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The SEC Cracks Down on Penny-Stock Fraud

Courtney Yeager

A "pump and dump scheme" is a form of stock fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements in order for the promoter to sell its cheaply purchase stock at a higher price. Once the schemers sell their overvalued shares, the price falls and investors lose their money. Fraudsters frequently use this ploy with small companies – known as penny stocks. While promoting stocks is legal, U.S. securities law prohibits market manipulation. The Securities and Exchange Commission ("SEC") routinely sanctions promoters for buying cheap stock, hyping it to investors, then secretly selling their holdings.

The SEC began its latest crackdown on penny-stock fraud in 2010 and had sued 40 individuals and 24 companies as of August 2013, according to its website. In March, it filed a lawsuit against the operator of one of the largest penny stock websites, AwesomePennyStocks. The lawsuit seeks to hold John Babikian liable for his use his website and an email list to tout a coal company's stock while dumping his own shares. The SEC alleged that Bibikian sold off his 1.3 million shares in the company 90 minutes after sending material to investors hyping the stock's rise. According to the SEC, Babikian made approximately 1.9 million in ill-gotten gains. You can read the complaint here.

Pump and dump schemes carry a number of recognizable warning signs. Fraudsters frequently use large-scale email pushes to lure in potential victims. Many of these emails tout a company's stock—typically small companies—through false and/or misleading statements. The false claims could also be made on social media sites, bulletin boards, and chat rooms. Often the promoters will claim to have inside information about an imminent development, or to use a foolproof system to pick stocks.

Subject lines and short messages are designed to lure investors into buying the stock—all with the goal of creating a run-up in price. The Financial Industry Regulatory Authority ("FINRA") and the SEC's Office of Investor Education and Advocacy have one message for investors: "Don't fall for these scams. They are the inbox equivalent of a boiler room sales operation, hounding investors with potentially false information about a company. When it comes to pump-and-dump spam, the smartest play is the easiest. Just hit the delete key." You can read the FINRA Investor alert here.