What Do the Regulatory and Industry Responses to the New York Pension Fund “Pay to Play” Scandal Mean for the Future of Hedge Fund Marketing?
Hedge Fund Law Report
New York’s so-called “pay to play” scandal – in which state officials conditioned investments of state pension money in hedge and private equity funds on payments by the funds’ managers to the officials or their affiliates – has yielded a range of regulatory and industry responses, of varying degrees of severity. At the most draconian is New York Attorney General Andrew Cuomo’s Code of Conduct (Code), to which three alternative investment managers have thus far agreed in settlement of pay to play charges. The Code bans the use of placement agents altogether, but is not yet law and has not yet been adopted by any industry group as a best practice. (However, it has been adopted by the New York State Teachers’ Retirement System.) Somewhat less severe is a recently proposed SEC rule intended to curtail pay to play practices. That rule generally provides that an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser to manage money for state or local governments would be barred for two years from providing advisory services for compensation, either directly or through a fund. A yet more measured response to the pay to play scandal – and in the view of many on the hedge fund side, a more practicable one – has come from CalPERS and other pension funds. These pension funds have required increased disclosure and transparency with respect to compensation arrangements between investment managers seeking to manage pension assets and any placement agents or third party marketers acting on behalf of such managers. Finally, lurking in the background has been Investment Advisers Act Rule 206(4)-3, which generally requires disclosure of the compensation arrangement between a registered investment adviser and a placement agent, to any “client” of the adviser that was solicited by the placement agent. The application of this rule in the pay to play scandal is subtle, as explained more comprehensively in this article. The regulatory responses have changed the game of hedge fund marketing. The difficult (though apparently improving) investment climate for hedge funds has made marketing more difficult as a practical matter, and the regulatory responses to the pay to play scandal have made marketing more treacherous as a legal matter. Therefore, this article provides background on the scandal and the various settlements; offers details of Cuomo’s Code; addresses the likelihood that other states will follow New York’s lead; discusses actions by pension funds in response to the scandal, the SEC’s recently proposed anti-pay to play rule and Rule 206(4)-3; and, importantly, explores the future of hedge fund marketing without placement agents, or with harsh restrictions on their activities.