On Nov. 5, when SEC Chairman William Donaldson addressed the Securities Industry Association's annual meeting in Boca Raton, Fla., it was an uncomfortable moment for brokerage executives. Donaldson recited a litany of costly scandals, including the mutual fund debacle that had cost the industry $900 million in restitution to clients and $730 million in penalties.

Chet Helck, president of Raymond James Financial, was not squirming. His firm had come through relatively unscathed: Its share of the mutual fund settlement was just $2.59 million. As a relative Mr. Clean, Helck had become an unofficial emissary for the brokerage business, helping press the SIA's case on Capitol Hill.

But now, Helck has his own special SEC problem. On Sept. 30, after nearly two years of negotiations, the agency charged Raymond James Financial Services with civil fraud in connection with the conduct of a rogue broker who worked off-site as an independent rep in Cranston, R.I. While employed there from August 1999 to December 2000, the SEC says, the rep, Dennis Herula, conned six well-heeled investors into plowing $44.5 million into a fraudulent venture. The agency also alleges that Raymond James Financial Services not only failed to adequately supervise the broker, but also lacked an appropriate system for supervising all its 3,500 independent reps, a charge that cuts to the core of its business model. As a result, many independent broker/dealers are watching the case anxiously.

To Catch A Thief

The SEC's complaint also charges J. Stephen Putnam, the former president of Raymond James Financial Services, and David Ullom, Herula's manager, with failure to supervise. It alleges that they knew that Herula was engaged in a suspicious venture. And, by failing to stop or discipline him right away, the SEC says, the firm allowed him to carry on his fraudulent solicitations. “Brokerage firms cannot turn a blind eye to the fraudulent conduct of their employees and expect to avoid the consequences,” SEC enforcement chief Stephen Cutler declared in a press release, announcing the 17-page complaint. The filing does not specify the penalties the agency will seek. Raymond James denies the charges.

The SEC's action against Raymond James alarms many securities lawyers, who say it is most unusual to charge a firm itself with fraud. “It is an extremely aggressive position for the SEC to take in charging a firm with fraud in conjunction with failure to supervise,” says Timothy Burke, a lawyer with the Boston firm of Bingham McCutchen. The last time that anyone can remember the SEC charging a firm with fraud was when it shut down Stratton Oakmont, a notorious boiler room operation on Long Island in 1996.

Taking Aim At Indies?

What troubles some other independent b/ds, which rely on independent contractors who work at remote locations, is that the regulators could be signaling that they consider the indie model to be inherently weak in broker supervision. Of Raymond James's 5,000 reps, about 3,500 are independent contractors.

“I'm scared about a mixed message [from regulators],” says one compliance official for an independent b/d. “We are sort of being made a scapegoat. There is no evidence that the independent contractor model causes problems.”

“This case may have broader implications,” he continues. “Anytime a regulator gets involved in a big action, we expect everybody to pay attention. This is one of those example cases.” Even an SEC official, who asked not to be identified, says the case is “uncommon.”

Herula, who is now in a federal prison in Denver, appears to be one in a long line of rogue brokers — slippery fellows whose usual M.O. is to siphon assets from customer accounts and successfully (for a while) conceal their handiwork from supervisors. The most famous recent example was Frank Gruttadauria, who stole $115 million from investors in Cleveland, before fleeing in January 2002. A month later, Gruttadauria turned himself in, and SG Cowen Securities and Lehman Bros., his former employers, paid $5 million and $2.5 million, respectively to settle SEC and the New York Stock Exchange charges for failure to supervise.

But neither firm was charged with fraud. “It was during a different time,” says Robert Duvin, a Cleveland attorney who is suing the firms on behalf of several Gruttadauria victims, including Samuel Glazer, a co-founder of Mr. Coffee. “They were extraordinarily gentle with the companies.” Also, one of the SEC lawyers who handled the case says there was no evidence that senior officials actually knew about Gruttadauria's schemes.

In cases like Herula's, many firms prefer to settle with the SEC, often without having to admit any guilt. But RJFS decided to fight. “Believing this to be an unwarranted expansion of a brokerage firm's responsibility, we feel we have no choice but to contest these charges,” says Richard Averitt, Raymond James' chief executive.

Essentially, the SEC's argument is that the firm knew enough about Herula's scheme to make it complicit in his fraud. SEC officials point to two alarming and central allegations in the complaint: Raymond James senior officials knew about $16.5 million in investor funds that were transferred into the RJFS account of Herula's wife, Mary Lee Capalbo, a Rhode Island attorney. At a Nov. 12 hearing, the SEC told the court that it would seek the $16.5 million from Raymond James to return to the investors. The second barrel of the SEC's smoking gun: Raymond James “contemplated terminating” Herula as early as July 2000, when Putnam learned that Herula sent correspondence with “misrepresentations” on the firm's letterhead, but did nothing to discipline him until December, when he was finally fired for sending out more improper letters.

An Air Of Respectability

But then Herula had some excellent camouflage. Shortly after he became affiliated with RJFS's Cranston office, Herula hooked up with Martin Fife, then in his 70s, who had been a director of several mutual funds operated by Dreyfus, and who sat on the boards of two publicly traded companies. Fife, who lived on Central Park West with his wife, a former deputy mayor of New York, was also president of Brite Business, which the SEC says was a fraudulent business. Herula worked with Fife to solicit investors for Brite Business, promising what the SEC calls “astronomical returns.” Investors deposited $44.5 million into the Brite Business account at Raymond James. One investor, Rheaume Holdings, a British Virgin Islands firm that invested $12.5 million in the Brite Business account, was told that the money would generate a return of 120 percent — or $15 million — in three months, the SEC says.

Three of the six investors who bought into the Brite Business scheme got wise. They demanded, and got, their money back. But Rheaume and a couple of others were not so lucky: About $16.5 million of their money wound up in the account of Herula's wife, of which Herula and Capalbo stole about $8.7 million of that amount, says the SEC. In April 2002, the SEC sued Herula and his cohorts — among them Fife (who has since died) and Charles Sullivan, son of the owner of the New England Patriots football franchise.

Herula pleaded guilty on Nov. 4 to charges stemming from his Cranston activities. Herula will pay $13.4 million in restitution and is expected to get a 10-year sentence. He is also facing 11 years on separate charges, involving a scam of a member of the Coors Brewing family. Herula and his associates allegedly convinced the Coors heir to invest $40 million in July 2002, promising him a return of 75 percent of his funds per week. In that case, he struck a plea bargain on Oct. 26 in which he agreed to testify against his co-defendant, pay back $4.3 million and forfeit property purchased with money from the fraud, including a vintage 1957 Thunderbird that he bought for $36,000.

Who Knew What, When

Herula was a bad apple, and, in his guilty plea, said he alone is responsible for his malfeasance. But the key question — and one that could affect how Raymond James Financial supervises independent brokers from here on — is what did the firm's top execs know about Herula, and when did they know it? The SEC's complaint alleges that senior officials at Raymond James, including Putnam, its president, “expressed skepticism” about Herula's activities — based on firsthand knowledge from their meetings with representatives from Brite Business.

There were two meetings, one when Brite Business opened its account in October 1999 and another in January 2000. At the January meeting, according to the SEC's complaint, Putnam “was skeptical as to whether Brite Business's program was an accepted business practice, and he found the program to be ‘less than forthright.’” Despite the skepticism, Herula's branch manager, Ullom, and Putnam, the firm's president, allowed Brite to maintain its account at Raymond James.

Raymond James officials declined to be interviewed by Registered Rep., but the company provided a two-page letter addressing the SEC's allegations. The letter admits Raymond James “was introduced to” Brite Business by Fife, and notes that “he was, as far as we were concerned, a respected member of the business community.” Fife was accompanied by a consultant from a Canadian office of Arthur Andersen as well as a representative of a “major U.S. law firm.” Raymond James “had no reason to think that it was in any way illegal,” according to the letter, signed by Tracey Bustamante, director of corporate communications for Raymond James.

The company statement also points out that every transfer of investor funds from the Brite account “was approved, in writing,” by Fife. But David Robbins, a New York lawyer who often defends brokerage firms, says the large transfers to the account of Capalbo, the relative of a broker, should have set off alarms at the firm. “That should have put them on notice that something was wrong,” says Robbins, a partner at Kaufmann Feiner Yamin Gildin and Robbins.

Why would Raymond James look the other way? The SEC suggests that the firm was happy to get $1.78 million in margin interest and about $32,000 in commissions when Fife purchased about $115 million worth of T-bills on margin in the Raymond James account.

Act Fast

The SEC, meanwhile, is clearly gettng tougher. William McLucas, who headed enforcement at the SEC from 1989 to 1998, says the agency will no longer let firms off the hook when they say they had a bad guy in their midst. “The SEC is trying to raise the liability risk for firms where the agency believes that the firm knew or should have known of the registered rep's misconduct,” says McLucas, a partner at Wilmer Cutler Pickering Hale and Dorr in Washington D.C. “From the firm's perspective, their defense will likely be that so long as they had reasonable systems and controls, they can't be a guarantor of ethical conduct by every employee.”

Walter Ricciardi, head of the SEC's Boston office, says firms “need to act promptly and decisively when there is even the slightest hint of impropriety” by one of its registered reps. But, to the brokerage industry, it seems excessive. A person familiar with the lawsuit says: “The SEC isn't looking just to crack some knuckles, they are trying to put firms out of business.”

When Raymond James filed its answer to the SEC's charges on Nov. 15, it blamed Ullom, alleging he “failed to follow specific directives” with respect to Herula — while collecting almost $200,000 as his share of Herula's profits from Brite Business. “The firm had no reason to suspect that Ullom was not doing his job,” the filing says. Ullom's lawyer, Willis Riccio, says that doesn't get Raymond James off the hook. “The supervisory responsibility is not with Ullom, its with the Raymond James managers,” Riccio says.

The SEC has also charged RJFS with failure to supervise. Raymond James refused to settle these claims, and it was only after that that the agency filed the fraud charges. “They got pissed off and decided to throw the book at the firm and make the firm look as bad as possible,” according to one of the defense lawyers in the case on failure to supervise. Still, other defense lawyers say this was a classic case where settlement was called for.

When Herula made his plea, his Denver lawyer, Michael Steinberg, said: “Today, Dennis Herula, by the plea, accepts full responsibility for his actions, blames no one for his actions but himself.” The SEC, obviously, does not agree. The Raymond James trial before an administrative law judge is set to begin Jan. 31. For the industry, especially firms with independent reps, it will be a scary way to begin the New Year.