Failure to Supervise in Action – Arbitration Case Examples and Evidentiary Proof (Part II)

In Part I, we explained the supervisory duties firms owe under FINRA rules and what investors must prove in a failure-to-supervise claim. In this installment, we examine illustrative arbitration cases to see how those standards are applied in practice and what kind of evidence is most persuasive in these disputes.

Case Examples in Arbitration

Over the years, many FINRA arbitration awards have held firms liable for failure to supervise, sometimes with significant damages. Below are a couple of examples illustrating how this claim is used and decided in practice:

Unauthorized Trading – Morgan Stanley (2022): In a FINRA arbitration, a panel awarded over $11.6 million to one investor, individually and as trustee of his revocable trust, in a case against Morgan Stanley. The claim asserted multiple causes of action, including negligence, breach of fiduciary duty, failure to supervise, fraud, breach of contract, and violations of FINRA Rules 2010, 2020, and 3260. At the core of the dispute were unauthorized and unsuitable sales of large positions in technology stocks, particularly Nvidia (NVDA), and the unauthorized opening of options contracts in the Trust’s account.

Claimant alleged a covered call writing strategy led to losses when high-performing stocks were “called away” without authorization and sought tens of millions in lost opportunity damages. The arbitration panel awarded $11.5 million in compensatory damages and $157,656.81 in costs, rejecting Morgan Stanley’s request to expunge the matter from the broker’s CRD record. Although the award did not specify which claims were sustained, the inclusion of failure to supervise and unauthorized trading among the pleading’s claims, along with the scale of the award, strongly indicates the panel found serious oversight failures. This case highlights the risks brokerage firms face when compliance systems fail to detect or prevent high-impact misconduct involving concentrated equity positions and options strategies.

Unsuitable Structured Products – Stifel Nicolaus (2024): In a major 2024 FINRA arbitration decision, a panel ordered Stifel, Nicolaus & Co. to pay over $14.2 million in total damages to clients who alleged negligent supervision, breach of fiduciary duty, fraud, and violations of the state securities law. The case centered on Stifel’s failure to properly oversee a broker’s recommendations of structured note investments, which the claimants argued were unsuitable and mismanaged.

The arbitrators awarded approximately $4.07 million in compensatory damages to the claimants (including statutory interest), along with an extraordinary $9 million in punitive damages under common law and state statute. Additionally, Stifel was ordered to pay $1.1 million in attorneys’ fees and $100,000 in costs. The firm’s request to expunge the matter from the broker’s record was denied with prejudice.

This award is noteworthy not only for its size but also for the arbitrators’ express finding of liability, justifying punitive damages, which suggests that Stifel's supervision failures rose to the level of willful or reckless disregard. The case illustrates that FINRA panels are willing to impose substantial penalties when firms ignore red flags or fail to adequately monitor complex product sales, especially when investors suffer large-scale harm.

These examples highlight that failure-to-supervise claims can succeed in a variety of contexts, from relatively straightforward negligence in oversight (resulting in five- or six-figure awards) to extreme cases of prolonged supervisory failures (resulting in multi-million-dollar awards, including punitive damages). The common thread is that in each instance, the firm was found to have fallen asleep at the wheel: failing to detect unauthorized trades, not vetting products and recommendations, or not reacting to red flags from a broker’s behavior.

It’s also worth noting that many settlements in FINRA arbitration cases involve supervisory claims. Firms often choose to settle if evidence shows, for example, that compliance personnel missed clear warning signs (such as a broker with a history of customer complaints allowed free rein, a situation where “heightened supervision” was warranted but not implemented). The prevalence of failure-to-supervise allegations (one of the “more frequently alleged” claim types in FINRA arbitration) means there is a considerable track record of both awards and settlements in this area.

Proving the Claim: What Constitutes “Failure to Supervise”?

Whether a firm’s supervision was inadequate is a fact-intensive inquiry. FINRA rules don’t guarantee perfect surveillance, but they do expect a “reasonably designed” system. As such, arbitrators will look at what steps the firm actually took to supervise and whether those steps met industry norms. Some considerations include:

Policies and Procedures: Did the firm have written supervisory procedures (WSPs) addressing the type of activity that led to the loss? For example, did it have policies for reviewing trades for suitability, for approving new accounts, for monitoring email communications, and for handling customer complaints? If a firm lacked a policy in an area (say, no procedure to monitor excessive trading or “churning” in accounts), that gap can be evidence of an unreasonable system. On the other hand, if policies existed but were ignored or unenforced, that also indicates failure.

Red Flags and Follow-Up: Perhaps the most critical evidence in many cases is the presence of “red flags” that supervisors missed or failed to act upon. Red flags can be unusual account activity (e.g., a senior citizen’s account racking up huge commissions from frequent trades), a pattern of customer complaints about the same broker, or compliance alerts (like electronic trade surveillance systems flagging a high cost-to-equity ratio in an account). If the investor can show that such warnings were evident and the firm’s managers did nothing or responded inadequately, arbitrators are likely to find that the supervision fell short. In one case, FINRA found a firm’s “flaccid response” to churning red flags, merely asking the customer to acknowledge the trading without truly investigating or stopping the abuse, was a serious supervisory failure. Similar patterns in arbitration evidence can be persuasive of liability.

Supervisory Structure and Culture: Arbitrators may consider whether the firm’s overall culture emphasized compliance or sales at all costs. For instance, if a branch manager was directly supervising himself (a violation of Rule 3110’s prohibition on self-supervision) or if the firm placed an inexperienced supervisor in charge of a high-risk broker, those can be viewed as contributing to the firm’s supervisory failures. Conversely, a firm that can document regular training, active compliance department engagement, and prompt disciplinary action against rogue brokers will appear to have taken supervision seriously. The quality of internal audits or branch inspections can also be highly relevant, e.g., did the firm routinely inspect the broker’s office, and should that have caught the wrongdoing?

Causal Connection: To prevail on a failure-to-supervise claim, the claimant must establish a clear causal link between the firm’s supervisory shortcomings and the investor’s losses. It is not enough to show that misconduct occurred; the investor must demonstrate that the firm’s failure to detect or prevent the misconduct was a proximate cause of the harm. For instance, if a supervisor ignored multiple red flags, such as excessive trading in a retiree’s account or repeated customer complaints about the same broker, and those warnings, if properly investigated, would likely have prevented further losses, the firm may be held liable. Conversely, if the firm had a reasonable system that the broker circumvented in an unforeseeable way, the firm would argue the losses were not due to its supervision but solely the broker’s deceit (see Defenses in Part III).

In sum, to prove failure to supervise, an investor will map out what the firm should have done versus what it did. They’ll often rely on industry rules and expert testimony to establish the standard of care. FINRA’s findings or guidelines can serve as useful benchmarks. For example, FINRA Regulatory Notice 18-15 emphasizes that firms must “reasonably surveil for, and respond to, red flags of excessive trading and churning” as part of a robust compliance system. Such language can be powerful in arguing that failing to respond to obvious misconduct is a violation of industry standards. If the case involves a broker with known past issues, FINRA expects the firm to impose heightened supervision on that individual; not doing so could be deemed unreasonable.

Ultimately, arbitrators will decide if the firm’s supervision was reasonable or not by weighing all this evidence. It’s a negligence-like analysis. Was the firm’s conduct (in supervising) prudent and in line with what a reasonably managed firm would do? If not, and that negligence was a cause of the investor’s loss, the panel can find the firm liable for failure to supervise.

Securities fraud often begins with a single act of broker misconduct, but it's a lack of supervision that allows it to persist. At AMW Law PLLC, our securities fraud attorney knows how to uncover these lapses and build strong arbitration claims for investors. Schedule a free consultation today to discuss how we can help you recover your losses.