Has the SEC opened a new frontier in the battle against off-channel communications?
On August 14, 2024, the U.S. Securities and Exchange Commission (“SEC”) settled an administrative proceeding with 26 firms for off-channel communications. Collectively, the firms were fined $390 million – at the high end four firms agreed to pay $50 million while the smallest fine was $400,000. Only one of those firms was an investment adviser, P. Schoenfeld Asset Management LP (“PSAM”), without also being registered as a broker dealer.
Many consultancies and law firms will cover the facts and the end result. However, what happened is easy enough to decipher from the Summary in the SEC’s Order. I am going to try a different approach by tying in a recent SEC examination request letter related to off-channel communications.
The SEC cited and fined PSAM for two distinct Advisers Act rules violations.
Recordkeeping Violation
The first violation has been a constant among previous off-channel communication actions – recordkeeping under Rule 204-2(a)(7) which requires investment advisers to keep records of communications received and sent by investment advisers.
PSAM had compliance policies and procedures in place that (1) were designed to ensure retention of business-related records and (2) prohibited from conducting PSAM business using any other electronic communication services . . . or accounts not provided by PSAM.”
Software and IT systems designed to archive and maintain communications have been around for years, but as personal and business communication has spread to more platforms keeping up with the recordkeeping requirement has become challenging. Whenever adviser personnel use unapproved electronic communication channels the SEC will have ample support to bring a recordkeeping action.
What is also interesting about the SEC’s off-channel communication actions is in the context of increasing legal challenge to the SEC’s rules and enforcement process recordkeeping actions are pretty straightforward. Advisers either have the records required in Rule 204-2 or they don’t making it easier for the SEC’s Enforcement Division in any arena.
Failure to Supervise
In addition to recordkeeping violations, previous off-channel communication actions have typically also cited compliance rule (Rule 206(4)-7) violations. However, as noted above, PSAM had compliance policies and procedures in place. Unfortunately for PSAM, the SEC found that PSAM did not have sufficient surveillance in place to ensure policy compliance under Section 203(e)(6) of the Advisers Act.
Section 203(e)(6) authorizes the SEC to impose various sanctions on an investment adviser that has failed reasonably to supervise another person who violates the federal securities laws if the other person is subject to its supervision. However, an adviser may not be deemed to have failed reasonably to supervise another person, if the adviser has established and complied with procedures that would reasonably be expected to prevent and detect, insofar as practicable, any such violation by the other person.
This is where it gets a little worrisome for other advisers looking for guidance. In the Order, the SEC stated: PSAM, however, failed to implement a system of monitoring reasonably expected to determine whether personnel were following its policies. While permitting its personnel to use approved communications methods, including on personal phones, for business communications, PSAM failed to implement sufficient monitoring to ensure that its recordkeeping and communications policies were being followed.
It seems to me PSAM (1) had policies and procedures in place prohibiting the use of non-approved communication channels, (2) captured and archived communications through approved channels of communication, and (3) sought assurance from employees that the employees read, understood and abided by PSAM’s policies, and yet, PSAM was cited for failure to supervise because PSAM employees engaged in prohibited conduct.
Which begs the question: How? How could PSAM know employees were using unapproved communication channels for business-related communication? How could PSAM properly surveil or monitor what wasn’t supposed to be happening? How should other advisers attempt to supervise employees who decide to operate outside of an adviser’s prescribed environment?
Examinations of Off-Channel Communications
This off-channel communication case was brought by the SEC as a result of an exam referral. The case could result in similar referrals from routine examinations and almost certainly ensures continued scrutiny of off-channel communication issues during examinations.
So, what is the SEC EXAMs staff looking for during examinations? Below is a direct request from a recent examination with a focus on off-channel communications.
Electronic Communications. Please explain the steps taken by the Adviser to monitor, review, and retain electronic Communications related to the Adviser’s business. Electronic Communications include, but are not limited to, email, text messages, messaging apps, instant messages, Bloomberg messaging, and private messaging on social media sites. Please address the following: (1) whether supervised persons are permitted to use personal devices for firm business or are permitted to use any form of electronic Communication other than Adviser email accounts for business purposes; (2) if so, what steps the Adviser takes to approve the use of such personal devices or additional means of electronic Communications; and (3) what steps the Adviser takes to ensure that supervised persons only use approved means of electronic Communications to conduct firm-related business. Please also explain the Adviser’s policies on use of Dropbox, Google Drive, and other forms of cloud storage by supervised persons.
Point 3 really drives home the SEC’s contention with PSAM’s conduct and gives advisers a new element to consider when drafting and implementing policies and procedures designed to reasonably supervise employees.
How Trillium Can Help
Testing and Surveillance: A key component of Trillium’s ongoing compliance support is reviewing your firm’s practices in key risk areas against policies and procedures and disclosures. The ability to identify and rectify problematic areas, prior to an examination, is integral in preventing potentially significant time and expense later on.
Compliance Program Development: Trillium helps you put in place policies and procedures that work for your firm. Developing and applying consistent policies and procedures is paramount to fulfilling a firm’s regulatory obligations and fiduciary duty.