Issue name: Failure to Supervise
Applicable law/agency: Securities and Exchange Commission (SEC), National Association of Securities Dealers (NASD)
Related topics: Securities, Stock Market Losses, Breach of Fiduciary Duty, Broker Fraud
Failure to Supervise
The National Association of Securities Dealers (NASD) mandates that member firms supervise all registered representatives under Rule 3010, which mandates that members retain customer records and transaction records in a format that can be reviewed. Member companies must create a system for monitoring representatives, educate employees about procedures, develop a system of record keeping for communications with the public, and report client complaints to the NASD. A frequent transgression noted by the NASD is companies’ tendencies to keep inadequate documentation of procedures. Often, supervisory procedures are not included. The NASD recommends that supervisory procedures include who is responsible for supervision, how the supervision will be conducted, when supervision will occur and how it will be documented.
Investment Firms Financially Liable for Failure to Supervise
All stockbroker/dealers, registered representatives, and individuals that trade securities or act as brokers for traders must follow clearly defined rules and regulations. The National Association of Securities Dealers (NASD) develops rules that govern the conduct of the securities industry, examines securities firms for compliance, and disciplines individuals and firms who fail to comply. This private-sector regulation provides tough, resource-intensive, front-line regulation together with close oversight by the Securities and Exchange Commission (SEC). These rules of conduct for every member or member firm include rules that require member firms to establish and maintain a system to “supervise” the activities of each registered representative.
Enforcement is a fundamental part of NASD’s mission. The association encourages member compliance and punishes wrongdoings with fines and suspensions. The NASD has the authority to remove firms and individuals who break the rules from being a part of the securities industry. The NASD initiates thousands of examinations “for cause” each year. Last year, more than 3,300 investigations were triggered by customer complaints. The NASD conducts more than 2,600 audits per year.
In recent years, one of the most common problems the NASD has uncovered is that the written procedures adopted by investment firms are often inadequate and do not meet industry standards. In general, the procedures do not describe exactly what the firm will do to supervise the daily activities of their representatives. The Association also discovered that some firms do not have any supervisory procedures that is a serious violation. Members are required to establish, maintain, and enforce written supervisory procedures (WSPs), which must include who is responsible for the supervision, the steps that ensure the firm is in compliance, 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 broker/dealers and seven persons registered with those firms. The cases were examples of the various ways that investment firms need to structure their compliance programs and supervisory systems and how the four firms failed. Each of the presidents of the broker/dealers was charged with failure to supervise along with other related charges. The SEC alleged an assortment of misconduct by the brokers, including unauthorized and unsuitable trading and the churning and theft of client funds. In bringing these cases, the SEC emphasized the importance of broker/dealers utilizing unannounced, internal inspections of their employees’ activities on a routine basis.
The SEC also highlighted the importance of:
• Senior management ensuring that adequate compliance procedures are in place and that sufficient resources are devoted to implementing those procedures.
• Reassessing supervisory responsibilities on a regular basis.
•Special supervision of individuals who have disciplinary histories.
• Adequate delineation of supervisory responsibilities and systems for follow-up and review.
• All customer complaints being thoroughly investigated.
In December 2003, the SEC filed its first “failure to supervise” enforcement action against an unregistered investment advisor. Previous failure to supervise actions had only been brought against registered investment advisers. By failing to reasonably supervise the unregistered advisor, with a view to preventing violations of the federal securities laws, the firm was found liable of misconduct. Charges included defrauding investors and potential investors by communicating inaccurate performance information, misrepresenting the management structure and risk management techniques of the firm and the concealment and attempted concealment of client financial losses.
The Commission barred the advisor from association with any investment firm, to cease and desist all securities industry activities and ordered the advisor to pay a civil penalty of $15,000. The Commission 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 considering the remedial acts taken by the supervisor. These acts included the payment of approximately $600,000 to reimburse investors for financial losses and the cooperation afforded to the Commission staff.