The Securities and Exchange Commission is poised to adopt a rule that while not advanced by the private equity community might nonetheless save some private equity professionals some money.

How so? Private equity professionals, like other citizens, are often besieged by requests for political contributions. Under a new rule proposed by the SEC on Aug. 3, as part of its efforts to address perceived pay-to-play practices by investment advisers, private equity sponsors may soon have a new, pithy and disarming response to those irksome dinnertime phone calls seeking political donations: "Sorry, I'd like to help, but the new SEC anti-fraud rule governing political contributions by investment advisers is so complicated and expansive that I can't afford the legal work to determine if I can make the contribution in the first place."

The proposed rule is designed to end perceived pay-to-play practices in the selection process of investment advisers by state and local governments. The proposed rule relates to state and local government clients only. It does not apply to federal or non-U.S. governmental clients.

A private fund sponsor will have to comply with the proposed rule even if it is not a registered investment adviser: The proposed rule applies to both registered investment advisers and advisers that are exempt from registration under Section 203(b)(3) of the Investment Advisers Act of 1940. Section 203(b)(3) is the exemption relied upon by private fund sponsors that have fewer than 15 clients.

The proposed rule has created quite a bit of controversy in the private equity community -- particularly over a proposal to prohibit fund sponsors and other investment advisers from compensating placement agents and solicitors in connection with the solicitation of governmental entities. However, the main focus of the Proposed Rule -- political contributions by investment advisers that might be designed to induce state pension plan investments -- could also have a significant impact on the activities of private fund sponsors and their employees. This article focuses on the political contribution component of the proposed rule.

The proposal is modeled on Municipal Securities Rulemaking Board Rule G-37, adopted in 1994, which addressed pay-to-play practices in the municipal securities markets. Rule G-37 prohibits a broker-dealer from engaging in municipal securities business with a municipal issuer for two years after the broker or certain of its employees make a political contribution to an elected official of the municipality who can influence the selection of the broker-dealer. Another MSRB rule prohibits broker-dealers from using consultants to solicit government clients.

In 1999, the SEC turned its attention to pay-to-play practices in the investment advisory business, but the proposal was met with stiff resistance and was never adopted.

The SEC's interest in pay to play was renewed recently following allegations of pay-to-play practices in New York, New Mexico, Illinois, Ohio, Connecticut and Florida. In addition to enforcement actions by the states and the SEC, several states have moved forward with new regulations to combat pay-to-play practices including, among others, an executive order issued by the New York State Comptroller mirroring the proposed SEC rule, a pension reform bill banning the use of placement agents in Illinois and increased disclosure requirements for placement agents in Connecticut and California.

The regulation of state and local campaign contributions would not necessarily seem to be within the expertise of the SEC, the federal agency charged with overseeing the securities markets and securities professionals. Nevertheless, in proposing the Rule, the SEC stated that pay-to-play practices implicate the fiduciary duties that are at the core of the Investment Advisers Act. According to the SEC, obtaining business or investments through pay to play "can distort the process by which investment advisers are selected and can harm advisers' public pension plan clients, and the pension plan beneficiaries, which may receive inferior advisory services and pay higher fees."

The proposed rule would prohibit investment advisers from accepting compensation for providing advisory services to a state or local government client for two years after the adviser or one of its covered associates makes a contribution to certain elected officials or candidates. In addition to the two-year bar, an adviser and its covered associates would also be prohibited from coordinating or soliciting any contribution or payment to an official of a government entity to which the investment adviser is providing or seeking to provide investment advisory services (as well as to a political party of a state or locality where such government entity exists).

The manager of a private fund in which a government entity invests would be treated as though the manager was providing investment advisory services directly to the government entity. Thus, the manager could not accept compensation (management fees, carried interest and other compensation) attributable to the investment of the government client.

As noted below, the broad and uncertain scope of the proposed rule may well result in a severe cutback in routine political contributions by private equity professionals to candidates for state and local office.

As is the case with any SEC rule, the devil is not so much in the details but in the definitions. The scope of the definitions are particularly important and sensitive in the case of the proposed rule due to the possible effects on constitutionally protected political speech. In this case, there are three definitions that deserve particular scrutiny: "contribution," "official" and "covered associate."

The term "contribution," while broad, is fairly straightforward. A contribution is any gift, subscription, loan, advance, or deposit of money or anything of value made for: (1) the purpose of influencing any election for federal, state or local office; (2) payment of debt incurred in connection with any such election; or(3) transition or inaugural expenses of the successful candidate for state or local office.

The proposed rule includes two exceptions for contributions of $250 or less. First, there is an exception for contributions of $250 or less made to the official for whom the contributor is entitled to vote. Second, the proposed rule also provides a less-helpful exception with respect to contributions made by a covered associate to officials other than those for whom the covered associate was entitled to vote. There are several conditions to this exception, including: (1) the contributions by the covered associate must be $250 or less in the aggregate; (2) the adviser must have discovered the contribution by the covered associate within four months of the date of the contribution; and (3) the adviser must cause the contribution to be returned to the covered associate within 60 days of learning of the contribution.

In order to trigger the rule's prohibition, the contribution must be made to an "official" who is (or who has the authority to appoint any person who is) directly or indirectly responsible for the selection of an adviser or who can influence the outcome of the selection process.

The definition of which officials of the state or local governments are covered presents a number of challenges. First, the term is not limited to incumbents, nor is it limited to candidates for the office that make the investment adviser selection. A candidate for the U.S. House of Representatives who will not, if he or she wins, be in a position to select the investment adviser, would nonetheless be an official if he or she is currently in a position to influence the selection of investment advisers. Furthermore, a contribution to a candidate who does not get elected would still trigger the two-year bar. Interestingly, a government employee who does not hold elective office, but may be in a position to select or influence the selection of an investment adviser, would not be an official unless he or she is seeking an elective office that would put him or her in a position to influence the selection process.

The subjective judgments inherent in the definition of an "official" further expand the potential application of the proposed rule. In particular, it is difficult to see how an adviser can identify with confidence each person who is "indirectly" responsible for, or who "can influence the outcome of" the selection of an investment adviser.

The expansive definition of "covered associates" also contains traps for the unwary. A political contribution by any of the following persons (or a political action committee controlled by them) will trigger the two-year bar: (1) the adviser's general partners or managing members, the president and any vice president in charge of a principal business unit, division or function; (2) any executive officer who in connection with his or her regular duties performs, or supervises any person who performs, investment advisory services; (3) any executive officer who in connection with his or her regular duties solicits, or supervises any person who solicits, investment advisory business; and (4) any employee who solicits a state or local government.

While the SEC stated in the proposing release that this definition would not include a comptroller, head of human resources or director of information services, it would include, for example, an executive officer who performs advisory services for one fund and contributes to an official of a government entity invested in another fund managed by the investment adviser. Donations by third parties including attorneys, family members, friends or companies affiliated with the adviser are not specifically included in the definition of covered associate but would also trigger the two-year bar if they are really indirect donations by a covered associate.

Further traps are created by temporal vagaries associated with one's status as a covered associate. Suppose an employee makes a contribution and is subsequently promoted to a position in which he or she is a covered associate -- does the political contribution trigger the two-year bar? The proposed rule is clear that it would. Furthermore, the two-year bar would continue even if a covered associate who made a donation leaves the firm or moves to another position where he or she is not a covered associate.

The two-year bar would also apply if the advisory firm hires a person into a covered-associate position who made a contribution prior to being hired. Thus, potential outside hires may be effectively disqualified from consideration due to their prior political contributions, even though those contributions were perfectly legal when made. This could lead to awkward politically oriented questions during the hiring process of a new covered associate. It may also make business school students interested in positions in private equity and other investment advisory firms think thrice before making political contributions to candidates.

It should be noted, however, that contributions made prior to the effective date of the proposed pule are "grandfathered" and thus will not trigger the two-year bar. Contributions made after the effective date of the rule to officials of existing governmental clients, however, would not be grandfathered.

If the adviser or its employees make an inappropriate contribution, the adviser is not prohibited from providing advice, only from receiving compensation for such advice. In fact, the SEC assumes that the adviser would be required to provide uncompensated advisory services for a reasonable period of time until the client retains a new adviser. Due to the expansive definition of "compensation" under the Investment Advisers Act, the types of banned compensation would include management fees, carry and any form of economic or other benefits received directly or indirectly by the adviser for providing investment advice with respect to the government entity in question. Reimbursement for overhead and other costs would also be considered compensation.

The two-year ban could cause particular issues for private equity funds because investor withdrawals are often not permitted or impracticable. There are simple fairness issues, of course, that may also have fiduciary implications. For example, why should a government entity get services free that other investors have to pay for? Also, who ultimately pays for the uncompensated advice, the adviser or the other investors? The impact of providing uncompensated advice could also trigger "most-favored nation" agreements. One suggestion that has been made to the SEC in comment letters is that a fund adviser, if it is faced with the two-year bar, should be permitted to return to fund the fees that are attributable to the government entity. This seems like an unsatisfactory result, at best.

The two-year bar will be the same regardless of the severity of the infraction. In addition to the possibility of returning certain contributions as discussed above, the proposed rule provides that the SEC may grant the adviser an exemption if it concludes the imposition of the prohibitions is unnecessary to achieve the rule's purpose. Each exemption would be examined based on a facts-and-circumstances approach. Along with the nature of the contribution itself (including the timing, amount, the contributor's status at that time and the contributor's intent), the SEC will also consider whether the adviser (1) has adopted and implemented policies and procedures reasonably designed to prevent violations of the proposed rule; (2) had no actual prior knowledge of the contribution; and (3) after learning of the contribution has taken all available remedial or preventive measures as may be appropriate under the circumstances including the return of the contribution.

At this writing, the SEC is considering the over 200 comments that have been submitted in response to the proposed rule. While most of the comments have been critical, given that pay-to-play stories continue to appear in the press, it should not surprise anyone if the SEC adopts the proposed rule, or something very similar to it, this time around.

Given the complexities of the proposed rule, as well as the state rules governing pay to play, there may be a natural inclination for a firm simply to prohibit employees from making political contributions to candidates for state and local office altogether. Unfortunately, such a policy may not be sufficient, since, for example, a contribution to a candidate for federal office may trigger the two-year bar if the candidate is currently a state or local official. For these reasons, developing a sufficiently comprehensive and up-to-date list of candidates and officials to whom contributions are prohibited may be the most cumbersome, and potentially costly, task for sponsors, even in circumstances where a sponsor imposes an outright ban on contributions to candidates for state and local office.

In all events, we believe private fund managers should resist the temptation to wait until after the proposed rule is finalized to adopt or revisit their existing policies relating to political contributions. Some states and localities are ahead of the SEC in adopting anti-pay-to-play rules that mirror the SEC approach. At a minimum, a private fund manager that is soliciting an investment by state or local entity should determine whether that jurisdiction has anti-pay-to-play rules and assure that its employees have not made any political contributions that may be problematic under those rules.

Kenneth J. Berman is a partner and Gregory T. Larkin is an associate in the Washington office of Debevoise & Plimpton LLP. A version of this article originally appeared in the fall issue of the Debevoise & Plimpton Private Equity Report.