Our AI Regulatory Tracker provides an overview of key federal, state, and international policies relating to AI legislation and depicts SEC enforcement cases that relate to AI or cybersecurity violations.

Insight Analytical Note

Read

First Ever Off-Channel Communications Case Against a Pure Play Investment Adviser

Background:

  • On April 3rd 2024, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) settled an administrative proceeding with an investment adviser for off-channel communications and Code of Ethics violations1.
  • First ever IA-only off channel case: This is the first ever off-channel settlement with an investment adviser that does not have an affiliated broker-dealer.
  • Exacerbating factors: The Order highlights that this adviser’s failure to retain communications may have interfered with the SEC’s ability to conduct an exam or investigation.
  • The adviser paid a $6.5 million penalty.

Key Facts and Allegations:

  • Books and Records: Junior and senior employees used off-channel communication methods to discuss firm business, including communications concerning recommendations made or proposed to be made and advice given or proposed to be given about securities. This was exacerbated by the fact that certain senior professionals had their devices set to delete messages every 30 days. This resulted in a charge under the SEC’s books and records rule, specifically Rule 204-2(a)(7).
    • Analysis: The Order does not discuss the adviser’s investment process and whether actual investment advice was crystallized over text message or whether this adviser was simply texting preliminary thoughts about investments. Nevertheless, Rule 204-2(a)(7)(i) requires records to be retained about proposed investments.
  • Compliance Program: This investment adviser adopted certain compliance polices and procedures that were not followed, specifically: (1) the firm did not retain ALL communications that it sent and received; (2) the firm’s senior employees used off-channel communication methods for business purposes; (3) employees falsely acknowledged and certified annually that they understood that off-channel communication methods were not permitted and that certain procedures were followed in case off-channel communications were unavoidably utilized; (4) the firm did not utilize its ability to search personal devices for off-channel communications; (5) senior professionals never precleared trades including trades in securities owned by the adviser’s funds.
    • Analysis –
      • The lack of pre-clearance of personal trades in securities owned by the adviser’s funds is an especially egregious fact and it is not surprising that the Commission took issue with this conduct.
      • The ability to search personal phones is not a common policy and the Commission utilized that policy, even though it may have lacked a firm requirement to utilize it, as an example of violative conduct.
  • Broker Statements: The adviser failed to effectuate a supervisory review of brokerage statements and therefore failed to identify personal trading which required pre-clearance.

Takeaways:

  1. A little more clarity around violations – The SEC’s Order clarifies that the off-channel communications had to do with investment advice either actual or proposed. The specific provision in question – Rule 204-2(a)(7)(i), includes a requirement to retain records on proposed investments, which could theoretically capture many communications including information about portfolio company performance, general thoughts about investments, and many other items which may not be top of mind as qualifying to be investment advice.
  2. No change in current posture – Many IA’s have responded to the SEC’s off-channel cases by applying the books and records provisions very broadly across their firm. This case supports that interpretation.
  3. Superfluous policies – This investment adviser appeared to have at least one superfluous policy – the ability to search personal devices – which it did not enforce and which became part of the basis for a violation. We recommend removing policies which you are unlikely to follow.

1 In the Matter of Senvest Management, LLC; File No. 3-21900