Shell Games: How Shell Companies Help Perpetuate “Pump and Dump” Schemes and What Can Be Done About It
June 2012
IN THIS ISSUE
— Microcap, Macro Hype: The Allure of Penny Stocks and Shell Companies
— Managing in an Ocean of Risk: Diligence and Vigilance in Penny Stocks
GREETINGS!
Welcome to the June edition of our newsletter! In this issue, we’ll examine the role shell companies play in promoting “penny stock” listings used in “pump and dump” schemes to bilk investors, and how you can protect your clients from such schemes.
MICROCAP, MACRO HYPE: THE ALLURE OF PENNY STOCKS AND SHELL COMPANIES
The “get rich quick scheme” has in all likelihood existed since well before the advent of currency. Somewhat perversely, these schemes tend to flourish more in difficult times than in opulent times, and as with any economic downturn, the so-called great recession dating from 2007 has seen its share of promoters seeking to cash in on investors’ desire — sometimes, the simple need — to make money more quickly than logic would normally allow.
Into this void of uncertainty promoters step, “sure thing” in hand, ready to promise extraordinary returns in exchange for upfront capital, usually with a minimum amount in six figures. Although some of these companies — with potentially profitable but unproven ideas, like extracting and transporting liquefied natural gas from the farthest reaches of Africa — are listed on major exchanges, most lurk in the “over the counter” bulletin board markets. Although required to file disclosures with the U.S. Securities and Exchange Commission like other public companies, over the counter “microcap” companies exist in a fast-paced, often speculative frontier that entails far more risk than even the newest Nasdaq technology offering.
MANAGING IN AN OCEAN OF RISK: DILIGENCE AND VIGILANCE IN PENNY STOCKS
Such “microcap” stocks are often prey to — and sometimes complicit in — so-called “pump and dump” schemes, where a stock promoter buys thousands or millions of shares for pennies per share, then unleashes an army of cold callers to promote the stock, solicit new investments, and also distribute information — true or not, often the latter — meant to advance their agenda, using positive information to drive the price up if they own the shares, negative information to do the opposite if they’re shorting the stock. One key component of these schemes is the use of shell companies — “empty” holding companies that can be used to obscure the identity of the true owner of a stock’s shares — and thus to hide the owner’s true motivations. The SEC recently halted trading in such shell companies in the fear that the companies could be used to “hijack” investor capital. This often happens when the target investment, struggling to raise working capital, looks to the promoter for a loan – typically provided at exorbitant rates. If the company succeeds, the promoter profits as the stock increases in value, and as the loan is repaid; if the investment fails, the promoter collects on the loan and whatever collateral was promised in the event of default.
How can you protect your clients from falling victim to these schemes? Generally speaking, if someone is promoting a given stock aggressively, there’s a reason they need to raise capital so desperately — that alone should be a sign. But if the allure of promised returns proves too much to resist for your clients, thorough due diligence is key to warn them of pitfalls ahead (whether they heed that warning or not.) Looking at the backgrounds of a firm and its principals — including regulatory and litigation histories, media citations and stock-trader chatter — are all key components to assessing the risk in a venture few people are likely aware of and for which significant questions may exist.