Beware of the Boiler Room: Pump & Dump Schemes Explained

The term pump and dump is not a widely known term outside of securities enforcement, but some of the names are more familiar. Stratton Oakmont and Jordan Belfort of Wolf of Street fame, Benjamin Conde and Power Traders, Rooney Pace, AR Baron and the granddaddy of them all, Bob Brennan and First Jersey Securities. Brennan introduced the world to stock boiler rooms, which have continued to be a blight on the securities industry ever since.

Pump and dump schemes involve thinly traded penny stocks that are held by unscrupulous broker-dealers through nominees who push stocks on unsophisticated investors, drive up the share prices and then sell at inflated prices that cause the stock value to drop significantly.

On a recent episode of the Fraud Eats Strategy podcast, we discussed Pump and Dump schemes with former Wolf of Wall Street prosecutor and current Gibson Dunn litigation partner Joel Cohen.  Joel was nicknamed by Forbes magazine as the Wall Street Wolfhound after his successful prosecution of Jordan Belfort. 

Pump and dump schemes entail insiders from the stock boiler room getting people to act as nominees to acquire large amounts of thinly traded stock on their behalf. Unscrupulous broker-dealers will appoint nominees, typically people that they're close to, and ask them to control shares of the company. What makes these thinly traded small-cap stocks so attractive to pump and dump scheme fraudsters is the fact that a lot of new companies are built on one idea, the so-called monoline businesses. They have one product or one idea that the business owners think is going to break through. It is important to note that most companies created on micro-cap, small-cap exchanges are legitimate companies. They may not be good investments, but they are legitimate investments.  Manipulators prey on these marketplaces is because those flashy ideas are a nice introduction for unsophisticated investors who think that they can make a quick buck. Single idea companies are easy to explain, and some unsophisticated investors believe that's the way that money is made quickly. It fits in well with a narrative. A manipulator must make as many sales as possible in a short period. That then causes the stock price to go up rapidly. Many micro-cap stocks value at pennies per share. A surge in demand enables them to manipulate the stock prices easily, a movement of just a few pennies can make a huge difference in the trading price of the stock. Then these unscrupulous broker-dealers can try to take advantage of the marketplace.

The fact that there are nominees controlling a large percentage of the stock on behalf the broker dealer is not readily discernable to outside investors. By getting relatively unsophisticated investors to buy the stock in a short time, the stock price goes way up. Once the now inflated share price has reached its peak, the nominee shareholders all sell their shares at the same time at an artificially inflated price before the price plummets. Then the rest of the investors are stuck holding the stock that has little to no share value once the broker-dealers secretly obtained the value of what the nominees sold at a higher price before anyone knew what happened.

Some pump and dump schemes are built around initial public offerings and are even more potentially lucrative to the fraudsters. When a legitimate company goes public, reputable, established investment bankers are backing that company by researching its prospects and then representing to the investing public that this looks like a legitimate long-term investment. They let them know founders of the company will share some of their ownership by selling shares in the company to investors. That model has been the bedrock of the securities investment world for decades in the United States since the early 20th century. When a company is taken public by a major Wall Street firm, they put their name behind the company going public, which conveys a level of credibility that this is a good investment backed by an investment bank. Boiler room operators take advantage of that expectation. When a boiler room takes a company public, everything looks the same except that the broker-dealers aren’t working with experienced investment banks. They have also not performed their due diligence or researched the underlying prospects to see if the company is solid. 

There are ways to sniff out a boiler room operation that is running a pump and dump scheme. Individual investors have access to public resources and can check the reputation of an individual registered rep and the broker-dealer promoting the stock. . More information is available to investors now than there ever has been. There are reliable databases maintained by the SEC, NASDAQ and the New York Stock Exchange. Also, most U.S. states have securities investor protection programs or an Attorney General's office that can provide information about known scams and scam artists. There are also international sources that provide information from various sources about people who prey on investors. One useful piece of information is that you can check are disciplinary records for individual registered representatives to see if they have ever been disciplined for misrepresenting or deceiving investors. Those same resources can tell you if the rep has bounced around from one unknown broker-dealer to the next and if they've ever been suspended or prohibited from selling securities for a period which is a pretty good indicator that they should be avoided. 

Fraudsters pushing valueless stocks on unsuspecting investors try to create a sense of urgency in their victims. They make them think that they must act quickly, or they will miss out on an opportunity of a lifetime. This a proven technique that all fraud schemes rely on. Deciding under time pressure often means suspending good judgment and acting on impulse. When someone comes to you with something that has been described as a great opportunity, take a deep breath, think about it and slow down. If it sounds too good to be true, it probably is. Take a little time to look into it. an investment opportunity that’s worth anything rarely has to be acted upon within a matter of minutes or hours. It doesn't work that way. If it's worth something today, it's going to be worth something tomorrow. And if you slow down, do your research and look online, you will find indications of prior disciplinary actions, previous pump and dump schemes, or other stock manipulations and current victims readily discoverable with a little bit of work.

To hear the full Fraud Eats Strategy podcast episode with Joel Cohen, click here. https://podcasts.apple.com/us/podcast/the-wall-street-wolfhound-explains-pump-dump-schemes/id1527816335?i=1000501076268

Note: The postings on this site are my own and do not necessarily represent FTI Consulting’s positions, strategies or opinions