Microcap stock fraud

The "night singer of shares" sold stock on the streets during the South Sea Bubble. Amsterdam, 1720.

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 $1 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]

• Dump and dilute schemes, where companies repeatedly issue shares for no reason other than than taking investors' money away. Companies using this kind of scheme tend to periodically reverse-split the stock.

• 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]

Pump and dump

Main article: Pump and dump

Chop stocks

A chop stock is an equity, usually trading on the Nasdaq Stock Market, OTC Bulletin Board or Pink Sheets listing services, that is purchased at pennies per share and sold by unscrupulous stock brokers to unsuspecting retail customers at several dollars per share.^[9][10]

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.^[11]

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". When a brokerage house sells such stock from its own inventory, a client will receive a trade confirmation stating the transaction was done as "Riskless Principal" or "Markup", which in fact, just like commissions, is also revenue to the firm, and such a practice is often subject to abuse. 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.

Organized crime involvement

Microcap fraud has been a major source of income for organized crime.^[12] 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.^[13] Weiss later explored the Mafia's Wall Street scams in a book.^[14]

Organized crime elements were believed to have been short-selling chop stocks in the late 1990s.^[15]

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.

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. Similarly, in the franchise's first computer game, Law & Order: Dead on the Money, the victim is a female stockbroker who was being investigated for a pump and dump scam involving a biotech company's suspicious IPO.

This strategy was also fictionalised by Jeffrey Archer in his book Not a Penny More, Not a Penny Less.

References

1. ^ "Micro-cap Fraud," North American Securities Administrators Assn.
2. ^ "Pump and Dump Schemes," Securities and Exchange Commission
3. ^ Investors Beware: Chop Stocks Are on the Rise by Gary Weiss, Business Week, Dec. 15, 1997
4. ^ "Investors Beware"
5. ^ "Micro-cap Fraud"
6. ^ "Investor Beware"
7. ^ "Micro-cap Fraud"
8. ^ "Microcap Fraud: Underside of the Bull Market," Arizona Securities Commission
9. ^ Investors Beware: Chop Stocks Are on the Rise," by Gary Weiss, Business Week, Dec. 15, 1997
10. ^ Microcap Fraud, North American Securities Administrators Association
11. ^ "Investor Beware," Business Week
12. ^ SEC Testimony: Organized Crime on Wall Street (R. Walker)
13. ^ "The Mob on Wall Street," by Gary Weiss, Business Week, December 16, 1996
14. ^ Born to Steal: When the Mafia Hit Wall Street, Gary Weiss, 2003, Warner Books, ISBN 0446528579
15. ^ "The Mob is Busier Than the Feds Think," by Gary Weiss, Business Week, Dec. 15, 1997

Further reading

• Gary Weiss, Born to Steal: When the Mafia Hit Wall Street (2003, ISBN 0446528579)

External links

• New York OAG Report on micro-cap fraud
• 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