YOU CAN SPOT THEM A MILE AWAY — the boiler-room operators who continue to plague the retail investment industry. They often set up shop in a tony zip code, adopt a fancy name that suggests old money and country clubs — remember Stratton Oakmont? — and get to work fleecing retirees, widows and other gullible investors with promises of quick, outsized returns. They grow quickly, adding more brokers and maybe even branches, and then, suddenly, they're gone: Regulators and law-enforcement officials swoop down, seize the files, padlock the office and, perhaps, make a show of perp-walking the principals past the media.

But the schemes go on. Within weeks, the many of the same rotten brokers are dialing for dollars at another boiler room — using high-pressure patter to put old ladies into fraudulent or unregistered securities or penny stocks that the firm is pumping and preparing to dump. And, they usually resume their smarmy work in the very same hotbeds: Boca Raton, Long Island, Orange County — places with lots of money and lots of old people.

These are the cockroaches of the investment business. You turn on the lights and they scatter, but they always come back. And, to an alarming degree, they continue to succeed. Despite a massive sweep of boiler rooms in 1996 and 1997, and again in 1999 and 2000 — when almost 100 firms were shut down, including the infamous Stratton Oakmont — new firms keep popping up. Regulators have gotten smarter about ferreting them out and coordinating with other enforcement authorities to shut them down. But the securities fraudsters have gotten smarter, too, and are working in smaller operations — sometimes through front men — that make them harder to detect.

But it's not just a matter of size. Boiler rooms continue to succeed because investor education has not. They're very good at covering their tracks, and the penalties — civil lawsuits, revocations of licenses, (relatively) small fines — are not a big deterrent when you're talking about making a quick million bucks. And even if the firms are found out, enforcement authorities' limited resources are spent trying to nail the principals while the small fry move across town to another boiler-room shop.

“We've seen, in Melville, Long Island, people running out the back door and taking records with them,” says Frank Widman, director of the New Jersey Bureau of Securities. Often, they're taking victim, or sucker, lists. “You close that firm, but unless you tag the reps with disciplinary action, they move on to another firm,” he says. And that is the point. The “reps” often don't get tagged.

Actually, most scamsters aren't even real reps. Securities regulators say that 60 percent to 70 percent of the complaints they receive concerning fraud are committed by unregistered individuals, while 97 percent to 98 percent of registered reps have virtually spotless records. But a few crooks can do a lot of damage to the industry's reputation, says Widman. The message for good reps, he adds, is that they should do everything they can to help regulators crackdown on bad brokers and firms. “Investor confidence is very important. And it needs to be real,” he says.

See Them Scuttle

Back in February 2000, the Dallas Business Journal wrote a story about a hot little broker/dealer that was growing like a lard-hog before the slaughter. That b/d was Salomon Grey. In 1998, when Kyle Rowe bought the company, it was a one-broker operation with almost no clients and offices only in Texas, the paper wrote. By 2000, it had 11 offices, 60 brokers and was registered to do business in 48 states. In an interview with the paper, Rowe offered the secret to his success: Attract veteran brokers by offering them fat pay packages.

Turns out they were veterans all right. Many had worked for a series of shady brokerage operations with numerous regulatory violations. In fact, a look at the CRD records for brokers who worked at Salomon Grey shows many of them had worked for 20 or more firms in a 10-year period, and some interesting names popped up on those lists: LH Ross, Weatherly Securities, First United Equities and Preferred Securities, among others. All of these firms were boiler-room operations that had already been, or would later be, shut down for securities fraud. Just this April, Salomon Grey was expelled from the industry (it's the most recent firm to be expelled), and Rowe was expelled from the business for life for committing securities fraud in a pump-and-dump scheme and other violations. (Salomon Grey and Rowe neither confirmed nor denied the allegations.)

Rowe himself was no stranger to boiler rooms. Before Salomon Grey, he had worked as a broker at a San Diego, Calif., b/d called Pacific Cortez Securities, which was accused of manipulating penny stocks in the late 1990s, costing some 400 victims $2.5 million. In 2003, the firm's principal, Harold Bailey “B.J.” Gallison, was sentenced to five years in prison for securities fraud. (He has since been released on parole, but is barred from association with any b/d or from participating in any offering of a penny stock.) Pacific Cortez was taken over by the state of California, and Gallison was barred from the securities industry. But Rowe wasn't charged in that case, and he and a number of the brokers who worked for Pacific Cortez ended up at Salomon Grey. (The lawyer for one of Salomon Grey's customers has speculated that, in fact, Gallison was running Salomon Grey from behind the scenes.)

Another alumnus of Pacific Cortez, albeit one who was actually fired from that firm, Ronald Duane Brouillette, is now in a California prison, sentenced to 14 years in 2004, for his role in a penny-stock swindle. Brouillette took Pacific's sucker lists with him when he left, and although he had already been banned from the industry, he set up shop in local hotels.

LH Ross, a Boca Raton-based b/d that was shut down in February of last year for numerous violations — including sales of unregistered offerings of its own stock in which investors lost over $12 million, as well as running pump-and-dump schemes — is another classic cockroach case. Seven of nine reps ultimately named in NASD fraud charges against a boiler-room operation named Florida Discount Securities were later employed by LH Ross — the majority of them immediately following their employment at Florida Discount. (They moved to LH Ross before they were named in the case against Florida Discount.)

Cracking Down

“The little guy, who starts out as a smurf in a boiler-room operation, progresses to own his own family. It's like the mafia,” says Joe Borg, who used to head up the enforcement department at NASAA, of the phenomenon. “They're the ones that didn't quite get caught up in the net.” Part of the problem — part of the reason why these guys never quit — is that most states securities regulators don't have criminal enforcement authority, and so the kinds of penalties they can apply to cases are relatively small fines, cease-and-desist orders — which require the targeted firm or individual to discontinue a specific fraudulent activity — and for the worst cases, a ban from the industry — not huge deterrents when you're talking about hitting it rich. Many firms and individuals consider disciplinary actions and fines to be just a cost of doing business, says Borg.

John Morgan, the director of the enforcement division for the state securities regulator in Texas, says he's working on a case now in which the scamster has gotten 10 cease-and-desist orders. In another case, the guy just changed the name of his company every time he got an enforcement order — at least five times. Often, the principals of a boiler room will also conceal their role, putting up straw men to take the blame when regulators step in, while they disappear to start all over again. Regulators are usually tipped off by customer complaints, but by then most of the money has already been swindled and spent, says Don Saxon, the head of Florida's state securities regulator.

“There is so much recidivism in this business, because the likelihood of detection is fairly low. Also, they're able to cloak themselves in legality,” says Peter Henning, a professor at Wayne State University Law School and a former attorney in the Division of Enforcement at the SEC, where he worked on cases involving penny-stock fraud. “They hire lawyers to draft the documents for them. They can make it look pretty good. Sometimes the companies have a measure of legitimacy, unlike the person who goes in to rob a 7-11.”

Another problem is that securities fraud cases are complex and expensive to sort out, and criminal enforcement authorities have millions of other criminal cases to handle; too often securities fraud cases that are referred away for criminal enforcement get lost in the shuffle. Strapped state budgets don't help. Only the most serious offenders get rapped. The little guys — the future serious offenders — slip away. Last year, the SEC referred 30 cases to the U.S. Department of Justice, 19 of which were closed.

Lately, states have been coordinating their investigations and pooling resources, says Borg. That helps. But ultimately, even for those who do go to jail, the sentences are not terribly onerous. “Often sentencing is reduced from 20 years to two years. Or there are suspended sentences because the jails are full and judges don't see the same threat to society as from violent crimes,” says Wayne Klein, the director of the Utah Securities Division. “Half of the enforcement cases we [bring] are against someone who has a prior disciplinary history — either a prior criminal conviction or a regulatory order to cease selling. It appears that sending people to jail is no longer serving as a deterrent,” he says.

Saxon says that a lot of the guys he's caught are actually intelligent enough to have been successful in legitimate businesses. “I've asked them why they didn't go that route,” he says, “And the answer has been, ‘There's no adrenaline in that.’ For these guys, there's a high in the scheme.”

The victims also do their part. “There is a factor of greed. People who try to make the big score, think well, it didn't happen this time, maybe next time. It's amazing the people who fall for it — doctors and lawyers, they see dollar signs. And once they report it to the SEC, the money is long gone,” says Henning. In fact, a recent study by the NASD Investor Education Foundation found that the victims of securities fraud are actually more financially literate than non-victims.

The Cockroaches' Nest

Securities fraudsters seem to be attracted to a few geographical hot spots: Southern California, Southern Florida, New Jersey, New York — particularly Long Island — and Texas. All five states — and particularly Southern California and Southern Florida — have long had the largest populations of senior citizens (over 65 years old) in the country, according to the U.S. Census Bureau. (In fact, seniors account for nearly half of all fraud-related complaints received by state securities regulators, says a recent NASAA survey.) And, well, crooks naturally follow the money. New Jersey happens to be the state with the second highest per-capita income in the country, behind Connecticut. And Southern Florida, Southern California and Long Island are centers of conspicuous living — where it's easier to find a person whose pocket is worth picking and easier to spend your quick millions on a vintage Ferrari or a 50-ft. yacht without attracting too much notice.

Boca Raton, in particular, has long been known as the capital of securities fraud. So much so that just last year the NASD opened an office there. “There's a lot of money there, a fancy address, and quite honestly, at most of these micro-cap firms, they don't hold the money, they spend it. They live off of it,” says Borg.

Indeed, take a look at the stats. Boca Raton had a median household income of $60,248 in 1999, retail sales per capita of $20,000 in 1997 and 19.8 percent of the population was over 65 in 2000, according to the latest Census Bureau statistics. Nationwide, median household income was $43,318 in 2002, retail sales per capita sat at $10,615 in 2003 and the percent of the population over 65 was 12.4 percent in 2004. Of course, Nassau County in New York (Long Island) stacks up quite like Boca does: The area had a median household income of $71,226 in 2003 and retail sales per capita of $14,668 in 2002, while 15 percent of the population was over 65 in 2004. Southern California's Orange County, meanwhile, had median household income of $55,861 in 2003, retail sales per capita of $12,205 in 2002 and 10 percent of the population over 65 in 2004.

Oh, and, oddly enough, at least where California, Florida and Texas are concerned, some say the weather may have something to do with it. “The operative word in hot spots is ‘hot,’” says Saxon. “If you're going to perpetrate that kind of activity, why not live in a nice place. The perpetrators like to live the high life,” he says. Other regulators echoed this theme — when asked, some scamsters say it's the weather. Simple as that.

What's a Boiler Room?

Boiler rooms generally sell registered and unregistered securities — frequently start-up penny stocks — using high-pressure sales techniques and egregiously misrepresenting the risks associated with those securities. They may employ a mix of registered and unregistered sales reps who tend to cold call potential victims from the firms' offices. Some boiler-room firms change their names periodically to try to cover their tracks. And a lot of them don't even bother with the pretense of legality — they set up a fake broker/dealer with no NASD registration at all. They're named boiler rooms, because originally, these firms would try to find the cheapest place to rent — often enough that happened to be in the basement, where the boiler was, says Peter Henning, a professor at Wayne State University Law School and a former attorney in the Division of Enforcement at the SEC, where he worked on cases involving penny-stock fraud.

Smarts Don't Help

It has long been an assumption that if investors were only educated enough — knew the basics about financial instruments and markets and how they work — well, then investment fraud would be wiped out. Everyone, from regulators to Alan Greenspan and Warren Buffet, have stumped for the investor education cause, and today there are hundreds, if not thousands, of financial literacy programs in the U.S.

But now that premise has been thrown into doubt. An Investor Fraud Study, prepared by the Consumer Fraud Research Group and released by the NASD Investor Education Foundation in May, showed that investment-fraud victims are actually more financially literate than non-victims. Victims outscored non-victims on an eight-question financial literacy test: 58 percent to 41 percent.

How could this be? The study came up with three possible explanations:

  1. The Knowing-Doing Gap. “Investors may actually have enough knowledge about financial investments to avoid trouble, but for some reason they do not employ that knowledge when it's needed the most.”

  2. The Expert Snare. There is an influence tactic con criminals use in which they praise the victim for their expertise. “Since most people like others to think of them as experts, this puts the victim in the position of not wanting to ask tough, probing questions, and be accused of not knowing the answer.”

  3. Lower Persuasion Literacy. “Having content knowledge of the nuts and bolts of financial instruments and investing may help one make better investing decisions with legitimate brokers, but it doesn't inoculate them from the persuasion tactics used by con criminals.”

Researchers suggested that No. 3 is most plausible, and that maybe financial literacy programs should include fraud-prevention education. The researchers also found out that investment-fraud victims are more often men, tend to live with others or be married, tend to be more educated and have higher levels of income than non-victims. They're also more likely to have suffered from more “negative life events” than non-victims. Oh, and they “dramatically” under-report fraud.