Liability of Legal and Compliance Officers. Richard D. Marshall Katten Muchin Rosenman LLP New York

Transcription

1 Liability of Legal and Compliance Officers Richard D. Marshall Katten Muchin Rosenman LLP New York

2 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 1

3 Liability of Legal and Compliance Officers 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. 2

4 Liability of Legal and Compliance Officers 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. 3

5 Liability of Legal and Compliance Officers 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. 4

6 Liability of Legal and Compliance Officers 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. 5

7 Liability of Legal and Compliance Officers 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. 6

8 Liability of Legal and Compliance Officers 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. 7

9 Liability of Legal and Compliance Officers 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. 8

10 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. 9

11 Allocation of Investment Opportunities The issue becomes critical when scarce and valuable investment opportunities are allocated among client accounts. 10

12 Allocation of Investment Opportunities 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. 11

13 Allocation of Investment Opportunities 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. 12

14 Allocation of Investment Opportunities 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). 13

15 Allocation of Investment Opportunities Allocations should be: Fast Fair Documented Disclosed 14

16 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. 15

17 Protecting Confidential Information 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. 16

18 Protecting Confidential Information 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. 17

19 Protecting Confidential Information 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. 18

20 Protecting Confidential Information 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? 19

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