Phone Hucksters Target Micro-Cap Stock Investors

"You've got to understand," said the voice on the other end of the telephone. "Typically, I don't make these types of calls. I've got people to do that. I've got 11 years in this business and worked my way up to senior vice president with 400 clients and $40 million dollars under management. I don't need this account, but I want it."

The caller was attempting to close a deal for an unknown micro-cap stock by trotting out some of his most impressive facts. But it was all a lie. In fact, he had been on the job for less than a month and was reading from a script supplied by his employer.

"Perhaps a return of 100 percent in 20 minutes sounds a bit unrealistic," he continued, reading from another script. "But that's exactly how all our initial public offerings trade. We did three deals last year yielding collectively 34 points within the first ten days of trading. That's a fact! All I ask for is your vote of confidence this one time. I won't let you down."

Taken from an actual script seized by state securities examiners in February 1997 from an Investors Associates boiler room in New Jersey, these words encapsulate the danger faced today by investors who purchase shares of stock in unknown companies over the phone from people they don't know. Although the companies are all small, it is not their size that is dangerous, but the dishonest way that the stock is manipulated and sold. Unfortunately, far too many investors are falling for the lure of this latest trend in boiler room scams. And the telemarketers, playing upon people's desire for ever-greater financial returns, have been running away with millions of dollars of hard-earned money.

Among the victims: An 85-year-old Washington man was persuaded to transfer over $75,000 worth of "blue chip" stocks to one of the targeted firms. The agent then sold all but $10,500 worth of these "blue chip" stocks without his the victim's knowledge or authorization. An elderly Connecticut man who was swindled out of $40,000 and suffered a stroke that his wife claims was directly tied to the loss. A 78-year-old Missouri man, who purchased $6,000 worth of stock, then was charged with $24,000 in six unauthorized trades, leaving him with $350.

The States Take Action

In response to a growing pattern of investor complaints against a number of small broker-dealer firms with headquarters in the metropolitan New York City area, the Board of Directors of the North American Securities Administrators Association, Inc. (NASAA) authorized a special project in late fall 1996. The mission of the special project was clear: To address the problem of fraudulent sales practices in the micro-cap marketplace.

In January 1997, NASAA President Mark J. Griffin created a strike force comprised of representatives from 12 states. The strike force was divided into five teams, each targeting the headquarters of a particular firm. In addition, branch offices in several other states were also scheduled for coordinated audits.

In late February, the teams struck without warning. Their examinations revealed four systematic abuses. They include:

• Evasion of broker-dealer registration requirements. Stockbrokers and the firms that employ them are required to register in the state in which they do business. This requirement serves an important purpose: To allow state securities officials to monitor the activities of the firms in order to ensure compliance with laws designed to protect investors. When a broker-dealer or its representative is not registered, that's a sure sign that something is wrong.
• Failure to report investor complaints. Most of the offices failed to have centralized procedures for handling and reporting customer complaints. Examiners found forms to respond to unauthorized trade complaints with blanks to be filled in with the name of the stock, its value, and the reason for the unauthorized trades. At several firms, complaints were found stuffed in customer complaint files, inquiry files, correspondent files, and stock jacket files. One firm's branch office had reported only one complaint to the NASD since July 1, 1996, yet over 90 complaints were recovered on-site by examiners. Another firm had no complaints on file with the NASD, but state officials found over 300 complaints throughout the office. The following pattern of abuse emerged: After receiving a complaint of an unauthorized trade, a registered representative called the investor and convinced that person to hold onto the trade. The investor was requested to fax a note that indicated the unauthorized trade was accepted. If the investor later changed his or her mind, the rep claimed otherwise. Records of unreported settlements were documented as "clerical errors" without any back-up documentation.
• Abusive cold calling practices. All of the firms and branches relied on high-pressure, scripted telephone "cold calling" practices. Many were classic boiler room operations with long tables and up to seven phone stations per table. At one firm, all the cold callers were on the first floor without any supervision. They "qualified" clients by determining their market assets and interest in the stocks that the firm was pushing. Average pay for cold callers is $200 per week.

 "I sense you like to make money and you think it's a compelling buy, but I think there is another factor here. A psychological comfort factor... I'm a stranger asking you for an order. Let me address that because it's our biggest problem. It's like the first kiss. We're not day traders. We position stocks for the long term." (From a script found during the sweep.) 

• Sales practice abuses. Victims report unauthorized trading at all of the firms. Firm and branch records appear falsified. Customer account forms were marked with the number of the registered rep whom the clients insist they never spoke to or traded with. Failure to execute sell orders (no commission is paid on a sell order and there is no market until the next victim is found), unsuitable recommendations, and other unethical practices were common customer complaints. At one firm, a review of a thousand customer accounts showed that all of the clients had bought only one or two stocks - stocks that only that particular firm was selling to the public. At a time when the Dow Jones Industrial Average was being driven by the S&P 500, these firms' clients were selling stocks in unknown micro-cap companies.  

A Changed Marketplace

In the late-seventies and early 1980s, so-called "penny stock" frauds were rampant in Colorado and Utah until state securities officials moved in and shut them down. Although the scams of today are similar to the swindles of that earlier time, there are significant differences.

The most obvious difference is the marketplace itself. Today, there are far more mid-income retail investors than ever. One in three U.S. households now owns securities, compared with one in 17 households in 1980. Products are more sophisticated and choices have multiplied. Due to the growth of 401(k) plans and other self-directed retirement programs and fears about the future of Social Security, people are encouraged to be more "aggressive" in their investments. The marketers of the most legitimate firms down to bottom-dwelling perpetrators of fraud are singing the same siren song: "You've got to be in the market or you're going to be left behind." The message is everywhere. It's hard to pick up a magazine or watch television or listen to the radio without hearing advertisements for mutual funds or other securities products.

There has also been a general assault on regulation as portions of industry, some elected officials, and large sectors of the media question its effectiveness. Intertwined with the current bull market is an undercurrent that declares state licensing procedures inefficient and a tax on capital. Unfortunately, this rhetoric helps provide the necessary cover for scam artists.  

To avoid becoming a victim...

1. Ask your state securities agency for help. When a securities industry representative contacts you, particularly if you do not know this person or have not heard of the firm, you must call your state securities agency in order to learn more about the caller and the firm. The simplest inquiry is to ask if they are registered to do business in your state. But you should also ask about the record of the firm and its representative. Are there any past disciplinary events? Are they subject to past complaints? Are they under active investigation? Are there other customer complaints in your state against this firm or agent? The majority of this information is available if you only ask.
2. Ask questions. Even if everything checks out with the state, don't rely on a company's glossy brochure. You need to ask about the investments themselves. Where is the company traded? Is it listed in the stock tables printed in your local newspaper? Investigate its trading history. Make phone calls. Find out more about it. Ask the salesperson - who is making a market in the stock? Who else is buying in your area? Is the salesperson's firm making a market in this company? The reason you want to ask is that they might be the only market maker. And they might be using cold calling techniques to create a buy demand for a stock that insiders will sell when the price is driven high enough.

 Send copies of your complaints to regulators. When you have problems with a firm, send a copy of your complaint to the Department of Financial Institutions Securities Division as well as the NASD. Examiners in the February sweep found hundreds of complaints that individual investors wrote to the firms that were never passed on to regulators. If you call to inquire about a firm, and a previous customer complaint never made it into the system, you won't be protected. So don't forget to send a copy of your complaint to the regulators as well.

 For more information...

If you suspect that you may be the victim of investment fraud, call or write the Washington State Department of Financial Institutions Securities Division. 

The Department of Financial Institutions
Securities Division
PO Box 41200
Olympia, WA 98504-1200
Or call
1-877-RING DFI (1-877-746-4334)
or
360-902-8760