There’s a claimant’s lawyer I’ve litigated against several times who is very good at his job, and who I personally like very much. Part of the reason for his success is that he is very engaging, so even when he utterly lacks any decent facts on which to base his claim – which is often the case – he still makes it a big show, with posters and charts and such. My favorite prop that he uses is a well-worn photo of an ostrich with its head shoved in the sand. As you could guess, this is the demonstrative he brandishes to support his inevitable argument that the firm failed to be diligent in its look-out for red flags. This week, FINRA issued a decision in a churning/excessive trading case that – without using an ostrich picture – included a nice analysis of whether, and when, the head of a broker-dealer can successfully avoid liability for a supervisory failure by arguing that it was someone else’s job. In other words, this decision makes for very instructive reading for anyone hoping to delegate away not just supervisory responsibility, but potential liability.
The law is clear, and FINRA readily acknowledges, that while a BD’s president is responsible for supervision at the firm, those supervisory responsibilities may be delegated away: “[A] brokerage’s president is ultimately responsible for supervision, unless he or she has delegated that responsibility to someone else at the firm and does not know or have reason to know that the responsibility is not being properly exercised.” The problem for supervisors who do this, but still find themselves involved in disciplinary actions, is the end of the quote, i.e., the part about neither knowing nor having reason to know that the individual to whom the supervisory responsibilities have been delegated is not doing the job. As FINRA put it, “[e]ven if the president delegates particular functions to another person, once on notice of the firm’s continuing failure to satisfy regulatory requirements, the president is ‘obligated to respond with utmost vigilance and take remedial action.’” Unfortunately for the respondents in the case at issue, Mr. Taddonio and Mr. Porges, while they had the delegation part covered, their defense fell short when they made the ostrich-with-its-head-in-the-sand argument.
Mr. Taddonio was the firm’s President and CEO. Mr. Porges was the COO and also a sales manager. Mr. Taddonio testified that he delegated all his supervisory responsibilities to the CCOs. He argued that the very reason he hired CCOs was because he “was not experienced in supervision and compliance issues.” Moreover, he stated that he did not supervise the CCOs. The CCOs, however, saw it differently. They testified that:
- They reported to both Mr. Taddonio and Mr. Porges;
- Their employment contracts gave them no responsibility for supervising the firm’s reps;
- Mr. Taddonio and Mr. Porges were responsible for managing and instructing the firm’s sales force;
- Their roles were limited to compliance, administration, and operations;
- Mr. Taddonio “could and did review the RRs’ trading electronically.”
In addition, the firm’s WSPs didn’t help the defense that it was the CCOs who were supervising the RRs. The principal problem is that the WSPs were ambiguous. Some portions did suggest that Mr. Taddonio had delegated his responsibilities. But, others read differently. And, worse, others were simply nonsensical. For instance, supervisory responsibilities were supposedly reflected on an “ORG Chart,” but there was no such chart in the WSPs. As a result of these ambiguities, FINRA concluded that there was no proper delegation of supervisory responsibilities in the WSPs: “[T]he ambiguities in the WSPs meant that no one [to whom Mr. Taddonio had supposedly delegated supervision] had clear responsibility for evaluating the suitability of individual trades or the quantity of trading in customers’ accounts.”
There was also “considerable evidence” that Mr. Taddonio, despite his titles, was functioning as the firm’s sales manager “and kept close track of the RRs’ sales activities.” He sent emails to the reps with specific trading ideas. He also “encouraged and rewarded the RRs” with sales awards.
Given all this, the hearing panel held that Mr. Taddonio did not delegate away his supervisory responsibilities. But, that’s not all. In addition, it held that even if he had delegated them properly, he was nevertheless aware of “red flags” indicating not just excessive trading by the RRs, but also “inadequate supervisory responses to those red flags, and was thus on notice of the firm’s continuing failure to satisfy regulatory requirements.” He failed, however, “to respond with utmost vigilance and take remedial action.” Even though the CCOs were concerned about excessive trading, and took certain steps to address the problem, “it should have been obvious to Taddonio” – who was aware of those concerns and the attempts at remediation – “that those steps were inadequate to ensure that his firm was meeting its supervisory responsibilities and protecting its customers from improper sales practices by its RRs.”
As for Mr. Porges, the COO, he claimed his role was primarily to deal with the firm’s finances, and was never assigned responsibility to supervise the RRs. To the extent he became aware of red flags, he insisted that “it was not appropriate for him to second guess the much more experienced CCOs of the firm.”
The hearing panel did not buy his arguments. Remember, the CCOs testified that they reported to Mr. Porges. He was actively involved in hiring the CCOs. He was involved in creating activity letters sent to customers, and became responsible for actually signing them. Mr. Porges received exception reports relating to account activity. In an 8210 response, Mr. Porges stated that he oversaw RRs’ “production, monitoring monthly commissions and compensation.” Along with Mr. Taddonio, he was responsible for issuing the awards for sales. Based on this evidence, the hearing panel concluded that Mr. Porges “had ample indications that [the RRs] were, or might be, excessively trading customer accounts,” and therefore “should have realized that the steps being implemented by the CCOs were insufficient to fully address the issue.” In conclusion, the hearing panel quoted the SEC: “When indications of impropriety reach the attention of those in authority, they must act decisively to detect and prevent violations of the securities laws.”
And therein lies the rub: the head of a firm must respond quickly and appropriately to red flags, i.e., “indications of impropriety,” but, at the same time, the head of the firm may not attempt to avoid learning of such red flags – and, therefore, supervisory liability – by burying his head in the sand and then claiming ignorance. Mr. Taddonio and Mr. Porges learned the hard way that for a firm president, or COO, to avoid supervisory liability, they must do several things correctly. First, they must properly delegate their responsibilities, and do so in clear, cogent, consistent, up-to-date documents. Ambiguous WSPs won’t cut it. Second, even if they do that, they must be able to demonstrate – through documents – the efforts they took to monitor the success of the supervisory activities of those people to whom they delegated their supervisory responsibilities. If they can make that showing, that they were watching carefully for red flags but never saw any, then, and only then, can they sit back while their delegates twist in the wind.