SEC proposes ending pay-to-play rule that prompted many advisers to ban all employee contributions

On September 3, the Securities and Exchange Commission proposed rescinding Rule 206(4)-5, the pay-to-play rule adopted in 2010 that bars an investment adviser from providing compensated advisory services to a government client for two years after certain political contributions, together with the recordkeeping requirements that travel with it. Its stated purpose was to protect beneficiaries of invested state and municipal assets—pension plans and their participants among them—by preventing advisers from using political contributions to influence the officials responsible for hiring advisers. The proposal is not final, and the agency has said the rest of the Investment Advisers Act would stay in place, including anti-fraud provisions, fiduciary obligations and codes of ethics.

If adopted, the proposal would relieve a compliance apparatus that in many shops grew larger than the rule itself. Michael Koffler, a partner at Eversheds Sutherland and a former SEC staff member, describes why: violating the rule risked a civil fraud claim, so firms built a buffer. "Many advisers prohibited political contributions across the board from anyone with the firm," Koffler says.

The buffer reached past the four corners of a contribution policy. According to Koffler, firms often had to monitor not only contributions made by current personnel but, in some instances, contributions made by newly hired employees before they joined the firm—an onboarding and diligence line item of questions at hire, attestations, and surveillance of money given years before a name appeared on a firm's roster. Take the rule away and that monitoring becomes a choice rather than a floor, a different decision for a small firm than for a large one, and different again for a firm that does no business with public plans.

In a separate statement, SEC Chair Paul Atkins called the rule "needlessly penalizing, burdensome and complex," said it discouraged political participation, and argued it imposed significant penalties for relatively small political contributions, a position Koffler says echoes earlier critics of the rule. "Matters involving political contributions are more properly governed by local ordinances, state laws, and federal election regulations—not by the SEC," Atkins said. "Rescinding the rule would not open the door to fraud because sufficient protections exist and have always existed."

The proposal notes that eliminating the rule could reduce compliance burdens for some firms while leaving many existing restrictions intact through federal, state and local regulations. For a practice with public pension clients, that qualifier carries the weight: a firm-wide ban written to clear an SEC rule sits inside a thicker stack of client-imposed policies, procurement terms, and whatever the states have enacted. Advisers to state and municipal plans are the population most exposed to that layer, so the practical compliance work shifts from Washington to the states rather than disappearing.

Koffler says he did not expect the SEC to propose repealing the rule rather than revising it, and the agency does not read the repeal as a handoff to no oversight. The anti-fraud provisions, fiduciary duty obligations and codes of ethics that the SEC says remain are the same obligations in force today; what a firm loses is a bright line. House Democrats introduced a retirement package that would count commissions from any source as compensation triggering fiduciary status on a rollover recommendation, so the rule book is being edited from both ends at once.

The decision in front of practice owners is unglamorous and specific: somebody has to open the compliance manual and read the contribution policy, then decide whether it was drafted to meet Rule 206(4)-5 or to meet the risk that a contribution, however small, becomes a civil fraud allegation. Most firms, by Koffler's account, chose the second path—an internal prohibition that covered everyone, not just the adviser who signs the government engagement letter. If Rule 206(4)-5 goes, the restriction on what employees may do with their own money becomes a policy a firm chooses, with its own costs and its own recruiting texture, rather than a requirement it satisfies.

The proposal is only a proposal, and Chair Atkins's preferred division of labor hands political contribution questions to local ordinances, state laws and federal election regulation, none of which is rescinded by anything the SEC does. Firms that built the widest buffers have the furthest to walk back, and a compliance committee that has spent years answering to a two-year clock has little reason to hurry toward a question it never had to price. The state layer Atkins points to, not the SEC vote, is where the next decision sits: whether firms treat a repealed federal rule as permission to tear up their policies or as a reason to leave them exactly where they are.