Supervision
Supervision
Every dealer is required to establish and
maintain written supervisory procedures
reasonably designed to supervise its
employees’ compliance with state, FINRA,
and federal securities laws.
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The Standard of
Reasonableness

What is reasonable? Is the standard nebulous,
hazy or vague?
 Does it require the firm to prevent every violation?
 Does it require the firm to detect each violation?
(“Crystal Ball Standard”)
 If an agent commits a violation, is it obvious the
firm failed to supervise him? (Respondent
Superior)
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The Standard of
Reasonableness

Requires the supervisory system be the product
of sound thinking and common sense.
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In the simplest of terms, the supervisor has
complied with the law if the firm’s procedures are
adequate, he followed the procedures, and no
red flags arose.

Supervisor is not required to be omnipotent.
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Rule Requirements
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Section 15(b)(4)(E) of the Securities Exchange Act
of 1934
NASD Rules 3010 and 3012 and FINRA Rules 3130
and 3310
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NASD Rule 3010 – Reasonable supervisory system to prevent
and detect violations
NASD Rule 3012 – Requires each member firm to designate
and identify one or more principals who shall establish, maintain
and enforce a system of supervisory control policies
FINRA Rule 3130 – Designation to the on an annual basis of a
principal of the member firm to serve as chief compliance officer.
Designation must be made on Schedule A of the Form BD
FINRA Rule 3310 – Supervisory system to establish procedures
for anti-money laundering program
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Basic Requirements of a
Supervisory System – Rule
3010
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Must be tailored to the firm’s business. No such
thing as “one size fits all.”
Firm is required to continually evaluate and
change its procedures as necessary.
Procedures must be written, adequate and
address all aspects of the firm’s business
Procedures should designate the person
responsible for each functional area (i.e., sales,
operations, compliance). Person must be
qualified. (exam and experience)
Each agent should be assigned a supervisor. 6
Basic Requirements of a
Supervisory System – Rule
3010

Compliance should meet with each agent at
least once a year. Meeting may be in person or
via the internet.
 A principal must approve each transaction.
 Firm must investigate the background and
qualification of prospective employees.
 Firms are required to investigate red flags, not
simply rely on the agent’s word.
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Supervision
Good
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Centralized
Comprehensive
Customized
Supported at highest
levels of organization
Continually reviewed and
updated
Testing and verification
systems “baked in”
Problematic

Fragmented
 Partial
 Boilerplate
 Emphasis on form over
substance
 No process to ensure
policies/procedures are
current
 Procedures manual
gathering dust on shelf or
agents don’t know how to
access electronic version
The best supervision cases are
those built on an underlying
violation by an agent.
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Examination Steps to Detect
Inadequate Supervision

READ THE FIRM’S COMPLIANCE MANUAL!

Do the procedures reasonably address, among
others:
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•
•
•
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Approval of order tickets and new accounts
Frequent review of the agents’ activity
Incoming and outgoing correspondence
Processing of customer complaints
Advertising
Registration
Branch office inspections
Outside business activity/Selling away
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Examination Steps to Detect
Inadequate Supervision (cont.)
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•
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Cashiering functions
Hiring
Anti-Money laundering
Privacy
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Examination Steps to Detect
Inadequate Supervision

Is the branch manager/supervisor following the
procedures?
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Review the firm’s exception reports.

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How is the review of customer accounts and orders
evidenced?
What action does the firm take with respect to the
exception reports?
Review the firm’s customer complaints.

Does the firm promptly and adequately follow up on
red flags?
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Examination Steps to Detect
Inadequate Supervision
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Interview the branch office manager and agents.
 What is the ratio of managers to agents?
 How often does an agent speak with the manager?
Review the firm’s internal audits.
 Are they meaningful and frequent?
 Are findings timely conveyed to branch office?
 Are problems corrected timely?
 Are problems allegedly corrected on previous audits
found to be recurring on subsequent significant
disciplinary audits?
Review the supervision of agents with disciplinary
problems.
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Recurring Supervisory Problems
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Audits are inadequate
 Over reliance on checklists; no verification; no
substance to the review
No surprise audits
Failure to audit
Inadequate responses to red flags
Findings allegedly corrected recur on subsequent
audits
Mechanical managers
“Do nothing” compliance personnel
No one assigned to supervise the agents
Flat supervisory structure
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Recurring Supervisory Problems
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Supervisors supervising themselves
Little or no review of off-site agents
No heightened supervision of agents with disciplinary
history
Supervisor geographically distant from the branch or
agent
Superficial internal investigations
Relying solely on the agent’s statement regarding
trading activity or in response to customer complaints.
Growth of compliance department lags that of the firm
“Blind eye” turned to actions of large producers
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Proof Checklist
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Element of the Violation

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Firm failed to establish adequate written procedures
Proof
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No supervisory procedures manual
Records and/or testimony establishing the
employee’s violation
Evidence of red flags that were not followed up
Testimony of the agent regarding supervision
Always obtain and review a copy of the supervisory
manual.
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Proof Checklist
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Element of Violation

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Firm failed to enforce its own written supervisory
policies
Proof
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Obtain copy of supervisory procedures
Records and/or testimony establishing the
employee’s violation
Evidence of red flags that were not followed up
Testimony of the agent regarding supervision
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Proof Checklist
 Element

of Violation
Firm had inadequate written supervisory
procedures
 Proof

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Obtain copy of supervisory procedures
Testimony of the supervisor’s understanding
of the firm’s supervisory procedures
Testimony from the examiner as to exactly
which policy was not followed
Important Considerations
A supervisor is really only a “supervisor” if he or
she has authority to impact behavior.
 Supervisors can be charged with failure to
supervise if they become aware of red flags, but
don’t take action.
 Be careful to differentiate between those people
that are only in advisory roles (legal or
compliance) with those that are in management
roles.
 The law does not require the firm to prevent or
detect all violations.

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Important Considerations

Be careful to avoid judging the firm based solely
on hindsight. Put yourself in the manager’s
shoes at the time the activity was occurring and
ask whether the supervision was reasonable as
opposed to perfect.

SEC Commissioner Unger stated in 1999: “I
believe the Commission must…resist the pitfall
of mistaking the cleverness of a wrongdoer in
eluding appropriate supervisory measures for a
failure at the supervisory level.”
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