doing, and may not have noticed any "red flags" warning of compliance problems. Nevertheless, the SEC still imposed administrative sanctions. For example, the SEC censured and fined Refco Securities, Inc., the sum of $250,000 for a series of schemes in which Stephen Wymer, a broker, assisted by other registered representatives, at Refco defrauded his clients of $80 million. The SEC determined that Refco failed to establish adequate written procedures to review, among other things, its audit confirmations and mail. In re Refco Securities, Inc., 62 SEC Docket (CCH) 1322 (N.A.S.D. Aug. 6, 1996).
In re Westcap Securities, L.P.
Westcap Securities had its registration revoked and was ordered by the SEC to pay over $800,000 in penalties and disgorgement when it failed to supervise its registered representatives. The SEC found that the brokers materially misrepresented the risk associated with investing in Real Estate Mortgage Investment Conduits or "REMICs" to its customers and failed to have compliance procedures in place to make sure their brokers disclosed the risks. The SEC also found that Westcap failed to follow its own compliance policy by not allowing its compliance officers to verify account information directly with customers. In re Westcap Securities, L.P., 61 SEC Docket (CCH) 709 (N.A.S.D. February 14, 1996).
What these cases further suggest is that brokerage firm supervisory personnel, from the CEO on down, must take affirmative steps to address compliance concerns early to guard against failure to supervise liability. A number of steps legal and compliance supervisory personnel should consider taking to protect themselves are discussed below. Suffice it to say that to shield themselves, broker-dealers will have to carefully scrutinize their compliance systems at all levels--making sure that they function well throughout firm hierarchy.
Controlling person
Both the 1993 Act and the 1934 Act impose liability for persons ("controlling persons") who control the person who commits the violation. A broker-dealer may be held responsible for actions committed by its managers and registered representatives under the controlling person theory of liability under section 20(a) of the 1934 Act. 15 U.S.C. section 78t(a). That statute states that any person who directly or indirectly controls any person who is liable for selling securities in violation of the Act is liable to the same extent as the seller, unless he acted in good faith, and did not directly or indirectly induce the act at issue. Section 20(a) makes any person who "controls" another liable for securities law violations to the same extent as the controlled person.
Who has control?
Although corporate officers responsible for the day-to-day operations of a broker-dealer or any other organization may possess the requisite "power to control or influence," it does not always follow that directors, principals, officers, and others are automatically liable as controlling persons for the violations of others. The degree of "control" necessary to hold a firm or its supervisory personnel liable under the controlling person statute is not always clear--even among the courts that have interpreted section 20(a).
Indeed, there exists a split among the courts on the degree of conduct needed to determine control person liability. Some courts have required so-called "culpable participation" conduct in the underlying securities law violation. The culpable participation approach or test requires evidence that the controlling person knew of the fraudulent misrepresentations and actually participated in them, or that the person's "inaction intentionally furthered the fraud or prevented its discovery." Other courts have imposed a two-part test which requires that:
* the controlling person had culpable participation in the transaction; and
* the controlling person also "possessed the power to control the specific transaction or activity upon which the primary violation is predicated." Metge v. Baehler, 762 F.2d 621, 631 (8th Cir. 1985) cert. denied 474 U.S. 1057 (1986). A plaintiff, however, does not need to prove that the power was exercised.
In Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873 (7th Cir. 1992), cert. denied, 509 U.S. 904 (1993), for instance, the Seventh Circuit Court of Appeals held that Dean Witter could be liable as a controlling person for the fraudulent acts of two of its employees--even without the firm's knowledge of the employees' actions. In this case, the employees gave the plaintiff, Harrison, certain promissory notes in exchange for funds to be invested in municipal bonds. The appeals court reached found Dean Witter to be a "controlling person" despite the fact that a lower court found that:
* The two employees conducted the transactions as individuals, making sure that Harris did not send payment for the transactions to Dean Witter;
* All payments on the promissory notes were made from the personal checking account of one of the employees; and
* The plaintiff never contacted Dean Witter to ask about the investments.
Aiding and abetting after Central Bank of Denver
The Supreme Court's controversial decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), destroyed the SEC's and private parties' use of the aiding and abetting theory of liability against broker-dealer firms, supervisory personnel, and others for the wrongdoing of an employee. The Supreme Court held that the text of the anti-fraud provision, section 10(b) of the 1934 Act, 15 U.S.C. section 78j(b) did not provide a private plaintiff with a private right of action against persons who aid an abet violations of section 10(b) of the 1934 Act and Rule 10b-5 thereunder. The decision meant that private investors could no longer recover from persons who substantially assist in a securities fraud, even if such persons acted knowingly or with a high degree of recklessness.
After Central Bank, the SEC urged Congress to pass legislation that would expressly permit it to seek injunctions and other relief against aiders and abettors. Legislation to restore the SEC's ability to seek injunctive relief or fines and penalties against aiders and abettors was passed as part of Congress' enactment of the Private Securities Litigation Reform Act ("Reform Act"), Pub. L. No. 104-67, 109 Stat. 737, in 1995. No such relief, however, was granted within the Reform Act to private litigants who may have wanted to allege aiding and abetting liability in a private action against a broker-dealer firm or its supervisory personnel. First Capital, as discussed above, is the most recent example of the SEC charging partners with willfully aiding and abetting violations of the Investment Advisers Act of 1940.
Respondeat superior
Respondeat superior is a legal doctrine that holds that a principal is vicariously liable for the acts or conduct of its agent. Traditionally, under "respondeat superior" (a nice term, though its significance is becoming less meaningful within the law), a broker-dealer could be held vicariously liable for the wrongful acts of its representatives committed within the scope of their employment. The issue of whether respondeat superior is a legitimate basis for imposing secondary liability on employers remains unsettled by the courts. Adding to the confusion is the fact that the courts are not in agreement on whether the controlling persons provisions of the federal securities laws, discussed above, preclude raising the theory of respondeat superior as a ground for imposing liability.
Ninth Circuit: Respondeat superior inapplicable to brokerage firms
The Ninth Circuit Court of Appeals found that respondeat superior may not be used against brokerage firms, and concluded that Congress intended to supplant, rather than expand, common law liability when it enacted section 20(a) of the 1934 Act, the controlling person provisions. Christoffel v. E.F. Hutton & Co., Inc., 588 F.2d 665, 667 (9th Cir. 1978).
Third Circuit: Limited application
However, the Third Circuit Court of Appeals has held that the doctrine is available only in actions against broker-dealers and accounting firms. Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880, 884-86 (3d Cir. 1975) (extending liability to broker-dealers); Sharp v. Coopers & Lybrand, 649 F.2d 175, 185 (3d Cir. 1981), cert. denied, 455 U.S. 938 (1982) (extending liability to accountants).
Second Circuit: Apparent authority
The Second Circuit Court of appeals has held, based on a theory of apparent agency, that these provisions do not preclude liability of corporate officials for misrepresentations of its representatives. Marbury Management, Inc., v. Kohn, 629 F.2d 705, 716 (2d Cir.), cert. denied, 449 U.S. 1011 (1980).
Notwithstanding unsettled case law, the SEC has not used agency theories in recent years in its injunctive or administrative proceedings. It may have even less reason to do so after Central Bank. Although the majority opinion did not say that respondeat superior liability is dead, the minority dissent in Central Bank suggested that it was probably dead.
In sum, all of these cases, no matter what a regulator's or private claimant's theory of liability, should be read to mean that firms and their supervisory personnel--from the CEO on down--expose themselves to substantial legal risk when they fail to take an aggressive, hands-on approach to supervising registered representatives within the firm. Put simply, officers and managers should continue to expect ever-increasing sanctions, including monetary damages, if they believe that delegating responsibility for compliance will absolve them.
Practice considerations
In the current environment of supervisory liability, officers, legal and compliance officers may want to consider the following possibilities to protect themselves and their firms from regulatory accountability.
1. Written compliance and supervisory procedures
Firms should adopt written supervisory policies and procedures--required by the self-regulatory organizations--not only as a road map to detect violations, but also to improve operational efficiencies. The SEC, NASD, the New York Stock Exchange ("NYSE") and the Amex all have rules requiring brokers and their firms to have written policies and procedures designed to prevent violations of the securities laws. Such procedures, while not prophylactic, can provide firms and their supervisors with a defense against supervisory liability. Adopting procedures may prove even more helpful when firms engage in transactions involving new, created and uncharted areas. Word-for-word copying of procedures from industry manuals and trade association guidelines is not a substitute for compliance. This is not to say that such procedures are not helpful. The NASD Compliance Checklist and other supplementary suggested procedures from the Exchanges provide a good starting point for creating procedures. Actual practices must not be inconsistent with written compliance procedures. See also, NASD Conduct Rule 3010; "Large Firm Project Report," 93-95 CCH Dec., Paragraph 85,348 (May 1994); "Joint Regulatory Sales Practice Sweep Report," 95-95 CCH Dec., Paragraph 85,742 (Mar. 1996); and NASD Notice to Members 97-19 (March 1997). Indeed, firms will, no doubt, find it appropriate to revise procedures when problems occur.
2. Compliance monitoring
Firms should consider establishing monitoring procedures to ensure that written supervisory procedures are being followed, and that the persons responsible for a particular supervisory function is, in fact, overseeing the supervisory responsibility and responding to actual and potential violations effectively. Monitoring should also include branch office activities. The compliance system might, arguably, begin with the branch manager, but to be effective, it must include regional managers, the compliance department, and other legal and compliance officers--all the way up the chain, ending with the CEO.
3. Compliance audits
The firm should periodically conduct mock regulatory audits not only in preparation for possible regulatory exams by the SEC, NASD, or other self-regulatory organization, but also to determine whether its branch managers, officers, and legal and compliance staff are responding to violations which inevitably negatively impact the firm's finances. Being objective when evaluating the firm's compliance program is important. Consideration should be given to hiring an outside consultant to evaluate the firm's compliance program and conduct a mock audit.
4. Reviewing correspondence
A procedure should be adopted for review and documenting of incoming and outgoing correspondence between reps and customers. Senior supervisors should be responsible for reviews.
5. Background investigation of brokers
SEC Forms U-4 and U-5 should be reviewed, as well as confirmation of previous employment relationships. Hiring a rep with a history for pure financial reasons or based purely on the recommendation of a colleague or friend is asking for trouble. The firm should consider asking the broker's permission to review complaint files against the broker maintained by a previous employer.
6. Supervisory and compliance training
In addition to firm-wide training, supervisors should attend continuing education programs designed to enhance compliance training. Compliance training should be conducted throughout the firm and its branch offices. Attendance of educational and training programs should be well documented. The firm's compliance personnel should at least once a year conduct in-person interviews with all reps including those not in retail sales.
7. Branch office reviews and examinations
Legal and compliance officers should regularly review branch office activities. Regular--perhaps quarterly--reviews of customer accounts may be in order. Such reviews might detect churning, unsuitability, over-concentrations, unauthorized trading and margin problems. Reviewing daily trading tickets for suspicious activity may detect violations. Surprise inspections may be appropriate for small offices with only a few representatives.
8. Documenting the documents
An examination of all offices should disclose that all supervisory policies are written and documented. Reviews should be thorough and should determine that firm personnel received and used supervisory procedures in conducting firm business. Asking questions about supervisory manuals and documents is not enough. Supervisors and compliance officers should observe documents first hand.
9. Prompt investigation of wrongdoing
When violations are discovered, firms and supervisors should act decisively to ensure that wrongdoing is invested and ended. After learning of the problem, management must notify the legal and compliance personnel responsible for investigating the matter. Delegating responsibility to investigate and correct problems solely to the branch manager or other lower-level employees, as discussed above, is not enough to withstand failure-to-supervise liability. Branch managers and others should cooperate fully with the compliance department's investigation of possible problems. An investigation should not end with hearing the representative's version of the facts. The customer must be interviewed about claims of fraudulent sales practices. Also consider whether restrictions on the activities of a representative under investigation is appropriate. Some investigations of broker misconduct might call for use of outside counsel. An investigation directed and conducted by outside legal counsel may allow the firm to assert the attorney-client and work product privileges when appropriate.
10. Customer complaints
Related to the prompt investigation of wrongdoing is the need to respond timely to customer complaints. The nature of the business generates customer complaints. In the long run, rapid response and evaluation of complaints by branch managers or other supervisors designated to respond to customer complaints limits and may prevent need for litigation. Branch managers and others who respond to complaints must view themselves more as compliance managers than sales manager.
11. Adequate resources and staffing
The CEO and other upper-level management must ensure that appropriate levels of resources and personnel exist to meet compliance demands commensurate with the nature and size of the firm's operations. The fact that a firm is small with limited personnel, far from absolving the head of the firm from supervisory liability, may mean that a CEO might be held directly responsible for supervisory lapses and wrongdoing. The supervisory responsibility of the CEO extends to other supervisors down the chain of command, and requires the ability to follow up to make sure that violations are reviewed and corrective action taken.
12. New and complex products
In light of staggering losses over the last few years involving derivatives and other hybrid investment products, it behooves officers and legal and compliance employees to pay close attention to the firm's offering of new and complex products. The kinds of products firms are allowed to sell changes rapidly. Although it sounds simple, supervisors must make every effort to see to it that brokers explain directly to their customers the nature of the product and the risks involved, no matter how complex the product or sophisticated the investor. Firms cannot expect to escape regulatory sanction by offering the simple defense that no matter what a representative may have told an investor, information in the prospectus was accurate.
13. Regulatory developments
Finally, firms should recognize, if they haven't already, that a great deal of Monday morning quarterbacking occurs in the regulatory environment. The lack of a bright-line test for determining whether there has been a failure to supervise is troubling to many. Strong arguments can, however, be made for not having such tests or standards. Nevertheless, the regulatory system is imprecise at best. There simply is no immutable, comprehensive source for determining the applicable rules, regulations, or policies which determine how a regulator might view supervisory responsibility for a particular violation. Often, ever changing new agency releases, agency positions, administrative decisions, as well as some regulations, simply do not filter down to smaller firms in the way that large firms are able to monitor and receive information about new developments. In short, continuous regulatory developments require the firm's management, compliance and legal personnel to be circumspect in protecting the firm and themselves from supervisor liability.
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This article was originally written for The Practical Lawyer, January, 1998. There have been other developments and possible changes in the law since that time.
Dexter B. Johnson is a partner with Mallon & Johnson, P.C. in Chicago.
By Brent H. Gwillim, Heyl, Royster, Voelker & Allen, Peoria
A recent Fifth District case provides an interesting set of facts and a good analysis of the current methods by which a court will consider piercing the corporate veil.
In The People of the State of Illinois v. V & M Industries, Inc., 233 Ill.Dec. 218, 700 N.E.2d 746 (Ill.App. 5th Dist. 1998), the state had sued a corporate landowner and individual defendant under the Environmental Protection Act in relation to air pollution caused when approximately 40,000-50,000 tires burned on property owned by the corporation. A shareholder of the corporation was sued individually on the basis that the corporation was just the shareholder's alter ego; however, the trial court dismissed the count as to the individual shareholder and the appellate court reversed finding that piercing the corporate veil was justified.
The court, in a lengthy dissertation of facts, analyzed the current law in Illinois with respect to piercing the corporate veil. The court began by stating that corporate officers can be found personally liable for corporate obligations through a remedy known as piercing the corporate veil. The court went on to state that in order to pierce the corporate veil, there must be (1) such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) circumstances which exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences. Further a corporate entity will be disregarded if it would otherwise present an obstacle to the protection of private rights or if the corporation is an alter ego or business conduit of the governing or dominant personality. More succinctly, some element of unfairness, something akin to fraud or deception, or the existence of a compelling public interest must be present in order to disregard or pierce the corporate veil. A reviewing court will only reverse a finding of the trial court on the issue of piercing the corporate veil if it is against the manifest weight of the evidence.
Interestingly, in the trial court it is noted that the wife of the target shareholder who was subject of the claim that the corporation was no more than his alter ego testified that "she was in the dark" as to any of the corporation's business activities and that her husband "runs the show." The court then analyzed the law pertaining to piercing the corporate veil. The court listed eight factors which a court should consider indicating that no single factor should be determinative. The eight factors cited by the court are as follows:
1 Inadequate capitalization.
2 The failure to issue stock.
3 The failure to observe corporate formalities.
4 The payment of dividends.
5 The insolvency of the debtor corporation at the time.
6 The nonfunctioning of other corporate officers or directors.
7 The absence of corporate records.
8 Whether the corporation is a mere facade.
In the present case the court found that the target shareholder's corporation, V & M Industries, Inc., was under-capitalized. The facts showed that V & M was unable to pay its debts for approximately five years prior to the incident which gave rise to this claim.
Second, there was a failure to issue stock. No stock certificates were ever prepared or issued.
Third, the corporation, V & M Industries, Inc., failed to observe corporate formalities. The records of the corporation and those of the Secretary of State's Office showed that the target shareholder, though executing certain documents as treasurer of the corporation, was not the treasurer of the corporation. Moreover, facts showed that the target shareholder "ran the show" and that no minutes were ever recorded. Though officers were elected, the