Pay to Play

Since as many as 50% of these placement agents are unlicensed and unregistered ' not directly registered with or regulated by the Financial Industry Regulatory Authority (FINRA) or the Securities Exchange Commission (SEC) ' the SEC proposed unpopular, and ultimately unenacted, rules as early as 1999 to attempt to regulate this industry. The 1999 proposed rule, which stopped short of banning the use of compensated placement agents altogether, nonetheless addressed pay-to-play on the part of investment firms by prohibiting firms from managing public funds' investments for compensation if they (or their “solicitors”) made campaign contributions to covered public officials.

The New York Investigation

While the SEC proposal languished, the New York Attorney General (NYAG) decided to regulate through indictments, expansive use of the Martin Act, and “voluntary” adoption of a “Reform Code” by targeted firms. The indictments began in March 2009, and led to eight guilty pleas from investment advisers, placement agents and political figures (such as Comptroller Alan Hevesi and consultant Henry Morris). In all, $161 million has been recouped for the New York retirement funds.

In what may be the outer boundaries of a prosecutor's reach, the national law firm of Manatt Phelps & Phillips agreed to a payment of $550,000 and a five-year ban on appearing before New York pension funds. According to the NYAG, a Manatt partner had acted as an unlicensed placement agent by setting up meetings between investment firms and public pension investment officials using his connections from prior service in the state legislature. It did not seem to matter that, according to the settlement documents, there were no political contributions, the meetings resulted in no investment of New York pension funds, and Manatt got no compensation. Instead, the New York AG used the Martin Act (New York General Business Law article 23-A, ” 352-353) to convert a lawyer into an unregistered securities “broker,” defined as one “engaged in the business of effecting transactions in securities for the accounts of others.” This interpretation of the Act was news to many in the industry, where up to 50% of placement agents are unlicensed, according to the NYAG's own analysis of records from more than 100 investment firms and their agents.

In addition to criminal prosecutions and negotiated resolutions, the NYAG made each settling party an offer they could not refuse ' sign onto the so-called Reform Code that, among other things, prohibits the use of compensated placement agents in connection with public pension fund investments altogether. The Reform Code further bans campaign contributions by investment firms to covered officials, above a de minimis amount, and imposes disclosure obligations pertaining to contributions, personnel, and payments to third parties.

The SEC followed the NYAG's trail and filed suit against several individuals and entities targeted in the NYAG's investigation, and has settled with several of them for significant amounts. Investment firm Quadrangle LLC and its co-founder, former Obama “Car Czar” Steve Rattner, each paid a penalty of $5 million. The SEC's suit against Henry Morris and former placement agents Saul Meyer, Julio Ramirez, Ray Harding, and Barrett Wissman is still ongoing.

Regulators Across the Country Examine Pay to Play

The New York experience reflects the heightened scrutiny around pay-to-play issues and public pension fund investments throughout the country, including these examples:

• The California AG filed suit against a former California Public Employees' Retirement System (CalPERS) board member-turned-placement agent;
• The former New Mexico Treasurer pled guilty to distributing investment contracts with state funds in exchange for kickbacks; and
• In Kentucky, the SEC has launched an informal inquiry into the Kentucky Retirement System after new Kentucky disclosure requirements revealed that advisers securing public investments paid over $15 million in placement agent fees in 2009.

The New Regulatory Regime

Beyond individual cases, regulators have also responded with new rules:

• This past July, the SEC adopted Final Rule 206(4)-5, which bars investment advisers from managing investments for a public fund for compensation for two years after a campaign contribution or gift to any government official who may have authority to decide on the investment of public funds. The SEC's rule also contains a “look-back” provision, under which the two-year compensation ban is triggered if any newly hired covered associate made a campaign contribution six months prior to hire. In addition, the rule prohibits investment advisers from soliciting donations to covered government officials or their PACs. Finally, the rule bars investment advisers from using outside compensated placement agents or solicitors unless the agent is registered with the SEC or with FINRA. (Notably, the SEC's original proposed form of the rule [put forward in September 2009] contained a provision entirely banning the use of third-party placement agents. After the feature drew intense criticism from the investing community, however, and FINRA assured the SEC that it would promulgate a rule to restrict pay-to-play activities by the registered broker-dealers it oversees, the SEC removed the complete ban from the final rule as adopted.)
• California passed legislation requiring anyone acting “for compensation as a finder” in connection with an investment advisor's offer to sell securities to a California state pension fund to register as a lobbyist. Registration triggers a battery of disclosures. These include identification of clients, as well as disclosure of compensation and of the government officials that the agents have been retained to lobby. The legislation also imposes a prohibition on campaign contributions or gifts to any state officials that lobbyists have registered to lobby. Significantly, even investment firms' in-house employees may have to register as lobbyists if they spend enough of their time soliciting new business.
• New Jersey's first pay-to-play regulations were adopted in 2004 and banned campaign contributions from investment advisers or placement agents to the governor, treasurer, legislators or political parties. In July 2009, the state required placement agents to register with the SEC or FINRA, to hold securities licenses and to disclose their clients and compensation.
• Connecticut has now prohibited contingency fees or finder's fees for agents, and they are subject to public disclosure requirements. Further, under the Connecticut provisions, investment advisers must disclose the use and compensation of placement agents.
• New Mexico has built a particularly robust set of pay-to-play restrictions that not only ban state investments with any adviser making a campaign contribution in the previous two years, or for two years after the relationship concludes, but also prohibit investing state money with any investment firm that uses a compensated placement agent (and requires any investment adviser soliciting public funds to file a certification that it has not paid any third-party agent).

Conclusion

The regulatory landscape is changing; many of the new pay-to-play provisions are just beginning to come into force. For example, California's lobbyist registration requirements for placement agents become effective Jan. 1, 2011; compliance with the SEC's new rule is not required until March and September 201l and new rules are expected from FINRA sometime in advance of the SEC's compliance deadline of September 2011.

While the economic impact of regulating and reducing the role of placement agents remains to be seen, the industry is now subject to both brighter lines and a very bright spot light being shined on past practices by regulators throughout the country. Keeping up with the effects of these changes will likely prove crucial to placement agents and their legal advisers.

Joseph F. Savage, Jr. ([email protected]), a member of this newsletter's Board of Editors, is a partner in the Boston office of Goodwin Procter LLP and a former federal prosecutor. Nicholas W. Pilchak and Stephen M. Hoeplinger are litigation associates in the same office.

Traditionally, you might have gotten the call from an investment adviser client who had provided lucrative contracts to a state investment officer's friend, after the state officer placed an even more lucrative investment with the adviser's firm. Then you would try to work your way through the government's latest attempt to address the reputed “pay to play” tradition that surrounds placement agents working with public pension funds.

Today, the phone call may come from your own law partner wondering how she can possibly be under investigation for assisting a firm client in obtaining a meeting with a public pension fund that did not lead to an investment and for which the firm got no money. As shown by the Manatt Phelps settlement in New York (discussed below), the world has changed radically for anyone trying to obtain investments from public pension funds.

Historically, relatively low-profile “placement agents” facilitated public fund investments based on personal and political relationships that provided access to those who control public pension fund investments. This role grew along with the expanded menu of alternative investments.

Since as many as 50% of these placement agents are unlicensed and unregistered ' not directly registered with or regulated by the Financial Industry Regulatory Authority (FINRA) or the Securities Exchange Commission (SEC) ' the SEC proposed unpopular, and ultimately unenacted, rules as early as 1999 to attempt to regulate this industry. The 1999 proposed rule, which stopped short of banning the use of compensated placement agents altogether, nonetheless addressed pay-to-play on the part of investment firms by prohibiting firms from managing public funds' investments for compensation if they (or their “solicitors”) made campaign contributions to covered public officials.

The New York Investigation

While the SEC proposal languished, the New York Attorney General (NYAG) decided to regulate through indictments, expansive use of the Martin Act, and “voluntary” adoption of a “Reform Code” by targeted firms. The indictments began in March 2009, and led to eight guilty pleas from investment advisers, placement agents and political figures (such as Comptroller Alan Hevesi and consultant Henry Morris). In all, $161 million has been recouped for the New York retirement funds.

In what may be the outer boundaries of a prosecutor's reach, the national law firm of Manatt Phelps & Phillips agreed to a payment of $550,000 and a five-year ban on appearing before New York pension funds. According to the NYAG, a Manatt partner had acted as an unlicensed placement agent by setting up meetings between investment firms and public pension investment officials using his connections from prior service in the state legislature. It did not seem to matter that, according to the settlement documents, there were no political contributions, the meetings resulted in no investment of New York pension funds, and Manatt got no compensation. Instead, the New York AG used the Martin Act (New York General Business Law article 23-A, ” 352-353) to convert a lawyer into an unregistered securities “broker,” defined as one “engaged in the business of effecting transactions in securities for the accounts of others.” This interpretation of the Act was news to many in the industry, where up to 50% of placement agents are unlicensed, according to the NYAG's own analysis of records from more than 100 investment firms and their agents.

In addition to criminal prosecutions and negotiated resolutions, the NYAG made each settling party an offer they could not refuse ' sign onto the so-called Reform Code that, among other things, prohibits the use of compensated placement agents in connection with public pension fund investments altogether. The Reform Code further bans campaign contributions by investment firms to covered officials, above a de minimis amount, and imposes disclosure obligations pertaining to contributions, personnel, and payments to third parties.

The SEC followed the NYAG's trail and filed suit against several individuals and entities targeted in the NYAG's investigation, and has settled with several of them for significant amounts. Investment firm Quadrangle LLC and its co-founder, former Obama “Car Czar” Steve Rattner, each paid a penalty of $5 million. The SEC's suit against Henry Morris and former placement agents Saul Meyer, Julio Ramirez, Ray Harding, and Barrett Wissman is still ongoing.

Regulators Across the Country Examine Pay to Play

The New York experience reflects the heightened scrutiny around pay-to-play issues and public pension fund investments throughout the country, including these examples:

• The California AG filed suit against a former California Public Employees' Retirement System (CalPERS) board member-turned-placement agent;
• The former New Mexico Treasurer pled guilty to distributing investment contracts with state funds in exchange for kickbacks; and
• In Kentucky, the SEC has launched an informal inquiry into the Kentucky Retirement System after new Kentucky disclosure requirements revealed that advisers securing public investments paid over $15 million in placement agent fees in 2009.

The New Regulatory Regime

Beyond individual cases, regulators have also responded with new rules:

• This past July, the SEC adopted Final Rule 206(4)-5, which bars investment advisers from managing investments for a public fund for compensation for two years after a campaign contribution or gift to any government official who may have authority to decide on the investment of public funds. The SEC's rule also contains a “look-back” provision, under which the two-year compensation ban is triggered if any newly hired covered associate made a campaign contribution six months prior to hire. In addition, the rule prohibits investment advisers from soliciting donations to covered government officials or their PACs. Finally, the rule bars investment advisers from using outside compensated placement agents or solicitors unless the agent is registered with the SEC or with FINRA. (Notably, the SEC's original proposed form of the rule [put forward in September 2009] contained a provision entirely banning the use of third-party placement agents. After the feature drew intense criticism from the investing community, however, and FINRA assured the SEC that it would promulgate a rule to restrict pay-to-play activities by the registered broker-dealers it oversees, the SEC removed the complete ban from the final rule as adopted.)
• California passed legislation requiring anyone acting “for compensation as a finder” in connection with an investment advisor's offer to sell securities to a California state pension fund to register as a lobbyist. Registration triggers a battery of disclosures. These include identification of clients, as well as disclosure of compensation and of the government officials that the agents have been retained to lobby. The legislation also imposes a prohibition on campaign contributions or gifts to any state officials that lobbyists have registered to lobby. Significantly, even investment firms' in-house employees may have to register as lobbyists if they spend enough of their time soliciting new business.
• New Jersey's first pay-to-play regulations were adopted in 2004 and banned campaign contributions from investment advisers or placement agents to the governor, treasurer, legislators or political parties. In July 2009, the state required placement agents to register with the SEC or FINRA, to hold securities licenses and to disclose their clients and compensation.
• Connecticut has now prohibited contingency fees or finder's fees for agents, and they are subject to public disclosure requirements. Further, under the Connecticut provisions, investment advisers must disclose the use and compensation of placement agents.
• New Mexico has built a particularly robust set of pay-to-play restrictions that not only ban state investments with any adviser making a campaign contribution in the previous two years, or for two years after the relationship concludes, but also prohibit investing state money with any investment firm that uses a compensated placement agent (and requires any investment adviser soliciting public funds to file a certification that it has not paid any third-party agent).

Conclusion

The regulatory landscape is changing; many of the new pay-to-play provisions are just beginning to come into force. For example, California's lobbyist registration requirements for placement agents become effective Jan. 1, 2011; compliance with the SEC's new rule is not required until March and September 201l and new rules are expected from FINRA sometime in advance of the SEC's compliance deadline of September 2011.

While the economic impact of regulating and reducing the role of placement agents remains to be seen, the industry is now subject to both brighter lines and a very bright spot light being shined on past practices by regulators throughout the country. Keeping up with the effects of these changes will likely prove crucial to placement agents and their legal advisers.

Joseph F. Savage, Jr. ([email protected]), a member of this newsletter's Board of Editors, is a partner in the Boston office of Goodwin Procter LLP and a former federal prosecutor. Nicholas W. Pilchak and Stephen M. Hoeplinger are litigation associates in the same office.