Expanded Supervisory Liability for In-House Lawyers

In-house lawyers, beware ' your exposure to potential supervisory liability may extend far beyond the confines of the legal department. In In the Matter of Theodore W. Urban, 2010 WL 3500928 (SEC Release No. 3-13655, Sept. 8, 2010), an SEC Administrative Law Judge held that an in-house lawyer at a broker-dealer with no direct supervisory authority over a retail financial adviser was, nonetheless, that financial adviser's “supervisor” under the federal securities laws.

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 adviser's supervisor is a disquieting development for all in-house lawyers at broker-dealers. Moreover, because failure to supervise liability can be asserted against investment advisers under Sections 203(e)(6) and 203(f) of the Investment Advisers Act of 1940, in-house lawyers at registered and unregistered investment funds could also be subject to this expansion of supervisory liability under the Urban holding.

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. In this role, Mr. Urban reported to Roger Calvert, the CEO of FBW, and headed three FBW departments: compliance, human resources and internal audit. Mr. Urban also served as a voting member of FBW's Board of Directors and Executive Committee, and the firm's Credit Committee.

Mr. Urban had no direct authority over the retail sales department of FBW, which housed the firm's financial advisers. Id. at *35. Instead, the retail sales department had line business managers who were responsible for supervising financial advisers in the department and possessed the traditional tenets of supervision, namely the ability to hire, fire, discipline, promote and set compensation for financial advisers. Id. at *3, *5, *35 and*53.

The SEC alleged that from 2003-2005, one of FBW's financial advisers, 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, and “marking the close” and manipulating trading in shares of Innotrac. Id. at *39. It also charged that, during the time he was committing these violations, Mr. Glantz's supervisors in the retail sales department failed to take any actions to stop his illicit trading activity. Id. at *50. While the SEC did not file “failure to supervise” charges against Mr. Glantz's immediate branch managers, it charged the head of retail sales and the assistant head of retail sales with failing to supervise Mr. Glantz. See In the Matter of Louis J. Akers, 2009 WL 2857622 (SEC Release No. 3-13612, Sept. 4, 2009); In the Matter of Patrick J. Vaughan, 2009 WL 321331 (SEC Release No. 3-13367, Feb. 10, 2009).

For his part, Mr. Urban, who became aware of Mr. Glantz's behavior through a memorandum from the head of compliance, raised the issue of Mr. Glantz's improper conduct on numerous occasions in 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 Mr. Glantz more closely, the SEC maintained that they did not take sufficient action. Id. at *50.

After becoming frustrated with upper management's reluctance to monitor Mr. Glantz appropriately, Mr. Urban eventually recommended that senior management terminate Mr. Glantz for his improper conduct. Senior management rejected Mr. Urban's recommendation and even questioned his motives, asking why he “wanted to drive a good producer out of the firm.” Id.

Mr. Urban went on administrative leave in November 2006 and resigned from the firm in March 2007. Id. at *38. In September 2007, Mr. Glantz pleaded guilty to criminal charges arising out of his conduct at FBW. Id.

The ALJ's Legal Reasoning

In ruling that Mr. Urban was Mr. Glantz's “supervisor” under the federal securities laws, ALJ Brenda Murray cited to a 1992 report of investigation that the SEC has relied on to define the contours of supervision. See John H. Gutfreund, 51 SEC 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. The CLO viewed this action as criminal and urged senior management to report it to the authorities. The CLO and the three senior executives, however, did not investigate or discipline the trader, or inform the government of the improper conduct for several months, during which time the illegal activities continued.

On these facts, the commission reasoned that because the CLO had the “requisite degree of responsibility, ability or authority to affect” the trader's conduct, and 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 Mr. Urban's efforts to seek enhanced supervision of Mr. Glantz and Mr. Urban's colleagues' inadequate supervision of Mr. Glantz, ALJ Murray nonetheless held that Mr. Urban was Mr. Glantz's supervisor. See Urban, 2010 WL 3500928, at *50-51. In so holding, ALJ Murray noted that, like the CLO in Gutfreund, Mr. Urban had the “requisite degree of responsibility, ability or authority to affect” Mr. Glantz's conduct. Id. (citing Gutfreund, 51 SEC at 113). ALJ Murray reasoned that, because he was general counsel, FBW personnel viewed Mr. Urban's opinions on legal and compliance issues as “authoritative” and “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 Mr. Urban was not in charge of FBW's response to Mr. Glantz's misconduct, ALJ Murray found that he nonetheless dealt with Mr. Glantz in his role as a member of the Credit Committee, and therefore shared in the responsibility to respond appropriately to Mr. Glantz's actions. Id. at *51 (citing Kirk Montgomery, 55 SEC 485, 500-02 (2001) (the fact that a manager's decision-making authority could be overruled is insufficient to relieve that manager of supervisory authority)).

Implications of the Decision

ALJ Murray did not 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 even where they have limited contact with employees outside of the legal and compliance departments. In ruling that Mr. Urban was a supervisor, ALJ Murray may have substantially altered the role of legal and compliance staff at broker-dealers.

ALJ Murray's conclusion that Mr. Urban was Mr. Glantz's supervisor contradicts the usual distinction between line business managers and legal and compliance staff at broker-dealers. Traditionally, consistent with regulatory notices and securities industry rules, line supervisors have been primarily responsible for overseeing financial adviser compliance with the securities laws. See NASD Notice to Members (NTM) 04-71 at 838 n.5 (October 2004) (“responsibility for discharging compliance policies and written supervisory procedures rests with the firm's business line supervisors, [who] are the persons responsible for executing the supervisory policies and procedures that Rule 3010 requires firms to establish and adopt”); FINRA, Rule 3130, Supp. Mat. 07, Effect of Certification on Business Line Responsibility (“The FINRA Board of Governors recognizes that supervisors with business line responsibility are accountable for the discharge of a member's compliance policies and written supervisory procedures”).

Accordingly, the overwhelming majority of the commission's failure to supervise proceedings have been brought against line business managers who were specifically charged with supervisory authority and had the “requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.” In the Matter of George J. Kolar, Admin. Proc. File No. 3-9580, Exchange Act Release No. 46127 (June 26, 2002) (quoting In the Matter of John H. Gutfreund, Thomas W. Strauss, and John W. Meriwether, 1992 WL 362753 (Exchange Act Release No. 31554, Dec. 3, 1992) (internal quotations omitted).

By comparison, legal and compliance staff at broker-dealers have focused on advising, developing, and monitoring policies and procedures, particularly as rules change. The general counsel or chief legal officer, in particular, has specific responsibility to investigate potential violations of law and ensure that senior management responds appropriately to evidence of misconduct. See 17 C.F.R. 205.3 (chief legal officer has the responsibility to initiate inquiries into evidence of a material violation as he or she reasonably believes is appropriate to determine whether the material violation “has occurred, is ongoing, or is about to occur,” and if so, shall “take all reasonable steps to cause the issuer to adopt an appropriate response”).

SEC precedent has similarly observed the distinction in the role of legal and compliance staff as compared to that of line supervisors. See, e.g., In the Matter of Arthur J. Huff, 1991 WL 291561, at *6, (Exchange Act Release No. 29,017, March 28, 1997). Indeed, the ability to give objective compliance advice, without being overly concerned with personal liability ' including the possibility of losing the ability to practice before the commission ' has been critical to allowing legal and compliance staff to remain focused on ensuring that broker-dealers establish the appropriate compliance policies and procedures to prevent securities law violations. See, e.g., In the Matter of Scott G. Monson, 2008 WL 2574441, at *4 (Exchange Act Release No. 28323, June 30, 2008).

ALJ Murray's decision may not be the last word on this subject. Currently there are cross-appeals pending before the commission ' the Division of Enforcement appealed the finding of no liability against Mr. Urban, and he appealed the finding that he was Mr. Glantz's supervisor. See In the Matter of Theodore W. Urban, 2010 WL 5092728, at *2 (SEC Release No. 63456, Dec. 7, 2010). The commission has received briefing from both the parties and amici curiae and will review the matter de novo. Whether the commission upholds ALJ Murray's analysis of supervisory liability or reaches a different conclusion, legal and compliance staff at broker-dealers likely await its ruling with great interest.

Practice Points

Notwithstanding the pending appeal of Urban, ALJ Murray's broad holding means that legal and compliance staff are 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 consider whether it is prudent to create a written report of their internal investigation of possible misconduct by a financial adviser in order to guard against a later finding
  by a regulator that they failed to supervise the financial adviser. Instead of recording the facts developed in the
  investigation, the report would record any supervisory steps recommended 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 adviser (including advising against heightened supervision that is recommended by line management), they should be certain to monitor the financial adviser'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 adviser's conduct. Any delegation to a line manager should be memorialized 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, making certain they fully understand the scope of their role on those committees.

James Q. Walker and Daniel C. Zinman are partners in Richards Kibbe & Orbe's New York office. Grant Mogan is an associate in the litigation department of the firm, also in the New York office. This article also ran in the New York Law Journal, an ALM sister publication of this newsletter.

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In-house lawyers, beware ' your exposure to potential supervisory liability may extend far beyond the confines of the legal department. In In the Matter of Theodore W. Urban, 2010 WL 3500928 (SEC Release No. 3-13655, Sept. 8, 2010), an SEC Administrative Law Judge held that an in-house lawyer at a broker-dealer with no direct supervisory authority over a retail financial adviser was, nonetheless, that financial adviser's “supervisor” under the federal securities laws.

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 adviser's supervisor is a disquieting development for all in-house lawyers at broker-dealers. Moreover, because failure to supervise liability can be asserted against investment advisers under Sections 203(e)(6) and 203(f) of the Investment Advisers Act of 1940, in-house lawyers at registered and unregistered investment funds could also be subject to this expansion of supervisory liability under the Urban holding.

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. In this role, Mr. Urban reported to Roger Calvert, the CEO of FBW, and headed three FBW departments: compliance, human resources and internal audit. Mr. Urban also served as a voting member of FBW's Board of Directors and Executive Committee, and the firm's Credit Committee.

Mr. Urban had no direct authority over the retail sales department of FBW, which housed the firm's financial advisers. Id. at *35. Instead, the retail sales department had line business managers who were responsible for supervising financial advisers in the department and possessed the traditional tenets of supervision, namely the ability to hire, fire, discipline, promote and set compensation for financial advisers. Id. at *3, *5, *35 and*53.

The SEC alleged that from 2003-2005, one of FBW's financial advisers, 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, and “marking the close” and manipulating trading in shares of Innotrac. Id. at *39. It also charged that, during the time he was committing these violations, Mr. Glantz's supervisors in the retail sales department failed to take any actions to stop his illicit trading activity. Id. at *50. While the SEC did not file “failure to supervise” charges against Mr. Glantz's immediate branch managers, it charged the head of retail sales and the assistant head of retail sales with failing to supervise Mr. Glantz. See In the Matter of Louis J. Akers, 2009 WL 2857622 (SEC Release No. 3-13612, Sept. 4, 2009); In the Matter of Patrick J. Vaughan, 2009 WL 321331 (SEC Release No. 3-13367, Feb. 10, 2009).

For his part, Mr. Urban, who became aware of Mr. Glantz's behavior through a memorandum from the head of compliance, raised the issue of Mr. Glantz's improper conduct on numerous occasions in 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 Mr. Glantz more closely, the SEC maintained that they did not take sufficient action. Id. at *50.

After becoming frustrated with upper management's reluctance to monitor Mr. Glantz appropriately, Mr. Urban eventually recommended that senior management terminate Mr. Glantz for his improper conduct. Senior management rejected Mr. Urban's recommendation and even questioned his motives, asking why he “wanted to drive a good producer out of the firm.” Id.

Mr. Urban went on administrative leave in November 2006 and resigned from the firm in March 2007. Id. at *38. In September 2007, Mr. Glantz pleaded guilty to criminal charges arising out of his conduct at FBW. Id.

The ALJ's Legal Reasoning

In ruling that Mr. Urban was Mr. Glantz's “supervisor” under the federal securities laws, ALJ Brenda Murray cited to a 1992 report of investigation that the SEC has relied on to define the contours of supervision. See John H. Gutfreund, 51 SEC 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. The CLO viewed this action as criminal and urged senior management to report it to the authorities. The CLO and the three senior executives, however, did not investigate or discipline the trader, or inform the government of the improper conduct for several months, during which time the illegal activities continued.

On these facts, the commission reasoned that because the CLO had the “requisite degree of responsibility, ability or authority to affect” the trader's conduct, and 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 Mr. Urban's efforts to seek enhanced supervision of Mr. Glantz and Mr. Urban's colleagues' inadequate supervision of Mr. Glantz, ALJ Murray nonetheless held that Mr. Urban was Mr. Glantz's supervisor. See Urban, 2010 WL 3500928, at *50-51. In so holding, ALJ Murray noted that, like the CLO in Gutfreund, Mr. Urban had the “requisite degree of responsibility, ability or authority to affect” Mr. Glantz's conduct. Id. (citing Gutfreund, 51 SEC at 113). ALJ Murray reasoned that, because he was general counsel, FBW personnel viewed Mr. Urban's opinions on legal and compliance issues as “authoritative” and “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 Mr. Urban was not in charge of FBW's response to Mr. Glantz's misconduct, ALJ Murray found that he nonetheless dealt with Mr. Glantz in his role as a member of the Credit Committee, and therefore shared in the responsibility to respond appropriately to Mr. Glantz's actions. Id. at *51 (citing Kirk Montgomery, 55 SEC 485, 500-02 (2001) (the fact that a manager's decision-making authority could be overruled is insufficient to relieve that manager of supervisory authority)).

Implications of the Decision

ALJ Murray did not 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 even where they have limited contact with employees outside of the legal and compliance departments. In ruling that Mr. Urban was a supervisor, ALJ Murray may have substantially altered the role of legal and compliance staff at broker-dealers.

ALJ Murray's conclusion that Mr. Urban was Mr. Glantz's supervisor contradicts the usual distinction between line business managers and legal and compliance staff at broker-dealers. Traditionally, consistent with regulatory notices and securities industry rules, line supervisors have been primarily responsible for overseeing financial adviser compliance with the securities laws. See NASD Notice to Members (NTM) 04-71 at 838 n.5 (October 2004) (“responsibility for discharging compliance policies and written supervisory procedures rests with the firm's business line supervisors, [who] are the persons responsible for executing the supervisory policies and procedures that Rule 3010 requires firms to establish and adopt”); FINRA, Rule 3130, Supp. Mat. 07, Effect of Certification on Business Line Responsibility (“The FINRA Board of Governors recognizes that supervisors with business line responsibility are accountable for the discharge of a member's compliance policies and written supervisory procedures”).

Accordingly, the overwhelming majority of the commission's failure to supervise proceedings have been brought against line business managers who were specifically charged with supervisory authority and had the “requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.” In the Matter of George J. Kolar, Admin. Proc. File No. 3-9580, Exchange Act Release No. 46127 (June 26, 2002) (quoting In the Matter of John H. Gutfreund, Thomas W. Strauss, and John W. Meriwether, 1992 WL 362753 (Exchange Act Release No. 31554, Dec. 3, 1992) (internal quotations omitted).

By comparison, legal and compliance staff at broker-dealers have focused on advising, developing, and monitoring policies and procedures, particularly as rules change. The general counsel or chief legal officer, in particular, has specific responsibility to investigate potential violations of law and ensure that senior management responds appropriately to evidence of misconduct. See 17 C.F.R. 205.3 (chief legal officer has the responsibility to initiate inquiries into evidence of a material violation as he or she reasonably believes is appropriate to determine whether the material violation “has occurred, is ongoing, or is about to occur,” and if so, shall “take all reasonable steps to cause the issuer to adopt an appropriate response”).

SEC precedent has similarly observed the distinction in the role of legal and compliance staff as compared to that of line supervisors. See, e.g., In the Matter of Arthur J. Huff, 1991 WL 291561, at *6, (Exchange Act Release No. 29,017, March 28, 1997). Indeed, the ability to give objective compliance advice, without being overly concerned with personal liability ' including the possibility of losing the ability to practice before the commission ' has been critical to allowing legal and compliance staff to remain focused on ensuring that broker-dealers establish the appropriate compliance policies and procedures to prevent securities law violations. See, e.g., In the Matter of Scott G. Monson, 2008 WL 2574441, at *4 (Exchange Act Release No. 28323, June 30, 2008).

ALJ Murray's decision may not be the last word on this subject. Currently there are cross-appeals pending before the commission ' the Division of Enforcement appealed the finding of no liability against Mr. Urban, and he appealed the finding that he was Mr. Glantz's supervisor. See In the Matter of Theodore W. Urban, 2010 WL 5092728, at *2 (SEC Release No. 63456, Dec. 7, 2010). The commission has received briefing from both the parties and amici curiae and will review the matter de novo. Whether the commission upholds ALJ Murray's analysis of supervisory liability or reaches a different conclusion, legal and compliance staff at broker-dealers likely await its ruling with great interest.

Practice Points

Notwithstanding the pending appeal of Urban, ALJ Murray's broad holding means that legal and compliance staff are 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 consider whether it is prudent to create a written report of their internal investigation of possible misconduct by a financial adviser in order to guard against a later finding
  by a regulator that they failed to supervise the financial adviser. Instead of recording the facts developed in the
  investigation, the report would record any supervisory steps recommended 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 adviser (including advising against heightened supervision that is recommended by line management), they should be certain to monitor the financial adviser'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 adviser's conduct. Any delegation to a line manager should be memorialized 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, making certain they fully understand the scope of their role on those committees.

James Q. Walker and Daniel C. Zinman are partners in Richards Kibbe & Orbe's New York office. Grant Mogan is an associate in the litigation department of the firm, also in the New York office. This article also ran in the New York Law Journal, an ALM sister publication of this newsletter.

For Twitter, LinkedIn and Facebook followers, click here to subscribe to The Corporate Counselor newsletter at a special introductory rate of $349. This offer is valid for new subscribers only.