Compliance and Regulatory Alerts | 04-07-22

FINRA Clarifies and Cautions Firms on Potential Supervisory Liability of Chief Compliance Officers

In a reminder to (i) firm management on their supervisory obligations under FINRA Rules, and (ii) Chief Compliance Officers (“CCOs”) on their potential liability within a firm’s supervisory system, FINRA distinguished between the two in a recent Notice and detailed how it would make liability determinations on an enforcement action against a CCO for a failure to reasonably supervise. This guidance on FINRA Rule 3110 (“Supervision”) is significant, as it gets to the entire workings of the regulator’s compliance framework. Indeed, FINRA clarifies its expectations on supervision by emphasizing the “vital” role of the CCO to help “protect investors and market integrity, as well as the member firm itself.” The Notice reviews the scope of the FINRA supervision rule, the role of the CCO, and how FINRA determines liability against a CCO when it is applicable under the rule. Here are some takeaways from the FINRA guidance.

FINRA Rule on Supervision

In reviewing the scope of Rule 3110, FINRA highlights the difference between the firm’s management’s supervisory responsibility and a CCO’s responsibility. The Notice makes clear that the management is responsible for designating individuals for supervisory responsibility. This might be done expressly (i.e., through written procedures) or impliedly (i.e., ad hoc or based on exigencies). Accordingly, FINRA asserted that it will look to management and supervisors first, “to determine responsibility for a failure to reasonably supervise.”

FINRA clarified that CCOs act in an advisory—not supervisory—capacity, drawing a distinction between supervision and compliance. As a result, supervisory liability does not attach to a firm's CCO unless the firm “conferred upon the CCO” a supervisory role and, if so, only when the CCO “failed to discharge those responsibilities in a reasonable manner.” Therefore, FINRA would first consider, for example, whether the CCO is responsible for creating the firm's supervisory procedures or for enforcing the firm's supervisory compliance procedures (in order to establish that the CCO is operating in a management supervisory capacity) before there could be a determination on CCO liability.

Determinations of Liability

Once a CCO is identified as a designated supervisor, FINRA would determine whether to bring an enforcement action after an assessment of the CCO’s actions under a reasonableness standard, judged against factors for reviewing supervisors. Examples of actions that could lead to CCO liability include: awareness of and failure to address red flags or misconduct, failure to establish or enforce written procedures, and failures that lead to violative conduct that were likely to cause customer harm. Mitigating factors to CCO liability include insufficient support by the firm (i.e., staffing, budgets or training) and poorly defined or unduly burdensome supervisory responsibilities, among others. Such mitigating circumstances may result in a Cautionary Action Letter rather than a disciplinary action. FINRA noted that these determinations are made on a case-by-case basis.

Conclusion

As the number of rules expands, pressure is mounting on CCOs to ensure adequate compliance on the entire range of regulatory oversight. In the Notice, FINRA acknowledges the importance of the CCO role to the entire regulatory framework:

“CCOs and their compliance teams help design and implement compliance programs, help educate and train firm personnel, and work in tandem with senior business management and legal departments to foster compliance with regulatory requirements.”

By asserting that CCO liability for supervisory failures only “represent a small fraction of the enforcement actions involving supervision that FINRA brings each year,” and by drawing attention to other designated supervisors as potentially liable for such failures, FINRA appears to be trying to assure CCOs that they are not being exclusively targeted within the framework due to their title alone. Bates will continue to keep you apprised.

How Bates Helps

Bates Compliance provides tailored solutions for financial institutions and investment advisers. Our compliance team includes senior compliance staff and former regulators, with expertise in the development of policies, procedures, supervisory and compliance processes, including in supervision and oversight, recordkeeping, and disclosure.

Contact us today to learn how we can support your team and your clients.

Hank Sanchez, Managing Director, Bates Compliance - hsanchez@batesgroup.com or 504-450-9632
Rhonda Davis, Managing Director, Bates Compliance & AML - rdavis@batesgroup.com
Rory O'Connor, Director, Bates Compliance - roconnor@batesgroup.com or 860-671-7270

For FINRA litigation and regulatory investigation matters, please reach out to:

Julie Johnstone, Managing Director, Securities Litigation and Data Analytics - jjohnstone@batesgroup.com
Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations - arussell@batesgroup.com