Failure to Supervise

A broker-dealer owes a duty to all of its customers under FINRA Rule 3010 to properly monitor and supervise its employees. FINRA Rule 3010 states:

Each member shall establish and maintain a system to supervise the activities of each registered representative, registered principal, and other associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable NASD Rules. Final responsibility for proper supervision shall rest with the member…

In short, a brokerage firm owes a duty to all of its customers to properly monitor and supervise its employees. A failure to supervise claim requires: (1) an underlying securities law violation; (2) association of the registered representative or other person who committed the violation; (3) supervisory jurisdiction over that person; and (4) failure of the broker-dealer and/or supervisory personnel to reasonably supervise the person who violated the securities laws.

The underlying securities violation to show a broker-dealer failed to supervise a broker can be a host of violations including: violations of a state blue sky laws, churning, securities fraud, or a violation of FINRA’s suitability rule. This will be very case specific.

Under FINRA Rule 12100(r) a “Person Associated with a Member” includes “a natural person engaged in the investment banking or securities business who is directly or indirectly controlling or controlled by a member, whether or not any such person is registered or exempt from registration with FINRA under the By-Laws or the Rules of FINRA.” Further, “a person formerly associated with a member is a person associated with a member.” In most cases, determining association will be as easy as going to the Website and reviewing the broker’s CRD.

In addition to FINRA Rule 3010, numerous other notices to members, FINRA, SEC, and court decisions hold the securities laws impose upon broker-dealers the duty and obligation to properly monitor and supervise its employees. FINRA Rule 3010 requires that broker-dealers review the activities of each office and branch and every broker in the branch. Broker-dealers must supervise by conducting periodic examination of customer accounts to detect and prevent irregularities and abuses. Broker-dealers must also supervise outside businesses including registered investment advisory firms and review those records as if the securities transactions were on the broker-dealer’s own books and records.

Broker-dealers must also inspect unregistered offices and review any on-site customer account documentation and other books and records, meet with individual registered representatives to discuss the products they are selling and their sales methods, and a examine correspondence and sales literature. Furthermore firms should have unannounced visits to the branch office the firm is required to supervise where appropriate, particularly where there are indicators of misconduct or potential misconduct, or 'red flags.’

Broker-dealers violate the supervisory standard when either: (1) awareness of ‘red flags’ are not followed up with proper supervision; and (2) policies and procedures are deficient resulting in failure to detect ‘red flags.’

The duty to supervise is a critical component of the securities regulatory scheme. Regulatory authorities such as the SEC and FINRA have steadily heightened the supervisory obligations of brokerage firms in recent years. Supervisors have an obligation to respond vigorously to indications of irregularity, often times referred to as “red flags.” A supervisor cannot ignore or disregard red flags and must act decisively to detect and prevent improper activity.

It is important that members review their supervisory procedures and systems that are in place to conduct adequate inspections and determine whether the systems are being followed. Failure to have systems in place to adequately supervise or failure to follow those systems lead to claims that a broker-dealer failed to follow the law.

The importance of proper supervision is manifested in various types of securities activities. Brokerage firms are responsible for monitoring a broker’s investment recommendations to clients, outside business activities, and representations to investors among other obligations. In addition, brokerage firms are responsible for conducting due diligence on the securities products they sell and devising a written supervisory system to achieve compliance with the securities laws. Below are several ways in which brokerage firms may violate their supervisory responsibilities.