The US Securities and Exchange Commission (“SEC”) issued an update to the guidance previously issued in the Staff Response to Questions about the “pay to play” rule (Investment Advisers Act Rule 206(4)-5). The updated information was meant to address pay to play issues raised as a result of the rules implemented by the Financial Industry Regulatory Authority (“FINRA”) related to “capital acquisition brokers” (“CAB”).
By way of background, Rule 206(4)-5 (the “Rule”) seeks to prevent investment advisers from engaging in pay to play practices that involve an adviser’s payments to third parties to solicit government business. Thus, the Rule prohibits an investment adviser subject to the rule, and its covered associates, from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser. However, the Rule does permit payments to a third party that is a “regulated person,” which is defined, in part, to include a registered broker or dealer that is itself subject to pay to play rules adopted by a registered national securities association. The compliance date of the third-party solicitation ban in the Rule was July 31, 2015, but because FINRA and the MSRB had not yet adopted pay to play rules at that time, the SEC indicated that it would not recommend enforcement action to the Commission against an investment adviser or its covered associates under the Rule for payment to any person to solicit a government entity for investment advisory services until the effective date of such rules.
On August 25, 2016, the SEC approved FINRA rules 2030 and 4580, which establish a regime to regulate the activities of member firms that engage in distribution or solicitation activities with government entities on behalf of investment advisers (the “FINRA pay to play rules”). The FINRA pay to play rules became effective, and the relief previously provided by the SEC expired on its own terms, on August 20, 2017.
On August 18, 2016, the SEC approved a new set of FINRA rules that applied only to firms that meet the definition of a CAB, and that elect to be governed under this rule set (collectively, the “CAB rules”). CABs are registered broker-dealers that are authorized to engage in a limited range of activities, including distribution and solicitation activities with government entities on behalf of investment advisers. However, while the CAB rules subject CABs to certain FINRA rules, they did not expressly provide that the FINRA pay to play rules apply to CABs. The result of this oversight is that currently, CABs are not within the definition of a “regulated person” for purposes of the Rule.
To address the issue, FINRA recently filed a proposed rule change to adopt CAB rules 203 and 458, which would apply the established FINRA pay to play rules to CABs with the SEC. (See Exchange Act Release No. 81438.) However, until the effective date of any rules subjecting CABs to the FINRA pay to play rules, CABs still are not included within the definition of regulated person, and thus an investment adviser and its covered associates would be prohibited from providing payments to any person that is a CAB to solicit a government entity for investment advisory services.
The current SEC guidance was issued to address that issue and it basically states that until the effective date of the new proposed FINRA rules subjecting CABs to FINRA’s pay to play Rules, the SEC would not recommend enforcement action against an investment adviser or its covered associates under the Rule for the payment to any person that is a CAB to solicit a government entity for investment advisory services.