A tangled web: Compliance director liability under the securities laws

Fordham Journal of Corporate & Financial Law, 2003 by Pirraglia, Anthony

INTRODUCTION

The current economic environment is ripe with dissatisfaction. Investors are disappointed with the performance of the stock exchanges and are skeptical of the advice offered by brokers and their associates.1 The bankruptcy of Enron and the subsequently revealed accounting scandals have exacerbated the apprehension and distaste investors currently feel for management.2 These scandals have focused not only the attention of investors but also that of regulatory agencies on firms' compliance with regulations. The attention is sure to result in increased litigation and investigation in both the private and public sectors regarding compliance supervisory systems implemented by the various corporations.3 Among the targets will almost certainly be the legal compliance director of the broker-dealer firm, to whom the firm usually delegates the responsibility of investigating and preventing violations.

The role of the compliance director is a product of the securities laws passed by Congress in the early 1930s5 and the rules promulgated by the securities and Exchange Commission ("SEC" or "Commission"). Congress inserted provisions in the securities laws that required broker-dealers to supervise their subordinates.6 Specifically, [sec] 15 of the Securities Exchange Act of 1934 ("1934 Act") permitted the sanctioning of a broker-dealer who inadequately supervised the firm's employees.7 Section 15 of the 1934 Act also permitted sanctions against authorized agents of broker-dealers for the agents' failure to supervise.8 Congress included these provisions to initiate in-firm mechanisms ensuring the compliance of brokerages with the securities laws.9

In fulfilling this mandate, brokerages have created departments dedicated to analyzing the securities laws and investigating the internal workings of the brokers' offices to assess whether the employees and procedures comply with the securities laws.10 As the importance of these departments increase in the wake of accounting and reporting scandals, the directors of such departments shoulder a greater burden. This increased burden and responsibility seems to place them at greater risk for SEC enforcement actions and private litigation.

This Note discusses the requirements of the supervisory mandate of the federal securities regulations and the liability imposed on brokerage compliance directors through the courts and the administrative process. In addition, this Note addresses some contradictions and concerns apparent in the multiple roles often assumed by compliance directors. Part I discusses the current regulatory scheme regarding supervisory structures elaborated by the SEC. Part II discusses the sanctions the SEC can impose on those who breach their duty to supervise. Part III sets forth particular considerations relevant when an attorney or other professional is serving as the compliance director or compliance department staff member. Finally, Part IV attempts to distill a satisfactory supervisory structure from the SEC cases that will allow the brokerages and the compliance director to avoid liability.

I. SUPERVISORY REQUIREMENTS UNDER THE secURITIES LAWS AND ADMINISTRATIVE CASELAW

Broker-dealer firms often attempt to satisfy their regulatory duty of supervision by creating compliance departments." The departments are staffed with individuals who analyze the supervisory structure of the firm, investigate alleged violations by employees, and draft recommendations on the path the firm should follow to comply with the federally imposed mandates.12 The compliance department is sometimes staffed with attorneys, accountants, or other professionals,13 which brings up additional considerations that will be addressed later in this Note.

Compliance directors and department staff are often included in administrative proceedings before the SEC because of their role in ensuring compliance with the securities laws.14 In most cases, the Division of Enforcement ("Division"), the body that acts as prosecutor in SEC administrative actions, alleges that the compliance officer or director failed to adequately supervise the firm's employees.15 However, for liability to issue, the compliance officer must inhabit a supervisory role within the framework of the corporate structure.16 This finding is necessary because inherent in a supervisory role is the duty to reasonably oversee the subordinate and ensure the subordinates' compliance with the securities laws." After proving that the respondent is a supervisor, the Division must then prove that the brokerage house and the supervisor failed to manage the subordinate in a manner reasonably expected to prevent violations of the securities laws.18

A. The Evolving Standard of Compliance Directors and Personnel As Supervisors Within the Meaning of [sec] 15 (b) (4)

Before the Division of Enforcement will succeed in its failure-to-supervise claim, the Division must show that the compliance officer was a supervisor of the individual who violated the securities laws.19 Compliance personnel do not become supervisors merely because they occupy positions in the compliance department.20 Instead, the determination of whether a compliance director can be labeled a supervisor for purposes of [sec][sec] 15(b)(4)(E) and 15(b)(6) is quite factual and rests on the particularities of each case.21 The Commission has elaborated on a framework that can assist in assessing whether the compliance director was in a supervisory position vis-as-vis the offender.22