Branch Manager Prevails in "Failure to Supervise" Enforcement Action
(NASD O.H.O, April 6th 2005)
In April 2005, the NASD Office of Hearing Officers concluded that a broker/dealer Branch Manager acted reasonably under the circumstances of a mutual funds switching case and reasonably exercised supervisory discretion during the course of supervising a registered representative who was independently charged with excessive trading of mutual fund shares. This case is encouraging to line-supervisors because it underscores the fact that a branch office manager is not required to be "prefect", and it is a helpful case because it offers insights into properly managing a branch office.
The facts themselves are relatively simple. The registered rep at this branch office engaged in over sixty transactions involving purchase and sales of various mutual funds over a period of eleven months, generating approximately $53,000 in commissions - many of the transactions involving sales charges since the customer held the funds for relatively short periods of time ranging from two weeks to nine months. The broker/dealer had various systems screening devices to pick up fund switching and breakpoint avoidance, but the registered rep had learned to navigate through the system to avoid detection. And because this rep escaped detection (at least in the short-term), his supervisory branch manager was tagged for failing to supervise.
In the end, the branch manager prevailed. Here are some of the key items that bolstered his credibility. First, he cooperated fully in the NASD investigation. In fact, NASD staff acknowledged this on the record. Second, the branch manager had a reputation for abiding by all of his firm's procedures, and even implemented various supervisory steps at the branch office that went beyond his firm's requirements. Third, his firm gave him full support, supplying the branch manager with important key witnesses. These three things combined to leave the NASD Panel with impression that the branch manager was "a knowledgeable, careful, and responsible professional". This is a good start when you are defending yourself in an Enforcement proceeding.
So why did NASD think that this branch manager failed to supervise his rep? It is not unreasonable for a regulator to view sixty transactions involving purchase and sales of various mutual funds over a period of eleven months, generating approximately $53,000 in commissions, to be excessive trading of mutual funds. These facts speak for themselves. And when a supervising principal fails to detect that excessive trading is going on, it is also not unreasonable for a regulator to conclude that there is a failure of supervision taking place.
So what did the branch manager do or not do? First, the branch manager did what he was supposed to do. He reviewed the blotters on a daily basis. The problem, it turned out, had nothing to do with the branch manager's methodology, but rather with the system. The daily blotter reflects only activity that occurred on a particular day - and, unless the switch took place on the same day, the switch would go undetected until the three-month commission report was released to the branch manager. In other words, there was nothing in the computer system that helped the branch manager to correlate a recent trade back to a previous trade. Also, the registered rep would switch between open-end funds to close-end funds. Since the firm regarded the close-end funds as the equivalent of an equity security, the transaction failed to trigger a mutual fund switch letter since the system viewed the customer as trading a mutual fund for a stock.
When the issue of breakpoints was raised by Enforcement, it appears that the Hearing Panel took a reasonable approach. The branch manager testified that funds within the same family have different breakpoints and, unless a branch manager knew and retained every breakpoint number, an individual review of a particular transaction would not be meaningful in the context of discount potential. It appears that the Panel gave considerable weight to an incident where the branch manager required his rep to "double up" a customer's purchase so that the customer could get a breakpoint. Another important piece of evidence was the fact that witnesses on both sides acknowledged that the advantage of achieving breakpoint discounts must be balanced against considerations of quality and diversity when choosing mutual funds. But apparently the most important fact seems to be the rep knew that the firm's breakpoint system whenever a mutual fund transaction came within 5% of a breakpoint. Evidently, the rep scrupulously avoided this 5% threshold in order to steer clear of detection. Again, it was the system that failed, more so than the branch manager. But this alone would not have saved the branch manager. Supervisory principals need to ask questions. Here, the branch manager asked questions, then went back again, and again - each time asking logical questions that were deemed consistent with the supervisory experience of the industry member or members of the Panel. Even though the branch manager's questions ultimately failed to uncover the rep's wrongdoing, this was not held against the branch manager. Perfection is not required; instead, a supervision that is reasonably undertaken to detect and prevent violations of securities laws is the duty required. This was plainly evidenced by the fact that the branch manager made a point of meeting with the target customer who was the object of the rep's mutual fund switching. The branch manager interviewed the customer at length, listening to the customer's complaints about performance and commissions. The branch manager explained to the customer that declines in fund NAV was consistent with the declines in 2001 overall market. But the branch manager listened to the customer's complaints about commissions, subsequently interviewing the rep and personally directing the rep to avoid further trading. Furthermore, the Panel credited the branch manager with giving the customer good advice when he told the customer to hold onto his income funds and stop trading.
Eventually, the customer's complaint was reduced to a letter that found its way to the firm's law department. Enforcement argued that this letter should have prompted the branch manager to "take some additional supervisory action" towards the rep. However, the Panel disagreed, finding that it is common practice throughout the industry that when a complaint reaches the law department, the law department takes over, advising managers to not talk to the customer directly about the details of the complaint. In short, the need to centralize responses from the law department removes the need for manager, such as this branch manager, to undertake any supervision over and above the supervision already undertaken.
While it is unfortunate that this branch manager was forced to defend himself, the good part is that valuable lessons can be learned from this case. The first lesson when defending yourself is to establish credibility at the outset. The second lesson is making sure that fulfilled your supervisory responsibilities to the letter and spirit of the law before you come to court. This case appears to have been well argued, strenuously, on both sides. Since this case represents one of those not-too-frequent cases where the branch manager prevails, it therefore well worth reading all of the details.
You can read a copy of the Hearing Panel Decision here.
