An SEC Administrative Law Judge (“ALJ”) recently held that an in-house lawyer at a broker-dealer with no direct supervisory authority over a retail financial advisor was, nonetheless, that financial advisor’s “supervisor” under the federal securities laws. In the Matter of Theodore W. Urban, 2010 WL 3500928 (S.E.C. Release No. 3-13655, Sept. 8, 2010). Although the ALJ ultimately found that the in-house lawyer’s supervision was “reasonable,” the fact that the ALJ concluded that the lawyer was a financial advisor’s supervisor, and then analyzed the effectiveness of his supervision, is a significant and disquieting development for all in-house counsel at broker-dealers. Moreover, considering that failure to supervise charges apply to investment advisers under Sections 203(e)(6) and 203(f) of the Investment Advisers Act of 1940, in-house counsel at registered and unregistered investment funds could also be subject to this expansion of supervisory liability under the Urban holding.

This memorandum discusses the Urban decision and suggests steps in-house counsel can take to reduce the likelihood of being deemed a “supervisor” of employees outside of the legal and compliance departments of their firms.

FACTUAL SUMMARY

Theodore Urban, the first lawyer ever hired at Ferris, Baker Watts, Inc. (“FBW”), and a former SEC enforcement lawyer, served as General Counsel and Executive Vice President of FBW from 2003-2005. See id. at *2. In this role, Urban reported to Roger Calvert, the CEO of FBW, and headed three FBW departments: Compliance, Human Resources and Internal Audit. See id. at *2. Urban also served as a voting member of FBW’s Board of Directors and Executive Committee, and the firm’s Credit Committee. See id. at *2.

As a lawyer working outside of the retail sales department, Urban had no direct authority over the retail sales department of FBW, which housed the firm’s financial advisors. See id. at *35. The retail sales department had its own management, which was responsible for supervising financial advisors in the department. See id. The supervisory authority of the executives in the retail sales department included the traditional tenets of supervision, namely the ability to hire, fire, discipline, promote and set compensation for financial advisors. See id. at *3, *5, *35 and*53.

The SEC alleged that from 2003-2005, one of FBW’s financial advisors, Stephen Glantz, violated the federal securities laws by, among other things, improperly classifying individual retail accounts as “institutional” to allow for the use of margin, improperly “marking the close” and manipulating trading in shares of Innotrac. See id. at *39. It also charged that, during the time he was committing these violations, Glantz’s supervisors in the retail sales department failed to take any actions to stop Glantz’s illicit trading activity. See id. at *50. While the SEC did not file “failure to supervise” charges against Glantz’s immediate branch supervisors during the relevant time period, it charged the head of retail sales and the assistant head of retail sales with failing to supervise Glantz. See In the Matter of Louis J. Akers, 2009 WL 2857622 (S.E.C. Release No. 3-13612, Sept. 4, 2009); In the Matter of Patrick J. Vaughan, 2009 WL 321331 (S.E.C. Release No. 3-13367, Feb. 10, 2009).

For his part, Urban, who became aware of Glantz’s behavior through a memorandum from the head of Compliance, raised the issue of Glantz’s improper conduct on numerous occasions, including at meetings with the head and assistant head of retail sales and the CEO, and urged these individuals to take appropriate remedial action. See Urban, 2010 WL 3500928, at *25. Although the managers overseeing FBW’s retail sales department promised to supervise Glantz more closely, the SEC maintained that they did not take sufficient action. See id. at *50.

After becoming frustrated with upper management’s reluctance to monitor Glantz appropriately, Urban eventually recommended that FBW terminate Glantz for his improper conduct. See id. Apparently, senior management in retail sales rejected Urban’s recommendation and even questioned Urban’s motives, asking why he “wanted to drive a good producer out of the firm.” See id.

After twenty-three years of service at FBW, Urban went on administrative leave in November 2006 and resigned from the firm in March 2007. See id. at *38. In September 2007, Glantz pleaded guilty to criminal charges arising out of his conduct at FBW. See id.

THE ALJ’s LEGAL REASONING

In ruling that Urban was Glantz’s “supervisor” under the federal securities laws, ALJ Murray cited to John H. Gutfreund, a 1992 report of investigation that the SEC has relied on in defining the contours of supervision. See Gutfreund, 51 S.E.C. 93 (1992). In Gutfreund, the Chief Legal Officer (“CLO”) of a securities dealer informed three members of senior management that the head of his firm’s government trading desk had submitted a false bid in an auction of U.S. Treasury securities. See 51 S.E.C. at 108. The CLO viewed this action as criminal and urged senior management to report it to the authorities. See id. The CLO and the three senior executives, however, did not investigate or discipline the trader, or inform the government of the improper conduct for a number of months, during which time the illegal activities continued. See id. at 98-101. On these facts, the Commission reasoned that because the CLO (i) had the “requisite degree of responsibility, ability or authority to affect” the trader’s conduct and (ii) failed to take the necessary steps to remediate the improper conduct, he failed to supervise the trader adequately. Id. at 113. However, the SEC chose not to charge the CLO and, as noted earlier, issued a report of investigation instead.

While acknowledging that the facts in Urban are distinguishable, due to Urban’s efforts to seek enhanced supervision of Glantz and to Urban’s colleagues’ efforts to misrepresent their supervision of Glantz, ALJ Murray nonetheless held that Urban was Glantz’s supervisor. See Urban, 2010 WL 3500928, at *50-51. In so holding, ALJ Murray noted that, like the CLO in Gutfreund, Urban had the “requisite degree of responsibility, ability or authority to affect” Glantz’s conduct. See id. (citing Gutfreund, 51 S.E.C. at 113). ALJ Murray reasoned that, as general counsel, FBW personnel viewed Urban’s opinions on legal and compliance issues as “authoritative” and that “his recommendations were generally followed by people in FBW’s business units, but not by [the director and assistant director] of Retail Sales.” Urban, 2010 WL 3500928, at *53. Even though Urban was not in charge of FBW’s response to Glantz’s misconduct, ALJ Murray found that he nonetheless dealt with Glantz in his role as a member of the Credit Committee, and therefore shared in the responsibility to respond appropriately to Glantz’s actions. See id. at *51 (citing Kirk Montgomery, 55 S.E.C. 485, 500-02 (2001) (following Gutfreund and holding the fact that a manager’s decision-making authority could be overruled at higher level is insufficient, standing alone, to relieve that manager of supervisory authority)).

In making her ruling, ALJ Murray agreed with the conclusion of both parties’ experts that, under a literal reading of Gutfreund, Glantz could have many supervisors, even from different divisions of FBW. See Urban, 2010 WL 3500928, at *52. She did not, however, pinpoint the precise degree of authority necessary to become a supervisor, leaving open the possibility that the Urban decision could serve as the basis of supervisory liability for in-house counsel who have even limited contact with employees outside of the legal and compliance departments.

PRACTICE POINTS SUGGESTED BY THE URBAN DECISION

Given ALJ Murray’s broad holding in Urban, legal and compliance staff would be well-advised to consider taking the following steps, all of which should minimize the chances of being considered a “supervisor” under the federal securities laws:

  • Legal and compliance staff should ensure that their firm’s written supervisory policies and procedures specify those people who are charged with supervising line employees, and clarify that legal and compliance personnel do not have supervisory authority outside of the legal and compliance departments.
  • Legal and compliance staff may want to consider whether a written report is prudent in certain circumstances to guard against the potential for a later finding that they failed to supervise an employee outside of the legal and compliance departments: instead of recording the facts developed in connection with an investigation of potential misconduct, this report would record any decisions made with respect to supervisory steps to be taken as a result of the investigation, and the persons responsible for implementing the supervision.
  • When legal and compliance staff become aware that supervisory steps recommended in response to the investigation of misconduct by an employee outside of the legal and compliance departments are not being implemented by line management, they should report those recommended steps to senior management, as well as line management’s efforts to implement those recommendations.
  • Legal and compliance staff should be careful not to supplant the supervision provided by line managers. If legal and compliance staff become involved in supervising a financial advisor (including advising against heightened supervision that is recommended by line management), legal and compliance staff should be certain to monitor the financial advisor’s conduct and document any follow-up supervision. They should also consider re-delegating direct supervision to line managers (who are in a better position to directly monitor the financial advisor’s conduct.), and if they do so, memorialize the delegation of supervisory follow-up in writing.
  • Legal and compliance staff should question whether serving on their firm’s oversight committees may contribute to a finding that they are acting as supervisors outside of their departments, and think carefully before taking on any such assignment, including fully understanding the scope of their role on those committees.

FUTURE DEVELOPMENTS

In light of the Urban decision, we will continue to monitor future developments in the area of supervisory liability and any potential implications for legal and compliance staff.