dollar signIt was the best of times, it was the worst of times. For investment advisers and others subject to the pay-to-play rules, that is. Although both vice presidential picks have gubernatorial experience, because Mike Pence is a sitting governor and Tim Kaine is a former governor, there are certain pay-to-play rules that apply to contributions to Trump/Pence that do not apply to Clinton/Kaine. Thus, the Pence pick has important implications for many companies and firms engaged in the financial services industry.

As reported by various news outlets, Governor Pence’s role with the Indiana Public Retirement System subjects contributions to the Trump/Pence ticket to the SEC’s and other pay-to-play rules. Violations of these rules can carry significant penalties. And the shadow of the pay-to-play fundraising restrictions has even caused some to speculate that Pence should resign as governor.

Continue Reading A Tale of Two Vice Presidents: Pay-to-Play and the Running Mates

Last week, the U.S. Government Accountability Office (GAO) released its long-awaited report on the gathering and use of so-called “political intelligence.” While the report targets the role of political intelligence in the financial markets, it may fuel attempts to regulate this growing Washington industry by using federal lobbying laws as a model. The report also underscores the risks of trading on non-public information about potential government action.  

The Stock Act

The report was required by the Stop Trading on Congressional Knowledge Act (STOCK Act), which was enacted after reports surfaced about Members of Congress profiting from trading securities based on inside information obtained while performing their official duties. The legislation mandated lengthy and cumbersome financial disclosures by government employees, which has been challenged in court.

There was also concern that investment advisers – particularly hedge funds – were able to profit from access to legislative or regulatory information (so-called “political intelligence”). The STOCK Act did not regulate the gathering and use of political intelligence (earlier versions of the bill included registration and reporting obligations by political intelligence firms), but instead required GAO to conduct a study.

Political Intelligence

The STOCK Act defines political intelligence as information:

“derived by a person from direct communications with an executive branch employee, a Member of Congress, or an employee of Congress; and provided in exchange for financial compensation to a client who intends, and who is known to intend, to use the information to inform investment decisions.”

The GAO Report noted that it is very difficult to determine:

  • When “political intelligence” is based on nonpublic versus public information,
  • When information is derived from a “direct communication” (is attending a  town-hall meeting or a hearing “direct communication?), and
  • Whether information remains political intelligence when it is mixed into a report containing analysis, media information, and other research.

Insider Trading

Profiting from material, non-public information is a federal offense under Rule 10b-5 of the Securities Exchange Act. In the context of government information, it can be difficult to determine when information is public or not and when information is material or not.

The GAO report provided two real-world examples to highlight an obvious case that resulted in a criminal  prosecution and another that raises more questions than it answers. In the first, an FDA official bought or shorted drug company stocks based on his knowledge of drug approvals or rejections. In the second, investors bought stock in companies that would benefit from legislation that would limit their liability for certain pending claims. The investors apparently purchased the stock after learning (before the general public) that a key Senator would support the bill. Although the legislation never became law, investors may have profited from their access to the information because they were able to purchase the stock before the public became aware of the Senator’s support and the stock prices did rise after the Senator spoke in favor of the legislation.

These two examples are helpful bookends for illustrating when information is material or not (it certainly was in the FDA example) and whether information is public or nonpublic (it was not public in the FDA case, but might have been in the legislative case), but there are a very broad range of examples in between. It is that range that makes it difficult to know when political intelligence crosses the line into insider trading. The report strongly reaffirms that that it is a violation of federal insider trading laws to buy or sell securities based on material, non-public information, including political intelligence.

Disclosing Political Intelligence Gathering?

The report also looked at whether political intelligence should be a regulated industry—like lobbying—that requires disclosure. The GAO Report considered the pros and cons but did not make a recommendation either way. Even some government watchdogs who provided input to the GAO questioned exactly what would be gained by disclosure.

The Takeaway

The report is a reminder that persons who use political intelligence to inform investment decisions must take precautions to make sure their information is not “material, non-public information.” This holds true regardless of whether the political intelligence is obtained directly, or from a third party or consultant.

In addition, it is possible (if not probable) that a registration requirement will be instituted for individuals and firms that engage in political intelligence activities. If implemented, such a regime is likely to be similar to the registration regime for lobbying activities under the Lobbying Disclosure Act. Persons who use political intelligence should consider whether they are comfortable disclosing their political intelligence activities and the effect that might have on business.

PepsiCo has agreed to more robust disclosure of its lobbying and political spending in response to a shareholder resolution filed on behalf of New York’s state pension fund, which owns about $400 million in PepsiCo stock. Just three weeks ago, the New York State Comptroller settled a suit with Qualcomm over similar issues.

As we have discussed here, activist shareholders, often led by labor-affiliated and social-investing funds, increasingly have turned to the proxy process to try to force companies to disclose more information about their spending on political activity and lobbying and to require more Board oversight of such spending. The NY Comptroller is using the leverage of the State’s public pension fund to pursue the same agenda. So far this year he has filed 26 shareholder resolutions and at least one lawsuit seeking to force disclosure of political spending by corporations.

Last week Qualcomm and New York State’s Comptroller, Thomas DiNapoli, announced that Qualcomm will begin posting its political spending on its website. In exchange, the NY Comptroller has agreed to drop the lawsuit it filed against the company.

As described here, last month the NY Comptroller sued Qualcomm on behalf of the state’s pension fund, which owns about $378 million in Qualcomm stock, seeking access to the company’s records so it can determine how Qualcomm spends corporate funds on political activity.

In connection with the settlement announcement, Qualcomm released a new Political Contributions and Expenditures Policy governing the company’s use of corporate funds for political expenditures. Under the new policy, Qualcomm will disclose its political activities on its website. The categories of information it plans to post online include:

  • Corporate contributions made to political candidates or committees, and ballot measure
  • Contributions made by the company’s PAC
  • Independent expenditures made by the company (if and when it decides to change its policy that it will not fund independent expenditures)
  • Certain payments made to trade associations and social welfare organizations

While these disclosure obligations are very similar to those adopted by other large corporations over the last few years, other aspects of Qualcomm’s policy go further. For instance, under the policy, each of the following senior officers must approve in writing all political expenditures: CEO, President, CFO, Senior Vice President of Government Affairs, and a Vice President or above in the Corporate Legal Department. This requirement is particularly striking because the definition of “political expenditures” is not limited to political contributions made by the company or PAC, but broadly includes all payments used in connection with any political campaign or ballot measure, including payments made to other businesses, advocacy organizations, and even educational groups.

The Comptroller’s announcement of the settlement contains a statement from a prominent watchdog group that “Qualcomm will become a standard bearer for corporations looking to provide stockholders with transparency with respect to its political spending.” This may portend additional pressure on companies that may have thought their recent adoption of policies in this area put the issue behind them. Indeed, Institutional Shareholder Services reports that it is tracking more than 110 stockholder proposals on this subject. And last week Commissioner Luis A. Aguilar of the Securities and Exchange Commission voiced support for a petition calling on the SEC to use the existing proxy-disclosure regime to provide investors with information about political spending.

Prominent Wall Street firm Goldman Sachs will pay almost $12 million to settle charges that one of its investment bankers made undisclosed campaign contributions to a state official responsible for awarding government contracts.

The case is the first SEC action for pay-to-play violations based on “in-kind” – meaning, non-cash – contributions to a political campaign. In the settlement order, the SEC charges that Goldman vice president, Neil M.M. Morrison, sought lucrative government contracts from the State of Massachusetts while at the same time doing political campaign work out of Goldman’s offices for state treasurer, Timothy P. Cahill. The SEC alleges that Morrison’s activities included fundraising, writing speeches, talking with reporters, and approving personnel decisions for the campaign. The Goldman executive also allegedly made cash payments to a third party, who then contributed to Cahill’s campaign.

The SEC order faults Goldman for failing to properly monitor the investment banker’s activities.  Goldman Sachs entered into the settlement without admitting or denying liability. Morrison did not settle.

This is the second major announcement from the SEC this month concerning pay-to-play practices. A couple of weeks ago, the SEC issued a “Risk Alert” urging municipal securities dealers to institute training, pre-clearance procedures for political contributions, and other compliance measures to prevent unlawful intervention in campaigns.

More broadly, the Goldman settlement serves as a potent reminder that political activity by employees – even personal political activity – can present substantial risks to employers doing business with state and local government. Using company staff and resources in connection with fundraising and directing contributions through third-parties may also violate federal and state campaign finance laws, even if the employer is not a contractor.

Last week the SEC’s Office of Compliance Inspections and Examinations issued a National Examination Risk Alert for brokers, dealers and municipal securities dealers regarding compliance with Municipal Securities Rulemaking Board (MSRB) Rule G-37. The Risk Alert noted that recent SEC examiners have observed practices that raise concerns whether firms are adequately complying with all of their obligations under the MSRB’s “pay-to-play” rules.

Although this Risk Alert specifically relates to brokers, dealers and municipal securities dealers subject to MRSB rules, it should be noted that investment advisers are subject to similar “pay-to-play” restrictions under SEC Rule 206(4)-5.

Concerns identified by examiners include:

  • Compliance with the Rule’s ban on doing business with a municipal issuer within two years of a political contribution to officials of the issuer by any of the firm’s municipal finance professionals;
  • Possible recordkeeping violations;
  • Failure to file accurate and complete required forms with regulators regarding political contributions; and
  • Inadequate supervision.

The Risk Alert goes on to note several practices certain firms are engaging in to minimize the potential for violations of the Rule. These practices include:

  • Training professionals on the requirements of the MSRB’s “pay-to-play” regulations;
  • Requiring firm employees to certify on an annual or other periodic basis that they understand all requirements regarding political contributions;
  • Having the firm actively search for political contributions made by employees to detect contributions that might violate the contribution restrictions; and
  • Pre-clearing political contributions by firm employees and, in some cases, family members.

That the SEC highlighted these practices suggests that the agency will expect a similar approach to compliance by investment advisors. At the same time, as we discussed in another recent post, certain practices encouraged by the SEC may be at odds with protections afforded by state employment laws.

In sum, risks are high for firms subject to pay-to-play rules, with a careful approach to compliance the best protection.

Last week the Securities and Exchange Commission issued a Final Rule extending the date by which investment advisers are required to comply with the ban on the use of third-party marketers under Rule 206(4)-5 (the Federal Pay-to-Play Rule”). This ban had been set to go into effect this Wednesday, June 13.

The ban will now take effect nine months after the SEC issues a final rule defining the term, “municipal advisor,” and creating a process for municipal advisors to register with the SEC (under the 1934 Securities and Exchange Act).  The  rule regarding municipal advisors is expected to be issued later this year.  The proposed rule was issued in December, 2010, and an interim final rule is set to expire on September 30, 2012.

The Federal Pay-to-Play Rule went into effect last year and, among other things, restricts the ability of investment advisers, and their “covered associates,” to make political contributions to candidates and elected officials who have the ability to influence investment decisions by government entities, primarily public pension funds.  A prohibited contribution triggers a two-year ban on compensation.

The Federal Pay-to-Play Rule also prohibits an adviser from paying any third-party to solicit advisory business from a government entity on its behalf unless the third-party is an SEC-registered investment adviser or a registered broker or dealer subject to pay-to-play restrictions adopted by a registered national securities association, like the Financial Industry Regulatory Authority.  FINRA has yet to implement a pay-to-play rule that meets these requirements.  In
addition, after proposing and then withdrawing pay-to-play rules for municipal advisors, the Municipal Securities Rulemaking Board has indicated it plans to resubmit a pay-to-play proposal once the SEC finalizes the definition of a “municipal advisor.”

Thus, the SEC’s decision will give FINRA and the MSRB time to continue their rulemakings
prior to implementation of the ban on third party marketers.