liability of legal and compliance officers · liability of legal and compliance officers theories...

Liability of Legal and

Compliance Officers

Richard D. MarshallKatten Muchin Rosenman LLP

New York

+1.212.940.8765

[email protected]

1

Liability of Legal and Compliance Officers

This is a controversial issue, prompting public dissents

from SEC Commissioners and criticism from the SEC’s

own judges.

Controversy surrounds two situations –

• officer “had clear responsibility to implement compliance

programs and policies and wholly failed to carry out that

responsibility” or

• officer “helped mislead regulators”

2


Theories of liability against compliance-legal officers

• Supervisory Liability

• All the SEC needs to assert in such a claim is that a person

was the supervisor of another person who violated the law.

The burden of proof then shifts to the supervisor to prove

that he or she exercised reasonable supervision over the

wrongdoer.

3


This theory of liability has been extended to legal and

compliance officers. In the Gutfreund case, the SEC

stated in dictum that a firm’s chief legal counsel, who

directly supervised the firm’s CCO, could be disciplined for

a failure to supervise based on the misconduct of

employees for whom he was not the direct supervisor but

where the CLO/CCO had knowledge of possible

misconduct and the authority to intervene to prevent it.

4


On October 19, 2009, the SEC instituted an administrative

proceeding against Theodore Urban, the former general

counsel of a broker-dealer, alleging that he had “failed to

supervise” a registered representative of the firm. Urban

was alleged to have been alerted to possible wrongdoing

by a person in a business unit, to have tried to investigate

and to stop any misconduct, but to have done too little.

This case ended without resolving whether this theory of

liability was valid.

5


• Causing Liability

The elements of “causing” a violation are (i) a primary

violation by one person and (ii) an act or omission that

the person being charged knew, or should have known,

(iii) would contribute to the violation. Negligence is

sufficient to establish “causing” liability unless the person

is alleged to “cause” a primary violation that requires

scienter. Causing liability requires only that the person

“contribute” to the primary violation.

6


A chief compliance officer was recently charged with

causing a misappropriation despite, upon learning of the

violation, “promptly [conducting] an internal investigation”

resulting in the offender’s termination, and reporting the

matter to law enforcement. The SEC charged him with

causing the violation he reported on the theory that the

CCO “was responsible for implementation of the policies

and procedures,” and those procedures allegedly were not

reasonably designed to prevent the misappropriation of

client funds. In the Matter of SFX Financial Advisory

Management Enterprises, Inc.

7


Judy Wolf was a compliance officer of a large firm. In September 2010, Wolf was asked to review the trading of a registered representative to determine whether insider trading had occurred. Wolf created a document memorializing her review, concluding that insider trading had not occurred. This turned out to be incorrect. In late 2012, the SEC began to investigate Wolf’s conduct and, in connection with this investigation, Wolf allegedly altered her 2010 document to make it appear that her September 2010 review was more thorough than it actually was. The altered document was produced to the SEC staff without mention of its alteration and Wolf at first claimed that the expanded document had been prepared in 2010, although she later admitted this was not the case.

8


An SEC administrative law judge dismissed the case

against Ms. Wolf based on a policy argument – the fact

that Ms. Wolf was a compliance officer.

9

Allocation of Investment Opportunities

As a fiduciary, an investment adviser owes a duty of

loyalty to each of its clients. Favoring one client at the

expense of others, or favoring the adviser’s own interests

at the expense of the clients, violates this fiduciary

obligation.

10


The issue becomes critical when scarce and valuable

investment opportunities are allocated among client

accounts.

11


“Mark P. Welhouse allegedly purchased options in an omnibus or master account for Welhouse & Associates Inc. and delayed allocation of the purchases to either his or his clients’ accounts until later in the day after he saw whether or not the securities appreciated in value. Welhouse allegedly reaped $442,319 in ill-gotten gains by unfairly allocating options trades in an S&P 500 exchange-traded fund named SPY. His personal trades in these options had an average first-day positive return of 6.28 percent while his clients’ trades in these options had an average first-day loss of 5.05 percent.”

12


“The SEC Enforcement Division has engaged in a data-driven initiative to identify potentially fraudulent trade allocations known as ‘cherry-picking,’ and this enforcement action is the first arising from that effort. Working with economists in the agency’s Division of Economic and Risk Analysis, enforcement investigators analyze large volumes of investment advisers’ trade allocation data and identify instances where it appears an adviser is disproportionately allocating profitable trades to favored accounts.”

13


“The allocation of IPO shares to director-clients was a material fact that MFS should have disclosed. Opportunities to invest in IPO shares are rare and therefore valuable to investors. . . . Thus, when MFS allocated some shares of the IPOs to its director-clients, it did so at the expense of the fund clients, as the funds were thereby allocated a smaller number of shares. In effect, MFS’s allocation to both director-clients and fund clients placed the parties in competition for the same shares. . . . this is particularly troublesome since MFS had an incentive to favor the director-clients over the fund clients when allocating the shares, given the directors' duty to monitor and police the fund's relationship with its investment adviser. . . . MFS had a duty to disclose the fact that it allocated IPO shares to the director-clients. Its failure to do so constituted fraud.” SEC v. Monetta, 390 F.3d 952 (7th Cir. 2004).

14


Allocations should be:

• Fast

• Fair

• Documented

• Disclosed

15

Protecting Confidential Information

Section 204A of the Advisers Act and Section 15(g) of the

Exchange Act require all registered advisers and brokers

to adopt procedures to prevent misuse of confidential

information.

Failure to adopt and enforce adequate procedures is a

violation, even in the absence of illegal trading.

16


Example - “As CEO and chairman of Lynch, Gabelli received potentially material, nonpublic information regarding Lynch, including information relating to Lynch’s financial position and results of operation. Under these circumstances, the Commission believes that the policies and procedures of the Respondents that relied in part on self-reporting were inadequate, because they provided for insufficient objective, third-party review to determine whether he possessed material, nonpublic information when he bought and sold Lynch securities.”

17


Example - “Morgan Stanley’s specific failures included:

* * *

• From at least 2001 until 2004, Morgan Stanley failed to conduct any of the surveillance required by its policies of certain types of securities traded in MSDW and MS & Co. accounts, including certain derivative securities, single stock futures, and equity options pertaining to issuers that Morgan Stanley had placed on its Watch List.”

18


The SEC recently alleged:

“From February to March 2012, Wolverine Trading, a broker-dealer, and Wolverine Asset Management, an investment adviser, repeatedly shared information in violation of their firms’ policies and procedures.

The affiliates shared their trading positions and strategies for TVIX, an exchange-traded note whose market price traded at a premium to its indicative value after new issuances of the note were temporarily suspended. In addition, despite information barriers between the affiliates, traders from both affiliates met to discuss issues regarding TVIX. The affiliates also discussed details surrounding the potential reopening of new issuances of TVIX. Prices for the note fell on March 22, 2012 before its issuer announced the reopening of issuances of the note.

Wolverine Asset Management subsequently profited from a market opportunity that it should not have received.”

19


Is there a further lesson from the case?

• What are “the risks present through cross-affiliate sharing of

information”?

• Is it “the risk that trading venues are not adequately

protecting sensitive customer order information”?

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