Proposed Rule 206(4)-5 covers only a portion of the investment advisers that might seek to become eligible for the award of advisory contracts by making campaign contributions to or solicitations from government officials. State-registered investment advisers are not covered, nor are those investment advisers that provide advice to government clients other than through a Private Investment Fund. Our concern is that, if the Rule does not adequately cover the universe of investment advisers, it will not adequately serve the Commission'spurpose, which we generally endorse; rather, it will not deter the same corruptive practices that are prohibited for covered investment advisers.

In contrast, MSRB Rule G-37 applies to all brokers, dealers and municipal securities dealers, as well as their finance professionals (collectively, "Municipal Securities Professionals"), engaged in a "municipal securities business".27 Such Municipal Securities Professionals are prohibited from serving government clients within two years after making a campaign contribution or solicitation to a government official. No classes of Municipal Securities Professionals are omitted from the coverage of MSRB Rule G-37. The same cannot be said for proposed Rule 206(4)-5.

The Commission provides little justification in Release 1812 for excluding some advisers from, and subjecting others to, the Rule. As justification for excluding state-registered advisers (the largest class of investment advisers)28 from the Rule, the Release states only "that the great majority of advisers to public funds are registered with theCommission."29 While it may be true that state-registered advisers do not typically advise public pension funds, government entities, as defined by the Rule, consist of much more than just public pension funds.30

The proposal that the Rule apply solely to advisers to Private Investment Funds --because "advisers to `private investment companies,' such as hedge funds and venture capital pools, have `reportedly' made contributions to elected officials who have influenced the decision of a government entity to invest in the adviser's company"31 (footnotes omitted) -- is also troubling to us. In the absence of more detailed evidence, the Subcommittees question the Commission's basis for concluding that advisers to Private Investment Funds are particularly inclined to engage in pay-to-play practices.

On these bases, the proposed Rule appears to us to be under-inclusive.32 That under-inclusiveness creates uneven regulation, and therefore competitive imbalances, among similarly-situated investment advisers, and leaves unrestricted the potential pay-to-play practices of many investment advisers that serve government clients. From a rulemakingstandpoint, a rule with these characteristics would be of little benefit in achieving the Commission's stated goals and should be seen to raise more serious constitutional issues than a more inclusive, and therefore more effective, approach. Nevertheless, we do not suggest that a rule if adopted should include offshore funds. This would be burdensome to the offshore fund, difficult to enforce, unlikely to apply to many government entities in the U.S. and otherwise be of questionable value to the purposes of the Rule.

The Rule, as applied to Covered Advisers and Covered Persons, appears to us to be over-inclusive in its reach in that it would apply to Covered Persons who have no relationship to or contact with government clients. In contrast, MSRB Rule G-37 applies only to the campaign contributions of a "municipal finance professional", a defined term that applies solely to associated persons of a Municipal Securities Professional who are (i) primarily engaged in certain "municipal securities representative activities," (ii) solicitors of a "municipal securities business" (which in this context means solicitors of business from the applicable government unit), (iii) municipal securities principals or sales principals supervising persons covered by (i) and (ii) of the foregoing, and (iv) supervisors, including the Chief Executive Officer, of persons identified in (iii) of the foregoing.33 No other associatedpersons are covered.34 In short, Rule G-37's complex definitions are intended to require a closer nexus between a municipal securities business and the pay-to-play practices.

The proposed Rule does not establish the same close nexus. Instead, the Rule would apply to a broad spectrum of persons associated with Covered Advisers regardless of their involvement with advisory clients that are government entities. It would cover every partner, every executive officer as defined in the Rule and every person who solicits clients for or refers clients to an adviser, even when none of those persons had, or has, anything to do with rendering services to or soliciting government entities.

The Rule would have a particularly broad impact on broker-dealers that also are registered as investment advisers, so-called dual registrants. The Rule would potentially cover not only every partner and every executive officer in every facet of the dual registrant's business, but also most, if not all, of their registered representatives. These representatives would potentially fall within the Rule either as officers of the dual registrant, or as "solicitors" if they solicit clients for wrap accounts and other investment advisory activities of dual registrants, whether or not their activities ever related even remotely to government entities. A political contribution by any of these employees within the proscribed two-year period could disqualify the entire firm from providing advisory services to a government entity, eventhough the employee may have played absolutely no role in soliciting or providing services to government clients and may have received no benefit from fees paid by such clients.

Likewise, to the extent that a Private Investment Fund may employ brokers to solicit investors for it, contributions by those brokers would be covered by the Rule regardless of the nature of the customers whom they solicit to invest in the Fund.

The Rule's broad application to other large financial service organizations that are registered as investment advisers is also unjustifiable. It will cover hundreds, if not thousands, of partners, executives and marketing personnel of such organizations who have nothing whatsoever to do with government clients. Indeed, its terms might even be read to cover employees in the telephone banks of large financial services firms if, on occasion, they refer a non-government caller to the firm's advisory services.35

The proposed Rule would impose one remedy -- the deprivation of the right to receive fees for two years -- on all violations, however remote and even if inadvertent.

Investment advisory relationships are fiduciary in nature and frequently long-term. The imposition of a restriction on receiving fees for two years would have the effect of terminating advisory relationships altogether. In the context of Private Investment Funds, it is not clear how the proposed Rule would be applied. Depending upon the answer to that query, the proposed Rule's actual application could be far harsher than, we believe, the Commission may have intended. Given the wide variety of relationships to which the Rule would apply, many interpretive issues could be expected to arise upon application of the Rule.

While factual situations vary, it is useful to illustrate the effect of a violation of the proposed Rule in one commonplace arrangement. A private buyout fund may have a public pension fund as an investor which has committed $200 million. In accordance with standard practices, the commitment is called as each separate acquisition is made. Assume that it is contemplated that during the life of the fund seven investments might be made and three acquisitions have already been closed. Each of the closed transactions is done through a separate entity, the ownership interests of each of the investors are fixed and a substantial portion of the services to be rendered by the general partner or adviser have been performed. The balance of contemplated services ordinarily will involve monitoring the acquisition, protecting the investment and arranging an exit from the investment. Suppose that, at this juncture, it is ascertained that a single executive of the general partner has made a $500campaign contribution to a government official. Under the proposed Rule, there are two choices:

(1) The government investor can be redeemed, although this is highly unlikely because the investor would not consent to such an event, there would be valuation issues and the other investors would not be willing to finance a premature takeout; or

(2) The general partner could forego compensation. This raises a number of interpretive issues. Does compensation include both the carry and the management fee? If, as illustrated, the discovery of the contribution occurs after three transactions have been closed, at what point does the two-year period commence and end? If the carry is earned after the profits are actually realized, must realization occur during the two-year period in order for it to fall within the prohibition? If it is earned later, is the general partner entitled to the entire fee or a pro-rated segment of the fee?

The Commission requested comment on whether less burdensome alternatives are available.36 We address this in two areas: (i) persons covered by the Rule and (ii) the approach to sanctions.

Coverage. One reasonable alternative would be to limit the broad prohibition against political contributions or solicitations to (1) executive officers of an investment adviser whohave as one of their principal responsibilities the provision of investment advisory services to, or the solicitation of investment advisory business from, government entities, (2) solicitors employed by an investment adviser who derive a material portion of their compensation from fees paid to the adviser by government entities and (3) any person employed by the adviser who, as a principal duty, supervises such officers or solicitors.37

Such an alternative would effectively cover those personnel within diversified financial firms who have a significant involvement in providing investment advisory services to, or soliciting advisory business from, government entities as well as those responsible for supervising such personnel. They are, therefore, the persons within the advisory organizations most likely to engage in pay-to-play practices. This alternative would prohibit those persons not only from making political contributions outside the de minimis exemption but also from soliciting others within the organization or elsewhere to make or solicit contributions on behalf of government officials who are in a position to influence the award of government business to the advisory organization. Such a rule in and of itself would be highly effective in curbing pay-to-play practices in the investment management industry.

If the Commission was nevertheless concerned that the alternative could be evaded if it was limited in application to officers, solicitors and supervisors of the type noted above, theCommission could impose self-regulatory obligations on investment advisers or a safe harbor with respect to political contributions and solicitations by other advisory personnel. Indeed, self-regulatory techniques have been successfully used in the form of the code of ethics requirements of Rule 17j-1 under the 1940 Act, which governs personal trading by advisory personnel.

The codes could (1) prohibit any person associated with an investment adviser from making or soliciting political contributions for the purpose of obtaining business from government entities, (2) require that advisers maintain records of political contributions outside the de minimis exemption and solicitations by their personnel to officials in a position to influence the selection of the investment adviser by their government clients and (3) otherwise provide policies and procedures reasonably necessary to prevent pay-to-play practices by all persons associated with the adviser.

Sanctions. Similarly, the penalty provisions could be revised to make them more appropriate to the nature and character of the violation.38 Because sanctions prescribed by a rule cannot necessarily be proportionate to the kinds of violations that may arise, the Ruleshould provide for alternative sanctions which may be invoked in appropriate situations. These include the following: (a) prohibiting an investment adviser from competing for new business from the particular government client for two years after the adviser or any of its covered persons makes a prohibited contribution, (b) prohibiting a person from sharing in commission or fee income from the particular government client for two years after that person has made a prohibited contribution and (c) requiring investment advisers to report any violations to the Commission, together with any sanctions which have been imposed or other actions taken. Many members of the Committee feel strongly that, because of the inherent difficulty in crafting a penalty appropriate to all circumstances, the only effective solution is Commission oversight and monitoring of codes of ethics that include appropriate compliance mechanisms to invoke proportionate sanctions, such as those suggested above.39

If the Commission proceeds as we propose, and practices develop that evade the Rule as adopted, it could subsequently revise the Rule to address those developments. But in an area such as this that is affected by constitutional limitations and considerations of fairness, the more appropriate approach is to adopt a rule responsive to current abuses and to broaden that rule only if, and when, a need for such action appears.

Other. The eradication of pay-to-play practices in the investment management industry also requires solutions that lie outside the scope of pay-to-play rules governing theconduct of investment advisers and their personnel. Indeed, one of the most effective safeguards against pay-to-play is provided by competitive RFP ("request for proposal") procurement processes for the retention of investment advisers and other service providers to government entities. The Commission could encourage increased reliance on such processes if it exempted from the Rule's coverage all government entities (and officials of those entities) who utilize objective RFP or other competitive processes that limit subjective decision-making on the part of elected government officials. The Subcommittees accordingly recommend that any rule dealing with pay-to-play practices in the investment advisory industry contain such an exemption.

Such alternatives also would be supplemented by state fiduciary laws governing the management of public pension money and the administration of other government assets. The fiduciaries of government-sponsored pension funds are typically subject to stringent fiduciary and conflict of interest restrictions under state pension codes that would be violated if the fiduciary retained a less qualified adviser merely because of campaign contributions made by that adviser or its principals or officers.40 At a minimum, these statutes would appear to regulate more directly the problems created by pay-to-play practices by prohibiting state and local officials from using state business as leverage to extract campaign contributions.

(c) Detailed Comments

The Rule should contain a provision which exempts from its application inadvertent violations to the extent that the adviser did not otherwise know that prohibited contributions had been made, has adopted reasonable procedures governing pay-to-play activities and has taken reasonable measures to enforce these procedures and to test compliance with them.41 This exemption would not apply to any pattern of political contributions by Covered Persons. This would ameliorate the proposed Rule's extreme results in the case of an inadvertent violation.

The proposed Rule would impose penalties for any campaign contribution by a Covered Person, even if the contribution was made while the Covered Person was employed in another job, and even if that job was not remotely related to rendering advisory services. This provision is overly expansive and would unreasonably hinder the ability of Covered Advisers to hire key personnel, assuming a Covered Adviser is in a position even to know of the prior political activities of a prospective employee. It also places a significant, and altogether unjustified, burden on the freedom of persons who might conceivably have an interest in participating in the investment advisory industry, but who are otherwise employed in other industries.

If the Commission is concerned that a Covered Adviser could attempt to evade the Rule by having a prospective employee make a contribution while at a previous employer, there is a less burdensome and better way to achieve this goal. Simply put, the Rule could apply only to political contributions by a prospective employee that were made after the employee entered into employment negotiations with the Covered Adviser. After employment negotiations begin, the Covered Adviser might at least have some ability to prevent the prospective employee from making political contributions that could unreasonably taint the entire advisory operations of the Covered Adviser.42

The proposed Rule may have the effect of limiting the ability of Covered Advisers or Covered Persons to make political contributions to local officials running for federal office. For example, the Rule would apply to campaign contributions to an incumbent governor (on the basis that the governor, while running for federal office, could presumably be someone who is "directly or indirectly responsible for, or [could] influence the outcome of, or the selection of an investment adviser"43) who was running for federal office, and would precludesuch contributions even if the governor were elected to federal office and could not influence a decision to select a particular Covered Adviser. The Rule simply should not have an effect beyond the kinds of local political activities it is intended to cover (i.e., state and local elections of officials who can influence the decision to select a Covered Adviser).44

The de minimis exemption should not be conditioned on whether a contributor is permitted to vote for a candidate. For example, a person may have legitimate interests in a candidate of another district running for state office even though that person could not vote for the candidate. Accordingly, a Covered Person should be able to make a de minimis contribution per official, per election. A code of ethics requirement prohibiting contributions made with the intent of securing advisory business and requiring the reporting of all contributions outside of the de minimis exemption to officials in a position to influence the award of business by the adviser's client, coupled with the Rule's provision prohibiting indirect actions, should be sufficient to prevent a Covered Adviser or its personnel from coordinating a collective effort among its Covered Persons to make de minimis contributions.45

As currently proposed, the exemptive relief provision offers only insignificant relief in the unusual circumstance where there is sufficient advance notice of potential technical violations. Given the potentially far-reaching impact of the proposed Rule's prohibitions, it can be expected that frequent and immediate relief will be necessary in the context of ongoing advisory relationships where it is not an option to cease providing investment advice while awaiting Commission action in the normal course.

In the context of obtaining exemptive relief, the Commission should clarify the method by which exemptive relief will be given. The Subcommittees believe the Commission will need to establish an exemptive process that will apply on an expedited (no longer than 30 days) and retroactive basis. Furthermore, we question whether an exemptive process would have the practical ability to deal with inadvertent violations.

The Rule's definition of "executive officer" would create a disturbing and unnecessary amount of uncertainty in its application because it includes any officer who performs a "policy-making function" or other persons performing similar functions for the adviser. The use of such a concept in the definition of "executive officer" appears to be unwarranted, since it would extend to all officers engaged in "policy-making functions," however defined, even though they had nothing whatsoever to do with the government business of the adviser.

Reference to a general partner should include the managing member of a limited liability company.

The Commission asserts that the benefits of the Rule outweigh the costs and burdens of complying with it.46 The Commission also asserts that costs to small advisers or advisers with broker-dealer affiliates covered by MSRB Rule G-37 would be negligible.47 Surprisingly, the Commission states that it "has limited data on the costs the proposed [R]ule and [R]ule amendments would impose on investment advisers with government clients."48 Any cost-benefit analysis of the Rule logically should begin, by analogy, with an analysis of the costs that have been borne by Municipal Securities Professionals in complying with MSRB Rule G-37, bearing in mind that the proposed Rule contains no reporting requirements. From a review of the Commission's cost-benefit analysis, it appears such a study was never conducted, even in light of the Commission's five-year experience in overseeing the regulation of pay-to-play practices in the municipal securities context.

Without such an analysis, it is difficult to determine with any degree of comfort whether the Commission's cost estimates actually support its conclusion that the benefits of the regulation outweigh the burdens of compliance. Moreover, the analysis is a congressional requirement that appears not to have been properly addressed by the Commission.

II. Conclusion

The Subcommittees respectfully recommend that the Commission revise its proposal in accordance with the comments contained herein. We are prepared to meet and discuss these matters with the Commission and its staff and respond to any questions.

Respectfully submitted,

Stanley Keller
Chair, Committee on Federal Regulation of Securities

Diane E. Ambler
Co-Chair, Subcommittee on Investment Companies and
Investment Advisers

John W. Gerstmayr
Co-Chair, Subcommittee on Investment Companies and
Investment Advisers

Robert Todd Lang
Chair, Subcommittee on Private Investment Entities

Drafting Committee:

Diane E. Ambler
John W. Gerstmayr
Mary Joan Hoene
Robert Todd Lang
Edwin C. Laurenson
Simon M. Lorne
C. Dirk Peterson
Richard M. Phillips
Paul N. Roth
Thomas R. Smith, Jr.
Fred M. Stone

cc: The Honorable Chairman Arthur Levitt
Commissioner Paul R. Carey
Commissioner Isaac C. Hunt, Jr.
Commissioner Norman S. Johnson
Commissioner Laura S. Unger
Harvey J. Goldschmid, Senior Special Counsel to Chairman Levitt
David M. Becker, General Counsel
Meyer Eisenberg, Deputy General Counsel
Paul F. Roye, Director, Division of Investment Management
Kenneth J. Berman, Associate Director of Public Utility and Investment Company Regulations

Footnotes

¹ We note that investment advisory services are generally provided to government clients in the context of long-term arrangements subject to close ongoing scrutiny and may involve the investment of large amounts of money in a highly competitive environment. Moreover, the nature of the compensatory arrangements applicable to differing types of advisory services vary from straightforward asset-based fees for services to highly complex performance fee arrangements, particularly in the private fund context. This state of facts causes some members of the Committee to believe that pay-to-play regulation should be undertaken as a self-regulatory initiative or at most left to the states, and that further study is warranted in any event.

² Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995), cert. denied, 517 U.S. 1119 (1996). MSRB Rule G-37 was the culmination of approximately four years of study and consultation with significant members of the municipal securities industry and bar, a process that began with the MSRB review initiatives of 1990, ultimately leading to two reports, one an MSRB report, Report of the MSRB on Regulation of the Municipal Securities Market, and the other a Commission staff report, Securities and Exchange Commission Staff Report on the Municipal Securities Market, Sept. 1993. Shortly after the publication of a draft of MSRB Rule G-37, hearings were held before Congress. See Hearings on the Municipal Securities Market Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, 103rd Cong., 1st Sess. No. 103-73 (1993) ("House Hearings"). Testifying at the House Hearings were, among others, officials of the MSRB, the National Association of Securities Dealers, Inc. and the Commission, including Chairman Levitt.

³ In view of the issues identified in this letter, including the differences between the municipal securities underwriting and investment advisory businesses, some members of the Committee believe that the Commission should consider further study in order to fashion a rule to address findings of abusive practices that is more closely tailored in scope and remedies.

⁴ As currently proposed, the Rule creates certain anomalies that some members of the Committee suggest the Commission reconsider, recognizing that they had been considered in the context of adopting MSRB Rule G-37. For example, it would provide that, if a currently elected state or local official runs for federal legislative office, the only members of the restricted groups who could make the minimal $250 contribution to that official's federal campaign would be those who happened to live in the district or state in which he is running. Moreover, the proposed Rule does not recognize numerous other legitimate political interests. For example: (i) every resident of a state has a legitimate interest in making a personal contribution to any statewide or legislative official elected in that state and to any municipal official elected in the county, city, town or village in which he lives; (ii) a covered person's personal interests can be affected by actions of state or municipal officials in a state or locality where he works, regardless of where he lives; and (iii) many people have ideologically-based interests in issues arising in states where they neither live nor work. Thede minimis exemption should apply per official, per election.

⁵ Some members of the Committee believe that the $250 de minimis exemption is too low.

⁶ As currently proposed, the consequences of the Rule's violation is a uniform sanction -- essentially the loss of two years' compensation -- that may bear no relation to the nature and materiality of the violation or other relevant circumstances. In many circumstances, in our opinion, this would constitute an excessive penalty and could create a difficult predicament for both the government entity and the adviser. In the case of a Private Investment Fund, it is not realistic to assume that the government entity would or could be obliged to withdraw from the Fund, and if the general partner, who customarily acts as adviser, elected to discontinue advisory services for the Fund, the impact would be felt by other investors in the fund as well as the government entity. As discussed, infra, the Subcommittees believe that, in view of the diversity and complexity of the investment advisory business, a more flexible system permitting sanctions to be tailored to the circumstances of a violation is necessary. Some members of the Committee endorse a self-regulatory approach as the only alternative that would permit proportionality.

⁷ The Commission has identified pay-to-play practices as referring to express or implicit requirements that market professionals give political contributions or other payments to government officials in order for such professionals to be considered for an award of government business. Brief for William B. Blount at 8, Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995)(No. 94-1336). (identifying pay-to-play practices in the municipal securities underwriting context).

⁸ Release 1812 at 43,556. The Commission also noted that investment advisers may obtain ancillary benefits in the form of soft dollar benefits from receiving awards of advisory contracts due to pay-to-play practices. The Subcommittees are puzzled as to the cause and effect relationship of pay-to-play with soft dollars arrangements, and would question the Commission's implicit, if not explicit, suggestion that these arrangements are by themselves illegal. As the Commission is aware, Congress expressly permits soft dollar arrangements that satisfy Section 28(e) of the Securities Exchange Act of 1934. See Securities Exchange Act Release No. 23170 (Apr. 23, 1986) (interpreting Section 28(e)).

⁹ Release 1812 at 43,560.

¹⁰ Id.

¹¹ This would include not only Commission-registered investment advisers but also investment advisers that would be required to register with the Commission but for reliance on an available exemption under Section 203(b) of the Advisers Act.

¹² The proposed Rule defines "government entity" to mean "any State or political subdivision of a State, including (i) any agency, authority or instrumentality of the State or political subdivision; (ii) plan or pools of assets controlled by the State or political subdivision or any agency, authority, or instrumentality thereof; and (iii) officers, agents, or employees of the State or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity."

¹³ The proposed Rule defines "contribution" to mean "any gift, subscription, loan, advance, or deposit of money or anything of value made for the purpose of (i) influencing any election for federal, state, or local office; (ii) payment of debt incurred in connection with any such election; or (iii) transition or inaugural expenses of the successful candidate for State or local office."

¹⁴ The proposed Rule defines "official" to mean "any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate, or successful candidate (i) for elective office of a government entity, if the office is directly or indirectly responsible for, or can influence the outcome of, the use of the investment adviser by a government entity; or (ii) for any elective office of a government entity, if the office has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the use of an investment adviser."

¹⁵ The proposed Rule defines "solicitor" to mean "any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser."

¹⁶ An exemptive request from the Commission is subject to conditions and, at a minimum, would need to demonstrate that a grant of exemption would be consistent with the purposes of the Rule, and that the investment adviser seeking the exemption had, before a contribution was made, implemented proceduresreasonably designed to ensure compliance with the Rule, had no actual knowledge of the contribution, and had taken all available steps to return the contribution, as well as such other remedial or preventive measures as may be appropriate under the circumstances.

¹⁷ Release 1812 at 43,563. The Commission notes that a Covered Adviser could be precluded from abruptly ceasing to manage a government client's portfolio in the event that the proposed Rule was violated. Rather, according to the Commission, the fiduciary obligations of a Covered Adviser could require it to continue managing the portfolio, and the proposed Rule would require the Covered Adviser to forego compensation until an appropriate successor could be found to manage the portfolio.

¹⁸ On October 11, 1996 Congress enacted the National Securities Markets Improvement Act of 1996 ("NSMIA"), which, among other things, amended the Advisers Act to add Title III, the Investment Advisers Supervision Coordination Act. This amendment added new Section 203A to the Advisers Act, which allocates jurisdiction between federal and state securities regulators for the registration and oversight of investment advisers. This amendment to the Advisers Act became effective on July 8, 1997. National Securities Market Improvement Act of 1996, Pub. L. No. 105-8, 111 Stat. 15. All states and territories, with the exception of the U.S. Virgin Islands and Wyoming, register and regulate investment advisers that are ineligible for Commission registration.

Generally, an investment adviser is permitted to register with the Commission under Section 203A(a)(1) only if it (i) has "assets under management" of $25 million or more or (ii) acts as an investment adviser to a registered investment company. 15 U.S.C. § 80b-3a(a). Section 203A(a)(2) defines the phrase "assets under management" as "the securities portfolios with respect to which an investment adviser provides continuous and regular supervisory or management services." Section 203A(c) grants the Commission the authority to exempt investment advisers from the prohibition against Commission registration. Accordingly, absent compliance with Section 203A(a)(1) or an available exemption, by Commission order or rule, an investment adviser would be ineligible to register with the Commission, and would need to determine if it is subject to registration and regulation under state law. At the time NSMIA was enacted, Congress estimated that there were approximately 22,500 investment advisers registered with the Commission. Congress estimated that after the reallocation of jurisdiction brought about by NSMIA, only 6,300 would remain registered with the Commission. S. Rep. No. 293, 104th Cong., 2d Sess. (1996) at 3-4.

¹⁹ In invoking its authority under the antifraud provisions of the Advisers Act, the Commission argued that many state statutes prohibiting certain types of campaign contributions to date have been ineffective in combating pay-to-play practices. Release 1812 at 43,560. There currently are a myriad of state statutes that could apply to ensure that government officials to state retirement and other entities do not select investment advisers on the basis of their campaign contributions or solicitations. The fiduciaries of government-sponsored pension funds are typically subject to stringent fiduciary and conflict of interest restrictions under state pension codes that would be violated should the fiduciary retain a less qualified adviser merely because of campaign contributions made by that adviser or its principals or officers. See, e.g., Sections 109-9 and 1-110 of the Illinois Pension Code (40 ILCS 5/1-109, 1-110) which would (i) require each fiduciary with respect to an Illinois public plan to discharge his or her duties on behalf of the plan prudently and in the exclusive interests of the plan and its participants and beneficiaries, (ii) prohibit such fiduciary from dealing with the assets of the plan in his or her own interests or for his or her own account and (iii) prohibit such fiduciary from receiving any consideration for his or her own personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan. Most state pension laws have provisions similar to those in Illinois. See, e.g., Cal. Ed. Code §§ 22225.5 and 22225.53 (applicable to the California Teachers' Retirement System) and New York Insurance Regulations §136.1 (applicable to the New York Common Retirement Fund). See also C. Moore, Protecting Retirees' Money, Fiduciary Duties and Other Laws Applicable to State Retirement Systems (1995). These statutes would appear to regulate more directly the problems created by pay-to-play practices by prohibiting state and local officials from using state business as leverage to extract campaign contributions.

²⁰ Blount at 940. The MSRB had argued that its functions did not constitute government action and, therefore, the plaintiff could not assert a grievance under the First Amendment. Brief for the Municipal Securities Rulemaking Board at 9-10, Blount v. SEC, 61 F 3d 938 (D.C. Cir. 1995) (No. 94-1336).

²¹ Blount at 941.

²² Although the Blount court expressly avoided deciding if MSRB Rule G-37 was "content-based" (thus requiring strict scrutiny) or "content-neutral" (thus requiring intermediate scrutiny), the court subjected MSRB Rule G-37 to a strict scrutiny analysis on the theory that, if it could survive strict scrutiny, there would be no need to decide whether the restriction was content-based or content-neutral. Blount at 943. Given the close similarities of the proposed Rule to MSRB Rule G-37, the Subcommittees would expect a comparable analysis of the proposed Rule.

²³ The Blount court's conclusion that MSRB Rule G-37 survived that level of scrutiny is of less import here than the level of scrutiny required by the court. Whether or not the Blount court's conclusion is embraced, the analysis it called for under the First Amendment has not yet been met here.

²⁴ Release 1812, at 43,557, n. 5.

²⁵ See, e.g., Citizens Against Rent Control/Coalition for Fair Housing v. City of Berkeley, 454 U.S. 290, 298 (1981); Village of Schaumburg v. Citizens for a Better Environment, 444 U.S. 620, 633 (1980); and Buckley v. Valeo, 424 U.S. 1 (1976) ("Buckley").

²⁶ First National Bank of Boston v. Bellotti, 435 U.S. 765, 776 (1987). See also Buckley, supra, note 24, at 14-15 ("Discussion of public issues and debate on candidates are integral to the operation of the system of government established by our Constitution" and "the constitutional guarantee [of freedom of speech] has its fullest and most urgent application precisely to the conduct of campaigns for political office"). The First Amendment also protects freedom of association. Inasmuch as the Blount court did not address any freedom of association issues under MSRB Rule G-37, our comments will focus solely on the Rule's infringement on the freedom of speech.

²⁷ The MSRB Manual defines the term "municipal securities business" as: (a) the purchase of a primary offering of municipal securities from the issuer on other than a competitive bid basis; or (b) the offer or sale of a primary offering of municipal securities on behalf of any issuer; or (c) the provision of financial advisory or consultant services to or on behalf of an issuer with respect to a primary offering of municipal securities in which the dealer was chosen to provide such services on other than a competitive bid basis; or (d) the provision of remarketing agent services to or on behalf of an issuer with respect to a primary offering of municipal securities in which the dealer was chosen to provide such services on other than a competitive bid basis. MSRB Rule G-37(a)(vii).

²⁸ See, supra, note 18.

²⁹ Release 1812 at 43,561.

³⁰ See, supra, note 12.

³¹ Release 1812 at 43,563.

³² The Blount court indicated that the Constitution does not require exactitude in crafting restrictions on protected speech. Rather, the government is obligated to "strike an appropriate balance between achieving [the government's] goals and protecting constitutional rights." Blount at 946. To the extent such a large community of investment advisers are omitted from the Rule's coverage, the Subcommittees question whether the Commission has established such an appropriate balance.

³³ MSRB Rule G-37(g)(iv).

³⁴ Id.

³⁵ The proposed Rule's application to all partners of a financial services firm registered as an investment adviser has uniquely anomalous results that depend entirely on the form of business organization. If the advisory firm is organized as a partnership, all those classified as "partners," whether limited or general, are apparently subject to the Rule regardless of their involvement in providing services to or soliciting advisory business from government entities. If, on the other hand, the advisory firm is organized in corporate form, those same owners of the firm would be classified as "shareholders" and would not be subject to the Rule unless they otherwise fit within the definition of an "executive officer" or "solicitor." As noted, the Subcommittees would restrict the Rule to partners who are principally engaged in providing services to or soliciting government clients or supervising those who do.

³⁶ Release 1812 at 43,562.

³⁷ We assume, solely for purposes of this letter, that disclosure of an adviser's pay-to-play practices would not provide a feasible alternative for affirmatively regulating these practices and that state statutes have to date been ineffective in combating these practices.

³⁸ One of the more difficult tasks in promulgating a pay-to-play rule for advisers is to establish a sanction proportionate to the nature and character of the violation. The difficulty is compounded by the almost infinite number of factual variables, the different kinds of advisory relationships, the varying impact on both government and non-government investors and the subjective nature of the motive for a political contribution. We doubt whether any rule as such is capable of providing a reasonable single proportionate sanction for different kinds of violations by advisers even with a prophylactic purpose. Furthermore, the exemption process to obtain relief from the Commission would not offer the needed flexibility to provide proportionality.

³⁹ Members of the Subcommittees will gladly work with the Commission and its staff and others in the industry in the development of codes of ethics and other mechanisms to achieve the purposes of the Rule.

⁴⁰ See, supra, note 19.

⁴¹ The Commission could incorporate these standards as conditions to this type of exemption. See, supra, note 16.

⁴² Certain members do not favor the lookback provision and believe that, if any is to be adopted, the two-year period is too long. In order to have some likely nexus to the proscribed activity, six months should be sufficient. Furthermore, many advisers provide services to wealthy individuals and families, endowments and other non-government investors. The Rule should not apply to such firms until and only so long as they provide services to at least one government entity.

⁴³ Release 1812 at 43,561.

⁴⁴ Some members of the Committee believe that, because the Commission considered and approved this consequence in the context of MSRB Rule G-37, it is similarly appropriate here.

⁴⁵ Some members of the Committee believe that, because the Commission considered and approved this issue in the context of MSRB Rule G-37, it is similarly appropriate here.

⁴⁶ Release 1812 at 43,564.

⁴⁷ Id. at 43,564.

⁴⁸ Id. at 43,565.