The Ninth Circuit recently found the principal of a broker-dealer liable for the extensive and aggravated sales practice violations of the firm’s registered representatives.  In its unpublished decision (not to be cited as precedent), the Circuit Court squarely applied control person liability in upholding summary judgment on behalf of the SEC.  The decision should remind firms and their principals that in certain circumstances principals can be held liable for the misconduct of their subordinates.

The SEC commenced the action in 2009, charging Brookstreet Securities Corp. and Stanley C. Brooks, the firm’s CEO, president, chairman of the board, and owner, with fraud for systematically selling risky mortgage-backed securities to customers with conservative investment goals.  According to the SEC, Brookstreet and Brooks developed a program through which the firm’s registered representatives sold particularly risky and illiquid types of collateralized mortgage obligations (CMOs) to more than 1,000 seniors, retirees, and others for whom the securities were unsuitable.  Brookstreet and Brooks continued to promote and sell the risky CMOs even after Brooks received numerous warnings that these were dangerous investments that could become worthless overnight.  The fraud resulted in severe investor losses and eventually caused the firm to collapse.

In 2012, the District Court granted the SEC’s motion for summary judgment, holding Brookstreet and Brooks liable for violating the anti-fraud provisions of the federal securities laws, enjoining them from future violations, and imposing a penalty of over $10 million.

In upholding Brooks’ liability for the conduct of the firm’s brokers, the Ninth Circuit squarely applied principles of control person liability.  The court found that Brooks controlled the primary violators, who made unsuitable sales and misrepresentations, due to:

His position as an officer; His involvement in the day-to-day affairs of the firm; His involvement in the CMO program.

The court also found that Brooks was not entitled to the good faith defense to control person liability that is available to persons who can show that the firm’s supervisory system was adequate and reasonably applied.  The court noted that Brooks knew about the sales of CMOs to retail customers and yet took three years to establish suitability standards.  During this period, he was on notice about the NASD’s guidance advising its members that CMOs were suitable only for sophisticated investors with a high-risk profile and detailing a broker’s responsibility to educate clients about the risks of CMOs.  (The Ninth Circuit also vacated the penalty imposed by the District Court and ordered the District Court to conform the penalty to the proof tendered to the court.)

The Ninth Circuit decision reminds firms that they and their principals risk liability for the actions of a firm’s registered representatives if they do not adopt an adequate supervisory system and exercise their responsibilities under it.  Firms should also be aware that control person liability is a key tool used by regulators to hold accountable those who were in a position to detect and prevent wrongdoing and, if they were aware of it, did not stop the conduct or, if they were unaware, did not adequately supervise those who directly committed the violations.  The industry can count on the securities regulators’ continued use of this tool.