SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 37409 / July 8, 1996 Admin. Proc. File No. 3-8725 __________________________________________________ : In the Matter of the Application of : : CHARLES E. FRENCH : 4712 Lakewood Drive : Metairie, Louisiana 70002 : : For Review of Disciplinary Action Taken by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : __________________________________________________: OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY PROCEEDINGS Violation of Rules of Fair Practice Failure to Inform Employer of Private Securities Transaction Fraud in Sale of Security Where salesman of member firm of registered securities association engaged in private securities transaction without informing member firm and committed fraud in connection with the sale of that security, held, association's findings of violation and sanctions it imposed sustained. APPEARANCES: Robert G. Stassi, of Chedardy, Sherman, Ellis, Breslin & Murray, for Charles E. French. T. Grant Callery and Deborah F. McIlroy, for the National Association of Securities Dealers, Inc. Appeal filed: June 15, 1995 Last brief filed: September 28, 1995 I. Charles E. French, a former salesman of LaSalle St. Securities, Inc. ("LaSalle St."), a member firm of the National ==========================================START OF PAGE 2====== Association of Securities Dealers, Inc. ("NASD"), appeals from disciplinary action taken against him by the NASD. The NASD found that French engaged in a private securities transaction without giving his firm the requisite prior written notification, and committed fraud in connection with the sale of that security. 1/ The NASD censured French, fined him $15,000, and barred him from association in any capacity with any member of the NASD. The NASD also required French to pay restitution of $50,000, plus interest of 9% per annum from September 3, 1991. 2/ Our findings are based upon an independent review of the record. II. During the relevant period, French operated a one-person satellite office in Metairie, Louisiana for LaSalle St., a Chicago-based broker-dealer. French was registered with the NASD as both a general securities representative and a foreign currency options representative. This matter relates to French's involvement in the issuance of a note by First Care Medical Corporation ("First Care") to a LaSalle St. customer, Kenneth Lang. The pertinent facts are as follows. In September 1991, about two years after Lang opened a LaSalle St. account through French, French recommended that Lang invest in First Care. 3/ The record makes clear that Lang was an unsophisticated investor reliant on French's investment advice. French explained to Lang that, for a minimum investment of $50,000, he could buy an interest in First Care, a medical 1/ The NASD found that French's activities violated Article III, Sections 1, 18 and 40 of the NASD's Rules of Fair Practice. Section 1 requires that members, in the conduct of their business, observe high standards of commercial honor and just and equitable principles of trade. Section 18 proscribes the use of deceptive or other fraudulent devices in securities transactions. Section 40 prohibits any person associated with a member firm from participating in any manner in a private securities transaction outside the regular course or scope of his employment without providing prior written notice to the member. 2/ The NASD also assessed costs. 3/ Lang initially deposited about $295,000 in the account, representing funds from an automobile accident settlement Lang had received. Lang told French that he wanted investments that would provide him with "safety of principal, a little bit of income, [and] a little bit of growth." ==========================================START OF PAGE 3====== corporation, from a doctor who "was getting out." French further explained that First Care operated the First Care Clinic (the "Clinic"), a walk-in medical clinic. French gave Lang certain financial statements and projection sheets reflecting First Care's earnings in past years, offered a tour of the Clinic, and suggested that monthly income statements would be made available to Lang if Lang invested in First Care. French falsely advised Lang that French was First Care's accountant, and, as such, would ensure that Lang was paid before any other First Care creditor. 4/ French was not First Care's accountant. In addition to misrepresenting his role in First Care, French did not disclose his own proprietary interest in the First Care venture. In May 1991, shortly before French recommended to Lang the First Care investment, French, along with Drs. John LaMartina and Robert Chugden, formed Emergency Physicians Group, Ltd. ("EPG"). EPG was a medical care corporation formed to provide medical care to employees of film companies on location in the New Orleans area. French served as EPG's president and secretary. LaMartina owned First Care and operated the Clinic. Shortly after EPG's incorporation, LaMartina decided to sell his interest in First Care to EPG and relinquish his EPG stock. French, on behalf of EPG, then set out to find the necessary capital to buy out LaMartina so that EPG could operate the Clinic. Although French was involved intimately in EPG's decision to buy out LaMartina's interest in First Care, French did not tell Lang that EPG planned to purchase First Care. 5/ Nor did French disclose that, consistent with EPG's acquisition plan, EPG would relieve present Clinic personnel of management responsibility and pay French a minimum of $1,500 per month for his Clinic management services. On September 3, 1991, within a few days of French's initial recommendation to Lang, 6/ Lang wrote a $50,000 check payable to LaMartina, who he understood was the "doctor who was getting 4/ French told Lang that First Care had been earning between $5,000 and $8,000 per month for the prior eight years through operation of the Clinic, and that First Care was worth approximately $250,000. 5/ Lang was aware that French was involved with EPG, but testified that, as far as Lang knew, EPG and First Care "didn't have nothing [sic] to do with each other." 6/ Lang testified that French pressed him into making a quick decision as to whether to accept certain proposed note terms, "because [French] had somebody else who was going to do it [lend the money]" if Lang did not. ==========================================START OF PAGE 4====== out" of First Care. In return, Lang received a promissory note from First Care. The terms of the note were that Lang was to receive $10,000 per year for five years; First Care stock certificates as collateral for the note; interest on the loan for the duration of the note, computed annually based on 20% of First Care's net revenues; free medical care from the Clinic until the note was repaid; and copies of First Care income statements for the period the note remained outstanding. Lang consulted only with French in considering whether to invest in First Care. One day after Lang signed the note, LaMartina executed an agreement with First Care specifying that, in exchange for payment of $49,000, LaMartina discharged all payment due him for loans he had made to First Care and for services he had performed. That same date LaMartina also sold First Care to EPG for $1,000, and resigned from EPG. French was present for the closing of these transactions; Lang was not. Indeed, Lang never met or spoke with LaMartina. Lang did not receive an income statement from French until June 1992, when French gave Lang copies of Clinic monthly statements dating back to January 1992. In June, the Clinic began to have financial difficulties. Before the September 1992 initial scheduled interest payment date, Lang sued French, First Care, LaMartina, and Chugden. Lang did so because he had not received timely monthly income statements, and then became concerned about his investment in First Care after reviewing the few income statements that he did receive. 7/ Although Lang did not receive any payments under the note, French received a monthly check in the minimum amount of $1,500 for Clinic management services beginning in October 1991. French concedes that he received a total of more than $22,000 in such pay- ments. 8/ In April 1993 French and Chugden, after failing to sell the Clinic, filed for bankruptcy protection on behalf of First Care. 7/ Lang testified that he had "seen no spot where they was [sic] putting money aside to pay [him], and [he] was getting worried." 8/ French maintains that he did not advise Lang in September that First Care would pay French management fees because this arrangement was not in place until October. The District Business Conduct Committee reasonably did not credit this explanation, which does not comport with French's own description of what he termed the "nuts and bolts" of the First Care transaction in a 1993 letter to the NASD. ==========================================START OF PAGE 5====== III. Section 40 of the NASD's Rules of Fair Practice ("NASD Rules") applies to private securities transactions. The rule prohibits any person associated with a member firm from participating in any manner in a private securities transaction outside the regular course of his employment unless that person provides prior written notice to the member. 9/ It is undisputed that French gave LaSalle St. no such notice of his involvement in Lang's investment in First Care. 10/ French initially claimed that he did not give LaSalle St. notice of the transaction between Lang and First Care because French did not believe the note was a security. He now concedes that the note could "fall within a very technical definition of a security." 11/ We find that the promissory note is a security. Consistent with the "family resemblance" test adopted by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990), a note is presumed to be a security unless (1) it bears a strong resemblance to certain types of notes recognized as being outside the investment market regulated under the securities laws, 12/ 9/ Article III, Section 40 of the NASD Rules, NASD Manual (CCH 1994 ed.) 2200, p. 2196. 10/ French answered in the negative the question on LaSalle St.'s routine compliance questionnaire, pertaining to the 1991 fiscal year, that asked whether French had raised or helped to raise money for any individual, company, or venture since his employment with the firm. 11/ French contends that the note, as originally drafted, was not a security. He claims that modifications to various of the note's terms (particularly one tying Lang's return to First Care's profits) made at the insistence of Lang's attorney "technically" may have transformed the note into a security. As indicated above, Lang never discussed the First Care investment with an attorney (or anyone other than French). In any event, French's arguments about who created the instrument miss the point, as our focus is whether the note before us is a security. 12/ Among the types of notes intended to be excluded from the definition of a security are those notes that are issued in a purely commercial or consumer context, such as notes secured by a mortgage on a home or short-term notes secured by assignment of accounts receivable. Id. at 65. See also William Louis Morgan, 51 S.E.C. 622, 626-27 (1993); William F. Wuerch, et al., 50 S.E.C. 811, 812 n.2 (1991). ==========================================START OF PAGE 6====== or (2) it should be added to that list of excluded notes, based on certain factors described by the Court. 13/ The note at issue does not bear any resemblance to the notes widely recognized as excluded from the definition of a security. Nor do we conclude that it should be added to that list of excluded notes, given that Lang's purpose in loaning the money was to obtain the promised return, and that nothing indicates that Lang made this loan to First Care for any purpose other than as an investment. We also have considered that the note was not insured, and that no other factor was present that reduced significantly the investment risk of the note. 14/ French also contends that he did not report the transaction to LaSalle St. because his role in the transaction was merely to facilitate the sale between Lang and LaMartina, and to prepare the paperwork. 15/ The record belies this. Moreover, the NASD rule at issue prohibits participation "in any manner" in a transaction covered by the rule. The District Business Conduct Committee ("District Committee") heard Lang's very specific testimony that French recommended the investment opportunity to Lang and handled all the negotiations concerning the note. In testimony before the District Committee, Lang denied that he ever had met LaMartina. The District Committee also heard the testimony of French, which contradicted Lang's testimony in virtually all relevant respects. The District Committee found Lang to be the more credible witness. The credibility determination of the initial decision maker is entitled to considerable weight and deference, since it is based on hearing the witnesses' testimony and observing their demeanor. 16/ Our review of the record provides no basis for disagreement with 13/ Reves, 494 U.S. at 66-67. 14/ Although Lang testified that, consistent with the note's terms, French gave him some First Care stock certificates and told Lang to put the certificates in a safe place, such as a safe deposit box, appearing to imply their negotiability, the certificates were not pledged to Lang. French contends the certificates were given to Lang simply as a demonstration of "good faith." 15/ French contends to us, as he did to the NASD, that it was LaMartina who raised the money from, and met to negotiate the note's terms with, Lang. 16/ See Robert E. Gibbs, 51 S.E.C. 482, 483 (1993), aff'd, 25 F.3d 1056 (10th Cir. 1994) (Table); Anthony Tricarico, 51 S.E.C. 457, 460 (1993); Jonathan Garrett Ornstein, 51 S.E.C. 135, 137 (1992); Universal Camera Corp. v. NLRB, 340 U.S. 474, 496 (1951). ==========================================START OF PAGE 7====== the NASD's assessment. 17/ Based on the above considerations, we conclude, as did the NASD, that French violated Article III, Sections 1 and 40 of the NASD Rules. IV. We further conclude that French induced Lang to invest by misrepresenting to Lang that French was First Care's accountant, and, as such, would ensure that Lang got his money before any other creditor. We also find that French, in inducing Lang's investment, failed to disclose to Lang material facts about both French's personal interest in securing the funds to buy out LaMartina, and First Care's prospects. 18/ For instance, French failed to disclose to Lang the material information that, as a consequence of arranging Lang's investment in First Care, EPG, a company in which French had a significant financial interest, would acquire LaMartina's First Care stock and assume control over Clinic operations. French further failed to 17/ Key portions of Lang's testimony were corroborated by LaMartina, who did not testify at the hearing (although both French and the NASD attempted to obtain his appearance) but did execute an affidavit. In that affidavit, LaMartina stated that he had never met Lang and that LaMartina understood that, in September 1991, LaMartina sold French the Clinic for $50,000. He further stated that, while French, on September 4, 1991, passed along to LaMartina Lang's $50,000 check, LaMartina did not know that First Care had issued a promissory note to Lang. This affidavit was admitted by the District Committee notwithstanding French's objections on hearsay and bias grounds. (French claims that the statements in LaMartina's affidavit were the result of the fact that LaMartina was involved in the lawsuit Lang had instituted against LaMartina, French, First Care, and Chugden.) We have stated on numerous occasions that hearsay statements, like those offered in LaMartina's affidavit, may be admitted as evidence and, in the appropriate case, even may afford the sole basis for findings of fact. See, e.g., Michael A. Niebuhr, Securities Exchange Act Rel. No. 36620 (December 21, 1995), 60 SEC Docket 2923, 2932 n.33. The District Committee properly admitted the affidavit. 18/ Information is material if there is a substantial likelihood that a reasonable investor would consider it important to an investment decision. See Basic v. Levinson, 485 U.S. 224, 230-31 (1988); TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). ==========================================START OF PAGE 8====== disclose that, pursuant to EPG's Clinic acquisition plan, French would be paid a minimum of $1,500 a month when he assumed, within a month of the acquisition, Clinic management responsibilities. In essence, French convinced Lang to invest in a concern that, one day later, was acquired by a company in which French, unknown to Lang, had a significant undisclosed financial interest. Moreover, French provided Lang financial information relating only to First Care, while withholding crucial financial information about EPG, the entity poised to acquire the Clinic. 19/ Lang relied exclusively on French to guide him in investment matters, and French took full advantage of that reliance. That French acted with the requisite scienter is apparent on this record. We conclude, as did the NASD, that, in securing Lang's investment in First Care, French violated Sections 1 and 18 of the NASD Rules. 20/ V. French asserts that the NASD regional staff attorney's hearing room demeanor was "confrontational and harassing." As a result, French contends, French appeared reluctant to respond to "legitimate" questions and defensive to what French describes as the "obviously misleading direction of the NASD counsel's line of questioning." The record does not substantiate this claim. We find nothing improper in the NASD regional staff attorney's examination of French. Moreover, French was afforded the opportunity to explain fully to the hearing panel his claimed lack of involvement in procuring Lang's investment. That panel simply found that French was not credible. 21/ 19/ Compare SEC v. Murphy, 626 F.2d 633, 643 (9th Cir. 1980) ("information crucial to the investment decision would be that concerning the entity which was responsible for the success or failure of the enterprise"); id. at 653 (materiality of information relating to a company's financial condition, solvency and profitability is not subject to serious challenge). See also SEC v. Blavin, 760 F.2d 706, 710 (6th Cir. 1985). 20/ Article III, Sections 1 and 18 of the NASD Rules, NASD Manual (CCH 1994 ed.) 2151 and 2168, pp. 2014 and 2080. 21/ French also claims that the hearing panel was presented evidence improperly gathered by an NASD compliance specialist. French posits that the compliance specialist copied French's personal documents (to which he concedes he gave her access) that were segregated from the relevant materials, and either unrelated to this matter or were (continued...) ==========================================START OF PAGE 9====== VI. French argues that the sanctions imposed on him are unwarranted and excessive. He also claims that the restitution order is inappropriate because he assertedly did not benefit personally from Lang's investment in the note. By engaging in a private securities transaction without notifying LaSalle St., French deprived Lang of the protection he was entitled to expect. 22/ In addition, French deceived Lang about an investment that French recommended. Given this serious misconduct, we are unable to conclude that the sanctions imposed by the NASD are excessive or oppressive. French also misunderstands one aspect of the sanction imposed against him by the NASD. Here, the NASD ordered restitution, not disgorgement. Disgorgement seeks solely to deprive the wrongdoer of his ill-gotten gains. 23/ Restitution seeks either to prevent a wrongdoer from being unjustly enriched by his or her wrongdoing 24/ or, alternatively, to require the wrongdoer to restore the victim to the status quo ante. 25/ 21/(...continued) superseded drafts of documents that are relevant to the NASD's complaint. French complains that the compliance specialist later testified about these documents and introduced some of them into evidence in support of the NASD charges. We have not relied on the contents of these documents in making our determinations on review. 22/ See Gordon Wesley Sordorff, Jr., 50 S.E.C. 1249, 1258 (1992), citing Anthony J. Amato, 45 S.E.C. 282, 285 (1973). 23/ Hately v. SEC, 8 F.3d 653 (9th Cir. 1993). 24/ Restatement of Restitution,  1 (1937); D. Dobbs, Remedies,  4.1 at 224 (1973). 25/ Franklin N. Wolf, et al., Securities Exchange Act Rel. No. 36523 (November 29, 1995), 60 SEC Docket 2417, 2432, appeals filed, Nos. 96-1023 (Petrantis and Sullivan) and 96-1024 (Wolf) (D.C. Cir.); Hibbard Brown, & Company, Inc., Securities Exchange Act Rel. No. 35476 (March 13, 1995), 58 SEC Docket 2769, 2787-2788, appeal filed, No. 95-3270 (3rd Cir.); Toney L. Reed, 51 S.E.C. 1009, 1013 (1994). ==========================================START OF PAGE 10====== Equity demands that, as between Lang and French, French should bear the loss. 26/ An appropriate order will issue. 27/ By the Commission (Chairman LEVITT and Commissioners WALLMAN, JOHNSON, and HUNT). Jonathan G. Katz Secretary 26/ Franklin N. Wolf, et al., 60 SEC Docket at 2432; Kirk Ferguson, 51 S.E.C. 1247, 1253 (1994). 27/ All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein. UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 37409 / July 8, 1996 Admin. Proc. File No. 3-8725 __________________________________________________ : In the Matter of the Application of : : CHARLES E. FRENCH : 4712 Lakewood Drive : Metairie, Louisiana 70002 : : For Review of Disciplinary Action Taken by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : __________________________________________________: ORDER SUSTAINING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION On the basis of the Commission's opinion issued this day, it is ORDERED that the disciplinary action taken by the National Association of Securities Dealers, Inc. against Charles E. French, and the Association's assessment of costs, be, and they hereby are, sustained. By the Commission. Jonathan G. Katz Secretary