Investment fraud has become a common part of internet spam, accounting for about 15% of spam email messages.  To trap the investors attention, the spam promises huge PR campaigns, mergers, buy-outs and other buzz-words.  The spams often contain outlandish price projections.

Unfortunately, the investment fraud spams do not advertise a web site and do not require the recipient to contact the spammer.  As such, they are anonymous and untraceable.  However, there are ways you can protect yourself.  You can be skeptical when reading your emails.  You can identify red-flags.  As stated above, heavy hype on an impending event in the stock is a good indication of a pump and dump style spam.  When you see multiple posts containing the same message, but different origins, you should be suspicious.  When you see nonsensical gibberish at the beginning or end of a post, you should be suspicious.  Also be careful when you see replaced characters meant to confuse spam filters.

Two of the more common types of internet investment fraud are scalping and the pump and dump scam:

SCALPING

On July 9, 2007, the Securities Exchange Commission (SEC) filed securities fraud charges against Darrel and Jack Uselton in the U.S. District Court in Houston for perpetrating “a high-tech scam that hijacked personal computers nationwide to disseminate millions of spam emails and cheat investors out of more than $4.6 million.” (SEC Litigation Release No. 20187, July 9, 2007) .

The fraudsters perpetrated what is commonly called a “scalping” scam.  “Scalping refers to recommending that others purchase a security while secretly selling the same security in the market.” (SEC Litigation Release No. 20187, July 9, 2007)  More precisely, scalping is when a stock broker or financial adviser recommends that an investor buy a security–and then sells that security at a profit immediately after the recommendation has been disseminated and investors have driven the price of the security up with their purchases.

In 1963, the U.S. Supreme Court held that scalping was fraudulent market manipulation and a violation of the Investment Advisers Act of 1940. SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963). Federal courts have ruled that scalping is securities fraud and a violation of Rule 10b-5 of the Securities Exchange Act of 1934. SEC v. Yun Soo Oh Park, 99 F.Supp.2d 889 (N.D. Ill. 2000).

Darrel and Jack Uselton obtained shares from a number of penny stock companies.  Then they sent out millions of spam emails saying those particular penny stocks were good investments.  This created an artificially active market.  Then the fraudsters sold their penny stock for a profit. (SEC Litigation Release No. 20187, July 9, 2007).

The Useltons were able to send out the millions of emails by using something called “botnets,” which is short for “proxy bot networks.”  Botnets are “networks comprised of personal computers that, unbeknownst to their owners, are infected with malicious viruses that forward spam or viruses to other computers on the Internet.” (SEC Litigation Release No. 20187, July 9, 2007).

PUMP AND DUMP SCAM

Scalping is very similar to what is called the “pump and dump scam.”  The pump and dump scam is a form of securities fraud that involves artificially inflating the price of a stock or other security through untrue or exaggerated promotion in order to sell stock, previously purchased cheaply, at the inflated price.  When the promotion stops (or flaws in the promotion are exposed) the artificial demand is removed.  This causes a collapse in the price of the investment, and the other investors lose their money.

For the purpose of simplification, here is a step-by-step explanation of the pump and dump scam:

STEP 1:  ACQUIRE STOCK AT CHEAP PRICE:  The people behind the pump and dump scam acquire a large number of stock at a cheap price in a particular company.

STEP 2:  PROMOTION:  The perpetrators artificially inflate the price of the stock through a promotion campaign based on untrue and exaggerated statements.  The most common vehicle for pump and dump promotion is internet spam.

STEP 3:  PUMP UP THE PRICE: In response to the fraudulent promotion, investors purchase the stock in droves, creating a high demand.

STEP 4: DUMP ARTIFICIALLY INFLATED PRICE:  The persons behind the scam sell their shares at the artificially inflated price and make a large profit.STEP 5:  PRICE PLUMMETS: The scam artist stop promoting the stock and the price plummets.  As a result, the other investors lose their money.

The stock in a pump and dump scheme is usually thinly-traded, penny stock.  The smallest and most thinly traded stocks cannot meet the listing requirements of the NASDAQ Stock Market or a national exchange, such as the New York Stock Exchange.  Instead, they trade “over the counter.”  For pump and dump scams the relevant markets are the OTC Bulletin Board and the Pink Sheets.  Stocks that trade in the OTC market are generally among the most risky and most susceptible to manipulation.  The reason is obvious:  It is easier to manipulate stock when there is little or no information available about the company.

Stocks that are the subject of pump-and-dump schemes are referred to as “chop stocks.”  The term “chop,” also called “rip,” describes the illegal profits realized by stock swindlers in their pump and dump scheme.  The swindlers employ a variety of techniques to pump up the price: a glowing press release on a company’s web site, newsletters recommending the latest “hot” stock, messages in chat rooms, bulletin board postings on internet, and of course internet spam.

THE CROOKS BEHIND THE SCENE

So who are the crooks behind the scenes?  They are difficult to identify.  The crooks could be the company offering the stock, friends of the company,or unrelated criminals just pumping new emerging companies.

The crooks behind the scene could be any of the following: the mafia, corrupt brokerage firms, a fifteen year old boy or even international terrorist.

MAFIA INVOLVEMENT

In the popular HBO series, The Sopranos, fictional mafia characters Matthew Bevilaqua and Sean Gismonte orchestrate a classic pump and dump scam. Viewers of the cable series might be suprised to find out that the storyline is not far removed from reality.  Mob figures from each of the Five Families of the New York mafia, as well as the New Jersey mob, have become involved in Mafia stock schemes. See Gary Weiss, “The Mob on Wall Street,” Business Week, Dec. 1996.

TERRORISTS

Some commentators go even further.  Fred Showker, editor of DTG Magazine and 60-Second Windows, writes:

“The most disturbing part of this story is the fact that there is a strong likelihood that these pump & dump schemes are conducted by organized crime or worse yet, terrorists trying to fund covert operations around the world.”

Fred Showker, Pump & Dump Stock Scams…you’re about to get ripped off, #179 January, 2006.

ADOLESCENT BOYS

In the dot-com era, a 15 year old named Jonathan Ledbed ran a successful pump and dump scheme on the internet.  Ledbed purchased penny stock and promoted them on message boards.  When the stock price increased, Ledbed sold his stocks for a profit, leaving the other investors holding the bag.  The SEC filed a civil suit against Ledbed which ended in a settlement.

BROKERAGE FIRMS

The SEC has actively pursued pump and dumps for years and prosecuted the primary violators.  But only recently has the SEC pursued a case against a major brokerage firm.  On April 12, 2007, the SEC brought charges against Park Financial Group for the role they played in a pump and dump scheme of the common stock of Spear & Jackson, Inc.  At the time of the scheme (2002-03), the stock of Spear & Jackson traded on the Pink Sheets.  The primary violator was Dennis Crowley, the CEO of Spear & Jackson.  In 2005, the SEC fined Crowley $6.1 million.  Now in 2007 the SEC wants to punish the brokerage house of Park Financial Group for not reporting suspicious activities in Crowley’s account.  Although the brokerage firm did not perpetrate the pump and dump scheme, it was in a position to observe the illicit activity.  Park Financial was supposed to file Suspicious Activity Reports (SARs) when it discovered red flags indicating Crowley’s involvement in a pump and dump scam.  Because Park Financial did not file the SARs, the SEC said Park Financial essentially aided and abetted Crowley’s fraud.  This is a step in the right direction.  Imputing brokerage liability will reduce the number of pump and dump scams in the country and will further protect the investor’s interest.