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The Business Lawyer

Winter 2022-2023 | Volume 78, Issue 1

Someone Should Have Done Something! A Critical Examination of Liability for Failure to Supervise Under Federal Securities Laws

Benjamin J. Catalano


  • There are few legal concepts as misunderstood or fraught with uncertainty as liability for failure to supervise to prevent misconduct by others. After careful study, Congress amended the Securities Exchange Act of 1934 to enhance the system of self-regulation to provide clear, affirmative supervisory duties for broker-dealers, with corresponding liability for them and their associates, as a necessary component to securities law enforcement. Almost immediately, the scheme was abandoned and replaced by an ersatz duty to supervise applied to individuals with regrettable results for institutional oversight.
  • This Article examines the nature of responsibility for supervision at common law, the sophisticated regime Congress created to impose specific supervisory obligations on broker-dealers and investment advisers, the misbegotten theory that replaced it, and the conditions for return to the original design.
Someone Should Have Done Something! A Critical Examination of Liability for Failure to Supervise Under Federal Securities Laws
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[A] duty omitted must be one which the party is bound to perform by law or contract, and not one the performance of which depends simply upon his humanity, or his sense of justice or propriety. In the absence of such obligations, it is undoubtedly the moral duty of every person to extend to others assistance when in danger; . . . and if such efforts should be omitted by any one . . . he would, by his conduct, draw upon himself the just censure and reproach of good men; but this would be the only punishment to which he would be subjected by society.

Companies are responsible for their employees’ misconduct; but that does not mean they are required to do anything to prevent it.

In 1964, Congress amended the Securities Exchange Act of 1934 to cause companies in the securities industry to do just that: Broker-dealers were relieved of administrative liability for violations of federal securities laws by their associates where they established and enforced programs reasonably designed to prevent and detect them. The perpetrators and their accomplices were subjected to discipline by the Securities and Exchange Commission. So were supervisors who failed to carry out their duties.

Initially, the SEC could not proceed directly against principals or employees of broker-dealers who committed or facilitated violations. A convoluted theory in administrative proceedings and settlements with the broker-dealers forced their ouster while enabling the companies themselves to avoid the severest discipline for isolated misconduct. The amendments authorized proceedings against individuals and provided them with hearing rights and other protections that were missing. They also created a sophisticated regime to prevent violations by incorporating oversight for compliance into the administrative operations of broker-dealers grounded in state law and self-regulation. Later, the scheme was applied to investment advisers.

The Commission abandoned the framework: first to overcome jurisdictional limits in cases that arose before the amendments; then to momentum in the theory it reinstated to deal with them. Its maxim reversed the extra incentive to supervise afforded by the revisions, transferred primary responsibility for oversight from companies to employees less capable of performing it effectively, and credited their reactions to wrongdoing over preventative measures. It was inherently arbitrary. Arguably, the approach has impeded development of systemic oversight envisioned by the law.

The need for effective supervision in a continuously growing, increasingly complex industry so crucial to the public welfare is unquestionable. It is an opportune time to reexamine statutory liability for failure to supervise in light of its objectives.

The Duty to Supervise at Common Law and Liability for It Under Federal Securities Laws

In order to understand the basis of liability for failure to supervise one has to keep in mind the nature of supervision relative to its consequences. It consists of action taken and not taken by someone to prevent harm inflicted by someone else on another person. In the securities industry, that might include a branch manager’s review of customer account activity to ensure securities recommended by a salesperson are not unsuitable. The manager is liable for it only if there is a duty to perform the function and it is not done or done improperly. The performance itself harms no one: If done properly, it benefits the customer who might have been harmed by the salesperson’s misconduct; if not, it merely withholds the benefit of that protection.

The Common Law Obligation to Prevent Misconduct

While the common law is replete with obligations to refrain from harming others, traditionally it does not compel action for someone else’s benefit. The latter, for the most part, is the province of morals and ethics. Courts, therefore, usually do not recognize a duty to protect, including intervention to prevent harm caused by someone else, unless it is imposed by statute. One can assume the obligation voluntarily in contract, but performance is not legally required and recourse for its omission typically is limited to an action by the beneficiary for the value of the benefit withheld. The quality of the loss distinguishes the duty from one at law. Thus, a person ordinarily is not legally responsible for failing to prevent a co-worker from performing an illegal act; although the person may be answerable to his or her employer or someone else on a promise to police the other’s conduct.

The same is true for the employer―natural person or entity. Regardless, an employer is responsible for an employee’s misconduct under the principle of respondeat superior at common law or similarly by statute. The liability is without fault: It does not require proof of causation or a wrongful state of mind by the principal. It is based on control. The policies behind it are twofold: (1) to induce the employer to supervise its employees and other agents to prevent their misconduct in connection with the enterprise; and (2) to reallocate the risk of loss associated with that misconduct. Each being a benefit, however, there is no legal obligation to do either that is enforceable separately. The employer simply is liable for the offense, whether it did everything in its power to prevent it or nothing at all. Its partners, shareholders, directors, officers, and other employees are not responsible on the same basis because normally they do not have the ability to accomplish the objectives by themselves. Nevertheless, because there are economic consequences to a company from an employee’s misconduct, its managing partners or directors may be obliged to protect against it as part of their fiduciary duties of care; while other partners, officers, and employees assigned to take precautions may be responsible for performing them properly. However, the duties are in contract or equity―not law. There is no legal obligation to do so.

Primary Obligations, Derivative Liability, and Failure to Supervise Under Federal Securities Laws

The federal securities laws impose certain duties on all or various categories of persons (individuals and entities) concerning securities activities in interstate commerce. Sections 5 of the Securities Act forbids anyone from offering or selling securities unless they are registered or the transaction is exempt. Section 17(a) makes it unlawful to do so by fraud or deception. Section 9(a) of the Exchange Act bans manipulative trading practices, while Section 10(b) and Rule 10b-5 outlaw all manner of conduct intended to defraud or deceive. Section 206 of the Advisers Act prohibits fraud, deception, manipulation, and other specified acts by an investment adviser. Other provisions impose reporting requirements on companies; compel filings by investors; regulate persons soliciting proxies or making tender offers; and require directors, officers, and large shareholders to report ownership and to disgorge short-swing profits in company shares.

Under Section 20(a) of the Exchange Act, any person who “controls” another person liable under any provision of the statute is liable to the same extent subject to an affirmative defense. The section is akin to respondeat superior. It provides a similar impetus―but no obligation―for principals to supervise their agents to prevent Exchange Act violations.

A broker-dealer is subject to comprehensive regulation under the Exchange Act. Among other things, it must register with the SEC, join an industry organization for regulating its professional behavior, maintain sufficient capital, protect customer assets, limit the extension of credit to customers, make and preserve books and records, and file financial and other reports. Section 15(c)(1) prohibits a broker-dealer from effecting, inducing, or attempting to induce the purchase or sale of a security “by means of any manipulative, deceptive, or other fraudulent device or contrivance” in contravention of SEC rules. It is responsible for the misconduct of persons under its control. An individual acting on behalf of a broker-dealer is an “associated person.” He or she is not required to register with the Commission, but must adhere to the anti-fraud and other provisions of general application under the federal securities laws and those specific to the person’s situation. Ordinarily, an associated person is not responsible for a violation by the broker-dealer or another associated person or required to prevent an offense by anyone. The Advisers Act provides for the registration of investment advisers and subjects them and their associates to disclosure and other substantive requirements. The only statutory provisions compelling oversight by broker-dealers and investment advisers require registrants to implement policies and procedures to protect against insider trading and other misuses of material, nonpublic information.

The SEC, however, has broad administrative authority. Under Section 15(b)(4) of the Exchange Act, it can institute disciplinary proceedings against a broker-dealer if the broker-dealer or any person associated with it “willfully violated any provision of [the federal securities laws]” or “willfully aided, abetted, counseled, commanded, induced, or procured [such a] violation by any other person” or “failed reasonably to supervise, with a view to preventing violations of such provisions . . . another person who commits such a violation, if such other person is subject to his supervision.” Section 15(b)(6)(A) authorizes proceedings against associated persons for the same offenses. Section 203(e) and (f ) of the Advisers Act provide for similar actions against investment advisers and their associates. Added to the Exchange Act as part of the 1964 Amendments, and to the Advisers Act in 1975, the provisions provide recourse against broker-dealers, investment advisers, and the individuals in varying degrees responsible for violations―the perpetrators, their enablers, and those who failed to supervise them. The sections themselves do not contain a duty to supervise. Like other bases for discipline, the grounds for supervisory liability originate outside of them―under other federal or state laws, SRO rules, or even foreign law. Responsibility rests primarily on broker-dealers’ and investment advisers’ discretionary efforts, which, if sufficient, prevent sanctions notwithstanding derivative liability for their associates’ misconduct. SRO rules requiring members to have comprehensive supervisory systems and procedures set expectations for broker-dealers. Normally, there is no supervisory liability for associates apart from those systems and procedures.

Supervisory Responsibility in Early SEC Enforcement Actions

Prior to 1964, the SEC could not discipline anyone other than a broker or dealer under the Exchange Act. Under Section 15(b), the Commission could revoke a broker-dealer’s registration if it found, after notice and opportunity for a hearing, that the action was in the public interest and the registrant or anyone controlling or controlled by it willfully violated the Securities Act or the Exchange Act. The broker-dealer was responsible without fault for its agent’s misconduct. The remedy, however, was extreme―effectively putting it out of business. In addition, under Section 15A(l)(2) or Section 19(a)(3), the Commission could suspend or expel a member from a securities association or exchange for violating the Exchange Act. The sanctions were less severe, but the provisions did not expressly provide for vicarious liability.

The SEC had no recourse against individuals. However, a broker-dealer could not maintain its NASD membership if it associated with someone who was the subject or the cause of an order of revocation, suspension, or expulsion, effectively banishing anyone who committed a violation or, more controversially, was instrumental in one. Aided by settlements in administrative proceedings, the Commission used a theory of supervisory responsibility to impose lesser sanctions on broker-dealers for isolated misconduct by their agents, to extend its reach over individuals, and to compel greater oversight by registrants.

The SEC Uses Supervision to Justify Lesser Sanctions Against Broker-Dealers and to Discipline Individuals

In an early SEC decision, a registered broker-dealer and NASD member employed a salesman who, acquiring bonds as agent for a corporate customer, made misleading statements to convince others to sell, then confirmed the trades as principal to hide profits. The conduct violated Section 17(a) of the Securities Act. The questions squarely before Commissioners Robert Healy, Sumner Pike, and Robert O’Brien were: Was the company responsible for the salesman’s misconduct? And, if so, what sanction was appropriate in the public interest?

The broker-dealer was responsible for the salesman’s violations under Section 15(b)(D) of the Exchange Act. The more difficult issue was whether it was liable itself under the section and as an NASD member for purposes of Section 15A(l). Citing evidence the customer considered the salesman to be the company’s agent, the Commissioners found his conduct “imputable” to the broker-dealer for purposes of Section 15(c)(1) and its rules. If vicarious liability was ambiguous under Section 15A(l)(2), nevertheless it was consistent with the statutory scheme and common law. It also allowed for lesser sanctions.

Faced with losing its ability to do business nationally, the broker-dealer insisted no one knew about the salesman’s misconduct. Invoking the policies behind vicarious liability, the Commissioners said that was irrelevant and criticized the company’s oversight.

[T]he protection of investors can obviously not be achieved if the firm is permitted to shield itself from the consequences of a subordinate’s undetected violations by pleading the very conditions which made the violations possible. It cannot, therefore, be allowed to point to the officers’ ignorance of the actual violations to insulate itself from the consequences of such actions. With responsibility imposed by statute upon the firm, and with business prudence, in addition, requiring the exercise of supervision, “wide eyed disavowals” of fraud committed by a subordinate can all too readily lead to a firm’s enjoying the fruits of wrongful conduct while avoiding the statutory consequences when such conduct is discovered.

They observed that “supervision” was a matter of “business prudence,” not a legal obligation, no less one under the federal securities laws. But the “public interest” hardly justified absolving liability that existed in large part to encourage oversight when it was missing. They were reluctant, however, to impose the harshest remedy for malfeasance “on the part of only one salesman out of many,” and suspended the company from the NASD for thirty days.

The SEC addressed supervision again a year later. The manager of the St. Louis “suboffice” of an established OTC broker-dealer headquartered in New York charged excessive, undisclosed mark-ups in numerous sales (mostly bonds) to customers (primarily three charitable funds), churned their accounts, and made fictitious or unauthorized trades. The manager, himself a registered broker-dealer and NASD member, was counter-party on some of the trades. Chairman Ganson Purcell and Commissioners Healy, Pike, and Robert McConnaughey, found the manager and the company violated Section 17(a) of the Securities Act and Section 15(c)(1) and Rule X-15C1-2 of the Exchange Act. The manager’s registration was revoked and he was expelled from the NASD. The issue was whether it was in the public interest for the company to suffer the same fate.

The broker-dealer was a substantial underwriter “that participated . . . in a larger number of registered issues than any other securities dealer.” It had five principal offices and twenty-four lesser offices across the country. St. Louis was supervised primarily by the midwest regional manager, a vice president and director, in the Chicago office. The manager was the region’s leading producer. He received 45 percent of the profit on business he generated; the regional manager earned 25 percent. The company professed its offices “enjoyed a high degree of independence” and “wide discretionary power over their own operations.” It emphasized the mischief was limited to “one of a large number of suboffices” and implored the repercussions for “the organization as a whole would injure a large number of people . . . who had no knowledge whatsoever of the violations.” The Commissioners countered that the public interest called for vigorous supervision to thwart bad behavior; nescience was no excuse when it ensued.

It is, of course, inherent in the very nature of a large organization that the bulk of transactions are handled by subordinates, that principal officers do not as a matter of course concern themselves with details, and that many officers and employees are ignorant of what other members of the organization may do. These facts make it especially imperative that the internal controls of such an organization be adequate and effective and that those in authority exercise the utmost vigilance whenever even a remote indication of possible irregularity reaches their attention.

They held up an arduous standard of oversight. But again it was to relieve liability―not to impose it. Any obligation, they affirmed, was prudential.

Although others were on notice of the manager’s transgressions, reprobation fell heavily on the regional manager:

With responsibility on [him] for the administration of [the broker-dealer’s] activities over a large area, he was, as far as the record shows, completely oblivious to the necessity for protecting the funds from [the manager’s] depredations, and a willing participant in the exorbitant profits therefrom.

Clearly, the Commissioners’ concerns went beyond substandard oversight. They observed, he “passed upon orders submitted by all salesmen in the area . . . including [the manager]” and “approved or fixed the prices on bonds sold . . . to the funds.” “He obviously was . . . aware of the spreads being charged them.” In their opinion, he knew enough about the excessive trading to be “deemed to have participated in the scheme.”

The broker-dealer was an “old organization” with no prior proceeding or evidence of misconduct elsewhere in the company, and the Commissioners credited steps taken “to increase the extent of supervision of its internal operations.” Still, the case had been made for revocation. They offered, however, “this result might well be avoided, and hardship on many innocent persons be made unnecessary, if [the manager] and [the regional manager] were separated from the organization,” and reserved action pending confirmation they were terminated. The case thus forced discipline against someone who apparently aided and abetted the violations apart from his oversight; although he was not in appearance. In the meantime, the company was suspended from the NASD for sixty days.

A Broader Theory of Supervisory Responsibility Extends Jurisdiction over Individuals and Commands Greater Oversight by Broker-Dealers

In 1961, Congress commissioned a broad study of the securities markets. The “Special Study of Securities Markets,” published two years later, reported that the period after World War II saw a dramatic increase in investors across the country, many with limited experience, met by corresponding growth in the brokerage industry. Many broker-dealers had large networks of branch offices great distances from headquarters. Rapid demand for salespersons in remote locations left many novices working beyond the watchful eye of seasoned professionals. Proper training and supervision were more important than ever to protect investors from incompetence and fraud by unscrupulous agents. The NASD and the NYSE adopted rules requiring minimum qualifications for representatives and internal controls to oversee their activities.

Competency and oversight became priorities for the Commission as well. But jurisdictional limits prevented it from addressing them directly. Instead, it exerted influence through legal theories and settlement tactics in enforcement cases. One effort involved re-characterizing supervision as a statutory obligation to discipline individuals perceived to have facilitated violations or done too little to prevent them.

Reynolds & Co. was a particularly egregious case. The order of proceedings alleged that between December 1, 1953, and January 9, 1959, the firm, a registered broker-dealer, “together with or aided and abetted by certain partners, branch managers, and employees,” traded excessively in customers’ accounts, made unauthorized trades, and coaxed investments by false or misleading information in willful violation of the anti-fraud provisions. The company also “permitted” the violations and the misappropriation of funds by another employee through inadequate supervision.

The action took place in the New York-based firm’s Chicago, Minneapolis, San Francisco, Berkeley, and Carmel, California, offices. In Carmel, a salesman abused discretion to burn through customers’ accounts. Under NYSE rules, discretionary authority had to be in writing and orders approved and initialed by a partner. The managing partner of the west coast offices, located in San Francisco, responsible for the accounts, did not endorse or review the transactions. He and the office manager were informed of a high volume of trades in two accounts, which they discussed with the salesman, but took no action. The partner relied on the office manager to monitor the salesman; the manager, in turn, trusted the salesman. In Chicago, another salesman made unauthorized trades in several accounts for over a year. The head cashier, the resident manager, and the resident partner were apprised of information that “should have resulted in the detection of the employee’s fraudulent activities,” including a complaint of unauthorized trading, several cancellations, and forged customers’ signatures on non-solicitation letters. In the Bay Area, an assistant manager and others in the Berkeley office engaged in a classic pump-and-dump scheme involving companies with interests in uranium claims in Utah. The west coast managing partner and the office manager knew about the promotions and stock sales despite a firm policy against recommending speculative investments. In Minneapolis, insufficient controls enabled a salesman to misappropriate funds, requesting cashier checks payable to customers and forging their signatures.

The broker-dealer and the partners and managers overseeing the offices submitted offers of settlement agreeing the Commission could find they “willfully violated” the anti-fraud and other provisions of the Securities Act and Exchange Act; the firm consented to suspension from the NASD, and the individuals agreed to findings they caused the suspension.

Chairman Edward Gadsby and Commissioners Harold Patterson and Earl Hastings found “[t]he activities in registrant’s branch offices . . . demonstrate serious and extensive misconduct by employees . . . and grave deficiencies in the supervision and internal control . . . by registrant and the individual stipulating respondents[.]” They recast supervision as an inexorable duty, its origin obscured in a footnote:

We have repeatedly held that brokers and dealers are under a duty to supervise the actions of employees and that in large organizations it is especially imperative that the system of internal control be adequate and effective and that those in authority exercise the utmost vigilance whenever even a remote indication of irregularity reaches their attention.

The omission was tantamount to “participation” in the underlying misconduct in “willful violation” of federal securities laws, notwithstanding the obligation resided outside of them.

The broker-dealer was suspended from the NASD for thirty days, based on the employees’ violations and its own failure to supervise them. The partners and managers, who did not commit the violations but nevertheless “participated” in them, including the firm’s supervisory offense, by their deficiencies in oversight, were found to have caused the suspension. Again, it was apparent there was as much if not more concern about their active involvement in the violations. Nevertheless, their official transgressions were a mixed bag of supervisory deficiencies under NYSE rules, firm policies and directives, and prudential norms. In addition to terminating the primary offenders, the firm, hoping to reduce its sanction, submitted: one of the branch managers “resigned by request”; one partner “has become a limited partner [with] no operating responsibilities”; the rest were “relieved of their supervisory responsibilities.”

The legal basis for disciplining the firm and its personnel for supervisory deficiencies was tenuous: The federal securities laws did not contain a duty to supervise and NYSE rules and internal policies and directives were not grounds for sanctions. The external obligations might have provided a causal nexus, but they were merely contractual. It was one thing to banish a person for intentionally committing or knowingly facilitating a violation; it was another to ban someone for failing voluntarily to prevent it. Certainly, it was disingenuous to equate the two.

In Reynolds, there was at least some evidence of suspicion if not outright knowledge of wrongdoing by the respondents. However, there was no such evidence in two cases against another broker-dealer shortly before the statutes were amended. In the first, nearly two dozen salesmen in four branch offices arranged for customers (mostly related accounts) to obtain credit from a factor that exceeded limits under Regulation T. The New York firm instituted a policy early on disallowing the practice. A branch manager in the Huntington, Long Island, office continued to encourage it, while he and others conspired with the lender to conceal the arrangements. In the second, a representative, working surreptitiously with a company’s controlling shareholder, and two other salesmen in the Washington, D.C. office sold unregistered shares of the company while the representative contemporaneously bid for and purchased the stock. The factoring arrangements violated Section 7(c) of the Exchange Act. The broker-dealer and the salesmen in the District of Columbia violated Section 5 of the Securities Act; the firm violated Section 10(b) and Rule 10b-6 of the Exchange Act.

The broker-dealer’s managing partner “was charged with the over-all responsibility for supervision of all the operations of the firm[.]” He issued the factoring prohibition but there were no procedural controls beyond disciplining individuals that violated it. He and the firm blamed the failure to discover the extent of the ongoing arrangements on the participants’ efforts to hide their activities and a “tremendous administrative burden” on the managing partner and others from increased business at the time. In Washington, D.C., the office manager, a general partner, inquired about the ability to sell the shares in exempt transactions. Unaware of the representative’s dealings with the controlling shareholder, the manager was shown information suggesting the company had sold a block of stock to the public with no indication the nominal accountholder was an affiliate. He approved trades with dealers only. He and the broker-dealer conceded the firm had a responsibility to assure customer sales complied with registration requirements. They contended the manager made a reasonable investigation and was deceived by the representative, “a victim and not a perpetrator of a fraudulent scheme.”

Chairman William Cary and Commissioners Manuel Cohen, Jack Whitney, and J. Allen Frear found the broker-dealer and its managing partner had a “responsibility . . . effectively to prevent violations of the credit regulations.” Given the firm’s previous involvement with the creditor, they had “to do more than issue notices, hold meetings and discipline some salesmen when and as instances of factoring came to [the managing partner’s] attention.” Despite its “policy and intent . . . more specific and self-executing procedures should have been instituted to discover and prevent factoring.” The managing partner in particular “should have made special inquiries or instituted special procedures to insure that [the owners] would not continue their factoring business with registrant or its representatives after [the prohibition].” The same Commissioners accepted the D.C. office manager was not involved in the scheme to distribute stock illegally, took steps to assure sales were proper, and was entitled to an extent to trust his subordinates. Nevertheless “there were factors present which should have called for a more searching inquiry and which indicate that effective supervision would have prevented the violations.”

The broker-dealer was liable for the underlying violations. However, in order to discipline the managing partner and the office manager, who, if they participated in them at all, did so unwittingly, supervision needed the imprimatur of the federal securities laws. In Sutro I, the Commissioners reasserted “brokers and dealers are under a duty to supervise the actions of employees” and reaffirmed expectations for an adequate and effective system of internal controls and utmost vigilance by those in authority to any indication of irregularity. Citing Reynolds, there was no reference to any external origin this time. Under similar accommodations, they found “for purposes of applying the sanctions” the broker-dealer’s supervisory deficiency constituted participation in the violations by the firm and its managing partner. The same in Sutro II.

The broker-dealer was suspended from the NASD for fifteen days in both cases, running concurrently; each partner was found to be a cause of the order of suspension, with limited impact. The sanctions were light, but a message was sent that comprehensive oversight was essential to compliance with the federal securities laws.

Congress Affirms Supervision Is an Industry Responsibility, Encourages Broker-Dealers to Develop Supervisory Systems and Authorizes the SEC to Discipline Individuals for Primary Violations, Aiding and Abetting, and Failure to Supervise

Early cases found the SEC’s administrative powers wanting in some respects and excessive in others. It could discipline broker-dealers but the sanctions were extreme and affected innocent people. It could not proceed against their associates but could punish them indirectly. The basis in “causation” was unlimited, the consequences were severe, and the individuals had no procedural rights. At the same time it became clear that to administer the securities laws effectively, broker-dealers, the principal instrumentalities for administering them, had to implement compliance and police adherence by their employees and others―issuers, lenders, correspondents, and customers―at least as it pertained to their businesses. Derivative liability provided some impetus, but no obligation. Sutro I sought to compel broker-dealers through management to establish supervisory policies and procedures and enforcement systems; Sutro II demanded performance from those assigned to administer them.

But the design lacked substance. There was no accepted cannon of supervision―evidenced by so many unsubstantiated pronouncements of what should have been done under the circumstances, which was infinitely clearer in hindsight. Actually, it depended on myriad considerations relating to operations, personnel, resources, and risks that did not lend themselves well to statutory prescription. It was questionable whether the SEC was in the best position to set those standards. In addition, it faced considerable jurisdictional constraints: Oversight ordinarily was a matter of corporate or firm governance controlled by state law, contract, and equity. And while the privilege to do business nationally might be conditioned on actions a broker-dealer had to take to supervise its employees and others, it was far from clear the Commission could compel a broker-dealer’s employees to perform functions―like examining trade blotters and statements―that did not involve their own activities in interstate commerce. Meanwhile, without reference to a statutory prescription or rule, establishing in disciplinary proceedings what a broker-dealer or an associate should have done under the circumstances smacked of legislating while adjudicating the case in violation of the separation of powers.

Those issues would be resolved in amendments enabling the Commission to discipline individuals for conduct that included violating the federal securities laws, aiding and abetting a violation, and failure to supervise under state law and industry standards.

The Special Study Recommends Increased Supervision by Broker-Dealers and Standards for Oversight

In commissioning the Special Study, Congress directed the SEC to review the adequacy of SRO rules for protecting investors and to report its findings and make recommendations including the need for additional legislation. The report followed a “very broad study of the rules, practices and problems of the securities business and the securities markets.” It reiterated the roles of the SEC and the SROs in the regulatory framework:

Under the statutory scheme of the Exchange Act, contemplating both Federal regulation and industry self-regulation, a natural division of labor allocates to the Commission control over clearly illegal selling practices . . . while improprieties in the nature of unethical practices are left to the industry bodies.

A section in the first part of the report, entitled “Supervision and Controls Over Selling Practices,” identified broker-dealers’ internal controls as the first level of investor protection in a system of overarching responsibility under SRO rules, state laws, and the federal statutes. It referred to an employer’s “legal duty to adequately supervise his salesforce”; though the motivation was attributed more accurately to the desire to stave off derivative liability and to comply with external supervisory commitments.

An examination of “internal supervision” identified three features of effective oversight: (1) centralized controls, (2) defined objectives, and (3) policies and procedures. Systems varied according to the size of the broker-dealer and its business; methods depended on practicality and expense. In larger companies, they included (1) executive management, audit programs, and computer support; (2) networks of supervisors, relying heavily on branch managers; (3) practices to review business in general; and (4) routines to monitor for specific abuses. But overall, the assessment was negative. Procedures were inadequate or did not exist in important areas. Findings of objectionable sales practices met with “neglect of the problem by home office supervisory personnel” in one case and “a total breakdown in supervision” in another. Although there was “growing awareness of the importance of adequate supervision,” more needed to be done.

A review of “external controls” focused on SEC and SRO rules and enforcement. It described the kinds of actions brought against broker-dealers under the federal securities laws. The Commission advised it could revoke a broker-dealer’s registration or suspend or expel it from the NASD or an exchange, but it could not “institute any administrative proceeding directly against an individual salesman.” Limited jurisdiction and remedies narrowed the cases it could bring. The NASD and the NYSE had broader authority. Both had rules requiring members to supervise their employees, but they were insufficient and not well enforced. As an ethical responsibility, however, it fell primarily to the industry to regulate supervision. Accordingly, the Special Study’s recommendations on the subject were directed to broker-dealers and the SROs:

The supervision by broker-dealers of the selling activities of their personnel, particularly in branch offices, should be generally strengthened by the adoption of appropriate procedures[.]

* * *

The self-regulatory agencies should establish clearer standards and stronger surveillance and enforcement procedures to assure more effective supervision by their member firms.

There was no mention of direct federal regulation in the area.

Congress Gives the SEC Authority to Discipline Individuals and Circumscribes Liability for Aiding and Abetting and Failure to Supervise

A year later, Congress passed the 1964 Amendments, addressing many of the issues and recommendations in the Special Study. Provisions for SEC administrative proceedings against broker-dealers were contained in Section 15(b)(5) (currently Section 15(b)(4)); grounds for discipline were expanded and itemized in subparagraphs (A) through (F). Advisers Act and Investment Company Act violations were included in subparagraph (D), while a new subparagraph (E) added willfully aiding or abetting a violation and failure to supervise to prevent one. The SEC was authorized to censure or to suspend a broker-dealer up to a year. As before, the Commission could sanction the broker-dealer if an employee or other “associated person” committed a violation. For the first time, under Section 15(b)(7) (currently Section 15(b)(6)(A)), it could proceed separately against the individual on “notice and opportunity for a hearing.”

The SEC had identified the need to discipline a broker-dealer’s representatives while limiting the effect on the broker-dealer. The Senate Report accompanying the bill explained:

At the present time, if an individual member or employee of a securities firm defrauds customers or otherwise violates the law . . . the Commission can take disciplinary action only by a proceeding against the entire firm, which, particularly in the case of large firms, may involve many people wholly innocent of the violation in question. This approach is awkward and may be unfair, and for this reason, violations by individuals may sometimes go unpunished.

Where appropriate, “the Commission would be authorized to proceed directly against offending individuals, in lieu of proceeding against the entire firm[.]”

The expansion did not shift liability away from the broker-dealer or diminish its supervisory responsibility. It remained accountable for associates’ misconduct based solely on control. However, under the new provision, supervision―the relevant consideration behind vicarious liability―could be evaluated for purposes of finding fault rather than relieving discipline. It increased the incentive to supervise by supplying a basis to avoid liability if it was performed properly. But while the amendments potentially curbed responsibility for broker-dealers, they broadened it for associates. Under the circumstances, it was important to define expectations, especially with respect to secondary liability.

Only affirmative conduct that willfully contributed to a violation was remediable under the aiding and abetting clause. Causation was not enough; mens rea was required. Innocent or negligent acts, the illegality of which could not be known ahead of adjudication, were excluded.

Supervisory liability also required clarification. Until then, only the broker-dealer was considered to have supervisory responsibility. Section 15(b)(5)(E) provided, in pertinent part:

The Commission shall, after appropriate notice and opportunity for hearing, by order censure, deny registration to, suspend for a period not exceeding twelve months, or revoke the registration of, any broker or dealer if it finds that such [action] is in the public interest and that such broker or dealer . . . or any person associated with such broker or dealer . . . has failed reasonably to supervise, with a view to preventing violations of [the federal securities laws], another person who commits such a violation, if such other person is subject to his supervision.

The broker-dealer was liable for its own deficiency as well as any lapse by an associated person. (An associate was responsible only for his or her omission.) Responsibility was limited to oversight for compliance with federal securities laws. Failure to supervise by itself was not grounds for discipline; there had to be a predicate violation.

Otherwise, the provision was quite open-ended: A broker-dealer and everyone associated with it―principals, employees, major shareholders, parent companies, subsidiaries (later, affiliates), their principals, employees, and agents―had supervisory responsibility. Anyone’s violation could trigger it―not just an associated person’s. The only limitation was that the person―individual or entity―had to be “subject to [their] supervision.” The term was undefined. The language did not specify what was required “reasonably to supervise, with a view to preventing violations”; or whether oversight was expected for all statutory provisions and rules, all the ways in which they could be violated, or just some of them (and if so, which ones). The broker-dealer and its associates potentially were responsible for monitoring compliance with laws that did not apply to their business, by persons with whom they had no professional relations. The shadow of supervisory liability eclipsed the ability to do anything else. And there was no authority to clarify or delineate expectations by rulemaking. It wasn’t necessary.

Supervisory Liability Is Based on Internal Systems and Procedures Subject to State Law and SRO Rules

Section 15(b)(5)(E) did not contain any duty to supervise. It referred to obligations outside the provision. States had laws of company governance and supervisory responsibility, and the Senate Report referred to “failure reasonably to supervise” under state blue sky laws. However, the main source of liability was expected to come from the policies and procedures of broker-dealers themselves, subject to SRO rules, as recommended by the Special Study. Increased reliance on self-regulation was central to the 1964 Amendments, and the SROs were considered the appropriate instrumentalities for regulating supervision as a professional or ethical obligation. Discussion of the provision came under the heading “Qualifications and Self-Regulation.” Legislators referred to non-compliance with SRO oversight requirements as grounds for discipline with other external offenses. At the time, the SEC’s Chairman wrote of the Commission’s advisory role in helping SROs develop their rules of supervision. Another Commissioner explained the provision was designed to “encourage” broker-dealers “to establish and enforce comprehensive supervisory procedures” to avoid derivative liability.

The NASD promptly revised Article III, Section 27, requiring members to “establish, maintain and enforce written procedures . . . to supervise properly the activities of each registered representative and associated person.” It mandated some specific routines but otherwise left it to members to formulate their own methods and objectives. They had to “designate a partner, officer or branch manager in each office of supervisory jurisdiction . . . to carry out the written supervisory procedures,” a copy of which had to be kept in the office. The member itself ultimately was responsible for supervision. The scope of the obligation was “to assure compliance with applicable securities laws, rules, regulations and statements of policy promulgated thereunder and with [NASD rules].” The rule established parameters for identifying who was a supervisor, who was subject to his or her supervision, and what he or she was required to do to supervise. Later, examinations were required to verify enforcement and to measure effectiveness. Eventually, other NASD rules called for monitoring certain activities of employees and service providers normally outside of the member’s control.

Section 15(b)(5)(E) accepted these criteria for establishing whether and to what extent a broker-dealer or associated person had an obligation to supervise a person who committed a violation. The basis essentially was contractual. While the antecedent duty was necessary under subparagraph (E), it did not foreclose derivative liability for the broker-dealer under subparagraph (D). For an associated person, however, responsibility rested essentially on what he or she agreed to do with respect to the person under the broker-dealer’s supervisory program. The Commission was given greater influence over SRO rules, including supervisory requirements.

The intention to rely primarily on industry parameters for purposes of supervisory liability was evident in the “SECO” provisions enacted at the same time. Membership in a securities association was not compulsory, and some OTC broker-dealers were not SRO members. A prior version of the bill would have required them to join the NASD. Instead, they were allowed to submit to direct regulation by the SEC and the Commission’s authority over them was expanded to mirror the NASD’s authority under Sections 15A.

Section 15(b)(8) of the Exchange Act prohibited a SECO broker-dealer from effecting OTC trades unless the broker-dealer and its associates adhered to SEC rules on training, experience, and other qualifications. Section 15(b)(10) prohibited the broker-dealer from doing business in contravention of rules designed “to promote just and equitable principles of trade . . . and . . . to protect investors.” The Commission subsequently adopted Rule 15b10-4, requiring a SECO broker-dealer to exercise “diligent supervision” over its associates’ securities activities. The broker-dealer was required to designate a qualified principal or employee to supervise each associate who would “be subject to [his or her] supervision.” It had to have written supervisory procedures, and one or more individuals had to review supervisors’ activities and inspect offices to ensure they were enforced. According to the House Report, the SECO provisions were added “to insure that the Commission has the necessary authority to provide regulation of nonmember brokers and dealers comparable to that imposed by associations on their membership[.]” That authority, including the power to define supervisory relationships and performances, was limited explicitly to SECO broker-dealers.

Rule 15b10-4, SRO rules, and the systems, policies, and procedures under them, together with applicable state laws, were the bases for supervisory liability under Section 15(b)(5)(E) and Section 15(b)(7). Exculpatory language was consistent with them and the desire to promote compliance with those regimes. It provided:

[N]o person shall be deemed to have failed reasonably to supervise any other person, if (i) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, in so far as practicable, any such violation by such other person, and (ii) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with.

The word “deemed” implied responsibility originated outside the provision; however, it was not actionable if the conditions in clauses (i) and (ii) were met.

Clause (i) related to the broker-dealer, which alone was required to have “procedures, and a system for applying [them] . . . to prevent and detect violations.” It was sufficient if they “would reasonably be expected to prevent and detect, in so far as practicable,” the offense. Rule 15b10-4 or SRO rules and other obligations informed expectations. Automatic liability, arbitrary or overly stringent standards had to be overlooked. Strict or excessive demands defeated the objective: to withhold discipline where the broker-dealer had a reasonable system of supervision. Arguably, good faith and rationality on the part of those charged with establishing, maintaining, and enforcing the system in compliance with external requirements was dispositive―management being in the best position to decide what was reasonable and practicable for the company under the business judgement rule.

Clause (ii) pertained mostly to associated persons. Unless a broker-dealer was a sole proprietor, enforcement of supervisory procedures had to be delegated. If an associate accepted the delegation, “the duties and obligations incumbent upon [him or her] by reason of such procedures and system” framed responsibility. There was no liability if they were reasonably discharged. The broker-dealer was responsible for a supervisor’s delinquency if there was reason to know about it. Likewise, the supervisor was answerable for a delegate’s performance.

Section 15(b)(5)(E) was artfully crafted to promote supervision by relieving broker-dealers of derivative liability for associates’ misconduct where they established and enforced reasonable systems of supervision that complied with industry standards. Discipline then centered on individuals more or less culpable in the line of causation: the primary violators; aiders and abettors; and associates derelict in their supervisory duties under the system. Language guarded against stricter standards that removed the incentive and protected individuals against un-assumed liability.

Unfortunately, the regime was ignored to overcome legacy constraints in pending enforcement actions. Early decisions after the amendments effectively reinstated automatic liability and advanced a tenet of supervision that undermined all the main objectives.

The SEC Disregards the Legislative Scheme for an Independent “Duty to Supervise” to Deal with Legacy Cases

Of course, the Commission continued to address cases arising before the amendments. One involved a classic boiler room operation and manipulation scheme. The president of a securities dealer and a number of associates fraudulently sold shares in a company they organized and charged excessive mark-ups in secondary sales. The president persuaded the head trader of another broker-dealer to publish “suggested” quotations for the stock at prices well above what the trader paid or received for the shares. No one else at the broker-dealer, a company of substantial size, was involved. Nevertheless, a hearing examiner recommended revoking its registration because of the trader’s actions.

Chairman Manuel Cohen and Commissioners Owens, Byron Woodside, Hamer Budge, and Francis Wheat agreed “[the trader] entered into an arrangement with [the president] to place quotations . . . pursuant to [his] instructions and thereby assist the latter in the creation of an artificial market.” Citing Reynolds, they said “the firm’s failure of supervision made it a participant in [the trader’s] misconduct[,]” finding “[the broker-dealer], together with or aided and abetted by [the trader,] . . . willfully violated the cited anti-fraud provisions.” If the 1964 Amendments were in effect, the Commission could have proceeded against the trader separately and found he manipulated the market or willfully aided and abetted the president’s fraud. Instead, in order to discipline him, it had to sanction the broker-dealer. The case, and others like it, set the stage for an eventual confrontation between the theory in Reynolds and the basis of supervisory liability contemplated by Section 15(b)(5)(E).

Less than three years later, the SEC decided an action involving a salesman in the Cleveland office of a large wire-house who misled customers about another client’s investments to entice them to trade excessively from 1962 to 1963. A hearing examiner recommended a four-month suspension for the salesman for personally violating the anti-fraud provisions. The examiner advised that proceedings against the broker-dealer and its office manager be dropped. The firm’s supervisory procedures, “although not above criticism, constituted a ‘reasonably acceptable system[.]’” And “while negligence [by the manager] in the enforcement of established procedures had been shown . . . the record did not establish that absent such negligence [the salesman’s] violations would have been prevented or detected.”

Chairman Cohen and Commissioners Owens, Budge, and Richard Smith agreed with the finding against the salesman, deciding to bar him instead, but not on the issue of oversight. In a footnote, they claimed:

Although Section 15(b)(5)(E) was not adopted until 1964 the standards of supervision which it prescribes in substance represented a codification of the standards which the Commission had established prior to 1964 through administrative adjudication.

“That Section,” they said, “requires reasonable supervision with a view to preventing violations of the securities acts.” Reynolds offered the criterion for evaluating it. In their opinion, “the[] procedures left important gaps,” and the broker-dealer and the manager “did not reasonably discharge their supervisory duties.” Both were censured. The examiner’s decision was consistent with the intentions behind Section 15(b)(5)(E). Seemingly little was accomplished by imposing the least possible sanctions. But Section 15(b)(7) was unavailable. So unless an order was issued against the broker-dealer, there was no basis for disciplining the salesman (whose conduct was egregious enough to warrant a much stiffer sanction).

At once, the rubric from an obsolete jurisdictional device replaced the SECO and SRO regimes for supervisory responsibility. Congress clearly intended to govern oversight through self-regulation. The Commission’s authority over it was limited to a small number of broker-dealers by rulemaking and influence over SRO rules for the rest (also subject to legislative process). The decision asserted the power over all broker-dealers and their associates by adjudication. Moreover, the formula was completely different: SECO and SRO rules provided for company-level responsibility, central administration, definite supervisory relationships, and procedures that emphasized proactive surveillance. The injunction in Reynolds diffused responsibility among employees, was silent on administration, shed no light on relationships or performances, and centered on reaction to evidence of wrongdoing. The implacable standard invoked to relieve vicarious liability clearly conflicted with the more measured one intended to promote greater oversight:

It is a rare violation that, when viewed in retrospect, cannot be said to have been preceded by at least “a remote indication” of an irregularity. And the stated obligation to exercise “utmost vigilance” makes virtually any oversight, no matter how minor, a potential basis for imposing sanctions against a firm.

There was no limit to the violations it covered. Not surprisingly, the SEC has never dismissed a failure-to-supervise claim against a broker-dealer.

The departure would hinder the development of supervisory systems and procedures by broker-dealers and investment advisers. It would affect more acutely individuals for whom “guarantor” liability was rejected and un-assumed, indefinite responsibility was anathema. With discipline no longer tied to procedures they agreed to perform with regard to particular individuals, two questions would continue to arise: “Who was a supervisor?” and “What was he or she supposed to do to avoid liability (if, indeed, that was possible)?” Answers, often inconsistent, would emerge over time through pronouncements in decisions and settlements. Unfortunately for those involved, the effects were retroactive.

The “Reynolds Doctrine” Breeds Ambiguity in Supervisory Relationships and Standards and Impedes Development of Centralized Controls

Initially, discipline against individuals for failure to supervise centered on branch managers and their superiors, and liability for them was as stringent as it was for the broker-dealer. Over time, companies expanded their approach to compliance, largely in response to SRO rules: They appointed chief compliance officers and qualified principals in specialized areas; employed additional personnel to perform oversight functions alongside branch managers and department heads; built out legal, compliance, and audit departments; developed computer systems and exception reports; and hired dedicated surveillance analysts to support them. Supervisory cases, however, continued to focus on an associated person’s performance apart from the broker-dealer’s system and procedures, rendering individual liability uncertain and diminishing the significance of institutional oversight.


In Michael E. Tennenbaum, three Commissioners, Philip Loomis, John Evans, and Barbara Thomas, upheld an administrative law judge’s decision that the senior registered options principal (“SROP”) of a New York broker-dealer failed to supervise a salesman in San Francisco who abused his discretion over customers’ accounts while misrepresenting the risks of options trades and the effects of commissions on their returns.

Tennenbaum was responsible for developing the broker-dealer’s options compliance program. Among other things, the program called for a registered options principal (“ROP”) “[i]n every office where sales personnel dealt in options” to “assume responsibility for the options transactions in their branches.” Representatives generally were forbidden to have discretion over options accounts. There were few exceptions. Tennenbaum had “sole authority” to make them. He made one for the salesman even though there was no ROP in the San Francisco office.

Tennenbaum admitted he was in charge of the program but denied supervisory responsibility for the salesman. He was not identified as the salesman’s supervisor under the firm’s written supervisory procedures. Nevertheless, for the Commissioners the circumstances painted “a picture of parallel or collateral responsibilities shared by different individuals depending upon the nature of the matter to be supervised” that included Tennenbaum. “Of critical importance” was that “[he] had sole authority to permit a salesman to handle discretionary options accounts” and the “power to revoke that permission.” In their view, “[o]nce Tennenbaum had given . . . his approval, he assumed responsibility for ensuring that this grant of authority, over which he continued to exercise control, was not being abused.” However, “[he] failed to fulfill his concomitant responsibility.”

The origin of that responsibility and what it entailed were clear only through construction and hindsight. As the Commissioners observed, there were fundamental deficiencies in the broker-dealer’s supervisory program with respect to the salesman―chiefly, the failure to have an ROP onsite to review his trades. Under SRO rules, the member had to provide for proper supervision of the salesman. In Tennenbaum’s case, knowledge of its failure to do so created or enlarged his own supervisory responsibility.

As Tennenbaum admitted, registrant’s supervisory system required an ROP in any office where there were retail options transactions. . . . One function of such a qualified supervisor was to analyze the transactions being effected to make sure that they were suited to the objectives expressed by the customers. * * * Despite that fact, there was no ROP in San Francisco until the spring of 1977. Absent was the effective local supervision on which Tennenbaum should have been able to rely in granting and continuing [the salesman’s] authority to handle discretionary accounts. And Tennenbaum was soon put on notice that stringent supervision of [the salesman] was required.

In effect, Tennenbaum was enlisted to fill the vacancy left by the firm because of his ability, in their view, to preempt the violations he should have foreseen.

The firm’s procedures did not govern Tennenbaum’s supervisory responsibility; the Commissioners decided it based on the facts and circumstances presented to them. Although he and others took steps to address the salesman’s conduct, the situation warranted Tennenbaum take or recommend additional action to examine the salesman’s accounts and to curtail his discretion.

Here it is clear that Tennenbaum had far more than “a remote indication of irregularity” with respect to [the salesman’s] activities. Yet he did not take appropriate action.

Tennenbaum was suspended for a month. The firm, instrumental to his liability by the aperture in its controls, was censured and ordered “to revise and amend its existing procedures, with a view to preventing similar violations in the future.”

Decisions that ignored supervisory designations and procedures under SRO rules already showed signs of fostering their neglect. But instead of the deficiencies foreclosing individual liability, they engendered it. If broker-dealers had no more incentive to supervise where they were not rewarded for their efforts, they had even less where the repercussions for defective programs were shared by associates who bore much of the blame and relatively stiffer sanctions.

In Tennenbaum, the broker-dealer and its associate were evaluated according to the same stringent standard, which was inconsistent with the language in the statute (by then renumbered Sections 15(b)(4)(E) and 15(b)(6)). Several years later, another associate’s performance was judged under a more forgiving―if not informative―combination of agency and negligence precepts.


A salesman in the San Francisco office of a national retailer based in New York misrepresented the risks of trading options on margin, made unauthorized trades, and churned accounts. The company and the branch manager agreed they failed to supervise him. The manager was cited for not performing certain supervisory procedures and for negligence in responding to signs of wrongdoing. The manager’s assistant, Louis Trujillo, also was accused of failure to supervise. A law judge ruled against him; he appealed to the Commission.

Trujillo’s duties included several compliance functions. In performing them, he discovered the salesman had extended a customer beyond his means. He monitored the salesman’s activities, discovered additional misconduct, and reported it to the manager and a senior compliance official. The company imposed a series of guidelines and enhanced supervision over the salesman. Later, Trujillo discovered more churning, and the salesman was dismissed.

Chairman David Ruder and Commissioners Joseph Grundfest and Edward Fleischman assumed for purposes of the decision that Trujillo was the salesman’s supervisor even though there was no explicit designation and he had little or no authority over the salesman. It was not alleged Trujillo failed to carry out any assignment. Instead, the Enforcement staff claimed “[he] failed to uncover many of [the salesman’s] offenses that later came to light, and that he reacted inadequately to customer complaints.” Although the Commissioners called Trujillo’s performance “less than exemplary,” they decided it did not warrant discipline under the statute:

It is “with a view to preventing violations” that the statutory proscription of failure to supervise is directed, and it is for the same preventative purpose that we have interpreted the statute to require “that those in authority exercise particular vigilance when indications of irregularity reach their attention.” However, the statute only requires reasonable supervision under the attendant circumstances, and, applying that standard, we cannot conclude that Trujillo’s overall performance with respect to the activities of [the salesman] amounted to a failure to supervise within the meaning of the statutory language.

They acknowledged responsibility under the broker-dealer’s procedures, but liability turned on Trujillo’s reaction to “indications of irregularity.” The standard for measuring it, however, was walked back, at least for individuals, to something akin to negligence.

The rationale created alternative bases for liability: failure to perform assigned procedures and responding inadequately to signs of misconduct. And though the standard for assessing the latter was more forgiving, still it was impossible to know precisely what it required. Consequently, even associates had reason to eschew procedures that could assure discipline if they were not followed but did not protect them when they were (and any protection there was resided outside of them). More uncertainty would follow attempts to define who was a “supervisor.”


Arthur James Huff joined the compliance department of a major wire-house as the SROP in July 1979. Prior to his arrival, a salesman in the broker-dealer’s Miami office embarked on an elaborate scheme to defraud customers in options trades by falsifying account records, intercepting their mail, and issuing them false statements. The compliance department was leery enough to examine his accounts. In June, the compliance director, members of his staff, and an attorney in the legal department met with the salesman and his branch manager to go over the findings, which included a number of accounts with identical or post office box addresses. The compliance director was sufficiently satisfied and the legal department approved the accounts with additional documentation. Upon starting, Huff was handed the file and instructed by the compliance director, his boss, “to keep on top of [the salesman’s] activities and to follow through if any question arose[.]” He reviewed the dossier and selectively monitored the salesman’s accounts. Aware of the results of the earlier review, he did not consider the salesman a “compliance concern” at the time. In April 1980, the compliance director instructed Huff to contact one of the salesman’s clients who had reported making money in his account―the result of bogus statements. Huff spoke with the customer but could not locate his account. So he analyzed twenty-five other accounts covered by the salesman, identifying losses in twenty-four of them totaling $7.6 million. He reported the results and recommended the salesman be fired. Still, a law judge found that prior “red flags” required he investigate sooner the salesman who was subject to his supervision.

Chairman Richard Breeden and Commissioner Richard Roberts did not find it necessary to decide whether Huff was the salesman’s supervisor. Rather, they determined his conduct was sufficient. Though it too was “less than exemplary,” citing Trujillo, they agreed “the statute only requires reasonable supervision under the attendant circumstances.”

In a separate opinion, Commissioners Philip Lochner and Mary Schapiro disagreed with their colleagues’ approach, fearing it lowered expectation. They favored the benchmark in Reynolds, as expressed in Wedbush, calling it an “exacting standard.” Since the duty arose from the relationship, they “prefer[red] to ask, first, whether Huff was a supervisor.” They concluded he wasn’t, thereby avoiding his performance.

Ambiguity in the absence of an explicit supervisory relationship obviously weighed on their analysis:

The statute requires a supervisory relationship and such a relationship can only be found in those circumstances when, among other things, it should have been clear to the individual in question that he could take effective action to fulfill that responsibility. Basic notions of fairness and due process reinforce this conclusion.

The key to it, they said, was “whether the person has the power to control the other person’s conduct.” They observed that the vast majority of cases involved persons in the “line” of authority. Branch managers, regional managers, and others up to and including the board of directors “have clear and direct authority and responsibility to control the conduct of salespersons.” Accordingly, “employees in a broker-dealer’s administrative structure are, at least presumptively, supervisors of those whom they have the authority and the responsibility to hire and fire and reward and punish.” For others, the relationship still rested on control. Recounting decisions involving non-line administrators, they noted each had authority to affect the activity involved. They concluded:

[A] supervisor for purposes of Section 15(b)(4)(E) ought to be defined . . . as a person at a broker-dealer who has been given (and knows or reasonably should know he has been given) the authority and the responsibility for exercising such control over one or more specific activities of a supervised person which fall within the Commission’s purview so that such person could take effective action to prevent a violation of the Commission’s rules which involve such activity or activities by such supervised person.

Huff did not have the requisite control over the salesman, so he was not a “statutory supervisor.”

The rationale helped protect personnel in non-business areas like legal, compliance, and audit, performing oversight functions but lacking authority over the people they monitored. Business executives, on the other hand, presumably were supervisors whether or not they were assigned any preventative measures to take with respect to subordinates. The formula defied the objective: to discipline associates who failed to perform their duties under the broker-dealer’s supervisory system and procedures and to preserve their immunities when there weren’t any. It also lessened the significance of supervisory systems removed from business influence. The false dichotomy stemmed from the apocryphal search for meaning to language in the statute that existed outside of it―in the supervisory relationships and performances agreed to between broker-dealers and their associates. Control over the person subject to supervision was not necessary and the provision did not require it. Discipline founded on contractual responsibility also alleviated concerns about fairness and due process; control alone did nothing to indicate how it was to be used.

Chairman Breeden and Commissioner Roberts purportedly tied Huff ’s liability to the broker-dealer’s supervisory system and procedures. In assessing his performance, however, they looked beyond what he had agreed to do under them to whether he responded appropriately to abnormalities. On that basis, his supervisor status alone was sufficient to establish responsibility, which explained why the “procedures” could consist of as little as an instruction to “keep on top of the salesman.” A spectacular case involving novel improprieties abandoned all pretext to broker-dealers’ procedures as the basis of supervisory responsibility for associated persons.


In the spring of 1992, the SEC charged a primary dealer in U.S. Treasury securities with fraud and recordkeeping violations for false bids by its head government trader in auctions between August 1989 and May 1991. In related settlements, the broker-dealer was censured and three officers were sanctioned and another admonished for improper supervision.

In July 1990, the Treasury Department limited to 35 percent the amount of an issue a person could bid for at auction, partly in response to outsized purchases by the broker-dealer, a dominant market-maker in Treasuries. In the February 21, 1991, auction for $9 billion of five-year notes, the trader requested $3.15 billion (35 percent of the offering) for the broker-dealer. He submitted two other bids for $3.15 billion, ostensibly for customers, then secretly arranged to “buy back” the allocations. One customer confronted him. The trader reported the incident to his boss, the head of the division, who called the conduct “career threatening.” The next day, April 25, the division head met with the company’s president and its senior legal officer to discuss the matter, and the three later conferred with the chief executive officer. They decided the matter should be reported to the government. They did not initiate a review, discipline the trader, or restrict his activities. Subsequent events prompted an internal investigation uncovering more false bids before and after the February 21 auction. On August 9, the CEO and the president disclosed the initial incident together with the results of the investigation. The trader was terminated the same day.

All three officers were supervisors by virtue of their authority over the trader. Their responsibilities were not based on supervisory procedures—there weren’t any. Each had an independent duty to supervise commensurate with his position. The order recited a litany of measures that should have been taken. All thought “someone else would take the supervisory action necessary.” Thus, each bore “some measure of responsibility for the collective failure of the group” to act. The disjointed response was symptomatic of the removal of primary responsibility for supervision from broker-dealers to their associates.

The Commission issued a report under Section 21(a) of the Exchange Act on the senior legal officer’s performance “to amplify [its] views on the supervisory responsibilities of legal and compliance officers in [his] position.” Unlike the others, he “was not a direct supervisor of [the trader] at the time he first learned of the false bid.” Nor did he control his actions. Control, however, no longer was necessary:

[D]etermining if a particular person is a “supervisor” depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.

True to earlier applications of Reynolds, his “ability” merely “to affect” the situation made him a supervisor once he was on notice of potential misconduct. Also consistent was the expectation he “ensure” the proper outcome.

The executives who, after learning of the trader’s initial misconduct, continued to direct his activities in general, were not cited for willfully aiding or abetting the subsequent violations, even though they might have been inclined to turn a blind eye to conduct that enabled the broker-dealer to maintain its prominent position in the Treasury market. Supervisory liability unencumbered by designations and procedures benefited them and others in similar positions under questionable circumstances. However, it meant uncontained liability for those whose only responsibilities were to protect investors.

Gutfreund and the 21(a) Report concluded a formal shift in primary responsibility for supervision from broker-dealers to their associated persons. In 1985, Commissioner Aulana Peters described the traditional hierarchy for policing the industry:

[A]t the top of the pyramid is the SEC, the federal watchdog. At the middle level are the SROs, and finally, at the largest and most important level are the broker-dealer firms themselves. It is at this level that customer protection begins.

Five years later, the Head of the SEC’s Enforcement Division wrote:

Former SEC Commissioner Peters’s pyramid metaphor, though accurate, is not quite complete. The real base of the supervisory pyramid is occupied not by the broker-dealers but by their individual supervisory personnel, who are governed by an independent statutory duty to supervise.

While it sounded like an extension to greater effect, responsibility fell to individuals with little or no “independent authority.” Their individual abilities did not approach what the broker-dealer could do through them by its authority. And though broker-dealers still had to maintain supervisory systems and procedures under SRO rules, there was far less incentive to build the comprehensive programs envisioned when responsibility at the federal level, where it mattered most, was measured by how associates performed autonomously under existing circumstances.

Following the SEC’s lead, the SROs similarly have shifted expectations for supervision from members to their associates. At each level, supervision has become an employee’s duty for which the company can be held responsible instead of the other way around. Meanwhile, the Reynolds doctrine has been applied to investment advisers and their associates under Section 203(e)(6) and (f ) of the Advisers Act, with no corresponding SRO regime, and expectations trained heavily on compliance officers under Rule 206(4)-7. Not surprisingly, the SEC’s Division of Examinations (formerly the Office of Compliance Inspections and Examinations (“OCIE”)), FINRA, and compliance professionals themselves routinely have found fault with broker-dealers’ and investment advisers’ supervisory programs and the resources dedicated to them.

State Law and SRO Rules Provide Appropriate Standards for Purposes of Section 15(b)(4)(E) of the Exchange Act and Section 203(e)(6) of the Advisers Act

In some states companies are compelled to provide sufficient internal regulations and controls to prevent undue risk of harm to others by their employees and agents. In many cases, managers and directors are bound by fiduciary duty to ensure there are systems to report, investigate, and respond to potential illegalities within their companies, including violations of federal securities laws. Proper supervision is expected of broker-dealers and investment advisers under state blue sky laws demonstrated by written supervisory procedures. And under the regime created by Congress, broker-dealers and investment advisers are relieved of supervisory responsibility integral to vicarious liability for their associates’ securities laws violations where they implemented and enforced systems reasonably designed to prevent them. State law and industry guidelines inform expectations, while SRO rules and Rule 206(4)-7 require them to devise written plans that specify who shall do what with regard to whom.

FINRA rules, in particular, require members to designate qualified supervisors for each representative, business, and major location, and to establish written procedures to monitor compliance with applicable securities laws and association rules. There are special requirements for brokerage, trading, investment banking, research, and other businesses. Members must review associates’ outside business activities, personal securities transactions, investments, and investigate their conduct prior to employment. They have to monitor functions outsourced to third parties. In some instances, the rules mandate specific practices or objectives. Otherwise, members have broad discretion over the substance of their programs. They must test and inspect periodically to ensure policies and procedures are enforced, and evaluate the efficacy of those procedures every year. The emphasis on administrative processes reflects the member organization’s responsibility to provide for appropriate supervision.

Rule 206(4)-7 provides a basic framework for similar efforts by investment advisers, supplemented by FINRA requirements for dual registrants.

In order to promote greater oversight by broker-dealers and investment advisers, they should be relieved of discipline when they complied with applicable laws, SRO rules, and other obligations for establishing, maintaining, and enforcing systems and procedures to prevent violations as Congress intended. Management approval of rationally designed surveillance programs and reporting systems administered in good faith normally should be dispositive of those duties. The companies themselves should be accountable for any substantive deficiencies or lapses in enforcement. Their associates—who do not have original supervisory responsibility—should be responsible only for performing their assignments under principles of agency and contract law. Individuals should not be held accountable for deficiencies in companies’ supervisory programs except as control persons. Indeed, consideration should be given to curtailing individual supervisory liability, which has detracted from institutional responsibility.


Undoubtedly, the vast majority of broker-dealers and investment advisers make genuine efforts to supervise their associates. Vicarious liability and reputational harm remain powerful incentives to prevent violations. As Congress recognized, however, more is needed to induce them to go further than visible risk would dictate and to extend their purview beyond employees.

The Reynolds doctrine, of questionable SEC judicial provenance, undermines the statutory regime created by Congress to promote comprehensive supervision by broker-dealers and investment advisers. Its vague exhortation to no one in particular supplants defined relationships and performances. The insuperable standard eliminates all added incentive to supervise. What remains is lessened by removing primary responsibility for oversight from companies to their employees. A false dichotomy places most of it with conflicted “line” managers over dedicated, unbiased, “non-line” professionals specially trained to administer complex legal requirements that take precedence over business considerations. Expectations focus on those individuals’ reactions to signs of wrongdoing over their administration of company-ordained procedures to prevent and detect specific violations. Central coordination is replaced by an admonition that individual supervisors should work together. The principle that holds the CEO or president, his or her delegate, or the CCO responsible for the entire organization’s policies and procedures lessens their potential. The 1964 Amendments and their legislative history make clear Congress intentionally withheld jurisdiction over supervision from the SEC in favor of state law, self-regulation, and the Commission’s ability to amend SRO rules (later granting it narrowly over the misuse of material, nonpublic information). The deleterious effects of Reynolds and its progeny on compliance with those regimes would seem to validate that decision.

Investor wealth, the health of the economy, and the country’s well-being depend on the integrity of financial services providers. A large part of it rests on diligent supervision. As the law recognizes, to maximize these efforts, broker-dealers and investment advisers must be rewarded―by dispensing with derivative liability in disciplinary proceedings where oversight was appropriate. By necessity, the standards must come from the industry itself. They rely on processes for establishing, enforcing, inspecting, and reevaluating policies and procedures that provide clear guidance on supervisory roles and assignments. Satisfaction depends less on the merits of methods that inevitably failed, than on genuine adherence to those processes.

Supervision is hard to judge: Success is immeasurable, while failure in the context of isolated misconduct can be deceiving. It is important, therefore, to evaluate statutory liability for it relative to the objective: to encourage broker-dealers and investment advisers to instill in themselves systems and procedures reasonably designed to prevent violations; and to extend to their associates supervisory liability only when they failed to do what they promised to do under those programs. Unfortunately, the design was discarded to implement ahead of time the legislation behind it. Formidable obstacles confront its reinstatement today, including a more attenuated SRO regime, purposefully vague legal requirements, and gained acceptance of the misguided notion of corporate illegality. Overcoming them will require rededication to self-government for professional and ethical standards, legal clarity, and renewed understanding of oversight as an institutional responsibility, with greater deference to the decisions made to carry it out, for broker-dealers, investment advisers, and their associates to do more to protect the public from miscreants in their midsts.