The need for risk and compliance officers is skyrocketing as lenders and financial market participants remain under strict scrutiny in the wake of the 2008 financial crisis. J. P. Morgan Chase & Co. recently announced plans to add 13,000 officers to its compliance staff. Sharp oversight and regulation has resulted in severe penalties for market participants. Industry members have faced astronomical costs for failure to supervise operations. A recent Seventh Circuit ruling reaffirms that government agencies and courts will apply the law to the fullest extent to promote financial industry compliance.
The Seventh Circuit addressed sanctions imposed on a registered broker-dealer for failure to supervise. Carl M. Birkelbach  (Mr. Birkelbach) of Chicago-based Birkelbach Investment Securities, Inc. (BIS) appealed a Securities and Exchange Commission (SEC) order imposing harsh sanctions, including a lifetime ban imposed for failure to supervise. The Seventh Circuit ruled that the sanction was not an abuse of discretion because “the conduct was sufficiently egregious.” Notably, the court held that the SEC can consider violative conduct outside the statute of limitations in shaping sanctions for violative conduct within in the statute of limitations.
The FINRA and SEC Enforcement Action
After a routine examination of BIS trading in 2005, the Financial Industry Regulatory Authority (FINRA) noticed discrepancies in certain accounts and initiated a formal investigation. Three years later, FINRA filed a nine count Complaint against Mr. Birkelbach, BIS, and another BIS trader. A hearing was held and the FINRA panel determined that there were numerous violations—including a violation by Mr. Birkelbach, individually, for failing to supervise. NASD Rule 3010(a) provides “Each member shall establish and maintain a system to supervise the activities of each registered representative, registered principal, and other associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable NASD Rules.” In connection with the violations, Mr. Birkelbach was temporarily banned from certain trading activities and fined $25,000.
Mr. Birkelbach appealed to FINRA’s National Adjudicatory Council (NAC). The appeal did not go as Mr. Birkelbach expected; in fact, the temporary ban on his activities was made permanent. Accordingly, he appealed to the SEC. After reviewing the case de novo, the SEC determined Mr. Birkelbach failed to supervise a previously disciplined broker who engaged in discretionary trading without written authorization, unauthorized trading, unsuitable and excessive trading, churning customer accounts, and misleading customer communications. The SEC concluded that Mr. Birkelbach’s failure to supervise was egregious and agreed that a permanent ban on Mr. Birkelbach’s activities was necessary to protect the investing public.
The Seventh Circuit’s Ruling
Mr. Birkelbach appealed to the Seventh Circuit for review of two key issues:
- Whether the July 30, 2008 FINRA Complaint was untimely because it was filed more than five years after Birkelbach’s supervision began; and
- Whether the lifetime ban was an excessive punishment for failure to supervise.
With respect to the statute of limitations, the Seventh Circuit agreed with the SEC’s determination that an ongoing failure to reasonably supervise “is continuing and divisible such that [the SEC] could consider the timely violative conduct, even if there was additional untimely violative conduct.” The Seventh Circuit concluded that “The rules contemplated a continuing duty to reasonably supervise, and any violative conduct that falls within the statute of limitations is independently sanctionable, regardless of whether there was additional violative conduct which occurred before that time.” Moreover, the Seventh Circuit went on to state that the SEC and courts may consider “events outside the [five-year] period in crafting sanctions.” Accordingly the Seventh Circuit applied the statute of limitations broadly to place greater responsibility on the financial industry and its participants.
The Seventh Circuit also agreed with the SEC with respect to Mr. Birkelbach’s lifetime ban for failing to supervise. Mr. Birkelbach took issue with the fact that his ban was increased from temporary to permanent when he appealed to the NAC. The Seventh Circuit was not persuaded—stating that the FINRA rules provide notice that “the NAC ‘may affirm, dismiss, modify, or reverse with respect to each finding . . . .'” Accordingly, the SEC did not abuse its discretion in affirming NAC’s increase of the suspension to a lifetime ban in all industry capacities.
The tone has been set. Government agencies and the judicial system are cracking down on financial industry compliance and oversight. Financial industry participants need to understand and be aware of the aggressive enforcement climate. Heightened efforts to thwart misconduct are now a business reality. Financial market participants must swiftly prepare for the continuing and growing oversight, regulation, and enforcement. It is critical to have supervisory procedures in place and mechanisms to ensure these procedures are effective.