[Federal Register Volume 64, Number 153 (Tuesday, August 10, 1999)]
[Proposed Rules]
[Pages 43556-43568]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-20489]



[[Page 43555]]

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Part VII





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Part 275



Political Contributions by Certain Investment Advisers; Proposed Rule

  Federal Register / Vol. 64, No. 153 / Tuesday, August 10, 1999 / 
Proposed Rules  

[[Page 43556]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-1812; File No. S7-19-99]
RIN 3235-AH72


Political Contributions by Certain Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules.

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SUMMARY: The Commission is publishing for comment a new rule under the 
Investment Advisers Act of 1940 that would prohibit an investment 
adviser from providing advisory services for compensation to a 
government client for two years after the adviser or any of its 
partners, executive officers or solicitors make a contribution to 
certain elected officials or candidates. The Commission also is 
proposing rule amendments that would require a registered adviser that 
has government clients to maintain certain records of the political 
contributions made by the adviser or any of its partners, executive 
officers or solicitors. The new rule and rule amendments would address 
``pay to play'' practices in the investment adviser industry.

DATES: Comments must be received on or before November 1, 1999.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Washington, D.C. 20549-0609. Comments also may be submitted 
electronically at the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-19-99; this file number 
should be included on the subject line if E-mail is used. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, N.W. Washington, 
D.C. 20549. Electronically submitted comment letters also will be 
posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Karen L. Goldstein, Attorney, 
, or Jeffrey O. Himstreet, Attorney, 
, at (202) 942-0716, Task Force on Investment 
Adviser Regulation, Division of Investment Management, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-
0506.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed rule 206(4)-5 (17 CFR 275.206(4)-5) and proposed amendments 
to rule 204-2 (17 CFR 275.204-2) under the Investment Advisers Act of 
1940 (15 U.S.C. 80b) (``Advisers Act'' or ``Act'').

Table of Contents

Executive Summary

I. Background
II. Discussion
    A. Rule 206(4)-5
    1. ``Pay to Play'' Restrictions
    2. Solicitation Restrictions
    3. Direct and Indirect Contributions or Solicitations
    4. Private Investment Companies
    5. Exemptions
    B. Recordkeeping
    C. Transition Period
    D. General Request for Comment
III. Cost/Benefit Analysis
    A. Benefits
    B. Costs
    C. Requests for Comment
IV. Paperwork Reduction Act
V. Summary of Initial Regulatory Flexibility Analysis
VI. Statutory Authority
Text of Proposed Rule and Rule Amendments

Executive Summary

    Public pension plan assets are held, administered and managed by 
elected officials for the benefit of citizens, retirees, and other 
beneficiaries. Elected officials who allow political contributions to 
play a role in the management of these assets violate the public trust 
by rewarding those who make political contributions. Moreover, they 
undermine the fairness of the process by which public contracts are 
awarded. Similarly, investment advisers that seek to influence the 
award of advisory contracts by public entities, by making or soliciting 
political contributions to those officials who are in a position to 
influence the awards, compromise their fiduciary obligations to the 
plans. These practices--known as ``pay to play''--distort the process 
by which investment advisers are selected and can harm plans, which 
may, consequently, receive inferior advisory services and/or pay higher 
fees. As a result, the millions of retirees and other beneficiaries who 
rely on these plans can be harmed.
    We believe that advisers' participation in pay to play is 
inconsistent with the high standards of ethical conduct required of 
them under the Investment Advisers Act. We are therefore proposing a 
new rule designed to eliminate an adviser's ability to participate. 
Proposed rule 206(4)-5 would prohibit an adviser from providing 
advisory services for compensation to a government client for two years 
after the adviser, or any of its partners, executive officers or 
solicitors, make a contribution to state treasurers or comptrollers or 
other elected officials who can influence the selection of the adviser. 
The prohibition also would apply to contributions to candidates for 
these positions, but would not result from contributions of $250 or 
less to elected officials or candidates for whom the person making the 
contribution can vote.
    Proposed rule 206(4)-5 also would prohibit an adviser from 
providing or seeking to provide advisory services for compensation to a 
government client while the adviser, or any of its partners, executive 
officers or solicitors, solicit contributions for an elected official 
or candidate. Finally, we are proposing rule amendments that would 
require an adviser registered with us that has government clients to 
make and keep certain records regarding the political contributions and 
solicitation activities of the adviser, its partners, executive 
officers and solicitors.

I. Background

    Persons seeking to do business with the governments of some states 
and municipalities are increasingly being expected to make political 
contributions to elected officials or candidates.\1\ In some cases, 
businesses that submit bids for public contracts make political 
contributions to elected officials, hoping to influence the selection 
process. In other cases, political contributions are solicited from 
businesses, or it is simply understood that only contributors will be 
considered for selection. Contributions do not typically guarantee an 
award of business to the contributor, but the failure to contribute 
will guarantee that another is selected. Hence the term ``pay to 
play.''
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    \1\ See generally Alexander Heard, The Costs of Democracy 142-
145 (1960); Peter M. Manikas, Campaign Finance, Public Contracts and 
Equal Protection, 59 Chi.-Kent L. Rev. 817 (1983). Pay to play 
practices have been found relating to a variety of government 
contracts outside of the financial markets. See, e.g., O'Hare Truck 
Service, Inc. v. City of Northlake, 518 U.S. 712 (1996) (independent 
towing service contractor).
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    Pay to play practices can be viewed as imposing a hidden tax on 
persons seeking to do business with governments. They increase the cost 
of government services, which is likely to reflect the cost of the 
political contribution, and may diminish the quality of services, as 
officials may award contracts to less qualified advisory firms. Pay to 
play practices are unfair to businesses, particularly smaller 
businesses, that cannot afford the required contributions. Pay to play 
practices call into question the integrity

[[Page 43557]]

of public officials and the fairness of the government contracting 
process.
    Pay to play practices have been a significant problem in the 
municipal securities market.\2\ Securities firms seeking to underwrite 
municipal securities offerings have made political contributions and 
other payments to officials who are in a position to influence the 
award of underwriting contracts. After studying pay to play practices, 
the Commission staff concluded that they harm the municipal securities 
markets by increasing underwriting costs, undermining the integrity of 
municipal securities underwritings and damaging investor confidence.\3\ 
We came to the same conclusion in 1994 when we approved Municipal 
Securities Rulemaking Board (``MSRB'') rule G-37 to end broker-dealer 
participation in pay to play practices.\4\
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    \2\ See Murky Depths (Municipal Finance), Economist, Nov. 4, 
1995, at 83 (``America's municipal bond market is more rife with 
corruption than even its fiercest critics have claimed''); Terence 
P. Para, The Big Sleaze in Muni Bonds, Fortune, Aug. 7, 1995, at 
113; Leah Nathans Spiro et al., The Trouble with Munis, Bus. Wk., 
Sept. 6, 1993, at 44. See also Lazard Freres & Co., Securities 
Exchange Act Release No. 39388 (Dec. 3, 1997) (enforcement action 
brought against municipal securities dealer for undisclosed 
contributions made by a former partner and officer through a 
consultant to obtain municipal securities underwriting business); 
SEC v. Rudi, Litigation Release No. 14421 (Feb. 23, 1995) (complaint 
alleged that financial advisor received ``kickbacks,'' the amount of 
which were to be reduced by campaign contributions).
    \3\ See Division of Market Regulation, U.S. Securities and 
Exchange Commission, Staff Report on the Municipal Securities 
Markets 9-11 (1993).
    \4\ See In the Matter of Self-Regulatory Organizations; Order 
Approving Proposed Rule Change by the Municipal Securities 
Rulemaking Board Relating to Political Contributions and 
Prohibitions on Municipal Securities Business and Notice of Filing 
and Order Approving on an Accelerated Basis Amendment No. 1 Relating 
to the Effective Date and Contribution Date of the Proposed Rule, 
Securities Exchange Act Release No. 33868, at sections V.A.1 and 2 
(Apr. 7, 1994) (59 FR 17621 (Apr. 13, 1994)) (``Rule G-37 Adopting 
Release'') (rule G-37 was adopted ``to establish industry-wide 
restrictions and requirements aimed at preventing fraudulent and 
manipulative practices''). In approving rule G-37, we also concluded 
that pay to play practices may harm the municipal markets by 
fostering a selection process that excludes those firms that do not 
make contributions, cause less qualified underwriters to be 
retained, and undermine equitable practices in the municipal 
securities industry. Id. at section V. In 1996, we approved MSRB 
rule G-38 to prevent persons from circumventing rule G-37 through 
the use of consultants. See Self-Regulatory Organizations; Order 
Approving Proposed Rule Change by the Municipal Securities 
Rulemaking Board Relating to Consultants, Securities Exchange Act 
Release No. 36727 (Jan. 17, 1996) (61 FR 1955 (Jan. 24, 1996)).
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    Rule G-37 prohibits broker-dealers from engaging in municipal 
securities business with a government issuer for two years after making 
a political contribution to an elected official of the issuer who can 
influence the selection of the broker-dealer.\5\ The prohibition 
applies to contributions made by the firm or any of its ``municipal 
finance professionals,'' including certain executive officers.\6\ A 
municipal finance professional, however, may make a contribution to a 
candidate of up to $250 per election without triggering the prohibition 
if he or she can vote for the candidate.\7\ Rule G-37 also prohibits a 
broker-dealer from providing or seeking to provide underwriting 
services to a government, if the broker-dealer or any of its municipal 
finance professionals solicits or coordinates contributions for a 
candidate or elected official of the government.\8\ The MSRB requires 
broker-dealers to file quarterly reports disclosing the political 
contributions made by the firm, its executive officers and municipal 
finance professionals,\9\ and to keep accurate records of those 
contributions.\10\
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    \5\ MSRB rule G-37(b). The prohibition also applies to 
successful and unsuccessful candidates for an office that can 
influence the selection of the broker-dealer. MSRB rule G-37(g)(vi). 
Shortly after rule G-37 became effective, a municipal securities 
dealer challenged it as an infringement on the constitutional rights 
of municipal securities professionals. A federal appeals court 
upheld the constitutionality of rule G-37, finding that the rule 
served a compelling government interest in preventing fraudulent and 
manipulative acts. Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995), 
cert. denied, 517 U.S. 1119 (1996).
    \6\ MSRB rule G-37(b). A ``municipal finance professional'' 
generally is an associated person of a broker-dealer firm who is 
``primarily engaged'' in municipal securities activities, solicits 
municipal securities business on behalf of a broker-dealer, or a 
person who supervises associated persons primarily engaged in 
municipal securities activities ``up through and including'' the 
chief executive officer of the firm (or person performing similar 
functions). MSRB rule G-37(g)(iv).
    \7\ MSRB rule G-37(b).
    \8\ MSRB rule G-37(c).
    \9\ MSRB rule G-37(e). Firms are required to make quarterly 
filings with the MSRB on Forms G-37 and G-38. Id. These filings are 
made available to the public through its website, at <http://
www.msrb.org> (visited July 22, 1999).
    \10\ MSRB rule G-8(a)(xvi); Rule G-37 Adopting Release, supra 
note 4, at section III.B.2.
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    Since the adoption of rule G-37, the Commission has become 
concerned about other pay to play practices that are not addressed by 
that rule; practices which involve public pension plans and other 
funds. We have received reports that the selection of investment 
advisers, which we regulate under the Advisers Act, may be influenced 
by political contributions,\11\ and as a result, the quality of 
management services provided to funds may be affected.\12\ We have 
become particularly concerned about the possibility that the adoption 
of rule G-37 has resulted in a shift of pay to play practices to this 
area as political contributions by broker-dealers are curtailed.\13\ We 
therefore have examined the role of investment advisers in the 
management of public pension funds and other assets, the role of pay to 
play in their selection, and the implications of pay to play practices 
on the fiduciary obligations of investment advisers under the federal 
securities laws.
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    \11\ Letter from Thomas Flanigan (former executive director of 
the California State Teachers' Retirement System) to Arthur Levitt, 
Chairman, SEC (June 7, 1997), available in File No. S7-19-99 (``(pay 
to play) potentially places the credibility of many investment 
operations, either through direct or indirect pressure, in 
jeopardy''). There also have been numerous press reports of 
investment advisers engaging in pay to play practices, some of which 
report an adverse impact on plans. See infra note 38.
    \12\ Anonymous Letter dated Feb. 5, 1999 to Arthur Levitt, 
Chairman, SEC, available in File No. S7-19-99 (marketer for 
institutional money manager is ``amazed at how many managers are 
awarded contracts by public funds due to the money they have donated 
when there were other more qualified managers available''). See, 
e.g., Wyatt, Lindsay, Paring the Politics from a Public Plan, Pens. 
Mgmt., Nov. 1995, at 12 (Connecticut treasurer quoted as saying that 
pay to play ``adversely influenced our treasury''); David A. Vise, 
D.C. Pension Plan Mishandled; Too Many Advisers, Poor Financial 
Results, Wash. Post, Aug. 15, 1993, at A1.
    \13\ See Eric Bailey, Firms with State Pacts Are Fertile Donors 
to Fong, L.A. Times, May 25, 1998, at A1 ($400,000 decline in 
contributions from underwriting firms attributed to rule G-37); Bill 
Krueger, Money Managers Giving to Boyles, News & Observer, May 2, 
1996, at A1 (noting that rule G-37 ``dried up'' a contribution 
source for a state treasurer, ``so now he is getting campaign 
contributions from a group (investment advisers) that is not subject 
to (rule G-37)''); Gerri Willis, Filling Carl's War Chest: 
Comptroller Getting Thousands From State's Money Managers, Crain's 
N.Y. Bus., Sept. 16, 1996, at 1 (securities executive observing that 
``(b)ecause of the SEC's crackdown on the pay to play nature of the 
muni bond business, the game has shifted to asset management and 
brokerage'').
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    Investment advisers provide a wide variety of advisory services to 
state and local governments.\14\ Advisers manage public monies that 
fund pension plans and a number of other important public programs, 
including transportation, children's programs, arts programs, 
environmental reclamation, and financial aid for education. In 
addition, advisers provide risk management,\15\ asset allocation,\16\ 
financial planning \17\

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and cash management services; \18\ structure bond offerings; \19\ help 
state and local governments find and evaluate other advisers that 
manage public funds (``pension consultants''); \20\ and provide other 
types of services.\21\
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    \14\ See Werner Paul Zorn, Public Employee Retirement Systems 
and Benefits, in Local Government Finance, Concepts and Practices 
376 (John E. Peterson and Dennis R. Strachota, eds., 1st ed. 1991) 
(discussing the services investment advisers provide for public 
funds).
    \15\ See Robert A. Fippinger, The Securities Law of Public 
Finance 669 (1997).
    \16\ See, e.g., Public Employee Retirement Systems, supra note 
14. See also Barry B. Burr, The New $100 Billion Club, Pens. & Inv., 
May 4, 1998, at 1.
    \17\ See Cal. Ed. Code Sec. 22303.5 (1999) (requiring teachers' 
retirement system to offer retirement planning services to 
beneficiaries); CalSTRS Financial Education Program <http://
www.calstrs.ca.gov/benefit/defined/mbrinfo/mctbl.html> (visited July 
22, 1999). Other funds are also considering whether to offer 
financial planning services to their beneficiaries. See, e.g., Steve 
Hemmerick, CalPERS Officials Consider `Comprehensive' Financial 
Planning for Participants, Pens. & Inv., Feb. 8, 1998, at 3.
    \18\ See Government Finance Officers Association, an 
Introduction to External Money Management for Public Cash Managers 5 
(1991).
    \19\ Not all persons who structure bond offerings for state and 
local governments are investment advisers subject to regulation 
under the Advisers Act. See The Knight Group (pub. avail. Nov. 13, 
1991); East Texas Investment Company (pub. avail. Nov. 14, 1975). 
But see In re O'Brien Partners, Inc., Investment Advisers Act 
Release No. 1772 (Oct. 27, 1998) (financial advisor was subject to 
the Advisers Act for rendering advice to municipal securities 
issuers ``concerning their investment of bond proceeds in 
securities, including (non-government securities), and was 
compensated for that advice''). Recently, a group of these firms 
agreed to a self-imposed ban on making political contributions to 
obtain business. See Financial Advisers Support SEC's `Pay-to-Play' 
Rules, WALL. ST. J., Mar. 2, 1999, at A8.
    \20\ In addition to assisting the fund in selecting investment 
advisers, pension consultants may also provide advice to state and 
local governments in designing investment objectives, determining 
available funding media, or recommending specific securities or 
investments for the fund. Pension consultants are generally 
investment advisers subject to the Advisers Act. See Applicability 
of Investment Advisers Act to Financial Planners, Pension 
Consultants, and Other Persons Who Provide Investment Advisory 
Services as a Component of Other Financial Services, Investment 
Advisers Act Release. No. 1092 (Oct. 8, 1987) (52 FR 38400, 38401 
(Oct. 16, 1987)).
    \21\ For example, public funds may retain advisers to perform 
custodial services. See, e.g., Public Employee Retirement Systems, 
supra note 14, at 376-77.
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    Most of the public funds managed by investment advisers fund state 
and municipal pension plans. These pension plans have over $2.3 
trillion of assets and represent one-third of all U.S. pension 
assets.\22\ They are among the largest and most active institutional 
investors in the United States.\23\ The management of these funds 
significantly affects publicly held companies,\24\ mutual funds \25\ 
and the securities markets themselves.\26\ But most significantly, 
their management affects the taxpayers,\27\ and the millions of state 
and municipal retirees who rely on the funds for their pensions and 
other benefits.\28\
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    \22\ Board of Governors of the Federal Reserve System, Flow of 
Funds Accounts of the United States, Flows and Outstandings, First 
Quarter 1999 (June 11, 1999) (at tables L.119 and L.120). Since 
1994, total financial assets of public pension funds have grown by 
almost 45%. Id. at table L.120.
    \23\ According to a recent survey, seven of the ten largest 
pension funds were sponsored by state and municipal governments (one 
was the Federal Retirement Thrift Fund). Top 200 Pension Funds/
Sponsors, Pens. & Inv., Jan. 25, 1999, at 30.
    \24\ See Corporate Governance: Funds Flex Their Muscles, Pen. & 
Inv., at 109 (Oct. 19, 1998) (``Public funds discover they have the 
clout to influence corporate boards they believe are not acting in 
the shareholders' best interests.'').
    \25\ See Louis Trager, Run on State Money Market Funds; Orange 
County Fallout: $1 Billion in Withdrawals, San Francisco Examiner, 
Dec. 19, 1994, at B1 (reporting that, shortly after Orange County 
filed for bankruptcy, investors withdrew $1.03 billion (nearly 7% of 
the funds' assets) from money market funds that held securities 
issued by the county). See also Richard Marcis et al., Mutual Fund 
Shareholder Response to Market Disruptions, Investment Company 
Institute Perspective, at 10 (July 1995) (noting that the Orange 
County bankruptcy caused outflows in both tax-exempt bond funds and 
money market funds). Public funds are exempt from regulation as 
mutual funds under the Investment Company Act of 1940. Sections 2(b) 
and 3(c)(11) of the Investment Company Act of 1940 (15 U.S.C. 80a-
2(b) and 3(c)(11)).
    \26\ Federal Reserve reports indicate that, of the $2.3 trillion 
in non-federal government plans, $1.5 trillion are invested in 
corporate equities. Flow of Funds Accounts, supra note 22 (at table 
L.120).
    \27\ See Paul Zorn, 1997 Survey of State and Local Government 
Employee Retirement Systems 61 (1997) (``(t)he investment of plan 
assets is an issue of immense consequence to plan participants, 
taxpayers, and to the economy as a whole'' as a low rate of return 
will require additional funding from the sponsoring government, 
which ``can place an additional strain on the sponsoring government 
and may require tax increases'').
    \28\ The most current census data reports that public pension 
funds have 13.6 million beneficiaries. 1992 Census of Governments, 
U.S. Bureau of Census, VOL. 4, No. 6, Employee-Retirement Systems of 
State and Local Governments, at ii, 19 (1995) (available at <http://
www.census.gov/prod/2/gov/gc92-4/gc924-6.pdf> (visited July 22, 
1999)).
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    Elected officials of state and local governments are involved, 
directly or indirectly, in the selection of advisers to manage most 
public pension fund assets. In some jurisdictions, one or more elected 
officials have sole authority to select advisers.\29\ In others, 
elected officials serve as members \30\ or appoint some or all members 
\31\ of a governing board that makes selections.\32\ The selection 
process typically begins with the issuance of a request for proposals 
(``RFP''). The staff of the governing board of the fund receives the 
proposals and evaluates the applicants, often with the assistance of a 
pension consultant. Specific criteria such as past performance, 
experience, management approach, services and fees are established and 
used to narrow the list of applicants. Finalists are then interviewed, 
and the board selects one or more advisers.\33\ The board may reject 
recommendations made by its staff and consultants and, in some 
instances, boards have selected advisers that were not among the 
``finalists.'' \34\
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    \29\ See ``What Are the Comptroller's Responsibilities?'' 
available at <http://www.osc.state.ny.us/divisions/press__office/
response.htm> (visited July 22, 1999) (noting that the placement of 
state and local government retirement systems assets is under the 
sole custodianship of the New York State Comptroller). See also S.C. 
Code Ann. Secs. 9-1-20, 1-11-10 (Law. Co-op. 1998) (five-member 
board consisting of five elected officials).
    \30\ See, e.g., Cal. Gov't Code Sec. 20090 (Deering 1999) (state 
controller, state treasurer); Md. Code Ann., State Pers. & Pens. 
Sec. 21-104 (Supp. 1998) (state comptroller, treasurer, secretary of 
budget, superintendent of schools, and secretary of the state 
police); Miss. Code Ann. Sec. 25-11-15(2) (1998) (state treasurer); 
N.C. Gen. Stat. Sec. 135-6 (1999) (state treasurer and state 
superintendent of public instruction); R.I. Gen. Laws Sec. 36-8-4 
(Supp. 1998) (state treasurer); Utah Code Ann. Sec. 49-1-202 (Supp. 
1998) (state treasurer); W. VA. Code Sec. 5-10D-1 (Supp. 1998) 
(governor, state treasurer, state auditor, secretary of the 
department of administration); Wyo. Stat. Sec. 9-3-404 (Supp. 1998) 
(state treasurer).
    \31\ See, e.g., Ariz. Rev. Stat. Ann. Sec. 38-713 (1999) 
(governor appoints all nine members); CAL. Gov't Code20090 (Deering 
1999) (governor appoints three of thirteen members); Hawaii Rev. 
Stat.Sec. 88-24 (Supp. 1998) (governor appoints three of eight 
members); IDAHO CODE Sec. 59-1304 (Supp. 1998) (governor appoints 
all five members); Kan. Stat. Ann. Sec. 74-4905 (Supp. 1997) 
(governor appoints four of nine members; speaker of the house and 
president of the senate each appoint one member); Me. Rev. Stat. 
Ann. tit. 5, Sec. 17102 (Supp. 1997) (governor appoints four of 
eight members); Nev. Rev. Stat. Sec. 286.120 (1997) (governor 
appoints all seven members); N.H. Rev. Stat. Ann. Sec. 100-A:14(i) 
(1998) (governor and council appoint two of thirteen members); VA. 
Code Ann. Sec. 51.1-124.20 (Michie 1998) (governor appoints five of 
nine members); W. Va. Code Sec. 5-10D-1 (1998) (governor appoints 
ten of fourteen members); Wyo. Stat. Sec. 9-3-404 (Supp. 1998) 
(governor appoints ten of eleven members (the state treasurer is the 
other member)).
    \32\ In some cases, state retirement systems have sought to 
insulate the selection process from the effects of political 
contributions by delegating the selection of investment advisers to 
the professional staff of the fund. See, e.g., Missouri State 
Employees Retirement System, External Manager Hiring and Termination 
Policy (Nov. 13, 1998). See discussion infra at section II.A.1.
    \33\ See Stephen A. Berkowitz & Louis D. Finney, the Selection 
and Management of Investment Managers for Public Pension Plans 40-45 
(1990) (discussing the RFP, selection criteria, performance 
measurement, interview process, and elements of a final contract); 
Public Cash Managers, supra note 18, at 12-13 (discussing elements 
of the RFP and selection process); M. Corrine Larson, an 
Introduction to Investment Advisers for State and Local Governments 
6 (1996) (discussing the process for drafting the RFP, evaluating 
RFP responses, interviewing candidates, and selecting advisers); 
Girard Miller et al., Investing Public Funds5 (1998) (discussing 
selection criteria, and the use of consultants and an investment 
committee to aid in the selection process).
    \34\ See, e.g., Josh Kosman, Manager Access to Trustees 
Examined, Investment Mgmt. Wkly., Aug. 25, 1997, available in 1997 
WL 15447410; Too Many Advisers, Poor Financial Results, supra note 
12.
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    The absence of a fully objective bidding process makes it possible 
for considerations other than merit to intrude into the selection 
process.\35\ The

[[Page 43559]]

management of public pension funds is highly lucrative, and there is 
keen competition among advisers vying for selection.\36\ The record 
suggests strongly that political contributions can play a significant 
role in the selection of investment advisers.\37\ Allegations of pay to 
play have been reported in at least seventeen states.\38\
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    \35\ In approving rule G-37, the MSRB observed, and we agreed, 
that in a competitive and objective bidding process, there is ``less 
possibility of collusion and political patronage,'' as bidders are 
able to publicly compete on price and their willingness to accept 
market risk. Rule G-37 Adopting Release, supra note 4, at section 
II.A. The prohibition contained in rule G-37 thus applies only to 
contracts that were awarded on a basis other than a ``competitive 
bid'' (i.e., negotiated offerings). MSRB rule G-37(g)(vii). 
Contracts awarded on the basis of a competitive bid remain subject 
to the federal securities laws. See In re Stephens, Inc., Securities 
Act Release No. 7612 (Nov. 23, 1998) (enforcement action brought 
against consultant who authorized undisclosed payments to two public 
officials and an outside pension consultant to obtain municipal 
finance business that was subject to competitive bidding).
    \36\ A recent investment adviser search by CalPERS, for example, 
yielded 269 proposals submitted by 189 managers. See Steve 
Hemmerick, 58 Managers Make CalPERS' First Cut, PENS. & INV., Aug. 
18, 1997, at 6.
    \37\ In most cases, these political contributions are lawful. 
Thus, we do not suggest that the elected officials, by accepting 
these contributions, are acting unlawfully. Also, the Commission has 
not investigated and therefore cannot confirm the validity of the 
allegations described in the articles cited or referenced in the 
footnotes that follow. The Blount court held that allegations of pay 
to play were sufficient to support the rulemaking and that ``no 
smoking gun is needed where, as here, the conflict of interest is 
apparent, the likelihood of stealth great, and the legislative 
purpose prophylactic.'' 61 F.3d at 945.
    \38\ The articles and other materials describing allegations of 
pay to play practices are available in File No. S7-19-99. See, e.g., 
Janet Aschkenasy, Pay-to-Play--Scrutiny of Unethical Practices at 
Public Funds Is Intensifying, But Will Self-Policing Efforts 
Succeed?, PLAN SPONSOR, Feb. 1998, at 58-60; Charles Gasparino & 
Jonathan Axelrod, Political Money May Sway Business of Public 
Pensions, Wall St. J., Mar. 24, 1997, at C1; Matt O'Connor, Santos 
Done in by Tape; `Time to Belly Up' Remark Called Key to Guilty 
Verdict, CHI. TRIB., May 4, 1999, at N1.
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    Pay to play practices are rarely explicit: participants do not 
typically let it be publicly known that contributions are made or 
accepted for the purpose of influencing the selection of an adviser. As 
one court noted, ``actors in this field are presumably shrewd enough to 
structure their relations rather indirectly.'' \39\ Some elected 
officials who are responsible for public pension plans have actively 
solicited contributions from advisers that either provide or seek to 
provide advisory services to the state or local government.\40\ Several 
have received large amounts of money from advisers and contractors to 
the pension funds.\41\ Some have participated in the selection of 
investment advisers shortly before, or shortly after, receiving 
contributions from the adviser.\42\
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    \39\ Blount, 61 F.3d at 945.
    \40\ See, e.g., Scrutiny of Unethical Practices Intensifying, 
supra note 38. Public fund officials also have provided us with 
first-hand reports of the solicitation activities of elected 
officials. See Letter from Maxie L. Patterson, Executive Director, 
Houston Firefighters' Relief and Retirement Fund, to Robert Plaze, 
Associate Director, SEC (Feb. 10, 1999), available in File No. S7-
19-99.
    \41\ See Houston Firefighters' Fund Letter, supra note 40; 
Office of Vermont State Treasurer James H. Douglas, If You Play, You 
Pay: New Campaign Finance Legislation Prohibits Contracts for Wall 
Street Firms Contributing to State Treasurer Races, a Provision 
Pushed by Douglas, available at <http://www.state.vt.us/treasurer/
press/pr970616.htm> (visited July 22, 1999); Scrutiny of Unethical 
Practices Intensifying, supra note 38.
    \42\ For example, a solicitor for an institutional adviser 
recently informed us that the solicitor received two invitations 
from the same elected official in the same week--one to make a 
presentation to the fund's selection committee, the other to attend 
a $1,000 fundraising dinner. Anonymous Letter, supra note 12. 
Representatives of the selection committee later requested that the 
solicitor inform them if a contribution was made ``so they could let 
the officials know it came from'' the parties making the 
presentation. Anonymous Letter, supra note 12.
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    Recently, the nation's largest public pension fund, the California 
Public Employees Retirement System (``CalPERS''), sought to end the 
participation of its trustees in pay to play practices. The CalPERS 
actions and subsequent litigation \43\ provide unusual insights into 
how pay to play can work in the selection of investment advisers for 
public funds. According to court documents submitted by CalPERS, 
elected officials serving as CalPERS trustees solicited campaign 
contributions from investment advisers and other fund contractors.\44\ 
Each raised a considerable amount of money from advisers that are 
providing, or are seeking to provide, advisory services to CalPERS.\45\ 
Failure to contribute reduced the interest of the elected official in 
the adviser's role in managing the fund; \46\ contributing a sufficient 
amount could lead to the official championing the selection of the 
adviser,\47\ which could even result in the fund selecting the adviser 
over the recommendation of its professional staff and consultants.\48\ 
In order to avoid the perception of a conflict, the elected officials 
voluntarily would abstain from a vote concerning an adviser that made 
contributions,\49\ but the officials could participate in the 
discussions that preceded the vote.\50\ CalPERS decided to bar 
contractors and prospective contractors from making political 
contributions as an effort to end pay to play, which it described as 
``an insidious form of corruption'' that ``infects the entire decision-
making process.'' \51\
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    \43\ An elected official who is a CalPERS fiduciary sued to 
overturn the CalPERS ban on pay to play practices. A California 
court invalidated the CalPERS resolutions on procedural grounds. 
Kathleen Connell for Controller v. CalPERS, No. 98CS01749 (Cal. Sup. 
Ct. Sept. 18, 1998). See also Charles Gasparino, California 
Controller's Committee Sues Calpers Over Campaign-Donation Rule, 
WALL. ST. J., July 9, 1998, at B7. CalPERS subsequently proposed 
similar pay to play prohibitions by regulation. California Public 
Employees' Retirement System, Proposed Regulatory Action, Notice 
File No. 98-1016-10 (Oct. 30, 1998).
    \44\ See Memorandum of Points and Authorities in Opposition to 
Petition for Writ of Mandate, Kathleen Connell for Controller v. 
CalPERS, No. 98CS01749, at 20 (Cal. Sup. Ct. Sept. 4, 1998) (stating 
that ``there was actual evidence of massive contributions solicited 
by (the state controller) from CalPERS contractors and other 
prospective contractors'') (emphasis in original); Oversight of 
Investment Procedures of the Public Employees' Retirement System and 
State Teachers' Retirement System, Before the Senate Committee on 
Public Employment and Retirement, Calif. Leg. 20-21 (Aug. 25, 1997) 
(testimony of James E. Burton, Chief Executive Officer, CalPERS).
    \45\ The state controller, for example, raised over $180,000 
from 1995 to 1998 from CalPERS contractors. CalPERS Brief, supra 
note 44 (declaration of Thomas W. Hiltachk). The state treasurer, 
who also is a CalPERS trustee, raised $150,000 from advisers and 
other CalPERS contractors in a recent U.S. Senate campaign. See 
Firms with State Pacts, supra note 13; Paul Jacobs, Firms Lobby, Woo 
State Pension Officials, Win Pacts, L.A. TIMES, Feb. 4, 1998, at A3.
    \46\ In connection with the litigation, CalPERS submitted a 
declaration in which an adviser stated that, after refusing to make 
a political contribution, the elected official's representative 
contacted the adviser less frequently about investment matters, and 
displayed a ``higher degree of skepticism'' about the adviser's 
recommendations. CalPERS Brief, supra note 44 (declaration of Leslie 
Brun, Hamilton Lane Advisors, Inc.). See also Paul Jacobs, Donations 
to Pension Officials Scrutinized; Politics: Connell, Fong Say They 
Are not Influenced by Contributions from Firms Doing Business with 
State Systems, L.A. Times, Aug. 21, 1997, at A1; Dan Smith, Connell 
Accused of Shunning Non-Donor, Sacramento Bee, Aug. 14, 1998, at A3.
    \47\ See Paul Jacobs, Firms Lobby, Woo State Pension Officials, 
Win Pacts, L.A. TIMES, Feb. 2, 1998, at A1. Elected officials may 
not only champion the selection of contributors, but also may 
advocate their retention. See California Pension Fund Weathers 
Investment Controversy, Nat'l Mortgage News, June 24, 1996, at 10.
    \48\ See Steve Hemmerick, California Funds to Review Voting, 
PENS. & INV., Sept. 15, 1997, at 36; Paul Jacobs, Investment Raises 
Questions About State Pension Fund Finance, L.A. TIMES, Sept. 16, 
1997, at A1; cf. Manager Access to Trustees Examined, supra note 34.
    \49\ See Scrutiny of Unethical Practices Intensifying, supra 
note 38.
    \50\ See CalPERS Brief, supra note 44, at n. 16 (noting that one 
trustee who abstained from voting to award contracts to contributors 
``has never'' sought recusal from ``participating in the discussions 
affecting the contributor''); Donations to Pension Officials, supra 
note 46.
    \51\ CalPERS Brief, supra note 44, at 8. CalPERS stated that pay 
to play negatively affects the decision-making process because ``it 
appears that decisions are made, not only by considering who gave a 
contribution, but also by considering who did not give a 
contribution.'' CalPERS Brief, supra note 44, at 8 (emphasis in 
original).
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    Two states and some funds have come to similar conclusions 
regarding pay to play. Vermont and Connecticut both have recently 
enacted statutes prohibiting any person doing business with state funds 
from making contributions to the treasurer of either

[[Page 43560]]

state.\52\ The Connecticut Treasurer noted that, before the legislation 
was enacted, ``investment managers (were) being chosen more for their 
political connections and campaign contributions than for their 
performance.'' \53\ Some funds have adopted codes of ethics prohibiting 
trustees from accepting contributions.\54\ Some have delegated the 
selection of investment advisers to professional staff members, aiming 
to insulate the selection process from considerations of campaign 
contributions.\55\ Not all efforts to address pay to play have been 
effective,\56\ and most jurisdictions and pension plans have not acted 
effectively to stop pay to play practices.\57\
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    \52\ See CONN. GEN. STAT. Sec. 9-333o (1997); VT. STAT. ANN. 
tit. 32, Sec. 109 (1997). Efforts to eliminate pay to play are not 
limited to the securities industry. Bar associations also are 
considering similar prohibitions to address pay to play practices in 
the legal profession. See American Bar Ass'n, Report and 
Recommendations of the Task Force on Lawyers' Political 
Contributions, Part I (July 1998); Special Committee on Government 
Ethics, Association of the Bar of the City of New York, Campaign 
Contributions by Lawyers Seeking Government Finance Work (Feb. 
1997).
    \53\ See Christopher Burnham, Reviving a Pension Plan, AM. City 
& County, July 1998.
    \54\ See, e.g., Oregon Investment Council, Standard of Ethics, 
at 1-2 (July 1998); State of New Hampshire, An Order Enacting a Code 
of Ethics for Public Officials and Employees of the Executive Branch 
in the Performance of Their Official Duties, Executive Order No. 98-
1, at 2 (May 19, 1998); Fulton County Employees Retirement System 
Board, Ethics Policy, at 4-5 (Feb. 11, 1998). Other funds require 
disclosure of political contributions. See, e.g., Cal. Gov. Code 
Sec. 20152.5 (1999); Texas Permanent School Fund Operating Rules, 
Chapter 4, Conduct and Public Relations (Mar. 6, 1998).
    \55\ See, e.g., Missouri Investment Adviser Selection Policy, 
supra note 32.
    \56\ Some public pension plans, for example, prohibit firms that 
contract with the plan from making contributions to plan trustees, 
but the prohibition does not apply to executives of the firm. 
Similarly, several statutory prohibitions apply only to 
contributions made to particular officeholders, but not to other 
elected officials who are plan trustees, appoint plan trustees, or 
otherwise can influence the selection of an investment adviser. Some 
codes of ethics can be difficult to enforce when plans are faced 
with evidence of pay to play. Also, some advisers have found a way 
to circumvent state and plan limitations and disclosure requirements 
by making political contributions indirectly, through the use of 
third parties such as consultants. See infra notes 92 to 93, and 
accompanying text (discussing the use of ``gatekeepers'').
    \57\ It is possible that many jurisdictions have found it 
difficult to address pay to play practices due to what the Blount 
court calls a ``collective action problem (that tends) to make the 
misallocation of resources persist.'' Blount, 61 F.3d at 945-46. 
Elected officials that accept contributions from state contractors 
may believe they have an advantage over their opponents that 
forswear the contributions, and firms that do not ``pay'' may fear 
they will lose government business to those that do. See id. See 
generally Mancur Olson, The Logic of Collective Action; Public Goods 
and the Theory of Groups 44 (17th ed. 1998) (group members that seek 
to maximize their individual personal welfare will not act to 
advance common objectives absent coercion or other incentive). See 
also Donations to Public Officials, supra note 46 (fund contractor 
quoted as saying, ``(i)f you don't contribute, you're subject to the 
concern that others might make contributions'').
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II. Discussion

    The Commission regulates investment advisers under the Investment 
Advisers Act of 1940. Section 206(1) of the Advisers Act prohibits an 
investment adviser from ``employ(ing) any device, scheme, or artifice 
to defraud any client or prospective client.'' \58\ Section 206(2) 
prohibits advisers from engaging in any act, practice or course of 
business which operates as a fraud on a client or prospective 
client.\59\ The Supreme Court has construed section 206 as establishing 
a federal fiduciary standard governing the conduct of advisers.\60\
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    \58\ 15 U.S.C. 80b-6(1).
    \59\ 15 U.S.C. 80b-6(2).
    \60\ Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 
17 (1979) (citations omitted); SEC v. Capital Gains Research Bureau, 
Inc., 375 U.S. 180, 191-192 (1963).
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    An adviser that participates in pay to play practices undermines 
the merit-based selection process established by the public pension 
plan.\61\ When an adviser makes political contributions to elected 
officials for the purpose of influencing the award of an advisory 
contract, the adviser contributes to the risk that the officials may 
``award the contracts on the basis of benefit to their campaign chests 
rather than to the governmental entity.'' \62\ If pay to play is a 
factor in the selection process, the public pension plan can be harmed 
in several ways. The most qualified adviser may not be selected, 
leading to inferior management, diminished returns or even losses.\63\ 
The pension plan may pay higher fees because advisers must recoup the 
costs of contributions, or because contract negotiations may not occur 
on an arm's-length basis.\64\ Moreover, the absence of arm's-length 
negotiations may enable advisers to obtain greater ancillary benefits, 
such as ``soft dollars,'' from the advisory relationship, which may be 
directed for the benefit of the adviser, at the expense of the pension 
plan, thereby using a fund asset for its own purposes.
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    \61\ See supra notes 29 to 34 and accompanying text.
    \62\ Blount, 61 F.3d at 944-45.
    \63\ Paring the Politics, supra note 12, at 12 (Connecticut 
treasurer quoted as saying that pay to play ``adversely influenced 
our treasury''); Too Many Advisers, Poor Financial Results, supra 
note 12 (municipal fund awarded contract to an adviser that ``had 
the worst performance numbers of all the candidates interviewed'').
    \64\ See State Street Effort Fails in Its Lawsuit On 
Pennsylvania Pact, Wall. St. J., May 28, 1998, at B17. Firm 
executives contributed ``perhaps several thousand dollars'' to the 
outgoing treasurer's campaign. Id.
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    Because pay to play has the potential to harm advisory clients, we 
believe that it is inconsistent with the high standards of ethical 
conduct required of fiduciaries under the Advisers Act. We have 
authority under section 206(4) of the Act to adopt rules ``reasonably 
designed to prevent, such acts, practices, and courses of business as 
are fraudulent, deceptive or manipulative.'' \65\ Congress gave us this 
authority to prohibit ``specific evils'' that the broad anti-fraud 
provisions may be incapable of covering.\66\ The provision thus permits 
the Commission to adopt prophylactic rules designed to prevent 
fraudulent conduct even if not all of the conduct prohibited is 
fraudulent.\67\
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    \65\ 15 U.S.C. 80b-6(4).
    \66\ S. Rep. No. 1760, 86th Cong., 2d Sess. 4, 8 (1960). The 
Commission has used this authority to adopt four rules addressing 
abusive advertising practices, custodial arrangements, the use of 
solicitors and required disclosures regarding the adviser's 
financial condition and disciplinary history. 17 CFR 275.206(4)-1; 
275.206(4)-2; 275.206(4)-3; and 275.206(4)-4.
    \67\ The Supreme Court, in U.S. v. O'Hagan, 521 U.S. 642 (1997), 
interpreted nearly identical language in Section 14(e) of the 
Securities Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 
78n(e)) as providing the Commission with authority to adopt rules 
that are ``definitional and prophylactic'' and that may prohibit 
acts that ``are not themselves fraudulent * * * if the prohibitions 
are reasonably designed to prevent acts and practices that are 
fraudulent.'' 521 U.S. 667, 673. The language of both section 206(4) 
and section 14(e) was taken from section 15(c)(2) of the Exchange 
Act (15 U.S.C. 78o(c)(2)). See SEC Legislation, Hearing on S. 1180, 
S. 1181 and S. 1182, Before the Senate Committee on Banking and 
Currency, Subcommittee on Securities, 86th Cong., 2d Sess. 137 
(1959) (testimony of Philip A. Loomis, Director, Division of Trading 
and Exchanges, SEC) (``(The language of Section 206(4)) is almost 
the identical wording of Section 15(c)(2) of the Securities Exchange 
Act in regard to brokers and dealers.'') and S. Rep. No. 1760, 86th 
Cong., 2d Sess. 8 (June 28, 1960) (``(The language of section 
206(4)) is almost the identical wording of Section 15(c)(2) of the 
Securities Exchange Act of 1934 in regard to brokers and 
dealers.''). See also H.R. Rep. No. 1655, 91st Cong., 2d Sess. at 4 
(Dec. 7, 10, 1970) (the amendment to section 14(e) ``is identical to 
that contained in existing section 15(c)(2) of the Exchange Act''). 
Congress, in amending section 15(c)(2) to expand the Commission's 
authority to prohibit fraud by municipal securities dealers, 
described the Commission's rulemaking authority under section 
15(c)(2)(D) as including ``the promulgation of prophylactic rules.'' 
S. Rep. No. 75, 94th Cong., 1st Sess. 228 (Apr. 14, 1975).
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    We are proposing new rule 206(4)-5 to prevent advisers from 
participating in pay to play practices and protect clients from the 
consequences of pay to play. The rule, and related rule amendments that 
we are also proposing today, are described below.

A. Rule 206(4)-5

    Under proposed rule 206(4)-5, it would be a fraudulent, deceptive, 
or

[[Page 43561]]

manipulative act for an investment adviser to provide advisory services 
for compensation to a government entity within two years after the 
adviser, any of its partners, executive officers or solicitors made a 
contribution to an elected official who could influence the selection 
of the adviser. The rule would also make it unlawful for an adviser to 
solicit contributions for an official of a government client while 
providing or seeking to provide the government client advisory 
services. Proposed rule 206(4)-5 would not be a ban on political 
contributions, but rather a ban, or ``time-out,'' on conducting 
advisory business with a government client for two years after a 
contribution is made.
    Investment advisers subject to the proposed rule would include all 
investment advisers that are not prohibited from registering with the 
Commission.\68\ As a result, the rule would apply to Commission-
registered advisers and those exempt from registration under section 
203 of the Advisers Act, such as those advisers that had fewer than 
fifteen clients during the last twelve months.\69\
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    \68\ Proposed rule 206(4)-5(a).
    \69\ Section 203(b) of the Advisers Act (15 U.S.C. 80b-3(b)). 
The Commission is including unregistered advisers within the scope 
of the rule principally to make the rule applicable to advisers to 
private investment companies. See discussion infra section II.A.4.
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    The rule generally would not apply to smaller advisers that are 
registered with state securities authorities.\70\ We believe that the 
great majority of advisers to public funds are registered with the 
Commission. We, therefore, are not proposing to cover state-registered 
advisers under the proposed rule. We request comment on our assumption, 
and on whether we should extend the scope of the proposed rule to 
include state-registered advisers.
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    \70\ Amendments to the Advisers Act in 1996 placed regulatory 
responsibility for these advisers in the hands of state regulators. 
See section 203A of the Advisers Act (15 U.S.C. 80b-3a) enacted as 
part of Title III of the National Securities Markets Improvement Act 
of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in 
scattered sections of the United States Code).
---------------------------------------------------------------------------

    The Commission modeled proposed rule 206(4)-5 after MSRB rule G-37, 
which we believe has successfully addressed pay to play in the 
municipal bond market. This approach should minimize the compliance 
burdens on firms that would be subject to both rules by allowing them 
to adopt common compliance procedures. We have modified the proposed 
rule, however, to reflect the different statutory framework under which 
the rule would be adopted and the differences between municipal 
underwriting and asset management. The differences between proposed 
rule 206(4)-5 and rule G-37 are highlighted below. Comment is requested 
on whether we should use rule G-37 as a model for proposed rule 206(4)-
5. Are there additional differences in the selection of municipal 
underwriters and investment advisers that should be reflected in the 
rule?
    The Commission considered proposing a different approach to address 
pay to play, which would require an adviser to disclose information 
concerning its political contributions. Disclosure, however, may not be 
effective to protect public pension plan clients. Disclosure to a 
pension plan's trustees would be ineffective because, in some cases, 
the trustees would have received the contributions. Disclosure to plan 
beneficiaries also would be ineffective because they are generally 
unable to act on the information by moving their pension assets to a 
different plan or reversing adviser hiring decisions.\71\ Moreover, 
disclosure requirements have not worked in the past at stopping pay to 
play practices and can be circumvented.\72\ We request comment on this 
approach.
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    \71\ For these reasons, the Commission is not proposing a 
reporting requirement for advisers required to keep records of their 
political contributions under the proposed amendments to the 
recordkeeping rules. See discussion of recordkeeping amendments 
infra at Section II.B. MSRB rule G-37, however, does establish a 
reporting and disclosure system for broker-dealers subject to that 
rule. MSRB rule G-37(e)(ii).
    \72\ See discussion of ``gatekeepers'' supra section II.A.2.
---------------------------------------------------------------------------

1. ``Pay to Play'' Restrictions
    Proposed rule 206(4)-5 would prohibit investment advisers from 
providing advice for compensation to a ``government entity'' \73\ 
within two years after a contribution to an official of the government 
entity has been made by (i) the adviser, (ii) any of its partners, 
executive officers or solicitors, or (iii) any political action 
committee (``PAC'') controlled by the adviser or by any of the 
adviser's partners, executive officers or solicitors.\74\ Each element 
of the proposed rule and one exception from the prohibition are 
discussed below.
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    \73\ ``Government entity'' is defined by the proposed rule as 
any State or political subdivision of a State, including any agency, 
authority, or instrumentality, plan or pool of assets controlled by 
the State or political subdivision or any agency, authority or 
instrumentality thereof; and officers, agents, or employees of the 
State or political subdivision or any agency, authority or 
instrumentality thereof, acting in their official capacity. Proposed 
rule 206(4)-5(e)(3). In this Release, we use the term government 
entity interchangeably with ``government client'' and ``public 
pension plan.''
    \74\ Proposed rule 206(4)-5(a)(1).
---------------------------------------------------------------------------

    Investment advisers making contributions covered by the proposed 
rule would not be prohibited from providing advisory services to a 
government client, but only from receiving compensation from the client 
for providing advisory services. This approach is intended to avoid 
requiring an adviser to abandon a government client after the adviser 
or any of its partners, executive officers or solicitors make a 
political contribution covered by the rule. An adviser subject to the 
prohibition would likely be obligated to provide (uncompensated) 
advisory services until the government client finds a successor.\75\ 
Alternatively, the rule could establish a time period after the 
expiration of which the adviser could no longer provide advisory 
services. We request comment on which approach would cause the least 
disruption to the government client.
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    \75\ An investment adviser that violates the rule may be 
required, under its fiduciary duties, to continue providing advisory 
services to the public fund, for a reasonable period of time, until 
the fund obtains a new adviser. See Temporary Exemption for Certain 
Investment Advisers, Investment Advisers Act Release No. 1736 (July 
22, 1998) (63 FR 40231, 40232 (July 28, 1998)) (describing an 
investment adviser's fiduciary duties to an investment company in 
the case of an unforeseeable assignment of the advisory contract).
---------------------------------------------------------------------------

    The prohibitions in the rule would be triggered by a contribution 
to an official of a government entity. Government entities under the 
proposed rule include all state and local governments, their agencies 
and instrumentalities, and all government pension plans and other 
collective government funds.\76\ An official would include an 
incumbent, candidate or successful candidate for elective office of a 
government entity if the office (or an appointee of the office) is 
directly or indirectly responsible for, or can influence the outcome 
of, the selection of an investment adviser.\77\ Generally, executive or 
legislative officers who hold a position with influence over the 
selection of an investment adviser are government officials under the 
proposed rule.\78\ These definitions are substantively the same as 
those in MSRB rule G-37.\79\
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    \76\ Proposed rule 206(4)-5(e)(3).
    \77\ Proposed rule 206(4)-5(e)(4).
    \78\ The scope of authority of the particular office of an 
official, not the individual, would determine whether the official 
may have influence over the awarding of an investment advisory 
contract. In some cases, authority to select and terminate an 
investment adviser is completely delegated to the staff of a public 
fund, in which case a government official may not be able to 
influence the selection. See supra note 32. Under the proposed rule, 
contributions to the official would not trigger the prohibitions of 
the rule.
    \79\ MSRB rule G-37(g)(ii) and (g)(vi).

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[[Page 43562]]

    The proposed rule covers contributions made by an investment 
adviser, its partners, executive officers and solicitors; and any PAC 
controlled by the adviser or any of its partners, executive officers or 
solicitors. The proposed rule uses the same definition of contribution 
as MSRB rule G-37.\80\ A contribution would generally be anything of 
value made to an official to influence a federal, state or local 
election, including any payments for debts incurred in an election, and 
transition or inaugural expenses incurred by a successful candidate for 
state or local office.\81\
---------------------------------------------------------------------------

    \80\ MSRB rule G-37(g). Like rule G-37, the proposed rule would 
encompass, for federal offices, only those contributions to an 
official of a government entity who is seeking election to a federal 
office. Proposed rule 206(4)-5(e)(3).
    \81\ Proposed rule 206(4)-5(e)(1). Contributions to political 
parties would not trigger the proposed rule's prohibitions, unless 
the contribution is earmarked or known to be provided to an 
official. Contributions to state and local political parties are, 
however, subject to the proposed rule's recordkeeping requirements. 
See infra section II.B.
---------------------------------------------------------------------------

    Contributions made to influence the selection process are typically 
made not by the firm, but by officers and employees of the firm who 
have a direct economic stake in the business relationship with the 
government client. This is why the MSRB also applied the prohibitions 
of rule G-37 to contributions made by ``municipal finance 
professionals'' employed by a broker-dealer. There is no group, 
however, within the typical investment advisory firm that corresponds 
to municipal finance professionals. In our examination of pay to play 
practices involving investment advisers, we found that political 
contributions intended to influence the selection of the advisory firm 
were typically made by executives of the adviser or persons who solicit 
government clients on behalf of the adviser. Therefore, we are 
proposing to limit application of the rule to contributions made by the 
adviser or its partners, executive officers or solicitors.
    Under the proposed rule, the term executive officer includes the 
adviser's president, vice-presidents in charge of a business unit or 
division of the adviser, and other officers or persons who perform a 
policy-making function for the adviser.\82\ A solicitor is any person 
who, directly or indirectly, solicits any client for, or refers any 
client to, an investment adviser.\83\ Employees who play a role in 
obtaining government clients are thus covered by the proposed rule as 
are third-party solicitors an investment adviser engages to obtain 
clients. Contributions by other employees of the adviser or other 
persons (such as spouses, control persons and affiliates) would not 
otherwise trigger the rule's prohibitions unless the adviser or any of 
its partners, executives or solicitors used the person to indirectly 
make a contribution. This could occur, for example, if a firm paid a 
non-executive employee a bonus with the expectation or understanding 
that the employee would make a political contribution that, if made by 
the firm, would trigger the rule's prohibition.\84\
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    \82\ Proposed rule 206(4)-5(e)(2). The definition of ``executive 
officer'' is the same as that used in Advisers Act rule 205-3. 17 
CFR 275.205-3.
    \83\ Proposed rule 206(4)-5(e)(6). The definition of 
``solicitor'' is the same as that used in Advisers Act rule 206(4)-
3. 17 CFR 275.206(4)-3.
    \84\ See discussion of indirect contributions infra section 
II.A.3.
---------------------------------------------------------------------------

    The Commission has drafted the proposed rule so that its 
prohibitions are triggered by political contributions by persons we 
have found are typically involved in pay to play practices and who, in 
the context of an advisory firm, are likely to have an economic 
incentive to make contributions to influence the advisory firm's 
selection. We are mindful of the burdens the proposed rule would place 
on advisory firms and on the ability of persons associated with an 
adviser to participate in civic affairs. We thus have narrowly tailored 
the rule to achieve our goal of ending adviser participation in pay to 
play practices. We request comment on the scope of the rule in its 
application to persons associated with an adviser. Are there less 
restrictive alternatives that would accomplish our goals?
    Proposed rule 206(4)-5 contains a de minimis provision that would 
permit a partner, executive officer or solicitor to make contributions 
of $250 or less to an elected official or candidate without triggering 
the rule's prohibitions if the person making the contribution is 
entitled to vote for the official or candidate.\85\ The Commission 
assumes that contributions of less than $250 are typically made without 
the intent or ability to influence the selection process for investment 
advisers and thus do not involve the conflicts of interest the rule is 
intended to prevent. Comment is requested on the scope of the 
exception. The $250 amount is the same as the de minimis amount 
excepted from MSRB rule G-37.\86\ Should the amount be increased or 
decreased? Should we provide a de minimis exemption for contributions 
of a lesser amount, e.g. $100, to officials for whom an individual is 
not entitled to vote?
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    \85\ Proposed rule 206(4)-5(b). Under the proposed rule, a 
partner, executive officer or solicitor of an investment adviser 
could, without triggering the prohibitions of the rule, contribute 
up to $250 in both the primary election campaign and the general 
election campaign (up to $500) of each official for whom the person 
making the contribution would be entitled to vote. For purposes of 
this rule, a person would be ``entitled to vote'' for an official if 
the person's principal residence is in the locality in which the 
official seeks election.
    \86\ MSRB rule G-37(b).
---------------------------------------------------------------------------

    Under the proposed rule, a contribution made by a partner, 
executive officer or solicitor of an adviser would also be attributed 
to any other adviser that employs or engages the person who made the 
contribution within two years after the date the contribution was 
made.\87\ As a result, an investment adviser would be required to 
``look-back'' in time to determine whether it would be subject to any 
business restrictions under the proposed rule when employing or 
engaging a partner, executive officer or solicitor. This provision, 
which is similar to one in MSRB rule G-37,\88\ would prevent advisers 
from circumventing the rule by channeling contributions through 
departing employees, or by influencing the selection process by hiring 
persons who have made political contributions. Comment is requested on 
the look-back requirement. Would a shorter period be sufficient to 
prevent circumvention of the rule?
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    \87\ Proposed rule 206(4)-5(a)(1)(ii). Persons who are employees 
as well as ``independent contractors'' would be covered by the 
proposed rule. In no case would the prohibition imposed by the 
proposed rule be longer than two years from the date the executive 
officer makes a covered contribution. If, for example, an executive 
officer becomes employed by an investment adviser one year and six 
months after making a contribution, the new employer would be 
subject to the proposed rule's prohibition for the remaining six 
months of the two-year period. The executive officer's employer at 
the time of the contribution would be subject to the proposed rule's 
prohibition for the entire two-year period regardless of whether the 
executive officer remains employed by the adviser. However, if an 
executive officer is not an employee of an adviser, the adviser 
would not be responsible for any recordkeeping requirements with 
respect to that executive officer. See supra section II.B.
    \88\ MSRB rule G-37(g)(iv).
---------------------------------------------------------------------------

2. Solicitation Restrictions
    Another way an adviser can attempt to influence the selection 
process is by soliciting contributions for an elected official. 
Therefore, like MSRB rule G-37,\89\ the proposed rule would prohibit an 
adviser from providing or seeking to provide advisory services for 
compensation while the adviser, or any of its partners, executive 
officers or solicitors, solicit any person or PAC to make, or 
coordinate, any contribution to an official of a government entity to 
which the adviser is providing or seeking to provide investment 
advisory

[[Page 43563]]

services.\90\ This provision would also prohibit advisers from seeking 
to influence the selection process by, for example, ``bundling'' \91\ 
contributions from its employees or by making contributions through a 
third party, such as a ``gatekeeper.''
---------------------------------------------------------------------------

    \89\ MSRB rule G-37(c).
    \90\ Proposed rule 206(4)-5(a)(2)(i). An investment adviser 
would be seeking to provide advisory services to a government entity 
when it responds to an RFP, communicates with a government entity 
regarding that entity's formal selection process for investment 
advisers, or engages in some other solicitation of investment 
advisory business with the government entity. A violation of 
paragraph (a)(2)(i) of the proposed rule would not trigger a two-
year ban on the provision of investment advisory services for 
compensation, but would be a violation of the rule.
    \91\ An employee or person acting on an adviser's behalf 
``bundles'' contributions by coordinating small contributions from 
several employees of the adviser to create one large contribution.
---------------------------------------------------------------------------

    In a gatekeeper arrangement, political contributions are arranged 
by an intermediary, typically a pension consultant, which distributes 
or directs contributions to elected officials or candidates. The 
gatekeeper ensures that advisers not making a requisite amount of 
contributions are not included among the final candidates for advisory 
contracts. In addition, the gatekeeper may arrange ``swaps'' of 
contributions between elected officials in order to shield the 
contributions from public disclosure or to circumvent plan restrictions 
on contributions to trustees.\92\ Under the proposed rule, the 
gatekeeper in these arrangements would be soliciting political 
contributions and, if the gatekeeper is an investment adviser, would 
violate the proposed rule.\93\
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    \92\ For example, Adviser A advises Plan X, while Adviser B 
advises Plan Y. The ``gatekeeper'' may direct a political 
contribution from Adviser A to the elected official, who is a 
trustee to Plan Y, and from Adviser B to the elected official, who 
is a trustee to Plan X, agreeing to place both advisers on each 
plan's approved list. Persons reviewing records of the political 
contributions would have no way of determining that the 
contributions were swapped and that they created conflicts of 
interest on the part of the advisers as well as the elected 
officials.
    \93\ Regardless of whether the gatekeeper is an investment 
adviser, a person participating in such a scheme would, if the rule 
is adopted, likely be aiding and abetting an adviser's violation of 
the rule. See section 209(d) of the Act (15 U.S.C. 80b-9(d)) 
(authorizing Commission enforcement action for aiding and abetting a 
violation of the Advisers Act or any Advisers Act rule).
---------------------------------------------------------------------------

3. Direct and Indirect Contributions or Solicitations
    The proposed rule would also prohibit acts ``done indirectly, 
which, if done directly would be considered a fraudulent, deceptive or 
manipulative act under the rule.'' \94\ Thus, an adviser could not 
circumvent the rule by directing or funding contributions through third 
parties, including, for example, consultants, attorneys, family members 
or persons controlling the adviser who have an economic interest in the 
adviser being awarded an advisory contract. This provision would also 
cover contributions made, directed or funded, with the expectation 
that, as a result of the contribution, another contribution would be 
made by a third party for the benefit of the adviser. Contributions 
made through gatekeepers (described above) thus would be considered 
made ``indirectly'' for purposes of the proposed rule.
---------------------------------------------------------------------------

    \94\ Proposed rule 206(4)-5(a)(2)(ii). See also section 208(d) 
of the Advisers Act (15 U.S.C. 80b-8(d)).
---------------------------------------------------------------------------

4. Private Investment Companies
    In some cases, advisers to ``private investment companies,'' \95\ 
such as hedge funds and venture capital pools, have reportedly made 
contributions to elected officials who have influenced the decision of 
a government entity to invest in the adviser's company.\96\ The 
proposed rule would treat an investment by a government entity in a 
private investment company the same as if the government entity entered 
into an advisory contract directly with the adviser.\97\ As a result, a 
contribution by an adviser, any of its partners, executive officers or 
solicitors to an official of a government entity who can influence the 
decision to invest in the private fund, would trigger the prohibitions 
of the proposed rule. If the government entity was an investor in the 
fund at the time of the contribution, the adviser would be required to 
cause the private investment company to redeem the investment of the 
government entity, or, alternatively, return to the government entity 
amounts it received as compensation for managing the assets of the 
private investment company attributable to the government entity's 
investment. The Commission requests comment on whether additional types 
of government investments should be covered by the proposed rule. In 
particular, should the rule apply to off-shore funds, which do not fall 
within the definition of private investment company, and therefore are 
not subject to the proposed rule? \98\
---------------------------------------------------------------------------

    \95\ The proposed rule defines a private investment company as 
an investment company exempt from Commission registration under 
section 3(c)(1) or (3)(c)(7) of the Investment Company Act of 1940 
(15 U.S.C. 80a-3(c)(1) and 3(c)(7)). Proposed rule 206(4)-5(e)(5).
    \96\ The articles describing allegations that advisers to 
private investment companies engage in pay to play practices are 
available in File No. S7-19-99.
    \97\ Proposed rule 206(4)-5(c). The proposed rule would thus 
``look through'' the private investment company and treat its 
security holders as clients of the adviser. Cf. rule 205-3(b) (17 
CFR 275.205-3(b)) (equity owners of private investment companies 
treated as clients for purposes of performance fee exemptive rule).
    \98\ Off-shore funds are generally not required to register with 
the Commission under section 8(a) of the Investment Company Act of 
1940 (15 U.S.C. 80a-8(a)).
---------------------------------------------------------------------------

5. Exemptions
    Under the proposed rule the Commission could, upon application, 
exempt advisers from the rule's prohibitions that are triggered by 
inadvertent contributions or when imposition of the prohibitions is 
inconsistent with the rule's intended purpose. In determining whether 
to grant an exemption, we would consider whether (i) the exemption is 
in the public interest and consistent with the purposes of the rule, 
(ii) the adviser, before the contribution is made, had developed 
procedures to ensure compliance with the rule and had no actual 
knowledge of the contributions, and (iii) the adviser, after the 
contribution was made, took appropriate preventative and remedial 
measures, including all available steps to obtain a return of the 
contribution.\99\
---------------------------------------------------------------------------

    \99\ Proposed rule 206(4)-5(d).
---------------------------------------------------------------------------

    These factors are similar to those considered by the NASD and the 
appropriate bank regulators in determining whether to grant an 
exemption under MSRB rule G-37(i). Under the proposed rule, however, 
exemptive authority will be exercised by the Commission.\100\ In 
applying the criteria, we expect to take into account, among other 
things, the varying facts and circumstances presented by each 
application. We would apply these exemptive provisions with sufficient 
flexibility to avoid consequences disproportionate to the violation 
while accomplishing the remedial purpose of the rule.\101\ We request 
comment on the proposed exemptive criteria. Are there additional 
criteria the Commission should consider when determining whether to 
grant an exemption.
---------------------------------------------------------------------------

    \100\ The MSRB has provided four ``Questions and Answers'' 
regarding application of MSRB rule G-37-(i). Question 4, Additional 
Rule G-37 Q&As, June 15, 1995, MSRB Rule Book at 196 (1999), 
Questions and Answers Regarding Rule G-37(i), June 29, 1998, MSRB 
Rule Book at 199 (1999). Denials of an exemption pursuant to MSRB 
Rule G-37(i) are not subject to appeal to the Commission. See In re 
Morgan Stanley & Co., Securities Exchange Act Release No. 39459 
(Dec. 17, 1997).
    \101\ Under the proposed rule, an adviser applying for an 
exemption, could place advisory fees earned between the date of the 
contribution triggering the prohibition and the date on which we 
determine whether to grant an exemption in an escrow account. The 
escrow account would be payable to the adviser if the Commission 
grants the exemption. If the Commission does not grant the 
exemption, the fees contained in the account must be returned to the 
public fund.

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[[Page 43564]]

B. Recordkeeping

    We are also proposing amendments to rule 204-2 to require an 
investment adviser that is registered with us and has government 
clients to make and keep certain records of contributions made by the 
adviser, its partners, executive officers and solicitors.\102\ These 
records would be confidential,\103\ and only reviewed by our staff in 
the course of an adviser examination. We believe they would be 
necessary to allow us to enforce compliance with rule 206(4)-5, if 
adopted.
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    \102\ 17 CFR 275.204-2.
    \103\ Section 210(b) of the Advisers Act (15 U.S.C. 80b-10(b)) 
prohibits the Commission staff from disclosing to anyone outside the 
Commission any information obtained as a result of an examination or 
investigation without Commission approval.
---------------------------------------------------------------------------

    The proposed amendments would require an adviser to make and keep a 
list of its partners, executive officers and solicitors, the states in 
which the adviser has, or is seeking, government clients, the identity 
of those clients, and the contributions made by the firm and its 
partners, executive officers and solicitors to government officials and 
candidates.\104\ These requirements would be similar to the MSRB 
recordkeeping rule for broker-dealers.\105\
---------------------------------------------------------------------------

    \104\ Proposed rule 204-2(l).
    \105\ MSRB rule G-8(a)(xvi). Like rule G-37, the proposed rule 
requires an investment adviser to keep, in addition to records of 
political contributions, records of any other ``payments'' made to 
officials. A payment is defined as any gift, subscription, loan, 
advance, or deposit of money or anything of value.
---------------------------------------------------------------------------

    These new recordkeeping requirements should not be burdensome. As 
discussed above, a single contribution could, under the rule, lead to a 
two-year suspension of advisory activities for a government client. We 
would expect, therefore, that advisers would adopt sufficient internal 
procedures to prevent the rule's prohibitions from being triggered. The 
records that we propose registered advisers make and keep would be 
those an adviser undertaking a serious compliance effort would 
ordinarily make, and thus we assume the amendments would involve no 
substantial additional burdens. Comment is requested on our assumptions 
and on whether our assessment of the burdens is correct. We request 
that commenters opposing the new recordkeeping requirements suggest 
alternative means we could use to enforce the new rule.

C. Transition Period

    The prohibition and recordkeeping requirements under the proposed 
rule would arise from contributions made on or after the effective date 
of the rule, if adopted. As a result, firms would need to begin 
monitoring contributions made by their partners, executive officers and 
solicitors on that date. The Commission requests comment on whether 
firms would require additional time to develop procedures to comply 
with the proposed rule and, if so, how long of a transitional period 
following the rule's adoption would be necessary?

D. General Request for Comment

    Any interested persons wishing to submit written comments on the 
proposed rule and rule amendment that are the subject of this release, 
or to suggest additional changes or submit comments on other matters 
that might have an effect on the proposals described above, are 
requested to do so. Commenters suggesting alternative approaches are 
encouraged to submit proposed rule text.

III. Cost/Benefit Analysis

    We are sensitive to the costs and benefits imposed by our rules, 
and understand that compliance with proposed rule 206(4)-5 and the 
proposed amendments to rule 204-2 may impose costs on some advisers. 
The proposed rule and rule amendments would apply only to investment 
advisers that provide advisory services to government clients and which 
make political contributions. In addition, the proposed rule and rule 
amendments would only affect the political contributions made by the 
adviser, and its partners, executive officers and solicitors. The 
majority of advisers and advisory employees thus would be unaffected by 
the proposed rule and rule amendments.

A. Benefits

    Proposed rule 206(4)-5 would likely yield several important 
benefits to investment advisers and state and local governments, both 
direct and indirect. The proposed rule would reduce or eliminate the 
costs of political contributions incurred by investment advisers 
through pay to play practices. While not readily quantifiable, the 
record above indicates that advisers, and their partners, executive 
officers and solicitors, have made substantial contributions to elected 
officials from whom the advisers are seeking business.\106\ We believe 
these contributions would decrease substantially if the proposed rule 
were adopted. This could result in lower advisory fees being paid by 
the state or local government for advisory services, as advisers would 
not have to recoup the cost of contributions through fees the advisers 
charge the government client.
---------------------------------------------------------------------------

    \106\ See supra note 38.
---------------------------------------------------------------------------

    The proposed rule should also yield several indirect benefits, 
including benefits to state and local governments and taxpayers. If 
state and local governments select an adviser on the basis of campaign 
contributions, the most qualified adviser may not be selected. As 
discussed above, awarding advisory contracts to advisers that make 
political contributions may lead to inferior management, and diminished 
or negative returns.\107\ Similarly, an adviser that is selected on 
bases other than merit may obtain soft dollars and other ancillary 
benefits at the expense of the government client. Finally, the proposed 
rule would level the playing field for advisers to state and local 
governments. Campaign contributions create artificial barriers to 
competition for firms that cannot or will not make political 
contributions. Eradicating pay to play arrangements enables advisory 
firms, particularly smaller advisory firms, to compete on the basis of 
merit, rather than their ability to make contributions.
---------------------------------------------------------------------------

    \107\ See supra note 63 and accompanying text.
---------------------------------------------------------------------------

B. Costs

    The proposed rule and rule amendments would impose some costs on 
advisers that provide advisory services to government clients. The 
proposed rule would require an adviser with government clients, and an 
adviser which solicits business from government clients, to incur costs 
to monitor contributions made by the adviser, and its partners, 
executive officers and solicitors, and to establish procedures to 
comply with the proposed rule and rule amendments. The initial and 
ongoing compliance costs imposed by the proposed rule would vary 
significantly among firms, depending on a number of factors. These 
include the number of partners, executive officers and solicitors of 
the adviser, the degree to which compliance procedures are automated, 
and whether the adviser is affiliated with a broker-dealer firm that is 
subject to rule G-37. A smaller adviser, for example, would likely have 
a small number of partners, executive officers and solicitors, and thus 
expend less resources to comply with the proposed rule and rule 
amendments than a larger adviser.
    As a comparison, Commission staff has been advised that the burden 
imposed by rule G-37 on smaller broker-dealer firms is negligible. 
Although a large adviser is likely to spend more resources to comply 
with

[[Page 43565]]

the rule than a smaller adviser, an adviser with a broker-dealer 
affiliate that is required to comply with MSRB rule G-37 could likely 
use some or all of the compliance procedures established by the 
affiliate. As a result, many advisers with broker-dealer affiliates may 
spend few resources to comply with the proposed rule and rule 
amendments.
    Based on compliance with other recordkeeping rules, Commission 
staff anticipates that most advisory firms would develop compliance 
procedures to monitor the political contributions made by the adviser 
and its partners, executive officers and solicitors. We estimate that 
the costs imposed by the proposed rule would be higher initially, as 
firms establish and implement procedures to comply with the rule and 
rule amendments. If we adopt the proposed rule and rule amendments, 
firms with government clients would likely develop and implement 
compliance procedures within 60 to 90 days after adoption. It is 
anticipated that compliance expenses would then decline to a relatively 
constant amount in future years.
    The Commission has limited data on the costs that the proposed rule 
and rule amendments would impose on investment advisers with government 
clients. We estimate that as many as 1,500 investment advisers 
registered with the Commission may be affected by the proposed rule and 
rule amendments.\108\ Based on registration information filed with the 
Commission, we estimate that approximately 450 advisers have fewer than 
five partners, executive officers, or solicitors that would be subject 
to the proposed rule (``smaller firms''); approximately 825 advisers 
have between five and 15 partners, executive officers or solicitors 
(``medium firms''); and approximately 225 advisers have more than 15 
partners, executive officers, or solicitors that would be subject to 
the prohibitions of the proposed rule (``larger firms'').
---------------------------------------------------------------------------

    \108\ This number was used for purposes of the Paperwork 
Reduction Act analysis, infra section IV.
---------------------------------------------------------------------------

    Advisers that are exempt from registration with the Commission 
would be subject to the proposed rule (but not the rule amendments). 
The Commission has limited data regarding the number of investment 
advisers that are exempt from registration under section 203(b) of the 
Advisers Act. Reports indicate that the number of exempt advisers may 
exceed 3,000.\109\ While not readily quantifiable, the estimated number 
of exempt advisers likely includes advisers to off-shore funds that 
would not be subject to the proposed rule. The Commission also has 
limited information regarding the number of partners, executive 
officers and solicitors of exempt advisers. For purposes of this 
analysis, it is anticipated that the number of persons of each exempt 
advisory firm that would be subject to the proposed rule are comparable 
to the ranges for registered investment advisers, described above.
---------------------------------------------------------------------------

    \109\ Hal Lux, Hedge Fund? Who Me?, Institutional Investor, Aug. 
1998, at 33; Bethany McLean, Everybody's Going Hedge Funds, Fortune, 
June 8, 1998, at 180.
---------------------------------------------------------------------------

    Although the time needed to comply with the proposed rule would 
vary significantly from adviser to adviser, the Commission estimates 
that firms with government clients would spend between 2.5 hours and 
250 hours to establish adequate procedures to comply with the proposed 
rule. These estimates are derived in part from conversations with 
industry professionals regarding broker-dealer compliance with rule G-
37. Commission staff estimates that ongoing compliance with the 
proposed rule would require between 10 and 1,000 hours, annually. 
Initial compliance procedures would likely be designed and administered 
by compliance professionals and clerical staff. We estimate that the 
hourly wage rate for compliance professionals is $114, including 
benefits, and for clerical staff, $15 per hour, including benefits. To 
establish and implement adequate compliance procedures, the Commission 
staff estimates that the proposed rule would impose initial compliance 
costs of approximately $285 \110\ per smaller firm, approximately 
$13,387.50 \111\ per medium firm, and approximately $22,312.50 \112\ 
per larger firm. It is estimated that the proposed rule would impose 
annual, ongoing compliance expenses of approximately $892.50 \113\ per 
smaller firm, $53,550 \114\ per medium firm, and $89,250 \115\ per 
larger firm.
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    \110\ The per firm cost estimate is based on our estimate that 
development of initial compliance procedures for smaller firms would 
take 2.5 hours of professional time (at $114 per hour).
    \111\ The per firm cost estimate is based on our estimate that 
development of initial compliance procedures for medium firms would 
take 112.50 hours of professional time (at $114 per hour) and 37.5 
hours of clerical time (at $15 per hour).
    \112\ The per firm cost estimate is based on our estimate that 
development of initial compliance procedures for larger firms would 
take 187.50 hours of professional time (at $114 per hour) and 62.5 
hours of clerical time (at $15 per hour).
    \113\ The per firm cost estimate is based on our estimate that 
ongoing compliance procedures for smaller firms would take 7.5 hours 
of professional time (at $114 per hour) and 2.5 hours of clerical 
time (at $15 per hour), per year.
    \114\ The per firm cost estimate is based on our estimate that 
ongoing compliance procedures for medium firms would take 450 hours 
of professional time (at $114 per hour) and 150 hours of clerical 
time (at $15 per hour), per year.
    \115\ The per firm cost estimate is based on our estimate that 
ongoing compliance procedures for larger firms would take 750 hours 
of professional time (at $114 per hour) and 250 hours of clerical 
time (at $15 per hour), per year.
---------------------------------------------------------------------------

    The prohibitions of the proposed rule may also impose other, less 
quantifiable costs on advisers and political officials. An adviser that 
becomes subject to the prohibitions of the proposed rule would no 
longer be eligible to receive advisory fees from its government client. 
The adviser, however, would likely be obligated under its fiduciary 
duties to continue providing advisory services to the government client 
for a period of time without compensation. An adviser that provides 
uncompensated advisory services to a government client may incur 
opportunity costs if the adviser is unable to pursue other government 
clients. Advisers to government clients, as well as the partners, 
executive officers and solicitors of the adviser, also may be less 
likely to make political contributions to political officials, possibly 
imposing costs on the officials if they are unable to secure alternate 
funding.
    We anticipate that the proposed rule amendments would impose few, 
if any, additional costs. As discussed above, advisers generally would 
establish internal compliance procedures to comply with the proposed 
rule. Advisers would create and maintain various records, as required 
by their own compliance procedures. The proposed rule amendments are 
intended to cover those records an adviser typically would maintain in 
complying with the proposed rule. Advisers that are exempt from 
Commission registration under section 203(b) of the Advisers Act would 
be subject to the proposed rule, but not the proposed recordkeeping 
amendments. We have requested comment on the scope of the proposed rule 
and rule amendments.

C. Requests for Comment

    The Commission requests comment on the effects of the proposed rule 
and rule amendments on individual investment advisers and on the 
advisory profession as a whole. We request data to quantify the costs 
and value of the benefits associated with the proposed rule. 
Specifically, comment is requested on the costs of establishing 
compliance procedures to comply with the proposed rule, both on an 
initial and ongoing basis. Comment also is requested on the costs of 
using compliance procedures of an affiliated broker-dealer that the 
broker-dealer established as a result of rule G-37. In addition, we 
request data

[[Page 43566]]

regarding our assumptions about advisers exempt from registration under 
section 203(b) of the Act, such as the number of advisers that would be 
subject to the proposed rule, and the number of partners, executive 
officers and solicitors of these exempt advisers. Commenters should 
provide analysis and empirical data to support their views on the costs 
and benefits associated with this proposal.

IV. Paperwork Reduction Act

    The proposed rule amendments contain a ``collection of 
information'' requirement within the meaning of the Paperwork Reduction 
Act of 1995,\116\ and the Commission has submitted the amendments to 
the Office of Management and Budget (``OMB'') for review in accordance 
with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The title for the collection 
of information is ``Rule 204-2'' under the Advisers Act. Rule 204-2 
contains a currently approved collection of information number under 
OMB control number 3235-0278. An agency may not sponsor, conduct, or 
require response to an information collection unless a currently valid 
OMB number is displayed.
---------------------------------------------------------------------------

    \116\ 44 U.S.C. 3501.
---------------------------------------------------------------------------

    Section 204 of the Advisers Act provides that investment advisers 
required to register with the Commission must make and keep certain 
records for prescribed periods, and make and disseminate certain 
reports. Rule 204-2 sets forth the requirements for maintaining and 
preserving specified books and records. This collection of information 
is mandatory. The Commission staff uses this collection of information 
in its examination and oversight program, and the information generally 
is kept confidential.\117\ The current collection of information for 
rule 204-2 is based on average of 235.47 burden hours each year, per 
Commission-registered adviser, for a total of 1,483,461 burden hours. 
The current total burden is based on 6,300 potential respondents.
---------------------------------------------------------------------------

    \117\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------

    The proposed amendments to rule 204-2 would require registered 
investment advisers that provide advisory services to government 
clients to maintain certain records of contributions made by the 
adviser or any of its partners, executive officers, or solicitors. 
These records would be required to be maintained in the manner, and for 
the period of time, as other books and records under rule 204-2(a). 
This collection of information would be found at 17 CFR 275.204-2. 
Advisers that are exempt from Commission registration under section 
203(b) of the Advisers Act would not be subject to the recordkeeping 
requirements.
    Commission records indicate that there currently are approximately 
8,200 potential respondents to the collection of information imposed by 
rule 204-2. As a result of the increase in the number of advisers 
registered with the Commission, the total burden is being increased by 
447,393 hours (1,900 new advisers  x  235.47 hours). We estimate that 
there may be as many as 1,500 advisers that provide advisory services 
to government clients and would thus be affected by the proposed rule 
amendments. Under the proposed amendments, each respondent would be 
required to retain the records on an ongoing basis. The proposed 
amendments to rule 204-2 are estimated to increase the burden by 
approximately two hours, to 237.47, per Commission-registered adviser 
with government clients. The weighted average burden per Commission-
registered adviser is 235.83. The annual aggregate burden for all 
respondents to the recordkeeping requirements under rule 204-2 thus 
would be 1,933,854 hours.
    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to (i) evaluate whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the agency, including whether the information will have practical 
utility; (ii) evaluate the accuracy of the agency's estimate of the 
burden of the proposed collection of information; (iii) enhance the 
quality, utility, and clarity of the information to be collected; and 
(iv) minimize the burden of the collections of information on those who 
are to respond, including through the use of automated collection 
techniques or other forms of information technology.
    Persons desiring to submit comments on the collection of 
information requirements should direct them to the Office of Management 
and Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
D.C. 20503, and also should send a copy of their comments to Jonathan 
G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, 
N.W., Washington, D.C. 20549-0609 with reference to File No. S7-19-99. 
Requests for materials submitted to OMB by the Commission with regard 
to this collection of information should be in writing, refer to File 
No. S7-19-99, and be submitted to the Securities and Exchange 
Commission, Office of Filings and Information Services. OMB is required 
to make a decision concerning the collections of information between 30 
and 60 days after publication. A comment to OMB is best assured of 
having its full effect if OMB receives it within 30 days of 
publication.

V. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed 
rule 206(4)-5 and proposed amendments to rule 204-2, both under the 
Advisers Act. The following summarizes the IRFA.
    As set forth in greater detail in the IRFA, the proposed rule would 
prohibit an investment adviser from providing advisory services for 
compensation to a government client for two years after the adviser or 
any of its partners, executive officers or solicitors made a 
contribution to certain elected officials or candidates. The 
prohibition would not result from contributions of up to $250 (per 
election) made by a partner, executive officer or solicitor of the 
adviser to an elected official or candidate for whom the person making 
the contribution can vote. The rule amendments would require a 
registered adviser that has government clients and makes political 
contributions to maintain certain records of their political 
contributions. The IRFA states that the new rule and rule amendments 
are designed to prevent advisers from engaging in pay to play 
practices, and to protect advisory clients (and their beneficiaries) 
from the consequences of pay to play.
    The IRFA contains the statutory authority for the proposed rule and 
rule amendments. The IRFA also discusses the effect of the proposed 
rule and rule amendments on small entities. For purposes of the 
Advisers Act and the Regulatory Flexibility Act, an investment adviser 
generally is a small entity if (i) it manages assets of less than $25 
million reported on its most recent Schedule I to Form ADV (17 CFR 
279.1), (ii) it does not have total assets of $5 million or more on the 
last day of the most recent fiscal year, and (iii) it is not in a 
control relationship with another investment adviser that is not a 
small entity.\118\
---------------------------------------------------------------------------

    \118\ Rule 0-7 (17 CFR 275.0-7).
---------------------------------------------------------------------------

    The Commission estimates that of the investment advisers subject to 
the proposed rule and rule amendments, approximately 1,000 are small 
entities. The Commission has no information regarding the number of 
small-entity advisers that provide advisory services

[[Page 43567]]

to government clients. Advisers to state and local governments, 
however, are unlikely to be small entities. The proposed rule and rule 
amendments, therefore, would likely affect few or no small entities.
    The IRFA states that the proposed rule and rule amendments would 
impose no new reporting requirements. The proposed rule and rule 
amendments, however, would create certain new compliance and 
recordkeeping requirements. The proposed rule imposes a new compliance 
requirement by prohibiting an adviser from providing advisory services 
for compensation to government clients for two years after the adviser 
or any of its partners, executive officers or solicitors makes a 
contribution to certain elected officials or candidates. The proposed 
rule amendments would impose new recordkeeping requirements by 
requiring an adviser to state and local governments that makes 
political contributions to maintain certain records of its 
contributions and its advisory clients. An investment adviser that 
either does not make political contributions or does not provide 
advisory services to a state or local government would be unaffected by 
the proposed rule and rule amendments. Moreover, as discussed above, 
few or no small entities are likely to be affected by the proposed rule 
and rule amendments. There are no rules that duplicate, overlap, or 
conflict with, the proposed rule and rule amendments.
    The IRFA discusses the various alternatives considered by the 
Commission in connection with the proposed rule amendments that might 
minimize the effect on small entities, including (a) the establishment 
of differing compliance or reporting requirements or timetables that 
take into account resources available to small entities; (b) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the proposed rule and rule amendments for 
small entities; (c) the use of performance rather than design 
standards; and (d) an exemption from coverage of the proposed rule and 
rule amendments, or any part thereof, for small entities.
    As discussed in more detail in the IRFA, we believe it would be 
both unfeasible and unnecessary to exempt small entities from the 
proposed rule and rule amendments. After taking into account the 
resources available to small entities and the potential burden that 
could be placed on small-entity investment advisers, the Commission is 
proposing to require small entities to be subject to the proposed rule 
and rule amendments. As discussed in more detail in the IRFA, we have 
taken steps to minimize the effects on small-entity investment 
advisers. We have determined that it does not appear feasible to 
establish different reporting or compliance requirements or to further 
clarify, consolidate, or simplify the reporting or compliance 
requirements.
    The IRFA includes information concerning the solicitation of 
comments with respect to the IRFA generally, and in particular, the 
number of small entities that would be affected by the proposed rule 
and rule amendments. A copy of the IRFA may be obtained by contacting 
Jeffrey O. Himstreet, Attorney, Securities and Exchange Commission, 450 
5th Street, N.W., Washington, DC 20549-0506.
    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, the Commission is also requesting information regarding 
the potential impact of the proposed rule and rule amendment on the 
economy on an annual basis. Commenters should provide empirical data to 
support their views.

VI. Statutory Authority

    The Commission is proposing new rule 206(4)-5 of the Act pursuant 
to the authority set forth in sections 206(4) and 211(a) of the 
Investment Advisers Act of 1940 (15 U.S.C. 80b-6(4), 80b-11(a)).
    The Commission is proposing amendments to rule 204-2 of the Act 
pursuant to the authority set forth in sections 204 and 206(4) of the 
Investment Advisers Act of 1940 (15 U.S.C. 80b-4 and 80b-6(4)).

List of Subjects in 17 CFR Part 275

    Reporting and recordkeeping requirements, Securities.

Text of Proposed Rule and Rule Amendments

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    1. The authority citation for part 275 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-
6a, 80b-11, unless otherwise noted.
 * * * * *
    2. Section 275.206(4)-5 is added to read as follows:


Sec. 275.206(4)-5  Political contributions by certain investment 
advisers.

    (a) Prohibitions. As a means reasonably designed to prevent 
fraudulent, deceptive or manipulative acts, practices, or courses of 
business within the meaning of section 206(4) of the Act (15 U.S.C. 
80b-6(4)), it shall be unlawful:
    (1) For any investment adviser not prohibited from registering with 
the Commission under section 203A(a) of the Act (15 U.S.C. 80b-3a(a)) 
to provide investment advisory services for compensation to a 
government entity within two years after a contribution to an official 
of the government entity is made by:
    (i) The investment adviser;
    (ii) Any partner, executive officer or solicitor of the investment 
adviser (including a person who becomes a partner, executive officer or 
solicitor within two-years after the contribution is made); or
    (iii) Any political action committee controlled by the investment 
adviser or by any partner, executive officer or solicitor of the 
investment adviser; and
    (2) For any investment adviser not prohibited from registering with 
the Commission under section 203A(a) of the Act (15 U.S.C. 80b-3a(a)), 
or any of its partners, executive officers or solicitors:
    (i) To solicit any person or political action committee to make, or 
coordinate, any contribution to an official of a government entity to 
which the investment adviser is providing or seeking to provide 
investment advisory services; or
    (ii) To do anything indirectly which, if done directly, would 
result in a violation of this section.
    (b) Exception. Paragraph (a)(1) of this section does not apply to 
contributions made by a partner, executive officer or solicitor to 
officials for whom the partner, executive officer or solicitor was 
entitled to vote at the time of the contributions and which in the 
aggregate do not exceed $250 to any one official, per election.
    (c) Special rule for private investment companies. For purposes of 
this section, an investment adviser to a private investment company in 
which a government entity invests provides investment advisory services 
to the government entity.
    (d) Exemptions. The Commission, upon application, may conditionally 
or unconditionally exempt an investment adviser from the prohibition 
under paragraph (a)(1) of this section. In determining whether to grant 
an exemption, the Commission will consider, among other factors, 
whether:

[[Page 43568]]

    (1) The exemption is consistent with the purposes of this section;
    (2) The investment adviser, before the contribution(s) resulting in 
the prohibition was made:
    (i) Developed and instituted procedures reasonably designed to 
ensure compliance with this section;
    (ii) Had no actual knowledge of the contribution(s); and
    (3) The investment adviser:
    (i) Has taken all available steps to obtain a return of the 
contribution(s); and
    (ii) Has taken other remedial or preventive measures as may be 
appropriate under the circumstances.
    (e) Definitions. For purposes of this section:
    (1) Contribution means any gift, subscription, loan, advance, or 
deposit of money or anything of value made for:
    (i) The purpose of influencing any election for federal, state or 
local office;
    (ii) Payment of debt incurred in connection with any such election; 
or
    (iii) Transition or inaugural expenses of the successful candidate 
for State or local office.
    (2) Executive officer means the president, any vice president in 
charge of a principal business unit, division or function (such as 
sales, administration or finance), any other officer who performs a 
policy-making function, or any other person who performs similar 
policy-making functions, for the investment adviser.
    (3) Government entity means any State or political subdivision of a 
State, including
    (i) Any agency, authority, or instrumentality of the State or 
political subdivision;
    (ii) Plan or pools of assets controlled by the State or political 
subdivision or any agency, authority or instrumentality thereof; and
    (iii) Officers, agents, or employees of the State or political 
subdivision or any agency, authority or instrumentality thereof, acting 
in their official capacity.
    (4) 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:
    (i) For an elective office of a government entity, if the office is 
directly or indirectly responsible for, or can influence the outcome 
of, the use of an investment adviser by a government entity; or
    (ii) For any elective office of a government entity, if the office 
has authority to appoint any person who is directly or indirectly 
responsible for, or can influence the outcome of, the use of an 
investment adviser.
    (5) A Private investment company is a company that would be an 
investment company under section 3(a) of the Investment Company Act of 
1940 (15 U.S.C. 80a-3(a)) but for the exceptions to that definition in 
sections 3(c)(1) and 3(c)(7) of the Investment Company Act (15 U.S.C. 
80a-3(c)(1)).
    (6) A Solicitor is any person who, directly or indirectly, solicits 
any client for, or refers any client to, an investment adviser.
    (f) Effective date. The prohibition on providing investment 
advisory services as described in this section arises only from 
contributions made on or after (the effective date of this section).
    3. Section 275.204-2 is amended by revising paragraphs (e)(1) and 
(h)(1) and adding paragraph (l) to read as follows:


Sec. 275.204-2  Books and records to be maintained by investment 
advisers.

* * * * *
    (e)(1) The following books and records must be maintained and 
preserved in an easily accessible place for a period of not less than 
five years from the end of the fiscal year during which the last entry 
was made on such record, the first two years in an appropriate office 
of the investment adviser:
    (i) Books and records required to be made under the provisions of 
paragraphs (a) to (c)(1) (except for books and records required to be 
made under the provisions of paragraphs (a)(11) and (a)(16) of this 
section); and
    (ii) Books and records required to be made under the provisions of 
paragraph (1) of this section.
* * * * *
    (h)(1) Any book or other record made, kept, maintained and 
preserved in compliance with Secs. 240.17a-3 and 240.17a-4 of this 
chapter under the Securities Exchange Act of 1934, or with rules 
adopted by the Municipal Securities Rulemaking Board, which is 
substantially the same as the book or other record required to be made, 
kept, maintained and preserved under this rule, shall be deemed to be 
made, kept, maintained and preserved in compliance with this rule.
* * * * *
    (l)(1) Every investment adviser registered or required to be 
registered under section 203 of the Act (15 U.S.C. 80b-3) that provides 
investment advisory services to a government entity, must make and keep 
the following records:
    (i) The names, titles and business and residence addresses of all 
partners, executive officers or solicitors of the investment adviser;
    (ii) The States in which the investment adviser or any of its 
partners, executive officers, or solicitors is providing or seeking to 
provide investment advisory services to a government entity;
    (iii) All government entities to which the investment adviser has 
provided investment advisory services in the past five years, but not 
prior to (insert effective date of rule); and
    (iv) All direct or indirect contributions or payments made by the 
investment adviser or any of its partners, executive officers, or 
solicitors or a political action committee controlled by the investment 
adviser or any of its partners, executive officers, or solicitors to an 
official, a political party of a State or political subdivision 
thereof, or a political action committee.
    (2) Records of the contributions and payments must be listed in 
chronological order and indicate:
    (i) The name and title of each contributor;
    (ii) The name and title (including any city/county/state or other 
political subdivision) of each recipient of a contribution or payment; 
and
    (iii) The amount and date of each contribution or payment.
    (3) For purposes of this section:
    (i) The terms contribution, government entity, official, executive 
officer and solicitor have the same meanings as set forth in 
Sec. 275.206(4)-5.
    (ii) The term payment means any gift, subscription, loan, advance, 
or deposit of money or anything of value.

    Dated: August 4, 1999.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-20489 Filed 8-9-99; 8:45 am]
BILLING CODE 8010-01-P