How To Spot A Stock Scam, Part 2: Selecting And Setting Up The Pump-N-Dump Target

by: Retired Securities Attorney

In this article, I'm going to continue to alert readers in how to spot a typical pump-n-dump scam. Part 1 here. It focused on the promotion aspect of a pump-n-dump. Part 2 is about the mechanics of selecting and obtaining a stock for a pump-n-dump and starting the setting up of the pump-n-dump.

This part is out-of-time order. Before you pump the stock (step 1), you have to own enough of the right stuff to make it potentially profitable.

The key players are: scammers, sellers of shell companies, stock promoters, transfer agents, broker-dealers, attorneys, and auditors. The SEC recognized this when it issued a press release July 2 announcing the formation of the Microcap Fraud Task force:

The Microcap Task Force

The Microcap Fraud Task Force will investigate fraud in the issuance, marketing, and trading of microcap securities. These abuses frequently involve serial violators and organized syndicates that employ new media, especially websites and social media, to conduct fraudulent promotional campaigns and engage in manipulative trading strategies to amass ill-gotten gains, largely at the expense of less sophisticated investors. The principal goal of the Task Force will be to develop and implement long-term strategies for detecting and combating fraud in the microcap market, especially by targeting "gatekeepers," such as attorneys, auditors, broker-dealers, and transfer agents, and other significant participants, such as stock promoters and purveyors of shell companies.

This article is essentially about how the scammers set up the pump-n-dump. You need to know this in order to know where the stock being pumped is vulnerable. You'll also need to know what is going on behind the scenes so that you can recognize the symptoms of these activities. If you want to play a pump-n-dump from the long side, it's best to get in before the pump starts. These are preliminary steps in setting up the pump, which have symptoms you will be able to detect. Then you can research looking for other symptoms. Symptoms are the subject of my next article.

First, you may have noticed that I used a different order than the SEC in listing the gatekeepers the SEC will be targeting. The SEC listed them in the order in which it thinks targeting them will have the most impact. Like the IRS, some at the SEC believe that attorneys and accountants have the most to lose -- their licenses to practice -- and make the best headlines in the press, so going after them will have the most impact. I don't agree.

The role attorneys play is minimal. Often, the scammers know as much about the fraud law in this area as the attorneys do. This area of the securities laws is very narrow, and the scammers have generally had a lot of experience evading the anti-fraud provisions of the state and federal securities laws. The attorneys the scammers use, on the other hand, are, by design of the scammers, not sophisticated securities lawyers. They are need to take the information provided by the scammers and the accountants without asking too many questions and file the necessary documents with the SEC. As far as written contracts go, different attorneys or no attorneys at all will often be used to prepare them. The reason is that they tend to be too enlightening.

The attorneys are also needed for a routine form of opinion of counsel, which can be bought for a few hundred dollars, and which is usually completely inaccurate anyway. True, sometimes the attorneys are among those orchestrating the scam, but then they can be targeted for perpetrating the fraud themselves, whether they are attorneys or not.

The role auditors play is also minimal. These scams do not usually depend upon cooked books. The scam goes off quite well with an audited financial statement saying that it is doubtful that the company will be able to continue in business. After all, the scammers are selling the hype, not past results.

On the other hand, the market makers (broker-dealers) and the transfer agents are essential to any successfully orchestrated pump-n-dump. They are both key players. And they are local and known. If you start putting a few of them in prison, you will put a severe crimp in the pumping-n-dumping. The purveyors of shell companies are often transfer agents or broker-dealers who have acted as market makers for the shell company. If they are not, they are either scammers themselves or merely middlemen. Unless the scammers can find a usable shell company, there will be no scam. So let's look at the first step in creating the pump-n-dump -- finding a usable shell company.

What is a shell company? It's a publicly traded company without any business. An empty shell. Usually, it was once a real business that didn't make it and stopped operating. It may or may not have filed bankruptcy. After a while, it doesn't matter since the statute of limitations bars any attempt to collect unpaid debts.

Who owns it? Well, that depends on what the "it" is. Let's take a typical situation. I'm going to make one up from nothing but imagination. Any relation to anything real is a pure remarkable coincidence.

A company in the business of selling chocolate is founded by two brothers, Sam and Tony. They call it Chocolate King. They open a store in Manhattan and do well. They open three more in the outer boroughs. It's working and they are making money. They decide to go big. Philadelphia, Baltimore, Boston and who knows, maybe Abu Dhabi one day. They go public. They sell 100,000 shares at $10 a share and keep 900,00 shares. Now they have $850,00 after commissions and expenses to spend; and they spend it. Oops. They go broke. They can't manage chocolate stores this far away. Managers steal (it's a cash business) and don't much care like Sam and Tony do. They can't pay their bills and close the stores, one by one. The stock falls to a penny. Some days it even trades. Some people will buy anything.

At a penny a share, it's too expensive to pay transfer agent fees even at a small fraction of a penny. The stock winds up accumulating at the market makers in street name.

Street name. That's important. These are stock certificates registered in the name of a seller. This may be the last seller; or it may be the seller who sold the stock ten years ago to John, who sold to Mary, who sold to Louise, who sold to ABC market maker. They are registered in John's name with a power of attorney authorizing someone to transfer the stock on the company's books and records. The "someone" is a line on the form, which is blank. So anyone who buys the stock, and gets delivery of the stock certificate this way, is getting, in effect, a bearer instrument, that is, an instrument owned by whoever happens to have it in his grubby little hand. What's his name? I don't have to tell you. I don't want to tell you, and I ain't gonna tell you.

Since the company is broke, it isn't paying the contract fees to its transfer agent. So when the stock comes into the transfer agent for transfer on the company's books to Archie, the transfer agent doesn't transfer it. Maybe it asks Archie for the money and he doesn't respond; or maybe it just sits on it. For a penny a share, nobody much cares, and the transfer agent winds up in possession of a whole lot of the previously publicly issued stock.

Remember Sam and Tony -- the chocolate kings of Manhattan? Sam is now working at a pizza place and Flipper finds him. Sam doesn't want to talk about chocolate. But for $1000, he'll be happy to sell you his whole interest in Chocolate King. For $500 more, he'll also deliver his brother's half (after all, a guy has to pay his bills). But he has no idea what happened to the stock certificate. No problemo. Just sign this lost or stolen affidavit here (in front of the notary lady here) and we'll take care of it for you. Here's fifteen hundred dollar bills. What's my name? Oh, you can call me Joe.

Now it's off to the transfer agent. Joe's dealt with him before. He'll reissue Sam and Tony's controlling block of stock to Joe's nominees -- any name Joe tells him to. Now I, or William P. Sturgis (a fake identity Joe bought online for $500) own 90% of Chocolate King. The transfer agent also has 9% of the remaining 10% in a cardboard box. It's in street name. This costs more. It's the stock Joe will fraudulently sell after the pump. How much does it cost? They negotiate. Of the 90,000 shares, the transfer agent has, he wants to keep 10,000. After a 300 for one stock split, and a pump to 10 cents a share, that 10,000 would be worth $300,000. That's too much. After all, Joe's got expenses. They settle on 1000 shares. Joe walks away holding 98% of Chocolate King for which he paid a grand total of $1,500 (not counting subway fares and notary expenses). And just maybe he can get it all the way to $1.00. But 5 cents will do just fine. His 90,000 shares become 27,000,000 shares after a 300 for one stock split; and at a nickel a share, that's $1,350,000.

This is only one of many scenarios of how the scammers get the shell. I picked it to start with because it's kind of a fun story. There are many others.

But enough for now. Now we have a shell, complete with street name stock. What next? More setup. And symptoms. That's Part 3.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.