Norm engages in writing on a variety of legal and financial subjects. His book, titled Going Public: My Adventures Inside the SEC and How to Prevent the Next Devastating Crisis, is now available in stores and online. The book chronicles his experiences at the agency and how they shed light on the regulatory process and government policy-making.
What the Outcome of BlackRock’s Petition Could Portend for the SEC’s Stance on Pay to Play
The Hedge Fund Law Report
By Michael Washburn
BlackRock has petitioned the SEC for an exemption from the prohibition against its collection of fees from Ohio-based “government entity” clients, following a violation of the so-called “pay to play” rule by one of its top executives. The violation occurred when a BlackRock senior managing director, Mark Wiedman, contributed $2,700 to the presidential campaign of Ohio Governor John Kasich in January 2016. Given that Kasich, in his role as Governor of Ohio, has oversight of public entities, such as pensions, that invest in or might be induced to invest in BlackRock-affiliated funds, and also has significant influence over appointments to the boards of public entities, the donation to Kasich’s campaign is a conflict of interest and violation of the pay to play rule. As a result, absent exemptive relief, BlackRock will be denied the ability to collect fees, totaling an estimated $37 million, from any Ohio government entity.
In its petition filed on May 26, 2017, BlackRock acknowledges missteps taken by its executive, but contended that the requirements for obtaining a waiver of the injunction have been met. These requirements depend on the circumstances of the contribution and investment adviser’s internal pay to play rule compliance procedures and protocols. BlackRock asserts that it went out of its way to educate employees about their compliance responsibilities and maintains a robust compliance culture. Therefore, BlackRock argues, any violation of the pay to play rule by an individual should not implicate BlackRock.
The case comes at a critical juncture, as top SEC roles have finally been filled, and many observers are closely following actions taken by the SEC to assess whether the new administration’s pro-business stance is rhetoric or a reality. BlackRock’s prospects for winning an exemption may be brighter than they would have been before President Trump took office, but many forces are likely to shape the outcome, including SEC actions as recent as January 2017 that sent a loud and clear message about the seriousness of pay to play violations.
To help readers understand these issues, this article analyzes BlackRock’s petition, along with insight from legal practitioners with experience with the pay to play rule and SEC enforcement matters.
Background of the Case
Announced by the SEC on July 1, 2010, Rule 206(4)-5(e) bars investment advisers from providing advisory services for compensation to a government client for two years following a contribution by the adviser, or its executives or employees, to certain elected officials or candidates.
Although BlackRock strongly contests the injunction against it collecting pension fees, it does not dispute the facts that led to the enforcement action and the current injunction. On January 15, 2016, Mark Wiedman, a senior managing director, head of the ETF and index investments division and member of the global executive committee at BlackRock, contributed $2,700 to Ohio governor John Kasich’s campaign for the Republican Party’s nomination and for the presidency. The contribution covered the fee for Wiedman to attend a lunch hosted by the campaign. Wiedman reportedly made the contribution at the invitation of an independent director of a BlackRock fund. On January 19, 2016, the Kasich campaign reported having received Wiedman’s contribution in a Federal Election Commission filing.
While these facts are not in dispute, BlackRock asserts in its petition that in making his contribution, Wiedman did not act on any desire to influence the award of investment advisory business to BlackRock. The petition contends that a brief personal introduction, made as the governor welcomed attendees at the lunch, was the only occasion on which Wiedman actually met the governor or dealt with the governor’s staff. The petition characterizes Wiedman’s actions as motivated solely by the same political interests and activism that typically motivate contributions to campaigns and as untainted by any improper or illegal intent, or scienter. It further argues that Wiedman was fully within his legal rights in taking an interest in the Republican Party primaries and planning to vote in the election.
“At the time he attended the campaign lunch and made the Contribution, the Contributor was focused on the Official in his capacity as a candidate for President of the United States, and the potential that a contribution to such a federal candidate would be covered under the Rule simply did not occur to him in that frame of mind,” the petition states. The contribution, it continues, was consistent with other donations made by Wiedman over the years.
Maintaining that BlackRock has robust policies and procedures in place to avoid any legal violations, the petition states that Wiedman did not obtain pre-authorization from BlackRock’s legal department before making the contribution to Kasich’s campaign. Further, Wiedman’s actions had no ramifications for Blackrock’s ability to solicit or retain investors or for its investment strategy. Not only did Wiedman not tell existing or prospective investors about the contribution, but he did not discuss it with BlackRock, its advisers or any of their covered associates.
Wiedman was the only individual associated with BlackRock to have any knowledge of the contribution until October 2016, the petition asserts. Moreover, the contribution took place after the end of the selection process in which BlackRock clients had decided to invest in a fund advised by a BlackRock adviser.
BlackRock’s Internal Reaction
On October 6, 2016, BlackRock’s compliance department conducted internal compliance testing that resulted in the discovery of Wiedman’s contribution to the Kasich campaign. While there is no specific requirement for BlackRock compliance personnel to scour public websites for data on contributions, the compliance staff do carry out such searches in the interest of meeting the highest possible compliance standards, the petition asserts.
Upon learning of the contribution from the Federal Election Commission’s website, BlackRock launched an investigative process to determine whether the contribution posed any problems under the pay to play rule. On November 11, 2016, Wiedman requested a full refund of the $2,700 contribution, which he received on November 23, 2016. BlackRock placed compensation attributable to clients’ investments since the contribution date into escrow and made plans to place future compensation subject to the two-year ban into escrow until the resolution of its petition.
BlackRock maintains that it has had robust policies and procedures in place since the pay to play rule’s effective date – long before Wiedman’s contribution to the Kasich campaign. “At the time of the Contribution, the Policy required, and continues to require, that all employees pre-clear all political contributions made in the United States. There is no de minimis exemption from this pre-clearance requirement,” the petition states. Moreover, BlackRock requires employees to make quarterly certifications of their compliance with the policy, sends biannual reminders about the policy to all employees and requires all employees to complete a yearly computer-based training module regarding the policy and the pre-clearance requirement.
BlackRock’s petition argues that the organization established comprehensive compliance policies and procedures, that Wiedman’s pay to play violation was not the result of any failure to maintain a strong internal compliance culture and that the organization swiftly took appropriate steps as soon as it learned of the violation.
Grounds for Granting the Petition
Criteria for an Exemption From the Pay to Play Rule
Rule 206(4)-5(e) directs the SEC to consider several factors in determining whether to grant an exemption. These include:
whether the exemption is necessary or appropriate in the public interest and consistent with the protection of investors;
whether the investment adviser adopted policies and procedures reasonably designed to prevent violations of the rule, before the violation in question occurred;
whether the adviser had actual knowledge of the contribution, prior to or at the time it took place;
whether the adviser, upon learning of the contribution, took all available steps to cause the contributor to obtain a return of the contribution;
whether the adviser took other necessary and appropriate remedial and preventive measures;
what the contributor’s intent and motive were in making the contribution; and
various other criteria relating to the contributor’s employment status at the time of the contribution, the timing and amount of the contribution and the nature of the election.
BlackRock’s position is that it has met its obligations under the aforementioned criteria.
The Davidson Kempner Precedent
The petition also cites the case of Davidson Kempner Capital Management as significant legal precedent for the granting of an exemption. In that case, an Ohio State Treasurer received a contribution of $2,500. The petition argues that the interactions between the contributor and the recipient of the contribution in Davidson Kempner went even further than in the present matter: the contribution followed a lunch meeting, a brief email exchange and a phone call. In the current matter, the personal interaction was, at least in BlackRock’s version of the events, limited to a brief personal introduction of Governor Kasich to attendees of the campaign lunch.
A further differentiator is that the contributor in the Davidson Kempner matter informed the petitioner’s executive managing member of his plans to meet with the Ohio State Treasurer. “In contrast, the Contributor in [the BlackRock] Application did not inform any officers or employees of BlackRock or the Applicants of his interest in the Official,” BlackRock’s petition asserts. “Moreover, no officer or employee of BlackRock or the Applicants, other than the Contributor, had any knowledge that the Contribution had been made until the Contribution was discovered by BlackRock’s Compliance department in October 2016.”
Tough Stance on Pay to Play
Based on the general record of petitions of this nature, it is unlikely that BlackRock’s petition will succeed, said BakerHostetler partner Walter Van Dorn. Recent actions by the SEC signal its aggressive posture toward pay to play violations. As recently as January 17, 2017, Van Dorn noted, the SEC announced that 10 investment advisory firms agreed to pay fees for comparatively minor violations of the pay to play rule, involving small donations of roughly $300 to $400 and none larger than $10,000. See “Campaign Contributions As Small As $500 Could Draw SEC Enforcement Action for Pay to Play Violations” (Jan. 26, 2017).
Although the donations that triggered the enforcement action against the 10 firms were relatively small, the fees that the advisers have agreed to pay ranged from $35,000 to $100,000, and the action itself signalled a harsh stance by the SEC toward violations of the pay to play rule. In its announcement, the SEC reiterated that investment advisers are subject to a two-year timeout from providing compensatory advisory services to a government or through a pooled investment vehicle after making contributions to a candidate in a position to influence certain selection processes. These include the selection of an investment adviser for a public pension fund, as well as the appointment of an individual with influence upon that selection.
A provision of the rule excepts certain donors who obtain a return of the contribution within a certain period, Van Dorn noted. Nevertheless, in the cases settled in January, some individuals did receive refunds of their contributions but still faced charges for violating the rule. Consequently, in Van Dorn’s analysis, the prospects for BlackRock’s petition are somewhat bleak.
New Environment May Offer Hope
Qualifying his assessment, Van Dorn noted that the SEC’s actions against those investment advisers occurred in January, prior to President Trump taking office.
Given President Trump’s public statements, and his well-known stance in favor of business and against excessive regulation, it is possible that the position taken by the SEC against pay to play violators last January may not continue, which would directly benefit BlackRock. See “How the Trump Administration’s Core Principles for Financial Regulation May Benefit the U.S. Funds Industry (Part One of Two)” (Feb. 16, 2017); and “Ways the Trump Administration’s Policies May Affect Private Fund Advisers” (Mar. 2, 2017).
“Maybe the Trump appointees will be a little more deregulatory and a little more permissive in their approach,” Van Dorn ventured. “We no longer have the same people in charge at the SEC as in January 2017. Although Trump had already been elected then, all the old Obama people were still in place, and the new Trump people were not in yet. Moreover, all the work that went into the January 2017 order undoubtedly took place before the election.”
“Having said that, so far the Trump SEC people haven’t shown any indication they’re changing business that much from the prior Obama people,” Van Dorn said, adding however that he would have been more skeptical of BlackRock’s chances under the prior administration than under the current one. Norm Champ, a partner at Kirkland & Ellis, concurred with Van Dorn that a better chance for relief exists now than under the Commission that passed the rule.
Time to Reconsider the Rule?
If BlackRock’s petition is successful, this may signal acknowledgment by the SEC that problems exist with the pay to play rule. The rule was widely criticized at its inception for its strict liability framework, which was viewed as highly aggressive and nearly without precedent in U.S. law, said Champ. For example, it is unclear whether nominal contributions really do influence candidates.
Moreover, the “do-not-contribute” list, Champ continued, is seen as overly broad. “Sometimes the politicians are on the pension board, but the rule also applies to anyone who can appoint someone to the board.” Noting that the fact that a politician can appoint someone means that, in the event of a contribution to that politician, the firm is prohibited from collecting fees, Champ explained, “That is a very strict regime with no requirement that there is influence or the intent to influence.”
In stark contrast, most laws in the U.S. require illegal intent, or scienter, as part of the basis for a criminal prosecution. Therefore, Champ contended that because the rule is, on the whole, unfair, it should be one of the first to be revisited and reconsidered.
Norm Champ, former director of the division of investment management at the US Securities and Exchange Commission, said he is not surprised to see Galvin’s office taking a stand given the absence of clarity at the federal level.
“I’m not smart enough to know where this is all going to end up, but I would like to see a coherent approach by the regulators,” said Champ, who is now a lecturer at Harvard Law School and a partner at Kirkland & Ellis LLP. “You’ve got to get everyone together so we can get to a rational regulatory approach.”
Read more here.
Here’s what WealthManagement.com had to say about my book, which was placed at #3:
#3. Going Public: My Adventures Inside the SEC and How to Prevent the Next Devastating Crisis
Compared to the toothless and hapless Securities and Exchange Commission described by Norm Champ’s Going Public, the Justice Department described in The Chickenshit Club comes off as a model guardian for the public interest. As a lawyer and hedge fund expert, Champ watched the 2008 financial crisis unfold with horror. In response, he quit his high-paying job and decided that the SEC could use his Wall Street experience to prevent other Bernie Madoffs and Allen Stanfords. Not so fast. Champ was quickly chewed up and spit out by a culture so toxic and inward-looking that it’s a surprise the SEC accomplishes anything of value. This is a very dispiriting account of an agency that investors count on to enforce a level playing field. He is also refreshing in his candor. Champ accurately describes the culture of the SEC as hopelessly undermined by a poisonous brew of civil service protections and public employee union contracts that make it virtually impossible to fire anyone. (It took five years to terminate an employee who simply failed to show up.) On his first week on the job, Champ received an anonymous letter warning him of the furies that will fall on his doorstop should he try to upgrade examiner standards. If the SEC spent as much time policing the markets as it does investigating anonymous accusations against other employees, corruption would be a thing of the past. By the end of Champ’s account, there is a glimpse of hope that the SEC is making baby steps to internal reform. This is a cautionary tale for any Wall Streeter who believes he can make a difference at the SEC.