SEC Orders Investment Adviser to Disgorge Two Years of Fees and Pay Substantial Fine for Violation of "Pay-To-Play" Rules

June 25, 2014 Advisory

In the first case under the "Pay-to-Play" rules adopted in 2010, the SEC sent a strong message to investment advisers that violations of these rules would be treated seriously.

The SEC Settlement

On June 20, 2014, the SEC announced that it had brought and settled charges against TL Ventures, Inc. ("TL Ventures"), a Philadelphia investment adviser to certain venture capital funds invested in early technology companies. The SEC's investigation found that TL Ventures had violated Rule 206(4)-5 of the Investment Advisers Act of 1940 by continuing to receive compensation from two venture capital funds in which Pennsylvania and Philadelphia governmental pension funds had been invested after an associated person of TL Ventures had made a $2,000 campaign contribution to the governor of Pennsylvania, Tom Corbett, in November 2011 and a $2,500 contribution to the re-election campaign of Philadelphia Mayor Michael Nutter in April 2011. Although TL Ventures neither admitted nor denied these allegations, an agreed settlement was reached in which TL Ventures was censured, ordered to disgorge $256,697.00 (the amount of adviser fees collected in the two years after the contributions) and to pay pre-judgment interest of $3,197 and a penalty of $35,000.

The Take-Away

This case highlights the harsh and potentially disproportionate consequences of violations of the pay-to-play rules. TL Ventures had been providing advisory services to these particular pension funds for over 10 years prior to any campaign contributions being made and the particular venture capital funds at issue were in wind-down mode at the time of the campaign contributions. However, Rule 206(4)-5 does not require the SEC to show any actual intent to influence an elected official or candidate nor any type of quid pro quo. Instead, the pay-to-play rules force a "time-out" on advisers from providing any advisory services for compensation, directly or through a pooled investment vehicle, to a government entity within two years after the adviser and/or its covered associates make a campaign contribution over a certain threshold to elected officials or successful candidates for office who can, directly or indirectly, influence that government entity's selection of any investment adviser. Because the Pennsylvania governor and Philadelphia mayor can appoint some members of the boards which oversee pension funds, they are considered to have influence over the investment of the pension funds and the selection of investment advisors.

The SEC pay-to-play rules apply to all SEC registered advisers and certain advisers exempt from registration with the SEC who provide investment advisory services, or are seeking to provide such services, to governmental entities. Because of the harsh consequences that can arise from violations of this pay-to-play rule, all investment advisers subject to this rule should have robust pay-to-play policies and procedures in place. It is important to note that the pay-to-play rule does allow an adviser to avoid the two-year timeout if it is able to obtain a return of certain small contributions (under Rule 206(4)-5(b)(3)) or to file for exemptive relief for any violation (under Rule 206(4)-5(e)), but these corrective actions are only available if an adviser is able to discover and address the potential violations in a timely manner. Accordingly, a strong employee contribution reporting program and periodic monitoring for unreported or inaccurately reported employee contributions are critical to any pay-to-play compliance program.

Unregistered Investment Adviser Violations

The SEC also charged TL Ventures, and its affiliated company, Penn Mezzanine Partners Management, L.P. ("Penn Mezzanine"), with violations of the Advisers Act's registration provisions.

TL Ventures and Penn Mezzanine had each separately reported to the Commission as an "exempt reporting adviser" under Section 204(a) of the Investment Advisers Act based on the belief that the exemption for each company should be looked at independently. The SEC found, however, that the two companies, although separate legal entities, were (1) under common control, (2) had several overlapping employees and associated persons, and (3) had significantly overlapping operations without any policies and procedures designed to keep the entities separate.

Based on the Commission's stated practice to treat as a single adviser two or more affiliated advisers that are operationally integrated even if they are separate legal entities, the Commission found that, for registration purposes, TL Ventures and Penn Mezzanine should be considered integrated entities and were not eligible to rely on exemptions that each might have qualified for if they had been truly independent entities. When looked at on an integrated basis, TL Ventures and Penn Mezzanine did not qualify for an exemption and therefore were required to register with the Commission. The settled actions included cease and desist orders and censures with respect to each entity.