The recent issuance of frequently asked questions and interpretive answers by the SEC's Division of Trading and Markets (the "FAQs") clarifies a "disturbingly murky" area of the federal securities law -- namely, what facts and circumstances transform compliance or legal personnel into supervisors of those outside of their departments.
This area of the federal securities law has remained underdeveloped over the years because, unlike failure to supervise cases against line supervisors or senior management (e.g., the administrative proceeding against Steven Cohen of SAC Capital Advisors, L.P.), such cases against compliance and legal personnel historically have been brought infrequently. The expanding roles of compliance and legal personnel in business matters and the confusion over when supervisory duties exist under the federal securities laws (caused by the 2010 Urban administrative decision and its subsequent dismissal by the Commission) have also contributed to the uncertainty in this area of the law.
As a result, the FAQs provide some much needed guidance to the industry.
SUPERVISORY RESPONSIBILITIES OF BOTH BROKER-DEALERS AND HEDGE FUND MANAGERS
Even though the FAQs focus on supervisory duties of associated persons of broker-dealers pursuant to Section 15(b)(4)(E) of the Securities Exchange Act of 1934, they also clarify the supervisory duties of associated persons of investment advisers pursuant to Section 203(e)(6) of the Investment Advisers Act of 1940 because the operative language of both sections is identical.
In particular, both sections make associated persons (including compliance and legal personnel) liable if they "fail reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision." Both sections also provide an affirmative defense to an associated person if a reasonable compliance program has been established and the associated person reasonably discharged the duties and obligations under the compliance program.
Indeed, SEC Commissioner Daniel M. Gallagher has repeatedly remarked that these two sections should be interpreted coextensively and that their key word is "if" the violator is subject to supervision.
As a result, compliance and legal personnel of broker-dealers and investment advisers for private investment funds should look to the FAQs for guidance on when supervisory duties exist and what constitutes reasonable supervision.
The FAQs importantly recognize that, because compliance and legal personnel perform advisory roles, they may supervise business units or personnel outside of their departments only in "limited circumstances." In this sense, there is "no presumption" that compliance or legal personnel are supervisors "solely by virtue of their compliance or legal functions." Moreover, "[c]ompliance and legal personnel do not become 'supervisors' solely because they have provided advice or counsel concerning compliance or legal issues to business line personnel, or assisted in the remediation of an issue."
Rather, according to the FAQs, supervisory relationships depend entirely on the "facts and circumstances" of the personnel's actual responsibilities and authority and not on "line" or "non-line" status. In particular, compliance and legal personnel are supervisors if they "have been delegated, or have assumed, supervisory responsibility for particular activities or situations, and therefore have 'the requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.'"
The FAQs note that the SEC first announced this standard in 1992 in the Gutfreund 21(a) Report, which stemmed from an administrative proceeding involving the general counsel of a broker-dealer. Back then, the Commission used Gutfreund "to amplify [its] views on the supervisory responsibilities of legal and compliance officers" and noted that, although compliance and legal personnel are not presumed to be supervisors "solely because they occupy those positions," they could become supervisors if "members of senior management ... involve [them] as part of management's collective response to the problem." The FAQs clearly echo this language.
This clarification by the FAQs is important and noteworthy because the Gutfreund standard recently had been muddied by an administrative proceeding against Theodore W. Urban, the general counsel of a broker-dealer, for allegedly failing to supervise an associated rogue trader. Applying Gutfreund, the administrative law judge found that Urban was the rogue trader's supervisor because, among other things, "[a]s General Counsel, [his] opinions on legal and compliance issues were viewed as authoritative and his recommendations were generally followed by people in [the firm's] business units." Ultimately, the ALJ found that Urban acted reasonably in supervising the rogue trader and dismissed the proceeding. On appeal to the Commission, the proceeding was once again dismissed after three of the Commissioners recused themselves and the remaining two Commissioners were "evenly divided as to whether the allegations in the [order instituting proceedings] ha[d] been established."
The FAQs, however, now clarify that, according to the SEC's rules of practice, the Commission's dismissal of the Urban administrative proceeding stripped the administrative decision of any and all effect. To be sure, Gutfreund (unaltered by Urban) is the prevailing standard on this issue.
To assist in interpreting this standard, the FAQs include the following questions:
- "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 FAQs also note that once compliance and legal personnel have supervisory obligations, they must exercise those responsibilities reasonably or know that others are taking appropriate action. Under those circumstances, being a "mere bystander" or "ignor[ing] wrongdoings or 'red flags'" is not reasonable.
Throughout the FAQs, the Division of Trading and Markets encourages compliance and legal personnel to "take strong and vigorous action regarding indications of misconduct" because they "play a critical role in efforts by broker-dealers to comply with legal and regulatory requirements through the implementation of effective systems." To this end, firms should "reasonably design" their compliance programs to ensure compliance with applicable laws and regulations and consider including, among other things, "robust compliance monitoring systems, processes to escalate identified instances of noncompliance to business line personnel for remediation, and procedures that clearly designate responsibility to business line personnel for supervision of functions and persons." The compliance programs should also "clearly defin[e] compliance and advisory duties and distinguish those duties from business line duties."
Although the FAQs are not binding (they are not rules, regulations or statements of the Commission), they provide helpful guidance to compliance and legal personnel in determining whether supervisory duties exist and, if they do, how they should exercise those duties.