Failure to Supervise due to Investment Firms

All stockbroker/dealers, individuals and registered representatives that trade securities or act as brokers for traders must follow clearly defined rules and regulations. Rules are developed by The National Association of Securities Dealers (NASD) that govern the conduct of the securities industry, disciplines individuals and examines securities firms for compliance and firms who fail to comply. This private-sector regulation provides resource-intensive, tough, front-line regulation together with close oversight by the Securities and Exchange Commission (SEC). These rules of conduct for member firm or for every member include rules which require member firms to establish and maintain a system in order to “supervise” the activities of each registered representative.

Enforcement is a fundamental part of NASD’s mission. The association punishes wrongdoings with fines and suspensions and encourages member compliance. The NASD has the authority to remove individuals and firms who break the rules from being a part of the securities industry. The NASD initiates at least thousands of examinations “for cause” each year. Last year, more than 3,300 investigations were triggered by the customer complaints. The NASD conducts more than 2,600 audits per year.

In recent years, one of the most common problems that the NASD has uncovered is that the written procedures which are adopted by investment firms are often inadequate and they do not meet industry standards. In general, the procedures do not describe exactly what the firm will do in order to supervise the daily activities of their representatives. The Association had also discovered that some firms do not have any supervisory procedures and that is a serious violation. Members are required to maintain, establish, and enforce written supervisory procedures (WSPs), which must include the steps that ensure the firm is in compliance, who is responsible for the supervision, when the supervisory steps will be taken and how the supervision will be evidenced.

Last year, the SEC brought “failure to supervise” charges against four dealers and brokers and seven persons had registered with those firms. The cases were examples of various ways that investment firms need to structure their supervisory systems and compliance programs and how the four firms failed. Each of the presidents of the dealers and brokers was charged with failure to supervise along with other related charges. The SEC alleged an assortment of misconduct by the brokers which included unauthorized and unsuitable trading and the theft and churning of client funds. In bringing these cases, the importance of dealers and brokers utilizing unannounced, internal inspections of their employees’ activities on a routine basis, was emphasized by the SEC.

The SEC also highlighted the importance of:

• Senior management which ensured that adequate compliance procedures are in place and also that sufficient resources are devoted in implementing those procedures.

• Reassessing all the supervisory responsibilities on a regular basis.

• Special supervision of those individuals who have disciplinary histories.

• Adequate delineation of systems and supervisory responsibilities for follow-up and review.

• All customer complaints being thoroughly investigated.

The first failure to supervise enforcement action which was against an unregistered investment advisor was filed by the SEC in December 2003. Any previous failure to supervise the actions had only been brought against registered investment advisers. If you fail to reasonably supervise the unregistered advisor, the firm was found liable of misconduct, with a view to preventing violations of the federal securities laws. Charges included defrauding potential investors and investors by misrepresenting the management structure and risk management techniques of the firm, communicating inaccurate performance information and the attempted concealment and concealment of client financial losses.

The Commission barred the advisor to cease and resist all securities industry activities, from association with any investment firm, and ordered the advisor to pay a civil penalty of $15,000. The Commission had also suspended the supervisor from holding a supervisory capacity with any investment firm for a period of six months. In this case, the determination of appropriate sanctions included the Commission which considered the remedial acts taken by the supervisor. These acts included the payment of approximately $600,000 to reimburse the investors for their financial losses and the cooperation afforded to the Commission staff.

If you fail to take any reasonable supervisory action, including maintenance of accurate records of investments, and distributions from, investment funds, the proper valuations of funds positions, the review of daily trading activity and the separation of the trading and back office functions are serious violations. If a supervisor relies on a dealer or a broker reporting and they do not independently verify representations and other information made by the employee they are violating supervisory rules. A key reason for this rule is that the reliance of the “word of mouth” information often enables fraudulent activities to continue and delays the discovery of any misconduct.

Every available resource is used by the SEC Division of Enforcement to expose securities fraud. Supervisors are held responsible by the commission if they do not take reasonable care to ensure that their employees act in the best interests of investors. Whether unregistered or registered, employees of the investment advisers will and can be subject to enforcement action if they fail to act appropriately to protect their clients. If you rely on what an employee says, without any independent verification, it is not appropriate supervision and creates legal exposure for the supervisor and the investment firm.