A look at how micro caps can be manipulated
The U.S. Securities and Exchange Commission defines micro caps or penny stocks as shares that have a price of less than $5, but they often trade at just a fraction of a cent.
The price of penny stocks can be more readily manipulated because the stock is thinly traded and allows for volatile price swings. It is also subject to less regulatory scrutiny than shares traded on notable exchanges.
Large blocks of penny stock are typically controlled by a small group of individuals, which enables perpetrators of fraud to orchestrate manipulative trades in the stock.
Insiders who want to commit fraud first have to form a business entity, typically with a nominee director or CEO. At this stage, the shell company will have minimal or no business activity and revenue.
To issue new securities in the U.S., the company must file form S-1 with the SEC. Perpetrators of the scheme must file a bogus business plan outlining the business model and the planned use of the offering proceeds, offering price and material business dealings between the company and its directors and outside service providers, such as legal counsel and auditors, whose reports are required for the filing.
The first shares are sold in a private transaction. They are restricted, meaning they cannot be sold to the public for a specific time period unless they are exempt from SEC registration requirements, set out in SEC rule 144.
Even if all the conditions of Rule 144 are met, the restricted securities still cannot be sold to the public until a restrictive legend, stating that the share is not for public sale, is removed from the certificate.
This can only be done by the stock transfer agent, who will remove the legend only if the issuer consents, generally with an opinion letter from the issuer’s legal counsel addressed to the transfer agent.
- To retain control of the shares, perpetrators of stock fraud will issue the shares to a group of nominees who never effectively take possession of the stock certificates.
- The insiders will set up offshore accounts in the name of corporate entities to anonymously hold the free trading stock.
- To trade the shares publicly, the scheme requires a broker who clears the shares on behalf of the offshore entities using its own account.
The company used for the scam then undergoes a merger, an acquisition, a name change or another kind of corporate transaction, which is linked to a forward stock split to increase the number of shares held by insiders. This maximizes the potential profit if there are sudden upswings in the share price.
Pump-and-dump schemes then hype the stock to increase the share price with false or misleading press releases, SEC filings and other statements – for example, the purported purchase of a mining plot, the potential acquisition of a company or any other potentially value-increasing transaction.
The schemes often use stock promoters who attempt to push the stock price with telemarketing and aggressive “boiler room” sales techniques, mass email campaigns or paid-for favorable blog and news coverage of the company and its stock.
The shares are then “dumped” on the public at inflated prices. The share price subsequently collapses quickly as it transpires that the company is effectively worthless and has no valid prospects of generating any revenue, let alone profits.
Penny stock scams do generate significant market activity because many of the outside investors are aware that the shares involved are subject to a pump and dump, but they invest nonetheless in the hope of timing the entry and exit of the investment correctly and catching the share price upswing before it collapses.
However, a considerable number of innocent, unsuspecting investors are also caught by the share price manipulation.