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Speech


 
 

Remarks at “The SEC Speaks in 2012”

Commissioner Daniel M. Gallagher

U.S. Securities & Exchange Commission

Washington, D.C.

Feb. 24, 2012

Good afternoon and thank you, Meredith, for that overly-kind introduction. As Meredith mentioned, we have known each other for a long time. It is an honor to be working with her, again, at the Commission, and I owe her a debt of gratitude for her patience and expert counseling as she has been getting me up to speed on the vast array of initiatives taking place in Corp Fin. It is a testament to the prowess of the SEC as an expert regulatory body that we are able to attract top experts such as Meredith, and it is a testament to Meredith’s commitment to public service that she came back to the agency at such a critical time. The nation’s investors are well served by Meredith and her team.

Before I continue, let me remind you that as always, my comments today are my own and do not necessarily represent the positions of the Commission or my fellow Commissioners.

It is great to be back at SEC Speaks, this time in a new capacity. I must confess, it is significantly different to be here as a Commissioner and not a staffer. For example, they do not have groupies and other autograph seekers backstage for the Commissioners like they did when I was a staffer, and there certainly weren’t any customized M&Ms and chocolate fountains like I used to enjoy as Deputy Director of Trading and Markets! And the car that PLI sent to pick me up was a Chevy Volt- a far cry from the stretch Hummer limousine that brings the staff here!

Seriously, though, it is nice to be back- both to the Commission and to this event. There have been many changes since I left the agency in January 2010 with one notable exception- the workload remains intense. The 100 plus Dodd-Frank related rulemakings and studies that the agency is working through represent a generation’s worth of regulatory activity, but will most likely be accomplished in a short time frame of just a few years. While it is certainly an exciting time to be at the SEC — and to be a securities lawyer on the outside for that matter — this workload brings with it a lot of responsibilities — in particular a responsibility to proceed with all due speed but with caution, with all available information, and with regulatory humility as well. We owe this to investors, to markets and those involved in the capital formation process, and to taxpayers.

As the Commission participates in this regulatory frenzy, however, we have a responsibility to carry out with vigor our core duties as the primary regulator of the US capital markets. These core duties, such as broker-dealer, investment adviser, investment company, clearing agency and transfer agent oversight may not seem as exciting these days as interesting new areas like OTC Derivatives, but they, along with corporate disclosure, are the core of what we have done at the SEC for more than 70 years. We must continue to perfect our craft in those areas while we move into new ones. As a recent noteworthy broker-dealer failure has shown us, sometimes even the old issues can present new challenges.

And so today I’d like to speak about an old issue that has been very relevant lately, and that is “failure to supervise” liability for compliance and legal personnel. The Exchange Act vests the Commission with the authority to impose sanctions on a person associated with a broker-dealer if that person “has failed reasonably to supervise, with a view to preventing violations of the provisions of [the securities] statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision.” The nearly identical language in the Investment Advisers Act grants the Commission the same authority with respect to associated persons of investment advisers. As several decades of failure-to-supervise cases illustrate, the devil is in the details of that last “if” clause.

Broker-dealers and investment advisers employ legal and compliance personnel to provide advice and guidance to firms and their employees regarding the application of laws and regulations to their businesses. Almost by definition, legal and compliance personnel work outside the direct chain of supervision for business activities, and few, if any, would think of themselves as “supervising” day-to-day activity. A key question, therefore, is at what point can legal and compliance personnel be reasonably deemed “supervisors” as they carry out their responsibility to prevent and, if necessary, address violations of laws or regulations by firm employees and to provide advice and guidance to management? Over the course of the past three decades, this question has been raised in a series of Commission broker-dealer enforcement cases, but it has never been answered in the clear and definitive manner such a weighty issue deserves. Without meaning to disappoint you, I — as just one of five Commissioners — cannot answer that question today. However, I’d like to say a few words on the subject in the hopes of encouraging the development of clearer guidance to firms as regarding the circumstances under which an individual carrying out legal or compliance responsibilities at a broker-dealer or investment adviser can be deemed to be a supervisor.

As I have noted, Commission failure-to-supervise precedent provides limited guidance for determining whether a given member of a firm’s legal or compliance staff is a “supervisor” for the purposes of Exchange Act and Advisers Act liability. Perhaps the clearest guidance was set forth in the Gutfreund Section 21(A) report issued by the Commission in 1992 in connection with an administrative proceeding involving the general counsel of a broker-dealer1. In that report, the Commission noted that legal and compliance personnel “do not become ‘supervisors’ for purposes of [the Exchange Act] . . . solely because they occupy those positions.” The Commission explained, however, that an in-house lawyer can be deemed a supervisor when other members of senior management “involve him as part of management’s collective response to the problem.” The Commission further noted that, “determining 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.” Although Gutfreund was a report issued in connection with a settlement, and therefore its precedential value is not the same as a formal Commission adjudication, for those struggling for resolution on the question of supervisory authority, Gutfreund remains a key authority.

Recently, the Commission considered a case regarding a broker-dealer general counsel’s alleged supervision of a rogue trader in light of the factors set forth in Gutfreund. In the Initial Decision in that case2 the ALJ found that the firm’s general counsel, “had no authority for hiring, assessing performance, assigning activities, promoting, or terminating employment of anyone outside of the people in the departments he directly supervised.” The ALJ further found that the general counsel “did not have any of the traditional powers associated with a person supervising brokers,” noting also that he “did not believe he was [the broker’s] supervisor or that he had authority to hire, fire, discipline, or direct the [broker’s] conduct.” Finally, she found that the general counsel “did not direct [the firm’s] response” to the rogue broker’s actions. Nevertheless, the ALJ, relying on Gutfreund, determined that the general counsel was the rogue broker’s supervisor because “[a]s General Counsel, [his] opinions on legal and compliance issues were viewed as authoritative and his recommendations were generally followed by people in [the firm’s] business units, but not by Retail Sales,” the department in which the alleged rogue broker worked. In addition, the ALJ cited the general counsel’s membership in the firm’s Credit Committee and the fact that he dealt with the rogue broker on behalf of that Committee. Despite these findings, the judge dismissed the proceeding, deeming the general counsel to have acted reasonably in his supervisory role. Last month the Commission issued an order dismissing the proceeding3 Notwithstanding faulty press reports that I abdicated my responsibilities with respect to this matter, I was informed by the Commission’s ethics office that I would need to recuse myself from the case, and thus I did not participate in the matter.

The Commission’s failure-to-supervise cases, including the one I just discussed, have provided some modicum of clarity on the responsibilities of a person deemed to be a supervisor. As the Commission stated in Gutfreund, “It is not sufficient for [a supervisor] to be a mere bystander to events that occurred.” Instead, a person deemed to be acting in a supervisory role must either discharge those responsibilities or know that others are taking appropriate action. In Gutfreund, the Commission explained that an in-house lawyer can be deemed a supervisor when other members of senior management “involve him as part of management’s collective response to the problem.” What Gutfreund and similar proceedings make clear is that once a person becomes involved in formulating management’s response to a problem, he or she is obligated to take affirmative steps to ensure that appropriate action is taken. 

The question of what makes a legal or compliance officer a supervisor, however, remains disturbingly murky. In searching for clarity on the issue, however, we must be mindful of the importance of the legal and compliance role and, critically, the ability of legal and compliance personnel to carry out their responsibilities.

Although the functions and responsibilities of legal and compliance personnel vary from firm to firm, they generally include such duties as providing regulatory and compliance advice with respect to applicable laws and regulations; developing policies, procedures, and guidelines designed to facilitate such compliance; and monitoring firm personnel to identify potential deviations from compliance. A firm’s compliance and legal function should promote a “culture of compliance” through active, visible engagement with management and employees. Employees can recognize a token effort when they see one, and a meek and invisible compliance department signifies to those employees a lack of commitment to an ethical firm culture.

Unfortunately, robust engagement on the part of legal and compliance personnel raises the specter that such personnel could be deemed to be “supervisors” subject to liability for violations of law by the employees they are held to be supervising. This creates a dangerous dilemma. A compliance officer or in-house attorney who stays ensconced in a dark corner of the firm drafting policies and sending out memoranda, but never interacting with the individuals governed by those policies or the recipients of those memos, risks diminished effectiveness or even irrelevance; but such a person would reduce his or her potential liability as a supervisor. On the other hand, the more engaged a firm’s legal counsel or compliance personnel become — the more they bring their expertise to bear in addressing important, real-world compliance issues and in providing real-time advice for concrete problems the firms and their employees face — the more likely they are to be deemed to be playing a supervisory role. Thus, the Commission’s position on supervisory liability for legal and compliance personnel may have had the perverse effect of increasing the risk of supervisory liability in direct proportion to the intensity of their engagement in legal and compliance activities.

Simply put, the Commission and, in the case of broker-dealers, the SROs, need to provide a framework that encourages in-house legal and compliance officers to depart, when necessary, from the safety of black and white categorizations of who is and who is not a supervisor. We need these folks to jump into crises, into thorny regulatory issues, and into operational and other issues that will be best resolved with the benefit of sage regulatory counseling. Our system of oversight for regulated entities such as broker-dealers and investment advisers is one of shared responsibility, in which the Commission oversees the firms that, in turn, oversee their associated persons, with SROs providing an additional level of oversight for broker-dealers. Broker-dealer and investment adviser firms in essence serve as the first line of defense in this system, and the system does not work if firm legal and compliance officers are too timid to jump into the difficult regulatory issues firms face on a regular basis. This is particularly important in the adviser area, as there are more advisers subject to our oversight than ever before after Dodd-Frank, and there is no SRO interpositioned between the industry and the SEC.

Any understanding of the issue must begin with the fact that broker-dealer or investment adviser compliance and legal personnel are, by default, not supervisors but rather providers of support for the firm’s other employees. We’re not talking about widget factories here — the business of regulated entities inherently involves regulatory issues at every turn. Almost every facet of broker-dealer and investment adviser “business” issues are also regulatory issues, and accordingly the Commission and the SROs should want legal and compliance in the discussion about most issues. To steal a line from Jack Nicholson in A Few Good Men: we want legal and compliance on that wall; we need them on that wall! We can and should be able to handle that truth.

Deterring such engagement is contrary to the regulatory objectives of the Commission, and I am concerned that continuing uncertainty as to the contours of supervisory liability for legal and compliance personnel will have a chilling effect on the willingness of such personnel to provide the level of engagement that firms need - and that the Commission wants. In resolving this uncertainty, we should strive to avoid attacking or penalizing the willingness of compliance and legal personnel to be fully involved in firms’ responses to problematic actors or acts. To put it simply, if a firm employee in a traditionally non-supervisory role has expertise relevant to a compliance matter, that employee shouldn’t fear that sharing that expertise could result in Commission action for failure to supervise. Furthermore, we must remain aware that the more legal or compliance personnel are deemed to be playing a supervisory role, or the more that continued uncertainty on the issue leads them to believe that they must act as if they were supervisors, the less ability they will have to carry out their core duties.

Over the past decades, broker-dealers and investment advisers have created robust functions dedicated to formulating policies and assisting management in creating a culture of compliance that has had a profoundly positive effect on investor confidence. Once again, I want to stress that firms and investors are best served when legal and compliance personnel feel confident in stepping forward and engaging on real issues. An overbroad interpretation of “supervision” risks tacitly deputizing as a supervisor, with concomitant liability, anyone who becomes actively involved in assisting management in dealing with problems. Deterring such active involvement will erode investor confidence in firms, to the detriment of all.

At the same time, however, it is critically important for in-house lawyers and compliance officers to be mindful of the types of activities that might indicate the type of supervisory control the Commission discussed in Gutfreund. For example, participation on firm boards and committees by legal and compliance personnel can undoubtedly be beneficial for regulated entities. Indeed, in the context of a credit committee, what may be viewed as a credit risk to a firm controller could be seen as a potential net capital violation by a lawyer or compliance officer, and management should have access to those views. However, one must carefully weigh the consequences of full voting membership in light of the substantial benefits of being a valued but non-voting advisor to the board or committee. I have personal experience with this issue and I believe that non-voting lawyers and compliance officers can be fully effective voices in those forums.

The Commission’s ability to impose sanctions for failures to supervise is a powerful tool to compel a broker-dealer or investment adviser’s managers and executives to proactively monitor subordinate employees’ compliance with laws and regulations. Those high-level personnel clearly fall within the ambit of the Commission’s failure-to-supervise authority, a fact of which such high-level personnel are well aware. Failure-to-supervise liability can therefore act as a key incentive for a firm’s management to carry out their responsibilities properly. We must strive to ensure, however, that the fear of failure-to-supervise liability never deters legal and compliance personnel from carrying out their own critical responsibilities. Such a result could only be described as perverse.

Thank you, and enjoy the rest of the conference.


1 In re John H. Gutfreund, Exchange Act Release No. 31554 (Dec. 3, 1992).

2   In the Matter of Theodore W. Urban, Admin. Proc. File No. 3-13655, Initial Decision Rel. No. 402 (Sept. 8, 2010)

3 Securities Exchange Act Release No. 66259 (Jan. 26, 2012).

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Modified: July 28, 2014