in the position to influence the public pension fund’s investment decisions, and political parties that assist these officials. In addition, the investment management firm is prohibited from making contributions during the term of its engagement.

The contribution prohibitions also apply to the investment management firm’s partners, members, executive officers, directors, employees, their respective agents other than limited partners, their respective relatives, including domestic partners living in the same household, and political action committees controlled by any of these persons or entities.

The contribution prohibitions also apply to solicitations of campaign contributions by any of these persons and entities. The Code of Conduct contains an exception for contributions of up to $300 to candidates and officeholders for whom the contributor is entitled to vote. The Code of Conduct also requires that the investment management firm adopt internal written procedures to monitor compliance with the prohibitions.

The Code of Conduct requires disclosure of the following information. The investment management firm must disclose political contributions made in the preceding two years, and during the term of the engagement. The contributions subject to disclosure are not only those prohibited by the Code of Conduct, but also contributions to state and local candidates and political parties. Second, the investment management firm must disclose information regarding its executive officers, investor relations personnel, and other personnel primarily responsible for communicating with, or responsible for soliciting, the public pension fund. Finally, the investment management firm must disclose all third-parties that the investment management firm compensated in connection with an investment or transaction with the public pension fund. The third-parties include those persons and entities providing legal, government relations, public relations, real estate, and other professional advice or services.

The Code of Conduct addresses quid pro quo employment arrangements between the investment management firm, and public officials in a position to influence public pension fund investment decisions. The investment management firm cannot employ or compensate any person who was an official, or an employee or fiduciary of a public pension fund, within two years after the termination of that person’s relationship with the public pension fund. The Code of Conduct contains an exception for persons who will have no contact with his or her former public pension fund.

Furthermore, the investment management firm and its partners, members, executive officers, directors, employees, and their agents cannot have financial, commercial, or business relationships with public pension fund officials, advisors, employees, and fiduciaries, or any of their relatives, unless the public pension fund consents after full disclosure. The Code of Conduct also provides that upon a public pension fund’s release of a request for proposal, an investment management firm cannot communicate or interact with the public pension fund and its officials, advisors, employees, and fiduciaries concerning the subject of the proposal until the contracting process is completed. The investment management firm may request technical clarifications of the proposal, or respond to requests for information from the public pension fund.

The Code of Conduct contains a broad prohibition on gifts. The investment management firm and its partners, members, executive officers, directors, employees, their agents and their relatives cannot give any gifts, including meals and entertainment, to public pension fund officials, employees, fiduciaries, and their relatives under circumstances “in which it could reasonably be inferred that the gift was intended to influence the person, or could reasonably be expected to influence the person, in the performance of the person’s official duties or was intended as a reward for any official action on the person’s part.” It is an open issue as to whether and how the prohibition applies to sponsorship events at investment conferences and seminars.

The Code of Conduct contains broad conflict of interest provisions. It defines a conflict of interest as circumstances that create a conflict with the investment management firm’s duty to act solely and exclusively in the best interest of the public pension fund’s participants. The Code of Conduct requires prompt disclosure of any apparent, potential, or actual conflict of interest, and requires the investment management firm to cure it. The methods of cure are eliminating the conflict, and terminating the relationship with a public pension fund as soon as responsibly and legally possible. Another method is that the investment management firm takes steps to isolate the person or entity that is the source of the conflict from decisions involving the public pension fund; the steps may be prudently taken without undue risk to the public pension fund; the nature of the conflict is not such that the conflicted person or entity must regularly and consistently withdraw from decisions that are normally his or her responsibility; the investment management firm makes full disclosure to the public pension fund; and the investment management firm’s general counsel or similar official would be entitled to conclude that no further action is necessary. Finally, the Code of Conduct allows the investment management fund to cure the conflict by disclosing it to the public pension fund and obtaining a waiver.

The Code of Conduct also contains a separate set of conflict of interest rules for investment funds sponsored by the investment management firm. The Code of Conduct requires the fund’s governing documents to contain provisions for addressing conflicts of interest. One permissible method is independent advisory committee approval.

Finally, the Code of Conduct requires the investment management firm to provide a copy of the Code of Conduct to all its partners, executive officers, directors, and employees. In addition, the investment management firm must post the Code of Conduct on its internal computer network. Investment management firms must conduct training seminars for personnel who come in contact with public pension funds, and conduct retraining annually.

The proposed SEC rule contains three broad prohibitions on investment advisers and their covered associates. First, an investment adviser and its covered associates cannot make or agree to make payments to third-parties, such as placement agents, to solicit a government entity for investment advisory business. Second, an investment adviser and its covered associates cannot receive compensation within two years after making a political contribution to an official of a government entity, or to a political party in a jurisdiction in which the investment adviser seeks business. Third, an investment adviser and its covered associates cannot solicit third-parties to make a political contribution to an official of a government entity to which the investment adviser provides, or is seeking to provide, investment advisory services.

An important exception to the first prohibition permits the investment advisory firm to use its, or its affiliates’, executive officers, general partners, managing members, and employees to solicit business from government entities.

The prohibition on political contributions applies to any person who becomes a covered associate within two years of making the contribution. Thus, investment advisory firms should conduct the appropriate due diligence when hiring new covered associates. In addition, the termination of a covered associate’s employment does not alter the requirement that the investment advisory firm take that covered associate’s contribution into account.

There are three exceptions to the prohibition on political contributions. First, a covered associate may contribute up to an aggregate of $250 to an official per election when the covered associate is entitled to vote in the election. Second, there is an exception for inadvertent violations of the prohibition if the violation is discovered within four months of making the contribution, the contribution did not exceed $250, and the contribution is returned within sixty days after the date of discovery. Third, the SEC may grant discretionary relief for violations.

The proposed rule applies to registered investment advisers, and to investment advisers that are not required to register because they do not hold themselves out to the public as investment advisers and had less than fifteen clients in the preceding twelve months. For a private investment fund in which a government entity invests, such as a private equity fund or hedge fund, the proposed rule applies to the fund’s general partner and investment manager.

Not surprisingly, the proposed rule broadly defines covered associates as the investment advisory firm’s general partners, managing members, executive officers, and other persons with a similar status or function; any employee who solicits a government entity for investment advisory business; and any political action committee controlled by any of the foregoing persons or entities.

Finally, the proposed rule broadly defines an official of a government entity as any person, and that person’s candidate committee, who on the date of the contribution was an incumbent, candidate, or successful candidate for elective office if the office (a) is responsible for, or can influence the outcome of, the hiring of the investment adviser; or (b) has the authority to appoint a person who is responsible for, or can influence the outcome of, the hiring of the investment adviser.

Should you have any questions regarding your own situation, please contact Steven H. Sholk of our Corporate Department.