SEC Guidance on Supervisory Liability of Broker-Dealer Compliance and Legal Personnel

Investment Management Update

Date: October 25, 2013

The Securities and Exchange Commission (SEC) recently provided guidance on when legal and compliance professionals are considered to be acting as supervisors subject to liability for failure to supervise. The SEC is authorized to commence proceedings against a person associated with a broker-dealer if someone under that person’s supervision violates provisions of applicable law and the supervisor has failed to provide reasonable oversight that might have prevented the violation. While it is clear that compliance and legal personnel play a critical role in ensuring that broker-dealers act in accordance with applicable law, there is little guidance regarding activities that create supervisory liability for such personnel.

To address this concern, the SEC’s Division of Trading and Markets recently provided staff guidance on supervisory liability for chief compliance officers and other compliance and legal personnel at broker-dealers under Sections 15(b)(4) and 15(b)(6) of the Securities Exchange Act of 1934, as amended (Exchange Act).1 The staff’s guidance came in the form of frequently asked questions, which are summarized below.

Note that the staff’s guidance does not constitute a new SEC rule, regulation or statement and the SEC has neither approved nor disapproved the guidance. Further, the guidance is subject to change from time to time.

Brief Background

Ultimate responsibility for a broker-dealer’s compliance resides with its chief executive officer and senior management.2 The SEC has brought failure to supervise actions against broker-dealer legal or compliance personnel in cases where the individuals were delegated, or assumed, supervisory responsibility for particular activities or situations, and therefore had “the requisite degree of responsibility, ability or authority to affect the conduct of the employee.”3 In these cases, the focus was on the roles and responsibilities of the respective parties.

The staff now clarifies that legal and compliance personnel will not be held liable solely for being ineffective at detecting and preventing violations of applicable law.4 This clarification helps resolve ongoing confusion after Theodore W. Urban.5

As a general matter, the staff notes that it does not single out compliance or legal personnel. Rather it encourages compliance officers and other compliance and legal personnel to take strong and vigorous action regarding indications of misconduct.

Who Is a Supervisor?

Compliance and legal personnel are not deemed supervisors solely because they occupy compliance or legal positions.

The determination of whether or not a person is a supervisor is based on whether the person has the requisite degree of responsibility, ability or authority to affect the conduct of the person whose behavior is at issue. The following questions should be asked when considering whether a person is a supervisor:

  • Has the person clearly been given, or otherwise assumed, supervisory authority or responsibility for particular business activities or situations?
  • Do the firm’s policies and procedures, or other documents, identify the person as responsible for supervising, or for overseeing, one or more business persons or activities?
  • Did the person have the power to affect another’s conduct? Did the person, for example, have the ability to hire, reward or punish that person?
  • Did the person otherwise have authority and responsibility such that he or she could have prevented the violation from continuing, even if he or she did not have the power to fire, demote or reduce the pay of the person in question?
  • Did the person know that he or she was responsible for the actions of another, and that he or she could have taken effective action to fulfill that responsibility?
  • Should the person nonetheless reasonably have known in light of all the facts and circumstances that he or she had the authority or responsibility within the administrative structure to exercise control to prevent the underlying violation?

Compliance and legal personnel can do the following without being considered a supervisor:

  • Set up a compliance program. Broker-dealers have a duty to build effective compliance programs that are reasonably designed to ensure compliance with applicable laws and regulations. Compliance programs should include robust compliance monitoring systems, processes to report instances of noncompliance to business line personnel, and procedures that clearly designate responsibility to business line personnel for supervision of functions and persons.
  • Provide advice to business line personnel. Compliance and legal personnel do not become supervisors solely because they provide advice on compliance or legal issues to business line personnel, or because they assist in resolving issues. Broker-dealers should clearly define the duties of compliance and legal personnel and distinguish them from those of business line personnel so that persons performing only compliance and legal functions avoid becoming supervisors of business line employees.
  • Participate in a management or other committee. Compliance and legal personnel do not become supervisors merely by participating in, providing advice to or consulting with a management or other committee. A broker-dealer should clearly define what role compliance and legal personnel perform on management or other committees, and consider whether compliance and legal personnel should serve as non-voting members with active but advisory roles.
  • Provide advice to senior management. Compliance and legal personnel do not become supervisors solely because they provide advice to or consult with senior management. Compliance and legal personnel play a key role in providing advice and counsel to senior management, including keeping management informed about the state of compliance at the broker-dealer, major regulatory developments and external events that may have an impact on the broker-dealer. In this regard, compliance and legal personnel should notify direct supervisors of business line employees about conduct that raises “red flags” and continue to follow up to help ensure the proper response.

A supervisor cannot be a mere bystander to events that occurred or ignore wrongdoing, “red flags” or other suggestions of irregularity.

Once a person has supervisory obligations, he or she must reasonably discharge those obligations or know that others are taking appropriate action. He or she must reasonably supervise with the intent of preventing violations of applicable laws and regulations.

The affirmative defense to potential liability for failure to supervise is that the firm has set up a system that would reasonably be expected to prevent and detect a violation, and the supervisor has reasonably discharged his or her duties without reasonable cause to believe that the procedures and system were not being complied with.

These questions and answers provide further guidance for broker-dealers’ compliance and legal personnel but a determination of supervisory liability continues to be based primarily on the facts and circumstances of the specific case. Broker-dealers are well advised to consult with legal counsel in setting up effective compliance programs and procedures.

FOR MORE INFORMATION

For more information, please contact:

Richard S. Heller
212.908.3907
Richard.Heller@ThompsonHine.com

Rachel G. Talay
202.263.4147
Rachel.Talay@ThompsonHine.com

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1Frequently Asked Questions about Liability of Compliance and Legal Personnel at Broker-Dealers under Sections 15(b)(4) and 15(b)(6) of the Exchange Act (Sept. 30, 2013) (http://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm).

2Sheldon v. SEC, 45 F.3d 1515, 1517 (11th Cir. 1995) (“The president of a corporate broker-dealer is responsible for compliance with all of the requirements imposed on his firm unless and until he reasonably delegates particular functions to another person in that firm, and neither knows nor has reason to know that such person’s performance is deficient.”), quoting Universal Heritage Investments Corp., 47 S.E.C. 839, 845 (1982) (finding securities firm’s president had properly delegated duties).

3John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992).

4Theodore W. Urban, SEC Administrative Proceeding File No. 3-13655, Initial Decision Release No. 402 (September 8, 2010), dismissed by Exchange Act Release No. 66359 (January 26, 2012).

5Under the SEC’s rules of practice, if a majority of the commissioners do not agree on the merits (as was the case in Urban), the initial decision is of no effect.