Canadian microcap stock manipulation often escapes detection

Guest columnist Paul Garside, CFE, says that Canadian businesses can be surprised by stock-price manipulation schemes. Here he details the basics of this fraud and provides some ways to detect it. As the former officer in charge of the Royal Canadian Mounted Police (RCMP) Integrated Market Enforcement Team (IMET) in Montreal, he investigated market crimes, including Project Carrefour — a substantial microcap stock manipulation case. — Tim Harvey, "Global Fraud Focus" editor

In 1993, the owner of a Canadian penny-stock mining company, Bre-X Minerals Ltd, a Calgary-based mining company, purchased the rights to some land in the middle of the jungles of Borneo. He bought the land on the advice of a geologist and explorer, John Felderhof, who estimated that it contained gold deposits.

Over the years, Felderhof's estimations grew, and in 1997, he told investors from J.P. Morgan in a conference call that the land could contain more than 13 million pounds of gold. And as his estimations grew, so did Bre-X's stocks. When Bre-X purchased the Borneo land, its stock was selling for around 30 cents apiece. By 1997, the share price had gone up to more than a CAD$250 and market capitalization of CAD$4.4 billion. One problem: the gold didn't exist in the Borneo land. (See The $6 Billion Gold Mine That Wasn't There, by Eric Grundhauser, Slate, Aug. 21, 2015.)

When the fraud was finally exposed, the share price quickly decreased, which left retail investors and numerous pension and investment funds with significant losses. To make matters worse, consequent criminal, regulatory and civil suits all eventually fizzled out with little justice for the thousands of individual and corporate victims. This case became Canada's iconic stock manipulation example.

Although CFEs might not regularly come across microcap stock manipulation, it's important to be aware of the methods and motivations behind this significant criminal activity. (A microcap is a publicly traded company whose stock might be worth only pennies, which causes prices to be volatile and easier to manipulate.)

In this scheme, promoters and insiders — after cheaply purchasing a stock — typically pump up its value through embellished or entirely false news. However, other fraudsters have successfully employed much more creative strategies. Several articles and books have told of the involvement of organized crime, especially throughout the '80s and '90s, in this highly profitable illegal business. Canada is no exception.

Pump-and-dump schemes can be relatively simple, such as an individual or small group releasing false information in a chat room or insiders publishing inflated company information. Sometimes the business owners are complicit, especially with shell corporations that have little actual operations or value.

Occasionally, scammers dupe business owners into participating in schemes through promises of investment and related marketing. Or fraudsters "hijack" their stock and falsely hype it, which often causes irreparable damage to the owners' and business' reputations.

CFEs working for small or venture businesses should be especially cautious of unsolicited offers to raise capital through microcap stock offerings. Criminals commonly target businesses in the pharmaceutical, energy or technology sectors by looking to use companies' names and ideas to manipulate stock for profit.

RCMP investigates microcap stock fraud

A microcap stock investigation — "Project Carrefour" — led by the RCMP, recently came to an end after a six-year lengthy judicial process. (See Fraude au REER: sept ans de recours pour les faire plaider coupable, TVA Nouvelles, August 3.) The case came to an uninspiring conclusion. With the jury and prosecution seemingly overwhelmed by evidence, the case's complexity and numerous trial delays, three of the accused, including its ringleader, apparently were offered considerably lenient probation sentences in exchange for guilty pleas. (Other conspirators who'd waived their right to a trial and pleaded guilty had previously received prison sentences of up to three years.)

Despite its rather lackluster conclusion, the project is noteworthy because it was a rare police venture into microcap stock manipulation. The investigation was also unusual because it employed wiretaps and undercover operations — usually reserved for drug and terrorism cases in Canada — which helped identify and prosecute the perpetrators.

The ability to manipulate microcap stocks with relative ease also makes the activity an ideal tool to hide payments between parties."

The fraudsters achieved this by selecting thinly traded stocks. The ringleader used public trading information, which allowed him to see outstanding bid and ask prices. He directed his brother, who controlled the victim accounts, to place orders that he knew would be matched with his. The brother sold his stock at inflated prices and then bought it back cheaply so the account values were transferred to his accounts.

The fraudsters recruited persons in dire financial straits through newspaper and online ads by offering them cash in exchange for controlling their self-directed retirement brokerage accounts.

The ads varied but generally stated something along the lines of "Need money and have an RRSP (IRA) or pension account? Call us and we can help." The fraudsters told some that they'd simply trade in the account and not to worry because values would fluctuate. They told a much smaller group that the account values would go down and to forget about them.

Now that the perpetrators had control of the registered retirement accounts, they were able to initiate a series of organized stock trades that essentially transferred all the accounts' value to their own accounts without actually withdrawing any funds. (That would've triggered a large tax bite.)

By controlling both the sell and buy prices ("ask" and "bid" in stock lingo), they essentially had the retirement accounts buy stock they owned at inflated prices, which then fell back to being nearly worthless as they cheaply repurchased the stock — starting the process over again. 

Online transactions purporting to be initiated by retirement account holders but actually completed by the criminal organization were done in public locations such as libraries and coffee shops with free Wi-Fi in an attempt to conceal their identities.

Nuts and bolts of microcap manipulation

More complex microcap stock manipulation schemes involving organized crime typically employ a number of persons who are instructed to buy in at various points that coincide with a series of false press releases and concurrent investor forum-controlled chat and spam email. This orchestrated activity provides the illusion of stock movement resulting from large investor interest thus drawing in the required funds of outsider victims.

The actual manipulation often resembles a series of smaller pumps and dumps instead of one large event. So the fraudsters can use the same stock over and over with less chance of detection by regulatory authorities.

More refined players also employ foreign or off-shore brokerage accounts as a further veil over their illegal activities.

When the organized manipulation plan succeeds, the ringleaders will permit the accomplices to sell and obtain their related profit depending on their hierarchies in the organization. However, the end process is often far from perfect. Occasionally, accomplices don't follow instructions — at their significant personal risk — and sell too early or late.

Even if the manipulation isn't always successful, organized crime members who have "invested" in the process expect and demand a certain profit, which places additional pressure on participants who might find they have debt on their hands because of their failures.

Occasionally, outsiders also take large positions either profiting from or destroying the momentum of the criminal group. In the '80s, when trades were completed through actual brokers, criminals could use threats or actual violence to control such unwanted participants. However, technological trading platforms have made this more difficult.

A less common, yet also profitable, technique is to put downward pressure on a stock (or cause the price to decrease) after buying the equity on loan through a contract, or "option," with the hopes of buying the stock or settling the contract once the stock has dropped in price. Fraudsters can initiate this manipulation technique, commonly known as "short and distort," by promoting rumors such as a bad quarter or failed new drug test.

In 1997, some Montreal residents were even more creative, ironically, after suffering losses with their Bre-X investments. After buying its stock short, they placed several bombs outside a pharmaceutical company. The exploding bombs caused the stock to drop and likely would've resulted in a considerable profit for the bombers had the stock exchange not halted its trading. Luckily, no one was hurt, and an informant exposed the plot to authorities. (See Verdict in Biochem Pharma case, CBC News, May 19, 2000.)

The ability to manipulate microcap stocks with relative ease also makes the activity an ideal tool to hide payments between parties. Instead of paying cash or wiring funds to settle a drug debt, one can simply provide a tip relating to a microcap stock that's about to be manipulated. The party who's owed the debt then only has to buy the stock cheaply and await for the pump to make the sale and profit. Perpetrators also have used the same process to offer bribes to public servants. Troublesome envelopes or bags of cash aren't required. The profit appears as a simple lucky or astute stock pick, and culprits can even report them as capital gains thus removing the risk of highly feared and powerful tax investigators becoming involved in a possible money-laundering investigation.

Police, securities regulatory authorities and the Financial Transactions and Reports Analysis Centre of Canada (Canada's version of the U.S. Financial Crimes Enforcement Network) have observed and reported such suspicious activity. However, it's often difficult to link those who profit from the manipulation with the culpable manipulators.

Also, considering that organized crime elements employ microcap manipulation for debt payments and as profitable crimes, it's again challenging for authorities to identify the goals of their participation without some inside knowledge. Proving all the elements of the crime is nearly impossible without wire taps or a co-conspirator witness.

Few microcap cases brought to justice (or not?)

Because law enforcement resources in Canada are mostly invested in drug and, more recently, terrorism investigations, it's not surprising that so few microcap manipulation cases are brought to justice in Canada despite the apparent prevalence of the activity. (See White-collar crime task force ‘doomed to failure' unless separated into its own agency: retired Mountie, by Douglas Quan, National Post, Nov. 29, 2015.)

Canada has been criticized on its weak white-collar crime enforcement. Fraudsters who cheat investors in Canada often suffer little more than a slap on the wrist, according to Crime without punishment: Canada's investment fraud problem, The Globe and Mail, by Jeff Gray and Janet McFarland, Aug. 24, 2013.) Police, victims say, aren't willing to investigate complex financial crimes especially when smaller frauds don't attract media attention, according to the article.

However, considering that microcap manipulation often involves concurrent jurisdictions, American civil and criminal authorities such as the Securities and Exchange Commission and the FBI have successfully targeted many Canadian players. While such U.S. investigative involvement in Canada is important in placing a damper on market manipulation, it could be argued that Canadian authorities would be better placed to carry out those enforcement endeavors. And that increasingly might be the case. Canadian efforts to crack down on white-collar and business crime might be gaining momentum, according to the paper, New Era of White Collar Crime Enforcement in Canada, by Norm Keith and Fasken Matineua.)

The authors write that regulators and the RCMP IMET are heavily scrutinizing more businesses, and the government is taking more cases to court. Penalties are increasing, and prosecutors are putting more fraudsters in jail.

Risky investments worth a look

It's ironic, yet not surprising, that more than one organized-crime figure has said they don't invest their own criminal earnings in microcap stocks because they deem such markets to be too risky and plagued by manipulators. So, the next time you come across information relating to a microcap investment, whether you work in Canada or not, you might want to take a closer look.

Paul Garside, CFE, is a partner with the Vidocq Group in Montreal, Quebec. His email address is: paul.garside@groupevidocq.com.

Tim Harvey, CFE, JP, is director of the ACFE's U.K. Operations and a member of Transparency International and the British Society of Criminology. His email address is: tharvey@ACFE.com.