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Addressing the SEC pay-to-play rule: five overlooked areas that could put your firm at risk

Is your firm equipped for the increased potential of pay-to-play risk and ramifications?

As we prepare for the 2022 midterm elections, firms political contribution risk will only continue to increase. And while pay-to-play regulations, including the SEC pay-to-play rule, usually get more attention during major, presidential or gubernatorial elections, the drastic increase in political contributions across the board only means one thing. Firms must proactively address any and all political contribution risk or face the consequences.

Put simply: the penalties are too steep not to do your due diligence.

So, what are the federal regulations governing financial firms? Let’s break it down.

  1. SEC Rule 206(4)-5, “applies to SEC-registered investment advisers and certain advisers exempt from registration with the SEC who provide investment advisory services or are seeking to provide investment advisory services to government entities and subjects them to several restrictions designed to curb pay-to-play activities. Rule 206(5) includes a provision that makes it unlawful for an adviser or certain of its executives or employees to do anything indirectly which, if done directly, would result in a violation of the rule.”
  2. FINRA Rule 2030, “prohibits all covered members from engaging in distribution or solicitation activities for compensation with a government entity on behalf of an investment adviser that provider or is seeking to provide investment advisory services to such government entity within two years after a contribution to an official of the government entity is made by the covered member or a covered association.”
  3. FINRA Rule 4580 states that, “a covered member who engages in distribution or solicitation activities with a government entity on behalf of an investment adviser that provides or is seeking to provide investment advisory services to such government entity shall maintain books and records that pertain to FINRA Rule 2030.”
  4. MSRB Rule G-37, “prohibits dealers from engaging in municipal securities business and municipal advisors from engaging in municipal advisory business with municipal entities if certain contributions have been made to officials of such municipal entities within the preceding two-year period and requires dealers and municipal advisors to disclose certain political contributions and other information.”
  5. CFTC Regulation 23.451 states that, “a swap dealer’s contributions for transition or inaugural expenses incurred by a successful candidate are only covered by the rule to the extent that such expenses are incurred by a successful candidate for a position as an official of a governmental Special Entity.”

However, it is important to note that while federal regulations may the be most well-known in the industry, they certainly aren’t the only regulations impacting firms. In fact, over the past few years we’ve seen a noted increase in both state and local regulations in the pay-to-play space.

In order to effectively mitigate risk, firms must have an active knowledge of all regulations AND be aware of any specific risk areas they face. To help you do so, we’ve gathered the top five overlooked areas of political contribution compliance that could put your firm at risk of violating the SEC’s pay-to-play rule and other federal, state and local regulations:

1.     Not having a thorough process of capturing and reporting political contributions.

What tools and processes does your firm have in place? Are controls designed to manage employees’ contribution activity at the local, state, and national levels? An astonishing 63% of firms surveyed recently reported they were monitoring contributions manually and another 6% admitted they were not monitoring contributions at all. These practices can put your firm at risk of violating numerous pay-to-play rules, facing consequences that include fines, debarment and more.

Your firm should have a thorough process of monitoring all covered associates and their family members, depending on your state and localities regulations. Additionally, you may want to consider implementing a policy that tracks associates who may be covered in the future. This ensures that when your organization audits contributions, it does so thoroughly and is not as likely to overlook potential risks and violations.

2. Not re-evaluating existing policies and procedures for their effectiveness.

While some firms might have a process of capturing and reporting political contributions, their policies and procedures may be five or 10 years old – light years in the way of compliance evolution. Changes in the compliance world and within your firm can affect how effective a process is. Although your firm’s process might have worked at one point in time, it might not in light of these changes.

With that said, make sure to regularly re-evaluate your process to ensure that it still stands the test of time…or make any necessary tweaks to avoid overlooking any potential risks.

3. Not having a process that accounts for digital donations.

Digital software has made it easier for people to make contributions, and harder for firms to manually keep track of them. Rather than write a check, employees today are using digital software to donate with the click of a button. This, combined with increased political participation, means that your firm must have a robust solution to proactively identify and address non-compliance.

4. Not running regular tests.

While some firms might test during major election seasons, they might neglect to run regular tests in “off-years.” Coupled with the increase in political activism in recent years, firms face an even greater pressure to regularly audit their political contribution compliance.

5. Not offering regular compliance training to your employees.

Some firms prohibit employees from making political contributions in their Code of Ethics (COE). However, educating your employees about the relevant pay-to-play rules should not end there. The penalties of violating the pay-to-play rule are too steep to assume that your COE is enough to deter your employees from violating any rules, whether directly or indirectly. To help mitigate risk, your firm should offer regular compliance training to employees to ensure a thorough understanding of all relevant pay-to-play regulations.

Financial firms must take political contributions monitoring seriously, especially during our 2022 midterm election year. Implementing tailored processes, regular employee training and leveraging technology solutions can help mitigate the risk of violating the SEC pay-to-play rule (as well as the countless other regulations) and facing the consequences. For more guidance on the pay-to-play rule, download the Ultimate Guide to Pay-to-Play Compliance