In Finding a Failure to Reasonably Supervise, SEC Highlights Responsibilities of Firms to Create Clear, Written Investigatory Procedures

April 10, 2019

A recent Securities and Exchange Commission (“SEC”) order imposed sanctions on a financial institution for failing to reasonably supervise a representative’s conduct. In its findings, the SEC highlights the institution’s failure to establish clear, reasonable steps for firm personnel to take when faced with “red flags” of serious misconduct by a representative. Put simply, the firm’s procedures lacked details regarding the “who,” “what,” and “when” for taking appropriate investigative steps.  The SEC’s Order provides insights for how broker-dealers and investment advisors can establish adequate supervisory and investigatory guidance for personnel.

In the Matter of Wedbush Securities, Inc., File No. 3-18411, issued March 13, 2019, the SEC determined that Wedbush Securities “failed reasonably to supervise one of its registered representatives” who was engaging “in manipulative trading activity of penny stocks.” The institution (including legal and compliance personnel and the representative’s direct supervisors) became aware of the representative’s allegedly suspicious activities in 2012 and 2013. However, due to a lack of clear supervisory policies and procedures, the SEC found that “Wedbush lacked reasonable procedures regarding the investigation and handling of red flags. There was substantial confusion as to whose responsibility it is to conduct investigations related to red flags.” The institution ultimately attempted to conduct two investigations into the representative’s activities, but according to the SEC, those investigations were not adequately documented or reported throughout the firm.

In short, the SEC found that because the institution lacked defined processes for actually investigating potential misbehavior, the institution failed to reasonably supervise its representative’s violations of Sections 17(a)(1) and (3) of the Securities Act, Sections 9(a)(2) and 10(b) of the Exchange Act, and Rule 10b-5(a) and (c) thereunder.

Firms should note that the focus of the SEC’s Order (and the resulting fine) was the lack of defined policies and procedures addressing potential red flags. The Order serves as a useful reminder to firms regarding the importance of establishing and documenting clear investigatory policies and procedures.

Key recommendations:

  • Establish clear written policies for identifying and addressing “red flags” of potentially improper behavior by registered representatives;
  • Clarify internal assignments and responsibilities to make clear whose responsibility it is to investigate red flag behavior (supervisors, managers, vice presidents, legal, compliance, etc.);
  • Specify the steps and methods to be used in the investigation, along with timing;
  • Determine how, when, and by whom results from an investigation should be escalated to management;
  • Define when and under what conditions an investigation will occur;
  • Establish procedures in which the scope of an investigation is expressly defined;
  • Document in writing the process and results of all investigations;
  • Maintain written records of any disciplinary actions, warnings, letters of caution, or complaints against an employee or independent contractor, including any supporting documentation; and
  • Consider the use of outside counsel for complex or sensitive situations and/or internal investigations so as to maintain privilege.