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Regulation and Compliance > Federal Regulation

Lawyer Breaks Down SEC’s Sweep of Advisors’ Texts

By Melanie Waddell

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As the Securities and Exchange Commission continues its sweep of advisors’ off-channel communications, including text messages, more firms can expect to “receive targeted inquiries regarding record retention” from the agency, according to Hayley Trahan-Liptak, partner in K&L Gates’ Boston office.

Off-channel communications are an SEC exam priority for 2023. The Financial Industry Regulatory Authority‘s biggest fine category last year was books and records, in which offenses included failure to supervise the use and preservation of business-related emails and texts.

Industry trade groups have told SEC Chairman Gary Gensler that the sweep exceeds the agency’s authority because, according to news reports, the SEC has asked each of the investment advisors “involved in the sweep to have the personal phones of several employees imaged and reviewed, and that the SEC seeks evidence of any off-channel business communication, regardless of its nature.”

We caught up with Trahan-Liptak after she spoke on a recent webcast, “‘Off-Channel’ Communications: Managing Risks as SEC & DOJ Scrutinize Personal-Device Use and Recordkeeping,” about the SEC’s sweep — and whether it’s legal — as well as what advisors and broker-dealers can do to prepare for heightened pressure from regulators.

THINKADVISOR: Is the SEC within its legal authority to monitor these off-channel communications — which includes advisors’ texts?

TRAHAN-LIPTAK: It is important to note that the SEC is not technically monitoring off-channel communication — it’s instead requiring that firms retain business communications.

The SEC’s authority to enforce business communication retention is derived from Section 17(a)(1) of the [Securities Exchange Act of 1934] and Section 204 of the [Investment Advisers Act of 1940].

These provisions permit the SEC to issue rules requiring, respectively, broker-dealers and investment advisors to make and keep for prescribed periods, and furnish copies of, certain records necessary to protect investors. Rule 17a-4 and Rule 204-2 were adopted pursuant to this authority. Given this authority, it follows that the SEC expects firms to develop policies and procedures that comport with the rules.

However, we do believe regulators are aware of — and will respect to a certain extent — competing employee interests and applicable employment laws.

While the SEC has not directly commented on these issues, the Department of Justice touched upon them in its March 3, 2023, guidance in which it identified what prosecutors should consider when evaluating a corporation’s policies and mechanisms for retaining off-channel business-related communication.

Specifically, the DOJ noted that record retention policies “should be tailored to the corporation’s risk profile and specific business needs” to ensure that, “to the greatest extent possible, business-related” communication is preserved. The DOJ further advised prosecutors to consider:

  1. The relevant code of conduct, privacy, security, and employment laws or policies that govern the organization’s ability to ensure security or monitor/access business-related communications; and
  2. Whether the organization’s policies permit the company to review business communications on “bring your own device policy” and/or messaging applications.

Still, regulators will certainly expect (and make sure) that business-related communication is retained. Firms will therefore need to ensure that off-channel business-related communication is retained “to the greatest extent possible” in light of applicable employment law and related policies.

On the webcast, you mentioned that the SEC has not specifically defined “business-related” regarding off-channel communications. Can you give more details on what “business-related” means, exactly? Do you see the SEC issuing more guidance on this, or will it take a proposed rulemaking?

It is important to look first at the relevant recordkeeping rules that support the SEC’s recent focus on off-channel communication.

Rule 17a-4 applies to communications relating to [a broker-dealer’s] “business as such.”

Rule 204-2 is a bit more specific, requiring preservation of an investment advisor’s communications relating to “advice given or proposed,” “receipt, disbursement, or delivery of funds or securities,” the “placing or execution of any order to purchase or sell” or “predecessor performance.”

The SEC has interpreted these rules broadly — most recently calling out communication related to a firm’s investment or business strategy, discussions of client meetings, and communications about market color, analysis, activity trends or events.

Without offering a definition, the SEC has deemed these communications “related to the business” of broker-dealers and registered investment advisors.

This broad definition increases the SEC’s flexibility in future enforcement actions, allowing the SEC to analyze communication on a case-by-case basis to determine whether it falls within the applicable rules. This flexibility suggests it is unlikely the SEC will issue formal guidance on the definition of “business related” and will continue to rely on the broad interpretation of the existing rules.

For the same reason, it is also unlikely the SEC will be more descriptive when it comes to defining “business-related” communication in future orders.

Historically, the SEC has been careful not to specifically identify or discuss the communications at issue in recordkeeping violations. For example, in one 2004 order relating to recordkeeping failures for internal email, the SEC did not specifically discuss the communication at issue and merely faulted the firm for failing to retain “‘internal email’ (email that was sent between only employees of the firm) that related to its business.”

Are you hearing other firms will be part of the sweep?

Industry reports have noted that nearly two dozen investment advisors have received requests from the SEC related to their use of third-party applications and that several others were the subject of SEC investigations last fall.

We expect that numerous other firms have, or will, receive targeted inquiries regarding record retention. Record retention has also been a subject of examination requests from the Division of Examinations.

You mentioned how advisors and broker-dealers should prepare. One way was: Issue company-owned phones or company-managed phones. Is this happening a lot? Firms are doing this?

While we are not aware of any statistics surrounding firms issuing company-owned phones, there are certainly firms in the industry that require business-related communication to be conducted only on a firm-issued device. Instituting such a policy is one way to both provide an avenue for business-related communication while ensuring proper retention.

You also mentioned that the SEC is “shoehorning” Investment Adviser Act Rule 204-2 7(i), this business-related issue, into its orders. Can you explain that a bit more? 

The text of Investment Adviser Act Rule 204-2(a)(7)(i) requires preservation of written communication relating to “any recommendation made or proposed to be made and any advice given or proposed to be given.”

As noted above, on its face, the Rule does not explicitly require the preservation of all business related communication and appears to be narrower than Rule 17a-4’s requirement that communication related to “business as such” be preserved.

However, the SEC has routinely cited Rule 204-2(a)(7)(i) as requiring record keeping for communications related to a firm’s “business, including investment strategy; discussions of investment banking client meetings; and communications about market color, analysis, activity trends or events” as well as “debt and equity underwriting and trading issues.”

This suggests the SEC’s has taken the position that nearly all communication related to the business of an investment advisor can be tied to a recommendation or advice given or proposed.

Are firms worried about their compliance with the off-channel communications issue or do they feel their policies are up to snuff in this area?

While the vast majority of firms likely already have a record retention policy, the September orders exposed fault lines in more traditional policies that may have historically been designed to focus on paper or email communications.

In its orders, the SEC noted that the firms maintained applicable policies, but that the policies were neither effective nor enforced. Effectiveness and enforcement of a firm’s policy will likely be an ongoing focus of future SEC investigations and exams.

At this juncture, eight months after the September orders, most firms likely have reviewed and revised existing policies as necessary to comply with applicable rules.

Moving forward, it will be essential that firms ensure compliance with their policies through consistent monitoring and audits. Firms should also be prepared to update policies that may be ineffective in practice. Looking forward, firms should pay attention to changes in technology and communication methods in order to forestall future reviews by the SEC.

(Pictured: Hayley Trahan-Liptak)

Melanie Waddell

@Think_MelanieW

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