Securities Fraud
Penny Stocks

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Securities Fraud

By Jay Perlman (TMF Jay)
February 23, 2000

As the bull market continues to rage, there are more and more stories about people who put a few thousand dollars in a stock and watched their investment soar to tens or even hundreds of thousands of dollars. For some investors, this translates into pressure to find the next "hot stock."

Unfortunately, an increasing number of people think the "hot stocks" are microcap or penny stocks. After all, who can resist a sales pitch that begins by telling prospective investors that if they had bought Microsoft, Intel, Yahoo!, or eBay when they were fledgling companies with stock prices of a few bucks, they'd be multimillionaires by now. The allure of these millions is what has spurred the popularity of the microcap stock market. Let's first take a look at what the microcap market is, and then we'll give you our Foolish opinion.

A microcap stock, or penny stock, is defined as a stock whose price is less than $5 per share. Most microcap companies have limited assets (anywhere from a few thousand dollars to a couple million dollars), and most of the time their stocks trade a few thousand shares per day, or may go days without trading at all. In many instances, these are companies that have no history of operations or earnings, and their entire business is still in the idea stage.

Microcap stocks are usually traded in The Wild West of the financial world -- the over the counter bulletin board (OTCBB) and the pink sheets. The OTCBB is an electronic quotation system that allows brokers to enter price bid and ask prices (The bid is the price closest to the last transaction that buyers are willing to buy at. The ask is the price closest to the last transaction that sellers are willing to sell at). The pink sheets are updated daily by the National Quotation Bureau and are only available to subscribing brokers. Unlike other trading markets, like the New York Stock Exchange or Nasdaq, neither the OTCBB nor the pink sheets have a minimum listing requirement, meaning that stocks with prices of just a few pennies can get listed on the OTCBB or in the pink sheets.

So you're thinking of investing in a microcap company -- where and how do you find out more about the company? Good question. Any company that has more than 500 shareholders and $10 million in assets is required to file annual and quarterly reports with the SEC. These reports are integral to any investment decision since they contain information about the company, its management, its products, and audited financial statements. Most microcap companies do not have to file these reports with the SEC because they do not have the requisite number of shareholders or level of assets.

This lack of public information is one of the biggest reasons the microcap market is a forum ripe for fraud. Public information is perhaps the most important ingredient to making an informed investment decision. You can't do that if you don't have this information. Additionally, because most microcap companies have no operating or earnings history, there is usually no analyst or press scrutiny of the stock. The end result is that there is an absence of unbiased information in the marketplace. Because of this dearth of information, and because microcap stocks usually trade a few thousand shares per day if at all, they can be illiquid, or hard to sell. Thus, if you get in, you may have trouble getting out. Currently, there are approximately 6,400 companies on the OTCBB. That's a lot of companies floating around without the information investors need.

What do we at The Motley Fool think of microcap stocks? Our counsel on any company that you like is to wait for it to be valued by the market for at least $5 a share. Because of a penny stock's low price, it is very easy for a fraudster to gain control of the outstanding shares. Once a fraudster secures a large percentage of the outstanding shares, it becomes quite easy to artificially manipulate the stock's price. Penny stocks are the public market's own brand of lottery ticket -- the engine of financial dissolution among those who have not been educated about money.

Why, when they present such little opportunity to long-term investors, do penny stocks still attract attention? Many new investors will buy them up, not having been taught that bankruptcy and microcap companies travel arm in arm. Inexperienced investors may be attracted by the fact that they can buy many shares for little money. For example, if you were looking to invest your $2,000 IRA contribution, you could buy only 40 shares of a stock trading at $50 per share. However, you could buy 4,000 shares of a microcap trading at 50 cents a share.

The combination of the opportunity to hold large share positions and the appearance of unlimited upside draws scads of new investors into this most highly speculative form of equities. After all, if the microcap stock goes up just fifty cents (using the example above), the stockholder would double his or her money. Never mind that the odds are very remote that this penny stock will rise and then sustain its gains.

For all of these and other reasons, The Motley Fool warns against the dreaded penny stocks. We do not report on penny stocks, except to share horror stories. Though we will not open discussion boards for our community members to discuss penny stocks, we do present the unfortunate confessions of burnt microcap investors, which litter our "My Dumbest Investment" message board at Fool.com. Also, this FoolU article has some more Foolish perspective on penny stocks.

Recent news reports have noted that microcap fraud bilks investors out of approximately $2 billion per year. With microcap fraud on the rise, securities regulators and law enforcement agencies are taking steps to combat microcap fraud. Criminal prosecutions have increased and securities regulators are taking measures to close loopholes in the law that are exploited by fraudsters. In a major investigation began in 1995 by the FBI, the United States Postal Inspection Service, the United States attorney's office for the southern district of New York, the SEC, and the National Association of Securities Dealers (NASD), approximately 80 people have been convicted or pled guilty of securities fraud charges in connection with microcap fraud schemes. On a regulatory front, both the SEC and the NASD have taken steps that will require all OTCBB companies to begin filing reports with the SEC by June of 2000.

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