EXPERIENCED SECURITIES REGULATORY LAWYERS
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Failure to Supervise

Approximately 1,800 FINRA arbitration cases involving claims of failure to supervise registered representatives are handled annually. Failure to supervise represents one of the more frequently alleged controversy types in FINRA arbitrations. The frequency of failure to supervise claims rests in the fact that failure to supervise can be linked to a broad spectrum of underlying claims, such as negligenceunauthorized trading or unsuitable trading.

Failure to supervise claims arise from a brokerage firm’s breach of its obligations to ensure that its registered representatives comply with internal as well as industry regulations. Moreover, the brokerage firm’s internal procedures for preventing securities violations must meet the standards outlined in FINRA’s rules. The firm’s failure to properly supervise its brokers is a separate cause of action and can lead to liability on the firm itself, separate from any claims asserted against its brokers.

The primary rule outlining the duty to supervise brokers is found in FINRA Rule 3110. That rule requires that a brokerage firm 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. Final responsibility for proper supervision shall rest with the member.

Under FINRA Rule 3110 (a) (1)-(7), compliance with applicable securities laws and regulations is accomplished through a diverse range of measures that include the following:

The registration and designation as a branch office or an office of supervisory jurisdiction (OSJ) of each location, including the main office.

The designation of one or more appropriately registered principals in each OSJ and one or more appropriately registered representatives or principals in each non-OSJ branch office with authority to carry out the supervisory responsibilities assigned to that office by the member.

The assignment of each registered person to an appropriately registered representative(s) or principal(s) who shall be responsible for supervising that person's activities.

The use of reasonable efforts to determine that all supervisory personnel are qualified, either by virtue of experience or training, to carry out their assigned responsibilities.

The participation of each registered representative and registered principal, either individually or collectively, no less than annually, in an interview or meeting conducted by persons designated by the member at which compliance matters relevant to the activities of the representative(s) and principal(s) are discussed. Such interview or meeting may occur in conjunction with the discussion of other matters and may be conducted at a central or regional location or at the representative's or principal's place of business.

Written Supervisory Procedures (WSPs)

FINRA’s supervisory guidelines further require that a brokerage firm maintains written supervisory procedures (WSPs) to supervise the activities of its staff. A brokerage firm's WSPs must address the supervision of its personnel and outline internal controls to monitor and flag violations, track correspondence and internal communications, customer complaints and offer proactive procedures to ensure compliance. A firm’s WSPs must also adopt procedures to monitor customer confirmation of certain transactions, changes in addresses and changes in investment objectives.

System of Supervisory Control Policies and Procedures (SCPs)

Under FINRA Rule 3120, a brokerage firm, in addition to WSP should also maintain a system of supervisory control policies and procedures (SCPs). SCPs are used as a means to test and verify that a firm’s WSPs are reasonably designed to comply with applicable securities rules.

Examples of Failure to Supervise

As outlined above, FINRA rules impose a rigorous and complex set of obligations on a brokerage firm. Appropriate systems and procedures must be in place to monitor employees and protect against policy and procedure violations. Failure to supervise can arise through the failure to monitor and flag potential violations or have adequate measures in place to prevent violations from occurring. The following represent common examples of the failure to supervise:

  • Failure to implement a rigorous pre-hire screening process.
  • Failure to monitor communications of individual brokers with existing customers and with potential customers for advertising purposes.
  • Failure to conduct a yearly review with individual brokers to discuss their compliance with FINRA rules.
  • Failure to conduct office-wide inspections to detect and prevent violations.
  • Failure to monitor transactions.
  • Failure to implement training and licensing
  • Failure to evaluate and change procedures as necessary

Although the above list is not exhaustive, it is important to understand that the failure to supervise can arise from any number of underlying securities violations. As such it is important for any broker-dealer to keep a proactive compliance system in place.

As for investors, they should be aware that a failure to supervise claim is a separate and distinct cause of action. Broker Dealers have a number of defenses they will seek to employ on cases alleging failure to supervise. First an Investor seeking to hold a brokerage firm liable for failure to supervise must prove that his financial advisor for some actionable claim under securities laws. If a broker has been found to have committed some violation related to securities fraud, the brokerage firm may still not be liable If:

  1. It was found to have maintained a reasonable system of supervision
  2. Broker dealer enforced that system with reasonable diligence.
  3. Brokerage firm did not directly or Indirectly Induce the violations by Its registered representatives

Whether a Broker Dealer maintained adequate supervision of its investment advisors at all relevant times Is a fact sensitive Inquiry. Assuming the broker dealer Is maintaining supervisory controls and systems consist with the standard of care In the securities Industry, an Investor must make out a very specific claim to successfully allege failure to supervise.

Heightened Supervision

FINRA recently Issued Regulatory Notice 18-15 which highlighted when a broker should be under "heightened supervision". A broker who has a history of customer complaints or regulatory Inquiries may be placed under heightened supervision by his broker dealer. This generally entails trade reviews and when necessary customer Interviews by the supervising branch manager. As stated In Notice 18-15 FINRA and the SEC have demanded from broker dealers heightened supervision for associated persons with a history of industry or regulatory related incidents.

It points to the need to consult with experienced securities arbitration attorneys, such as Lubiner, Schmidt & Palumbo, if a client feels that her brokerage account has been mishandled or if she otherwise has questions concerning the activity in the account.

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