SEC Commissioner Daniel M. Gallagher gave his views on the liability of an investment adviser’s legal and compliance personnel at remarks for PLI’s “The SEC Speaks in 2012” seminar.  The remarks address “failure to supervise” liability for compliance and legal personnel.  The Exchange Act vests the SEC with the authority to impose sanctions on a person associated with a broker-dealer if that person “has failed reasonably to supervise, with a view to preventing violations of the provisions of [the securities] statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision.” The nearly identical language in the Investment Advisers Act grants the SEC the same authority with respect to associated persons of investment advisers.  A key question, therefore, is at what point can legal and compliance personnel be reasonably deemed “supervisors” as they carry out their responsibility to prevent and, if necessary, address violations of laws or regulations by firm employees and to provide advice and guidance to management?

Perhaps the clearest guidance on this question was set forth in the Gutfreund Section 21(A) report issued by the SEC in 1992 in connection with an administrative proceeding involving the general counsel of a broker-dealer. In that report, the SEC noted that legal and compliance personnel “do not become ‘supervisors’ for purposes of [the Exchange Act] . . . solely because they occupy those positions.” The SEC explained, however, that an in-house lawyer can be deemed a supervisor when other members of senior management “involve him as part of management’s collective response to the problem.” The SEC further noted that, “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.”

According to Commissioner Gallagher, the question of what makes a legal or compliance officer a supervisor, however, remains disturbingly murky.  Unfortunately, robust engagement on the part of legal and compliance personnel raises the specter that such personnel could be 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, according to Commissioner Gallagher. A compliance officer or in-house attorney who stays ensconced in a dark corner of the firm drafting policies and sending out memoranda, but never interacting with the individuals governed by those policies or the recipients of those memos, risks diminished effectiveness or even irrelevance; but such a person would reduce his or her potential liability as a supervisor. On the other hand, the more engaged a firm’s legal counsel or compliance personnel become — the more they bring their expertise to bear in addressing important, real-world compliance issues and in providing real-time advice for concrete problems the firms and their employees face — the more likely they are to be deemed to be playing a supervisory role. Thus, the SEC’s position on supervisory liability for legal and compliance personnel may have had the perverse effect of increasing the risk of supervisory liability in direct proportion to the intensity of their engagement in legal and compliance activities.

Commissioner Gallagher said “Any understanding of the issue must begin with the fact that broker-dealer or investment adviser compliance and legal personnel are, by default, not supervisors but rather providers of support for the firm’s other employees.”  Almost every facet of broker-dealer and investment adviser “business” issues are also regulatory issues, and accordingly the SEC and the SROs should want legal and compliance in the discussion about most issues.  Commissioner Gallagher also stated “Deterring such engagement 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.”

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