Penny Stock Scams

The problem with low value, low volume stocks is that they can be manipulated by those with enough money. A company worth billions of dollars requires an organization to manipulate it, a currency worth trillions of dollars requires a nation to manipulate it, but a company worth $20 million can be shoved around by a few rich people looking to make more money, or by some genius markets that can convince a few thousand people they can get rich quick if they buy shares of a specific stock.

Penny stocks have their advantages and they have a place in both the stock traders and stock investor’s arsenal, but you need to know the common penny stock scams so you can watch out for and avoid them. Too many people make their penny stock fortunes by exploiting these scams, and shorting other investors.

Pump and Dump

Probably one of the most famous, and most fallen for, types of penny stock fraud is the pump and dump. In this scheme a thinly traded, unknown penny stock is hyped. The hype starts to send the stock price up and create more interest in the stock, making investors think this is the real deal. Then when the stock starts to take off and increase in price — because it goes from nearly zero buying activity to a significant amount virtually overnight — the stock pumpers start to sell their shares at an inflated rate. When their shares are gone they stop marketing the stock and buy a new unknown stock to start the scam again. Meanwhile the price of the stock they promoted then sold plummets, leaving the remaining investors with stock that is worth a fraction of what they paid for it.

The most popular means of marketing this scheme is via internet sites, forums, email campaigns, and phone calls that are, sadly, sometimes geared at the elderly.

Chop Stocks

Chops stocks are stocks that are bought off the market for pennies on the dollar. These stocks are usually sold to foreign “investors” under Article S of Securities Act of 1933 which allows foreign investors to buy stocks without the regulations required of US investors. These stocks are usually sold by insiders who need to move a large number of shares without dumping the value of the company. The foreign owners sell the stocks to US brokers who sell the stock on the market for the given price or slightly less. The brokers and the foreign investors split the profit and it never has to be reported to the new owners which may indicate to investors that the stock is worth less than the current market price.

The worse part of chop stocks is in order to move the larger than normal volume of shares in this equity the brokers are paid a premium commission to push the stock on willing investors (suckers). When your broker profits excessively from your purchase they break the trust of advice which is part of value in their commission. This loophole still needs to be closed.

The Businessweek article INVESTORS BEWARE: CHOP STOCKS ARE ON THE RISE mentions how organized crime buys rule 144 stock usually issued to inside employees, which legally has to be held for two years. The stock literally mentions that it can’t be sold on the market until a given date, yet since these transactions are mainly electronic no one ever sees the physical stock. They then sell the stock, via Article S, back to the brokers. In some cases these chop stocks are literally funding organized crime in the 21st century.

Bait and Switch

Another tactic of unscrupulous brokers is to offer incredible promises in their marketing material and then when you arrive to make the purchase they will tell you the window of opportunity has passed, but you should consider XYZ now. In normal products this is called false advertising, in investing it still passes.

Be careful when you choose a broker. Search for reputable online stock brokers or a reputable local broker.

Buyer Beware

When it comes to penny stocks you must do your own due diligence. Brokers and financial advisers literally can’t be trusted for individual stock recommendations in the microcap world. Use your advisers to determine how penny stocks fit in your overall investing plan, but make your own picks and always keep an eye on these stocks until the day you sell them.