Protecting Yourself From Small Stock Fraud

nvestors nationwide lament when they hear names such as Concorde Capital, Biltmore Securities, A.R. Baron & Co., Sterling Foster & Co., Stratton Oakmont and La Jolla Capital. Unlike their brethren at the major brokerage firms (where claims of unsuitable investments, failure to disclose risks and excessive trading persist), these brokerage firms (known as "boiler rooms", chop shops" or "bucket shops") take defrauding investors to a new level, in what may be viewed as the brokerage industry's sweatshop. As one former sweatshop broker said, "There are three people that stand to make money on Wall Street - the firm, the broker and the client. The bucket shop's philosophy is, "What the hell, two out of three ain't bad' "

Generally, the scheme is quite simple. In a nutshell, these firms push unknown, low priced, small capitalization stocks. First, they gain an investor's trust by temporarily buying a well known stock - called the "hook". Then they devise some excuse for selling the well known stock to purchase the unknown stock(s), manipulate the market by committing unauthorized purchases and by refusing to execute sell orders - called the "pump". Finally, and once the insiders have safely sold at a hefty profit - called the "dump" - the stock price falls precipitously, leaving the investors with large losses.

The Hook

The most common theme that we hear is that the broker sounded likable and credible on the telephone. In fact, the brokers are credible initially. A key element of the scheme to defraud is the "hook". The boiler rooms realize that too few investors are willing to send thousands of dollars to a stranger to invest in an unknown company - at least initially. But many more investors are willing to send thousands to invest in a well known company (Motorola is a favorite ploy in this area). And even the most suspecting investors usually will send a few thousand dollars to invest in Motorola.

The chop shops have trained their brokers not to take "no" for an answer, and to keep the investor on the telephone for as long as possible. An especially attractive target is the entrepreneurial, small business owner. Any objections are met with quick, rehearsed retorts charted on written sales scripts. For example, if an investor tries to delay saying "yes", such as with the objection, "I have to talk to my spouse", the broker may counter with, "I understand sir, but did you get where you are today by listening to your spouse? You are so successful because you took action, and did what you wanted when you wanted to do it. I know you are a leader, not a follower, and those are the people I want to deal with as my customers."

The Pump

Once the investor is hooked, for example purchasing $5,000 worth of Motorola, the broker will contact the investor to re-establish the relationship, and attempt to solidify the trust ("I told you that I could be trusted - you saw on your confirmation that I bought Motorola for you just as I had promised"). That's when the real scam begins. The broker may say, "Our trading analysts have followed Motorola for years, and have recommended purchasing it from time to time. But right now, they believe that, due to short term market conditions, China and so forth, Motorola no longer is in the Buy range. They are recommending a Sell. You should sell now, and buy a stock that our analysts are strongly recommending."

Of course, chop shops have no trading analysts. But the reason sounds plausible. Many of the firm's customers will follow the "experts", deciding to sell the well known company and buy the unknown company.

The bucket shop's most important goal during this "pump" stage is to convince the investor to turnover all of his cash and securities. This usually is accomplished because investors see nice paper profits (not actual profits) in their unknown stocks, and the brokers aggressively push for more purchases. Here are some common examples taken from actual sales scripts:

Price Predictions

"Okay, I haven't been this excited about a situation in a long time ... Take your 5,000 shares. I think I could book you 20 grand in profits in three weeks...."

"Own this stock tomorrow at the open. Alright? I think this stock will be up at least a buck tomorrow. Okay? It looks too big. I got a million and close to a million and a half buy-in tomorrow. Alright? I want to put your money alongside my clients ... that are making money in the stock already...."

Access to Inside Information

"And now, the company has news pending ... Certain things that I'm not at liberty to talk about."

Misrepresentations about the Company

"I've told you, they do the whole entire metropolitan area of New York City, every skyscraper by the year 2000 has to replace their CFCs ... they have virtually no competitors.

Must Purchase Specific Amounts

"... and it's a block that I can only locate, and it's a 30 [thousand shares]. It's kind of an all or nothing deal..."

The Dump

Now the nightmare begins. Suddenly, the stocks that have risen in price so nicely (and artificially, of course) head downward. While the bucket shop's insiders are unloading their shares, brokers are instructed not to execute the investors' sell orders, not to return telephone calls from complaining investors, and have their fellow brokers pretend to be their supervisors, who promise to promptly investigate and resolve the investors' complaints. In the rare instance when a persistent investor succeeds in having his sell order executed, the broker is heavily penalized - usually, his $1 per share (or more) payout - a huge payout, give that the price of the stocks usually is less than $5 per share - is cancelled, and he is warned not to allow that to happen again.

Meanwhile, the brokers also continue to pump the next deal. Even when the investor has seen losses, the broker may say:

"But you know something? I have another IPO coming and I'll make it up there."

"I can monitor your downside very carefully."

"I'm on tape telling you that if the stock's down an eighth, you're out. That's it."

Too many investors take the bait. The process of pumping and dumping thus continues until all of the investor's assets are lost.

How can investors protect themselves? The easiest way is to say "no" to the unsolicited telephone call from brokers whom you do not know, no matter how promising their claims appear to be.

Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.

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