The SEC has certainly been active in 2022. We wanted to provide our perspective on two current SEC focus areas that may have gotten lost a bit amongst the flurry of recent rule proposals.
The new investment adviser marketing rule, which accommodates evolving marketing techniques like use of testimonials and social media, was an acknowledgement that investment advisers and their clients want the advisory business to modernize. Accordingly, the SEC is now focused on modern communication techniques advisers may be utilizing for their business communications.
In October 2021, the new Director of the Division of Enforcement gave a speech where he focused on record retention issues observed by Enforcement related to unapproved methods of business communication (e.g. text messages) and the need for financial firms to put in place appropriate policies and procedures to preserve these communications. This referenced a 2020 enforcement action against a broker-dealer for failing to preserve business-related text messages.
In December 2021, the SEC announced it had settled with another broker-dealer, including a $125M penalty, for failure to maintain and preserve business communications made by employees through text message, WhatsApp and personal email accounts. As part of this announcement, the SEC said it had commenced additional investigations of record retention practices at financial firms.
Here are some easy steps you can take to assess whether your compliance program may require changes or enhancements:
• Policies and Procedures – Review your compliance policies and procedures that deal with electronic communications. Your policies and procedures should either prohibit or detail the way employees should use the following types of electronic communications: text messaging, personal email accounts, personal social media accounts (including direct messaging), instant messaging (e.g., Slack, Microsoft Teams, Bloomberg chat) and mobile messaging applications (e.g., WhatsApp, WeChat).
• Training – Provide training to your employees to remind them which communication methods are allowed and prohibited. The method you choose for training may vary based on risk and how long it has been since employees have been reminded of the firm’s policies, but training may be as simple as sending an email to all employees with a summary of the firm’s policies.
• Poll Your Team – Check in with your employees that are frequently communicating with clients and key business partners to see if they are being asked to communicate via a communication method that is currently not approved, such as text messaging. Employees are more likely to violate policies if they are feeling outside pressure to communicate through unapproved channels. If there is enough demand from clients or business partners to utilize certain electronic communication methods, the firm may decide it is safer to allow such communications after ensuring it can do so in a compliant manner.
• Test Your Archives – Periodically review the archives of any electronic communications channels which are currently being retained to ensure all records are being retained as expected and in a manner that allows for efficient retrieval in the event of a regulatory examination.
Recently, the SEC has clarified its views and highlighted its concerns on the use of hedge clauses by advisers in advisory agreements. A hedge clause is language that attempts to limit the adviser’s liability within an advisory agreement or private fund governing document. The SEC’s concern is that use of a hedge clause can mislead a client into believing they have waived rights of action against the adviser that are not permitted to be waived by the federal securities laws.
The SEC clarified its position on use of hedge clauses within a footnote of its 2019 Investment Adviser Fiduciary Duty Interpretation. Specifically, while the question of whether a hedge clause violates the Advisers Act antifraud provisions depends on the facts and circumstances (including the sophistication of the client), the SEC believes there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those anti-fraud provisions.
In January 2022, the SEC settled an enforcement action with an investment adviser for improper use of hedge clauses within its advisory agreements used with retail clients.
In late January 2022, the SEC’s Division of Examinations (EXAMS) published a Risk Alert directed at advisers to private funds which highlighted deficiencies EXAMS observed regarding use of hedge clauses. Less than 2 weeks later, the SEC proposed rules to enhance private fund investor protection. As part of this rule proposal, advisers to private funds are prohibited from certain activities, including seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for breach of the adviser’s fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund. It is now clear that the SEC’s concerns around the use of hedge clauses extends beyond agreements with retail clients. We recommend you review your advisory agreements and work with your outside counsel to ensure any hedge clauses or other language that seeks to limit liability are appropriate and permissible.