The vanishing supervisor.

• Author: Fanto, James A.
• Position: Broker-dealer supervisor liability

1. INTRODUCTION II. THE SUPERVISORY DUTY OF THE MID-LEVEL SUPERVISOR AND ITS ORIGINS A. The Statutory Framework and Its Uniqueness B. SRO Rules on the Intermediate Supervisor C. A Look at the History of the Regulation of Intermediate Supervisors III. LIMITATIONS OF THE INTERMEDIATE SUPERVISOR AND REGULATORY RESPONSES A. Regulatory Responses to the Limitations of the Intermediate Supervisor 1. Compliance as a Response 2. Technology as a Response B. The Threats to Intermediate Supervisors Posed by Compliance and Technology IV. THE NEED FOR THE INTERMEDIATE SUPERVISOR A. The Psychological and Organizational Benefits of the Intermediate Supervisor B. Regulatory (Re)Promotion of the Intermediate Supervisor V. CONCLUSION I. INTRODUCTION

   Let us begin with two stories about the brokerage industry today, which are based on real life events. In the first, a broker-dealer, (1) which earns most of its money from sales of securities products to retail investors, has a head of sales called Louis. Louis is a big man and something of a bully who does not appreciate the people at the firm--call them compliance officers--who remind him of the legal and professional obligations that he and the brokers must follow. He once referred to a former chief compliance officer as a member of "Hitler's Reich" and to one of the compliance officers as "Igor, Frankenstein's assistant." Louis recruits Stephen, in industry parlance, a "big producer," to the broker-dealer. Louis is very friendly with Stephen and gives him free rein to work. Stephen soon comes to the attention of the compliance officers for various reasons: for example, he appears to be doing trading in several of his retail customer accounts that is not in accordance with their investment objectives, and in these accounts he generates a lot of commissions which are high in relation to the value of the accounts. Moreover, one of his institutional accounts appears to be that of a stock manipulator who borrows money from the broker-dealer to do the manipulation (and the stock being manipulated ends up in the accounts of Stephen's retail customers!). Theodore, the current chief legal and compliance officer, wants Louis to put Stephen on a short leash, but Louis resists, and Stephen continues his misconduct. Theodore urges the CEO to fire Stephen, but Louis mollifies Theodore by agreeing to keep an eye on Stephen. This oversight does not stop Stephen, who eventually leaves the firm in the wake of customer complaints and losses, requiring the broker-dealer to pay millions of dollars to abused customers. The Securities and Exchange Commission (SEC) learns of the situation and fines the broker-dealer for allowing the misconduct to occur. Then, in a highly controversial administrative action, it charges Theodore for not having stopped Stephen's misconduct. The administrative law judge finds Theodore (who is in fact a former SEC lawyer and division assistant head) not at fault, but the SEC's Enforcement Division takes the case all the way up to the SEC Commission level. It ends there because three out of the five Commissioners recuse themselves, and the other two are split as to whether Theodore should be liable. (2)

   In the second story, a broker-dealer decides to sell alternative investments to retail customers, who make up most of its client base. "Alternative investments" is a catch-all phrase for non-traditional investments--such as investment trusts, partnerships, and hedge funds--that are not publicly traded. Since these kinds of investments are illiquid, highly speculative, and not always easy to value, they are not suitable for retail investors. Even for those retail investors who are qualified to purchase them, alternative investments should be a small part of an investor's overall portfolio. Large and with many offices, this broker-dealer operates under a model that exists today in a number of national broker-dealers: many of its branches are independently owned and operated by brokers. To help link together all of these branches, to provide them efficiently with products and order execution facilities, and to supervise them, the broker-dealer uses an automated system that, among other things, gathers together all the information about its brokers, customers, and their transactions. As one part of the oversight of customer transactions in alternative investments, the firm runs all transactions through the automated system, which can identify, and even reject, ones that do not comply with its product and customer guidelines. For example, a transaction would be flagged for further investigation by compliance and supervisory staff in the home office if a customer purchasing an alternative investment is not an appropriate investor for it on the basis of the customer's sophistication and size of portfolio, or if the customer already has too large a concentration of his or her portfolio in alternative investments. However, it turns out that, as a result of programming errors and limitations, the automated system often fails to flag or to reject transactions in alternative investments that should not have been made for certain customers. As a result of an enforcement action brought against it by the Financial Industry Regulatory Authority (FINRA) (3) on its sales of alternative investments, the broker-dealer pays a $1 million fine, hires an outside consultant to advise it on revamping its compliance procedures, and undertakes a significant revision as to how it oversees the sale of alternative investments to retail customers, including with respect to its automatic system's failure to identify suspicious or problematic transactions. (4)

   These two stories are emblematic of two significant, related trends in the broker-dealer world. The first trend, exemplified by the first story but which also figures in the second, is the important role of a compliance officer in the oversight of brokers. The SEC's enforcement action against Theodore was based on the allegation that he did not go far enough in stopping the misconduct of Stephen, the rogue broker, despite the resistance of Louis, Stephen's nominal supervisor. Even the second story emphasizes the importance of compliance, for compliance officers and supervisory staff at the home office of the broker-dealer are supposed to review the transactions flagged by its automated system. The other trend, highlighted by the second story, is the significant role of technology in the oversight of activities in a broker-dealer and thus in the identification, or even the prevention, of problematic transactions. As shown by the example, technology allows a broker-dealer to keep an eye on brokers in numerous, far-flung offices in an economical way. Moreover, technology becomes a useful tool in the hands of compliance officers who, with its help and from a remote location, use automated systems to review transactions.

   But another, less evident message of these two stories, which goes hand-in-hand with the importance of compliance and technology in the oversight of brokers, is the lessening importance of the supervisor who is "on the ground" in the branches of broker-dealers. It is true that, in his opinion in the first story, the administrative law judge unfavorably portrays the conduct of Louis, who protects the rogue broker Stephen. But Louis is not a branch manager; he is the head of retail sales and thus near the top of the broker-dealer's hierarchy. In the story, the rogue Stephen went his merry way, working in and out of several different branches relatively free of interference or control by the branch managers in them. In the second story, FINRA faulted the broker-dealer for not training its mid-level supervisors adequately so that they could better oversee customer transactions in alternative investments solicited by brokers under their supervision. However, the main emphasis of this settled proceeding, particularly with respect to the remedial measures undertaken by the broker-dealer, involves the firm's commitment to fix its reporting forms for alternative investments, which would be entered into the automated system, and to enhance the oversight of alternative investment sales by a special compliance and supervisory group in the main office.

   This outcome of a diminished mid-level supervisor is surprising, even shocking, in the federal regulation of broker-dealers. The history of this regulation, which essentially began with the Exchange Act, (5) reveals that Congress, the SEC, and self-regulatory organizations (SROs) (6) like FINRA sought to prevent brokers from abusing customers by enhancing the role and competence of mid-level broker-dealer supervisors, best exemplified by the branch manager. Indeed, the Exchange Act, as well as other federal securities laws modeled upon it, does something that was not in the common law of agency or in the regulation of businesses under corporate or other business organization law: it imposes a direct liability upon broker-dealer supervisors for their failure to supervise those under their control who commit securities law violations. (7) The creation of this liability, which in essence imposes a duty to supervise on them, was a reaction to a new business reality that came into existence in brokerages during the middle of the last century. From operating primarily as small businesses in partnership form with a few partner owners and a small group of employees who collectively worked out of a handful of offices, broker-dealers became larger organizations with multiple offices spread across a region or even the entire country in order to serve the growing number of investors in the post-World War II years. In these larger organizations, the partner/owners could no longer control and supervise every branch or office. They thus began to hire, train, and rely upon new midlevel supervisors, often drawn from the brokerage ranks, to assist them in the management and supervision of the brokers...