NASD Appeal, control person liability.
Time between appeal and decision - 10 months, 0 days.
Time between last brief and decision - 7 months, 0 days.
Pages - 26
Comment
NASD found that respondent (the president of a broker-dealer) failed to supervise a branch office and failed to establish and enforce an adequate supervisory system. He was also found liable for violations of NASD rules concerning failing to register a registered representative and principal, failure to report customer complaints to the NASD and other rule violations. Respondent was barred in all capacities, ordered to pay restitution to customers of $3.8 million plus interest, and assessed costs of $9,500. Because the Commission dismissed findings of control person liability, the matter was remanded for a redetermination of sanctions.
This case presents a classic failure to supervise situation, unfortunately very typical of some small firms. It is of interest for its laundry list of fairly obvious supervisory failures.
Almost as an afterthought, at the conclusion of the opinion, the Commission makes a startling pronouncement about the scope of control person liability under Exchange Act Sectcion 20(a). The Commission found that Respondent did not have control person liability for violation of NASD Rules of Conduct because he did not personally participate in the underlying violative conduct. The opinion supports this strange conclusion by distinguishing the two cases relied on by the NASD, finding that in each, the presidents of the firms had actual personal involvement in the underlying conduct. Thus, 20(a) liability is being limited to actual participants in the underlying conduct. This is a remarkable pronouncement because, without extensive analysis, it seems to narrowly limit the scope of Section 20(a) liability beyond the specific language and clear intent of the statue simply because cases cited by the NASD involved personal involvement. Further, such a reading would render Section 20(a) unnecessary as persons with knowledge will usually be liable as direct participants or as aiders and abetters. The Commission's analysis obviously begs the question of why the statute itself should be so interpreted. Query whether the Commission believes that this qualification should apply in all potential Section 20(a) contexts? One has to wonder why such a significant matter is dealt with summarily and with so little discussion. Also, the Commission simply announced that it found the record did not support control person liability under Exchange Act Section 20(a) for respondent based on violations of Exchange Act Section 10(b) by salesmen. It unfortunately offered no explanation for this pronouncement.
In an ambiguous footnote 31, the Commission implies that a person who cannot hire and fire, reward and punish, cannot be a supervisor. Surely the Commission does not mean that this footnote be taken literally and instead it should be interpreted to mean that ability to hire and fire is simply a factor in determining on a case by case basis whether a person is in fact a supervisor. This is because there are in fact supervisors who do not have the ability to hire and fire.
Key Points
- "Assuring proper supervision is a critical component of broker-dealer operations."
- Whether a particular supervisory system or written procedures is "in fact reasonably designed to achieve compliance" is a fact specific inquiry.
- "The president of a brokerage firm is responsible for the firm's compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties."
- Compliance systems must be tailored specifically to the firm's business and must address the activities of all of its reps and associated persons.
- Firm's president, CEO, financial and operations principal, and compliance officer had ultimate responsibility for the firm's operations.
- Even if there is a chain of qualified supervisors in the chain of command, "it is not sufficient for the person with overarching supervisory responsibilities to delegate supervisory responsibility to a subordinate, even a capable one, and then simply wash his hands of the matter until a problem is brought to his attention. . . . Implicit is the additional duty to follow up and review that delegated authority to ensure that it is being properly exercised." Here Kresge failed in that duty because he made no inquiry of his subordinate supervisors about anything happening at the branch office except it's financial performance.
- Respondent's argument that he delegate supervisory responsibility to others was rejected because, among other things, there is "an obvious need to keep [a] new office with . . . untried personnel under close supervision."
- Supervisory procedures were not specifically changed and tailored to reflect the fact that this very small firm acquired a new branch office.
- Supervisory procedures must set forth a specific chain of command and describe the division of supervisory duties in each office.
- Respondent cannot escape his supervisory failures by the fact that the NASD staff approved the firm's written procedures.
- Registered reps who change firms frequently in a short period are a red flag for compliance and supervision issues.
- A registered rep with a criminal conviction, or a pending customer arbitration, or less than two years of industry experience present supervisory red flags.
- Firms are required to make reasonable efforts "to determine that all supervisory personnel are qualified by virtue of experience or training to carry out their assigned responsibilities." Respondent failed in this duty concerning a branch manager who had only 6 months previously passed the principal's exam, had repeatedly changed firms in the last 5 years, and because he did not contact any of the manager's previous employers.
- Respondent had a duty to supervise the supervisor of the branch office, and failed to do so. He never reviewed any of the office's records and made no attempt to review the branch manager's performance. Although there was another individual designated as the immediate supervisor of the branch manger, that individual had been with the firm for only 6 months, had a wide variety of other duties, including personal customer accounts which Respondent knew were "overwhelming." Further, that individual almost never actually visited the branch office. Respondent also knew that individual did not review suitability of transactions in the branch office.
- The fact that someone has passed the supervisory exam does not automatically qualify them to be a supervisor. The firm must still determine that the individual can "effectively conduct their . . . responsibilities."
- An individual who negotiated the sale of a branch office, which he financed and owned, to the firm, was often present at the office was an associated person who should have been registered with the NASD. This is because he financed the office, was actively involved in hiring and firing, participated in meetings, and purported to act as the leader of registered reps in the office.
- Respondent's recantation at the hearing of previous sworn testimony was rejected by the hearing panel which credited his earlier inculpatory testimony. The Commission noted that "credibility determinations of an initial fact finder are entitled to considerable weight" and declined to overturn that determination.
Addition Discussion
Respondent has been in the industry since 1978 and founded the broker dealer in 1986. He was president, CEO, financial and operations principal, and owned 95 percent of the firm. He was the firm's compliance officer except during the period January 2002 through June 2002. The firm employed 10 persons and until January 2001 specialized in bonds, mutual funds, and listed securities.
In January 2001 the firm acquired a branch office that had 50 registered reps. In August 2001 the firm entered into an arrangement where it "acquired" another branch office in Brooklyn, purportedly controlled by one Ferragamo. There was no written agreement for this arrangement. In September 2001 on Ferragamo's recommendation, Respondent hired a branch manager for the Brooklyn office. The branch manager had worked for 6 firms in 5 years and Kresge did not contact any of them before hiring the manager. The new branch manager received no training. The office manager had passed the principal's examination only 6 months previously. Kresge also hired a number of registered reps for the Brooklyn office on Ferrigamo's recommendation, despite knowing that each had worked for a number of brokerage firms over a short period. Kresge knew none of these reps received a compliance manual and didn't know if they received any training concerning sales practices or suitability.
The Brooklyn branch primarily sold penny stocks, contrary to Ferragamo's representation to Kresge before the acquisition that it mainly sold listed securities. Other than casual conversations about the financial status of the branch office, Kresge did nothing to monitor the supervision of that office. Kresge never reviewed any records of the office, including records of customer complaints and customer account activity. He admitted that information in those records raised serious questions about the propriety of certain penny stock sales activity by the branch. Kresge knew that the person he had designated to supervise the branch manager was overwhelmed with other duties, but never monitored his supervision of the branch.
In January 2002, because the Brooklyn office was overwhelming, Kresge hired a consultant on compliance, who he made compliance officer in February 2002. The compliance director was supposed to revise the firm's written supervisory procedures as Kresge knew at the time that the current procedures did not establish a supervisory chain of command. A draft of revised procedures was distributed throughout the firm in March and April 2002. This draft did not deal with penny stocks or bonds. It did not provide for methods to detect violations or ensure compliance. Further, there was no chain of command specified. The duties of the new compliance director were unclear. He did not have hiring and firing authority. Before he left the firm in June 2002 he recommended that the firm begin tape recording of Brooklyn reps. He also recommended that sales scripts be banned. Kresge ignored these recommendations. In April 2002 Kresge learned that two Brooklyn reps were operating from an unregistered location. That office was closed and the reps were placed under heightened supervision based on customer complaints about their sales practices.
From October 2001 when it opened, until April 2002, three reps in the Brooklyn office engaged in egregious sales practice fraud in selling three penny stocks. Each was tiny, and had assets of less than $100,000, minimal revenues, and operating losses. Each had "going concern" opinions issued by their auditors. The three reps solicited firm customers to buy $8.3 million of the three penny stocks. They enthusiastically recommended the stocks to customers, predicted rising prices for the stocks, but failed to disclose the poor financial condition of the companies. Many of the customers were retirees who were not interested in, and had no history of investing in speculative stocks.
From October 2001 until January 2002, when Kresge was the firm's compliance director, the Brooklyn office sold $3 million of one of the penny stocks. Kresge admitted the firm never attempted to determine whether it was in compliance with rules pertaining to penny stocks.
NASD rules require firms to report customer complaints. While compliance director Respondent was responsible for doing so, yet he never reviewed customer complaint files and never discussed customer complaints with the manager of the Brooklyn office. Respondent claims he did not report complaints because he was unaware of them. This in itself demonstrates the failure of the firm's supervisory procedures.
The Commission dismissed findings by the NASD that Respondent was liable under Exchange Act Section 20(a) for various activities of registered reps as a control person. Without explanation the Commission simply found that the record did not support this conclusion.
