Securities Regulation Daily 'Pay to play’ rule doesn’t pass the smell test, say AMAC panelists
Monday, November 30, 2020

'Pay to play’ rule doesn’t pass the smell test, say AMAC panelists

By John M. Jascob, J.D., LL.M.

Industry members expressed concern that rules limiting certain political contributions by advisers and institutional investors are stifling the voice of minority communities.

Panelists at a meeting of the SEC’s Asset Management Advisory Committee have asked the Commission to repeal the rule banning certain investment advisers from making federal contributions, citing a negative impact on minority political participation. In a session titled "Improving Diversity and Inclusion in the Asset Management Industry," panelists said that one of the unintended consequences of Advisers Act Rule 206(4)-5, the so-called "Pay to Play" Rule, has been to prevent minority voices from being heard, not just on issues concerning access to capital, but also on issues involving diversity, the environment, and human rights issues. Accordingly, certain members asked the SEC to rethink the purpose of the rule and the impact that it is having on American democracy.

Cracks in the foundation. Martin Cabrera, the CEO and founder of Cabrera Capital Markets, one of the largest minority broker dealers in the U.S., said that the issue of access to capital clearly shows how the nation’s financial systems are cracked at the foundation. In his view, this accounts for why we see some of the social unrest taking place around the country. Cabrera noted that minority- and women-owned money management firms have been denied access to capital from corporate and public pension funds, endowments and foundations, citing a 2017 Knight Foundation study which found that only 1.4 percent of the $69 trillion pension fund industry is being managed by minority- and women-owned firms. "We can put it this way," Cabrera said. "Every two weeks minority and women employees of municipalities and corporations around the country are putting another portion of their paychecks into the pension fund systems. But what the pension funds are telling minorities is that you're good enough to put your money into the pension fund systems, but you're not good enough to manage those assets."

Cabrera added, however, that there is a paradigm shift taking place in the form of a movement which serves as a wake-up call to the United States by shining a light on these economic disparity gaps and by addressing issues of how we can bring solutions to both the financial systems as well as to the country. "We've had Martin Luther King, Jr. fight for civil rights, and Cesar Chavez and Dolores Huerta fight for workers’ rights and equality. This is a modern day civil rights movement that is taking place, and some of us refer to it as the financial civil rights movement," Cabrera said.

Cabrera offered two specific recommendations to put minority firms on a level playing field and give them the opportunity to compete for pension fund business. First, he believes that the SEC should require the disclosure of a "diversity and inclusion scorecard" that discloses the fees being paid by issuers to money management and other professional services firms. This disclosure, which would be filed quarterly along with companies’ Form 10-K reports, would also require companies to include an EEOC report detailing the composition of their staff, along with insight on the composition of senior leadership.

Cabrera's second recommendation concerned repealing Advisers Act Rule 206(4)-5, the Pay to Play Rule, which has banned institutional investors from making certain political contributions. Cabrera said that it is everyone's fundamental right and part of the First Amendment and freedom of speech to support individuals that are taking up causes that are important to the minority constituency, and not just on access to capital. "We feel it's our fundamental right for the SEC to repeal this rule and allow firms to participate in the American democracy," Cabrera said. "The public is asking for disclosure and transparency and diversity, and the SEC has an opportunity to be proactive."

Garcia Rule. Ruby Dang, a partner and the Director of Marketing and Client Services at Garcia, Hamilton & Associates, observed that consultants are the gatekeepers to the industry, with one of their main roles being the sourcing of money managers. Dang referenced a report by Pensions & Investments which found that the ten largest consulting firms were advising on 83 percent of pension fund assets, a concentration that has not changed much over time. She expressed concern about consultants’ lack of transparency and their "pay to play" practices, saying that many of them are receiving economic benefits from the same managers that they are recommending, without disclosures.

Dang said that while many of these consultants will say that they have over 1,000 managers in their database, this does not matter if their searches do not lead to opportunity for minority-owned firms. After witnessing these outcomes while serving as a trustee of the Houston transit agency, Dang said that she urged the board to adopt what is now known as the "Garcia Rule," which requires women-, minority- and disabled-owned firms or managers to be included in every asset class search. According to Dang, the rule gives these firms the opportunity to present and get familiar with how to present to a board, while also giving the consultant the opportunity to do research. "If you don't cast a wide enough net, you'll never find that next diamond in the rough," Dang said, observing that the Garcia Rule has now been adopted by the Illinois State Treasurer's Office, among others.

Returning to the topic of political empowerment, John W. Rogers, Jr., the founder and chairman of Ariel Investments, cited a Wall Street Journal article finding that while nine of the largest 25 cities were run by African-Americans in 2000, that number had dropped to just four by 2017. In his view, this reversal does have something to do with Rule 206(4)-5. Rogers observed that the securities industry is the only industry in the nation that is not allowed to fully participate in the capitalist democracy in the United States. "I think it's a direct reason why we have less elected officials, and the wealthier communities have a chance to get mayors and governors seats and senatorial seats," Rogers said, "So I think it's really important for us to try to open up those doors, so all of us can fully participate and get elected progressive mayors that are going to fight for economic justice in the boardroom."

Passing the smell test. Moderator Gilbert Garcia, managing partner of Garcia, Hamilton & Associates, also questioned the benefit to the public of the Pay to Play Rule. "When you talk about the pay to play rules, the thing that comes to my mind is, does it pass the smell test? Are we really eliminating money?" Garcia said that, in reality, the largest firms have even more access politically, whether it is through their PACs, their lobbyists, or through their community outreach. In contrast, the smaller firms, a group in which minority firms are over-represented, do not really have those resources. "All we're really doing is creating unfair burdens on the smaller firms for compliance," Garcia said. Stressing the importance of transparency, he asked: "Are we really achieving what we're trying to do? Or would we achieve much more by making consultants disclose the economic benefit that they get?"

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