Microcap stock fraud
Encyclopedia
Securities fraud
Securities fraud, also known as stock fraud and investment fraud, is a practice that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of the securities laws....
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. Many microcap stocks are penny stock
Penny stock
In the United States, penny stocks are common shares of small public companies that trade at less than $1.00. In some countries, similar shares of stock are known as cent stocks.-Concerns for investors:...
s, which trade at below $1 a share.
Microcap stock fraud generally takes place among stocks traded on the OTC Bulletin Board
OTC Bulletin Board
The OTC Bulletin Board or OTCBB is an interdealer electronic quotation system in the United States that displays real-time quotes, last-sale prices, and volume information for many over-the-counter equity securities that are not listed on the NASDAQ stock exchange or a national securities exchange...
and the Pink Sheets
Pink Sheets
OTC Markets Group, Inc., informally known as "Pink Sheets", is a private company that provides services to the U.S. over-the-counter securities market including electronic quotations, trading, messaging, and information platforms. According to the U.S. Securities and Exchange Commission, OTC...
Electronic Quotation Service, stocks which usually do not meet the requirements to be listed on the stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
s. Some fraud occurs among stocks traded on the NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
Small Cap Market, now called the NASDAQ Capital Market
NASDAQ Capital Market
Originally called the NASDAQ Small Cap Market, NASDAQ announced a name change to the NASDAQ Capital Market on September 27, 2005.The NASDAQ Capital Market exists for securities of smaller, less-capitalized companies that do not qualify for inclusion in the Nasdaq National Market....
.
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.
- 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.
- 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 switchBait and switchBait-and-switch is a form of fraud, most commonly used in retail sales but also applicable to other contexts. First, customers are "baited" by advertising for a product or service at a low price; second, the customers discover that the advertised good is not available and are "switched" to a...
," unauthorized trading, and "no net sales" policies in which customers are prohibited or discouraged from selling stocks.
Chop stocks
A chop stock is an equity, usually trading on the Nasdaq Stock Market, OTC Bulletin Board or Pink SheetsPink Sheets
OTC Markets Group, Inc., informally known as "Pink Sheets", is a private company that provides services to the U.S. over-the-counter securities market including electronic quotations, trading, messaging, and information platforms. According to the U.S. Securities and Exchange Commission, OTC...
listing services, that is purchased at pennies per share and sold by unscrupulous stock brokers to unsuspecting retail customers at several dollars per share.
This practice differs from a pump and dump
Pump and dump
"Pump and dump" is a form of microcap stock fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price....
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.
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 crimeOrganized crime
Organized crime or criminal organizations are transnational, national, or local groupings of highly centralized enterprises run by criminals for the purpose of engaging in illegal activity, most commonly for monetary profit. Some criminal organizations, such as terrorist organizations, are...
. Mob figures from each of the Five Families
Five Families
The Five Families are the five original Italian-American Mafia crime families which have dominated organized crime in America since 1931. The Five Families in New York remain as the powerhouse of the Italian Mafia in the United States.-History:...
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
Gary Weiss
Gary Weiss is an American investigative journalist, columnist and author of two books that critically examine the ethics and morality of Wall Street...
in a December 1996 Business Week article. Weiss later explored the Mafia's Wall Street scams in a book.
Organized crime elements were believed to have been short-selling chop stocks in the late 1990s.
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
Gary Weiss
Gary Weiss is an American investigative journalist, columnist and author of two books that critically examine the ethics and morality of Wall Street...
. It described the microcap underworld of the 1990s through the eyes of a young broker named Louis Pasciuto. Although the book focuses on Mafia
Mafia
The Mafia is a criminal syndicate that emerged in the mid-nineteenth century in Sicily, Italy. It is a loose association of criminal groups that share a common organizational structure and code of conduct, and whose common enterprise is protection racketeering...
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
Boiler Room (film)
Boiler Room is a 2000 American drama film written and directed by Ben Younger, and starring Giovanni Ribisi, Vin Diesel, Nia Long, Ben Affleck, Nicky Katt, Scott Caan, Tom Everett Scott, Ron Rifkin and Jamie Kennedy....
. According to press accounts, the director and writer of the film worked briefly as a cold-caller for the Stratton Oakmont
Stratton Oakmont
Stratton Oakmont was a Long Island, New York, "pump and dump" boiler room brokerage house founded by Jordan Belfort, Danny Porush, COO Steven Carter and CFO Kenny Greene that was shut down in the late 1990s. Jordan Belfort wrote a book about it entitled The Wolf of Wall Street...
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
The Sopranos
The Sopranos is an American television drama series created by David Chase that revolves around the New Jersey-based Italian-American mobster Tony Soprano and the difficulties he faces as he tries to balance the often conflicting requirements of his home life and the criminal organization he heads...
, pulled off by Matthew Bevilaqua
Matthew Bevilaqua
Matthew Bevilacqua, played by Lillo Brancato Jr., is a fictional character on the HBO TV series The Sopranos.-Background:Matthew Bevilacqua, a.k.a. Matt Drinkwater, was Sean Gismonte's partner-in-crime and an associate in the Soprano Crime Family. Matt and Sean were from West Orange, New Jersey....
and Sean Gismonte
Sean Gismonte
Sean Gismonte, played by Chris Tardio, is a fictional character on the HBO TV series The Sopranos.-Background:Sean Gismonte aka Gis is an associate of the Soprano crime family. He was Matthew Bevilaqua's partner in crime and an associate in the Tony Soprano/Gualtieri crew in 2000. Sean and Matt...
.
On an episode of the legal drama
Legal drama
A legal drama is a work of dramatic fiction about crime and civil litigation. Subtypes of legal dramas include courtroom dramas and legal thrillers, and come in all forms, including novels, television shows, and films. Legal drama sometimes overlap with crime drama, most notably in the case of Law...
Law & Order
Law & Order
Law & Order is an American police procedural and legal drama television series, created by Dick Wolf and part of the Law & Order franchise. It aired on NBC, and in syndication on various cable networks. Law & Order premiered on September 13, 1990, and completed its 20th and final season on May 24,...
, 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
Mafia
The Mafia is a criminal syndicate that emerged in the mid-nineteenth century in Sicily, Italy. It is a loose association of criminal groups that share a common organizational structure and code of conduct, and whose common enterprise is protection racketeering...
crime family
Crime family
A crime family is a term used to describe a unit of an organized crime syndicate, often operating within a specific geographic territory. The term is used almost exclusively to refer to units of the Mafia, both in Sicily and in the United States, although it is occasionally used to refer to other...
. Similarly, in the franchise's first computer game
Personal computer game
A PC game, also known as a computer game, is a video game played on a personal computer, rather than on a video game console or arcade machine...
, Law & Order: Dead on the Money
Law & Order: Dead on the Money
Law & Order: Dead on the Money is the first in a series of computer games based on the television series Law & Order by Legacy Interactive. The game was first published in September 2002....
, the victim is a female stockbroker who was being investigated for a pump and dump scam involving a biotech
Biotechnology
Biotechnology is a field of applied biology that involves the use of living organisms and bioprocesses in engineering, technology, medicine and other fields requiring bioproducts. Biotechnology also utilizes these products for manufacturing purpose...
company's suspicious IPO
Initial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...
.
This strategy was also fictionalised by Jeffrey Archer in his book Not a Penny More, Not a Penny Less
Not a Penny More, Not a Penny Less
Not a Penny More, Not a Penny Less was Jeffrey Archer's first novel, first published in 1976. It was said to have been inspired by Archer's real-life experience of near-bankruptcy.-Synopsis:...
.
Further reading
- Gary Weiss, Born to Steal: When the Mafia Hit Wall Street (2003, ISBN 0446528579)