The SEC's Anti-"Pay to Play" Rule is Challenged in Court

"Pay to play" occurs when an investment adviser contributes to the political campaign of a political candidate who, if elected or re-elected, can influence the selection of an investment adviser for public funds* - with the contributor and the candidate having improper motives.  Some "pay to play" practices are outright quid pro quo corruption:  a lucrative investment advisory assignment is exchanged for a campaign contribution.  Most "pay to play" practices are subtle, allowing plausible deniability for those involved.  Sometimes the subtlety involves intermediaries who make campaign contributions and receive compensation from an investment adviser ostensibly for other services provided to the adviser, with murky causality between the campaign contribution outflow and the compensation inflow.

Investment advisers have sometimes made campaign contributions not with a mindset that a contribution will result in a significant probability of receiving investment advisory business, but with the mindset that not contributing will eliminate the non-contributing investment adviser from a list of advisers to be considered for future business.  

In response to several headline-making "pay to play" scandals, in 2010 the SEC adopted a rule to prevent "pay to play."**  The rule is complicated - several pages long - so here's the nutshell version:  in general, the rule prohibits a campaign contributor, for two years after the contribution, from managing public funds for which the recipient politician has influence in the selection of an investment adviser for those funds.  The rule's blanket two year prohibition avoids the difficulty of discerning motivations:  which contribution motivations are well-intended and which are improper.  

The stated purpose of the anti-"pay to play" rule is to provide integrity in the selection of investment advisers for public funds.  In this writer's view the rule also has the significantly beneficial effect of reducing the investment costs associated with public funds investment management.

Why?

Because considering politics in adviser selection distorts decision-making.  Distortions increase costs.  More objective decision-making in adviser selection tends to reduce costs including because low investment costs are the best indicator of desirable long-term risk-adjusted investment returns. 

Last month, in a little noticed lawsuit, two state political organizations sued the SEC seeking to invalidate the SEC's anti-"pay to play" rule.  New York Republican State Committee and Tennessee Republican Party v. SEC (United States District Court for the District of Columbia; Case No. 1:14-cv-01345-BAH).  The plaintiffs allege that the rule violates First Amendment rights and exceeds the SEC's rulemaking authority.     

If the federal courts declare the SEC rule invalid then, nationwide, investment costs borne by public funds will increase.  The increased costs will be borne by taxpayers and pensioners.  (There is no free lunch; incrementally increased investment costs must be borne by someone, soon or later.)  Taxpayers will bear most of the burden through taxes that pay for incrementally larger ongoing contributions to public pension funds, to keep those funds from becoming underfunded or, all too frequently, more underfunded.  Retired government employee pensioners will bear some of the cost increase, too, in those infrequent occasions when government pension benefits can be reduced through the government unit's bankruptcy.    

*Another "pay to play" situation involves the selection of underwriters of municipal and other government debt.  A anti-"pay to play" rule of the Municipal Securities Rulemaking Board is analogous to the SEC's anti-"pay to play" rule.  Municipal Securities Rulemaking Board Rule G-37, upheld by the D.C. Circuit Court of Appeals in Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995).

**Rule 206(4)-5 under the Investment Advisers Act of 1940, as amended.  17 C.F.R. Section 275.206(4)-5.