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Supervision is the lifeblood of a securities broker-dealer. Without proper supervision, a broker-dealer is exposed to both regulatory and civil liability. A clear example of such liability is where the broker-dealer has no system of supervision or internal controls in place and a fraud is committed by its registered representative. Further, the best supervisory systems may not protect the broker-dealer from liability for its registered representative’s fraud if the broker-dealer failed to properly implement and enforce its supervisory system. Liability attaches because civil litigants and regulators claim that the broker-dealer should have known about its registered representative’s fraud and there was no impetus to prevent the fraudulent activity. FEDERAL SECURITIES LAW Broker-dealers may be liable for a registered representative’s fraud pursuant to ��15 and 20 of the Securities Exchange Act of 1934 (Exchange Act). Initially, a broker-dealer must supervise a registered representative. Broker-dealers must establish, maintain and enforce a reasonable system of supervision and internal controls that would enable the broker-dealer to supervise a registered representative. If the broker-dealer fails to establish, maintain or enforce this system, it would violate federal securities law. Federal securities law — Exchange Act ��15 and 20(a) — provides that this form of liability is one of a control person. See Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1573-1578 (9th Cir.1990); SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1472 (2d Cir. 1996). Thus, the general rule is that a broker-dealer is always its own registered representative’s control person. CONTROL PERSON LIABILITY CLAIMS To be or not to be a control person, that is truly the question in this day of enormous plaintiff’s and arbitration claimant’s awards as well as SEC and SRO regulatory actions. Most broker-dealers prefer to avoid the entire discussion, but an ostrich-like approach may only increase a firm’s liability in any subsequent legal action. Proving claims for control person liability pursuant to Exchange Act ��15 and 20(a) require several layers of proof. For example, a plaintiff or arbitration claimant must initially demonstrate a primary violation of the securities laws by the registered representative. The plaintiff or arbitration claimant must also show that the broker-dealer was a “control person” for that registered representative. First Jersey, 101 F.3d at 1472-1474; Marbury Management, Inc. v. Kohn, 629 F.2d 705, 716 (2nd Cir. 1980); Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880, 885 (3rd Cir. 1975); Hollinger, 914 F.2d 1564. Once a plaintiff or claimant establishes those elements, the burden shifts to the broker-dealer to prove there was no fraud or that the broker-dealer acted in good faith regarding the supervision of its registered representative. If fraud was established, the broker-dealer was a control person and it failed to supervise the registered representative or establish a reasonable system of supervision and internal controls to enable it to supervise the registered representative, a plaintiff or arbitration claimant may then be able to recover from the broker-dealer for the fraud committed by the broker-dealer’s registered representative. This result may seem onerous, but it gets worse. A broker-dealer may also be found liable even if the broker dealer did not have actual knowledge of or participate in the fraud as described below. THE GOOD FAITH DEFENSE Avoiding the draconian application of control person liability requires careful planning and execution of a well-reasoned, thoughtful supervision system. Initially, the broker-dealer must demonstrate that it acted in good faith by supervising its registered representatives and/or establishing a system that would have enabled it to supervise its registered representatives. See First Jersey, 101 F.3d at 1473; Hollinger, 914 F.2d at 1573-78. Because the burden of proof is shifted to the broker-dealer, it is required to “put forth [its] own evidence of [the good faith] defense.” Dietrich, 126 F. Supp. 2d at 768. Accordingly, the broker-dealer must affirmatively prove that it supervised the registered representative. See id. See also Jefferson Pilot Securities Corp. v. Blankenship, 257 F. Supp. 2d 962, 967 (N.D. Ohio 2003) (NASD Rule 3010(a) requires a broker dealer to “establish and maintain a system to supervise the activities” of its representatives or agents). Proving good faith, however, is not a simple exercise. Such a showing requires the broker-dealer to demonstrate that it reasonably supervised the registered representative or that it established, maintained and enforced a reasonable and proper system of supervision and internal controls. See Marbury Management, 629 F.2d at 716; First Jersey, 101 F.3d at 1472-1474; Dietrich v. Bauer, 126 F. Supp. 2d 759, 767-769 (S.D.N.Y. 1996); Jairett v. First Montauk Securities Corp., 153 F. Supp. 2d 562, 571 (E.D. Pa. 2001); Carroll v. John Hancock Distrib., Inc., Docket No. 92-5907, at *6 (E.D. Pa. March 14, 1994). The broker-dealer essentially must prove that it exercised due care in supervising the registered representative. NASD Conduct Rule 3010 provides some guidance. The NASD Rule states that a broker must show that it “maintained and enforced a reasonable and proper system of supervision and internal control[s].” See Marbury Management, 629 F.2d at 716; First Jersey, 101 F.3d at 1473. “To satisfy the requirement of good faith it is necessary for the defendants to show that some precautionary measures were taken to prevent the injury suffered.” Lorenz v. Watson, 258 F. Supp. 724, 732 (E.D. Pa. 1966). The First Jersey case demonstrates that, although the broker-dealer may introduce evidence of a system of supervisory controls, it must prove that such a system was actually enforced and not merely cosmetic. First Jersey, 101 F.3d at 1473. Accordingly, broker-dealers may not demonstrate good faith simply by claiming that they did not discover or know about the registered representative’s fraud if the broker-dealer did not have a supervisory system in place to detect it in the first place. Broker-dealers also have no support for claims of no knowledge if there is evidence indicating that the broker-dealer otherwise should have known about the registered representative’s fraud if it had a proper supervisory system. Where a broker-dealer “should have known of the fraud,” the broker-dealer “had a duty of care to take steps to prevent it.” Dietrich, 126 F. Supp. 2d at 768. The Dietrich court explained in its rejection of a broker-dealer’s “theory that he [the broker-dealer] had no notice of any alleged wrongdoing, and, therefore, no duty to investigate or control [the registered representative's] activities,” that the broker dealer was required and failed to “point to” any steps it took to prevent the fraud. Id. “Willful blindness … cannot form the basis for a defense of good faith to a charge under [Exchange Act] � 20(a).” Id. Citing In re Boesky, 1995 WL 456368, at *1 (S.D.N.Y. 1995); Ingenito v. Bermec Corp., 441 F. Supp. 525, 533 (S.D.N.Y. 1977) (“If the perpetration of the fraud went unnoticed because of willful or reckless disregard, the good faith defense is unavailable.”) Therefore, to demonstrate good faith in a proceeding, the broker-dealer must point to activity showing the supervision of the registered representative and the actions designed to prevent the registered representative’s fraud. See id. There are numerous ways a broker-dealer may satisfy this standard. Such steps include periodic reviews and audits of registered representatives and their clients. Broker-dealers may also demonstrate good faith by including comprehensive and multiple continuing education programs, requiring the attendance of all its registered representatives, as part of its compliance program. (Continuing education is already a facet of many broker-dealers’ compliance programs because SRO Rules dictate these programs. This suggestion is in addition to those requirements.) These programs must include education and training concerning all facets of regulatory requirements. Further, the broker-dealer must also include procedures to discipline its registered representatives, and document such sanctions when a registered representative violates firm policies. Nonetheless, if the evidence demonstrates that the broker-dealer should have known about its registered representative’s fraud and did nothing to prevent it, the broker-dealer will likely be held liable. Similarly, if the evidence demonstrates that the broker-dealer failed to supervise the registered representative, establish, maintain or enforce a reasonable system of supervision and internal controls, liability will also attach. However, if the broker-dealer implemented and executed a well-crafted supervisory system, it may escape liability pursuant to Exchange Act ��15 and 20(a). Control person liability is one of the more far-reaching aspects of liability in the securities industry. Ignorance of a registered representative’s fraud will be anything but bliss if the broker-dealer does not have a reasonable system in place to detect fraud. Only proper planning, implementation and review of its internal systems will ensure that a broker-dealer has satisfied its duties as a control person. Ernest E. Badway, a former SEC Enforcement attorney, is a partner at Saiber Schlesinger Satz & Goldstein of Newark, N.J., where he practices securities law. He is also an adjunct assistant professor of law at Brooklyn Law School, where he teaches a course on securities enforcement. Anthony Del Guercio is an associate in Saiber’s securities regulatory and litigation practice group.

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