The Truth Behind Penny Stock Spam
A deluge of e-mail come-ons puts gullible investors at risk while the government does little to stop it.
Promoters of penny stocks typically pitch these high-risk investments as if they were valuable real estate, like oceanfront property. With little money down, you can make a quick-and-easy profit. But in reality, penny stocks are more like swampland. And now, thanks to spam, the muck is spreading at an alarming rate, and efforts to stop it have so far been as effective as ordering the tide not to come in.
You probably trashed an e-mail message last December touting Goldmark Industries. A spam campaign predicted that investors would earn spectacular returns. One e-mail, which forecast the stock would gain 1,077%, said, "Watch GDKI [Goldmark's symbol] soar on Wednesday, Dec. 20!"
Maybe you didn't bite, but many others did. On December 19, the day before the spam campaign began, Goldmark closed at 17 cents a share. Nine days later, when the spam barrage ended, the stock closed at 35 cents. Those who held the stock before the e-mail campaign doubled their money. Investors who bought at the top lost their shirts. The stock closed at 6 cents in mid April.
If you think we're talking about chump change, think again. The Securities and Exchange Commission says spam campaigns promoting Goldmark and 34 other stocks that the agency recently suspended from trading for ten days robbed investors of tens of millions of dollars. And those 35 are just a few acres of the swamp. The SEC estimates that 100 million stock-spam messages are sent daily. Postini, an e-mail-security company, says the volume of spam that hypes stocks has grown 120% in the past six months, and that about one-fifth of all spam is stock-related. (On April 13, the SEC suspended trading on three more penny stocks that it suspected were being manipulated through spam campaigns.)
Spammers never let facts get in the way. Take an e-mail about Goldmark sent last October, before the campaign cited by the SEC. The note claimed that Goldmark, which says it produces and distributes hip-hop music, films and TV shows, had struck a deal with rap impresario Sean "Diddy" Combs. A Combs representative says the claim was fiction. None of the firms whose stocks were suspended, including Goldmark, acknowledge involvement in the spam campaigns.
People behind those campaigns have a big edge over those who buy on the hype: They know when the spam will end. A well-executed spam attack can produce triple-digit gains in a matter of days. Because of a December spam campaign, for example, the stock of Apparel Manufacturing Associates rose from 6 cents to 45 cents in just five days. It was among the stocks later suspended by the SEC.
Almost all stock spam is illegal. That's because these e-mails violate the Securities Act of 1933, which, among other things, bars paid promoters from touting stocks without disclosing the details of their compensation. Spam that doesn't allow you to opt out of the e-mail list (and most stock spam does not) also violates the 2003 CAN-SPAM Act, as well as state anti-spam laws.
You may have noticed that your spam blocker is letting more stock touts through. That's because spammers have become more sophisticated. The e-mails you open look ordinary, but many messages are in the form of digital images that spam filters can't read. And spammers avoid detection by using computer viruses to infect vast networks of computers, which then disseminate millions of e-mails.
Stock spam would wither without a healthy supply of junk-company shares, of which there is no shortage in the U.S. Most of these low-priced, thinly traded stocks are found on the Pink Sheets and the OTC Bulletin Board. NASD, the self-regulatory body of the brokerage industry, runs the OTCBB, and stocks quoted by this service must register with the SEC. That cuts down -- but doesn't eliminate -- the number of stocks that can be manipulated. The Pink Sheets, a private company, permits stocks that don't file with the SEC to be listed on its service.
NASD won't venture a guess at the number of OTCBB stocks involved in penny-stock spam. Cromwell Coulson, chief executive of the Pink Sheets, estimates that 10% of the more than 4,800 stocks that trade on his service are easy marks for spammers because the companies provide little or no financial information. The Pink Sheets has stopped quoting prices for the 35 stocks the SEC suspended as well as shares of more than 300 companies about which the company has received spam-related complaints from investors.
Draining the swamp
Suspending trading may help drain the swamp -- although how effective the tactic is remains to be seen. Other methods of dealing with the surfeit of stock spam are shutting down or prosecuting promoters, educating investors, and flagging stocks that are ripe for manipulation.
Although illegal e-mail touts are generally untraceable, other markets have developed ways of stopping criminals from pumping up share prices. For example, the free-wheeling Vancouver Stock Exchange was long home to many penny stocks that were subject to "pump and dump" schemes. But in the late 1990s, Canadian regulators began requiring executives and promoters of small-company stocks to register their promotional activities and submit to background checks.
As a result, Canada eliminated the most egregious penny-stock scams, says Martin Eady, director of corporate finance at the British Columbia Securities Commission. Regulators crack down hard against those who violate the rules. In November 2005, for example, the commission suspended Ray Dabney, president of Xraymedia, after he admitted to sending out 22 false news releases about the company. Several Xraymedia directors serve on Goldmark's board, and the two companies share the same Vancouver address, according to filings with the Pink Sheets. Xraymedia was the subject of a 2003 spam campaign, according to Spamnation.info, a Web site that tracks penny-stock spam. Shares of Xraymedia are quoted on the Pink Sheets. Although barred from the Pink Sheets, Goldmark shares may still trade if a broker is willing to sell them to investors (few are).
Because markets north of the border are unfriendly to stock scammers, they focus their efforts on Canadian companies that trade in the U.S., where they face fewer restrictions, says the Pink Sheets' Coulson. Eady estimates that more than 660 companies from British Columbia are quoted on the OTCBB and the Pink Sheets but don't trade on a Canadian exchange. Canadian regulators are considering even tougher measures to restrain their home-grown stock scammers, Eady says, even though most investors ripped off by their spam live in the U.S.
Not all spam involves Canadian companies. Coulson believes that groups of scammers based in Florida, Nevada and Texas hype many U.S.-based companies that are the subjects of pump-and-dump campaigns.
As a practical matter, prosecuting spammers isn't easy. For a promoter's claims to run afoul of the SEC, the law states that a "reasonable" person would have to believe a touter's claims are true, says Donald Langevoort, a Georgetown University law professor and a former SEC special counsel. But because most reasonable people would not believe the claims, the law doesn't view many of these assertions as illegal, he says. The SEC says it knows who orchestrated the spam campaigns behind some of the 35 stocks it briefly suspended. But as of mid April, the commission hadn't lodged complaints against any of the perpetrators.
What's needed next
The best way to protect investors is to keep reminding them of the dangers of acting on e-mail touts. Over the past three years, NASD has issued six alerts about stock spam on its Web site, but the gullible continue to be taken in. "Only investor education can have a real effect," says Langevoort.
PAID TO TOUT
It's legal, but so what?
Not all touting of penny stocks is illegal. Jonathan Lebed runs a legal tout business. On February 5, he signed a contract to promote the stock of mPhase Technologies, receiving 400,000 shares as compensation. In return, he sent out dozens of e-mail messages to his thousands of readers. A February 8 e-mail said mPhase stock "is going to the MOON and NOTHING will hold it back!!!!!!!!!!!!!!"
Hyperbolic e-mails of this sort essentially create a self-fulfilling prophecy. In this case, mPhase shares, which trade on the OTC Bulletin Board under the symbol XDSL.OB, rose from 16 cents at the start of the campaign to 27 cents in just 11 days. In mid April, the stock traded at 15 cents.
As a teenager, Lebed gained notoriety as the youngest person ever prosecuted by the Securities and Exchange Commission. The SEC accused him of racking up hundreds of thousands of dollars in profits by visiting Internet chat rooms and talking up "micro cap" stocks he owned. Lebed negotiated a settlement in which he did not admit wrongdoing but agreed to forfeit $285,000 in profits plus interest. Now 22, he says he wants to help good companies find investors. His service reaches 5,000 people who have signed up for his e-mails. Every e-mail discloses the stock and cash payments he receives on behalf of a "third party." That's all he needs to do to stay legal.
There may be a better solution than education: identifying stocks that are ripe for manipulation. Coulson plans to label Pink Sheets stocks suspected of being involved in pump-and-dump schemes with a skull-and-crossbones on the Pink Sheets Web site. He has also proposed that the SEC require more information about promoters who legally tout stocks. An SEC spokesman says the agency is reviewing Coulson's proposal but adds that the commission doesn't have the power to impose Canadian-style rules without congressional action. Congress hasn't considered any legislation to limit penny-stock spam or restrict stock promoters.
Meanwhile, stock spammers mock efforts to impede them. On March 11, only three days after the SEC announced its crackdown, a flood of spam touted United Environmental Energy (UTEV) as a "HOT NEW SEC APPROVED STOCK FOR YOUR ATTENTION!" The spam asserted that United was not a "Pump&Dump" stock. Over the next four days, the shares rose from 5 cents to 40 cents, then quickly fell to 10 cents. The Fort Lauderdale, Fla., company, which does not file financial statements with the SEC, says it was not involved in the spam campaign.
Calculated risk: A safe approach to penny stocks
Penny stocks get the greed glands going -- with good reason. It's a lot easier for a 10-cent stock to double or triple in no time than it is for a $100 stock, even though price, by itself, is not a measure of value. But penny stocks -- defined by the Securities and Exchange Commission as those that don't trade on Nasdaq or on an exchange and sell for less than $5 -- are generally far riskier than higher-priced stocks. If you're still tempted by low-priced stocks, here are some ways you can avoid being ripped off.
Look for the financials. Tiny companies don't have to file audited financial reports with the SEC. If a company you're interested in doesn't file, stay away. Financial data for most penny stocks touted in e-mails is either crummy or nonexistent.
Check the market value. Not all low-priced stocks are small companies. If a company's market value (share price times shares outstanding) is $50 million or more, chances are it's legit. Among the stocks recently recommended by the Turnaround Letter, a newsletter with a superior stock-picking record, five traded in mid April for less than $5 but sported market capitalizations of $218 million and up. The best known: Gateway, the computer maker, with annual sales of $4 billion and a market value of $848 million. It traded at $2.23.
Don't bet the ranch. Use only a small portion of your money to dabble in penny stocks and buy only if you can afford to lose 100% of your investment.