Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "The Role of Compliance Personnel" National Regulatory Services 10th Anniversary Investment Adviser & Broker-Dealer Compliance Conference Paget Parish, Bermuda April 7, 1995 * The views expressed herein are those of Commissioner Roberts and do not necessarily represent those of the Commission, other Commissioners or the staff. "The Role of Compliance Personnel" I. Introduction I appreciate the opportunity to participate once again in an NRS conference. It has been my pleasure during the past few years to discuss with you a number of securities public policy issues in such diverse areas as market structure, wrap fee programs, investment adviser legislation, derivative securities and foreign listings, and I have always found the inevitable debate that follows both enjoyable and educational. This year it is my intention to speak on what I view to be the proper role of compliance personnel for broker-dealers and investment advisers. I plan to provide you with an overall personal view of that role, discuss a few noteworthy Commission enforcement actions in the area, and conclude with a few remarks about wrap fee programs. II. The Role of a Compliance Officer It should come as no surprise to you that the Commission views the role of inhouse compliance personnel as being critical to the maintenance of the integrity of our securities markets. You are the first line of defense against fraud and sales practice abuse, and you can serve your employer well by serving the public well. The Commission enforcement cases against Prudential Securities and Paine Webber should have demonstrated that point adequately. As the first line of defense, what weapons should you have in your arsenal? First, in my view, it is essential for a compliance officer to have the authority within the firm to remedy inappropriate conduct. This authority should include the ability to sanction, or maybe even fire, rogue employees. At a minimum, there should be the ability to notify and follow up with supervisors all the way up to the top of the chain of command until the problem is remedied. Second, the firm should have in place strong compliance procedures that both educate and monitor employees. For procedures to be effective, however, there must be a commitment by the firm to enforce the procedures and to educate the employees appropriately. Last, compliance must have the proper resources to be effective. I recognize that a compliance department is without immediate tangible benefits; and, as such, it is not naturally high on the priority list for resource allocation. Nevertheless, public trust and confidence is a critical component of any successful securities market operation in my view, so compliance should be provided with sufficient resources to be effective. Certainly, any compliance officer must exercise vigilance in monitoring conduct. A compliance officer must be especially alert for "red flags" that suggest questionable conduct. The best early warning systems, as far as I can tell, are automated exception reports and, most importantly, customer complaints. A compliance officer that fails to take adequate steps to respond to these red flags risks a visit from the Commission's Division of Enforcement. Unfortunately, the Commission's enforcement personnel are ordinarily the last to arrive on the scene, and by then there usually has already been significant damage to the firm and its customers. III. Compliance Procedures No doubt you heard this morning how to develop effective compliance procedures. Except for Section 15(f) of the Securities Exchange Act of 1934 ("Exchange Act") and Section 204A of the Investment Advisers Act of 1940, there are no federal securities law requirements of which I am aware that imposes a duty to adopt compliance procedures.-[1]- Reasonable procedures, however, can be an affirmative defense to a failure to supervise action. Further, good compliance procedures make excellent business sense as they protect the integrity of the firm. Just as important as developing compliance procedures is the need to revisit them periodically to determine their effectiveness. Procedures that are not adequately monitored and updated are little better than having no procedures at all. As I indicated, there is a federal securities law requirement contained in Section 15(f) and Section 204A to adopt compliance procedures; however, these provisions address the misuse of material nonpublic information only. These sections require that broker-dealers and investment advisers establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information by such broker-dealer, investment adviser, or any person associated with them. Of course, these requirements were a part of the Insider Trading and Securities Fraud Enforcement Act of 1988. The Commission brought its first enforcement case under these sections late last year against Gabelli & Company and GAMCO Investors, Inc.-[2]- This case arose out of trading in Lynch Corporation securities by the defendant companies. The policies, procedures, and practices in place at the defendant firms did not adequately take into account the special circumstances presented by Mario Gabelli's role as chairman of the board of directors and chief executive officer ("CEO") of Lynch and his roles as de facto chief investment officer of Gabelli & Company and GAMCO. In the Commission's view, the policies in place were not reasonably designed, in view of the defendant's overall business, to prevent the misuse of material, nonpublic information. As CEO of Lynch, Gabelli was in a position to possess material, nonpublic information about Lynch's financial position and operating results. The Gabelli investment companies had an informal "three day rule" which put Lynch securities on the restricted list only on the three days surrounding the issuance of Lynch press releases and board meetings. There were no written procedures in place, and compliance with the three day rule was not consistent. The defendants were ordered to cease and desist from further violations of Sections 15(f) and 204A and were fined $50,000. In addition, they undertook to implement changes recommended by an independent consultant, who would provide the Commission with follow up reports. IV. Failure to Supervise Liability While failure to implement reasonable procedures to prevent the misuse of material, nonpublic information is an actionable offense, the failure to adopt procedures to address other types of misconduct is not necessarily a violation. Yet, as I mentioned earlier, adopting reasonable procedures is an affirmative defense to a charge of failure to supervise under Exchange Act Section 15(b)(4)(E). Although the subject of failure to supervise lends itself easily to a long discussion; I plan to touch upon only the area that I believe is of greatest interest to this audience ... and that is failure to supervise liability for legal and compliance personnel. In 1964, Congress enacted what are now Sections 15(b)(4) and (b)(6) of the Exchange Act. Section 15(b)(4)(E) authorizes the Commission to impose sanctions against a broker-dealer if the firm has "failed reasonably to supervise, with a view to preventing violations [of the federal securities laws], another person who commits such a violation, if such other person is subject to his supervision." It is interesting to note that this statutory provision refers to "preventing violations of the provisions of ... statutes, rules, and regulations ..." The word "order" does not appear on this list, which has given rise to some intriguing discussions at the Commission. Section 15(b)(6) of the Exchange Act incorporates Section 15(b)(4)(E) by reference and authorizes the Commission to impose sanctions for deficient supervision on individuals associated with broker-dealers. Unfortunately, the legislative history behind these provisions provides little guidance as to what was intended by the phrase "subject to his supervision." This has led to a great deal of uncertainty as to who can be a supervisor within the meaning of the failure to supervise liability provisions of the Exchange Act. Typically, a finding of liability involves two distinct considerations: (1) whether the person was the supervisor of a person who violated the federal securities laws and (2) whether the person performed reasonably in discharging his or her supervisory responsibilities. Both of these questions ordinarily entail a fact specific inquiry, especially in the case of "non- line" personnel, such as most legal and compliance personnel, where the concept of supervisory responsibility is far less developed than in the case of "line supervisors." Taking the second liability consideration first, as the case law demonstrates, it is easier to determine when a person has performed reasonably in discharging supervisory responsibilities than it is to determine when a person is a supervisor. There exist a few Commission proceedings involving compliance or non- line supervisory personnel where the Commission declined to find that the person acted unreasonably. For example, in "Louis J. Trujillo", the Commission overturned an administrative law judge's determination that a surveillance and compliance person had failed to supervise a registered representative who churned and made unauthorized trades in customer accounts.-[3]- The Commission found that Trujillo's conduct, although not exemplary, was reasonable in that he had taken diligent efforts to inform the branch manager of the need to discipline the employee. The opinion took no position as to whether Trujillo was a supervisor of the rep in question. Another example is "Arthur James Huff", in which the Commission divided over whether Huff, a compliance officer, was a supervisor.-[4]- Chairman Breeden and I found that although Huff may have been a supervisor, he did not act unreasonably in view of the limited scope of duties he was given by the firm. The more difficult issue unresolved by "Huff" was when compliance officers are considered to be supervisors of a non- line employee. A segment of the securities industry apparently continues to question whether compliance officers should ever be deemed supervisors within the meaning of Exchange Act Section 15(b)(4)(E) when they are not a line supervisor of the employee who committed the violation. Although this debate does continue, I think it is fair to say that the present Commission does not view itself as being barred from charging compliance officers with liability for failing to supervise, even when the compliance officer is not a line supervisor of the employee in question. So, when is a compliance officer a supervisor? The test is necessarily a facts and circumstances determination. As such, there is no bright-line standard, rather guidance must be gleaned from Commission decisions and orders. Three fairly recent Commission proceedings do shed some light on the subject. In the "Gary W. Chambers" case, the Commission found that Chambers had failed reasonably to supervise in failing to discharge his responsibility to ensure that his firm "adopted and maintained adequately supervisory and compliance policies and procedures."-[5]- Although the firm compliance manual vested him with designing procedures, he failed to do so. The Commission order identified other factors as well suggesting that Chambers assumed supervisory responsibility for the persons committing the violations, including his role in reviewing transactions, his failure to discover misconduct of the persons at a previous employer, and his knowledge that there was no one else supervising the persons. In the 1992 case of "First Albany Corporation", the firm's chief compliance officer was also the general counsel and had the responsibility to implement compliance procedures and enforce the firm's trading restrictions.-[6]- This compliance person had the power "to take disciplinary action against a registered representative who violated firm policy by removing commissions and imposing small fines." The Commission concluded that a violation occurred when the compliance person was alerted to a violation and failed to determine whether the branch office instituted corrective measures. The most important Commission proceeding in the area in my view, however, was the Commission report under Section 21(a) of the Exchange Act concerning the actions of Donald Feuerstein, the chief legal officer of Salomon Brothers. Of course, the Commission did charge John Meriwether, Thomas Strauss, and John Gutfriend with failure to supervise Paul Mozer, a Salomon trader who submitted false bids to the Treasury Department. The false bids came to the attention of these three top management supervisors, as well as Feuerstein. Although Feuerstein was not technically Mozer's line supervisor, he became part of the management team response to the violation of law. Given the confusion that resulted from the divided "Huff" opinion, rather than name Feuerstein in the action with the other supervisors, the Commission elected instead to issue a report under Section 21(a) of the Exchange Act (the "Report").-[7]- The Report clarified the "Huff" opinion to some extent and validated the progression of cases holding that non-line supervisors can become supervisors, depending upon the facts and circumstances, even where the person has no hire, fire, reward or punishment authority. In my opinion, the key sentence in the Report appears on page 23. "Rather, determining if a particular person is a 'supervisor' depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue." This language, in my view, expanded the traditional definition of "supervisor" even from that contained in the Breeden-Roberts opinion in "Huff". Interestingly enough, there is no specific knowledge condition appearing in the Feuerstein standard. However, I am of the view that the more knowledge a compliance person has of misconduct, that is not responded to in a reasonable compliance manner and then is repeated, the more likely that person will be deemed to be a supervisor within the meaning of Exchange Act Section 15(b)(4)(E). Hopefully, future Commission actions in the failure to supervise area involving legal and compliance personnel will clarify how the Feuerstein standard will be applied. I know that those employed in this sector of the securities industry would welcome some certainty in the area. It is my fervent hope that the Commission would not waver from utilizing its enforcement authority in this area when the facts and circumstances are appropriate, but would do so in a balanced and responsible manner. I see nothing to be gained from a policy of instituting failure to supervise actions against legal and compliance personnel on a routine basis. V. Wrap Fee Accounts Before concluding my remarks today, I would like to discuss briefly the primary legal issue surrounding wrap accounts. I believe that the members of this audience should be on the lookout for Commission enforcement activity which may be forthcoming in this area. I know that you have already heard a program about wrap accounts this morning and about the potential for troubling conflicts of interest that may appear in the administration of these accounts. For a long time, the Commission has been concerned that some have obliterated the admittedly fuzzy line that exists between a legitimate wrap fee program that does not need to be registered and a wrap account program that pools investment capital and selects securities for the pool as a whole. The latter may be no different from a mutual fund and may need to be registered if there are more than 100 participants. Of course, in wrap fee programs, clients matched with a particular portfolio manager often receive substantially the same securities advice and their accounts often hold the same or substantially the same securities. If the investors do not retain individual ownership of the securities in their accounts and do not receive individualized treatment, the program probably should be treated as an investment company because it would be an "issuer" primarily engaged in investing and trading in securities. The first Commission foray in this area was more than twenty years ago with an enforcement action against an investment adviser and a broker-dealer who operated a program similar to a wrap fee program.-[8]- While the program involved in that action was advertised as offering personalized advice, the Commission found that the adviser invested client funds in a virtually uniform manner. As you heard this morning, fifteen years ago the Commission proposed Investment Company Act Rule 3a-4 to provide some clarity in the area. This proposed rule would have provided a safe harbor for programs satisfying the requirements of the rule. Although the rule was never adopted, the Division of Investment Management has issued more than twenty no-action letters using, in part, the standards contained in the proposed rule. I understand that some wrap fee sponsors have taken a mechanical approach to providing individualized treatment to clients. I am of the view that quarterly mass mailings and perfunctory annual check-ups are insufficient, by themselves, to demonstrate that clients are receiving investment advice tailored to their individual needs. A lack of diversity among client accounts suggests to me that clients are not receiving a meaningful opportunity to exclude particular securities from their accounts. In my opinion, this opportunity to exclude certain securities is one of the most telling differences between a wrap fee program and a mutual fund. Apparently, the Division of Investment Management's long- anticipated release more clearly delineating the line between a legitimate wrap fee program and an unregistered investment company is expected to be considered by the Commission shortly. I have been somewhat frustrated by the length of time necessary to bring this project to Commission consideration, but I have recently been assured that the release is just around the corner. Therefore, I do advise you to remain alert for potential Commission action in this area. VI. Conclusion In its enforcement program, the Commission has attempted to be tough and aggressive on the one hand and fair and reasonable on the other. That is a difficult balance to maintain, especially in the failure to supervise area involving legal and compliance personnel where the facts and circumstances so often control. I can assure you that the Commission strives to "do the right thing" in its enforcement program, and in the almost five years that I have been on the Commission, I generally have been proud of the result. My parting advice to you today is to consider whether you have the authority, procedures, and resources to carry out your compliance functions effectively. They are critical to the success of your employer. Further, it may be worth revisiting your wrap fee programs to ensure that they provide the necessary individualized client treatment to qualify as a legitimate wrap fee program. ENDNOTES -[1]- Arguably, Rule 17j-1(d) under the Investment Company Act of 1940 imposes such a requirement by requiring a fund to adopt a code of ethics. -[2]- In the Matter of Gabelli & Co., Inc. and GAMCO Investors, Inc. Securities Exchange Act Release No. 35057 (Dec. 8, 1994). -[3]- Exchange Act Release No. 26635 (March 16, 1989). -[4]- Exchange Act Release No. 29017 (March 28, 1991). -[5]- Exchange Act Release No. 27963 (April 30, 1990). -[6]- Exchange Act Release No. 30515 (March 25, 1992). -[7]- Exchange Act Release No. 31554 (Dec. 3, 1992). -[8]- SEC v. First National City Bank, Litigation Release No. 4534 (Feb. 6, 1970).