SEC

New SEC Proxy Regulations for Proxy Voting Advice Businesses and More Proxy Guidance for Investment Advisers

I. Introduction

At an open meeting on July 22, 2020, the Securities and Exchange Commission (SEC) voted 3-1 to adopt amendments to its proxy rules and to issue supplemental SEC guidance (Guidance) for investment advisers.1

The amendments to the proxy rules impose a number of new requirements on proxy voting advice businesses (PVABs). The Guidance discusses the proxy voting responsibilities of investment advisers when using a PVAB, and in particular, it focuses on adviser responsibilities when using the electronic voting platform of a PVAB.

II. Amendments to Proxy Rules

A quick summary of the rule amendments is highlighted in this chart:

A. Definition of Solicitation

Section 14(a) of the Exchange Act and the rules thereunder govern the solicitation and voting of the proxies of issuers. The amendment to Rule 14a-1(l)(1)(iii) confirms that Proxy Voting Advice generally constitutes a “solicitation.” Under this amendment, a “solicitation” involves persons that make voting recommendations to shareholders and who market their expertise separately from other forms of investment advice and sell such advice for a fee. The amendment excludes persons who furnish reports only in response to an unprompted request from the definition of solicitation.2

Institutional Shareholder Services, one of the main PVABs, had filed a lawsuit challenging the SEC’s interpretation that proxy advice constitutes a solicitation. It is unclear whether that litigation, which was stayed pending the final rule, will move forward.3

B. The Exemptions

As noted above, PVAB’s may rely on exemptions from the definition of solicitation (in either Rule 14a-2(b)(1) or (b)(3)4(exemptions)), provided that they meet certain conditions.5

a. Conflicts of Interest Disclosures

Disclosure Requirement. New Rule 14a-2(b)(9)(i) requires as a condition to reliance on the exemptions that a PVAB disclose in detail to clients material conflicts of interest so that PVAB clients can fully understand the nature and scope of such an interest, transaction or relationship. PVAB clients must also be provided with any policies and procedures used to identify, and steps taken to address any such material conflicts. These disclosures will have to be provided either in the PVAB’s reports or in an electronic medium, such as a client voting platform. The Release notes that these disclosures should be readily accessible to clients and facilitate their ability to consider such disclosures together with the report at the time they make their voting decisions.

b.  Notice to Issuers and Safe Harbor

Notice Requirement. New subparagraph A to Rule 14a-2(b)(9)(ii) requires as a condition to reliance on the exemptions that a PVAB adopt and publicly disclose written policies and procedures reasonably designed to ensure that issuers have a report made available to them at or prior to the time when such report is disseminated to the PVAB’s clients. Provided that this initial notice is given to issuers, PVABs are under no obligation to provide issuers with additional opportunities to review the report, including if the report is later revised or updated in light of subsequent events. This condition does not apply to voting advice: (1) that is based on a “custom policy,” i.e., a policy proprietary to the client; and (2) regarding certain mergers and acquisitions and contested matters.6

Safe Harbor. New Rule 14a-2(b)(9)(iii) provides a non-exclusive safe harbor that a PVAB will be deemed to satisfy the notice requirement if it has written policies and procedures that are reasonably designed to provide issuers with a copy of its report, at no charge, no later than the time it is disseminated to the PVAB’s client.7

c. Mechanism to Become Aware of Issuer’s Response and Safe Harbor

Mechanism to Become Aware of Issuer’s Response. New subparagraph B to Rule 14a-2(b)(9)(ii) requires a PVAB, as a condition to relying on the exemptions, to adopt and publicly disclose policies and procedures reasonably designed to ensure it provides clients with a mechanism by which they can reasonably be expected to become aware of any written responses by an issuer to a report, in a timely manner before the shareholder meeting or other action.

Safe Harbor. A non-exclusive safe harbor is available if the PVAB provides electronic notice on its electronic client platform (or through email or other electronic means) that the issuer has filed, or has informed the PVAB that it intends to file, additional soliciting materials (and includes an active hyperlink to those materials on EDGAR when available). The PVAB must provide a hyperlink to materials even if it believes the information is non-material or false or misleading.8

C. Amendments to the Anti-Fraud Provision

Largely consistent with the proposal, the SEC amended Rule 14a-9, the anti-fraud provision for proxy solicitations, to add examples of what may be misleading within the meaning of the rule. The amendment provides that “the failure to disclose material information regarding proxy voting advice, such as the proxy voting advice business’s methodology, sources of information, or conflicts of interest” could, depending on the particular facts and circumstances, be misleading within the meaning of the rule. In response to comments that the examples would heighten legal uncertainty and litigation risk, the Release emphasizes that the examples do not change the rule’s scope or application or make “mere differences of opinion” actionable, and the rule is still grounded in materiality.9

III. Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers

The Guidance addresses an investment adviser’s fiduciary duty and obligations under Rule 206(4)-6 under the Investment Advisers Act of 1940 as it relates to the adviser’s use of a PVAB to exercise of voting authority on behalf of its clients and supplements prior guidance issued by the SEC last year.10 The Guidance reiterates that an investment adviser should have policies and procedures in place that are reasonably designed to ensure that it exercises voting authority in the best interests of its clients.11

This Guidance focuses on an adviser’s use of PVABs’ pre-populated and automated voting services, which some advisers use to more efficiently address the thousands of votes they may make during a short proxy season. While the final rule amendments no longer require a PVAB to provide an issuer the ability to review a report prior to the PVAB client receiving it, and the SEC did not pursue imposing a “speed bump” on automated voting,12 the Guidance puts the onus on advisers to create and maintain policies and procedures that address any issuer response to a report. The Guidance also suggests advisers should disclose details regarding its use of automated voting and get client consent to such practices. The Guidance recommends the following:

  • Issuer’s Additional Soliciting Materials. Investment advisers follow policies and procedures that address situations where the adviser becomes aware of an issuer that has filed or intends to file additional soliciting material after the investment adviser has received the PVAB’s voting recommendation but before the proxy voting submission deadline.
  • Review of Proxy Advisory Firm Agreement. An investment adviser that uses a PVAB’s pre-populated and automated voting services should review its agreement with the PVAB to ensure that any non-public information possessed by the PVAB relating to the proxy vote of the investment adviser is not used in a manner that would not be in the best interests of the adviser’s client. This includes information on aggregated voting intentions of the investment adviser’s clients.
  • Informed Consent. An investment adviser wishing to use a PVAB’s automated voting service should obtain informed consent from its client prior to doing so.13 In particular, the investment adviser should disclose (1) the extent of its use of automated voting services and under what circumstances it uses such services; and (2) how its policies and procedures address the use of automated voting in cases where it becomes aware before the submission deadline for proxies to be voted at the shareholder meeting that an issuer intends to file or has filed additional soliciting materials with the SEC regarding a matter to be voted on. The Guidance recommends that an adviser’s policies and procedures address these disclosures.

IV. Conclusion

While the final amendments to the proxy rules are less prescriptive than the proposal, it is likely that PVABs will need to make some adjustments to their current practices, which may result in increased cost to clients and potential delays during the short proxy voting season. As Commissioner Allison Lee stated in her remarks opposing the adoption of the amendments, “The final rules will still add significant complexity and cost into a system that just isn’t broken” and “are still designed to, and will, increase issuer involvement in what is supposed to be independent advice from proxy advisory firms.”14It will be interesting to follow whether, as has been suggested, PVAB advice becomes less independent (i.e., if PVABs bow to issuer pressure due to concerns about threatened litigation). It is unclear whether the proposed amendments to the shareholder submission/resubmission thresholds, which were not addressed in the Release, will be finalized.15

The Guidance constitutes the latest SEC foray into fiduciary duty of advisers. Advisers will have to balance competing concerns and consider a cost-benefit approach to the review of policies and procedures and disclosure. The Guidance was not subject to notice and comment, is quite prescriptive and suggests an unusual level of detail with regard to policies and procedures and disclosure to clients.16 The SEC’s ability to enforce the Guidance, therefore, is not clear. It is also unclear whether the SEC will attempt to second guess an adviser’s good faith efforts to conform to the Guidance and best interest determinations required therein.


1 Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 34-89372 (July 22, 2020) (“Release”); Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Adviser, Release No. IA-5547 (July 22, 2020) (“Guidance”); Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 34-87457 (Nov. 5, 2019) (“Proposal”); Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release Nos. IA-5325; IC-33605 (Aug. 21, 2019) (“Prior Guidance”). See also, Commissioners’ statements: Jay Clayton, Chairman, SEC, Proxy Voting – Reaffirming and Modernizing the Core Principles of Fiduciary Duty and Transparency to Provide for Better Alignment of Interest Between Main Street Investors and the Market Professionals Who Invest and Vote on Their Behalf (July 22, 2020); Hester M. Peirce, Commissioner, SEC, Statement at Open Meeting on Exemptions from the Proxy Rules for Proxy Voting Advice and Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers (July 22, 2020); Elad L. Roisman, Commissioner, SEC, Open Meeting to Adopt Amendments to the Proxy Solicitation Rules (July 22, 2020).

2 The final rule clarifies that the SEC does not intend this definition to cover investment advisers, and presumably broker-dealers, that provide reports as part of their advisory services: “[The rule] is not intended to include communications made in the normal course of business by other professionals to their clients that may relate to proxy voting. Instead, the amendment is intended to apply to entities that market their reports as a service that is separate from other forms of investment advice to clients or prospective clients and sell such advice for a fee.” Release, supra note 1, at 35 n.124. It is understood that investment advisers and broker-dealers routinely vote proxies for their clients, both with and without their clients’ explicit voting instructions.

3 The Release includes wording designed to preserve other portions of the rule should litigation be successful. See Release, supra note 1, at 136; Institutional S’holder Servs. Inc. v. SEC, No. 1:19-cv-03275 (D.D.C. Oct. 31, 2019).

4 Rule 14a-2(b)(1) exempts solicitations by persons who do not seek the power to act as proxy for a shareholder and do not have a substantial interest in the subject matter of the communication beyond their interest as a shareholder. Rule 14a-2(b)(3) exempts reports furnished by an adviser to any other person with whom the adviser has a business relationship.

5PVABs are not required to comply with the Rule 14a-2(b)(9) conditions until December 1, 2021. However, this transition period does not apply to the amendments to the definition of solicitation and the anti-fraud provisions.

6 Commenters, including investment advisers, had argued that advice based on custom policies should not be required to be provided to issuers because those custom policies are formulated by and tailored to a particular client and based on proprietary and often confidential information.

7 These policies and procedures can contain conditions requiring that such issuers have filed their definitive proxy statement at least 40 days before the shareholder meeting and expressly acknowledged that they will only use the report for their internal purposes and/or in connection with the solicitation, and the report will not be published or otherwise shared except with the issuer’s employees or advisers.

8 The Release did clarify that inclusion of a hyperlink would not, by itself, make the PVAB liable for the content of the issuer’s hyperlinked statement.

9 See Release, supra note 1 at p.132.

10 See Guidance, supra note 1; Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release Nos. IA-5325; IC-33605 (Aug. 21, 2019) (“Prior Guidance”); see also Risk&Reward Client Alert, SEC Adopts Guidance on Proxy Advisory Firms and Proxy Rules (Aug. 29, 2019) (discussing the Prior Guidance).

11 Consistent with the terminology in the Release, the Guidance also uses the term PVAB rather than “proxy advisory firm,” which was previously used in the Prior Guidance.

12 As discussed in our prior client alert, the SEC requested comments on whether PVABs should be required to disable the automatic submission of votes unless a client clicks on the hyperlink and/or accesses the issuer’s response or otherwise confirms any pre-populated voting choices before the PVAB submits the votes to be counted. Risk&Reward Client Alert, New SEC Proposal May Complicate Proxy Voting & Engagement by Advisers (Nov. 19, 2019).

13 Informed consent requires that the adviser make full and fair disclosure such that the client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent. See Guidance, supra note 1.

14 Allison Herren Lee, Commissioner, SEC, Paying More For Less: Higher Costs for Shareholders, Less Accountability for Management (July 22, 2020).

15 It appears that this aspect of the rulemaking has been a point of contention in the SEC’s 2021 budget appropriation with Democrats seeking to prohibit the use of funds to finalize rulemaking under Rule 14a-8. See House Committee on Rules, H.R. 7617 – Defense, Commerce, Justice, Science and Energy and Water Development, Financial Services and General Government, Homeland Security, Labor, Health and Human Services, Education, Transportation, Housing, and Urban Development Appropriations Act 2021.

16 In this respect, it can be argued that the Guidance is subject to similar criticism as the recently proposed valuation rule. See Hester M. Peirce, Commissioner, SEC, Statement on Good Faith Determinations of Fair Value under the Investment Company Act of 1940 Proposal (April 21, 2020) (questioning whether the benefits of the proposed rule “may be diminished significantly by an overly prescriptive approach to ensuring adequate board administration of the fair valuation process.”)

SEC readies for additional proxy voting rules

As announced by the SEC:

Open Meeting Agenda

Wednesday, July 22, 2020

The two items of the Open Meeting will address the Commission’s continued efforts to enhance transparency, improve disclosures, and increase confidence in the proxy process. The specific matters to be considered are:

Item 1: Exemptions from the Proxy Rules for Proxy Voting Advice
Office: Division of Corporation Finance
Staff: William Hinman, Michele Anderson, Ted Yu, Luna Bloom, Daniel Greenspan, and Valian Afshar

The Commission will consider whether to adopt proxy rule amendments to provide investors who use proxy voting advice with should receive more transparent, accurate, and complete information on which to make voting decisions, without imposing undue costs or delays.

For further information, please contact Daniel Greenspan or Valian Afshar in the Division of Corporation Finance at (202) 551-3430.

Item 2: Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers
Office: Division of Investment Management
Staff: Dalia Blass, Paul Cellupica, David Bartels, Holly Hunter-Ceci, and Thankam Varghese

The Commission will consider whether to publish supplementary guidance to the Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5325 (Aug. 21, 2019), 84 FR 47420 (Sept. 10, 2019), regarding how the fiduciary duty and rule 206(4)-6 under the Investment Advisers Act of 1940 relate to an investment adviser’s proxy voting on behalf of clients.

For further information, please contact Thankam Varghese or Holly Hunter-Ceci in the Division of Investment Management at (202) 551-6825.

Surviving Election Season: Refresher on Pay-to-Play Rules for Investment Advisers

Election season is already in full swing. As a result, investment advisers may wish to increase their attention to applicable pay-to-play compliance obligations, as further described herein.

I. Background on the Rule

In connection with political contributions, registered investment advisers, certain exempt reporting advisers and foreign private advisers (collectively referred to herein as “advisers”),1 as well as their “covered associates”2 (which is broadly defined), are subject to Rule 206(4)-5 of the Advisers Act, otherwise known as the “pay-to-play” rule. The purpose of the rule is to curtail “pay-to-play” practices by advisers seeking to manage the assets of state and local governments (e.g., public pension funds and investments by public universities) in return for political contributions. The SEC does not have to show any intent or quid pro quo to allege a violation of this anti-fraud rule. Penalties imposed by the SEC in connection with violations of the rule are severe even for foot-faults. Such penalties generally include disgorgement of any advisory fees received from such governmental entities, as well as the imposition by the SEC of civil monetary penalties (which are regularly in the hundreds of thousands of dollars).3

II. Prohibitions

     A. Ban on Fees Following Contributions

As a general matter, the rule prohibits advisers and their covered associates from making political “contributions”4 to any “official”5 of a “government entity”6 who was, at the time of the contribution, an incumbent, candidate or successful candidate for an elective office of a government entity if that office could influence the hiring of an investment adviser for such entity or have authority to appoint a person who could have such influence. If such a political contribution is made, the adviser is prohibited from receiving any compensation from advisory services to that government entity for two years thereafter – otherwise known as the “time-out” period. The adviser can still provide uncompensated advisory services to such entity during the time-out period, or provide uncompensated advisory services until the entity locates a replacement adviser. Note that an adviser to a “covered investment pool”7 in which a government entity invests or is solicited to invest shall be treated as though that adviser was providing or seeking to provide investment advisory services directly to the entity.

     B. Ban on Using Third Parties to Solicit Government Business

The rule further prohibits an adviser from providing payment8 to (or agreeing to pay), directly or indirectly, any person to solicit9 a government entity for advisory services on behalf of the adviser. However, such solicitation is not prohibited if the person is a (1) “regulated person”10 (such as a registered investment adviser, broker-dealer or municipal adviser) or an (2) executive officer, general partner, managing member, similar person or employee of the adviser. The rule also prohibits an adviser from coordinating or soliciting a person or PAC to: (1) contribute to an official of a government entity to which the adviser provides or seeks to provide advisory services or (2) make a payment to a political party of a state or locality in which the adviser provides or seeks to provide advisory services to a government entity.

     C. Catchall Ban

As a sort of catchall provision, the rule prohibits any acts done indirectly which, if done directly, would violate the rule. For example, the SEC staff has indicated that while a covered associate’s contribution to a PAC generally would not trigger the two-year time-out, if the contribution is earmarked or known to be provided for the benefit of a particular political official, it would implicate the catchall provision because the covered associate would be doing indirectly what it could not do directly.11

III. Exceptions and Exemptions from the Rule

     A. Exception for Certain New Covered Associates

Whereas the rule requires a two-year look-back for all covered associates who solicit clients, it only requires a six-month look-back for “new” covered associates who do not solicit clients. The “look-back” period will follow covered associates that change advisers, such that a prohibited contribution by a covered associate will result in a “time out” for the covered associate’s new firm for the remainder of the two-year or six-month period, depending on whether the covered associate solicits clients for the new firm. To prevent advisers from channeling contributions through departing covered persons, if a covered person makes a prohibited contribution and then leaves the employ of that adviser, the former adviser will also still be subject to the two-year time-out period, despite the departure of the covered associate who made the contribution.

     B. De Minimis Exception

The primary exception to the pay-to-play rule is the de minimis exception. The de minimis exception allows an adviser’s covered associate that is a natural person to contribute: (1) up to $350 to an official per election (with primary and general elections counting separately) if the covered associate is entitled to vote for the official at the time of the contribution; and (2) up to $150 to an official per election (with primary and general elections counting separately) if the covered associate is not entitled to vote for the official at the time of the contribution. Most firms implement pre-clearance requirements in connection with covered person political contributions in order to ensure compliance with this exception. Any contribution above such de minimis amounts, no matter how small, can trigger a violation of the rule.

     C. Returned Contribution Exception

If a covered associate makes a contribution that triggers the two-year time-out period solely because he or she was not entitled to vote for the official at the time of the contribution, the adviser can undo the contribution under very narrow circumstances. To be eligible for the returned contribution exception, the contribution had to be less than $350, the adviser must have discovered the contribution within four months of the date of such contribution, and the adviser must cause the contributor to re-collect the contribution within 60 days after the adviser discovers the contribution. However, an adviser can only rely on the returned contribution exception on limited occasions (for advisers with fewer than 50 employees, twice in a 12-month period; for advisers with more than 50 employees, three times in a 12-month period), and an adviser can never use the returned contribution exception for the same covered associate twice. Again, this exception is only applicable if the violation is discovered and remedied on a timely basis.

     D. Request for Exemptive Relief

In extremely narrow circumstances, the rule also allows an adviser to apply for an order exempting it from the two-year time­out requirement in the event of an inadvertent violation that falls outside of the exceptions set forth above. The SEC will grant orders only when, according to the SEC, the imposition of the time-out provision is unnecessary to achieve the rule’s intended purpose.12 Advisers applying for an order must do so through an application process that exposes the firm and the covered associate to public scrutiny.

IV. Recordkeeping Requirements

As part of their recordkeeping requirements under the pay-to-play rule, advisers must collect and maintain:

  • the names, titles and business and residence addresses of all covered associates;
  • all government entities to which the adviser provides or has provided investment advisory services, or which have been investors in any covered investment pool to which the adviser provides or has provided investment advisory services, in the last five years;
  • all direct and indirect contributions made by the adviser or its covered associates to an official of a government entity or direct or indirect payments made to a political party or PAC; and
  • the name and business address of each regulated person to which the adviser agrees to provide direct or indirect payment to solicit a government entity.

V. Summary

If an investment adviser would like to remain eligible to bid for government contracts, it should take affirmative steps to ensure that the firm and its covered persons do not violate the pay-to-play rule. Robust pay-to-play policies and procedures, as well as pre-clearance of political contributions, are recommended best practices for advisers that seek government clients. Re-education of adviser personnel and covered associates as to the requirements of the rule, especially in light of the upcoming election season, is also advised.13 An adviser should also consider pre-screening new covered person candidates for the applicability of the rule. Finally, it may be helpful to conduct periodic checks of campaign contribution databases, as well as require quarterly pay-to-play compliance reporting. The SEC may bring enforcement actions for even minor foot-fault violations of the rule. Such cases generally result in disgorgement and fines. Compliance with the relevant recordkeeping obligations is also important, as the SEC regularly reviews pay-to-play recordkeeping as part of adviser exams.


The rule applies to all investment advisers registered (or required to be registered) with the Securities and Exchange Commission (SEC), or unregistered in reliance on the exemption available under section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) (15 U.S.C. 80b-3(b)(3)), or that is an exempt reporting adviser, as defined in section 275.204-4(a) – which includes venture capital fund advisers and private fund advisers.

A “covered associate” broadly includes (1) a general partner, managing member, executive officer or other individual with a similar status or function; (2) any employee who solicits a governmental entity for the adviser (and any person who supervises, directly or indirectly, such an employee); or (3) a political action committee (PAC) controlled by the adviser or by any of its covered associates.

3 See e.g., In the Matter of Ancora Advisors LLC, SEC Administrative Proceeding File No. 3-18937 (Dec. 18. 2018), found here.

4 The definition of “contribution” is broad and encompasses any gift, subscription, loan, advance or deposit of money or anything of value made for (1) the purpose of influencing any election for federal, state or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office.

5 An “official” means any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (1) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by a government entity; or (2) has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.

A “government entity” means any state or a political subdivision of a state, including: (1) any agency, authority or instrumentality of the state or a political subdivision, (2) a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to a “defined benefit plan” as defined in section 414(j) of the Internal Revenue Code (26 U.S.C. 414(j)), or a state general fund; (3) a plan or program of a government entity; and (4) officers, agents, or employees of the state or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity.

7 “Covered investment pool” means: (1) an investment company registered under the Investment Company Act of 1940 (Investment Company Act) that is an investment option of a plan or program of a government entity; or (2) any company that would be an investment company under section 3(a) of the Investment Company Act, but for the exclusion provided from that definition by either section 3(c)(1), 3(c)(7) or 3(c)(11) of that Act.

8  “Payment” means any gift, subscription, loan, advance, or deposit of money or anything of value.

9  “Solicit” means: (1) with respect to investment advisory services, to communicate, directly or indirectly, for the purpose of obtaining or retaining a client for, or referring a client to, an adviser; and (2) with respect to a contribution or payment, to communicate, directly or indirectly, for the purpose of obtaining or arranging a contribution or payment.

10 “Regulated person” means: (1) a registered investment adviser that has not (and whose covered persons have not) made, coordinated or solicited a contribution within the last two years that would violate the rule; (2) a broker-dealer that is a member of a registered national securities association, so long as such association’s rules prohibit members from engaging in distribution or solicitation activities after making political contributions and the SEC finds, by order, that such rules are at least substantially equivalent to the restrictions imposed on advisers under the rule; and (3) municipal advisors registered under section 15B of the Securities Exchange Act of 1933 and subject to pay to play rules adopted by the Municipal Securities Rulemaking Board (MSRB), provided that the MSRB rules: A) impose substantially equivalent or more stringent restrictions on municipal advisors than the pay to play rule imposes on investment advisers and B) are consistent with the objectives of the pay to play rule.

11 Staff Responses to Questions about the Pay to Play Rule.

12 The rule outlines a number of factors that the SEC will consider, including an assessment of the adviser’s compliance environment, the nature of the contribution and the covered associate’s intent in making the contribution. Since the rule’s adoption, the SEC has granted 16 exemptive orders. See e.g. In the Matter of D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5496 (May 5, 2020) (order), found here; D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5475 (Apr. 9, 2020) (notice of application), found here; In the Matter of D.B. Fitzpatrick & Co., Inc., File No. 803-253 (Apr. 9, 2020) (application), found here.

13 For example, even though the rule applies to advisers seeking to influence state and local entities and not federal entities, if a state office holder that has influence over the selection of investment advisers, which could include a sitting state governor, were to be nominated as a Vice Presidential running mate, contributions to that ticket could implicate the rule.

Authors
Nicole Kalajian
Aliza Dominey
Sara Crovitz

Lessons from the SEC’s Private Fund Adviser Risk Alert: Conflicts of Interest and the Importance of Disclosure

On June 23, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert discussing three general areas of deficiencies identified by OCIE staff in recent examinations of hedge fund and private equity managers: (1) conflicts of interest, (2) fees and expenses and (3) policies and procedures relating to material non-public information. This note will focus on certain observations from OCIE with respect to conflicts of interest and the related lessons in terms of investor disclosure, which are rooted in the concept of “informed consent,” as discussed in the SEC’s June 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers (the 2019 Release).

While the Risk Alert describes deficiencies observed in examinations of registered investment advisers, the fiduciary duty and anti-fraud provisions cited by OCIE[1] apply equally to “exempt reporting advisers.” As such, below are selected topics from the Risk Alert for private fund advisers to consider in reviewing conflicts of interest-related disclosure provided to investors.

Allocation of Investments. OCIE staff raised concerns about private fund advisers’ inadequate disclosure with respect to allocation of investment opportunities among various clients, including flagship funds, co-investment vehicles, separately managed accounts (SMAs), and employee or partner vehicles. The SEC has previously noted, in the 2019 Release, that an adviser “need not have pro rata allocation policies, or any particular method of allocation…” Further, “[a]n adviser and a client may even agree [emphasis added] that certain investment opportunities or categories of investment opportunities will not be allocated or offered to a client.” In the Risk Alert, however, OCIE staff described instances of allocations in inequitable amounts among clients “without providing adequate disclosure about the allocation process…thereby causing certain investors…not to receive their equitable allocations of such investments.”

Preferential Liquidity Terms. The Risk Alert described conflicts related to preferential liquidity rights granted to certain investors in side letters, as well as conflicts related to advisers that had set up SMAs that invest alongside flagship funds without providing sufficient disclosure to fund investors of the SMAs’ preferential liquidity terms. In OCIE’s view, such advisers’ “[f]ailure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact.”

Seed and other Strategic Investors. In addition, OCIE highlighted seed investor arrangements and other economic relationships between advisers and certain fund investors as another area of insufficient transparency, noting that “[f]ailure to provide adequate disclosure about these arrangements meant that other investors did not have important information related to conflicts associated with their investments.”

Co-Investment Opportunities. With respect to co-investments, OCIE cited observations of private fund advisers with inadequate disclosure regarding agreements to provide preferential access to such opportunities to a subset of investors. As such, those investors may not have understood “the scale of co-investments and in what manner co-investment opportunities would be allocated among investors.” There were also failures to follow disclosed policies in allocating investments, including between flagship funds and dedicated co-investment vehicles.

[1] The Risk Alert cites an investment adviser’s fiduciary duty under Section 206 of the Investment Advisers Act of 1940, as amended (Advisers Act), as well as advisers’ obligations under Advisers Act Rule 206(4)-8, which is an anti-fraud provision aimed specifically at protecting pooled investment vehicles and their investors.