On June 20, 2014, the U.S. Securities and Exchange Commission (“SEC”) charged two U.S. private equity firms with violating obligations under the U.S. Investment Advisers Act of 1940 (“Advisers Act”) that had been adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank Act”).

The administrative proceedings represented the first enforcement action the SEC had ever brought under the new “pay-to-play” rules of the Advisers Act, which prohibit investment advisers from providing advisory services for compensation to government entities within two years of making a political contribution, and highlighted the scrutiny with which the SEC was reviewing efforts by investment advisers to rely on the newly-introduced investment adviser registration exemptions adopted under the Dodd Frank Act.  The SEC settled both charges with cease and desist agreements and modest monetary penalties.  Nonetheless, the case serves as a warning that four years after their passage, the SEC is taking its gloves off and enforcing the new rules.

The SEC brought two separate administrative proceedings against two related investment advisers: TL Ventures Inc. (“TL Ventures”) and Penn Mezzanine Partners Management, L.P. (“Penn Mezzanine”).  The SEC charged TL Ventures with violation of the Advisers Act’s registration requirements and its “pay-to-play” rules, while  Penn Mezzanine was only charged with the former.

Registration requirement

Both TL Ventures and Penn Mezzanine claimed exemptions from the obligation to register as investment advisers under the Advisers Act.   TL Ventures claimed exempt reporting adviser status under Section 203(l) of the Advisers Act, based on the assertion that it was an adviser solely to one or more venture capital funds.  Meanwhile, Penn Mezzanine claimed exempt reporting adviser status under Rule 203(m)-1 of the Advisers Act, based on the assertion that it acted solely as an adviser to private funds and had regulatory assets under management (“RAUM”) in the U.S. of less than $150 million.

While relieved of the extensive reporting and compliance obligations of SEC- registered investment advisers, their status as exempt reporting advisers still required them to file certain basic reports with the SEC. In these reports, both advisers disclosed that they are under common control with each other, and that they had overlapping employees and associated persons, including individuals who provided investment advice on behalf of both advisers.  The reports also revealed that the two advisers had significant overlapping operations without any policies or procedures in place to keep them separate.

The SEC concluded that the two funds were operationally integrated, and that for purposes of determining their eligibility for an exemption, the two advisers had to be viewed as a single adviser.   As a result, Penn Mezzanine did not qualify for its claimed exemption under Rule 203(m)-1 under the Advisers Act because the combined operations of the two advisers exceeded the $150 million RAUM limitation.  Similarly, TL Ventures was not eligible for the exemption available under Section 203(l) of the Advisers Act since the combined operations of the two advisers meant that it was not an adviser solely to venture capital funds.  Accordingly, the SEC determined that both advisers failed to register as an investment adviser when they were required to do so.

Pay-to-play rules

In a case of first impression, the SEC also brought an enforcement action under the Advisers Act “pay-to-play” rules.  Under Section 206(4) of the Advisers Act and Rule 206(4)-5 thereunder, investment advisers (whether registered, required to be registered or exempt reporting) are prohibited from providing 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 the investment adviser or any “covered associate” of the adviser.  In April 2011, an officer or employee of TL Ventures that qualified as a “covered associate” of the adviser made a $2,500 campaign contribution to the campaign of a candidate for Mayor of Philadelphia and in November 2011 a $2,000 campaign contribution to the Governor of Pennsylvania.   Both political positions have appointment powers over the city and state pension and retirement boards.

The two public pension plans fell under the definition of “government entities” for purposes of the rules, and were investors of TL Ventures that had continued to pay advisory fees to TL Ventures during the two-year “time-out” period following the covered associate’s campaign contributions.  As a result, the SEC determined that TL Ventures was in violation of the Advisers Act’s “pay to play” rules.

Settlement

In no small part due to remedial efforts undertaken by the two advisers to reorganize their operations and separate their advisory functions, as well as the adoption of policies and procedures designed to ensure compliance with the rules, the SEC agreed to a relatively modest settlement with the two advisors:

  • Both advisers agreed to cease and desist from committing the prohibited acts in the future; and
  • TL Ventures agreed to pay to the SEC $256,697 in disgorgement penalties, prejudgment interest of $3,197 and a civil money penalty in the amount of $35,000.

Take-aways

That the SEC had combined two operationally integrated advisers for purposes of determining their eligibility for a registration exemption should not have come as a surprise.  In its adopting release, the SEC specifically warned that it would “treat as a single adviser two or more affiliated advisers that are separately organized but operationally integrated”.  With advisers frequently looking for ways to cut costs, sharing resources and personnel between affiliated advisers may be attractive from a financial perspective.  However, where one or both advisers are relying a registration exemption, special care should be taken that policies and procedures are in place to avoid being considered operationally integrated.

On the other hand, the SEC has indicated that it would continue taking a more lenient approach to non-U.S. advisers sharing operations with their SEC registered U.S. affiliates, allowing resources and personnel to be shared without risking loss of the non-U.S. adviser’s registration exemption.  The SEC hinted that further guidance may be coming from its staff as various fact patterns are presented for their consideration.

With respect to the pay-to-play rules, the TL Ventures administrative proceeding provides a few important lessons:

  • The rules do not apply solely to SEC registered advisers—they also apply to exempt reporting advisers (those relying on the private fund adviser exemption and the venture capital adviser exemption), foreign private advisers and sub-advisers;
  • There is no grandfathering exception—the prohibition applies even to government clients that the adviser advised since before adoption of the new rules;
  • The pay-to-play rules do not prohibit an adviser from providing advisory services to government clients, only to receive compensation for such service during the “time-out” period—thus, an adviser could continue to provide services during the time out period without charging fees until a replacement is hired; and
  • It is the adviser’s obligation to ensure that employees and officers of the adviser are aware of and compliant with the “pay-to-play” rules, particularly employees and officers falling under the definition of a “covered associate”.

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