Investment Management Compliance Update: Placement Agents Under Fire

Sunday, October 4, 2009 - 01:00
R. Scott Beach
James E. Bowers
Shawn T. Wooden

In early August, the Securities and Exchange Commission (the "SEC") issued a proposed rule that would prohibit an investment adviser, and certain of its executives and employees, from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the adviser. Likewise, a few states and public pension funds have already, or are considering, banning or otherwise restricting the use of placement agents.

The use of placement agents has come under regulatory scrutiny at a time when investment managers increasingly have turned to these intermediaries to secure scarce capital. Accordingly, investment managers that hire placement agents need to be aware of the changing regulatory environment, especially relating to attempts to raise capital from public pension funds. Institutional investors also may find this an appropriate time to review their due diligence procedures for selecting managers to ensure they receive adequate disclosure of finder's fees and other compensation paid to placement agents.

• In New York, placement agents and the state's former deputy comptroller face criminal charges in an alleged kickback scheme involving the state's $117 billion Common Retirement Fund ("NYCRF"). As a result, New York State Comptroller DiNapoli hired Day Pitney to review all NYCRF investments with firms under investigation by the New York Attorney General and the SEC and to advise NYCRF on its contract and other rights. As a result of this, Day Pitney is representing Comptroller DiNapoli in connection with a suit filed against Dallas-based Aldus Equity Partners LP and its principals. The suit asserts, among other things, that defendants were knowing and willful participants in an elaborate pay-to-play kickback scheme.

• On a related note, The Carlyle Group and Riverstone Holdings LLC, two significant private equity management firms formerly represented by a placement agent, have paid $20 million and $30 million respectively to settle investigations by the New York Attorney General's Office. The firms also agreed to end "pay-to-play" campaign contributions and cease using placement agents altogether in their dealings with public pension funds.

• In New Mexico, the state treasurer has questioned the activities of a placement agent who collected $11.5 million in fees and whose father is involved in state politics.

In addition, reforms are being considered and implemented on multiple levels by state legislatures and regulators, and public pension funds themselves as well as the SEC.

• Under the SEC's proposed rule, an investment adviser (as well as certain executives and employees of the adviser) would be prohibited from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser. In addition, an investment adviser that makes a political contribution to an elected official or candidate for a position that can influence the selection of the adviser would be barred for two years from providing advisory services to a state or municipal fund. The rule also would prevent advisers from circumventing the rule by directing or funding contributions through third parties, such as family members, lawyers or companies affiliated with the adviser. There is a de minimis provision that would permit an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate. The SEC's restrictions are similar to those imposed on underwriters of municipal bonds by the Municipal Securities Rulemaking Board ("MSRB") under MSRB Rule G-37.

• In Illinois, the governor signed a pension reform bill on April 3, 2009 that bans contingent fee arrangements and placement fees for attempts to influence the outcome of an investment decision or procurement of investment services of a retirement system or pension fund. The law applies to virtually all pension systems at the state and local level.

• Connecticut has prohibited the payment of "finders' fees" in exchange for arranging state investments since 2000. And, investment managers have been required to disclose their use of placement agents, which are allowed only to the extent they perform legitimate marketing and due-diligence services. However, on May 5, 2009, the Treasurer announced an increase in Connecticut's third-party disclosure requirements to require any managers disclosing payments to placement agents in connection with an investment contract with Connecticut, to disclose whether the placement agent, in turn, paid any sub-agents related to the Connecticut engagement. Additionally, the Treasurer said she would require all fund of funds managers to provide sub-fund manager disclosures of any third-party payments made by the sub-fund manager in connection with its engagement on behalf of the Connecticut fund.

• On April 22, 2009, NYCRF prohibited investment managers seeking pension fund investment from using placement agents.

• Likewise, on April 22, 2009, the New York City Comptroller called on the five New York City Pension Funds to suspend the use of placement agents or other compensated intermediaries, and all five funds have favorably responded.

• On September 23, 2009, the New York State Comptroller issued an executive order that prohibits NYCRF from doing business with an investment adviser that has made a political contribution to the State Comptroller or a candidate for State Comptroller.The ban, which closely parallels the SEC's proposed rule, will last for two years from the date of the contribution.

It should be noted that parts of the SEC's proposed rule have not been met with universal acceptance, especially by some public pension funds. In a comment letter to the SEC, Connecticut's Treasurer has opposed the proposed ban on third-party solicitors like placement agents because, in the Treasurer's opinion, such a blanket ban would deprive public pension fund investors of valuable services. It was observed that placement agents add value, for example, by providing extensive due diligence on their investment fund clients that is helpful to public pension funds in selecting quality investment products. Additionally, the Connecticut Treasuser asserted that without the efforts of placement agents, mid-sized and smaller pension funds would not know about certain fund opportunities, especially from foreign, emerging, and women- and minority-owned investment funds, or would be less likely to know of investment funds in a timely manner. Rather than ban all third-party solicitors, the Connecticut Treasurer has recommended that the rule limit the use of such solicitors to those individuals and entities that are licensed or registered and therefore subject to the same restrictions as other investment advisers.

Further, the Connecticut Treasurer has urged the SEC to abandon a "look-back" provision on campaign contributions. The proposal would prohibit an investment manager from providing investment advisory services to a public pension fund if one of its associates had made a campaign contribution to a pension trustee within the prior two years. The look-back rule would apply to contributions made even before the associate's employment with the advisory firm. Connecticut said that retroactive attribution could prove costly for pension funds that have illiquid investments that cannot be easily unwound.Since all long-term pooled investment vehicles have significant default provisions, governmental investors cannot be placed in the position of potentially losing 50 percent or more of their capital account because a future hire triggers the retroactive attribution of a campaign contribution.

Going Forward: Steps To Be Taken By Managers And Investors

Investment managers should be aware of their legal responsibilities when using placement agents. Managers accepting investments arranged by placement agents, whether or not they are aware of improper conduct, may find themselves faced with liability under state and federal law. Additionally, subject to the terms of the investment documents with investors, managers may also face breach of contract and failure to disclose material information claims. As the activities of less-reputable placement agents continue to make headlines, investment managers can expect regulation in this area to continue. In this environment, investment managers need to strengthen their compliance controls to ensure that policies and procedures are put in place that prevent violations of law from occurring, and detect, correct and promptly report violations that have occurred.

In addition, investment managers should consider new approaches to contracting with placement agents. First, thorough background checks should be conducted on placement agents. Second, managers should impose stringent compliance requirements and certifications on agents (e.g., certification on not making illegal payments to third parties). In addition, given the SEC's efforts to ban the use of placement agents by investment managers seeking to manage state and local governments' pension funds, such managers should consider developing ways of doing business without the use of placement agents. For example, managers should consider enhancing their internal marketing capabilities to interact directly with public pension fund staff and consultants as a way of getting on the radar screen of funds.

Public institutional investors should institute rigorous policies and procedures governing due diligence practices for selecting managers. These policies and procedures should address the past practices of such managers, ensure adequate disclosure of finder's fees and other compensation paid to placement agents and require contract provisions that provide sufficient recourse in the event that a manager fails to comply with its disclosure obligations. In addition, institutional investors should consider an on-going review of investment managers' back-office compliance processes.

R. Scott Beach is the Co-leader of the Private Equity and Investment Funds practice group. He represents private equity investors and emerging growth companies in formation, debt and equity financing, mergers and acquisitions, strategic joint ventures technology arrangements and general corporate matters. He practices in the firms's Greenwich, CT office. James E. Bowers is Director, Compliance Risk Services and practices in the areas of compliance risk management, corporate governance, ethics, and antitrust and securities law. He practices in the firm's Hartford, CT office. Shawn T. Wooden, Partner, practices in investment, general corporate and securities law with an emphasis on alternative investments, formation, and regulation of private investment funds, and investment advisory compliance. He practices in the firm's Hartford, CT and New York, NY offices.

Please email the authors at, or stwooden@daypitney.comwith questions about this article.