Internet fraud has exploded over the last several years, and a tried and true securities fraud known as the "pump and dump" is one reason for its growth. We know it exists because we all have received those spams that interrupt us at home, at work, even on our cell phones. The spams go something like this – "get in on the ground floor … we have found a company that is going to be the next Google," or better yet "it has a product that can turn garbage into energy." These spams typically contain outlandish price projections like "watch this hot stock to go from $0.25 to $5.00 over the next week." Following these claims, there’s almost always an increase in price and volume followed by a steep decline.
Why should brokerage firms and their compliance departments care? These schemes are not perpetrated by their employees …. Well, to sell these illegally pumped shares a brokerage account is needed and this places firms in a position to observe this illicit activity. If it is permitted to occur in an account with any frequency, a firm may become a facilitator of this activity and may incur liability under the Securities Act of 1933 or the Securities Exchange Act of 1934 for participating in an illegal distribution. This kind of selling activity usually raises anti-money laundering issues, too. But, the worst fears for firms may be that the illicit activity occurs with enough frequency and pattern to impute notice or knowledge of and sufficient evidence to support a charge of aiding and abetting in a fraud scheme.
The SEC has actively pursued pump and dumps for years and has brought a significant number of successful prosecutions against primary violators. It appears, however, that the SEC and other regulators now may be giving broker-dealers who facilitate this activity a closer look. In November, for example, in a conference in New York, securities regulators warned firms to shape up their anti-money laundering compliance, complaining that many firms have been failing to collect proper identifications, keep records, and to have and follow procedures. Indeed, NASD recently settled such a matter against a major brokerage firm for $3 million. And as recently as April 11, 2007, the SEC has brought its first case against a broker-dealer for failing to timely file suspicious activity reports (SAR reports). The SEC also charged the firm and a principal for ignoring "red flags" that supported an aiding and abetting fraud violation (Release No. 34-55614). A senior SEC official commented that this action demonstrates the SEC’s "intent to hold all responsible parties liable for their roles in victimizing investors through pump-and-dump schemes."
Liability for facilitating suspicious selling activity arises because the securities laws obligate brokerage firms and their registered representative to investigate to prevent their clients from violating the securities laws. Section 5 of the 1933 Securities Act prohibits sales of securities unless a registration statement is in effect or an exemption from registration is available. When an account receives a large block of a thinly traded security and subsequently unloads this position while it’s being touted over the Internet, the concern raised (leaving aside fraud concerns) is whether this seller is engaged as an "underwriter" in an unregistered distribution of shares and thus not entitled to an exemption. The definition of an "underwriter" is broadly defined under the Act and appears to apply to our "seller."
The SEC has been concerned about this type of illicit selling activity dating back to 1960’s when the Internet was not even an idea. It has repeatedly warned in releases that greater scrutiny needs to be given when a substantial block of an unseasoned security is sold by a customer into the secondary market within in a condensed period of time without the benefit of registration. The SEC has noted that under these circumstances, a broker should make a searching inquiry to ensure that those securities do not come from the issuer or persons controlling the issuer, or a stock promoter. See Distribution by Broker-Dealers of Unregistered Securities, Release No. 33-4445, (February 2, 1962); and Sale of Unregistered Securities by Broker-Dealers, Release No. 34-9239 (July 1, 1971). It is also well settled that the burden rests with those who claim to be entitled rely on an exemption.
When "red flags" are present a broker must find out the following: what is the source of the shares to be sold, under what circumstances were they acquired and from whom? The purpose behind these questions is to determine whether the seller is an issuer, a person in a control relationship with an issuer, an underwriter or is benefiting from an illicit stock promotion. Here are some activities that may be considered "red flags" and require a more in depth inquiry:
- A large block of unseasoned stock is deposited into the account;
- Stock is a thinly traded security prior to substantial selling activity in the account;
- Seller has multiple accounts at the firm or on the street;
- Substantial stock promotion is timed with the selling activity;
- Account is held by an offshore entity or customer and is often a seller of blocks of shares in a company with a weak financial condition;
- Seller has a disciplinary history with securities regulators;
- A pattern of transfers of low priced shares have been deposited into the account;
- Significant wire transfer activity in the account, particularly following the sale of substantial shares;
- Wire transfers to offshore accounts
These are also many of the same red flags that would a trigger an anti-money laundering review. See NASD Notice to Members 02-21.
Although the Internet has become an effective tool to perpetrate these scams, it is an equally effective tool for a brokerage firm to conduct a more in depth inquiry. For example, the Internet may be used to learn more information about a suspicious seller: Google the seller, his address, telephone number. Compare this information with that of the company to see if a relationship exists. Google the company’s address – you may be surprised by what you learn. You may learn that the company’s home office is truly a home!
Review the seller’s account and check the trading activity of the companies held in the account to see if they trade like pump and dumps. Google the company’s name and/or trade symbol to see if there is Internet promotion. Do the same for the other holdings in the account. Use the SEC’s Edgar database and run a search of the seller’s name to see if he has any involvement with other suspicious companies or has a regulatory disciplinary history. What are the chat rooms and bulletin boards saying? Research the company through its SEC filings or information contained on the Pinksheets (www.pinksheets.com). Is your seller mentioned? Was the company involved in a reverse merger just prior to your seller unloading his shares? Use Google Earth to see if the company has the operations that it claims. What does the company say it is worth and compare that to its public claims?
These are just a few examples of investigative techniques that a compliance officer and/or registered representative may use from their desktops. A record of these inquiries should be maintained to show the regulators. A firm may not be right if it undertakes these steps, but evidence of a reasonable inquiry will at a minimum mitigate a firm’s problems. An active review for this type activity should help a compliance officer sleep better in knowing that he has helped protect the investing public from "pump and dump" scams and his firm from regulatory exposure.
David Katz is a former Director of fraud surveillance for the Market Regulation Department of the NASD and a partner of Petillon, Hiraide, Loomis & Katz specialising in Securities Regulation.
For more information on this subject or any questions relating to the article please contact the author directly and/or Petillon, Hiraide, Loomis & Katz
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
