Responding to Potential Misconduct Inside a Company: The Goals and Benefits of Internal Investigations

When executives and directors become aware of potential misconduct within their company – whether from a whistle-blower report, an inquiry from prosecutors or regulators or compliance reviews – they are faced with immediate questions about how to respond, often while lacking complete information about the scope and severity of the potential misconduct. In almost all circumstances, the prudent course of action is to take immediate steps to formulate and initiate an appropriate internal investigation. Drawing on FDH’s recent experience conducting internal investigations in a variety of industries and circumstances, this article highlights the core goals and benefits of a well-conducted internal investigation.

The first and primary goal of an internal investigation is to gather all relevant facts concerning the potential misconduct, so that company decision-makers and their counsel are equipped to assess the legal implications of what has occurred. Companies are often faced with important decisions on a short timeframe when faced with potential misconduct, including:

• whether to take employment action against potential wrongdoers;
• how to respond to government and regulatory inquiries; and
• whether obligations to auditors, investors and other stakeholders require disclosures relating to the potential misconduct.

None of these questions can be addressed effectively or responsibly without an understanding of the underlying facts.

To that end, investigators at the outset of an investigation will prioritise identifying and preserving potentially relevant communications, documents and financial records. This step often entails preliminary interviews of IT and finance personnel and, in more complex circumstances, may require digital forensics work to ensure preservation of communications and data that may have been concealed or stored on devices and platforms outside of the company’s IT systems.

After investigators have gathered and preserved relevant documents and evidence, their focus will generally turn to interviews of knowledgeable employees and other witnesses to the conduct at issue. Effective witness interviews are crucial to a successful internal investigation, as documents and data rarely tell a complete story. Investigators’ ability to assess individuals’ motives and credibility through the interview process is often fundamental to the company’s ability to draw conclusions regarding the conduct at issue: Was the conduct intentional? Were subordinates acting at the direction of others, or independently? What role, if any, did deficient training and compliance controls play in allowing the conduct to occur?

Prompt, thorough and credible internal investigations provide company leadership with crucial benefits, including the ability to do the following.

• Stop and mitigate the consequences of misconduct before it expands and potentially recover lost funds: internal investigations the firm has conducted have stopped ongoing fraudulent activity and misappropriation of assets by employees and counterparties, resulting in the recovery of significant funds, and uncovered and stopped executive misconduct that created substantial liability exposure.
• Identify procedural and compliance weaknesses or failures that allowed the misconduct to occur or go undetected, and formulate remedial action: a primary focus of FDH’s investigation work is in counselling boards and executives regarding the firm’s findings, and how to address control and compliance failures on a going-forward basis to ensure that similar conduct is not repeated.
• Identify bad actors for appropriate disciplinary action: the firm’s investigations have allowed company leadership to take disciplinary action against wrongdoers with confidence that the factual basis for such action is reliable, and can withstand scrutiny in any subsequent claims or actions brought by an employee.
• Determine whether disclosure and co-operation with government entities is appropriate: navigating a company through its interactions with the government is one of the most important and sensitive aspects of FDH’s internal investigation practice, and effective interaction with the government – sometimes including disclosure and co-operation – has been crucial to ensure that clients receive appropriate credit for taking prompt action to address misconduct.
• Formulate responses to potential civil litigation or enforcement action: while an investigation and remedial action can often mitigate the likelihood of civil claims or enforcement action, litigation is sometimes unavoidable; the firm’s internal investigations aim to provide clients with a thorough understanding of the underlying facts and law relating to the misconduct, allowing them to prepare and strategise for litigation.
• Identify any financial reporting or other related disclosure obligations: many of FDH’s investigations have involved misconduct, with obvious implications for the accuracy and reliability of financial reporting, but even investigations without an immediate financial impact often require close analysis regarding potential disclosure obligations due to liability exposure and government interest in the misconduct at issue.
• Maintain credibility with and satisfy the concerns of interested constituents: this is an under-appreciated but often critical aspect of internal investigations, where many of FDH’s clients face scrutiny and demands from a host of stakeholders and interested parties, such as investors, counterparties, employees, the public and the media; the firm’s clients’ ability to demonstrate to these constituents that potential misconduct is being investigated in a thorough and credible manner has been critical to the clients’ commercial and reputational interests.

While the goals and benefits of an effective internal investigation are clear, investigations are fraught with potential pitfalls that can compromise the independence and credibility of the work. Outside counsel experienced in internal investigations can be a critical asset to companies in navigating their response to potential misconduct within their ranks.

Best Practices to Consider in Light of SEC’s Recent Off-Channel Communications Sweep

Background

Beginning in September 2021, the Securities and Exchange Commission (SEC) began a sweep of broker-dealers and registered investment advisers and their communications to determine whether firms were properly retaining business-related messages sent and received on personal devices (“off-channel communications”). As described in SEC’s orders, its investigations uncovered widespread and long-standing failures by the firms and their employees to maintain and preserve off-channel communications. SEC found that employees across many firms communicated both internally and externally relating to the business of their respective broker-dealers and/or investment advisers by personal text messages or other messaging platforms, such as WhatsApp. Since the sweep began, SEC has brought charges against more than 100 broker-dealers and registered investment advisers.

SEC has brought charges for violations of Section 17(a) of the Securities Exchange Act and Rule 17a-4(b)(4) thereunder, which require broker-dealers to preserve for three years communications sent and received relating to their business as such. SEC has brought similar charges against registered investment advisers for violating Section 204 of the Investment Advisers Act of 1940 and Rule 204-2(a)(7) thereunder, which require investment advisers to preserve written communications relating to, among other things, any recommendations or advice made or proposed, any receipt, disbursement or delivery of funds and the placing or execution of any order to purchase or sell any security.

In connection with these orders, SEC has required firms to undertake various remedial actions to bring firms into compliance with the record-keeping rules, including by engaging independent compliance consultants. The compliance consultants are tasked with conducting comprehensive reviews of the firms’ policies and procedures, training, surveillance, discipline and technological solutions as they relate to off-channel communications (the authors of this article have been engaged as independent compliance consultants on a number of matters).

Reasons for non-compliance

Past non-compliance does not appear to have been caused by an absence of written policies and procedures, which in most cases were already in place and prohibit off-channel communications. Nor does it appear that employees’ non-compliance was part of deliberate efforts to evade record-keeping requirements or conceal off-channel communications from their employers or regulators. Rather, non-compliance seems to be due to a combination of factors including:

• inadvertent evolution of conversation from permitted off-channel communications about logistical matters (eg, “running late to the meeting”) to prohibited off-channel communications regarding substantive business-related discussion;
• confusion regarding what is considered a substantive business-related communication;
• the convenience of off-channel communication platforms and the related shortcomings of firm-provided communication platforms;
• client preference; and
• adapting to new work conditions following the COVID-19 pandemic and the shift to remote work.

Employee awareness

Employees’ lack of focus on the importance of the issue is likely a significant driver of past non-compliance. Thus, maintaining employee focus on the issue is critical. Firms can increase awareness with more frequent, focused and interactive trainings, desktop reminders of firm policy upon network sign-in, requiring employees to make periodic certifications of compliance with off-channel communication policies, periodic email reminders from senior compliance officials and other similar interventions designed to keep the issue and relevant policies top-of-mind.

Communication platforms

Firms should also understand the range of communications applications used by clients and employees and deploy to employees firm-sponsored applications that the firm can capture in records systems or otherwise prohibit employees from using these platforms for business communications. Off-channel communications tend to be more prevalent in business segments with more client-facing roles. In client-facing positions, communications may be initiated by the client using platforms such as iMessage or WhatsApp, putting the onus on the employee to redirect the communication. However, the problem can also arise in intra-team communications, in which employees themselves may initiate group chats on personal devices for logistical communications that inadvertently turn substantive. Applications like iMessage and WhatsApp are popular because they are easy to use, allow for a quick exchange among users and have other useful functionalities such as group chat features. Some firms have mandated that all employees use firm-issued phones and limit the available applications on such phones, whereas others have continued to permit employees to use their own mobile device but have sought alternative technologies to retain and monitor communications sent on popular communication applications. Firms face challenges capturing communications from applications like iMessage and WhatsApp due to their end-to-end encryption. Thus, firms must find alternative technologies that allow them to monitor, ingest and retain messages from these channels. However, the technology that exists is nascent, and users report that the ease-of-use of applications like iMessage and WhatsApp has been difficult to replicate with the new technology.

Surveillance for non-compliance

Surveillance for non-compliance also faces technological limitations. The traditional compliance surveillance tool – lexicon search functionality, ie, word searches – is effective when trying to identify suspicious or improper communications that exist on firm systems. However, using a word search to find something that is not there, but should be, is challenging. Lexicon-based surveillance will not flag problematic communications unless the employee uses the exact word or phrase in the lexicon library. Firms are beginning to explore technologies that utilise artificial intelligence, such as natural language processing, to fill in the gaps of lexicon-based searches. Natural language-processing programmes use machine learning to find phrases in communications that semantically match something that could be problematic but may not be an exact match. These programmes can also take the context of a conversation into account in assessing whether a communication is problematic and worthy of flagging for further review. Some firms are also beginning to leverage usage reports. With these reports, firms can monitor whether employees are actually using the communication applications available to them and investigate further if there are any outlier employees not using firm-monitored communication platforms consistently. Much of this technology is still in its early stages, but it is worthy of monitoring and consideration for adoption as it becomes more developed and used across the industry.

Discipline for non-compliance

Discipline for non-compliance with off-channel communication policies is another area of focus for many firms, but this is an area requiring a sensical and balanced approach. On the one hand, adopting a model of swift and sure discipline might deter violations. But on the other hand, such a rigid disciplinary programme would also likely deter prompt repatriating (eg, capturing on firm-monitored systems) of off-channel communications. The goal of a sound disciplinary programme should be to ensure that any off-channel communications are promptly repatriated, with punishment a secondary consideration, more appropriately applied to calculated or repeat violations. Thus, it is important that any disciplinary framework build in credit for prompt repatriation to encourage the reporting and capture of off-channel communications in circumstances where the conduct was not committed for illicit purposes (eg, to evade detection). Finally, firms should consider communicating or publicising their disciplinary framework to employees to emphasise that firms take their record-keeping obligations seriously and will discipline employees who do not take appropriate care to ensure they comply with relevant policies and procedures.

Conclusion

Given SEC’s focus on off-channel communications in recent years, it is important for firms to assess their current systems and consider whether there are areas for improvement. There is no single solution that will eliminate and/or detect all instances of off-channel communications. However, FDH believes that through increased awareness, adopting more advanced technological solutions and encouraging employees to repatriate inadvertent off-channel communications, sent or received, firms can make meaningful improvements in their compliance with applicable books and records obligations.

The Potential Impact of the Supreme Court’s Ruling in SEC v Jarkesy on the Connecticut Department of Banking (DOB): Should “At Common Law” Have a Common Meaning?

Introduction

For over 30 years, SEC possessed the statutory power to impose civil monetary penalties (“fines”) against respondents in contested administrative proceedings. This past summer, in SEC v Jarkesy, the Supreme Court removed that power. The Court ruled that the Seventh Amendment to the United States Constitution, which preserved the right to a jury trial in “suits at common law”, prohibits SEC from imposing a civil fine in a contested administrative proceeding because a civil fine is a “prototypical common law remedy”. From now on, in contested cases, SEC may only seek civil fines in federal court where defendants enjoy the constitutional right to a jury trial.

Jarkesy’s impact on the administrative enforcement regimes of SEC and other federal agencies will be immediate and seismic. Less clear is what impact, if any, Jarkesy will have on Connecticut’s Commissioner of Banking, who oversees DOB. Although the Seventh Amendment does not apply to the states, Connecticut’s Constitution preserves the common law right to a jury trial in the same manner as the Seventh Amendment. And similar to SEC, DOB has statutory authority to impose civil fines in contested administrative proceedings.

It is only a matter of time before a respondent in a contested DOB administrative proceeding argues that the Connecticut Constitution affords him the right to a jury trial in state court, and the matter makes its way up to and through the Connecticut court system. Ultimately, the Connecticut Supreme Court will have to decide whether the scope of the common law jury trial right enshrined in the Connecticut Constitution differs from that of the US Constitution. In this author’s view, the scope of both provisions should be the same.

A resolution of this issue consistent with the Jarkesy opinion will bring uniformity and fundamental fairness to the dual federal/state securities enforcement regimes. Such a ruling would impose certain stresses on DOB’s current enforcement regime. DOB currently brings all of its enforcement matters as administrative proceedings (and only runs into state court to enforce its administrative orders) and has neither the resources nor the jury trial expertise to actively litigate Connecticut Uniform Securities Act (CUSA) enforcement cases in state court. But these practical consequences should not deter the Connecticut courts from properly resolving this critical constitutional issue.

SEC and DOB – parallel enforcement regimes

SEC and DOB operate parallel securities regulatory regimes. At the federal level, SEC regulates and enforces, among other statutes, the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 (collectively, the “federal securities laws”). These federal securities laws address securities registration, issuer disclosure, broker-dealer and investment adviser registration and operations, and fraud.

At the state level, DOB regulates and enforces CUSA. CUSA is based on the Uniform Securities Act of 1956 as amended, which in turn was modelled on the federal securities laws. CUSA and the rules thereunder address the same subject matter as the federal securities laws.

SEC and DOB also enjoy parallel enforcement powers. Both agencies can:

• bring actions in court;
• institute in-house administrative proceedings; or
• do both.

In court, both agencies may obtain injunctions, disgorgement of ill-gotten gains, civil fines and other remedies. And in administrative proceedings, both agencies may obtain cease-and-desist orders, disgorgement and civil fines; and may impose licensing sanctions, such as revoking the registration of a broker-dealer or investment adviser or suspending or barring an individual from associating with a broker-dealer or investment adviser.

Under the SEC enforcement framework, the “Commission” (ie, the sitting SEC Commissioners) is the statutory hearing officer in an administrative proceeding. SEC delegates that power to “administrative law judges” (ALJs), who are all SEC employees. Under the parallel DOB enforcement framework, the Banking Commissioner is the statutory hearing officer in administrative proceedings. The Banking Commissioner delegates that power to a DOB employee.

There is no right to a jury trial in either SEC or DOB administrative proceedings. The hearing officers under both administrative regimes serve as both judge and jury in the proceedings. Further, the strict rules of evidence generally applicable in court proceedings do not apply in either SEC or DOB administrative adjudications (eg, hearsay evidence may be admissible).

While SEC, with its large staff of enforcement attorneys spread throughout the country, routinely brings original proceedings in federal district court to enforce the federal securities laws, DOB, armed with less than a handful of attorneys with little-to-no jury trial experience, only brings original enforcement actions as administrative proceedings. DOB rarely brings an action in state court, doing so only to enforce a remedy such as a fine or a cease-and-desist order awarded in an underlying administrative action.

SEC v Jarkesy

In Jarkesy, SEC brought an administrative proceeding against Jarkesy and his company (together, the “respondents”) for securities fraud. SEC sought, among other remedies, the imposition of civil penalties against the respondents. At the outset of the proceeding, the respondents argued that SEC’s in-house adjudication of the case violated their Seventh Amendment right to a jury trial.

The Seventh Amendment, ratified in 1791, provides, in pertinent part: “In Suits at common law... the right of trial by jury shall be preserved... ” Common law, also known as case law or judge-made law, is a legal system based on judicial decisions rather than statutes or codes. The common law originated in England during the Middle Ages and is still used today in many countries, including the United States.

Traditional common law causes of action included various property and contract claims, and tort claims such as fraud, breach of fiduciary duty and defamation. Common law remedies typically were split into “legal” and “equitable” relief. Equitable remedies included injunctions, accountings, liens and rescission. Legal remedies included compensatory monetary damages, punitive damages and fines.

Before the ratification of the US Constitution in 1789, there was no federal common law in the United States. Instead, each state’s highest court applied and interpreted the common law inherited from England in its own manner.

The ALJ in the Jarkesy matter rejected the respondents’ Seventh Amendment jury trial argument. After holding evidentiary hearings, the ALJ found respondents liable for securities fraud and ordered them to pay a civil money penalty. The matter eventually made its way to the Supreme Court.

On 28 June 2024, the Supreme Court ruled that Jarkesy was denied his Seventh Amendment right to a jury trial. SEC v Jarkesy, 144 S. Ct. 2117 (2024). In essence, the Court ruled that a SEC administrative action to recover statutory civil penalties is a type of “action in debt” under the common law requiring trial by jury. The Court ruled as follows.

“In this case, the remedy is all but dispositive. For respondents’ alleged fraud, SEC seeks civil penalties, a form of monetary relief. While monetary relief can be legal or equitable, money damages are the prototypical common law remedy... That conclusion effectively decides that this suit implicates the Seventh Amendment right, and that a defendant would be entitled to a jury on these claims”.

Connecticut’s constitutional right to a jury trial and case law precedent

Jarkesy is not directly binding on the states because the Seventh Amendment applies only to trials in the federal courts. However, Jarkesy is a definitive interpretation by the nation’s highest court of the term “at common law” with respect to the scope of the common law jury trial right, and it should therefore be highly instructive regarding the interpretation of the common law jury trial right guaranteed by Connecticut’s Constitution.

Article I, Section 19 of the Connecticut Constitution (1818) as amended, provides, in pertinent part: “The right of trial by jury shall remain inviolate”. The phrase “remain inviolate” in the Connecticut Constitution and the phrase “shall be preserved” in the Seventh Amendment are different expressions of the same concept. See State v Gannon, 75 Conn. 206, 52 A. 727, 735 (1902) (“[W]hen... our constitution declared, ‘The right of trial by jury shall remain inviolate,’ it referred to a trial by jury the same in its essential features as the jury trial at common law, which had been adopted by the constitution of the United States and by the constitutions of other states”).

The firm is unaware of a contested DOB enforcement proceeding seeking civil fines in which the respondent argued s/he was deprived of the right to a jury trial under the Connecticut Constitution. But 30 years prior to Jarkesy, the Connecticut Supreme Court rejected a constitutional challenge to the authority of another state regulatory agency to issue civil fines without a jury trial.

In Commissioner of Environmental Protection v Connecticut Building Wrecking Co., 277 Conn. 175, 629 A.2d 1116 (1993), the Connecticut Department of Environmental Protection (DEP) sued defendants in state court seeking civil fines for violations of state environmental regulations. The judge denied defendants’ request for a jury trial under the Connecticut Constitution. Following a bench trial, the trial court rendered a judgment for DEP and imposed civil fines against the defendants.

In affirming the ruling, the Connecticut Supreme Court rejected the defendants’ argument that the underlying enforcement action was similar to a common law action in debt. The court further ruled that the state’s environmental enforcement suit was primarily equitable in nature and was brought in the public interest, entitling the state agency to try defendants without a jury. The lone dissenting Justice argued that because civil fines were a legal remedy at common law, the defendants were entitled to a jury trial solely on the issue of civil penalties.

Conclusion

Jarkesy set up a conflict between the federal and state courts regarding the meaning of the term “at common law” and the scope of the common law right to a civil jury trial in their respective constitutions. The Supreme Court in Jarkesy ruled that a SEC administrative proceeding seeking a civil fine is akin to a common law action in debt, and therefore a suit at common law entitling the respondent to a jury trial in federal court.

Hopefully, in the wake of Jarkesy, the Connecticut Supreme Court will have an opportunity to reassess its ruling in Connecticut Building Wrecking Co. that a state agency proceeding seeking a civil fine is not a common law action in debt in which the respondent is entitled to a jury trial in state court. A reversal of that ruling will bring much-needed uniformity to state and federal agency enforcement processes.

The status quo, in contrast, will lead to absurd and unfair results. Consider the case of a hypothetical financial adviser in Connecticut who is regulated by both SEC and DOB. Both SEC and DOB could bring enforcement actions against the adviser based on the same conduct, and for violating virtually identical statutes and rules, and both agencies could seek the imposition of civil fines for the alleged misconduct. In the SEC matter, per Jarkesy, the individual is entitled to have the matter heard by a jury of his peers in federal court, and the trial would be governed by the strict Federal Rules of Evidence. In the DOB matter, on the other hand, the individual’s case would be tried before a DOB employee in an in-house administrative proceeding without any meaningful evidentiary constraints. Yet the United States Constitution and the Connecticut Constitution contain the same guarantee to a jury trial at common law.

In the firm’s opinion, wholly inconsistent interpretations by federal and state courts of the meaning of “at common law” and the scope of the common law right to a jury trial is untenable. There was one common law inherited by America from England, and it should be interpreted and applied uniformly at the federal and state court level, particularly when it concerns something as fundamental to the US system of justice as the right to a jury trial.