It’s been a busy year in American politics, with a presidential race as memorable—for better or worse—as any in recent history.

All that attention, all those choices, and all the emotion will translate into more political donations being made in the run-up to the Nov. 3 election.

More donations means more chances that the Securities and Exchange Commission (SEC) will pursue investigations into the little-known and often overlooked “pay-to-play” rule that applies to investment firms and their executives, managers, analysts, and others who solicit fees to manage public investments.

“When the contributions start piling up, the improper contributions can start piling up as well,” said Kelli Haugh, managing director of Foreside, a compliance and consulting tech firm based in Portland, Maine.

The pay-to-play rule, officially Rule 206(4)-5 under the Investment Advisers Act of 1940, can be triggered when a firm or covered employee donates money to a government official who has control over assigning an investment manager, or allocating money, for public investment funds.

Enforcement of the pay-to-play rule “has been on a little bit of a hiatus,” said Vivek Pingili, a director at ACA Compliance Group, a cyber-security and risk consultant. “But it’s very likely there will be another enforcement sweep in 2021.”

“The biggest issue for an advisory firm is the loss of advisory fee income for a two-year period. This also applies to new employees/covered associates, so firms need to make sure they are asking the right questions of new hires so they can comply with the two-year cooling off period.”

Amy Lynch, Founder and President, FrontLine Compliance

The idea behind the rule is to tamp down the possibility that a firm or its employees would donate money to a government official with the expectation that financial support might help the firm receive a contract, or continue a contract, to manage public fund investments. The funds at issue are most often public employee pension funds or public university endowments.

Penalties for missteps can be steep.

In July 2018, Houston investment firm EnCap Investments was fined $500,000 because several covered employees made $60,000 worth of donations to government officials in Texas, Indiana, and Wisconsin. EnCap managed investments for public funds in all three states.

Here’s a chilling fact: The SEC reached back six years, to 2012, to find the donations at issue in that case.

2018 was a big year for pay-to-play enforcement actions, with the SEC fining California-based Sofinnova Ventures $120,000; Ohio-based firm Ancora Advisors $100,000; and Los Angeles-based firm Oaktree Capital Management $100,000.

As part of those enforcement actions, the firms had to stop accepting management fees for those public investment funds for two years and return any funds they collected. Those penalties might have hit harder than the fines, although the amounts returned were not revealed in the SEC’s releases.

“The biggest issue for an advisory firm is the loss of advisory fee income for a two-year period,” said Amy Lynch, founder and president of FrontLine Compliance. “This also applies to new employees/covered associates, so firms need to make sure they are asking the right questions of new hires so they can comply with the two-year cooling off period.”

The SEC hasn’t levied a pay-to-play enforcement action since December 2018, but the rule itself has stayed in the news.

The law has been challenged numerous times, and courts have repeatedly upheld it, most recently in June 2019 by the U.S. Court of Appeals for the D.C. Circuit. The ruling was called “a substantive, precedent-setting defeat” in a blog by law firm Covington and Burling.

Political donations covered under the pay-to-play rule can be made to local, county, or state officials who have some measure of control over public investments—think governors, state and county treasurers, school administrators, and the like. The rule is triggered at donations worth more than $150-$350, depending on if the donation is made in the state where the covered employee can vote ($350) or not ($150).

Another potential tripping point of the law: Donations over $350 made by the spouses of covered employees can trigger the rule as well, Haugh said.

Federal government officials—presidents, senators, members of Congress—are not covered by the rule, because they do not have decision-making power over management contracts for these types of public investment funds. However, donations to governors running for federal office, such as the now-since-ended Democratic presidential campaigns of Montana Gov. Steve Bullock and Washington Gov. Jay Inslee, could trigger the rule.

“This is a trap for the unwary,” Pingili said. “It can really hit firms at their pocketbook.”

Mitigate the risk of running afoul of pay-to-play

Investment firms react to this risk in three ways.

One, firms can prohibit all political donations by the firm and any covered employees. It’s an ironclad policy, but also draconian. Even with that policy in place, covered employees should be required to respond to an annual questionnaire detailing any political donations made by themselves or their spouses.

The rule on spouses “applies under the ‘doing indirectly what you cannot do directly’ prohibitions, so most firms consider spouses to apply under this rule,” Lynch said.

Two, firms can require all political donations made by the firm or covered employees be approved by someone in management. For analysts, this is typically their supervisor; for C-suite employees, this is the CEO or someone else in the C-suite who has been authorized to make the call. For the CEO, it should be the board of directors.

If the firm allows employees to make political contributions, compliance departments should fully understand the risks being incurred. Compile a list of all public investment funds the firm manages and ask managers and analysts to alert the compliance department when the firm earns new business from managing public investment funds. Make it clear in training sessions that political donations to candidates in the states where those funds are located could trigger a violation.

Three, some firms take a “trust but verify” approach by allowing the firm and its covered employees to make political donations, require those donations be disclosed, but also monitor their covered employees’ political contributions and hoist the red flag when necessary. Firms can accomplish this monitoring using public sites like, Lynch said, or by using more advanced searches being offered by some vendors.

“There are technology solutions that can streamline the back office considerations of complying with this rule,” Pingili said.

For compliance departments and the firms they work for, a robust reporting and monitoring of covered employee political donations can really pay off. The SEC allows donations at issue, discovered within four months of being made, to be returned within 60 days to avoid running afoul of the pay-to-play rule. That might save a firm not only a fine, but also being forced to return two years’ worth of fees earned from managing a public investment fund.