How to Spot a Penny Stock Scam

Have you ever played a penny stock?  Or invested in one you believed or hoped was real, perhaps even the Next Big Thing?  If so, you probably know the roads in Pennyland are full of potholes.  Many of the locals are promoters, and they’re aided, wittingly or not, by amateur pumpers who spread the word about hot new “picks” across the social media.  Both stress the potential for short term gains far greater than those achievable on the national exchanges.  They aren’t entirely wrong.  Penny stocks can be extremely volatile; they can run hundreds of percentage points for little reason, or for no reason at all.  

No stock quadruples or quintuples in price over a few days and continues to rise.  What goes up really does come down, usually as quickly as it went up.  When touts say a stock is about to “go parabolic,” that’s often literally the case.  It may well return to the range it traded in before it was pumped.  That process, repeated countless times every year in the OTC market, is called a “pump and dump.”  Pumps and dumps are considered by the SEC to be illegal securities manipulation.  Unfortunately, only the most blatant are investigated by the agency, and their ringleaders eventually sanctioned.  Taken by surprise, the inexperienced and unwary find themselves trapped, stuck with stock they’ll only be able to sell if another pump and dump is launched at some future date.  Even seasoned traders can miscalculate.  If they jump on board too late, and the play peaks too early, they may end up with unexpected losses.

How Do Pump and Dump Operations Work?

All pump and dump operations, big or small, successful or unsuccessful, have a number of things in common.  First of all, they’re illegal manipulations; despite what many traders like to say, equities do not climb from, say, $0.0003 to $0.03 in three days “organically.”  There will be a story concocted to make the play attractive to potential buyers.  Usually the story, which may be partly or wholly untrue, will have to do with a currently hot sector like marijuana or cryptocurrency.  Another popular theme is a mining company’s sudden acquisition of mineral claims—often located in Russia or some other faraway place—supposedly worth billions.  Because they attract a lot of attention, those “billion dollar baby” pumps are often suspended by the SEC, but not before the perpetrators have made out like the bandits they are.  It’s Joe Sixpack who’s left holding the bag in a Grey Market security that will remain worthless forever.

The most important thing for any OTC player to remember is that when a stock is promoted, it’s almost always because a company insider, or group of insiders, wants to unload a large position.  It’s far easier for insiders to buy than it is for them to sell.  They can purchase stock at very low prices in a private placement, or receive it for services rendered, but when they want to sell—in most cases having waited for the expiration of rule 144 holding periods—they must do so on the open market.  Needless to say, a sudden dump of millions or tens of millions of shares of a thinly-traded penny would send its price into an immediate tailspin.  To prevent that happening, interest in the stock must be sparked, and significant volume must be generated. 

Pumps and dumps are nothing new.  As everyone who’s seen Wolf of Wall Street knows, back in the pre-electronic age, cheap junk stocks were promoted through boiler rooms whose brokers cold-called likely prospects.  Though that’s largely been abandoned in favor of more cost-effective online pumping, boiler rooms have been making a bit of a comeback in recent years.  Favorite targets are retired people who don’t trade online and aren’t as comfortable with computers as members of younger generations.  The SEC regularly identifies and brings civil lawsuits against the owners and operators of boiler rooms, and issues regular warnings about the dangers of saying yes to fast-talking salesmen, but there’s no shortage of new victims.  Boiler room pump and dumps often move more slowly than the online variety, simply because only a small number of the people contacted agree to play, and because some who show interest in buying must open a brokerage account, but in the end, victims may lose even more.

Gaining Control of a Public Shell and Creating a Pump

A professional pump and dump operation is disciplined, and requires the cooperation of a number of different people who will play different roles.  Usually one individual, or a small group, controls the public shell that is to be used as the vehicle for the pump.  In many cases, the identities of these control persons are not known to the public, because they appear in no SEC filings or OTC Markets disclosures.  Their stock is held in a number of nominee accounts, with no account holding more than 10 percent of the company’s shares outstanding.  One, two, or three individuals may control very large positions of which retail shareholders know nothing at all.  And once they’ve held those positions for more than six months, in the case of an SEC registrant, or one year, in the case of a non-registrant, they will want to sell their stock and reap a fat profit.

Often a considerable amount of forethought goes into preparing a penny stock to be pumped and dumped.  These preparations can take a year or more.  First, the originators of the scheme will need to find a suitable shell to use.  Shells may be obtained in a number of different ways.  Our masterminds will need to decide how legitimate they want their play to look.  If the idea is to create a story that may actually be persuasive, they’ll obtain a shell that’s an SEC registrant.  One option is to buy an old shell, but a newish one is better, because it will typically have less history and fewer skeletons in the closet, and will have issued less stock in its short life. 

There are, and always have been, specialists in the creation of registered penny stock shells.  Once upon a time, they were fairly respectable.  They would write a Form 10 for what’s known as a “blank check” company.   The company would have no operations, or even a business plan; its raison d’etre was to be sold to, and merged with, an active private company.  Back in the late 1990s, an attorney called Anthony DeMint registered a large number of shells.  He sold many of his creations, but a few with whimsical names like “Nothing Corp” and “Too Late Financial Corp” failed to appeal to prospective buyers.  What DeMint did was entirely above board.  He kept his companies current with their required periodic reports, and made insider reports of his own holdings in them.  Buyers would purchase DeMint’s control block of stock, and so take over ownership of the shell.  DeMint presumably did well over the next 10 years, as a clean registered shell could command $500,000 or more. 

In 2008, the SEC effectively pulled the plug on blank checks by changing its rules regarding shells.  From that time, Rule 144 was not available to holders of restricted stock in any public company that was, or had ever been, a shell.  To lose shell status, a company that was already an SEC registrant would have to declare it was operational, and then wait for a year before holders of restricted stock could sell it; non-registrants would have to file Forms 10, declare themselves operational, and wait for one year.  Both were required to keep current with their SEC filings, or they’d return to shell status.  This rule change greatly affected the value of blank check companies; they could no longer be sold for anything close to $500,000.  DeMint, seeing the writing on the wall, deregistered his remaining shells in 2008.

Registered shells—SEC registrants that were not “shells” within the SEC’s definition of the word—were still considered highly desirable.  Legitimate businessmen who wanted to take their private companies public were interested, and so were fraudsters who needed vehicles for pumps and dumps.  Creating these registered shells became a cottage industry for dishonest attorneys.  Sometimes the entity is commissioned by a shell peddler who intends to sell it to any interested buyer; sometimes the attorney himself is a shell peddler; and sometimes the idea from the outset is to run a pump and dump.  Some forethought is required.  Usually the attorney will file a Form S-1 as the company’s initial registration statement, rather than a Form 10.  An S-1 is different from a Form 10 in several important ways.  First of all, it registers an offering rather than a class of stock.  The offering can be self-underwritten by the company, or be comprised of stock sold earlier—at least one year earlier, but our hypothetical case involves crooks who may not care deeply about the rules—in a “friends and family” placement. 

Most of the fake companies created by these fraudulent S-1s have a single officer/director, often not a U.S. resident; a preposterous business plan intended to be executed in some distant place—a photo booth rental service in a provincial city in Poland comes to mind—and a very small amount of money to be raised in the offering.  The sole officer is generally said to be the only shareholder, and to own a control position, but it’s clear to anyone with good sense that he’s just fronting for an unnamed Man Behind the Curtain.  S-1s for these types of companies are very simple, and unwary or uninterested reviewers at the SEC’s Division of Corporation Finance usually deem them effective quickly. 

About a year, or a little more, from the filing of the S-1, the company will undergo a change in control.  An unrelated—or at least supposedly unrelated—entity will step in and purchase the sole officer’s control position.  The people who owned that “friends and family” stock will still own it, because there’ll have been no interest in buying the offering.  New management will be announced, along with a new business plan, this one more plausible than the first.  Often a forward split will be effected, giving that new management and those friends and family investors a great deal more stock than they originally owned.  Its price will be proportionately lower, but that will be an advantage once the pump begins.

At that point, the stage is almost set.  As the next step, promoters will be brought in, and immediately paid an initial fee in free trading stock.  Often it’ll be up to them to do more than promote.  They’re expected to be familiar with the mechanics of a pump and dump, and what’s needed to pull one off successfully.  Usually the shell to be used has barely traded in the past.  A couple of the touts will do a little trading in the stock, gradually bidding it up.  It may take them awhile to get it into the range they want, but when they do, the pump will begin in earnest.  The company CEO will issue a torrent of exciting press releases.  The promoters, and lesser touts they subcontract, will disseminate email blasts.  They or people they hire will push the stock on Twitter, Facebook, and financial message boards.  Add to that some professional (and illegal) wash trading, and the stock will rise quickly on increasingly high volume.

Excitement will build, and as it does, the insiders who created the play and the promoters who helped them will sell into their own pump.  All of them got their stock very cheaply; they’ll make a profit no matter what.  A sharp rise in price isn’t a necessity; it’s the cherry on top.  Retail traders, on the other hand, are unlikely to have bought anywhere near the bottom.  By the time they realize what’s going on, they’ll be selling for a small gain or at a loss.  Will the insiders succeed in unloading all their stock?  Probably not, but it doesn’t matter.  They’ve made a healthy profit, and if they want, they can always try a secondary promo a few months later.  Some people will fall for the same pump and dump more than once.

Pumps Commissioned by Toxic Funders

Pennies aren’t always pumped by their own insiders.  As every player knows, penny companies, like most small businesses, are money pits that need financing to survive and expand.  Many businessmen take their private companies public imagining their financing problems will quickly be solved:  attracting investment is, in many cases, the chief reason for any company to go public.  Unfortunately, it’s not as easy as it sounds.

One obvious way to raise cash is to conduct an offering of equity, debt, or a mixture of the two.  SEC Regulations D and A allow penny companies to sell securities that are exempt from registration requirements, although certain restrictions apply.  The most popular choices are Rule 506(b) and Rule 506(c) of Reg D.  Both allow the issuer to raise an unlimited amount from a mix of accredited and non-accredited investors.  Rule 506(c) additionally permits solicitation and advertising; it was created in response to the crowdfunding provisions of the JOBS Act, which was signed into law in 2012.  Reg D offerings generally require very little paperwork, and can be prepared and launched quickly.  Reg A, which was rewritten and expanded a few years ago, is more demanding.  Issuers must prepare a complex prospectus, and a Form 1-A must be submitted to the SEC for review.  The agency’s reviewers will comment, and may insist on successive amended filings before pronouncing the offering “qualified.” It is only at that moment the company can begin selling its securities to interested parties.  Once the 1-A is filed, the process can take months as the reviews go forward.  Reg A has two tiers, depending on the amount of money to be raised; companies that choose Tier 2 will need to file audited financial reports and make ongoing reports as well. 

Naturally, if the issuer is already an SEC registrant, it will probably already have an offering underway:  its S-1 initial registration statement.  Reg D stock, once issued, is subject to restrictions on resale under Rule 144; buyers must wait six months in the case of a registrant, and one year in the case of a non-registrant.  Reg A stock is immediately free trading upon issuance, and S-1 stock will become unrestricted as soon as the offering is deemed effective. 

All of these are options used frequently by microcaps, and sometimes they meet an issuer’s needs.  But it isn’t a given that the public will be interested in buying a company’s offering.  About a week ago, a penny company trading at $0.0001 by $0.0002 filed a 1-A to sell 20 billion shares, in order to raise $2 million.  If it’s eventually qualified, it’s highly unlikely the company will be able to sell all the stock on offer; in fact, probably there won’t be enough interest to sell more than a few hundred million shares at best.  That’s an extreme example, but a great many companies fail to raise the amount they need or want, even if that amount is modest. 

Those companies’ needs will be met by what are known as toxic funders.  They lend microcaps cash, and get promissory notes in return.  The terms of the financing agreements the companies sign are almost always highly favorable to the lenders.  Rule 144 requires the funders to hold their notes for six or 12 months, but once that time has passed, they’re free to convert the notes and sell the resulting stock.  To compensate for the lender’s risk, he receives a generous discount to market, sometimes as much as 50 percent, upon conversion.  Worse yet, the conversions are typically “floorless”:  the amount of stock issued is based on the recent closing price of the stock.  As more and more stock is converted and sold, stock price sinks lower and lower.  That’s why the lenders’ financial instruments are called “death spiral convertibles.”  Eventually the company will be forced to execute a reverse split, and then it’ll start the process all over again.

Along the way, the toxic funders will need to sell, and when they do, they’ll usually be dumping large amounts of stock.  Like company insiders with big positions to unload, they’ll need high volume to support their sales.  Some, though not all, will hire promoters to generate that volume.  The buzz started by the promoters, and the wash trading they may arrange, will generate volume, sometimes in the hundreds of thousands of shares daily.  The sudden surge will hit stock screeners everywhere, and believers in the old axiom “volume precedes price” will hit the buy button.  The usual email blasts will go out, and the company may even cooperate by issuing press releases.  The stock price may rise, but even if it doesn’t, the funders will still profit, thanks to the hefty discount to market they receive when they convert.  As the pump subsides, price and volume will do the same.  Players who didn’t get out in time will have to await the next round of conversions.  By that time, however, the stock price will likely have declined further.

Social Media Pumps

The SEC began to apply greater pressure to professional stock promoters beginning around 2013.  Enforcement actions and parallel DOJ criminal prosecutions were brought against a considerable number of high profile touts and the insiders who paid them and created the vehicles to be used in the plays.  The most prominent promotional group, Awesome Penny Stocks, bit the dust after the SEC suspended trading in three of its plays.  Some of the APS leaders fled to parts unknown; others were charged in connection with a variety of stock manipulation schemes.  A few who were not associated with APS agreed to work as informants, aware that if they didn’t spill the beans, they could find themselves facing lengthy prison terms.

Smart promoters backed off, or at least kept their heads down.  Big-name promotional groups, once avidly followed, all but disappeared.  Penny players hadn’t lost interest in the game, though.  Something had to fill the void; nature, after all, abhors a vacuum.  That something was the social media.  Online financial chat boards had been around since the mid-1990s, but had a limited audience.  For years after its inception, Facebook was chiefly used by people interested in exchanging posts and photos with friends and family.  Twitter was created in 2006, but didn’t initially pique the interest of many penny stock people.  The SEC’s 2013 decision to allow companies to to make official disclosure on sites including, but not limited to, Twitter and Facebook was a game changer.  Suddenly the social media, and especially Twitter, became the place to push penny stocks.  It was anonymous, easy to use, and, with its limit on the number of characters in a tweet, didn’t require or encourage deep thoughts. 

And so professional promoters were to some extent supplanted by Twitter, Skype, and Discord groups that pushed pennies.  These groups seem to consist of a mixture of amateurs and semi-pros.  It’s said some of the more prominent participants accept cash to pitch their picks to less experienced followers. 

Regardless of whether a pick is financed or not, the group leaders will frontload the stock before the name of the stock and its ticker are officially publicized.  Frontloaders buy at low prices—“loading”—and then commence a pump.  They’ll sell into the pump while still encouraging others to buy.  That is called “scalping,” and it’s illegal.  Once they’ve loaded, the leaders will share the pick with their lieutenants.  Days later, the pick will be announced, and the fun will begin.  Some of these groups are extremely influential, and evidently have large numbers of followers.  They can and do generate volume in the hundreds of millions of shares. 

Apart from the organizers of these pumps, only the nimble have a chance to profit.  Usually neither the volume nor a new and higher stock price can hold for more than a very short time, because it lacks the sustained financial backing that can be provided by company insiders or toxic lenders.  The stock soon crashes and burns, and the group moves on to its next play.  The professional promos of the past could last for weeks, with several runs followed by retracements.  Nowadays, there’s usually one run, and it lasts no more than a few days.

How to Avoid Falling for a Pump and Dump

It would be fair to say more people lose money in a pump and dump operation than make money.  Who wins?  The company insiders, toxic funders, promoters, and social media group leaders.  If you’re not one of those people, but still think you can beat the odds, learn from the example of most successful penny players:  take profits early and often, and try to conserve capital.  As price rises, take enough stock off the table to cover your original investment, if you can.  You’ll be able to sleep at night knowing that whatever happens, you won’t have lost any money.

It’s also important to know what NOT to do if you find yourself tempted to place a bet on the latest promoted play.  Here are some suggestions:

• Whatever the story is, don’t believe it. It’s almost certainly been exaggerated, and may be entirely untrue.
• Don’t fail to understand that if volume in the stock in question has increased by thousands of percentage points, the stock is being pumped, and will be dumped.
• In the heat of the moment, don’t forget that what goes up will come down. What follows a large and sudden price increase is almost always a correction.  In a pump and dump, the correction will be fast and extremely sharp.
• Do not imagine you’ll be able to buy at an attractive price level. The frontloaders are the only ones who have that opportunity.
• If you get in too late, or the play fails to take off, don’t neglect to cut your losses.
• Don’t ever average down. It’s a poor idea with nearly any penny stock; in a pump and dump it’s suicidal.

Resist peer pressure.  If you participate on a message board or in the social media, feel free to express any doubts you may have about the stock under discussion.  Don’t allow yourself to be bullied out of selling, if you think that’s the right thing to do.  The people bullying you may be selling themselves, and they may not want competition. \

We’ve provided information that can help you recognize a pump and dump operation, and suggestions for avoiding heavy losses.  Pennyland is a deceptive and sometimes dangerous place.  Strangers offering stock tips don’t always have your best interests in mind.  Remember:  If it sounds too good to be true, it probably is.

This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates Law Group, P.A provides ongoing corporate and securities counsel to private companies and public companies listed and publicly traded on the Frankfurt Stock Exchange, London Stock Exchange, NASDAQ Stock Market, the NYSE MKT and OTC Markets. For two decades the Firm has served private and public companies and other market participants in corporate law matters, securities law and going public matters. The firm’s practice areas include, but are not limited to, forensic law and investigations, SEC investigations and SEC defense, corporate law matters, compliance with the Securities Act of 1933 securities offer and sale and registration statement requirements, including Regulation A/ Regulation A+ , private placement offerings under Regulation D including Rule 504 and Rule 506 and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, Form F-1,  Form S-8 and Form S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including Form 8-A and Form 10 registration statements, reporting on Forms 10-Q, Form 10-K and Form 8-K, Form 6-K and SEC Schedule 14CInformation and SEC Schedule 14A Proxy Statements; Regulation A / Regulation A+ offerings; all forms of going public transactions; mergers and acquisitions; applications to and compliance with the corporate governance requirements of national securities exchanges including NASDAQ and NYSE MKT and foreign listings; crowdfunding; corporate; and general contract and business transactions. The firm provides preparation of corporate documents and other transaction documents such as share purchase and exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The firm prepares the necessary documentation and assists in completing the requirements of federal and state securities laws such as FINRA and DTC for Rule 15c2-11 / Form 211 trading applications, corporate name changes, reverse and forward splits, changes of domicile and other transactions. The firm represents clients in London, Dubai, India, Germany, India, France, Israel, Canada and throughout the U.S.