:By Dexter Johnson, partner at Mallon and Johnson in Chicago, 
e-mail at feedback@mallonandjohnson.com

Whether it was the SEC holding officers at Salomon Brother's trading department liable for its employee submitting false bids in an auction of Treasury securities, PaineWebber and its management being sanctioned stiffly for its failure to supervise sales-related activities in its branch offices, or supervisors at Kidder, Peabody & Co. being sanctioned by the SEC for failure to supervise a senior trader conducting ``phantom'' trades, lawyers and the industry alike believed that executives from the branch manager level to the highest echelons of broker-dealer firms would move quickly to curb the behavior of renegade brokers who violated the securities law. Many of these firm supervisors did take decisive remedial action to deter future violations in response to increased regulatory investigations, sanctions, and arbitration decisions targeting the firm and its supervisory personnel. Unfortunately, for varying reasons, including lax practices, some firms, their supervisors, and managers have not gotten the message.

As a whole, these cases have forced brokerage firm management to take a more expansive view of their responsibility to supervise brokers to prevent wrongdoing. The question where that responsibility for supervision, and the liability for failing to do so, begins and ends might be subject to debate. However, there is little argument that it does not always end with a wrongdoing broker's immediate boss or supervisor. For proof, one need look no further than Frederick Joseph, Drexel Burnham Lambert's former CEO. Joseph was sanctioned for his failure to supervise Michael Milken. Despite Joseph's lack of knowledge about what Milken did, the SEC concluded that Joseph should have recognized Milken's actions as red flags and investigated his activity. Nor, despite the SEC's somewhat amorphous standards for imposing liability for failure to supervise, does it have to end at the top of the brokerage firm's hierarchy.

One thing is certain: The current SEC is intensely focused on sales practice issues and, in particular, brokerage firms and their managers. Along with increased administrative actions against firms and their managers, the SEC is meting out stiffer sanctions against those supervisors who fail to supervise registered representatives who violate the federal securities laws. The SEC's rationale appears to be that by focusing its resources on firms and their managers, its administrative efforts will have a greater impact on firm culture and how firms conduct their business.

Theories of Liability?

The legal theories underpinning brokerage firm and supervisory liability for the wrongful conduct of its brokers include:

•Failure to supervise;

•Controlling person;

•Aiding and abetting; and

•Respondeat superior.

There is no shortage of cases in which the SEC, National Association of Securities Dealers (``NASD''), and state securities regulators have not successfully tested these theories. Unfortunately, examples abound and a few are summarized below.

Failure to Supervise

Since the Salomon Brothers treasury auction and the Painewebber sales practices administrative actions, the SEC has brought administrative actions against numerous retail brokerage firms, their officers, and employees based on its determination that the broker-dealer or supervisory person ``has failed reasonably to supervise, with a view to preventing violations of . . . {the Securities Act of 1933 {`1933 Act'}, the Securities Exchange Act of 1934 {`1934 Act'}, the Investment Advisers Act of 1940, the Investment Company Act of 1940, the Commodity Exchange Act, or the rules or regulations thereunder, or the rules of the MSRB} . . . another person who commits such a violation, if such other person is subject to his supervision.'' 15 U.S.C. §78o(b)(4)(E).

Basis of the Theory

The SEC's more aggressive posture toward supervisors, whether CEO or branch manager, holding them responsible for failing to supervise those who commit securities law violations, derives from sections 15(b)(4)(E) and 15(b)(6) of the 1934 Act, 15 U.S.C. §78o(b)(4)(E) and 78o(b)(6). Section 15(b)(4)(E) also provides a safe harbor against a failure to supervise charge if the broker-dealer or individual can show that:

•There were established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect violations; and

•The supervisor reasonably discharged his duties under the system without reason to believe that the procedures and the system were not being satisfied.

No better example exists of the SEC's use of section 15(b)(6) of the 1934 Act, which incorporates by reference section 15(b)(4)(E) of the 1934 Act, than the SEC's bar of Frederick Joseph, Drexel's CEO, for life from acting as the Chairman or CEO of a broker-dealer and from association in a supervisory capacity with any broker-dealer for a period of three years. The SEC found that Joseph failed reasonably to supervise Michael Milken who at the time was manager of Drexel's high-yield bond department in the mid-'80s. The SEC determined that, while Joseph did not supervise Milken directly (and probably had little knowledge of Milken's activities), he bore personal responsibility for not bringing questionable purchases made by a group controlled by Milken to legal and compliance personnel for advice to determine whether those activities violated the law.

Continuing Problem

The number of recent administrative enforcement actions in which the SEC and other regulators have imposed liability upon supervisors, throughout the management chain, since the Salomon Brothers and Painewebber administrative actions is extensive. A steady stream of brokerage firm supervisors have continually failed to grasp lesson from what has become now a familiar chorus of sanctions imposed for their failure reasonably to supervise brokers.

First Capital

On August 13, 1997, as part of a settlement, the SEC and the CFTC ordered First Capital Strategists and four of its partners to pay $2.6 million to colleges and universities who invested through The Common Fund, a nonprofit corporation that manages $17 billion for 1,300 educational institutions. As a result of a trader's unauthorized trading, The Common Fund lost approximately $137.6 million over a period of approximately three years.

The SEC and CFTC charged that the partners failed to adequately supervise the trader, overstated actual performance, and misrepresented the firm's internal controls. The regulators further concluded that First Capital should have known about the trader's unauthorized day trading which exposed The Common Fund to an unauthorized level of risk. In a separate criminal action the trader pled guilty and was sentenced to 34 months in prison and ordered to pay $237,465 in restitution for losses he sustained in the unauthorized trading.

The SEC suspended the partners from doing securities business for one year and barred them from acting as supervisors in the securities industry, with a right to reapply in five years. The SEC also revoked First Capital's registration as an investment adviser.

In the Matter of Orlando Joseph Jett and Melvin Mullin

The SEC suspended Melvin Mullin, a supervisor of Orlando Joseph Jett, a trader and one-time head of Kidder, Peabody & Co.'s Government Securities Trading Desk. Mullin was suspended for three months, and given three months supervisory suspension, from association with any broker, dealer, investment company, investment advisor, or municipal securities dealer and was subject to a civil penalty of $25,000 for failure to reasonably supervise Jett. In the Matter of Orlando Joseph Jett and Melvin Mullin, Exchange Act Release No. 34-37226, 61 SEC Docket (CCH) 2440 (May 20, 1996).

The SEC alleged that Mullin failed reasonably to supervise Jett when for approximately three years, Jett utilized an anomaly in the broker-dealer's trading and accounting system when trading U.S. Treasury bonds issued pursuant to the Treasury's program of Separate Trading of Registered Interest and Principal (``STRIPS'') to create the appearance of large trading profits when in fact Jett was continually losing large amounts of money. The SEC determined that Mullin failed reasonably to supervise Jett in that he did not monitor Jett's trading in sufficient detail to prevent and detect Jett's violations of the federal securities laws.

Painewebber's BOM:  In re James Warren

Less publicized recent violations, include the Branch Office Manager (``BOM'') of Painewebber's Omaha, Nebraska office, being suspended from association in supervisory capacity with any broker-dealer, investment advisor, investment company, or municipal securities dealer. The SEC found that the BOM failed to supervise a registered representative in the Nebraska office. The SEC alleged that the BOM failed to conduct a reasonable inquiry into the apparent over-concentration of customer accounts in illiquid and unsuitable direct investments. The SEC determined that the overconcentration was readily apparent from a review of the registered representative's customer account records and that the BOM's failure to detect the overconcentration constituted a failure to supervise. In re James Warren, 62 SEC Docket (CCH) 2447, 1996 WL 539165 (N.A.S.D. Sept. 24, 1996).

In re: Refco Securities, Inc.

Significantly, in all of these cases the firm, CEO, or other supervisor was not actively involved in the wrongdoing, and may not have noticed any ``red flags'' warnings of compliance problems. Nevertheless, the SEC still imposed administrative sanctions. For example, the SEC censured and fined Refco Securities, Inc., $250,000 for a series of schemes in which Stephen Wymer, a broker, assisted by other registered representatives at Refco defrauded his clients of $80 million. The SEC determined that Refco failed to establish adequate written procedures to review, among other things, its audit confirmations and mail. In re Refco Securities, Inc., 62 SEC Docket (CCH) 1322 (N.A.S.D. Aug. 6, 1996).

In re: Westcap Securities, L.P.

Westcap Securities had its registration revoked and was ordered by the SEC to pay over $800,000 in penalties and disgorgement when it failed to supervise its registered representatives. The SEC found that the brokers materially misrepresented the risk associated with investing in Real Estate Mortgage Investment Conduits or ``REMICS'' to its customers and failed to have compliance procedures in place to make sure their brokers disclosed the risks. The SEC also found that Westcap failed to follow its own compliance policy by not allowing its compliance officers to verify account information directly with customers. In re Westcap Securities, L.P., 61 SEC Docket (CCH) 709 (N.A.S.D. February 14, 1996).

What these cases further suggest is that brokerage firm supervisory personnel, from the CEO down, must take affirmative steps to address compliance concerns early to guard against failure to supervise liability. A numbers of steps legal and compliance supervisory personnel should consider taking to protect themselves are discussed below. Suffice it to say that to shield themselves, broker-dealers will have to carefully scrutinize their compliance systems at all levels--making sure that they function well throughout firm hierarchy.

Controlling Person

Both the 1933 Act and the 1934 Act impose liability for persons ("controlling persons'') who control the person who commits the violation. A broker-dealer may be held responsible for actions committed by its managers and registered representatives under the controlling person theory of liability under section 20(a) of the 1934 Act. 15 U.S.C. §78t(a). That statute states that any person who directly or indirectly controls any person who is liable for selling securities in violation of the act is liable to the same extent as the seller, unless he acted in good faith and did not directly or indirectly induce the act at issue. Section 20(a) makes any person who ``controls'' another liable for securities law violations to the same extent as the controlled person.

Who Has Control?

Although corporate officers responsible for the day-to-day operations of a broker-dealer or any other organization may possess the requisite ``power to control or influence,'' it does not always follow that directors, principals, officers, and others are automatically liable as controlling persons for the violations of others. The degree of ``control'' necessary to hold a firm or its supervisory personnel liable under the controlling person statute is not always clear--even among the courts that have interpreted section 20(a).

Indeed, there exist a split among the courts on the degree of conduct needed to determine control person liability. Some courts have required so-called ``culpable participation'' conduct in the underlying securities law violation. The culpable participation approach or test requires evidence that the controlling person knew of the fraudulent misrepresentations and actually participated in them or that the person's ``inaction intentionally furthered the fraud or prevented its discovery.'' Other courts have imposed a two-part test requiring:

•That the controlling person had culpable participation in the transaction; and

•That the controlling person also ``possessed the power to control the specific transaction or activity upon which the primary violation is predicated.'' Metge v. Baehler, 762 F.2d 621, 631 (8th Cir. 1985), cert. denied, 474 U.S. 1057 (1986). A plaintiff, however, does not need to prove that the power was exercised.

In Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873 (7th Cir. 1992), cert. denied, 509 U.S. 904 (1993), for instance, the Seventh Circuit Court of Appeals held that Dean Witter could be liable as a controlling person for the fraudulent acts of two of its employees--even without the firm's knowledge of the employees' actions. In this case, the employees gave the plaintiff, Harrison, certain promissory notes in exchange for funds to be invested in municipal bonds. The appeals court reached this conclusion despite the fact that a lower court found that:

•The two employees conducted the transactions as individuals, making sure that Harris did not send payment for the transactions to Dean Witter;

•All payments on the promissory notes were made from the personal checking account of one of the employees; and

•The plaintiff never contacted Dean Witter to ask about the investments.

The appeals court determined, based on its reading of the facts of the case, that Dean Witter still may have had the power or ability to control its employees' transactions. In addition, some brokerage firms are often held liable under the controlling person theory based on their failure to adequately supervise.

Aiding and Abetting After Central Bank of Denver

The Supreme Court's controversial decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), destroyed the SEC's and private parties' use of the aiding and abetting theory of liability against broker-dealer firms, supervisory personnel, and others for the wrongdoing of an employee. The Supreme Court held that the text of the antifraud provision, section 10(b) of the 1934 Act, 15 U.S.C. §78j(b) did not provide a private plaintiff with a private right of action against persons who aid and abet violations of section 10(b) of the 1934 Act and Rule 10b-5 thereunder. The decision meant that private investors could no longer recover from persons who substantially assist in a securities fraud, even if such persons acted knowingly or with a high degree of recklessness.

After Central Bank, the SEC urged Congress to pass legislation that would expressly permit it to seek injunctions and other relief against aiders and abettors. Legislation to restore the SEC's ability to seek injunctive relief or fines and penalties against aiders and abettors was passed as part of Congress's enactment of the Private Securities Litigation Reform Act (``Reform Act''), Pub. L. No. 104-67, 109 Stat. 737, in 1995. No such relief, however, was granted within the Reform Act to private litigants who may have wanted to allege aiding and abetting liability in a private action against a broker-dealer firm or its supervisory personnel.

First Capital, as discussed above, is the most recent example of the SEC charging partners with willfully aiding and abetting violations of the Investment Advisers Act of 1940.

Respondeat Superior

Respondeat superior is a legal doctrine that holds that a principal is vicariously liable for the acts or conduct of its agent. Traditionally, under ``respondeat superior'' (a nice term, though its significance is becoming less meaningful within the law), a broker-dealer could be held vicariously liable for the wrongful acts of its representatives committed within the scope of his employment. The issue of whether respondeat superior is a legitimate basis for imposing secondary liability on employers remains unsettled by the courts. Adding to the confusion is the fact that the courts are not in agreement on whether the controlling persons provisions of the federal securities laws, discussed above, preclude raising the theory of respondeat superior as a ground for imposing liability.

Ninth Circuit: Respondeat Superior Inapplicable to Brokerage Firms

The Ninth Circuit Court of Appeals found that respondeat superior may not be used against brokerage firms, and concluded that Congress intended to supplant, rather than expand, common law liability when it enacted section 20(a) of the 1934 Act, the controlling person provisions. Christoffel v. E.F. Hutton & Co., Inc., 588 F.2d 665, 667 (9th Cir. 1978).

Third Circuit: Limited Application

However, the Third Circuit Court of Appeals has held that the doctrine is only available in actions against broker-dealers and accounting firms. Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880, 884-86 (3d Cir. 1975) (extending liability to broker-dealers); Sharp v. Coopers & Lybrand, 649 F.2d 175, 185 (3d Cir. 1981), cert denied, 455 U.S. 938 (1982) (extending liability to accountants).

Second Circuit: Apparent Authority

The Second Circuit Court of Appeals has held, based on a theory of apparent agency, that these provisions do not preclude liability of corporate officials for misrepresentations of its representatives. Marbury Management, Inc. v. Kohn, 629 F.2d 705, 716 (2d Cir.), cert. denied, 449 U.S. 1011 (1980).

Notwithstanding unsettled case law, the SEC has not used agency theories in recent years in its injunctive or administrative proceedings. It may have even less reason to do so after Central Bank. Although the majority opinion did not say that respondeat superior liability is dead, the minority dissent in Central Bank suggested that it was probably dead.

SUMMARY

In sum, all of these cases, no matter what a regulator's or private claimant's theory of liability, should be read to mean that firms and their supervisory personnel--from the CEO down--expose themselves to substantial legal risk when they fail to take an aggressive, hands-on approach to supervising registered representatives within the firm. Put simply, officers and managers should continue to expect ever-increasing sanctions, including monetary damages, if they believe that delegating responsibility for compliance will absolve them.

Practice Considerations

In the current environment of supervisory liability, officers, legal and compliance officers may want to consider the following possibilities to protect themselves and their firms from regulatory accountability.

1. Written Compliance and Supervisory Procedures

Firms should adopt written supervisory policies and procedures--required by the self-regulatory organizations--not only as a road map to detect violations, but also to improve operational efficiencies. The SEC, NASD, the New York Stock Exchange (``NYSE'') and the Amex all have rules requiring brokers and their firms to have written policies and procedures designed to prevent violations of the securities laws. Such procedures, while not prophylactic, can provide firms and their supervisors with a defense against supervisory liability. Adopting procedures may prove even more helpful when firms engage in transactions involving new, creative and uncharted areas. Word-for-word copying of procedures from industry manuals and trade association guidelines is not a substitute for compliance. This is not to say that procedures are not helpful. The NASD's Compliance Checklist and other supplementary suggested procedures from the Exchanges provide a good starting point for creating procedures. Actual practices must not be inconsistent with written compliance procedures. See also, NASD Conduct Rule 3010; ``Large Firm Project Report,'' 93-95 CCH Dec., ¶85,348 (May 1994); ``Joint Regulatory Sales Practice Sweep Report,'' 95-95 CCH Dec., ¶85,742 (Mar. 1996); and NASD Notice to Members 97-19 (March 1997). Indeed, firms will, no doubt, find it appropriate to revise procedures when problems occur.

2. Compliance Monitoring

Firms should consider establishing monitoring procedures to ensure that written supervisory procedures are being followed and that the persons responsible for a particular supervisory function is, in fact, overseeing the supervisory responsibility and responding to actual and potential violations effectively. Monitoring should also include branch office activities. The compliance system might, arguably, begin with the branch manager but to be effective it must include regional managers, the compliance department, and other legal and compliance officers--all the way up the chain ending with the CEO.

3. Compliance Audits

The firm should periodically conduct mock regulatory audits not only in preparation for possible regulatory exams, by the SEC, NASD, or other self-regulatory organization, but also to determine whether its branch managers, officers, and legal and compliance staff are responding to violations which inevitably negatively impact the firm's finances. Being objective when evaluating the firm's compliance program is important. Consideration should be given to hiring an outside consultant to evaluate the firm's compliance program and conduct a mock audit.

4. Reviewing Correspondence

A procedure should be adopted for review of and documenting of incoming and out-going correspondence between reps and customers. Responsibility for reviews should be handled by senior supervisors.

5. Background Investigation of Brokers

SEC Forms U-4 and U-5 should be reviewed as well as confirmation of previous employment relationships. Hiring a rep with a history for pure financial reasons or based purely on the recommendation of a colleague or friend is asking for trouble. The firm should consider asking the broker's permission to review complaint files against the broker maintained by a previous employer.

6. Supervisory and and Compliance Training

In addition to firm-wide training, supervisors should attend continuing education programs designed to enhance compliance training. Compliance training should be conducted throughout the firm and its branch offices. Attendance of educational and training programs should be well documented. The firm's compliance personnel should at least once a year conduct in-person interviews of with all reps including those not in retail sales.

7. Branch Office Reviews and Examinations

Legal and compliance officers should regularly review branch office activities. Regular--perhaps quarterly--reviews of customer accounts may be in order. Such reviews might detect churning, unsuitability, over-concentrations, unauthorized trading, and margin problems. Reviewing daily trading tickets for suspicious activity may detect violations. Surprise inspections may be appropriate for small offices with only a few representatives.

8. Documenting the Documents

An examination of all offices should disclose that all supervisory policies are written and documented. Reviews should be thorough and should determine that firm personnel received and used supervisory procedures in conducting firm business. Asking questions about supervisory manuals and documents is not enough. Supervisors and compliance officers should observe documents first hand.

9. Prompt Investigation of Wrongdoing

When violations are discovered firms and supervisors should act decisively to ensure that wrongdoing is investigated and ended. After learning of the problem, management must notify the legal, and compliance personnel responsible for investigating the matter. Delegating responsibility to investigate and correct problems solely to the branch manager or other lower-level employees, as discussed above, is not enough to withstand failure-to-supervise liability. Branch managers and others should cooperate fully with the compliance department's investigation of possible problems. An investigation should not end with hearing the representative's version of the facts. The customer must be interviewed about claims of fraudulent sales practices. Also consider whether restrictions on the activities of a representative under investigation is appropriate. Some investigations of broker misconduct might call for use of outside counsel. An investigation directed and conducted by outside legal counsel may allow the firm to assert the attorney-client and work product privileges when appropriate.

10. Customer Complaints

Related to the prompt investigation of wrongdoing, is the need to respond timely to customer complaints. The nature of the business generates customer complaints. In the long run, rapid response and evaluation of complaints by branch managers or other supervisors designated to respond to customer complaints limits and may prevent need for litigation. Branch managers and others who respond to complaints must view themselves more as compliance managers than sales managers.

11. Adequate Resources and Staffing

The CEO and other upper-level management must ensure that appropriate levels of resources and personnel exist to meet compliance demands commensurate with the nature and size of the firm's operations. The fact that a firm is small with limited personnel, far from absolving the head of the firm from supervisory liability, may mean that a CEO might be held directly responsible for supervisory lapses and wrongdoing. The supervisory responsibility of the CEO extends to other supervisors down the chain of command and requires the ability to follow up to make sure that violations are reviewed and corrective action taken.

12. New and Complex Products

In light of staggering losses over the last few years involving derivatives and other hybrid investment products, it behooves officers, legal and compliance employees to pay close attention to the firm's offering of new and complex products. The kinds of products firms are allowed to sell changes rapidly. Although it sounds simple, supervisors must make every effort to see to it that brokers explain directly to their customers the nature of the product and the risks involved no matter how complex the product or sophisticated the investor. Firms cannot expect to escape regulatory sanction by offering the simple defense that no matter what a representative may have told an investor, information in the prospectus was accurate.

13. Regulatory Developments

Finally, firms should recognize, if they haven't already, that a great deal of Monday-morning quarterbacking occurs in the regulatory environment. The lack of a bright-line test for determining whether there has been a failure to supervise is troubling to many. Strong arguments can, however, be made for not having such tests or standards. Nevertheless, the regulatory system is imprecise at best. There simply is no immutable, comprehensive source for determining the applicable rules, regulations, or policies which determine how a regulator might view supervisory responsibility for a particular violation. Often, ever-changing new agency releases, agency positions, administrative decisions, as well as some regulations, simply do not filter down to smaller firms in the ways that large firms are able to monitor and receive information about new developments. In short, continuous regulatory developments require the firm's management, compliance and legal personnel to be circumspect in protecting the firm and themselves from supervisory liability.