SEC Official Addresses Role of Supervisors and Oversight of Back-Office Personnel

In a luncheon address at the Practising Law Institute’s fall conference on supervision, Daniel M. Gallagher, Jr. made clear the Commission’s position that once a person becomes involved in management’s response to a problem, he or she is obligated to take affirmative steps to ensure that appropriate action is taken. Gallagher, the co-acting director of the Division of Trading and Markets, also talked about the possibility of adopting a new system to improve the oversight and professional requirements of the back-office personnel at broker-dealer firms. Recent events have led to the staff to more closely examine the role these personnel play when they are involved in effecting securities transactions.

Gallagher emphasized that supervisory obligations are not determined solely by a person’s title. Depending on the circumstances and the person’s level of responsibility, he said these obligations may extend to legal and compliance personnel. The question of whether and when legal and compliance offers may become liable for failure to supervise is not a new one, according to Gallagher. He cited the SEC’s Gutfreund case in 1992 in which an in-house lawyer was deemed a supervisor when management involved him in a response to a problem.

Gallagher explained that counsel may direct or monitor an investigation, make recommendations with respect to a problematic employee and verify that appropriate actions are taken. If management fails to act, Gallagher said counsel should consider going to the board, resigning from the firm or reporting the matter to regulatory authorities. Counsel cannot be a mere bystander with respect to the events that occurred, he said.

In some instances, a firm’s oversight responsibilities may extend beyond traditional securities brokerage activities. Gallagher said this is important if an employee holds himself out as a professional member of a firm, because the firm may be legally at risk, or its reputation may be at risk, even if the particular business dealings do not directly involve the firm.

Gallagher noted that a recent special review committee at FINRA recommended that FINRA more aggressively exercise its jurisdiction. The SEC has affirmed FINRA disciplinary actions involving conduct related to insurance applications and premiums, tax shelters, and the general entrepreneurial conduct of member firms, according to Gallagher, and even the use of a co-worker’s credit card.

Employees who wear two hats are a continuing concern, according to Gallagher, such as when firms have reps that provide advisory services. The RAND study which was conducted at the SEC’s request made clear that investors are confused about the roles of brokers and advisers. For firms whose reps provide advisory services, Gallagher said they must have a clear understanding of their duties under each regulatory regime when customers have both brokerage and advisory accounts.

Firms that maintain their brokerage and advisory businesses in separate entities may face unique concerns, Gallagher added, but no matter how a firm is structured, it must effectively inform customers about the different services and obligations relating to their brokerage and advisory accounts.

Gallagher noted that SEC Chair Mary Schapiro has endorsed the Administration’s view that investors should receive the same level of protection for similar financial services, regardless of the label attached to the provider. The issue may be resolved through the legislative process.

Gallagher said the staff is working to implement the lessons learned from the financial crisis, including heightened attention to the role of back-office personnel. Many of these personnel are not required to register with the SEC. They do not undertake qualification exams or undergo continuing education. Gallagher said that FINRA has committed to establish a new system to improve the oversight and professional requirements of personnel who perform back-office functions at broker-dealer firms. The SEC has asked FINRA to “cast the regulatory net as broadly as necessary to achieve the right level of back-office oversight for today’s firms,” according to Gallagher.

Under current rules, registration is optional for a representative who performs legal, compliance, internal audit, back-office operations or similar responsibilities for a FINRA member. There is a statutory carve-out for persons whose functions are solely clerical or ministerial. Once FINRA identifies the personnel that should be subject to oversight, Gallagher said it must determine the appropriate kind of oversight. At a minimum, Gallagher said it is important to identify any person who is subject to a statutory disqualification or has had other disciplinary history.

Gallagher suggested that new examinations could be developed for certain back-office employees. Continuing education requirements may also be appropriate. Gallagher said a range of registration categories could be adopted, some of which could require licensing and education while others could require only notice registration. The goal is to foster an environment that is less hospitable to fraud, he said.