Microcap stock fraud
From Wikipedia, the free encyclopedia
Microcap stock fraud is a form of securities fraud involving stocks of "microcap" companies, generally defined in the United States as those with a market capitalization of under $250 million. Its prevalence has been estimated to run into the billions of dollars a year.[1][2][3] Many microcap stocks are penny stocks, which trade at below $5 a share.
Microcap stock fraud generally takes place among stocks traded on the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service, stocks which usually do not meet the requirements to be listed on the stock exchanges. Some fraud occurs among stocks traded on the NASDAQ Small Cap Market, now called the NASDAQ Capital Market.[4]
Microcap fraud encompasses several types of investor fraud:
- Pump and dump schemes, involving use of false or misleading statements to hype stocks, which are "dumped" on the public at inflated prices. Such schemes involve telemarketing and Internet fraud.[5]
- Chop stocks, which are stocks purchased for pennies and sold for dollars, providing both brokers and stock promoters massive profits. Brokers are often paid "under the table" undisclosed payoffs to sell such stocks.[6][7]
- Other unscrupulous brokerage practices, including "bait and switch," unauthorized trading, and "no net sales" policies in which customers are prohibited or discouraged from selling stocks.[8]
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[edit] Pump and dump
"Pump and dump" is a form of microcap fraud that involves artificially inflating the price of a stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price. Once the operators of the scheme "dump" their grossly overvalued shares, the price falls and investors lose their money. Stocks that are the subject of pump-and-dump schemes are sometimes "chop stocks."[9][10]
While fraudsters in the past relied on cold calls, the Internet now offers a cheaper and easier way of reaching large numbers of potential investors.[11]
[edit] A typical pump and dump scenario
Pump and dump schemes tend to take place either on the Internet including e-mail spam campaigns or through telemarketing from "boiler room" brokerage houses (for example, see Boiler Room). Often the stock promoter will claim to have "inside" information about impending news. Newsletters that purport to offer unbiased recommendations then tout the company as a "hot" stock. Messages in chat rooms and email spam urge readers to buy the stock quickly.[12]
Unwitting investors then purchase the stock, creating high demand and raising the price. When the people behind the scheme sell their shares and stop promoting the stock, the price plummets, and other investors are left holding stock that is worth significantly less than what they paid for it.
[edit] Pump and dump markets
Fraudsters frequently use this ploy with small, thinly traded companies—known as "penny stocks," generally traded over-the-counter (in the United States, this would mean markets such as the OTC Bulletin Board or the Pink Sheets), rather than markets such as the New York Stock Exchange or NASDAQ—because it is easier to manipulate a stock when there is little or no independant information available about the company.[13] The same principle applies in the United Kingdom, where target companies are typically small companies on the AIM or OFEX.
Some stocks that are the subject of pump-and-dump schemes are referred to as "chop stocks." The term "chop," also called "rip," describes the massive and often illegal profits realized by stock swindlers in their schemes. In chop stocks, stocks are obtained at lower than market prices, sometimes under Regulation S of the securities laws. That scenario applies in some but not all pump and dump scams.[14]
[edit] Specific examples
See also Robert E. Brennan
During the dot-com era, when stock market fever was at its height and many people spent significant amounts of time on stock Internet message boards. A 15-year-old named Jonathan Lebed showed how easy it was to use the Internet to run a successful pump-and-dump. Lebed bought penny stocks and then promoted them on message boards, pointing at the price increase. When other investors bought the stock, Lebed sold his for a profit, leaving the other investors holding the bag. He came to the attention of the U.S. Securities and Exchange Commission (SEC), which filed a civil suit against him alleging security manipulation. As is commonly the case in SEC actions, Lebed settled the charges by paying a fraction of his total gains. He neither admitted nor denied wrongdoing, but promised not to manipulate securities in the future.[15]
In April 2007, the SEC brought charges against Park Financial Group as a result of an investigation into a pump and dump scheme during 2002-2003 of the Pink Sheet listed stock of Spear & Jackson Inc.[16]
[edit] Pump and dump spam
Pump and dump stock scams are prevalent in spam, accounting for about 15% of spam e-mail messages. A survey of 75,000 unsolicited emails sent between January 2004 and July 2005 concluded that spammers could make a return of 6% by using this method, while recipients who act on the spam message typically lose 5% of their investment within two days.[17] A study by Böhme and Holz[18] shows a similar effect. Stocks targeted by spam are almost always "penny stocks", selling for less than $5 per share, not traded on major exchanges, are thinly traded, and are difficult or impossible to sell short. Spammers acquire stock before sending the messages, and sell the day the message is sent.[19]
Pump and dump spam differs from many other forms of spam (such as advance fee fraud emails and lottery scam messages) in that it does not require the recipient to contact the spammer to collect supposed "winnings," or to transfer money from supposed bank accounts. This makes tracking the source of pump and dump spam difficult, and has also given rise to "minimalist" spam consisting of a small untraceable image file containing a picture of a stock symbol.[citation needed]
[edit] Chop stocks
A chop stock is an equity, usually trading on the Nasdaq Stock Market, OTC Bulletin Board or Pink Sheets listing services, is purchased at pennies per share and sold by unscrupulous stock brokers to unsuspecting retail customers at several dollars per share.[20][21]
This practice differs from a pump and dump in that the brokerages make money, in addition to hyping the stock, by marketing a security they purchase at a deep discount. In this practice, the brokerage firm generally acquires the block of stock by purchasing a large block of the securities (usually from a large shareholder who is not affiliated with the underlying company) at a negotiated price that is well below the current market price (generally 40% to 50% below the then-current quoted offer/ask price) or it acquires the stock as payment for a consulting agreement.[22]
The subject stocks usually have little or no liquidity prior to the block purchase. After the block is purchased, the firm's participating brokers will sell the stock to their brokerage customers at the then-current quoted offer/ask price, to the often victimized investors who are generally unaware of this practice. This large difference, or "spread" between the then-current quoted offer/ask price and the deeply discounted price the block of stock was purchased is almost always shared with the stockbroker at the firm who solicited the trade. For this reason, there is a large benefit and an inherent conflict of interest for the firm and the broker to sell these "proprietary products".
Because the firm is technically "at risk" on the block of stock (if the price of the stock drops below the price at which the block was purchased, the firm will be at a loss on the stock) and stock is usually sold at or even slightly below the then-current prevailing market price offer/ask, the practice is still legal in the United States. In fact, it is not required that this profit spread be disclosed to the client, since it is not technically a "commission". Only the amount of fees charged over and above the offer/ask are commissions, and must be disclosed. But even though it is still legal, it is frowned upon by the Securities Exchange Commission, and they are using other laws and methods of attack to indirectly thwart the practice.
[edit] Organized crime involvement
Microcap fraud has been a major source of income for organized crime.[23] Mob figures from each of the Five Families of the New York mafia, as well as the New Jersey mob, have become involved in stock scams.
Mafia involvement in 1990s stock swindles was first explored by investigative reporter Gary Weiss in a December 1996 Business Week article.[24] Weiss later explored the Mafia's Wall Street scams in a book.[25]
Organized crime elements were believed to have been short-selling chop stocks in the late 1990s.[26]
[edit] Microcap stock fraud in popular culture
Microcap stock fraud has been explored in several books and movies.
A book that explored microcap fraud was the 2003 book Born to Steal by Gary Weiss. It described the microcap underworld of the 1990s through the eyes of a young broker named Louis Pasciuto. Although the book focuses on Mafia infiltration of brokerages, it also describes in detail the operation of microcap fraud.
Microcap fraud was explored in the anonymously written books License to Steal and in The Scorpion and the Frog. Both books explore pump and dump schemes in some detail but, unlike Born to Steal, do not provide the real names of the specific firms and people described.
This kind of fraud has also provided the title for a book by Robert H. Tillman and Michael L. Indergaard called Pump and Dump: The Rancid Rules of the New Economy.
A fictional account of pump and dump schemes can be seen in the movie Boiler Room. According to press accounts, the director and writer of the film worked briefly as a cold-caller for the Stratton Oakmont brokerage house, which was shut down by regulators in the late 1990s.
Another movie exploring brokerage chicanery is Wall Street, starring Michael Douglas and Charlie Sheen.
A pump and dump scam was also the subject of several episodes of the popular HBO series, The Sopranos, pulled off by Matthew Bevilaqua and Sean Gismonte.
On an episode of the legal drama Law & Order, entitled "Trade This," the murder of a young stockbroker at a prestigious firm is found to be related to his boss's involvement in several pump and dump scams financed by members of a Mafia crime family.
This strategy was also fictionalised by Jeffrey Archer in his book Not a Penny More, Not a Penny Less.
[edit] References
- ^ "Micro-cap Fraud," North American Securities Administrators Assn.
- ^ "Pump and Dump Schemes," Securities and Exchange Commission
- ^ Investors Beware: Chop Stocks Are on the Rise by Gary Weiss, Business Week, Dec. 15, 1997
- ^ "Investors Beware"
- ^ "Micro-cap Fraud"
- ^ "Investor Beware"
- ^ "Micro-cap Fraud"
- ^ "Microcap Fraud: Underside of the Bull Market," Arizona Securities Commission
- ^ "Pump and Dump Schemes," Securities and Exchange Commission
- ^ "Investors Beware: Chop Stocks Are on the Rise," by Gary Weiss, Business Week, Dec. 15, 1997
- ^ "Pump and Dump," SEC
- ^ "Pump and dump," SEC website
- ^ The Page You Requested Has Moved
- ^ "Investor Beware," Business Week
- ^ NYTimes
- ^ Wall Street Journal, April 12, 2007, pg. C2
- ^ Frieder, Laura and Zittrain, Jonathan, "Spam Works: Evidence from Stock Touts and Corresponding Market Activity" (March 14, 2007). Berkman Center Research Publication No. 2006-11. Results of this study are also discussed in a BBC article
- ^ The Effect of Stock Spam on Financial Markets, 2006
- ^ (Hanke and Hauser, 2006)
- ^ Investors Beware: Chop Stocks Are on the Rise," by Gary Weiss, Business Week, Dec. 15, 1997
- ^ Microcap Fraud, North American Securities Administrators Association
- ^ "Investor Beware," Business Week
- ^ SEC Testimony: Organized Crime on Wall Street (R. Walker)
- ^ "The Mob on Wall Street," by Gary Weiss, Business Week, December 16, 1996
- ^ Born to Steal: When the Mafia Hit Wall Street, Gary Weiss, 2003, Warner Books, ISBN 0446528579
- ^ "The Mob is Busier Than the Feds Think," by Gary Weiss, Business Week, Dec. 15, 1997
[edit] Further reading
- Robert H. Tillman and Michael L. Indergaard, Pump and Dump: The Rancid Rules of the New Economy (2005, ISBN 0813536804).
- Gary Weiss, Born to Steal: When the Mafia Hit Wall Street (2003, ISBN 0446528579)
[edit] External links
- New York OAG Report on micro-cap fraud
- The SEC on Pump-and-Dump stock Schemes
- 1997 Article on chop stocks and stock fraud, from Business Week
- SEC Testimony on Organized Crime in the Markets, 13 September 2000
- Chop Stock Suey
- Investors Beware: Chop Stocks Are on the Rise
- Stock Market Scams & Stock Spam Reports
