Tag Archives: stock fraud

The Versatile Microcap

A microcap is a publicly traded company whose stock might be worth only pennies, which causes its price to be volatile and thus easier for fraudsters to manipulate. Although CFEs like our Central Virginia Chapter members might not regularly come across microcap stock manipulation, it’s important for all of us to be aware of the methods and motivations behind this significant criminal activity. In this scheme, promoters and insiders, after cheaply purchasing a stock, typically pump up its value through embellished or entirely false news. However, as reported recently in the trade press, other fraudsters have successfully employed much more creative strategies in exploiting microcaps. Several articles and books have told of the involvement of organized crime, especially throughout the ’00s and ’10s, in this highly profitable illegal business.

Basic pump and dump schemes, also known as hype and dump manipulation, involve the touting of a company’s stock (typically micro-cap companies) through false or misleading statements to the marketplace. After pumping up the stock, scam artists make huge profits by selling or dumping their cheap stock onto the market. Today, pump and dump schemes have been updated and most frequently occur over the Internet, where it is common to see e-mail and other messages posted that urge consumers to buy a stock quickly or to sell their stocks before the price goes down. In some cases, a spam-call telemarketer contacts potential investors using the same sort of pitch. Often the promoters claim to have inside information about an impending development, or to have employed an infallible combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create. Once these fraudulent promoters dump their shares and stop hyping the stock, the price typically falls and investors lose their money.

In another recent but simple form of the micro-cap scheme, a caller leaves a message on a potential victim’s voice mail under the guise of someone who dialed the wrong number. Sounding as if they didn’t realize they had misdialed, the message contains a hot investment tip for a friend. However, the caller is actually a spammer, someone being paid to tout this stock on hundreds of cell phones. Those behind the scheme generally own some of the stock and hope to profit by pumping up the share price and selling off their investments.

Pump-and-dump schemes can be as relatively simple as the one above, or such as an individual or small group releasing false information in a chat room or insiders publishing inflated company information. Sometimes the business owners themselves 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 support and/or related marketing help. Or fraudsters, unbeknownst to the victim company, hijack their target company’s stock and falsely hype it, which often causes irreparable damage to the owners’ and to their business’ reputations. CFEs whose clients include small or new venture businesses should be especially cautious of unsolicited offers made to their clients to receive loans or to raise capital through microcap stock offerings. Criminals commonly target businesses in the pharmaceutical, energy or technology sectors, attempting to use their names and initial offerings to manipulate stock for profit.

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 emails. 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 hierarchy 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 1990s, 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.

The ability to manipulate microcap stocks with relative ease also makes the activity an ideal tool to hide payments between parties and launder money. 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 generate the 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 and securities regulatory authorities 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 exact 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.

With all this said, 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, in summary, if you, as a CFE, come across information relating to a microcap investment involving a case you’re working, you might want to take a closer look.

With regard to preventing investment fraud schemes in general … caution your clients:

• to not invest in anything based upon appearances. Just because an individual or company has a flashy website doesn’t mean it is legitimate. Websites can be created in a matter of hours and taken down even faster. After a short period of taking money, a site can vanish without a trace.
• to not invest in anything about which they are not absolutely sure. Do homework on an investment to ensure it is legitimate.
• to thoroughly investigate the offering individual or company to ensure legitimacy.
• to check out other websites regarding this person or company.
• to be cautious when responding to special investment offers (especially through unsolicited e-mail) by fast talking telemarketers. Know with whom you are dealing!
• to inquire about all the terms and conditions involved with the investors and the investment.
• Rule of thumb: If it sounds too good to be true, it probably is.

Empire Lost

marthastuart2Last week my wife and I were confronted with the challenge of  hosting a Christmas party for 24 of our relatives.  We thought we’d serve a standing prime rib roast to the guests and turned to a Martha Stewart Cooking School episode on PBS for preparation guidance.  Needless to say, the roast was delicious but seeing Stuart again after all this time got me thinking about her classic insider trading case of what now seems so long ago.

In June 2002, Martha Stewart began to wrestle with allegations that she had improperly used inside information to sell a failed personal stock investment to the unsuspecting investing public. That was when her personal friend Sam Waksal was defending himself against Securities and Exchange Commission (SEC) allegations that he had tipped off his family members so they could sell their shares of ImClone Systems Inc. just before other investors learned that ImClone’s stock was about to tank. Observers presumed that Stuart was also tipped off and, even though she proclaimed her innocence, the rumors would not go away. On daily TV as the reigning guru of homemaking, Ms. Stuart was the multimillionaire proprietor, president, and driving force of Martha Stewart Living Omnimedia Inc. (MSO), of which, on March 18, 2002, she owned 30,713,475 (62.6 percent) of the class A, and 30,619,375 {100 percent) of the class B shares.

On December 27, 2001, her class A and class B shares were worth approximately $17 each, so on paper her MSO class A shares alone were worth over $500 million. Class B shares were convertible into class A shares on a one to-one basis. What was not known was that Stewart had sold 3,928 shares of ImClone for $58 each on December 27, 2001.  This was not public until the information surfaced in June 2003.  The sale generated $227,824, and she avoided losing $45,673 when the stock price dropped the next day.  The whole sorry episode over this relatively small amount of money wound up causing her endless personal grief and humiliation, dealt a devastating blow to her reputation, and precipitated a punishing drop to $5.26 in the MSO share price.

As some of your probably remember, it turned out that Stuart had made an investment in ImClone, a company that was trying to get the approval of the U.S. Food and Drug Administration (FDA) to bring to market an anti-colon cancer drug called Erbitux. Samuel Waksal, then the CEO of ImClone and a friend of Stuart’s, was apparently warned on or close to December 25, 2001, that the FDA was going to refuse to review Erbitux. Per later SEC allegations, Waksal relayed the information to his family so they could dump their ImClone shares on the public before the official announcement. Martha claimed (and still claims) that she didn’t get any early inside information from Waksal, but regulators believed that she may have either gotten it from her broker or from her broker’s aide. The activities of several of Waksal’s friends, including Stuart all came under almost immediate investigation by the SEC.

Waksal was arrested on June 12, 2002, and charged with “nine criminal counts of conspiracy, securities fraud and perjury, and then freed on $10 million bail. In a related civil complaint, the SEC alleged that Waksal “tried to sell ImClone stock and tipped family members before ImClone’s official FDA announcement on Dec. 28.”  Per the SEC, two unidentified members of Waksal’s family sold about $10 million worth of ImClone stock in a two-day interval just before the announcement. Moreover, Waksal also tried for two days to sell nearly 80,000 ImClone shares for about $5 million, but two different brokers refused to process the trades. Stuart denied any wrongdoing. She was quoted as saying: “In placing my trade I had no improper information…. My transaction was entirely lawful.”  She admitted calling Waksal after selling her shares, but claimed: “I did not reach Mr. Waksal, and he did not return my call.”  She maintained that she had an agreement with her broker to sell her remaining ImClone shares “if the stock dropped below $60 per share.” Stuart’s viewing public, however, was skeptical. She was asked embarrassing questions when she appeared on TV for a cooking segment, and she declined to answer saying: “I am here to make my salad.”

Martha’s interactions with her broker, Peter Bacanovic, and his assistant, Douglas Faneuil, quickly came under scrutiny. Merrill Lynch & Co. suspended Bacanovic (who was also Sam Waksal’s broker) and Faneuil, with pay, in late June. Later, since all phone calls to brokerages are taped and emails kept, it appeared to be damning when Bacanovic initially refused to provide his cell phone records to the House Energy and Commerce Commission for their investigation. Then, on October 4, 2001, Faneuil “pleaded guilty to a charge that he accepted gifts from his superior in return for keeping quiet about circumstances surrounding Stewart’s controversial stock sale.”  Faneuil admitted that he received extra vacation time, including a free airline ticket from a Merrill Lynch employee in exchange for withholding information from SEC and FBI investigators.

Per court records:

“On the morning of Dec. 27, Faneuil received a telephone call from a Waksal family member who asked to sell 39,472 shares for almost $2.5 million. Waksal’s accountant also called Faneuil in an unsuccessful attempt to sell a large block of shares. Prosecutors allege that those orders “constituted material non-public information.” They also allege that Faneuil violated his duty to Merrill Lynch by calling a “tippee” to relate that Waksal family members were attempting to liquidate their holdings in ImClone. That person then sold “all the tippee’s shares of ImClone stock, approximately 3,928 shares, yielding proceeds of approximately $228,000.”

One day later, on October 5th, it was announced that Stuart had resigned from her post as a director of the New York Stock Exchange (a post she held only four months) and the price of MSO shares declined more than 7 percent to $6.32 in afternoon trading. From June 12th to October 12th, the share price of MSO declined by approximately 61 percent. Stuart’s future took a further interesting turn on October 15th, when Sam Waksal pleaded guilty to six counts of his indictment, including: bank fraud, securities fraud, conspiracy to obstruct justice, and perjury. But he did not agree to cooperate with prosecutors, and did not incriminate Stuart. Waksal’s sentencing was postponed until 2003 so his lawyers could exchange information with U.S. District Judge William Pauley concerning Waksal’s financial records.  After October 15th, the price of MSO shares rose, perhaps as the prospect of Stuart’s going to jail appeared to become more remote, and/or people began to consider MSO to be more than Stuart and her reputation. The recovery from the low point of the MSO share price in October to December 9, 2002, was about 40 percent.

Stuart still had a lot to think about, however. Apparently, the SEC gave Stuart notice in September of its intent to file civil securities fraud charges against her. Stuart’s lawyers responded and the SEC deliberated. Even if Martha were to get off with a fine, prosecutors could still bring a criminal case against her in the future. It is an interesting legal question, however, that if Stuart had simply pled guilty to the civil charges, would she have avoided criminal liability completely? On June 4, 2003, Stewart was indicted on charges of obstructing justice and securities fraud. She then quit as Chairman and CEO of her company, but stayed on the Board and served as Chief Creative Officer. She appeared in court on January 20, 2004, and watched the proceedings throughout her trial. In addition to the testimony of Mr. Faneuil, Stewart’s friend Mariana Pasternak testified that Stewart told her Waksal was trying to dump his shares shortly after selling her ImClone stock. Ultimately, the jury did not believe the counterclaim by her broker, Peter Bacanovic, that he and Stuart had a prior agreement to sell ImClone if it went below $60. Although the judge dismissed the charge of securities fraud for insider trading, on March 5, 2004, the jury found Stewart guilty on one charge of conspiracy, one of obstruction of justice, and two of making false statements to investigators.

The announcement caused the share price of her company to sink by $2.77 to $11.26 on the NYSE. Stuart immediately posted the following on her website:

“I am obviously distressed by the jury’s verdict, but I continue to take comfort in knowing that I have done nothing wrong and that I have the enduring support of my family and friends. I will appeal the verdict and continue to fight to clear my name. I believe in the fairness of the judicial system and remain confident that I will ultimately prevail.”

Stuart was subsequently sentenced to 5 months in prison and 5 months of home detention-a lower than maximum sentence under the U.S. Sentencing Guidelines-and she did appeal. Although she could have remained free during the appeal, on September 15, 2004, she asked for her sentence to start immediately so she could be at home in time for the spring planting season. Martha’s appeal cited “prosecutorial misconduct, extraneous influences on the jury and erroneous evidentiary rulings and jury instructions” but on January 6, 2006, her conviction was upheld.

Stuart may continue to disagree with the verdict to this day but there is little doubt that the allegations and her subsequent convictions had a major impact on her personally, and on the fortunes of MSO and the shareholders that had faith in her and in her company. Assuming a value per share of $13.50 on June 12th, the decline to a low of $5.26 in early October 2003 represents a loss of market capitalization (reputation capital) of approximately $250 million, or 61 percent. The value of MSO’s shares did return to close at $35.51 on February 7, 2005, but fell off to under $20 in early 2006. Per a New York brand-rating company, the Martha Stewart brand reached a peak of 120 (the baseline is 100) in May 2002, and sank to a low of 63 in March 2004.

As my wife and I can attest, Stuart has returned to TV with a version of her usual homemaking and design shows, her new Martha Stewart Cooking School and related books.  Her products and magazines continue to be sold.  Still, what a catastrophe for so many to save just $45,000.