ALJ Issues Decision in Case Involving Short Sales, the Role of Compliance and Supervisory Liability
Commentary by Nihal Patel and Steven Lofchie
An SEC administrative law judge ("ALJ") found that (i) the chief compliance officer ("CCO") of the broker-dealer Penson Financial Services, Inc. ("Penson") "caused" Penson's violations of short-sale regulations and (ii) the CEO and president of Penson was not liable for failing to supervise its CCO.
The two findings stemmed from alleged violations of Rules 204 and 204T of Regulation SHO by Penson. Penson allegedly failed repeatedly to close out Continuous Net Settlement ("CNS") and allegedly failed to deliver in accordance with the timing requirements of the rule. (Penson has since gone bankrupt and is no longer operating.).
In connection with the violations by Penson, the SEC charged (i) the CCO with (a) willfully aiding and abetting and (b) causing Penson's violations; and (ii) the CEO/President with failing to reasonably supervise the CCO and an executive in Penson's stock loan department with a view to preventing their violations of the law.
The ALJ's initial decision found that the CCO was not liable for aiding and abetting Penson's violations, since (i) there were not enough "red flags" to show that the CCO was "reckless as opposed to simply negligent" (and thus the scienter requirement of aiding and abetting was not satisfied) and (ii) although the CCO might have "assisted" in the violations, he did not "substantially assist . . . in the violations." However, the ALJ did find that CCO was liable for "causing" Penson's violations under a negligence standard. As a result, the ALJ entered a cease-and-desist order and required the CCO to pay a fine of $20,000 ($5,000 for each of the four violations).
The ALJ also found that the CEO was not liable for failing to supervise the CCO, and stated that he remained "unconvinced" that the CEO was confronted with "'red flags' requiring follow up that he failed to take." Additionally, the ALJ found that the CEO could not be held liable for failing to supervise the executive in the stock loan department, since in the ALJ's view, that executive was not subject to the CEO's supervision.
Commentary
This case addresses a number of important points to be considered by regulated entities (obviously, broker-dealers, but not only broker-dealers) and their personnel:
(1) Short Sales. Over the past few years, the SEC brought a number of cases against broker-dealers and individuals for failing to satisfy their obligations to make timely closeouts under Reg. SHO. While the ALJ does not question the fact that Penson violated the relevant rules (the parties stipulated that there were "at least 1,500 violations"), the case does raise the question of how material these violations were. In setting the penalty for the CCO, the ALJ noted that the SEC Division of Enforcement did not show that any investors were harmed by the violations, and that the "quantified benefit" of the violations by Penson to Penson was $59,000 – approximately 0.008% of the firm's revenue during the period. The ALJ noted that, based on these figures, ordering disgorgement would have resulted in the CCO's being responsible for a total sum of $3.20 of the unjust enrichment, and so declined to issue a disgorgement order with respect to such a small sum.
(2) The Role of Compliance. In great detail, the ALJ decision discusses the facts of Penson's compliance program and the CCO's actions in implementing procedures designed to comply with Regulation SHO, and analyzes a number of these incidents to determine whether the CCO acted appropriately. While it is lengthy, this section of the decision (in particular, paragraphs 40-42) provides a good case study for compliance personnel as to how their decisions may be judged in hindsight by legal authorities.
For example, the ALJ noted that Penson's compliance department provided "guidance, training and conducted testing with respect to Rule 204T/204," and that the CCO did not simply pass along rules and guidance from authoritative sources, but also "passed guidance on to the business units. . . ." In response to a contention by the Division of Enforcement that it was reckless for the CCO to fail to convene meetings with relevant personnel when Rule 204T was implemented, the ALJ found that not doing so was an example of negligence and "represent[ed] a missed opportunity that a prudent CCO would have taken," but did not find that this reached the level of extreme recklessness.
(3) Supervisory Responsibility. The ALJ agreed (as stipulated by the parties) that the CEO had supervisory responsibility over the CCO; however, the ALJ found that even if the CCO aided and abetted violations of the rules willfully, the Division of Enforcement was unable to show that the CEO failed to supervise him reasonably. Instead, the ALJ found that the CEO "exercised consistent, robust supervision over all his direct reports, including [the CCO]." The ALJ noted numerous examples of meetings and other actions by the CEO to support this finding, and also found that he was not confronted with "red flags" requiring follow-up that he failed to take.
In addition, the ALJ found that the CEO was not responsible for the supervision of the executive in Penson's stock loan department (who was found to have aided and abetted violations by Penson) because there was sufficient evidence that the CEO reasonably delegated supervisory responsibility to another person at Penson and there was no supervisory responsibility present as a matter of law. As with the facts regarding the role of compliance, so with those of supervisory responsibility: the decision provides a number of examples of how lines of supervisory delegation will be drawn and what types of actions by a firm may be considered to be appropriate when delegating supervisory responsibilities.
(4) Administrative Proceedings. In many types of cases, the SEC may choose whether to pursue the matter in administrative proceedings or the federal courts, and Dodd-Frank gives the SEC greater authority to seek penalties in administrative proceedings. In recent months, the SEC has come under fire for using administrative proceedings, given a long streak of wins for the Division of Enforcement in such proceedings. See, e.g., The Wall Street Journal, "SEC Is Steering More Trials to Judges It Appoints" (Oct. 21, 2014). Although this is only the initial decision of one ALJ, it is a reminder that the SEC is not guaranteed to be victorious in court or in the administrative process. (It remains to be seen whether this particular case will be appealed for the SEC Commissioners' consideration.)
Commentary
Compliance and senior supervisors should take a close look at this case. The ALJ delved deeply into the facts and the result is an opinion that is quite thoughtful and rich in detail. Though the decision can't be summarized in a few paragraphs, here are a few observations about it:
(1) The Number of Regulatory Inquiries. The ALJ noted that on average the firm received 1,100 to 1,500 regulatory inquiries in a year. That seems a tremendous number. If larger firms are receiving a proportionately greater number of inquiries, then firms may be receiving as many as 10,000 inquiries a year. These inquiries, of course, go beyond the routine regulatory reports and filings that the firm would have under the rules. The number of regulatory inquiries seems excessive. Perhaps this is something that the regulators themselves should study: how many "requests" are they making of firms? How much value is in these requests? How expensive are the requests to fulfill? Is there any way that the number could be reduced?
(2) Only so Many Hours in the Day. The ALJ made two important points that he used in support of his decision regarding the firm's CCO: 1) the CCO prioritized problem areas reasonably, and 2) it was sensible for the CCO to focus on the firm's AML issues rather than less significant short-sale problems.
(3) Critical of the Division of Enforcement. In many respects, the decision is quite critical of the Division of Enforcement. For example, it asserts that the Division overstated the firm's gains due to the violations by a factor of more than 100 (asserting a gain of $6.2 million, as opposed the court's finding of a "meager $59,000" (at page 34)). On page 38, the ALJ states that in spite of the "Division's repeated insinuation that [Delaney] was lying, [he] found Delaney a credible and convincing witness." In numerous places in the decision, the ALJ chastises the Division along the lines of the prior quote.
(4) Testimony. The testimonies of expert witnesses comprised a key element of the defense.