"Recent Initiatives Related to Supervisory Practices" Remarks of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. 1997 NSCP National Membership Meeting National Society of Compliance Professionals Washington, D.C. October 9, 1997 ______________ * The views expressed herein are those of Commissioner Hunt and do not necessarily represent those of the Commission, other Commissioners or the staff. Good morning. I appreciate the opportunity to speak at this fine conference. I can tell from your agenda that some of the most important issues facing the brokerage industry and the Commission will be addressed. While I'll try not to dwell on the issues covered by your workshops, there probably will be some overlap since I'll focus on several recent initiatives related to the supervision of brokerage firm employees. Let me begin with the standard disclaimer that the views I express today are my own, and not necessarily those of the Commission, other Commissioners, or the Commission's staff. I also should note that I know the NSCP is committed to strong and effective supervision of securities firm employees, and I applaud the NSCP for its leadership in this area. Joint Sweep. Early in 1996, staff from the Commission, the states, and the SROs undertook a "Joint Regulatory Sales Practice Sweep." Their objective was to review sales practices of select registered reps, and the hiring and supervisory practices of firms employing those sales reps. The Sweep identified 300-plus reps with significant disciplinary and customer complaint histories, and the firms targeted had employed two or more of those sales reps. A "Sweep Report," issued in March 1996, concluded that at least as to the firms examined, supervisory and compliance systems needed to be improved. The Sweep Report made several non-mandatory recommendations -- they were not mandatory since, as I noted, the report was issued by the staff of these regulators. Nevertheless, the recommendations were good ones, such as enhanced background checks, tying compensation for supervisors to how well they supervise brokers, and tougher supervision of those brokers with disciplinary or complaint histories. The Sweep Report found, for example, that some firms would hire sales reps with suspect histories and, then, not take greater efforts to supervise those reps. That is an unacceptable practice in my view. I appreciate that the Securities Industry Association generally endorsed the report's regulatory findings, even if there still is disagreement as to how the report's recommendations should be implemented. Commission Enforcement. Next, I want to highlight a change in my agency's enforcement policy: that is, our decision to increase the severity of disciplinary sanctions in so-called "failure to supervise" cases. The Commission now disfavors settlement offers in failure to supervise cases that do not include "time out" from the securities industry for at least some period of time. In the past, the Commission routinely accepted settlement offers which required an individual charged with failure to supervise to limit his or her supervisory functions, and just those functions. There were several reasons why I thought that time outs from just supervisory functions were insufficient. First, I considered several cases where, by the time an offer was made, the supervisor was, in fact, no longer a supervisor. In many of those cases, the former supervisor was now a sales rep or a non- supervisory officer. It made little sense to me to accept an offer only limiting supervisory activities when no such supervisory activities were being performed. Next, for small firms, our old policy was problematic even when the individual was a supervisor at the time a settlement offer was made. This is because it is hard to see how, as a practical matter, a supervisor at a small firm could be walled off from all supervisory responsibilities. Next, and perhaps most importantly, I decided that more "complete" bars were in the public interest and better protected investors. Our change in policy should make firms heighten their focus on sales and supervisory practices. It also seems to be having positive consequences that I hadn't anticipated: for example, I've been told that some firms, concerned their supervisors now may be suspended outright, are more closely examining prospective sales rep hires. I also have heard that some firms have formed a special committee to make hiring decisions as to reps who have been disciplined or who have customer complaints. On a related note, let me point out that, in a recent 3-1 vote, the Commission decided that it had the authority under the relevant statute to bar brokerage firm employees and supervisors from the industry as a whole, rather than just from the brokerage industry. The name of the case I refer to is Meyer Blinder. I dissented from this decision because I do not believe that our authority can be so broadly construed. So please consider my earlier remarks -- about why more "complete" bars are necessary -- as pertaining to why I believe that more complete bars from the brokerage industry, and not the industry as a whole, are needed. Form U-5. Moving on, let's talk a bit about Form U-5. SRO rules call for a firm to file a Form U-5 when an associated person leaves the firm, and to disclose why that person left. A firm making a hiring decision must review the person's Form U-5. Arbitration claims have been brought against supervisors and firms based on allegedly defamatory statements contained in these forms. In a few cases, punitive damages were awarded where the panel concluded that the firm either intentionally or recklessly made misstatements on the Form. Understandably, firms and supervisors are concerned, and they contend that the ability to sue makes them less candid on these forms. The policy issue is clear: firms have a duty to file complete and candid responses on Form U-5, but how they discharge that duty may be affected as liability concerns overshadow the Form's purposes. In theory, of course, a firm's duty to prepare an accurate Form does not expose it to liability since there is no liability for telling the truth. In practice, however, the more negative the statements on Form U-5, the more likely there is to be a lawsuit. Given this, absent some kind of protection from liability, firms have an incentive to be less than frank. The importance of candor on the Form can't be understated. It is a critical warning mechanism, alerting prospective (hiring) firms. Accurate reports help rid the industry of problem sales reps, or at least ensure that firms have adequate notice of the potential risks and accompanying supervisory responsibilities if they hire those with suspect histories. It is said, however, that some firms supply "clean" Forms U- 5 to avoid possible defamation exposure. There also are charges that the Form is misused to punish sales reps with whom a firm has an unrelated employment dispute. A false report on Form U- 5 to punish a sales rep is potentially as serious an abuse as withholding information about a problem rep. All of these problems compromise the usefulness of the reports on Form U-5. There seems to be a consensus among regulators, firms, courts and arbitrators that firms should receive some protection for U-5 disclosures, but the consensus ends there. Two approaches have been discussed. The first is absolute immunity: complete immunity for statements without consideration of motive or bad faith. The second is qualified immunity: generally defined as immunity for statements made in good faith. Courts that have addressed the issue have, as a preliminary matter, found that firms enjoy some form of immunity, but those courts have disagreed on whether it is absolute or qualified. Let me offer just a few basic observations on the qualified- or-absolute-immunity debate. A few years ago, Commission staff recommended that the Commission find ways to implement a uniform policy of qualified immunity. In the Sweep Report I referred to earlier, Commission staff again suggested that qualified immunity was the preferable approach. The U-5 debate has heated up recently, and an SRO proposal may be before the Commission shortly. While I am open to other ideas and have not yet formed an opinion on any rule proposal, I currently favor a qualified immunity approach. I agree with an observation in the Seventh Circuit's Baravati decision that, absent safeguards, such as civil liability, the risks of abuse are too great and the consequences too onerous for brokerage firms to be granted absolute immunity. We should be wary of policies that insulate intentional retaliatory conduct from review. Further, toleration of such conduct could frustrate legitimate law enforcement objectives. Indeed, in Baravati, the associated person claimed that the defamatory statements made on his U-5 were in retaliation for reporting improper conduct at the firm. I also have concerns about the potential lack of uniformity on the immunity issue across state jurisdictions. Currently, the issue of immunity for statements made on Form U-5s is a state law question either of statutory or common law. This has resulted in different standards of liability in different jurisdictions. Because candid and accurate disclosure on Form U-5 is important to our self-regulatory system of broker-dealer oversight and supervision, I would prefer a uniform standard. Finally on this issue, we must not lose sight of the ultimate regulatory objective: firms must provide candid disclosure on U- 5's regardless of how the immunity debate plays out. Firms have been held liable for subsequent acts committed by a sales rep at another firm when the former firm conceals the rep's problem history. Further, a knowing failure to identify problem sales reps also may lead to disciplinary action. I urge SROs to take strong disciplinary action against any firm that is deficient in discharging its U-5 obligations, especially where the deficiencies enable a rep to defraud customers at another firm. SRO Initiatives. Two other SRO initiatives deserve mention. First, the NASD's "taping" proposal, has raised a good bit of controversy. It would require a firm whose work force is made up of a specified percentage of persons that have been associated with a so-called "disciplined firm," or each firm that is itself a "disciplined firm," to tape telephone conversations of all of its associated persons with existing and potential customers. The NASD contends that the proposal responds to concerns expressed in the Sweep Report regarding the need for heightened supervision of sales reps with troubled regulatory and compliance records. While associated persons who would be affected by the proposal may not have been disciplined themselves, the NASD's rationale for its proposal is that such persons may not have been adequately trained and supervised at the disciplined firm. The proposal wasn't warmly received by the brokerage industry. Complaints seem to focus on the proposal's "Big Brother" nature and its expense, its taint of all sales reps from a disciplined firm (even reps not involved in any violations), and the overall effectiveness of taping as a supervisory mechanism. I have not had a chance to fully consider the NASD's proposal or the issues it raises. Moreover, since the proposal may be before the Commission in the near future, I will offer only two brief observations. First, the NASD's proposal shows the level of concern the NASD has with the supervision of suspect, or potentially suspect, reps. I share that concern. Second, I would urge critics of the NASD's proposal not just to condemn it, but to offer reasonable alternatives or modifications. Next, the New York Stock Exchange has filed with the Commission proposed rule changes dealing with e-mail and other correspondence. While I understand that the NASD filed a similar proposal, my remarks generally refer to the NYSE's proposal, because I am a little more familiar with it. NYSE Rule 342 would allow firms to establish "reasonable procedures" for the review of sales rep correspondence, thereby affording firms and supervisors with greater flexibility than they have today. What constitutes "reasonable procedures" does not seem to be clearly defined, but I understand that the term includes, among other things, the actual review of some percentage of sales rep correspondence. NYSE Rule 472 then would be amended to require prior approval only for sales literature, market letters, advertisements, or other similar communications generally made available or distributed to customers or the public. As you know, the current standard calls for prior approval of any communication generally distributed or made available to customers or the public. I have not seen the latest version of the NYSE's proposal. I have not discussed it with Commission staff. But because the proposal physically is "at" the Commission, I'll just be able to offer a few thoughts. When I first heard of the NYSE's proposal, my chief concern was how the proposed changes would apply to incoming correspondence from investors, and whether such correspondence must continue to be reviewed by supervisors. Incoming correspondence, of course, raises special concerns, for it may give an early warning of a potential problem with a sales rep's conduct or state an actual complaint. I understand that the NYSE modified its proposal so as to maintain its current rule requiring review of all incoming written communications, and that seems to be a good approach. But I also understand that incoming "e-mail" would be treated differently by the NYSE than all other "written communications," so that incoming e-mail would not be automatically reviewed. Instead, incoming e-mail would be subject to the new, and much more flexible, "reasonable procedures" standard. The Commission must carefully consider whether this approach is adequate. Having said that, I believe that the NYSE already has a rule -- Rule 351(d) -- which requires that firms report to the NYSE certain information regarding all customer complaints, whether they are received by a firm via e-mail or in written form. If the NYSE's proposal is adopted, I'd expect the NYSE to vigorously enforce its Rule 351(d), especially with respect to customer complaints received via e-mail. I also have questions about whether and how the NYSE proposal would apply to e-mail recommendations made by sales reps to customers. I can't answer those questions until I see the proposal. In general, however, I believe that review of outgoing correspondence is an important part of a firm's supervisory responsibilities. Nevertheless, what kind of review is necessary is not an easy question since, for example, the benefits of automatic review of all recommendations must be weighed against the obvious costs and other attendant obstacles of that approach. Finally on this matter, and to make the proposals most effective, the NYSE probably should provide sufficient guidance to firms as to what procedures are acceptable. I am concerned about this because, while affording additional flexibility to firms in this area may be quite appropriate, affording the absolute maximum flexibility may not. In other words, not offering any real guidance except through an occasional enforcement action may not be the right way to go. Moreover, assuming that the proposal is adopted, the issue of what constitutes reasonable procedures probably should be revisited from time to time by the NYSE, the firms, and the Commission and its staff. Conclusion. Thank you for allowing me to share my views. I look forward to exploring many of these issues further with the industry in the months ahead.