Tearing the veil on the classic 'pump and dump'

The Port of New York and New Jersey describes itself  as the "gateway to one of the most concentrated and affluent consumer markets in the world." As the East Coast's largest port, thousands of container ships have entered into its metropolitan harbor carrying billions of dollars worth of cargo. For several years, however, the Port — whose history evokes memories of organized crime, racketeering and corruption — also served as the hub for a $7 million market manipulation scheme, more commonly known as a "pump and dump."

In January 2010, a multi-agency task force, composed of federal and state law enforcement agencies, apprehended a corrupt longshoreman involved in cocaine trafficking at the Port. When law enforcement questioned him, the longshoreman said he knew of other criminal activities, including a fraudulent stock scheme in which a number of longshoremen had participated.

An ensuing federal investigation revealed an elaborate pump-and-dump scheme to artificially inflate the market activity of several publicly traded stocks through fraudulent stock tips on Internet websites and social media. Once the perpetrators had sufficiently inflated the targeted stocks, those involved in the scheme liquidated their shares at profit, which caused millions of dollars in losses to unsuspecting investors. In October 2010, the U.S. Attorney's Office for the Southern District of New York charged 11 defendants in connection with the pump-and-dump scheme. (See Case No. 1-10-mj-02190.) Several defendants plead guilty with varying penalties of forfeiture and prison time.

Pump-and-dump basics

The pump-and-dump scheme is a classic form of stock manipulation that's generally thought to include two basic phases: 1) the pump, in which the market activity of a stock is fraudulently inflated through misleading publicity, such as inaccurate press releases and promotion and 2) the dump, in which perpetrators of the scheme liquidate their shares at artificially inflated price levels.

As was the case of the longshoremen pump and dump, perpetrators of these schemes typically target microcap stocks to manipulate. Many of these stocks are quoted "over the counter" on the OTC Bulletin Board or OTC Link markets because the companies fail to meet the stringent listing requirements of a stock exchange like NASDAQ or NYSE. (See Microcap Stock: A Guide for Investors.)

These stocks are easier for fraudsters to manipulate and control because of their illiquid and thinly traded nature. Also, many of these stocks aren't registered with the Securities & Exchange Commission; therefore, these companies aren't required to file periodic financial reports. This lack of transparency plays perfectly into the fraudsters' hands. In the absence of audited financial statements and disclosure, investors might be forced to rely on limited publicly available information (e.g. fraudulent news and fabricated financials).

Establishing liquidity

Microcap stocks or penny stocks often are illiquid with minimal historical trading activity. For the pump and dump to be successful, it's imperative that the fraudsters demonstrate liquidity in stocks to attract investors.

Fraudsters often manipulate trading activity to create the appearance of an active market in stocks and to prepare them for ensuing publicity campaigns. They can do this through coordinated purchases and sales of stock, including "wash" or "matched" orders.

For example, a fraudster — who owns hundreds of thousands of worthless shares — might enter an order to sell shares of the company's stock at Broker Dealer A. At or around the same time, the fraudster — or a co-conspirator — would arrange to enter an order to purchase the same amount of shares through Broker Dealer B. In a thinly traded stock, the fraudster's purchase and sell orders could be easily executed against one another. He could repeatedly orchestrate and execute these fraudulent transactions to establish liquidity and artificially inflate the stock's trading price and volume.

Defendants charged in the longshoremen pump-and-dump scheme coordinated their purchase activity in the target stocks to give the appearance of active markets and inflate stock prices. The federal government recorded the following conversation in a May 2010 telephone call:

We all have to coordinate on like the other phone for maybe the first couple of hundred thousands or quarter million. I'll just coordinate with [a defendant] because we'll all go in there with even numbers and buy like, you know, 200,000 apiece. But not in one block. You know, like 25, 20, 15, this and that. We'll all take turns doing it. ...

Methods of pumping

This list, though not exhaustive, represents several ways that fraudsters can pump a stock and create sufficient liquidity:

• Disseminating false and misleading press releases.
• Filing fraudulent financial statements.
• Releasing stock touts and promotions, including spam emails, fax blasts, text blasts, glossy mailers, newsletters, Internet articles and social media.
• Bribing stockbrokers to solicit clients.
• Running boiler rooms to solicit investments.
• Coordinating trading activity to create the appearance of an active/rising market — often coinciding with issuing fraudulent press releases and promotions.

In the longshoremen pump-and-dump scheme, the perpetrators employed coordinated trading activity and stock touts to fraudulently inflate the market activity of the targeted stocks. As stated in court records, the promotional material recommended targeted stocks and enticed investors with projections of short-term gains. For example, in one website post, a targeted stock was touted as the "Next Big Pick! . . . We believe that this company has a lot going for it and we recommend that everyone puts it on their watch list! Last price is .62 per share and technical indicators are pointing up!" The government found these stock recommendations to be fraudulent because the recommendations weren't based on technical indicators but on the defendants' agreement to pump the stock.

Tips for identifying perpetrators

Look for those shareholders who have obtained significant control over a company's free-trading shares or those shares that don't bear restrictive legends so they can be easily sold into the market.

You can obtain shareholder lists and other documents from a company's transfer agent that will detail the names and addresses of the company's shareholders and any issuance, cancellation and transfer of stock certificates. Analyze these records to trace the stock that's sold during a pump-and-dump scheme to its original issuance.

The perpetrator might also be a significant creditor of the company who obtained his shares at significantly discounted prices to make a substantial profit in the stock.

Analyze the company's current and historical financial statements, including balance sheets and statements of cash flows. Particularly focus on any issuance of common stock, convertible preferred stock and convertible debt because these financial transactions are often the source of the stock that has been liquidated during a pump and dump.

If you believe the company has participated in the scheme by disseminating false press releases, be aware that the ill-gotten proceeds generated from the sale of shares during the pump and dump might have been funneled back into the company in the form of a loan or cash infusion or into the wallets of management as a form of compensation for assisting in the scheme. In these instances, interview and question at length the company's management.

Be aware of any agreements the company might have had with consultants or so-called "market awareness" professionals (i.e. stock promoters). A company could have fraudulently issued common stock to the perpetrator under the guise of a consulting agreement in the absence of any validly performed service.

If the company has made its financial reports public, it would be wise to review the list of beneficial owners included in the company's annual report, prospectus or registration statement. Often, these names might include individuals who have regulatory and criminal histories of securities fraud and market manipulation, among other crimes.

Perpetrators of pump and dumps might go to great lengths to conceal their involvement in public companies. They might conceal their ownership interest in the public company to prevent corporate disclosure and evade regulators via nominees, trusts, offshore entities, shell corporations, offshore broker dealers, corrupt attorneys and dizzying private security transactions.

In these instances, obtain significant documentation to expose the fraudster's identity, including brokerage account and bank statements, transfer agent records, telephone records and various corporate documents. I highly recommend interviews with company management, stock promoters and other relevant parties; they're often required to fully develop an investigation.

Stifling pumping and dumping

Don't be deceived by this classic form of stock manipulation. To investigate these schemes and expose the fraudsters, identify those who have obtained significant control over a company's free-trading shares. Analyze the company's current and historical financial statements for issuances of stock and convertible debentures. Examine brokerage account and bank statements, transfer agent records, telephone records and various corporate documents to uncover ownership interest and identity manipulative activity. And interview all relevant parties, including management and stock promoters, to uncover fraud schemes. This will empower you to uncover the truth and tear the veil on the pump and dump.

Nick Savona, CFE, CFCS, is a securities fraud investigator in Washington, D.C. He wasn't personally involved in the investigation of the longshoremen pump-and-dump case in this article. His views are his own.

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