By Dan Macy

Investment Advisory Chief Compliance Officers (CCOs) might count among their worst nightmares the specter of being charged by the SEC as a “supervisor” in connection with fraud committed by a wayward broker at their firm. With memories of a 2010 failure-to-supervise case still fresh, CCOs and now an SEC commissioner have grappled with the issue. Commissioner Daniel Gallagher expressed concerns over a possible chilling effect created by that case and others involving CCO liability for supervision, concerned that fear of getting on the hook could discourage CCOs from getting actively involved in preventing fraud. 

Against that backdrop, speakers at a discussion panel March 8 at the Investment Adviser Association (IAA) compliance conference sought to dispel what they characterized as unfounded fears. “It is a myth that just because you are the CCO that you are somehow liable for what goes on in your firm,” panel member Christine Carsman, senior vice president and general counsel at Affiliated Managers Group, Inc., said. “The media,” she said, “[have] helped a lot to really keep the drum beat of misunderstanding going, creating a very nerve-wracking environment for those of us who work in the business.”

The speaker panel members, which included SEC Division of Investment Management Deputy Director Robert Plaze, built on points made earlier that day by recently-appointed SEC Commissioner Daniel Gallagher, who gave the keynote speech. Gallagher said, “We must strive to ensure that failure-to-supervise liability never deters legal and compliance personnel from diving into the firm’s real-world legal and compliance problems.” (Both Gallagher and Plaze noted, as all SEC commissioners and staffers do when they speak publicly, that their opinions were their own and do not necessarily reflect the views of the commission or staff.)

Failure-to-supervise Question Still ‘Disturbingly Murky’

But in a Feb. 24 speech, Gallagher acknowledged that “the question of what makes a legal or compliance officer a supervisor, however, remains disturbingly murky.”

Gallagher noted the 2010 case, In the Matter of Theodore W. Urban (see Finding out More), in which an administrative law judge (ALJ) found that under a precedent set in a 1992 case called Gutfreund (see Finding out More), a firm’s general counsel was a “supervisor” of a rogue trader -- citing the authoritativeness of the general counsel’s legal and compliance opinions and recommendations, his membership on the firm’s credit committee and the fact that he dealt with the rogue broker on behalf of that committee. Gallagher said, “Nonetheless, the finding that a general counsel could be deemed the supervisor of an employee in a business unit is a sobering one.”

Gallagher noted that even though the ALJ found Urban to be a “supervisor,” she concluded that he had not failed in his duties as such. The commission later dismissed the proceeding altogether. “However,”
Gallagher continued, “and this is quite unfortunate – that sort of robust engagement on the part of legal and compliance personnel puts them at risk of being deemed to be ‘supervisors’ subject to liability for violations of law by the employees they are held to be supervising. This creates a dangerous dilemma.”

In a telephone interview with Thompson Publishing Group March 26, Urban stated he “was pleased that he was ultimately vindicated by the commission’s dismissal of the proceeding,” but noted that “it’s small consolation after the five plus years for the commission’s investigation and administrative proceedings to reach that conclusion and still not bring clarity to the question of when compliance personnel can become supervisors. “I think the existing standard is much too vague, and the fact that the commission permitted the [Enforcement Division] to bring the case in factual circumstances like mine continues to be a serious threat to compliance personnel.”

Urban said that as counsel, he “clearly did not have authority to fire that broker or otherwise impose particular sanctions on him” for his actions. “I never viewed myself as a supervisor,” he said. “There were others who explicitly were. I wasn’t among those folks.”

Urban and the broker in question, Stephen Glantz, worked for Ferris, Baker Watts (FBW), a brokerage firm that was later acquired by Royal Bank of Canada; the trades in question began in 2003. Urban was general counsel and was in charge of the compliance functions at the brokerage firm. Other personnel at the firm were variously described in the opinion, written by Chief ALJ Brenda P. Murray, as having supervisory responsibilities over Glantz, but the opinion goes into considerable detail about “the unusual arrangement” that FBW had set up for Glantz -- he worked in more than one branch office, each with its own branch supervisor, during the same timeframe, conducting business as an “institutional sales” broker sometimes and as a “retail” broker at others, using different broker numbers.

The opinion states, “Branch managers were charged with direct supervision of brokers, and FBW considered them the firm’s first line of defense against sales practice violations.” For his part, Glantz testified that he considered FBW’s head of retail sales to be his supervisor. At one point, Urban advised the head of retail sales, Louis J. Akers, described in the record as “the most powerful person at the firm,” to terminate Glantz; Akers refused to do so. Instead, Akers committed to implement a “special supervisory” arrangement in which he personally would directly oversee Glantz. 

Glantz resigned in 2005; according to the record of the case, in 2007, he admitted he lied to the FBI and the SEC in connection with the investigation of him. He pled guilty to one count of securities fraud and one count of making a false, fictitious or fraudulent statement, according to Murray’s decision, dated Sept. 8, 2010 (see Finding out More). Glantz was sentenced to 33 months in prison followed by three years of supervised release, and served approximately 12 months of that sentence, the opinion notes. 

In the wake of the investigation, Urban resigned voluntarily as general counsel from the firm in March 2007. Even though Urban was ultimately cleared of any charges of failure to supervise and found to have acted appropriatley, the damage had been done. The ALJ wrote, “Separating from FBW, under these circumstances, has caused Urban severe personal and financial loss. His professional opportunities have been damaged, and he estimates that he lost between $800,000 and $1.3 million in terms of his ownership interest because of the timing and conditions of separation from FBW.”

“I retired from [FBW] and went on about my life in a variety of other ways,” Urban said of the 5-year ordeal. But, he cautioned, “a person in the middle or early stages of their career -- the fact that you could be charged as a supervisor for being actively and competently involved in providing legal or compliance advice to line supervisors within an advisory or broker-dealer entity could be career-threatening. The time and expense of defending such charges, while suspending your career, effectively leave you with no alternative than to settle with [the SEC Enforcement Division].”

Urban said he took some heart in Gallagher’s speech but “the fact that the commission didn’t take the opportunity of an appeal of Judge Murray’s decision to give the legal and compliance community definitive guidance is unfortunate.”

No Bright Line Test

Panel member James Anderson, partner at law firm WilmerHale, noted that smaller and mid-sized advisory firms cannot always support a full-time CCO and might have someone fill that role as well as another role at the firm, most commonly that of general counsel. “What we see mostly is that the general counsel or another lawyer will play the role of CCO,” he said. “You are less likely to be involved in the business-generating end of the business. Chief Operating Officer is another common [position] because of existing oversight responsibilities.”

Anderson, noting that the duty to supervise derives from the Investment Adviser Act (Advisers Act) rules 203(e)(6) and 203(f), said, “the real question is whether being CCO subjects you to personal liability. Merely being a CCO isn’t enough to give you supervisory responsibilities,” he said, “but if you indeed do have responsibility for supervising,” you could be liable. “There is no bright line test” to determine this, he said.

ALJ Decisions

Anderson noted the Gutfreund case (see Finding out More), in which Salomon Brothers’ chief legal officer was found to be a supervisor and to have failed to carry out his supervisory responsibilities in a situation in which the head of Salomon’s government trading desk submitted false bids. Anderson said there are two theories of responsibilities that the case identifies:

1. Salomon’s chief legal officer had the ability to influence the conduct of others; and
2. He took on supervisory responsibilities as a management response to a particular set of circumstances that arose.

“The second is a fair place to assume you could incur supervisory liability as long as the supervisory capacity is relatively clear,” he said. “If somebody gives you the bullet, that makes you responsible for its use,” he said, giving credit to the 1960s television sitcom The Andy Griffith Show for the analogy.

“You could also acquire responsibility through course of conduct,” Plaze added, “but it’s very fact-intensive.” Plaze said the SEC wants CCOs to be able to influence employees, but to “draw the line between being able to influence vs. operating as a supervisor” is a very fact-intensive analysis.

“While you are influential, you can’t compel them  -- that’s the sort of line that commissioner Gallagher is struggling with for you because he wants you to be able to say there’s a bright line and wants you to understand” where it is, Anderson said.

Gallagher expressed concern in a Feb. 24 speech -- to which panel members referred several times -- at an event called “The SEC Speaks,” about the possibility of a chilling effect on CCOs who might be able to put a stop to potentially fraudulent activities but are afraid of becoming entangled in liability. Said Gallagher:

Deterring [robust] engagement [by CCOs] is contrary to the regulatory objectives of the commission, and I am concerned that continuing uncertainty as to the contours of supervisory liability for legal and compliance personnel will have a chilling effect on the willingness of such personnel to provide the level of engagement that firms need -- and that the commission wants. In resolving this uncertainty, we should strive to avoid attacking or penalizing the willingness of compliance and legal personnel to be fully involved in firms’ responses to problematic actors or acts. To put it simply, if a firm employee in a traditionally non-supervisory role has expertise relevant to a compliance matter, that employee shouldn’t fear that sharing that expertise could result in commission action for failure to supervise.

What Should Be Done?

Ted Sonde, a former Associate Director of the SEC Division of Enforcement and now a partner at Patton Boggs in Washington, D.C., said, “I think it is incumbent upon the [SEC] staff and the commission to be realistic about what they should and should not expect of compliance officers, and quite frankly, one of the first things the staff ought to be demanding from its own perspective is that there be clarity.”

In a broker-dealer context, Sonde said, “the line people are the supervisors; the compliance people are not the supervisors. The line people, the branch manager, the vice presidents -- those are the supervisors and they are the people who have the explicit authority to hire and fire the people that they supervise, and you don’t need a court case or an ALJ case or a [legal] precedent to understand that,” he said. “If you or I are responsible for supervising a person, we ought to know that and there oughtn’t to be any ambiguity about that,” he said, pointing out that in other professional settings there is generally no question of who supervises whom. “I’ve never had any doubt about who my subordinates are,” he said looking back on his own career. “It’s totally unfair to make the compliance people responsible for supervising someone who they’re not responsible for.” 

Urban said he was familiar with Gallagher’s recent speech on the question of supervision and appreciated the commissioner’s interest in it. “I think Commissioner Gallagher’s comments are to a degree reassuring,” Urban said, “but they are nonetheless views of a single commissioner and it doesn’t give the compliance community the definitive guidance they deserve.”

How to Cope with Potential Liability

Ownership of processes

Mary Keefe, managing director and director of compliance at Nuveen Asset Management and a panel member, advised CCOs to ensure employees involved in conducting the business of the firm “are well integrated in the compliance program,” and that they “own” the compliance program,” including monitoring business processes. “The business is the first line of defense for guideline compliance,” she said. Owning the process means having business managers review policies, implementation and having them monitor compliance, giving them direct oversight.

But Keefe drew a distinction between encouraging others to “own” processes and relinquishing responsibility. “On exams,” she said, “I think it’s really important that the CCOs are the ones who run the process of the exams but bring the business people in as the subject matter experts so the CCO isn’t the only one responsible for the process.”

Non-voting committee membership

Anderson shared some advice for CCOs who want to strike a balance between being involved in their firm’s activities and becoming liable for supervision. CCOs should be ex officio members of committees at the firms, “but you attend in your capacity of a CCO not as a member of the committee,” and not become a voting member.

Spell out the role of the line supervisor

The SEC staff might assert that a complete and properly structured compliance program should spell out the role of line supervisors in overseeing the employees under them, say industry experts. If there is a violation by an employee, and a failure to supervise by that employee’s supervisor, the staff might also raise a question of whether that failure to supervise was a compliance breakdown, for which the CCO has some accountability. Thus, being specific about the line supervisors’ role is important because even if regulators are not looking to the CCO for failure to supervise, they might be looking at him or her for failure to outline a properly robust role for the supervisor and/or failure to evaluate whether the supervisors were doing their jobs right all along. 

Gallagher: a ‘key incentive’ for management to carry out responsibilities

Gallagher said Feb. 24 that the SEC -- and in the case of broker-dealers, the self-regulatory organizations -- “need to provide a framework that encourages in-house legal and compliance officers to depart, when necessary, from the safety of black and white categorizations of who is and who is not a supervisor.” He said the SEC’s ability to impose sanctions for failures to supervise “is a powerful tool to compel a broker-dealer or investment adviser’s managers and executives to proactively monitor subordinate employees’ compliance with laws and regulations.” High-level personnel are “well aware” of the SEC’s sanctioning power, Gallagher said, so “failure-to-supervise liability can therefore act as a key incentive for a firm’s management to carry out their responsibilities properly.”

At the IAA conference, Gallagher said, “We must strive to ensure that failure-to-supervise liability never deters legal and compliance personnel from diving into the firm’s real-world legal and compliance problems.” And taking a bit from his own Feb. 24 speech at the SEC Speaks event, he said, “To steal a line from Jack Nicholson in A Few Good Men: We want you on that wall; we need you on that wall!”

Finding out More

In the Matter of Theodore W. Urban , Administrative Proceeding File No. 3-13655, Initial Decision Release No. 402 (ALJ Sept. 8, 2010, Brenda P. Murray, Chief Administrative Law Judge. It can be accessed at http://www.sec.gov/litigation/aljdec/2010/id402bpm.pdf.

In 1992, the Commission issued a rare Section 21(a) report in connection with In re John H. Gutfreund, an administrative proceeding involving several senior executives at a prominent broker-dealer. See In re John H.
Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992). 51 S.E.C. 93 (1992).