C.) Block’s Liability for the Stock Purchase Agreement and the Private Placement
Memorandum
1.) the stock purchase agreement
In April of 1998, the firm, Block, and Burke executed a stock purchase agreement
whereby two investors purchased shares of Block Trading stock for $600,000 (CX-
27, pp. 2583-2597). The agreement, signed by Block and Burke (Id., at 2597),
recites the delivery to the investors of a financial statement which “present[s] fairly the
financial condition” of the firm as of December 31, 1997 (Id., at p. 2587). The
agreement further states that all information furnished to the investors “do[es] not …
omit to state any material fact” (Id., at 2592). As of that date, the firm had a net
capital deficit of over $300,000 and had been in a net capital deficit situation for the
preceding two months (Jt. Ex. 1). Block admitted that the financial statement supplied
to the investors did not disclose the net capital violation and that if he were investing in
Block Trading, he would want to know if the company was in net capital violation (Tr.
654).
The Fifth Cause alleged that Block induced the purchase of the stock by providing
financial information which he knew or should have known was false and misleading,
in violation of Rules 2110 and 2120. Rule 2120 is the NASD’s anti-fraud rule, which
parallels SEC Rule 10b-5. “To find a violation of Conduct Rule 2120 and Rule 10b-
5, there must be a showing that: (1) misrepresentations and/or omissions were made
in connection with the purchase or sale of securities; (2) the misrepresentations and/or
omissions were material; and (3) they were made with the requisite intent, i.e.
scienter.” District Business Conduct Committee v. Michael R. Euripides, 1997
NASD Discip. LEXIS 45, at *18 (NBCC, July 28, 1997).
Those requirements are satisfied here. The financial information furnished to the
investors was false and misleading; it falsely understated liabilities and also failed to
disclose that the company was in a net capital deficit. “The test for materiality is
whether the reasonable investor would consider a fact important in making his or her
investment decision.” In re Martin R. Kaiden, Exchange Act Rel. No. 41629, 1999
SEC LEXIS 1396 (July 20, 1999), citing TSC Industries, Inc. v. Northway, Inc.,
426 U.S. 438, 444 (1976). The misrepresentation and the omission were material.
The correct total of a firm’s liabilities is plainly material when, as here, such a
statement would establish the existence of a net capital deficiency, which would trigger
immediate disclosure to the SEC and NASD (SEC Rule 17a-11) and could cause the
firm to cease operations. Any reasonable investor considering putting money into such
a firm would want to know of an adverse net capital situation. As noted, Block
himself acknowledged that if he were investing, he would have wanted to know of the
net capital violation.
Rule 2120 requires proof that Block acted with scienter (knowingly intending to
deceive or acting recklessly).9 As to this element, Respondent argues that he did not
know that the financial statements were inaccurate and that, in any event, the investors
did not rely on the statements in them (Brief, pp. 9-10). Neither contention has merit.
As shown supra, there is ample evidence that Block knew of the accounting
irregularities and had personal involvement in some of them. Finally, in enforcement
cases, “it is well established that reliance need not be shown to establish a violation of
the antifraud rules.” In re New Allied Development Corporation, Exchange Act Rel.
No. 37990, 1996 SEC LEXIS 3262, at *20 (November 26, 1996)(citations
omitted).
The Panel concludes that Block is liable under Rule 2120 for failing to disclose the
firm’s true net capital status to the investors.
2.) the private placement memorandum
The Fifth Cause also alleges that the firm’s September 1998 private placement
memorandum similarly concealed the company’s true net capital deficit status, in
violation of Rules 2110 and 2120. This memorandum described Block as “Chairman,
Director, CEO and Acting President [Burke having resigned by this time], and COO”
(CX-28, p. 6760). He was the sole management official listed in it (Id., at 6771).
Block was the addressee for subscription notices, subscription agreements, and
purchaser questionnaires, and he was the signatory for acceptance of any subscription
agreement (Id., at 6831, 6837, 6842, 6844). The memorandum was in essence a
communication from Block to prospective investors.
Attached to it were financial statements for periods ending December 31, 1997 and
March 31, 1998 (CX-28, pp. 6805-6806, 6810-6811). In a representation not
challenged by Block, Enforcement states that “[t]he staff compared the information
contained in these financials … to information contained in the [false] FOCUS IIA
filings of the firm for the same time periods and noted that the information is identical”
(Brief, p. 8). The December 31, 1997 balance sheet, attached to the memorandum,
while not precisely identical, is virtually the same as the FOCUS report for that
period, which erroneously represented a positive net capital (CX-26, pp. 9177-9178;
CX-28, pp. 6806-6807). The Panel concludes that the private placement
memorandum failed to disclose the firm’s true net capital situation and, as shown
supra, that Block knew of the deficits. In these circumstances, his circulation of the
memorandum constituted fraud.
D.) Supervisory violations
The Complaint’s Sixth Cause alleges that Block and Burke failed to exercise
reasonable supervision of Gonzalez, the firm’s FINOP, with regard to concealment of
the firm’s net capital deficiencies, as alleged in the First, Third and Fourth Causes.
However, a respondent who is “substantively responsible” for misconduct alleged in
specific causes of a Complaint cannot also be responsible “for inadequate supervision
with respect to those violations.” Market Surveillance Comm. v. Markowski, No.
CMS920091, 1998 NASD Discip. LEXIS 35, at *52-*53 (NAC, July 13, 1998),
and authorities there cited.
As found, supra, Respondent Block is liable for the violations alleged in the First
through Fifth Causes of the Complaint, and Respondent Burke is liable for the
misconduct alleged in the Second Cause. Each cannot also be liable for supervisory
failures regarding such violations. However, if Block had not been charged as a
primary violator, the Panel would conclude that he was liable for supervisory failures
pertaining to the misconduct alleged in the First through Fifth Causes. Similarly, if
Burke had not been charged as a primary violator under the Second Cause, the Panel
would conclude that he committed supervisory violations pertaining to that
misconduct.
1.) Block
As shown supra, Block’s attempt to avoid supervisory violations by virtue of his
delegation to Gonzalez has no merit. Despite the advice of the firm’s outside auditor,
Block delegated responsibility for the financial aspects of a multi-million dollar
company to a person who was not a certified public accountant, had no accounting
degree, and admitted that she was grossly unqualified for the position. In those
circumstances, his delegation was unreasonable and cannot be the basis for avoiding
supervisory liability.10
Block’s assertion that he saw no supervisory “red flags” until the meeting of June 15,
1998 (Tr. 509-510) is not persuasive. As far back as June of 1997 (when he hired
Mr. S), Block realized that Gonzalez was “overwhelmed” by the firm’s accounting
work (Tr. 509, 662). He installed Gonzalez as the FINOP, knowing, as he admitted,
that she “didn’t have a degree in accounting, ... was not a CPA, and she had no prior
accounting experience, probably other than balancing her checkbook” (Tr. 485).
From “early on” in the firm’s operations, the outside auditor recommended to Block
that because of the firm’s size and complexity, its FINOP should be an accountant
(Tr. 140, 181). He ignored that recommendation.
Block knew from Gonzalez’ report in October of 1997 that the firm might have a
forthcoming net capital violation. As she explained, thereafter there was a monthly
“number,” known to Block, which was necessary to bring the firm into net capital
compliance (Tr. 315). Mr. C, who was “always” concerned about the firm’s need to
avoid net capital deficiencies, talked to Block about that subject “in the past” (Tr.
153). In April or May of 1998, Mr. S questioned the booking of certain liabilities to
the management company. Gonzalez said that she would discuss the matter with
Block and then returned, telling Mr. S that she would take over this aspect of the
work (Tr. 669-671). Prior to June of 1998, Katz, who had compliance
responsibilities at the firm and whom Block trusted, told him that obligations of the
firm could not be booked to another entity (CB-33, par. 10).
There were thus a number of “red flags” which should have alerted Block to the need
for careful supervision.
Finally, Block’s reliance on the hiring of Mr. S as supposedly illustrating his sensitivity
to supervisory responsibility is wholly without merit (Brief, p. 13). After Mr. S
questioned one of the accounting techniques which enabled the firm to conceal its net
capital deficits, Block participated in reducing his responsibilities, putting him on
vacation, and ultimately obtaining his resignation (Tr. 671, 687-689). Far from
reflecting meaningful supervision, these actions suggest Block’s own complicity in the
accounting irregularities.
2.) Burke
Burke was the firm’s President during eleven of the twelve months at issue (Jt. Ex. 1;
Tr. 745, 751). He and Block were the principal stockholders and drew equal salaries,
and the firm’s supervisory manual provided that they “share in the ultimate supervision
of the firm” (CB-21, p. 2). That Burke may have become a “de facto” branch
manager, and not a “functional” President (Br. 3; Tr. 959, 962, 964), is no defense.
The manual’s provision for his share of “ultimate” supervisory responsibility is
dispositive. See In re William H. Prince, Exchange Act Rel. No. 11680, 1975 SEC
LEXIS 741, at *7 (September 26, 1975) (a “conditional president,” who held himself
out as chief executive, was nevertheless responsible for the firm’s misconduct).11
Burke’s contention that he cannot be liable because Block told Gonzalez not to give
him financial information (Br. p. 15) also lacks merit. See In re George Lockwood
Freeland, Exchange Act Rel. No. 32192, 1993 SEC LEXIS 878, at *7-*8 (April
22, 1993), where the Commission rejected a FINOP’s contention that he was not
liable for supervisory misconduct involving net capital violations because the firm’s
president refused to provide him with necessary information. Freeland’s reasoning
applies a fortiori to Burke here: “Freeland [the FINOP] was aware at the time that
Barham [the president] was withholding information from Freeland concerning the
Firm’s finances, correspondence, and transactions. Freeland was required to insist on
Barham’s cooperation and compliance with applicable requirements or to resign. As
long as Freeland remained FINOP and a registered securities principal, he was
responsible for the performance of his duties.”
Despite the friction between the two men, Burke remained as President of the firm
throughout most of the twelve-month net capital deficiency period, and its compliance
manual continued to provide that he and Block “share in the ultimate supervision of
the firm” (CB-21, p. 2). NASD is entitled to look to persons holding themselves out
as supervisors, and may properly conclude that they are responsible for the firm’s
conduct.
E.) Sanctions
1.) Causes One through Four: Block
As noted, the misconduct alleged in the Complaint’s first four Causes arises out of the
firm’s net capital violations. Each cause depends upon the same underlying
misconduct, the existence and attempted concealment of net capital deficits. The
NASD Sanction Guidelines (1998) recognize that violations can sometimes be
aggregated or “batched” for sanctions purposes (at p. 5). Block’s counsel urged that
the Panel take such an approach for the first four counts, and Enforcement agreed as
to three of them (Tr. 994). The Panel concludes that it will aggregate Causes One
through Four for sanctions purposes.12
The Guideline for net capital violations recommends a fine of $1,000 to
$50,000 and, in egregious cases, a suspension of thirty days to two years, or a bar
(Guidelines, supra, p. 27). The Panel finds that there were egregious circumstances.
The violations occurred over many months and involved substantial deficits. Block
allowed the firm to continue in operation, while knowing the true “number,” and
attempted to conceal the deficiencies by various bookkeeping devices.
There are also mitigating circumstances. As stipulated, Block “fully cooperated with
the NASD in its investigation … [and] provided NASD regulators with unrestricted
access to all books and records of Block Trading” (Id., at par. 8). Similarly, during
the hearing, Block (and Burke) acknowledged the existence of the net capital
violations (Jt. Ex. 1) and did not seek to hide them by providing inaccurate or
misleading testimony.13
Enforcement seeks a bar in all capacities. The Panel will limit the bar to principal or
supervisory activities. Block’s conduct reflected his failures as a principal, but not
necessarily as a Series 7 registered representative. As stipulated, there was no
evidence of any sales practice misconduct on his part or at his direction.
On balance, the Panel concludes that the appropriate sanctions for Block’s net capital
violations (the First through Fourth Causes) are: a fine of $25,000 (midway on the
recommended range) and a bar from associating with any member of the Association
in any principal or supervisory capacity.
2.) Cause Five (Block)
The Panel found that Block committed fraud in using financial statements which failed
to reflect the firm’s true net capital deficits. These statements were part of an
unsuccessful private placement memorandum and a stock purchase agreement which
culminated in a $600,000 sale of the stock to two investors. For such conduct, the
Guidelines recommend a fine of $10,000 to $100,000 and a suspension for ten days
to two years, or a bar in egregious cases (at p. 80).
Attempting to deceive potential investors by hiding the firm’s precarious
financial condition is serious misconduct. But as to the private placement
memorandum, no one was injured, as it failed to raise any money. The stock
purchase agreement victimized only two persons, whose representative testified that
Block “put a lot of effort” into making the investment good (Tr. 218-219, 255).
Again, this misconduct occurred in Block’s capacity as the firm’s principal, and did
not involve any of its customers.
As appropriate sanctions for this offense, the Panel imposes a fine of $25,000
and bars Block from associating with any member firm in any principal or supervisory
capacity.
3.) Second Cause (Burke)
As noted, the recommended sanctions for net capital violations are a fine of $1,000 to
$50,000 and a suspension of up to thirty days, or a lengthier suspension or bar in
egregious cases (Guidelines, supra, p. 27). For Burke’s allowing the firm to operate
while in net capital violation, Enforcement seeks a fine of $25,000, a three-month
suspension in all capacities, and a six-month suspension in functioning as a principal
(Tr. 1013).
Burke, the President, unquestionably allowed the firm to operate while in substantial
net capital deficiencies which persisted for many months. But, as noted, his role
differed sharply from that of Block, the person primarily responsible for the net capital
violations. Burke’s acts were those of omission, not commission. Enforcement “does
not contend that Burke was an active participant in the manipulation of the firm’s
record” (Brief, p. 14), and the record shows that he was not such a participant.
It is true that he did not take sufficient action to address the deficiencies when he
learned about them, and that silence or inaction by Burke would preserve the value of
the stock he was trying to sell to Block. But, Burke’s approach was also consistent
with the outside auditor’s advice that he should proceed cautiously. Finally, the
stipulation’s recital of full cooperation with NASD investigators also applies to Burke;
and he (like Block) acknowledged the net capital violations and did not seek to
conceal them by providing inaccurate or misleading testimony (Jt. Ex. 1).
The Panel has weighed the aggravating and mitigating factors as to Burke and
concludes that the appropriate sanction for his allowing the firm to operate while in net
capital deficiency is a fine of $10,000 and a thirty-day suspension from acting in any
principal or supervisory capacities.
4.) Sixth Cause (supervisory violations as to Block and Burke)
a.) Block
As noted, if Block had not been charged as a primary violator under the First through
Fifth Causes, the Panel would conclude that he committed supervisory violations as to
the misconduct there alleged.
As to sanctions for such supervisory violations, the Guidelines recommend a fine of
$5,000 to $50,000 and a suspension of up to thirty days, or, in egregious cases, a
suspension of up to two years or a bar (Guidelines, supra, p. 89). The Department
recommends that Block be barred, or, in the alternative, fined $50,000 (Brief, p. 14).
If sanctions for supervisory failures were necessary, the Panel believes that the
appropriate remedial sanction does not require a total bar. The Department did not
spell out a relationship between the supervisory misconduct and a bar in all capacities.
The Panel sees no apparent link between Block’s supervisory defects and his
remaining in the industry as a Series 7 representative, particularly on a record which
contains no evidence of any sales practice misconduct. Considering the principle that
disciplinary actions should be remedial (Guidelines, supra, p. 3), the Panel would bar
Block from associating with any member firm in a principal or supervisory capacity,
and would fine him $10,000.
b.) Burke
The following conclusions as to sanctions apply to Burke’s supervisory failures
involving the misconduct alleged in the First, Third and Fourth Causes (where he was
not named as a violator).
Burke’s supervisory situation was obviously different from Block’s. It is true that he
retained the title of “President” and the firm’s manual gave him joint supervisory
responsibility. But for sanctions purposes, additional considerations are relevant.
Personal difficulties between Burke and Block effectively left Burke running a branch
office, while Block ran the firm. It was Block, not Burke, who trusted the unqualified
Gonzalez, installed her as FINOP, and supervised her on a day-to-day basis. In
addition, the record shows that Block himself was involved in certain details of the net
capital violations, while Burke, as noted earlier, was not an active participant in the
manipulation of the firm’s records. Indeed, Enforcement’s recommendation (a three-
month suspension in all capacities, a six-month suspension in principal capacities and a
$25,000 fine) reflects these differences.
To impress upon Burke the importance of supervisory responsibility, the Panel
imposes a requirement that he re-qualify for a Series 24 license. Finally, a fine at the
low end of the range is appropriate for him, and the Panel accordingly imposes a fine
of $5,000. 14
III. Conclusion
A.) Block
Respondent Block committed the following violations involving Block Trading, Inc.’s
net capital: first, failing to ensure the maintenance of proper books and records for
Block Trading Inc. (Rules 2110 and 3110); second, allowing that firm to conduct a
securities business while its net capital was below the required minimum (Rule 2110);
third, failing to provide the required notification that the firm’s net capital was below
the required minimum (Rule 2110); and fourth, filing inaccurate FOCUS reports (Rule
2110). He also violated Rules 2110 and 2120 by using false and misleading financial
information in a private placement memorandum and in a stock purchase agreement.
If Block were not charged as a primary violator, as found above, the Panel would
conclude that he violated Rules 2110 and 3010 by failing to exercise supervisory
responsibility.
The Panel aggregated the first four violations for sanctions purposes and, for them,
imposed a fine of $25,000 and a bar from associating with any member of the
Association in any principal or supervisory capacity. For the misleading financial
information, the Panel imposed a fine of $25,000 and a similar bar. For the
supervisory violations, the Panel would impose a fine of $10,000 and a similar bar.
In connection with a defense of inability to pay, Block submitted a financial disclosure
statement for which he sought confidentiality. He withdrew the defense when the
Hearing Officer explained that some aspects of the statement might appear in a Panel
decision and that in any event, he could not assure confidentiality in an appeal to the
SEC or the courts (Tr. 1007-1008). That withdrawal should not prevent Block from
seeking permission to pay the fines assessed on an installment basis. See Notice to
Members 99-86.
B.) Burke
Respondent Burke allowed Block Trading, Inc. to conduct a securities business while
its net capital was below the required minimum, in violation of Rule 2110. He also
violated Rules 2110 and 3010 by failing to exercise supervisory responsibility, with
respect to the firm’s books and records.
For the net capital violation, the Panel imposed a fine of $10,000 and a thirty-day
suspension from functioning in any principal or supervisory capacities. For the
supervisory violation, the Panel imposed a $5,000 fine and a requirement that Burke
re-qualify for his Series 24 license.
Respondents shall jointly and severally pay costs of $7,339.80, reflecting $6,589.80
for transcripts plus the standard administrative fee of $750. 15
These sanctions shall become effective on a date set by the Association, but not
earlier than 30 days after the final disciplinary action of the Association. If this
decision becomes the final disciplinary action of the association, the suspension as to
Respondent Burke shall become effective with the opening of business on Monday,
November 6, 2000 and end at the close of business on Monday, December 18,
2000.
HEARING PANEL
Jerome Nelson
Hearing Officer
Dated: Washington, DC
September 5, 2000
Copies to: Christopher M. Block (via overnight and first class mail)
Jeffrey S. Burke (via overnight and first class mail)
G. Scott Williams, Esq. (via facsimile and first class mail)
Andrew R. Harvin, Esq. (via facsimile and first class mail)
Ralph J. Veth, Esq. (via electronic and first class mail)
Andrew J. Favret, Esq. (via electronic and first class mail)
Rory C. Flynn, Esq. (via electronic and first class mail)
1 Respondent Jennifer Gonzalez, the firm’s Financial and Operations Principal
(FINOP), settled with Enforcement prior to the hearing and appeared as a witness for
the Department.
2 In the Sanctions section of this Decision, the Panel similarly combines or
“batches” these Counts.
3 In re William H. Gerhauser, Exchange Act Rel. No. 40639, 1998 SEC
LEXIS 2402 (Nov. 4, 1998).
4 Br., pp. 3-4; Tr. 857-859.
5 See also In re Charles L. Campbell, Exchange Act Rel. No. 26510, 1989
SEC LEXIS 174, at *10 (February 1, 1989), where the FINOP’s inability to balance
trial balances “gave an immediate demonstration” that Respondent “could not
reasonably rely on her to carry out her responsibilities.”
6 The firm grossed $10 million in 1997 and $25 million in 1998 (Tr. 508).
7 See Market Surveillance Comm. v. Markowski, No. CMS920091, 1998
NASD Discip. LEXIS 35, at *52 (NAC, July 13, 1998).
8 Burke claims that he had no knowledge of net capital violations when he first
proposed to sell his stock (Br. p. 3). But he was certainly not ignorant of them at the
time of the million dollar agreement in June of 1998.
9 See, e.g., Department of Enforcement v. Levitov, No. CAF970011 (NAC,
June 28, 2000) and cases there cited.
10 In re J.B. Hanauer & Co., Exchange Act Rel. No. 41832, 1999 SEC LEXIS
1773, at *20 (September 2, 1999); Market Regulation Committee v. La Jolla Capital
Corp., 1998 NASD Discip. LEXIS 26, at *16-*17, *21-*22 (NAC, February 27,
1998), aff’d, In re La Jolla Capital Corp., Exchange Act Rel. No. 41755, 1999 SEC
LEXIS 1642 (August 18, 1999).
11 See also In re Joseph Elkind, Exchange Act Rel. No. 12485, 1976 SEC
LEXIS 1581, at *3 (May 26, 1976) (“We have consistently rejected the notion that
the president of a broker-dealer firm can be a mere figurehead, able to disclaim
responsibility for his firm’s compliance with regulatory requirements”); In re
Management Financial, Inc., Exchange Act Rel. No. 12098, 1976 SEC LEXIS
2427, at *25 (February 11, 1976) (“His assertion that he ‘was acting president only
because there were no other officers’ does not aid him”)(citing Prince).
12 Enforcement sees the First Cause (bookkeeping violations) as somehow
distinct from the net capital violations (Tr. 994). The Panel disagrees. The
bookkeeping violations had no independent significance or purpose; they were simply
tools for concealing the net capital violations (Jt. Ex. 1).
13 See “Principal Consideration,” number 12, Guidelines, at p. 9.
14 Had Burke not been charged as a primary violator under the Second Cause,
the Panel would have found him liable for supervisory failures pertaining to that
misconduct. But, considering the above imposed re-qualification and fine, it would
not assess any further sanction.
15 The Hearing Panel considered all of the arguments of the parties. All
arguments are rejected or sustained to the extent they are inconsistent or in accord
with the views expressed here. |
