SEC Hits The ‘Reset Button’ On Failure To Supervise Liability For Legal And Compliance Personnel

Author:Mr Ivan Knauer and Min Choi
Profession:Pepper Hamilton LLP
 
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On September 30, 2013, the U.S. Securities and Exchange Commission (SEC) - quietly, and with little fanfare - released an informal statement of policy in the form of frequently asked questions (FAQ), in which it addressed its recent case against Ted Urban.1 In doing so, the SEC shed light on when and how the agency will seek to hold legal and compliance personnel responsible for failing to supervise employees on the business side.

As many will recall, the Urban case was closely watched by securities legal and compliance professionals, who worried that a decision by the commissioners could be used by enforcement staff to make such professionals easier targets in future enforcement actions. Ultimately, the commissioners dismissed the case. That said, given the circumstances surrounding the case's dismissal, legal and compliance officers were left with little guidance as to whether the case against Urban could be used against them to establish supervisor liability.

On the one hand, although the FAQ attempts to alleviate worries about such potential exposure, it nevertheless reinforces a broad legal standard as to when a legal or compliance professional becomes a supervisor. On the other hand, the FAQ makes clear that the SEC's enforcement staff cannot cite to or rely on the Urban case when bringing future enforcement actions. In other words, the FAQ is an announcement that the SEC has hit the "reset button," so to speak, effectively erasing the Urban case from its memory. The FAQ nevertheless suggests that another similar case could be brought in the future.

This article will first look back at the history of the SEC's attempts to pursue legal and compliance personnel under a failure to supervise theory. It will then conclude with some thoughts on how firms should read the policy statement when considering the status of legal and compliance personnel going forward.

The SEC's Adoption of the 'FeuersteinStandard'

By way of background, the issue of whether a legal or compliance officer can be secondarily liable for a business line employee's violations of the federal securities laws, based on a "failure to supervise," was first squarely addressed in an SEC enforcement action dealing with the government bond trading scandal at Salomon Brothers (Salomon). Many will remember the casebecause the underlying scandal resulted in the resignation of the firm's high-profile Chief Executive Officer John Gutfreund. Legal and compliance personnel will remember the case because of the 21(a) Report regarding the firm's chief legal officer (CLO), Donald Feuerstein.2

The Gutfreundcase stemmed from the conduct of one of Salomon Brothers' individual brokers, Paul Mozer, who was head of the firm's Government Trading Desk.3 Mozer circumvented limitations on the number of government bond auctions that a single entity could purchase by making unauthorized purchases in clients' names. He would then transfer bonds purchased at auctions to the firm, at the original sale price, and disguise or otherwise conceal the transactions from clients.

John Meriwether, vice president and head of fixed-income trading, was Mozer's direct business line supervisor. Meriwether was first alerted to the problem on April 24, 1991. Shortly afterward, Meriwether reported Mozer's conduct to three members of the senior management of Salomon: the firm's CEO Gutfreund, President Thomas Strauss, and CLO Feuerstein. After listening to Meriwether's account of Mozer's trades, Feuerstein advised Meriwether, Gutfreund, and Strauss that Mozer had committed a criminal act and advised that the firm report Mozer to the government. The four executives then discussed the option of reporting Mozer to the Federal Reserve Bank of New York. After the meeting ended, however, no one reported Mozer to the Federal Reserve Bank.

Mozer continued to engage in suspect or illegal trading on April 25, 1991 and May 22, 1991. The latter transaction caught the attention of the national financial press, and resulted in an inquiry by the Treasury Department and an investigation by the SEC. In the meantime, Salomon retained an external law firm to investigate. The resulting investigation uncovered misconduct dating back to December 27, 1990. Salomon then reported the incidents to the government and terminated Mozer. Shortly thereafter, Meriwether and the executives who attended the April 1991 meeting resigned.

The SEC eventually brought a settled...

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