What Constitutes Failure to Supervise?
Brokerage firms must diligently supervise the activities of their brokers and financial advisers in the handling of customer accounts by FINRA Rule 3110.
FINRA Rule 3110(a) requires member firms to “establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.”
To effectively implement and maintain these systems, FINRA Rule 3110(b) requires member firms to “establish, maintain, and enforce written procedures to supervise the types of business in which it engages.” Assuring proper supervision is a critical component of broker-dealer operations.
Supervisory obligations include the responsibility to investigate “red flags” that suggest that misconduct may be occurring and to act upon the results of such investigation.
Brokerage Firms Have a Duty to Supervise
Brokerage firms are required to create, maintain, and enforce their own internal rules regarding their supervisory duties concerning the activities of their brokers/advisors. When a brokerage firm disregards rules that it has established to govern the conduct of its employees, evidence of those rules may be used against the firm to determine the correct standard of care in a securities arbitration.
The content of such laws may also indicate knowledge of the risks involved and the precautions that may be necessary to prevent the risks.
In addition to primary liability for failure to supervise, the FINRA-member firms are secondarily liable for the acts and omissions of their broker/advisers under general agency principles and the common law doctrine of respondeat superior.
As the Restatement (Second) of Agency § 261 states: “A principal, who puts a servant or other agent in a position which enables the agent while acting within his authority, to commit fraud upon third persons is subject to liability to such third persons for the fraud.”
FINRA Rule 2010
FINRA Rule 2010 requires FINRA members and their associated persons to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of their business. It mandates that securities industry participants not only conform to legal and regulatory requirements, but also conduct themselves in the course of their business with integrity, fairness, and honesty.
Because industry participation carries an expectation of regulatory compliance, any conduct that runs afoul of FINRA or SEC rules necessarily violates Rule 2010.
Lack of proper supervision has resulted in numerous enforcement actions by FINRA and the SEC against non-compliant firms. Some firms have been cited for repeated failures of oversight.
Often these firms are charged with the supervision of registered representatives who have their advisory firms with offices outside of the broker-dealer firm. These firms are usually required to supervise hundreds of far-flung offices.
Practically speaking, that would be very difficult even if the firm devoted sufficient resources to it.
Common problems with these repeat offenders include pre-announced branch office examinations that did not detect red flags, failure to implement heightened supervision for problem brokers with significant customer complaints.
Many failure-to-supervise cases involve indicators of misconduct, or “red flags,” that should immediately alert management to potential wrongdoing. In circumstances where a firm’s compliance and supervision system is inadequate to discover the indications of problematic conduct, the personal responsibility for supervision cannot be fulfilled by a supervisor who is unaware of the indicators.
In one such instance, the firm operated 1,500 offices with 2,700 registered representatives. Some 49 of these were one-person offices. In that case, the SEC found that the firm’s failure to scrutinize adequately the securities-related businesses of its registered representatives, which were conducted beyond the direct aegis of the firm, was a sure recipe for trouble.
Further, the firm’s practice of holding a pre-announced compliance examination only once a year was inadequate to satisfy its supervisory obligations. Indeed, the SEC stated: “[W]e harbor grave doubts that this practice would necessarily discharge the supervisory obligations of any firm that incorporates a structure in which only one or two representatives operate smaller branch offices.”
Failure to Supervise Claims
Failure to supervise is a common claim that is present in almost all FINRA securities arbitration cases. The brokerage firms are almost always legally liable for the wrongdoing of their br4oker/advisers. Even in selling away cases, where the broker engages an undisclosed investment-related business away from the brokerage firm with which s/he is registered, the firm may be responsible if there sufficient “red flags” to put the firm on “inquiry notice” that selling away is going on. Legally speaking, in such cases, the firm is said to have clothed its agent with “apparent authority” so that the customer reasonably believes that the broker/adviser is acting as an agent of the firm.
Failure to supervise claims is an essential part of any securities arbitration case for the practical reason that the errant broker/adviser may not have sufficient funds to pay an award. For that reason, it is always advisable to name the firm as a respondent in a FINRA arbitration claim. Often the firm is the only named respondent, and broker/adviser is not named as a party, because the firm is liable for the broker/adviser’s misconduct.
When Does Failure to Supervise Result in Legal Action?
As noted above, in most cases, failure to supervise should result in legal action (i.e., a FINRA arbitration claim being filed) when there is actionable misconduct by the broker/adviser.