SEC Brings Failure to Supervise Administrative Proceeding against Broker-Dealer General Counsel

On Oct. 19, 2009, the U.S. Securities and Exchange Commission instituted an administrative proceeding against the former general counsel of Ferris Baker Watts Inc., a well-known regional broker-dealer in the mid-Atlantic area which has since merged into a national firm. The case alleges that the general counsel ignored numerous red flags and failed to supervise a registered representative at that broker-dealer. Theodore W. Urban, Exchange Act Rel. No. 60837 (Oct. 19, 2009). SEC failure to supervise proceedings against in-house lawyers have been extremely rare, especially concerning the supervision of line-level registered representatives, and we believe the case bears careful scrutiny by lawyers and compliance officers in all SEC-regulated entities. The SEC may have reignited the debate about the supervisory responsibilities of legal and compliance officers sparked by the Feuerstein Section 21(a) report in 1992.

The SEC's case against Urban is contested, and therefore one must assume that the SEC's allegations put its case in the most favorable light possible to the Commission and may omit significant facts helpful to the respondent. As alleged, Urban (a former senior SEC staff member) held a variety of securities licenses, and in addition to serving as General Counsel, served on the firm's Board of Directors and Credit Committee and supervised the firm's Compliance Department. The case involves the supervision of Steven Glantz, a registered representative based in Ohio whom the firm recruited in January 2003 and who worked there until November 2005. Glantz ultimately pled guilty to criminal charges of securities fraud and false statements to law enforcement officals, was sentenced to nearly three years in federal prison and has been barred from the securities industry.

According to the Commission's allegations, Glantz brought with him to the firm accounts in the name of IPOF, an Ohio limited partnership, controlled by David Dadante.¹ The Commission alleges that Dadante, together with Glantz and an unnamed representative at another broker-dealer, manipulated the stock of Innotrac, a thinly traded Nasdaq-listed company. According to the SEC, IPOF controlled some 30 percent of the outstanding common stock of Innotrac, and accounts managed by Glantz controlled another 25 percent. IPOF typically accounted for a substantial portion of the daily trading volume of Innotrac.

The Commission alleges that the firm's Private Client Director and Retail Sales Director recruited Glantz, and Urban approved his hiring, even though he had 10 customer complaints and according to several individuals in the firm's Ohio office had a questionable reputation in the industry.² The Private Client Director and Retail Sales Director agreed with Glantz on an unusual arrangement in which Glantz handled both retail accounts out of the firm's Ohio office, and institutional accounts from its Baltimore trading desk. Urban, it is alleged, found out about this arrangement after it was implemented and "did not object to it." In May 2003, personnel in the firm's Compliance Department wrote a memorandum finding that Glantz was accumulating Innotrac stock for customers at steadily increasing prices potentially suggestive of manipulation, that Glantz was buying Innotrac stock in the accounts of customers for whom it was unsuitable and that Glantz was mismarking many of the trades as unsolicited. The memorandum concluded that it appeared that Glantz was not being effectively supervised. Urban discussed the memorandum with the Private Client Director and the Retail Sales Director, and the SEC alleges that Urban "did not follow-up" to determine if the Private Client Director and Retail Sales Director actually had followed through on the steps they promised to take in response.

In June 2003, a senior institutional trader at the firm told the Compliance Department he suspected Glantz was manipulating the price of Innotrac, and Compliance recommended to Urban that Glantz be placed on special supervision. According to the SEC, Urban disregarded this recommendation, although he did restrict IPOF's purchases of Innotrac stock until IPOF filed a Form 13D disclosing its position in the stock. However, over the course of that summer, the Commission alleges that Dadante began a new manipulative scheme involving placing and then canceling limit order bids so as to prevent short sales in Innotrac stock; again the institutional sales desk brought this to the attention of the Compliance Department, which notified Urban. Shortly thereafter, the Operations Department told Urban about potential wash sales, free-riding issues and excessive account concentrations relating to Glantz's customers' Innotrac positions. Urban raised these issues with the firm's Private Client Director, who agreed to delegate the supervision of Glantz to the firm's Baltimore office, and with the Retail Sales Director. However, the SEC alleges that none of the three adequately followed up on the issues highlighted by Compliance.

In January 2004, Urban restricted Glantz from purchasing Innotrac stock for customer accounts, and in February he wrote a memo to the firm's Credit Committee which resulted in the committee barring IPOF from using margin for any further Innotrac purchases. The firm's Private Client Director met with a lawyer for Dadante and Glantz to explain these restrictions, and after February, there were no further purchases of Innotrac at the firm. However, the Commission alleges that Urban (together with the Private Client Director and Retail Sales Director) did not adequately address other issues that had come to their attention concerning Glantz. According to the SEC, when the supervision of Glantz eventually was transferred to Baltimore, no one informed the Baltimore branch manager of the prior issues with Glantz, and when the firm hired new Compliance staff, including a new Compliance Director, Urban did not inform them of those issues. In September 2004, the Baltimore branch manager told Compliance that he could not supervise Glantz and that he should be terminated; Compliance noted unsuitable trading in Glantz's customer accounts and raised new issues about potentially manipulative trading in Innotrac stock. Again, the SEC alleges that Urban did not respond appropriately to these red flags.³

In December 2004, Compliance personnel discovered that Glantz had bought substantial positions in Innotrac for several of his customer accounts, and determined that not only were the customers unaware of the trades, they also were not aware that Glantz was using margin in their accounts. Urban wrote a memo to the Private Client Director and Retail Sales Director recommending that Glantz be terminated. However, the Private Client Director challenged the recommendation, and offered to take personal responsibility for special supervision of Glantz. Urban withdrew his recommendation and acquiesced in the special supervision arrangement. Urban caused the firm to file a Form RE-3 with the NYSE concerning Glantz's trading without written authorization, but did not mention the other issues uncovered by Compliance.

In February 2005, Glantz placed a series of trades in his own and his customer's accounts that had the effect of substantially increasing the price of another stock, ATC Healthcare. At the end of the trades, Glantz sold the shares in his own account at a profit, but not any of the customers' shares. The SEC alleges that the firm's AML Officer brought these trades to Urban's attention and recommended that unless the firm obtained a reasonable explanation for the trades, it should file a Suspicious Activity Report ("SAR"). Urban allegedly ignored the inquiry for several months until the AML Officer came to his office and refused to leave until he received an answer, at which point Urban instructed the AML Officer not to file a SAR.⁴ The SEC also alleges other red flags concerning manipulative trading and unsuitable account activity that were escalated to Urban in 2005 without an adequate response. In its case against Urban, the Commission alleged that he, along with the Private Client Director and Retail Sales Director, all "had the requisite degree of responsibility, ability, or authority at [the firm] to affect the conduct" of the registered representative, Glantz, and thus all three were his supervisors for the purposes of the Exchange Act. The SEC alleges that Urban's failure to respond to the various red flags set forth in the complaint constitute failure to supervise Glantz with a view to detecting and preventing violations of the antifraud provisions.

The fact that Urban had business roles at the firm, including serving as Director and as a member of the Credit Committee (which oversaw Glantz's repeated margin issues), may have assisted the Commission in concluding that Urban was a supervisor. One lesson from the Urban case is that legal and compliance officers should think carefully before taking on business roles in addition to their core responsibilities.

The SEC has made it clear at least since the Donald Feuerstein Section 21(a) Report concerning the Salomon Brothers Treasury trading scandal, Exch. Act Rel. No. 31,554 (Dec. 3, 1992), that in certain circumstances, legal and compliance personnel can become "supervisors" even if they do not have the ability to hire or fire employees and the employees do not report to legal or compliance. Rather, in the Commission's view, the test for whether a legal or compliance officer is a supervisor is whether that person has "a requisite degree of responsibility, ability or authority to affect the conduct" of the employee at issue - precisely the language used in the Urban complaint. In this view, once a legal or compliance officer becomes involved in formulating management's response to a problem, that person becomes responsible for taking reasonable and appropriate action, and must either discharge those responsibilities or know that others have taken appropriate action. Failure to take such steps may constitute failure to supervise on the part of the legal or compliance officer.

The Feuerstein Section 21(a) report was highly controversial at the time it appeared, and it is notable that the Commission declined to litigate its theory in that matter, and instead simply issued a Report of Investigation.⁵ Since 1992, the SEC has been very sparing in its application of failure to supervise or other theories of liability against in-house legal and compliance officers. Indeed, last year the SEC dismissed an administrative proceeding against a broker-dealer general counsel, noting that such proceedings could interfere with lawyers' ability to provide independent, unbiased advice concerning the securities laws and chill advocacy on behalf of clients before the Commission. Scott G. Monson, Inv. Co. Act Rel. No. 28323 (June 30, 2008).⁶ However, the number of Commission cases against lawyers (primarily in-house counsel) has risen substantially in recent years, although many of those cases have alleged deliberate involvement in fraud, such as some of the stock option backdating cases. Even so, the immense public pressure on the Commission to demonstrate that it still can be effective may weaken its historical sensitivity concerning cases against lawyers and compliance officers. While the number of "red flags" alleged to have come to Urban's attention in this case is substantial, it is important to remember that allegations are only that, and there may be mitigating facts unmentioned in the Commission's charging document. If the case does proceed to a hearing, the Commission may finally obtain judicial review of the extremely broad theory of supervisory liability set forth in the Feuerstein Section 21(a) report in 1992.