Educate why aggressive promotion can lead to charges for Penny Stock Securities Fraud.
My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation. I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company. I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania.
Having worked as the CCO for Registered Investment Advisers (“RIAs”) with the Securities and Exchange Commission (“SEC”), I have been through numerous regulatory audits and examinations. Experience gives me insight into how the regulatory bodies conduct investigations and attempts to obtain enforcement actions, often including jail and prison sentences.
After completing this case study, the participants will be able to:
- Define Penny Stock.
- Define Micro-capitalization.
- Understand the meaning of a “pump and dump” scheme.
- Understand how unscrupulous stockbrokers prey on eager investors by encouraging investments in penny stocks.
- Identify best practices with respect to investments.
Securities Fraud, Penny Stock, Micro-Capitalization, Pump and Dump, Low-Cost Investments
Penny 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. Trading professionals generally define microcap stocks, as securities that trades at less than $5 per share, and are not listed on a national exchange. Many of those types of stocks actually trade under $1 which gives rise to them being generally referred to as penny stocks.
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.
Investors also are drawn to penny stocks because of the perceived opportunity to make huge percentage gains in a short period of time. Penny stocks can be extremely volatile from day to day, enabling investors to literally double their money overnight if a stock trading at $0.10 per share jumps to $0.20 the next day.
Penny stocks and securities fraud is rampant and growing in different ways to defraud investors. Penny stocks trade less frequently than stocks listed on a public exchange because they are bought and sold over-the-counter. This lower liquidity means it may be challenging to find a buyer for one’s penny stocks when an investor is ready to sell them. Even after finding a buyer, the owner of penny stocks may be forced to sell at a lower-than-expected price due to low liquidity. These obstacles that penny stocks pose to unknowing investors are increasing in the stock markets.
The greatest danger of investing in penny stocks is becoming the frequent occurrence of illegal “pump and dump” schemes, which investors should be wary of for the foreseeable future. A pump and dump occurs when an investor or group of investors heavily promote a stock they are holding, then sell immediately after the stock price has risen due to the initial interest in the promotion. The investor(s) behind the hype walks away with a big gain by selling into strength. However, the unsuspecting investor who bought the promoted stock is now left holding a losing stock that has fallen in price due to this unethical and illegal act.
Pump and dump scams typically start when a penny stock is promoted as a “hot tip” or “the next big thing,” along with hyped details of an upcoming news announcement that will “send the stock through the roof.” The promotion is usually done through a combination of email, social media, and other types of internet marketing. There are even subscription-based websites focused on trading penny stocks that may be designed to entice unsuspecting investors.
The exact details of each individual pump and dump may be different each time, but is always tied to artificially shifting supply and demand to affect the stock price. As mentioned earlier, the scam is normally restricted to “pink sheets” that are traded over-the-counter, as stocks traded on a central exchange are much more highly regulated.
Through heavy and targeted promotion, the group behind the scam increases the demand and volume in the stock, which leads to a sharp rise in the price. After the price has risen, the group will sell their position to make a large short-term gain.
A stockbroker, Songkram Roy Sahachaisere, is sentenced to 27 months’ imprisonment for participating in a multi-million-dollar international market manipulation scheme. According to court documents and trial testimony, Sahachaisere participates in an international “pump and dump” operation, which fraudulently pumps up the share price of worthless penny stocks, and then dumps billions of shares on unsuspecting victim investors across the globe. They “pump up” the share prices of the companies’ stock by engaging in fraudulent and illegal sales campaigns, which includes distributing false press releases, announcing non-existent business ventures and fake mergers, posting false information on Internet message boards and bribing stock promoters.
These schemes by Sahachaisere fraudulently inflate the value of the shares by approximately $100 million. Sahachaisere’s role in the scheme is to arrange promoters to “pump” the stocks to potential victims.
Sahachaisere also conspires with other members of the conspiracy to artificially affect the trading price and volume of stocks so that they appear legitimate to investors. In addition, the conspiracy uses brokerage houses to manipulate transfers of shares, effectuating matched and wash trades in their targeted securities.
“Sahachaisere promotes a scheme to overstate the value of stocks and sells them to unwitting investors worldwide,” per the Federal Bureau of Investigations. “This elaborate plan has one intention – to profit from the misfortune of others.
Microcap fraud is rampant, growing, and encompasses several types of investor fraud:
- Pump and dump schemes, as already referenced, involve the 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.
- Chop stocks, which are stocks purchased for pennies and sold for dollars, provide both brokers and stock promoters massive profits. Brokers are often paid “under the table” undisclosed payoffs to sell such stocks.
- Dump and dilute schemes occur when companies repeatedly issue shares for no reason other than taking investors’ money away. Companies using this kind of scheme tend to periodically reverse-split the stock.
- Other unscrupulous brokerage practices include the “bait-and-switch”, unauthorized trading, and “no net sales” policies in which customers are prohibited or discouraged from selling stocks.
The expanding use of the Internet and personal communication devices has made penny stock scams easier to perpetrate. Investors will encounter difficulty selling their positions after the buying pressure has abated, and the manipulators have fled.
If an investor should not invest in penny stocks, what should an investor look for in an investment? Each individual should invest based on their goals. Often investors should consult with a fiduciary financial advisor to come up with a specific plan for his or her situation.
That said, there are some general rules of investing that can help one invest successfully.
First, one should invest in a diverse portfolio of investments. This investing is known as “not putting all of your eggs in one basket.”
Many people accomplish diversification by investing in index funds that track large portions of the market, such as the S&P 500. By not investing in only one or two stocks, an investor spreads out the risk.
If an investor owns 500 stocks through an index fund, it could drop to zero and it would not make a major dent in one’s portfolio. If that same investor only owns two stocks in equal dollar amounts and one drops to zero, he or she would lose 50% of his or her portfolio.
In addition, investors should keep costs low through low-cost investments. By lowering cost, an investor keeps more of his or her money over time. Due to the power of compounding returns, lowering one’s cost could result in a much larger nest egg in retirement.
- https://www.justice.gov/usao-edny/pr/stock-promoter-sentenced-27-months-prison-his-role-international-pump-and-dump-scheme https://www.ftc.gov/datasecurity
- https://en.wikipedia.org/wiki/Microcap_stock_fraud#Organized_crime_involvement https://www.mybanktracker.com/investing/where-invest