Failure to Supervise” is what industry regulators often call a violation of NASD Conduct Rule 3000. But that characterization is wrong. Rule 3000 actually requires each member to establish and maintain supervisory systems “reasonably designed” to achieve compliance. As such, the violation should be known as a “failure to reasonably supervise.”
The SEC says that supervisors have a duty to investigate so-called “red flags,” (or “irregularities”) and, where necessary, respond with prompt, decisive action. But the industry's cops (many of whom never worked a day in a branch office) often appear to think that detecting these red flags is as simple as seeing someone standing in your office doorway waving a crimson banner.
Case in Point
One branch manager fought back and won. In an August 8, 2006 decision, the NASD National Adjudicatory Council (NAC) decided that in the case of the Department of Enforcement vs. Respondent (Complaint #C9B0400), the NASD failed to prove that the branch manager did not reasonably supervise. The respondent, the branch manager for a 20-rep office (about 10,000 accounts with $1 billion in assets under management and about $10 million in commissions), was charged by NASD with failing to supervise a broker who engaged in excessive trading of mutual funds in two accounts. The broker settled with NASD for a six-month suspension and $22,500 in restitution. But the manager contested the charges and prevailed at a hearing, as well as on appeal to the NAC.
NASD Enforcement alleged that the respondent failed to respond to the five red flags listed below. But the NAC panel found that the manager did, in fact, respond reasonably.
- Broker's improper trading of mutual funds in customer's account.
NAC FINDING: Broker hid his improper switching for months by spacing purchases/sales and by transferring between open and closed-end funds. Manager acted reasonably once he discovered the potential irregularities.
- Broker's inconsistent explanations.
NAC FINDING: Manager pressed broker for additional explanations and sought clarifications, and, as such, reasonably accepted broker's rationale for making certain questionable trades.
- Customer's complaints at two meetings.
NAC FINDING: Manager instructed broker to maintain positions in order to avoid further commission charges, which was the customer's initial complaint. Further, once the firm's legal department intervened, the manager was restricted as to disciplinary action against the broker and from conducting further investigation.
- Broker's use of firm letterhead.
NAC FINDING: Broker drafted a letter rescinding the customer's complaint, which the client signed and sent to the firm. Although such use of company letterhead was a violation of firm policy, the manager was subject to the legal department's input and, in fact, placed the employee under closer supervision.
- Broker's further trading in customer's account.
FINDING: Manager placed broker under heightened supervision in connection with permitting the resumption of trading in the customer's account. The subsequent trades were in a higher-yielding bond fund and in no-load municipals.
For additional details of the NAC's decision in this case, go here:
www.nasd.com/web/groups/enforcement/documents/nac_red_disciplinary_decisions/nasdw_017620.pdf
To Err is Human
While second guessing may be the NASD's bread and butter, it is not a substitute for proving a case by the preponderance of the evidence. Not every sign unfolds itself with such clarity as to put a competent supervisor on immediate notice of a problem — particularly if the rep is engaged in a scheme to defraud and has undertaken steps to disguise his or her conduct. How do you prove that you reasonably responded to red flags or conducted a reasonable investigation? You should start by producing logs of conversations with customers/registered persons, copies of documentation and correspondence provided to/by them, and the reports you reviewed. Be prepared to show that you followed your firm's written supervisory procedures.
Regulators frequently see violations through the prism of hindsight — they have the luxury to connect dots that did not all exist when the supervisor was in the thick of a day on Wall Street. NASD may believe you could have done things better — and they should educate you so that in the future you can — but Monday morning quarterbacking is not the same as standing in the pocket while a 300 pound lineman is preparing to bore you into the ground.
Writer's BIO: Bill Singer is a practicing regulatory lawyer and the publisher of RRBDLAW.com