Failure to Supervise

Financial and securities brokerage firms have a legal duty to supervise their brokers and their brokers’ recommendations to clients to ensure compliance with the rules of the securities industry. When an individual broker is negligent or acts in an unlawful manner against the interests of the client and that client suffers damages, the firm may be held liable for the investor’s losses.

Below is a summary of a recent case that illustrates a failure to supervise claim:

A client recently came into a lawyer’s office and complained that his accounts had suffered losses and that his adviser would not return his calls. The attorney reviewed his monthly account statements and noticed that a large portion of his investment losses occurred in “penny stocks.” Historically, a penny stock was defined as a stock valued at less than $1 per share. The SEC modified that definition to include shares valued at less than $5 per share. Penny stocks are typically issued by small startup companies with limited resources and cash. These companies issue penny stocks to raise money for their operations. Penny stocks are thinly traded, meaning that they are not traded in high volumes, which makes it difficult for investors to sell their shares. Penny stocks are extremely risky investments, and most brokerage firms have written compliance procedures that expressly prohibit their representatives from selling them.

Knowing these facts, the lawyer requested that the client provide her with all trade confirmations that he received from the brokerage firm. A trade confirmation is a written document that brokerage firms are required to send to the customer after the transaction is completed. Importantly, trade confirmations are marked as either “solicited” (i.e., the broker made the recommendation) or “unsolicited” (i.e., the customer instructed that the brokerage firm purchase or sell an investment). The client kept good records and provided the attorney with a stack of trade confirmations. All of the confirmations pertaining to the penny stocks were marked “unsolicited,” which could mean either that the client actually recommended the trades or that the broker was intentionally mislabeling the trades to avoid the firm’s compliance department.

Without explaining to the client the significance of the “unsolicited” language, the attorney asked the client whether he had ever contacted the broker and instructed him to purchase any of the penny stocks. The client stated that he had never even heard of the penny stock companies, much less instructed the broker to purchase them. This confirmed the attorney’s suspicion that the broker had been mislabeling the trades to avoid detection by the brokerage firm’s compliance department.

The attorney then obtained a copy of the broker’s Central Registration Depository (CRD) report. FINRA, as well as state and federal securities regulators, requires that brokers and their firms provide certain information about the broker and broker- age firms (e.g., customer complaints, broker employer information, facts relating to broker termination, etc.). This information is compiled by regulators and a CRD report is generated. The CRD report is public information and is extremely helpful to consumers who are aware that such reports exist. CRD reports can be obtained from the FINRA website,, under the term “Broker Check report” or from state securities regulators.

In this case, the CRD report stated that the broker had been terminated the month before for “violating firm policy by recommending penny stocks to customers.” The CRD report also listed several complaints from other customers about sustaining losses in penny stocks.

Proving Failure-to-Supervise Claims

New York Stock Exchange Rule 405(b) requires that a brokerage firm “[s]upervise diligently all accounts handled by registered representatives of the organization.” Proper supervision in the securities industry is mandatory. Firms must create, maintain, and enforce a plan that will supervise the day-to-day activities of their workforce. Addition- ally, FINRA Conduct Rule 3010 provides, in part, that “[e]ach 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. . . .”

A brokerage firm may also be responsible for its brokers’ conduct under the concept of vicarious liability. In the context of an employer/employee relationship, a firm’s vicarious liability stems from the common law doctrine of agency or respondeat superior. Under this doctrine, the employer (or superior) is responsible for the negligent or wrongful acts of its employee (subordinate). That is to say, the employer is charged with a legal responsibility for the employee because the employee is acting as the agent of the employer or principal.

Finally, firms may have to accept responsibility for the wrongful conduct of their broker employees under the theory of “control person liability.” This theory of liability is set out in section 20(a) of the Exchange Act of 1934, 15 U.S.C. 78t(a). That section provides:

Every person who directly or indirectly controls a person liable under any provision of this chapter or any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

Who Supervises Brokers and How Do They Do It?

Stockbrokers are supervised by branch managers or branch office managers (BOMs). BOMs are obligated to make sure that the brokers they oversee comply with regulatory rules and sales practices. They do this in a number of ways. BOMs may conduct prehire screening or evaluation of broker candidates. Once a broker is hired by a firm, BOMs may review broker-client communications, order tickets, account opening documents, account holdings, and customer complaints. The BOM may also review account activity in the client accounts for which a broker is responsible. To do this, the BOM may use exception reports that are created upon certain types of account activity, such as high-volume orders, high-dollar-value orders, concentrated positions (too much of one stock in a single account), excessive use of margin, or unusual or excessive commissions.

If a BOM determines that a broker has acted negligently or fraudulently, the BOM must take action and create a written record of the broker’s conduct. This written record is often helpful in proving a case against the broker or firm. Another source of information about a broker’s past conduct is the CRD. A copy of a broker’s CRD information can be obtained by contacting the state securities regulator in the state in which the broker is or should be licensed or by visiting FINRA’s broker check website at

What Constitutes Failure to Supervise?

Brokerage firms must diligently supervise the activities of their brokers and financial advisers in the handling of customer accounts by FINRA Rule 3110. 

FINRA Rule 3110(a) requires member firms to “establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.” 

To effectively implement and maintain these systems, FINRA Rule 3110(b) requires member firms to “establish, maintain, and enforce written procedures to supervise the types of business in which it engages.” Assuring proper supervision is a critical component of broker-dealer operations.  

Supervisory obligations include the responsibility to investigate “red flags” that suggest that misconduct may be occurring and to act upon the results of such investigation.

Brokerage Firms Have a Duty to Supervise

Brokerage firms are required to create, maintain, and enforce their own internal rules regarding their supervisory duties concerning the activities of their brokers/advisors. When a brokerage firm disregards rules that it has established to govern the conduct of its employees, evidence of those rules may be used against the firm to determine the correct standard of care in a securities arbitration.  

The content of such laws may also indicate knowledge of the risks involved and the precautions that may be necessary to prevent the risks.  

In addition to primary liability for failure to supervise, the FINRA-member firms are secondarily liable for the acts and omissions of their broker/advisers under general agency principles and the common law doctrine of respondeat superior. 

As the Restatement (Second) of Agency § 261 states: “A principal, who puts a servant or other agent in a position which enables the agent while acting within his authority, to commit fraud upon third persons is subject to liability to such third persons for the fraud.”     

FINRA Rule 2010     

FINRA Rule 2010 requires FINRA members and their associated persons to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of their business. It mandates that securities industry participants not only conform to legal and regulatory requirements, but also conduct themselves in the course of their business with integrity, fairness, and honesty.  

Because industry participation carries an expectation of regulatory compliance, any conduct that runs afoul of FINRA or SEC rules necessarily violates Rule 2010. 

Lack of proper supervision has resulted in numerous enforcement actions by FINRA and the SEC against non-compliant firms. Some firms have been cited for repeated failures of oversight. 

Often these firms are charged with the supervision of registered representatives who have their advisory firms with offices outside of the broker-dealer firm. These firms are usually required to supervise hundreds of far-flung offices. 

Practically speaking, that would be very difficult even if the firm devoted sufficient resources to it. 

Common problems with these repeat offenders include pre-announced branch office examinations that did not detect red flags, failure to implement heightened supervision for problem brokers with significant customer complaints.

Many failure-to-supervise cases involve indicators of misconduct, or “red flags,” that should immediately alert management to potential wrongdoing. In circumstances where a firm’s compliance and supervision system is inadequate to discover the indications of problematic conduct, the personal responsibility for supervision cannot be fulfilled by a supervisor who is unaware of the indicators. 

 In one such instance, the firm operated 1,500 offices with 2,700 registered representatives. Some 49 of these were one-person offices. In that case, the SEC found that the firm’s failure to scrutinize adequately the securities-related businesses of its registered representatives, which were conducted beyond the direct aegis of the firm, was a sure recipe for trouble. 

Further, the firm’s practice of holding a pre-announced compliance examination only once a year was inadequate to satisfy its supervisory obligations. Indeed, the SEC stated: “[W]e harbor grave doubts that this practice would necessarily discharge the supervisory obligations of any firm that incorporates a structure in which only one or two representatives operate smaller branch offices.” 

Failure to Supervise Claims

Failure to supervise is a common claim that is present in almost all FINRA securities arbitration cases. The brokerage firms are almost always legally liable for the wrongdoing of their br4oker/advisers. Even in selling away cases, where the broker engages an undisclosed investment-related business away from the brokerage firm with which s/he is registered, the firm may be responsible if there sufficient “red flags” to put the firm on “inquiry notice” that selling away is going on. Legally speaking, in such cases, the firm is said to have clothed its agent with “apparent authority” so that the customer reasonably believes that the broker/adviser is acting as an agent of the firm.

Failure to supervise claims is an essential part of any securities arbitration case for the practical reason that the errant broker/adviser may not have sufficient funds to pay an award. For that reason, it is always advisable to name the firm as a respondent in a FINRA arbitration claim. Often the firm is the only named respondent, and broker/adviser is not named as a party, because the firm is liable for the broker/adviser’s misconduct. 

When Does Failure to Supervise Result in Legal Action?

As noted above, in most cases, failure to supervise should result in legal action (i.e., a FINRA arbitration claim being filed) when there is actionable misconduct by the broker/adviser.  

If you have experienced investment losses involving failure to supervise, call The Doss Firm for a free consultation at (770) 578-1314.

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