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SEC Hits the ‘Reset Button’ on Failure to Supervise Liability for Legal and Compliance Personnel

Friday, October 18, 2013

This article originally appeared in the October 2013 issue of NSCP Currents.

On September 30, 2013, the U.S. Securities and Exchange Commission (SEC) – quietly, and with little fanfare – released an informal statement of policy in the form of frequently asked questions (FAQ), in which it addressed its recent case against Ted Urban.1 In doing so, the SEC shed light on when and how the agency will seek to hold legal and compliance personnel responsible for failing to supervise employees on the business side.

As many will recall, the Urban case was closely watched by securities legal and compliance professionals, who worried that a decision by the commissioners could be used by enforcement staff to make such professionals easier targets in future enforcement actions. Ultimately, the commissioners dismissed the case. That said, given the circumstances surrounding the case’s dismissal, legal and compliance officers were left with little guidance as to whether the case against Urban could be used against them to establish supervisor liability.

On the one hand, although the FAQ attempts to alleviate worries about such potential exposure, it nevertheless reinforces a broad legal standard as to when a legal or compliance professional becomes a supervisor. On the other hand, the FAQ makes clear that the SEC’s enforcement staff cannot cite to or rely on the Urban case when bringing future enforcement actions. In other words, the FAQ is an announcement that the SEC has hit the “reset button,” so to speak, effectively erasing the Urban case from its memory. The FAQ nevertheless suggests that another similar case could be brought in the future.

This article will first look back at the history of the SEC’s attempts to pursue legal and compliance personnel under a failure to supervise theory. It will then conclude with some thoughts on how firms should read the policy statement when considering the status of legal and compliance personnel going forward.

The SEC’s Adoption of the ‘Feuerstein Standard’

By way of background, the issue of whether a legal or compliance officer can be secondarily liable for a business line employee’s violations of the federal securities laws, based on a “failure to supervise,” was first squarely addressed in an SEC enforcement action dealing with the government bond trading scandal at Salomon Brothers (Salomon). Many will remember the case because the underlying scandal resulted in the resignation of the firm’s high-profile Chief Executive Officer John Gutfreund. Legal and compliance personnel will remember the case because of the 21(a) Report regarding the firm’s chief legal officer (CLO), Donald Feuerstein.2

The Gutfreund case stemmed from the conduct of one of Salomon Brothers’ individual brokers, Paul Mozer, who was head of the firm’s Government Trading Desk.3 Mozer circumvented limitations on the number of government bond auctions that a single entity could purchase by making unauthorized purchases in clients’ names. He would then transfer bonds purchased at auctions to the firm, at the original sale price, and disguise or otherwise conceal the transactions from clients.

John Meriwether, vice president and head of fixed-income trading, was Mozer’s direct business line supervisor. Meriwether was first alerted to the problem on April 24, 1991. Shortly afterward, Meriwether reported Mozer’s conduct to three members of the senior management of Salomon: the firm’s CEO Gutfreund, President Thomas Strauss, and CLO Feuerstein. After listening to Meriwether’s account of Mozer’s trades, Feuerstein advised Meriwether, Gutfreund, and Strauss that Mozer had committed a criminal act and advised that the firm report Mozer to the government. The four executives then discussed the option of reporting Mozer to the Federal Reserve Bank of New York. After the meeting ended, however, no one reported Mozer to the Federal Reserve Bank.

Mozer continued to engage in suspect or illegal trading on April 25, 1991 and May 22, 1991. The latter transaction caught the attention of the national financial press, and resulted in an inquiry by the Treasury Department and an investigation by the SEC. In the meantime, Salomon retained an external law firm to investigate. The resulting investigation uncovered misconduct dating back to December 27, 1990. Salomon then reported the incidents to the government and terminated Mozer. Shortly thereafter, Meriwether and the executives who attended the April 1991 meeting resigned.

The SEC eventually brought a settled enforcement action against Gutfreund, Strauss and Meriwether, and issued a 21(a) Report concerning Feuerstein. According to the SEC, each of the three line executives – the CEO, president, and vice president – discussed the idea of reporting Mozer’s trades to the Federal Reserve Bank. However, the SEC further noted that they did not discuss who would actually be responsible for reporting those trades, nor did they discuss how such reporting should be implemented. The SEC concluded, “although there may be varying degrees of responsibility, each of the supervisors bears some measure of responsibility for the collective failure of the group to take action.” The SEC sanctioned all three for failure to supervise.

With respect to Feuerstein, the CLO, the SEC recognized that he was not a line supervisor of the trader, so no disciplinary action was taken against him.4 Despite Feuerstein not having direct line authority over Mozer, the SEC went on to state:

Employees of brokerage firms who have legal or compliance responsibilities do not become “supervisors” … solely because they occupy those positions. Rather, determining if a particular person is a “supervisor” depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability, or authority to affect the conduct of the employee whose behavior is at issue.

The SEC added that, under this standard, and given Feuerstein’s “role and influence” inside Salomon, he shared in the responsibility to take appropriate action. For example, according to the SEC, he could have ordered an internal investigation of Mozer’s conduct, ensured that there was follow-up on his recommendation to report the conduct to the government, instituted other policies to ensure future compliance, and reported the conduct to the compliance department.

Under the Feuerstein standard, legal or compliance officers who do not have the power to fire or punish an employee may nevertheless qualify as a “supervisor” if they have “responsibility, ability, or authority to affect the conduct of the employee whose behavior is at issue.” There was concern within the industry that, under the facts of the Gutfreund case, the standard could be interpreted to mean that if a legal or compliance officer becomes aware of a particularly egregious violation of the securities laws, any involvement by that officer in formulating a response could turn the officer into a supervisor, and expose that officer to sanctions, fines, and penalties.

The Urban Case

The concern by securities legal and compliance professionals about the Feuerstein standard grew deeper in light of the SEC’s case against Ted Urban, the former general counsel of the broker-dealer, Ferris, Baker Watts, Inc. (FBW).5 The Urban case stems from a market manipulation that started as early as January 2003, when the firm hired Stephen Glantz as a registered representative in its retail sales division. Glantz brought a number of clients to the firm, including David Dadante and his IPOF Fund. Dadante was ultimately found to be running a Ponzi scheme.

Throughout 2003 and 2004, Glantz and Dadante accumulated large positions in a small company called Innotrac. Dadante traded shares of Innotrac through his IPOF Fund. Glantz traded shares in his other retail customer accounts, without disclosing the trades to the account holders. Through the IPOF and customer accounts, Glantz and Dadante controlled a substantial block of Innotrac stock. Eventually, IPOF itself gained such a large position that it triggered the poison pill at the company. The fund also accumulated millions of dollars in margin debt, which at one point exceeded $18 million.

Eventually, FBW’s compliance department became concerned about a possible manipulation. As the firm began reviewing the activities of Glantz and Dadante, margin and trading restrictions were imposed on the IPOF account. At one point, Urban halted IPOF trading in Innotrac until certain Exchange Act filings were prepared and submitted. Urban also expressed concern, in writing, to senior management about a lack of supervision over Glantz. The trading in Innotrac, however, continued.

In December 2004, Urban wrote a memorandum recommending that Glantz be terminated. At this point, the head of retail sales, Louis Akers, stepped in and recommended that Glantz be instead put on “special supervision.” Notably, Akers was the former CEO of FBW. However, after stepping down as CEO, Akers continued to be extremely influential within FBW because of his client relationships. Further, it was well known within FBW that Akers had a difficult relationship with the Compliance Department. (At one point, Akers allegedly referred to the chief compliance officer as “a member of Hitler’s Third Reich.”) Upon Akers’ assurance that Glantz would be “specially supervised,” Urban withdrew his recommendation. The chief compliance officer, however, resigned and later testified that the firm’s handling of Glantz was one of the reasons she resigned.

Eventually, the Justice Department launched an investigation into trading in Innotrac stock, and a parallel administrative action was brought by the SEC. In addition, several shareholders in the IPOF Fund filed a private lawsuit and named FBW as a co-defendant. Glantz left the firm in December 2005, and both he and Dadante later pleaded guilty to securities fraud charges. Glantz was sentenced to 33 months in prison while Dadante received a 13-year sentence.

Meanwhile, Urban became the focus of the SEC’s case, which was tried before SEC Chief Administrative Law Judge Brenda P. Murray. In her opinion, Judge Murray ruled that, under the Feuerstein standard, Urban was Glantz’s supervisor. According to the opinion:

As General Counsel, Urban’s opinions on legal and compliance issues were viewed as authoritative and his recommendations were generally followed by people in [FBW’s] business units ...

However, Judge Murray further ruled that Urban acted reasonably under the circumstances. According to Judge Murray, throughout the time period, Urban took appropriate follow-up action when confronted with a “red flag.” Further, the evidence showed that branch managers and executives in retail sales either lied to Urban or kept information from him. For example, Judge Murray noted that it was “reasonable” for Urban to expect that, after insisting that Glantz be fired, the head of retail sales, Akers, would follow through on his commitment to “specially supervise” Glantz. Thus, according to Judge Murray, it was reasonable for Urban to believe that appropriate measures were being taken to oversee Glantz and address concerns about his trading.

Judge Murray also found that, as a practical matter, Urban had few other options. He understood that Akers had virtually unquestioned authority over retail sales, and that other senior officials at the firm would not interfere with Akers’ decisions. Likewise, going to the board of directors was not, as the enforcement division argued, a viable option. Without the support of other executives, which he could not obtain, challenging Akers at the board level would be futile. Thus, Judge Murray concluded the evidence was that Urban performed his responsibilities in a “cautious, objective, thorough and reasonable manner.”

The Urban case had a long and complicated history after Judge Murray’s decision. The SEC’s enforcement staff appealed the initial decision to the commissioners, who refused to affirm Judge Murray and set oral arguments on the matter. Meanwhile, securities legal and compliance professionals monitored the progress of the appeal carefully, worrying that a decision by the commissioners could be used by enforcement staff to make such personnel easier targets in future enforcement actions.

Ultimately, the commissioners dismissed the case. According to the SEC, three commissioners recused themselves, and the two remaining commissioners – Aguilar and Paredes – were split in their views and deadlocked. The SEC would not comment on why the other three commissioners recused themselves. That said, given the circumstances surrounding the case’s dismissal, legal and compliance officers were left with little guidance as to whether the initial decision in the Urban case could be used against them to establish supervisor liability.

The FAQ

Perhaps in order to address this confusion, on September 30, 2013, the SEC released an informal policy statement entitled “Frequently 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” (FAQ). According to the FAQ:

Question 7.

What is the status of the initial decision in the Theodore W. Urban matter?

Answer:

Under the Commission'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 “shall be of no effect.”

In light of this FAQ, Judge Murray’s decision and analysis in Urban should not have binding or precedential value because it was dismissed by the commissioners as a result of a deadlock. However, the FAQ also makes clear that compliance and legal professionals will still be measured according to the Feuerstein standard. Specifically, the FAQ essentially restates the section from the Gutfreund report dealing with how the CLO in that case, Feuerstein, could have been found liable as a supervisor. According to the FAQ:

Question 1.

Is a chief compliance officer or any other compliance or legal personnel a supervisor of broker-dealer business personnel solely by virtue of the compliance or legal position?

Answer:

No. Compliance and legal personnel are not “supervisors” of business line personnel for purposes of Exchange Act Sections 15(b)(4) and 15(b)(6) solely because they occupy compliance or legal positions. Determining if a particular person is a supervisor depends on whether, under the facts and circumstances of a particular case, that person has the requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.

That said, the FAQ further states that the determination of whether a legal or compliance officer qualifies as a supervisor is a fact-intensive inquiry, rather than one based on title or designated position, that compliance and legal personnel are permitted to provide guidance without becoming supervisors, and that a robust compliance program should not expose compliance officers to more liability by virtue of involving themselves. In addition, the FAQ lists several clear examples of when a legal or compliance professional crosses the line into supervisor territory:

Question 2.

What does it mean to have the requisite degree of responsibility, ability or authority to affect the conduct of another employee?

Answer:

A person’s actual responsibilities and authority, rather than, for example, his or her “line” or “non-line” status, determine whether he or she is a “supervisor” for purposes of Exchange Act Sections 15(b)(4) and 15(b)(6). Among the questions to consider in this regard:

  • 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?

The clearest example of when a legal or compliance officer may be considered a “supervisor” is when he or she wears “two hats” and acts as an executive officer – as is the case in some smaller firms. In addition, supervisor status will be found if the firm’s policies and procedures give the legal or compliance officer express supervisory authority, or if the legal or compliance officer regularly engages in supervisory activities, like hiring and firing. However, even in the absence of express authority, or authority established by de facto granting of supervisory responsibilities, the SEC has left itself some wiggle room to pursue actions against legal and compliance personnel. The examples in the last three bullet points above suggest that the SEC may consider several factors when determining if a legal or compliance professional should be targeted in a failure to supervise case. Those examples seem to consider the knowledge that the legal or compliance officer has about the underlying violation, as well as the ability and opportunity that the legal or compliance officer has to prevent or otherwise report the violation to authorities.

Conclusion

The FAQ does not change the Feuerstein standard. The FAQ does, however, provide some assurance that the SEC cannot cite to or rely on the Urban case when pursuing an enforcement action against legal and compliance personnel. Further, the FAQ suggests ways that firms can make the line between supervisor and legal and compliance personnel clearer, as well as ways that firms can create signposts enabling legal and compliance personnel to do their jobs more effectively without taking on unintended liability.

Although the SEC has quietly withdrawn any reliance on the Urban decision, it appears that the agency is seeking to preserve the authority to pursue legal and compliance professionals for failing to supervise business line personnel. The risk, of course, is that legal and compliance professionals will see ignorance as preferable to action. That cannot be a good result for the securities industry.

Endnotes

1 Frequently 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, available at: http://www.sec.gov/divisions/marketreg/faq-cco-supervision-093013.htm. (FAQ)

2 In re John Gutfreund, Exch. Act. Rel. No. 34-31554 (Dec. 3, 1992). The 21(a) Report regarding Feuerstein was part of a larger SEC release encompassing the enforcement action against Gutfreund and others. Possibly because of this, other commentators have referred to the legal standard discussed below as the “Gutfreund standard.” We prefer the “Feuerstein standard” as we believe it to be more accurate.

3 All facts set forth herein are drawn from the SEC’s allegations in the Gutfreund case, which the parties neither admitted nor denied.

4 By way of further background, in the actual Gutfreund document that was released to the public, the SEC named Gutfreund, Strauss, and Meriwether as Respondents, and issued an Order Instituting Proceedings, Making Findings and Imposing Remedial Sanctions (OIP) against them. Because Feuerstein was not Mozer’s line supervisor, the SEC chose not to name Feuerstein as a Respondent. Instead, the portion of the publicly filed document dealing with Feuerstein was described as a Section 21(a) Report. Section 21(a) Reports are reports of the SEC, written in the form of opinion statements. The SEC typically uses these reports as a vehicle to signal how it views a particular problematic area or set of practices. Importantly, they are understood as putting the public on notice that, going forward, the SEC’s enforcement division will consider similar conduct by similarly situated individuals or entities as proper subjects of an enforcement action.

5 In the Matter of Theodore W. Urban, Adm. Proc. File No. 3-13655, Initial Decision (Sept. 8, 2010). The facts set forth herein are set forth in this Initial Decision.

Ivan B. Knauer and Min Choi

Written by

Ivan B. Knauer
Phone: 202.220.1219
Fax: 202.220.1665
knaueri@pepperlaw.com

Min Choi
Phone: 202.220.1451
Fax: 202.220.1665
choim@pepperlaw.com


Mr. Knauer is co-chair of the Securities and Financial Services Enforcement Group at Pepper Hamilton LLP and Mr. Choi is an associate in that group. The authors wish to thank Michael Ambinder, a law clerk in the Washington, D.C. office, for his contributions to this article.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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