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Penny Stock Fraud, What is it?
Chapman, Spira & Carson - Disscusion

From: Chapman Spira and Carson
Date: 4/11/99
Time: 9:54:44 AM
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Penny Stock Fraud has become a pervasive term used out of proportion to its intrinsic meaning. It has almost become a catchall for any type of security fraud. We are told that the phrase originated with the present New York City Mayor (Guliani) when he was a high ranking official with the U. S. Attorney's Office. Everybody that he arrested seems to have committed a Penny Stock Fraud no matter what the price of the stock. All of the brokerage firms that were operating during that period were also involved in Penny Stock Fraud, that is if they got into trouble, if they didn't, they were "White Shoe". It may be that the term penny, meaning "small value" refereed more to the people that were committing the crime than what they were doing, but we are not certain.

No matter where or how the phrase originated, everyone jumped unto the bandwagon and a new phrase was ushered into the realm of criminal justice. We think it is used so frequently because it makes excellent copy for newspapers on slow days. Headlines like "Penny Stock Swindler Exposed" which could mean that he was caught with his pants down in public or he could be guilty of something which has not yet been proven or "Brokerage House Indicted in Penny Stock Swindle" which is easier to decipher; the firm was illegally selling securities of various prices to the investing public. In neither case did the price of the stock have anything to do with the action that was taken. It has been assumed that crooks can only sell low priced securities to the public if they are illegal. Swindlers have been selling large items such as the Brooklyn Bridge for years Would that headline read, Penny Bridge Swindle Uncovered? No one has every called the Brooklyn Bridge, penny ante. Maybe the headline should have read Nickel Bridge Swindle Uncovered, but then people would assume that the bridge was made of nickel rather than steel and it was about to collapse.

All kidding aside, there is a ton of securities theft omnipresence in the system and it is a grueling job dealing with it. Law Inforcement people keep coming up with great solutions and the bad-guys come up with a way around it before the sun has gone down.

We found a piece by the "Better Business Bureau" on the Web that addressed the problem as well as anything else we have seen and reprint it here for your reading pleasure.

Penny Stock Frauds

Consumer Information Sponsored by Member Businesses

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Penny stock swindles are now the number 1 threat of fraud and abuse facing small investors in the United States. A September 1989 report by the North American Securities Administrators Association (NASAA) to the U.S. House Telecommunications and Finance Subcommittee estimates that Americans lose at least $2 billion each year as a result of schemes involving penny stocks - the shadowy netherworld of the U.S. equity markets. NASAA found that the penny stock industry increasingly is dominated by utterly worthless or highly dubious securities offerings that are systematically manipulated by repeat offenders of state and federal securities laws and other felons, some of whom have been identified as having ties to organized crime. Since unmanipulated penny stock investors are believed to lose all or some of their investment 70 percent of the time and the presence of fraud pushes up that figure to 90 percent, abusive promoters of these low-priced securities rely on sophisticated, high-pressure telemarketing techniques to lure in hundreds of thousands of new, unsophisticated investors, a majority of whom appear to be first time entrants to the market and are clearly unsuitable candidates for risky penny stoc

The consumer bulletin is a joint effort of NASAA, the national organization of the 50 state securities agencies and the Council of Better Business Bureaus (CBBB). Research for this NASAA/CBBB bulletin revealed numerous indications of the growing national scope of the penny stock problem. New penny stock investigations opened by state securities agencies of penny stock cases rose 97 percent from 1987 to 1988, according to the September 1989 NASAA report. During the same period, small investor reports of penny stock fraud and abuse climbed 51 percent. State securities agencies reported a two-year total of almost 4,500 penny stock related consumer complaints, with 1,767 logged in 1987 and another 2,660 made in 1988.

PENNY STOCKS: FROM COTTAGE INDUSTRY TO THE BIG TIME Abuse of penny stocks, which are low-priced securities trading from as little as a penny to as much as $5 a share, is not new and dates back at least to the 1940's and 1950's, a period when worthless shares in uranium mine stocks were bought and sold over the counter of a Salt Lake City coffee shop. However, it is only in the last decade that broker-dealers specializing in penny stocks have grown from a handful of small firms plagued by fits and starts to a booming, multi-billion dollar national growth industry. Since 1983, the U.S. penny stock marketplace has undergone dramatic and disturbing changes:

Penny stocks have evolved from a primarily regional phenomenon (with active penny markets in Denver, Utah and Spokane), to a problem of truly national proportions. The number of firms specializing in penny stock trading has increased almost five-fold in recent years. Half a decade ago, 55 penny stock firms were headquartered in fewer than 6 states. Today, an estimated 325 penny stock firms have set up main offices in 29 states employing several thousand brokers at more than a thousand branch offices that now reach down into even the smallest communities of America.

Trading in penny stocks is extremely lucrative, with broker-dealers and individual stockbrokers taking in massive profits far in excess of what is attainable in the mainstream of the securities brokerage industry. In 1987, the president of one penny stock firm drew a salary of between $7.4-$9 million, more than the combined reported salaries and bonuses of the chief executive officers (CEO's) of Merrill Lynch & Co., Shearson Lehman Hutton and First Boston. Many individual penny stock brokers earn $20,000 to $50,000 a month or more. A now-defunct penny stock firm has at $19 million advertising budget in 1984 and ran ads on evening network news shows and the Super Bowl, where 30 second spots were sold for $300,000. The penny firm's advertising budget was just $1 million dollars under the promotional allocation of the largest brokerage firm in the U.S. In one case, the branch office of a penny stock brokerage made more than $1 million in profit in a single day through its penny stock activities.

The recent ascendancy of so-called "blank-check" blind pools, in which the new company generally has no assets, no employees and no stated business plan, has fueled the spread of fraud and abuse in the penny stock market. Once relatively rare, blind pools accounted for an estimated 70 percent of new penny stock offerings in 1988 and the first half of 1989, compared to less than 5 percent as recently as 1983. A high percentage of blind pools frequently are indirectly controlled by broker-dealers and unnamed promoters, many of whom have been identified as repeat violators of securities laws and felons, who use the offerings as a vehicle for systematic market manipulation. A number of direct links have been made between promoters of "blank-check" blind pool penny stocks and organized crime, according to the NASAA report to Congress.

The names of one or more individuals with a background of violations of securities laws, felony indictments and/or convictions or reported ties to organized crime were found in more than four out of five of the major penny stock enforcement cases examined in the NASAA report to Congress. Two individuals with organized crime backgrounds have been involved in some way at least 40 (11 percent) of the 360 "blank-check" blind pool offerings registered by the SEC since 1985. One of this pair is now in prison in Paris for his alleged part in a global penny stock scheme involving a U.S. take that may have reached $1 billion. The penny stock promoter in question has been identified before Congress and by the Federal Bureau of Investigation as being involved in organized crime, particularly the Genovese crime family in New York. He was barred for life from the securities industry by the SEC in 1966.

HOW THE MARKET WORKS - IN THEORY Historically, the over the counter (OTC) stockmarket has acted as the birth-place and cradle for many new and expanding companies. It is in this marketplace that many of these companies raise the capital needed to commence, or build upon, existing operations. The process of distributing ownership certificates (stock) is called "initial public offering" (IPO) or a "new issue."

Trades in exchange-listed stocks are facilitated by a stockbroker who seeks the best available price in an auction system, with the transaction taking place on the floor of the New York Stock Exchange (NYSE), or other national or regional stock exchange. OTC trades are carried out within, or between, the trading departments of brokerage firms. These brokerages or, a single brokerage firm, as often is the case in penny stocks, are called "market makers" when they carry an inventory of the stock and quote the prices at which they are willing to buy and sell securities. The difference between the "bid" (the price at which a customer may sell a security) and the "asked" (the price at which a customer may buy a security) is known as the "spread". For instance, if a penny stock in bid at 1 1/2 ($1.50) and asked at 2 ($2), then the spread in 50 cents or 33 percent. This latter amount is the minimum that an investor would have to recoup in order to break even on an investment in the stock.

Since the creation of the National Association of Securities Dealers Automated Quotation (NASDAQ) system in 1971, price information on may OTC stocks has appeared in all major newspapers, allowing investors to track bid and ask quotations. However, this same information is almost unavailable for "pink" sheet penny stocks, leaving the unwary investor at the mercy of whatever quotes are supplied by the broker-dealer, who, in any event, may be the only market maker trading in the stock. The competitive pressures that act as a check on the manipulation of the spreads of upper echelon OTC securities is absent in the penny stock market. As a result, abusive and unreasonable markups and spreads on penny stocks are widespread in the pink sheets.

THE MYSTERY OF THE PINK SHEETS There are 18,000 or more publicly-traded corporations in the United States. About 2,500 of the largest and most established firms trade on national stock exchanges, including 1,600 that are listed on the New York Stock Exchange (NYSE). Another 4,600 firms are listed on the NASDAQ system, which is home to most of the major firms in the over-the-counter (OTC) market. More than 2,800 NASDAQ securities are listed on the NASDAQ/National Market System, which imposes the highest standards on OTC stocks. Outside of regional exchanges, the balance of publicly-held firms are traded in the murky netherworld of U.S. equity transactions known as the "non-NASDAQ OTC" market. Almost all of these securities - more than 11,000 - are quoted in a daily circular known as the "pink sheets," so named for the color of the paper on which they are printed.

The pink sheets are home to almost all penny stocks, which, with very few exceptions, are not traded on the exchanges or NASDAQ. Unlike exchange-listed stocks and those on NASDAQ, pink sheet securities are subject to no meaningful listing requirements and escape almost all of the computer-guided surveillance and policing of the other segments of the equities market. For this reason, the pink sheets also are the primary playing field of penny stock swindlers, who thrive in the obscurity of the lowest rung on the ladder of the U.S. securities market. Some non-U.S. companies whose financial statement do not conform to American accounting standards and formats also appear in the pink sheets.

Why would companies choose to be listed in the pink sheets? Most have no choice; they are unable to satisfy the minimum listing standards for the NASDAQ market. Some of the securities are those of dormant or bankrupt companies - "shells" that are made to order vehicles for manipulative secondary market trading.

Some pink sheets stocks are those of low-profile, closely-held firms, a number of which trade at $50 a share or even in multiples of hundreds of dollars. A number of small and medium sized financial institutions of primarily or entirely local and regional interest have their market in the pink sheets.

Not all pink sheets securities are penny stocks, but virtually all penny stocks are found in the pink sheets. While a number of even the low-priced securities are perfectly legitimate, it is apparent that the pink sheets are increasingly being overrun by abusive promoters of manipulated penny stocks. Even in unmanipulated pink sheet securities, the absence of meaningful information for decision-making purposes poses a serious hazard. An investor's risk of losing all or some of his or her funds in penny stocks is all but assured when the considerable handicap of manipulation is combined with the almost total "black out" on information in the pink sheets.

THE RISK TO INVESTORS There is convincing and growing evidence that the non-NASDAQ OTC market - the 13,000 stocks trading in the "pink sheets" - has been substantially overrun by fraud and abuse at the hands of unscrupulous promoters. It is for this reason that securities regulators say that "penny stocks are bought and not sold." While there are reputable dealers in low priced securities and legitimate pink sheet stocks do exist, the rise of fraud in the penny stocks has seriously imperiled the current and future potential of this marketplace as the "starting line" for new and growing companies.

Recent cases and enforcement trends suggest that $2 billion or more of investor funds are lost each year due to fraud and abuse in the penny stock market. This loss to the U.S. economy is profound. For example, the estimated penny stock fraud toll is equal to two-thirds of the $3 billion raised by U.S. venture capitalists in 1988. Taking the rule of thumb that $25,000 in outside financing is needed to get a small business off the ground, the amount is reflective of the loss of 80,000 potential new firms, which would employ well over 150,000 workers. Ironically, penny stock boosters promote the market as a contributor of new businesses and jobs. However, it appears unlikely that the non-NASDAQ OTC market is actually a net "plus" to the U.S. economy.

The $2 billion in penny stock fraud and abuse is in addition to the estimated 70 percent profitability that an unmanipulated penny stock investor will lose some or all of his or her investment. Combining this inherent high degree of risk with the staggering amount of penny stock fraud and abuse results in an extremely bleak picture of the prospects for investors in the low-priced securities. These figures suggest that there is only about one chance in ten that many penny stock investors will break even, much less earn a single dollar in net profit through trading in the low-priced securities. This is a degree of risk that is slightly greater than that generally associated with commodity futures trading. It may be that use of the term "risk" is inappropriate in the context of the rigged marketplace of penny stocks, since there is, in fact, a virtual certainty of loss of funds by investors.

Penny stocks are thinly traded and subject to domination and control by a single market maker. As such, unlisted securities are attractive vehicles for manipulative, artificial schemes which are intended to raise the price or volume of the securities, primarily for the benefit of often unnamed insiders and, frequently, the brokerage firm itself, which may unload its own shares of a stock into the market it has helped send skyward.

The hallmarks of penny stock manipulation include: control by one or only a few brokers who often have contacts with the promoter or the issuer; matched purchases and sales to drive up prices, a practice also known as cross-trading; excessive spreads between "bid" and "ask" prices; false and misleading rumor-mongering and hype to inflate the prospects for a stock; and, the dumping of the securities at inflated prices by the promoters or brokers who then move on to the next manipulation. Penny stock investors routinely are victimized by grossly-inflated markups, which have been reported as high as 400, 500 and even over 1,000 percent. Other penny stock market abuses include refusing "net sales" (insisting that customers roll over paper profits), trading by unregistered salespersons, unauthorized trading in customer accounts, sales prior to the registration of a new issue, and over-subscription of initial public offerings.

A fundamental abuse that seems deeply rooted in the penny stock market (and, most likely, is crucial to its continued expansion) is the placement of unsuitable investors in the risky, volatile securities, including low-income elderly individuals whose primary sources of income are Social Security and other retirement benefits and those who are seeking low-risk investments with strong income potential. Documented cases of abuse include those in which penny stockbrokers have convinced clients to place penny stocks in their IRA accounts. It may be said that the suitability test applied by abusive penny stock firms is, quite simply, the ability to pay.

THE "BLANK CHECK" BLIND POOL PROBLEM An estimated 70 percent of penny stock new issues floated in 1988 and through mid-1989 were blind pools, virtually all of them "blank check" offerings, so named because investors are provided with almost no meaningful information about the company in which they have placed their money. For example, "blank check" business plans are not detailed in the offerings' prospectuses. Frequently, "blank check" blind pools are merely sham corporations that are brought public as vehicles for future manipulative conduct, which is widespread. In a matter of weeks after a "blank check" offering closes, a "reverse merger" or "reverse acquisition" may be announced and the underlying blind pool becomes and immediate candidate for hype and manipulation in the secondary marketplace, which is where stocks trade after an initial public offering (IPO) has been made. Similar abusive activity also takes place with so-called "shell corporations," which are generally inactive or bankrupt publicly-traded companies that are "raised from the dead" and merged with private companies.

The result of "blank check" and "shell game" craze is the sale to the public each year of stocks in hundreds of insubstantial and, in many cases, failing firms which, if they had attempted to come to market in a traditional IPO, most likely would have never passed the muster of state securities law. No academic literature or anecdotal evidence suggests that a net economic benefit results from the existence of "blank check" blind pools. In fact, it appears that the dollars raised in these offerings are matched several times over by the volume of resulting market manipulation, which, in short, means that the cost of "blank check" blind pools to society far outweighs any benefit they are known to bring about.

STATE EFFORTS TO COMBAT PENNY STOCK FRAUD A number of state initiatives are either in place or underway to curb the rising tide of penny stock fraud and abuse, including:

A total of 36 states have outright prohibitions or substantial restrictions of the registration of "blank check" blind pools. Utah, once the home of the "blank check" blind pools, has acted to clean up its soiled reputation. New regulations passed in Utah in 1986 imposed escrow and other requirements on blind pool offerings. In fiscal 1983, 217 blind pools in Utah raised $19.8 million. That number fell to 116 in 1986, 17 in 1987 and 5 in 1988, raising just $500,000. The New Jersey Bureau of Securities recently was given the discretion to deny registration to blind pools. In April 1989, the membership of the North American Securities Administrators Association (NASAA), declared "blank check" blind pools to be abusive "per se" and called for their elimination.

A number of states, including Missouri, Florida and Connecticut, have developed innovative and extensive programs to keep as much penny stock fraud as possible outside of their borders. The three states are among those that have developed extensive penny stock branch office auditing programs, which have generated dozens of enforcement actions. Missouri and Florida also have been trend-setters in the use of existing disciplinary information as the basis for pre-registration screening of individual stockbrokers and the handling of requests for the opening of new branch offices. Both states routinely deny registration to penny stockbrokers with established histories of disciplinary infractions.

A total of 36 states use "merit review" powers to screen out securities offerings that would be patently unfair, abusive or fraudulent to investors. This authority has been a major tool in the campaign by states to squelch problem initial public offerings (IPO's) of penny stocks.

States also are working together with the SEC and NASD on joint examinations of problem penny stock firms. Cooperative enforcement projects have also been undertaken, in order to more effectively ration the small pool of state, federal and industry regulatory manpower. Eight states joined earlier this spring in the joint examination of a Denver-based penny stock firm, including the simultaneous entry of the firm's eight branch offices around the nation. The state of Oklahoma, the SEC and NASD collaborated in 1987 and 1988 on actions taken against a Tulsa-based penny stock brokerage firm that engaged in driving up the market valuation of a bogus gold mining stock from $2 million to $315 million.

IF YOU DECIDE TO GAMBLE ON PENNY STOCKS... Few investors are likely to be suitable candidates for penny stocks, which involve a high or total degree of risk of the entire amount invested. As a result, penny stocks should be looked upon as being on the same order as playing the lottery or betting at the horse track. There are some means by which investors can minimize their risk of total loss in penny stocks. Consider the following tips before investing:

Determine how much you can afford to lose. Don't gamble on penny stocks any of the money you need for regular expenses or future plans.

Get it in writing - and read it. Don't rely on the glib talk of a penny stock salesperson. Get everything in writing about the investment in question. If the stock is more than a year old, ask the broker for the most recent 10K. If the company is a new one, ask to see the prospectus and then read it. Pay particular attention to the sections of the prospectus that discuss the risk factors and firm's management, outstanding litigation and financial status. Keep in mind that these factors all could be crucial to the firm's success.

Hang up on abusive, high pressure telephone salesmen. Remember that penny stocks salespeople will go to any lengths to get a sale. If you are not interested in making a purchase, say so and then get off the line.

Try to get independent verification of the "bid" and "ask" prices that are quoted. Ask the broker for the names of at least two other firms trading in the stock. Call those firms and determine if the prices quoted to reflect other market activity in the stock. (Keep in mind, however, that many penny stocks are traded in earnest by as few as one brokerage firm.)

Beware of claims of advance knowledge about pending announcements that will drive up the price of the stock. When it comes to penny stocks almost all such claims are phony. Insider trading is against the law; no legitimate brokerage firm is going to encourage you to invest on the basis of "secret" or "not yet announced" information.

Don't be impressed that the brokerage firm owns a big chunk of the stock. A penny stock salesperson may attempt to woo a prospective customer by pointing out that his or her brokerage firm holds a major portion of the outstanding float of a stock. Keep in mind that the firm may have paid little or nothing for the stock - possibly a very small fraction of what you are being asked to shell out. Such a holding may actually be a sign of trouble, since the holding can be sold into the stock's rising market, thereby causing the value of outstanding stock held by public investors to plummet in value.

Exercise caution when it comes to profit predictions and special analysis. If the broker indicates that his firm is recommending the stock, ask to see a copy of the related research report. Established brokerage firms have research department that publish detailed analysis on the pros and cons of individual stocks. If there is no such report available on the stock then the chances are good that you are getting nothing more than hot air.

Check out the brokerage firm and the stockbroker. Call your state securities agencies for a report on their track record of disciplinary infractions, if any. For the number of your state agency, call NASAA at 202-737-0900.

Use common sense. The chances of a penny stock becoming the next Apple Computer or Standard Oil are extremely thin. Don't listen to hype and feverish talk about "guaranteed," "can't lose," or "no risk" investments. They don't exist in the world of penny stocks.

FOR MORE INFORMATION The securities administrator in your state, province or territory is responsible for the protection of the investors. If you have questions about investments, contact the securities administrator in your state. Your prompt action could save you money. For the telephone number of your state securities administrator call NASAA at 202-737-0900.


Last changed: March 17, 2000