September 16, 2022

What you need to know about the major federal pay-to-play regulations and the future of local regulations

Pay-to-play regulations (and associated risk) doesn’t simply turn off during the off-election years.

In fact, according to a recent analysis, the dollar amount for political contributions on a federal level has nearly doubled between 2017 and 2021. Years which, it is important to note, held no primary or midterm elections and would not typically be associated with such high contribution levels. Political activity continues to rise and with it, so does the risk of violating pay-to-play regulations.

And the consequences? If you aren’t actively monitoring your employees direct or indirect contributions, you could face paying fines up to a staggering $100,000.

Understanding the federal pay-to-play regulations at play

Understanding what regulations are at play and how they impact your firm is critical to mitigating risk and safeguarding your firm’s best interests. Let’s breakdown the federal pay-to-play regulations:

SEC Rule 206(4)-5

In the simplest terms, SEC Rule 206(4)5 “prohibits, whether directly or indirectly, the use of contributions (monetary or otherwise) as a means to solicit government work. The rule applies to all registered investment advisers and even some unregistered advisers. This rule is in place to protect investors, and maintain fair, orderly, and efficient markets. If a financial firm violates this rule, not only does its reputation suffer but so does the integrity of the market.”

SEC Rule 15Fh-6

“Rule 15Fh-6, as adopted, imposes certain pay-to-play restrictions on SBS Dealers. The rule generally prohibits an SBS Dealer from engaging in security-based swap transactions with a “municipal entity” within two years after certain political contributions have been made to officials of the municipal entity. As with other pay-to-play rules, Rule 15Fh-6 does not prohibit political contributions.”

FINRA Rule 2030

FINRA Rule 2030 “applies to broker-dealers and places stipulations on their distribution and solicitation activities with government entities. More specifically, the rule prohibits all covered members from engaging in distribution or solicitation activities for compensation with a government entity on behalf of an investment adviser that provides or is seeking to provide investment advisory services to such government entity within two years after a contribution to an official of the government entity is made by the covered association. According to FINRA, “the rule is intended to discourage covered members from participating in pay-to-play practices by requiring a cooling-off period, during which the effects of a political contribution on the selection process can be expected to dissipate.”

FINRA Rule 4580

FINRA Rule 4580 “requires that all covered members who engage in distribution or solicitation activities with a government entity on behalf of an investment adviser that provides or is seeking to provide investment advisory services to such government entity maintain books and records that pertain to FINRA Rule 2030. Essentially, the rule requires that all covered members maintain records of such interactions with government entities. The rule requires that the following information be included in the records:

  • The names, titles and business and residence addresses of all covered associates.
  • The name and business address of each investment adviser on behalf of which the covered member has engaged in distribution or solicitation activity with a government entity within the past five years.
  • All direct or indirect contributions made by the covered member or any of its covered associates to an official of a government entity, or direct or indirect payments to a political party of a state or political subdivision thereof, or to a PAC.
  • Direct and indirect contributions or payments made by covered members or any of its covered associates must be listed in chronological order.”

MSRB Rule G-37

MSRB Rule G-37 “prohibits dealers from engaging in municipal securities business and municipal advisors from engaging in municipal advisory business with municipal entities if certain contributions have been made to officials of such municipal entities within the preceding two-year period and requires dealers and municipal advisors to disclose certain political contributions and other information. The rule aims to curb the giving of political contributions to state and local officials in exchange for the award of municipal advisory business. The rule also aims to provide greater transparency regarding the municipal activities.”

CFTC Regulation 23.451

CFTC Regulation 23.451 states that “a swap dealer’s contributions for transition or inaugural expenses incurred by a successful candidate are only covered by the rule to the extent that such expenses are incurred by a successful candidate for a position as an official of a governmental Special Entity. To comply with the regulation, a firm registering as a swap dealer may implement a compliance strategy to identify its officer and employees covered by the rule and track and preclear, or prohibit, political contributions made by the swap dealer and its covered officers and employees.”

The rise of local pay-to-play regulations

However, federal regulations aren’t the only factors at play in determining your pay-to-play risk. In 2022, political activity continues to rise and, in response, so do the number of state and local regulations. Now, in addition to the federal pay-to-play regulations many firms are faced with increased state and local regulations.

The trend of more regionalized pay-to-play regulations appears to only be gaining in popularity, but the complexity doesn’t end there. As Venable, LLP reported, “Some specialty pay-to-play laws apply only to certain types of businesses, such as state licensees, companies receiving contracts from retirement funds, redevelopment authorities or casino operators. Some laws apply to all types of contracts, including grants and real estate leases, while others apply only to contracts awarded through a non-competitive bidding process.”

For those firms reliant on government contract work, the quantity of pay-to-play regulations and the varying requirements and qualifications have created distinct compliance challenges. Such complexity warrants hours upon hours of work to comprehend and comply with each individual regulation and mitigate risk.

The level of complexity created by federal, state and local pay-to-play regulations has created an environment in which even the best firms struggle to remain compliant.

For that reason, every firm should have a unique set of policies and processes to help monitor and mitigate pay-to-play risk. Here are some steps your firm can take to determine how best to proceed with political contribution preclearance requests based on your firm and your employee’s level of risk:

  • Identify applicable regulations for your firm.
  • Identify whether you’ve got a covered associate.
  • Decide whether an employee’s contributions are direct or indirect.
  • Identify who the employee is contributing to.
  • Assess political committee status and remember public funds requirements.

To avoid potentially detrimental penalties, it’s essential for firms to create policies and procedures which not only detect violations that have occurred, but actively work to prevent intentional or accidental pay-to-play breaches.

For more guidance on pay-to-play regulations and the benefits of automating your firm’s political contribution monitoring, down the Ultimate Guide to Pay-to-Play Compliance.

Political contributions made by firm employees pose a significant threat to investment advisory firms. And even firms with the best compliance teams can be at risk of violating pay-to-play regulations, like the Securities and Exchange Commission’s (SEC) rule 206(4)-5, given the complexity of the rules and the myriad of regulations to which firms must comply.

Because of this, investment firms must arm themselves with the access to and support of real-time data, which can help identify potential violations and anomalies in the political donation process.

By leveraging real-time data, investment firms can quickly detect suspicious or unauthorized activities and take prompt action to prevent pay-to-play violations.

SEC Rule 206(4)-5 is arguably the most well known regulation regarding political contributions compliance or pay-to-play compliance. However, it certainly isn’t the only regulation to which firms must comply.

In fact, beyond federal regulations, firms which take part in government contracted work must contend with numerous and varied state and local regulations as well. Such regulations present unique challenges because of the various requirements within each, which should they be neglected, can cause significant financial and reputational damage.

While it would be almost too easy to treat the Securities and Exchange Commissions’ (SEC) pay-to-play rule 206(4)-5 as a special requirement implemented only during election years, that mistake can cause serious, firm-wide damages. In fact, for investment firms, establishing a compliance program which actively and regularly incorporates compliance with the SEC pay-to-play rule is essential to avoiding fines, sanctions, lockout periods, loss of revenue and a damaged reputation.