Same Scam, New Medium

By Jay Perlman
Fool Associate General Counsel

(Dec. 16, 1999) -- On Wednesday, December 15, 1999, the U.S. Securities and Exchange Commission (SEC) and the United States Attorney for the Central District of California announced that it had charged three individuals with manipulating the price of NEI Webworld, Inc. (OTC: NEIP) by posting false information about the company on Internet message boards.

Beginning in November, the three individuals, all of whom were in their 20s, bought approximately 97% of the company's stock at prices ranging from $0.05 to $0.17 per share. After opening around 50 accounts with Internet message board services, the individuals posted more than 500 messages stating that NEI was an imminent takeover candidate. This information was completely untrue. Though NEI was in bankruptcy, messages claimed the company was a "fast mover" with a target price of "$5-$10" per share. The messages fueled investor interest and caused the stock price to go from $0.13 to a high of $15 between November 13 and 14. On November 15, the individuals sold their stock, securing profits of approximately $364,000.

This is not the first time something like this has happened. In April of 1999, an employee of PairGain Technologies (Nasdaq: PAIR) posted a message claiming that PairGain would be acquired by an Israeli firm. The message then provided a link to a completely fabricated Bloomberg News website that contained the details of the purported deal. PairGain's stock price increased about 30% in a matter of hours before the hoax was exposed. Ultimately, the individual pled guilty to securities fraud charges.

These two cases illustrate the concerns The Motley Fool has about penny stocks and Internet message boards. Penny stock scams have evolved from the traditional boiler room operations of the 1980s to the cyber boiler room operations of the late 1990s. In both cases, the scheme is the same -- run up the price of a penny stock, lock in your profits, dump the stock, and move on. It's the same scam, just a new medium. How do you avoid getting burned? Let's first look at what's behind the pump-and-dump scheme.

In the traditional pump-and-dump scheme, cold callers painstakingly went through lead lists or phone books harassing investors to purchase penny stocks by making claims that the investment was a "once-in-a-lifetime opportunity." The Internet, and specifically message boards, have resulted in schemes being taken online. These cyber boiler rooms don't require much overhead, and, with one click of a mouse, con artists can reach millions of potential investors from the comfort of their own living rooms.

Whether online or off, the targets are often over-the-counter (OTC) penny stocks. Why? Most OTC penny stock companies do not have to file annual or quarterly reports or audited financial statements with the SEC. Because they don't have to file these reports, there is a lack of unbiased information about the company in the market place. In many cases, the only information about these companies that is available to investors is the information on Internet message boards.

Additionally, because penny stocks have low prices (below $5, and usually below $1), it's very easy to gain control of a majority of the stock, and it can be done cheaply. Once these con men get control, they disseminate false information about the company, causing the price to rise. Investors who see the price rise jump on the bandwagon, causing the price to rise even more. At that point the con artist sells, walking away with a handsome profit, causing the stock's price to collapse and leaving innocent investors holding the bag.

Because of the lack of unbiased public information about these stocks and the fact that they are easy to manipulate, The Motley Fool hates penny stocks! In fact, we won't even open message boards to discuss penny stocks. We, too, are aware of the stories about people getting in on the ground floor of a start-up company and becoming a millionaire when the stock goes from a few pennies to a few dollars. Yet the reality of the situation is that those cases are the exceptions rather than the norm. The risks of investing in penny stocks far outweigh the benefits.

How should you treat information you see on Internet message boards? Treat contributors to the message boards the same way you'd treat anyone you had met for the first time at a party. You shouldn't make an investment just because some stranger (or even a friend) talks it up; you shouldn't treat cyberspace any differently.

The fundamental concept is that you should NOT rely on the information or opinions you read. Rather, you should use what you read on the message boards as starting points for doing independent research on companies and investing techniques. Then judge for yourself the merits of the material that has been shared. The key is to do your own research and make your own decisions.

[For more, read "Buy ZEIGLETICS!" -- one of The Motley Fool's first shots at penny-stock hype.]