Supervisory Responsibilities: “See No Evil, Hear No Evil” Won’t Fly
It’s a big week for art collectors, including as Steven A. Cohen, hedge fund advisor and owner of SAC Capital Advisors, who is disposing of about $80 million worth of art at auctions at Sotheby’s and Christie’s. As the New York Times reported, the sales come just as Cohen’s fund “has agreed to plead guilty to insider trading violations and pay a record $1.2 billion penalty, becoming the first large Wall Street firm in a generation to confess to criminal conduct.”
Prosecutors have not brought criminal charges against Cohen, but in July, the SEC charged him with failing to “reasonably supervise two of his senior employees who engaged in insider trading under his watch.” These charges should make all investment professionals with supervisory responsibilities stop and think about whether they are “reasonably supervising” their employees.
CFA members and candidates must follow Standard IV(C) of the CFA Institute Code of Ethics and Standards of Professional Conduct, which states that members and candidates “must make reasonable efforts to detect and prevent violations of applicable laws, rules, regulations, and the Code and Standards by anyone subject to their supervision or authority.” However, all investment professionals who supervise employees — regardless of whether those employees are CFA Institute members, charterholders, or candidates — should recognize that can be held liable for the actions of their employees. In the United States, the applicable laws and regulations are Section 10(b) of the Exchange Act of 1934 and Rule 10b-5.
So how can you make reasonable efforts to detect violations? First, you need to understand what constitutes an “adequate” compliance system for your firm and make reasonable efforts to see that appropriate written compliance procedures are established, documented, communicated to all your employees. Second, you need to periodically review these procedures to ensure that they are being followed and enforced. Although you may not be in violation of Standard IV(C), if one of the employees you are responsible for does something wrong, you could be in violation if you “know or should know that the procedures designed to detect and prevent violations are not being followed.”
In other words, willful blindness is no defense. In a 2011 deposition, Cohen said, “I’ve read the compliance manual, but I don’t remember exactly what it says.” John Coffee, a securities-law professor at Columbia University Law School told Bloomberg, “That’s a dangerous statement. The fact that he doesn’t know what’s in his compliance manual is useful to the SEC’s case.”
In the case of SAC Capital, there were approximately 140 almost completely autonomous teams that were responsible for managing hundreds of millions of dollars. As a result, it would have been very difficult for Cohen to know if anyone on these teams was in violation of any laws, rules, etc. According to the SEC complaint, however, two employees whom Cohen supervised provided information to him, which indicated that they may have inside information to support their trading. This information should have “caused any reasonable hedge fund manager in Cohen’s position to take prompt action to determine whether employees under his supervision were engaged in unlawful conduct and to prevent violations of the federal securities laws,” according to the SEC’s filing against Cohen. “Cohen failed to take reasonable steps to investigate and prevent such violations. Instead, faced with red flags of potentially unlawful conduct by employees under his supervision, Cohen allowed his traders to execute the recommended trades and stood by while the portfolio managers traded in the portfolios they managed.”
If you believe that the compliance system at your firm is inadequate or the rules are “very vague,” you should bring it to the attention of your firm’s senior management and recommend corrective action. If your firm does not take corrective action, you “should decline in writing to accept the supervisory responsibility until the firm adopts reasonable procedures to allow adequate exercise of supervisory responsibility,” as Standard IV(C) instructs.
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