Microcap stock fraud is a form of securities fraud 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 stocks, which the SEC
defines as a security that trades at less than $5 per share, is not
listed on a national exchange, and fails to meet other specific
criteria.
Microcap stock fraud generally takes place among stocks traded on the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service, stocks which usually do not meet the requirements to be listed on the stock exchanges. Some fraud occurs among stocks traded on the NASDAQ Small Cap Market, now called the NASDAQ Capital 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 taking investors' money away. Companies using this kind of scheme tend to periodically reverse-split the stock.
- Other unscrupulous brokerage practices, including "bait-and-switch", unauthorized trading, and "no net sales" policies in which customers are prohibited or discouraged from selling stocks.
- Pump and dump
- Many penny stocks, particularly those that trade for fractions of a cent, are thinly traded. They can become the target of stock promoters and manipulators.
These manipulators first purchase large quantities of stock, then drive
up the share price through false and misleading positive statements,
and then sell their shares at a large profit. This is referred to as a
"pump and dump" scheme. The pump and dump is a form of microcap stock
fraud. In more sophisticated versions of the fraud, individuals or
organizations buy millions of shares, then use newsletter websites, chat
rooms, stock message boards, press releases, or e-mail blasts to drive
up interest in the stock. Very often, the perpetrator will claim to have
inside information
about impending news to persuade the unwitting investor to quickly buy
the shares. When buying pressure pushes the share price up, the rise in
price entices more people to believe the hype and to buy shares as well.
Eventually the manipulators doing the "pumping" end up "dumping" when
they sell their holdings.
The expanding use of the Internet and personal communication devices has made penny stock scams easier to perpetrate. Though not a scam per se, one notable example is rapper 50 Cent's use of Twitter to cause the price of a penny stock (HNHI) to increase dramatically. 50 Cent had previously bought 30 million shares of the company, and as a result made $8.7 million in profit. Another example of an activity that skirts the borderline between legitimate promotion and hype is the case of LEXG. Described (but perhaps overstated) as "the biggest stock promotion of all time", Lithium Exploration Group's market capitalization soared to over $350 million after an extensive direct mail campaign. The promotion drew upon the legitimate growth in production and use of lithium, while touting Lithium Exploration Groups position within that sector. According to the company's December 31, 2010 form 10-Q (filed within months of the direct mail promotion), LEXG was a lithium company without assets. Its revenues and assets at that time were zero.Subsequently, the company did acquire lithium production/exploration properties, and addressed concerns raised in the press.
Penny stock companies often have low liquidity. Investors may encounter difficulty selling their positions after the buying pressure has abated, and the manipulators have fled.
Chop stocks
A chop stock is an equity, usually trading on the Nasdaq Stock Market, OTC Bulletin Board or Pink Sheets 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 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 securities dealer sells such instruments 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. (Information courtesy from wikipedia )