Chronology of Controversial Practices in a Microcap Company A Case Study of Ziasun Technologies
Saturday, August 31, 2002
Euromoney.com
In 1998, numerous “new economy” companies that conducted business through the Internet floated very successful initial public offerings. Many investors believed that any company with the suffix dot-com could become the next Microsoft or Intel. They became willing to pay an absurd price for a dot-com company with no prospects.
A variety of opportunists took advantage of this irrational exuberance. They rushed to bring many conceptual companies to the Over-the-Counter through reverse mergers. Ziasun Technologies (ZSUN) was one of them, brought to the Over-the-Counter Bulletin Board (OTCBB) in September 1998.
The predecessor of ZSUN was formed on March 19, 1996, under the name of Carlisle Enterprise, Inc. The company’s stated business operation was executive search and employee recruitment, although it never engaged in human resource management—it mostly issued stock. At the time of inception, the founder, Jennifer McMinn, contributed $5,000 to the company, receiving 50,000 shares of common stock. Right before inception, the company issued 750,000 shares under Rule 504 of Regulation D to 50 non-U.S. citizens for a total consideration of $75,000. The stock was then quoted on OTCBB under the ticker symbol of CLEP.
Following this first private placement, the company acquired a company called Fountain Fresh International (FTFR), whose main business concept was to sell beverages through specially designed machines in grocery or convenience stores. The company then issued 15 million shares of Regulation S shares to offshore investors for a total consideration of $1.5 million. By April 1997, FTFR acquired Katori Consultants, a company owned by Bryant Cragun, father of the founder, Jennifer McMinn, and a related party to FTFR. Mr. Cragun claimed that Katori owned a license agreement to FTFR products. FTFR agreed to pay Katori $5 million over 20 years for the license agreement. The name of Fountain Fresh International was changed to BestWay USA, Inc. and was traded in OTCBB under the ticker symbol BTTF.
ABUSIVE REGULATION S OFFERING
Selling Regulation S securities in foreign countries exempts a company from the rigorous registration requirement provided by Securities Act of 1933. The assumption is that buyers of private placements are sophisticated foreign investors who understand the risk that they are taking. The restricted period reduces the immediate impact to the general public. When the restricted period expires, the investors must file Statement 144, proposed sale, to register the Regulation S securities. Additionally, investors can sell only 1% of the total outstanding shares in any given 90-day period. The regulatory agency believes that these rules offer protection to the current shareholders.
A closer examination of the offshore investors who initially bought the Regulation S shares from CLEP or BTTF reveals that they were nothing but front companies that were established by insiders and related parties of CLEP or BTTF in foreign countries. Those front companies bought CLEP or BTTF at the wholesale price of $0.10 and then resold the shares to neophyte foreign investors through boiler room operators. Although any party that acquires securities through private placements is required to file Statement 144 to sell after expiration of the restricted period, the SEC cannot stop a foreign party from reselling Regulation S shares to other foreign parties during the restricted period.
The front companies involved in these sales included International Assets Management, Oxford International Management, Amber Group, Pacific Continental Securities, and Capital Growth Reports, which operated in Brussels, Barcelona, Dublin, Jakarta, Manila, Hong Kong, Taipei, Melbourne, and Bangkok. These front companies and their unscrupulous operators were taking advantage of the growing demand for U.S. stock by foreigners during the bull market of the 1990s. They frequently resold the restricted S shares to uninformed foreign investors. The promoters moved from country to country, each move designed to elude the enforcement agencies.
Besides ZSUN, they promoted a basket of illiquid, money-losing microcap companies such as BTTF, Chequemate International (DDD), Titan Motorcycle Co. of America (TMOT), Dynatec International (DYNX), Fountain Fresh International (FTFR), BEVEX (BEVX), Loraca International, Inc. (LCAI), and Kensington International (KNGI). All these microcap companies eventually either filed for Chapter 7 bankruptcy or became inoperative. Their stock prices fell to near nothing.
In July 1997, BestWay USA made a private placement, and sold 129,994 shares for a total consideration of $324,984, or a price of $2.50 per share. For unknown reasons, these shares were not accounted for in Ziasun’s initial registration statement two years later. One possible explanation is that the shares were originally issued to insider-related parties and later resold to a new group of uninformed investors.
FAILURE OF BESTWAY USA
The business concept of BestWay USA has never become operative. By September 1998, the company had consumed all the cash from the private placement. Without any significant business operations, BestWay USA had become a shell corporation.
Meanwhile, the front company investors who bought those shares through private placements had gradually dumped all their shares either in the OTCBB or through their unscrupulous foreign brokers and also to uninformed individual investors in various countries. Although the company was inoperative and had consumed all the cash, the stock was quoted on OTCBB at $3 to $5 in 1997 and at $1 to $3 in 1998.
At that time, companies trading on the OTCBB did not have to file financial statements. Thus, investors were completely in the dark as to the company’s actual financial condition. They relied on the penny stockbrokers: boiler room operators who were adept at selling pitches and little else. When these ill-informed investors wanted to sell, the unscrupulous brokers gave them many reasons not to sell. In some cases, the brokers disappeared, leaving investors with worthless slips of paper.
In September 1998, the company announced a one-for- two reverse stock split, and changed its name to Ziasun Technologies. The company wrote down the license agreement to Katori Consultants for $50,000 and spun off the beverage business to an inactive company called BEVEX. BEVEX was quoted on OTCBB and later on the Pink Sheets. Ziasun Technologies had truly become a shell corporation, with no business earnings operations, but plenty of outside stock: 7.9 million shares after the reverse split.
A REVERSE MERGER
On October 5, 1998, the company announced a reverse merger by acquiring a financially strapped Philippines company, New Age Publication, whose principal business was in printing and telemarketing. Many of New Age’s clients had connections to Ziasun’s insiders or the companies peddled by International Assets Management, Oxford International Management, and so on. New Age Publication changed its name to Momentum Asia. Ziasun issued 2 million shares to acquire Momentum Asia.
On the same date, ZSUN also announced that it would acquire Momentum Internet, which was organized in the British Virgin Islands but had no assets or revenues. ZSUN, however, issued 565,000 shares to the sole shareholder of Momentum Internet, Vulcan Consultants. Vulcan Consultants had only one shareholder— who was at the time the president of Ziasun Technologies, Anthony Tobin.
ZSUN lent Anthony Tobin $75,000. Tobin paid the company back with 65,000 shares of stock. In other words, the total consideration was $75,000 plus 500,000 shares for a company that had nothing but the expectation of becoming an Asian Internet portal.
ZSUN claimed that the sources of revenues of Momentum Internet included online financial services, banner advertising, website advertising, e-mail list rentals, and online marketing. The sources of revenues of Momentum Asia included Internet support services such as website design, database management, telemarketing, and printing. A closer examination of the 10K statements of 1998, 1999, and 2000 reveals that both subsidiaries produced no meaningful revenues from Internet businesses at all.
Interestingly, ZSUN hired the same attorney, George C. Chachas, who was found to have participated in the fraud of Electro-Optical Systems and violated the registration provisions of the Securities Act of 1933 on April 20, 1998, as its legal counsel. Chachas drew all the legal documents of the reverse merger. Moreover, ZSUN employed a penny stock auditor, Jones & Jensen of Salt Lake City, Utah, as its independent accountant. Jones & Jensen has constantly been charged by the SEC for issuing opinions without performing audits according to generally accepted accounting principles.
CREATIVE ACCOUNTING
ZSUN also swapped its own common stock with other related microcap companies such as DDD, TMOT, or LCAI through the related parties. When ZSUN filed the first version of its registration statement on September 16, 1999, it listed two strange items as “other assets.” One was membership in country clubs for $142,857. The other was a common stock “held to maturity” valued at $857,243. The sum of these two unrelated items is exactly $1 million. The probability that two unrelated items with such odd values would have the sum of $1 million is ridiculously low.
One plausible explanation is that the parties intended to take advantage of the $1 million cap set by Rule 504 on Regulation D offerings. They then contributed a group of illiquid penny stocks and memberships in country clubs to come up with the $1 million in an effort to obtain ZSUN shares.
Like Regulation S, Regulation D permits a publicly held company to raise capital through private placements, except that the buyers can be U.S. citizens. Rule 504 limits the amount of an offering to $1 million within 12 months. Many microcap companies commonly abuse Rule 504 because the issuer is exempt from filing audited financial statements.
Moreover, bonds mature; one cannot hold a common stock to mature at a certain value. The most likely interpretation of “common stock held to maturity” is that these stocks are the restricted Regulation S securities of DDD, TMOT, and LCAI that were acquired from related parties. When the restricted periods expire, ZSUN can then reclassify these as marketable securities in the current assets section of its financial statements.
This accounting magic is very important to ZSUN. If ZSUN had issued its own stock, it would have had to record all the proceeds as contributed capital in the shareholders’ equity section. This stock would have no impact on the earnings per share. When it swapped the securities with other penny stocks, however, ZSUN was now able to record them as marketable securities.
Realized and unrealized gains on marketable securities would then be reported in the income statement, not as contributed capital on the balance sheet. The additional gains would increase the earnings per share. ZSUN could then tout these phantom profits to naive and illinformed investors. Unsophisticated investors would not understand these discrepancies; indeed, most cannot understand financial statements. They became easy targets or the boiler room operators.
STOCK PROMOTION AND EXAGGERATED ANNOUNCEMENTS
ZSUN then hired the penny stock market promotion firms, Veritas Group of Vancouver, Canada, and OTC Financial, to promote its stock. Many speculators with connections to the front companies of IAM and Oxford acquired shares before starting their game of stock manipulation in early February 1999. Some resorted to stock chat rooms such as Silicon Investor and Raging Bull to tout the stock.
Meanwhile, ZSUN issued a press release on February 8, 1999, claiming that it would achieve a $950,000 record profit on $2.4 million revenues and earnings per share exceeding $0.11 for 1998. In fact, ZSUN lost money from its two subsidiaries, Momentum Internet and Momentum Asia. The profit was from selling or holding the penny stocks such as DDD, TMOT, and LCAI that ZSUN had exchanged between related parties on or before the reverse merger.
On March 3, 1999, ZSUN announced that its Momentum Internet subsidiary produced a profit of $325,355 and revenues of $1,013,267. On April 9, 1999, ZSUN announced a two-for-one stock split. On April 19, 1999, it announced the completion of 1998 audited financial statements that achieved profit of $1,152,210 and revenues of $3,537,397 and EPS of $0.11.
ZSUN also posted the audited financial statements on its website—but a completely different financial statement from the audited financial statements ultimately filed with the SEC on September 16, 2001. The same accountant, Jones & Jensen, audited both these statements.
All this stock touting from different angles was very effective. The stock soared from a split-adjusted price of $2.50 in early February 1999 to as high as a split-adjusted price of $17.50 on March 31, 1999.
ACQUISITION FRENZY
On March 25, 1999, ZSUN acquired Asia4sale.com Ltd. for $15,000 and 100,000 common shares, plus one additional share for every dollar of earnings before income tax, interest, and depreciation expenses. ZSUN also lent $50,000 to Asia4sale for developing its website. Asia4sale was supposed to become the Asian version of Amazon. com, despite the fact that it had only a few thousand dollars in computer equipment and produced hardly any revenue.
Managers knew their earnings were mainly from touting games in the penny stock portfolio. They realized that this gain could not go on forever. ZSUN therefore began searching for a business that could produce a high profit margin so it could masquerade as a high-growth Internet holding company. On March 31, 1999, ZSUN announced it had acquired an investor education company, Online Investor Advantage (OIA). At the time of the acquisition, OIA had hardly any assets. It operated traveling investment seminars on Internet stock trading or day trading for $2,995 apiece.
ZSUN offered a very generous package to former OIA shareholders: $400,000 cash and 1 million common shares, plus 5 million common shares in escrow. OIA had to achieve $2.5 million in earnings before taxes, interest, and depreciation expenses for the first 12 months. If the earnings were above $2.5 million, the former OIA shareholders would receive two common shares for every dollar of earnings. If the earnings were below $2.5 million, the escrow shares would be reduced by two shares for every dollar of earnings. ZSUN also granted 150,000 shares to Global Marketing Direct for arranging the acquisition.
After this merger, OIA produced 85% of ZSUN’s revenues. The former OIA shareholders become the largest shareholders of ZSUN.
When ZSUN calculated the total shares it had to award to former OIA shareholders on March 31, 2000, it discovered that it had to issue over 21.8 million shares. The former OIA shareholders decided to sell 12 million shares back to ZSUN for $6 million, and received in exchange the remaining 9,820,522 shares. ZSUN recorded the total amount as goodwill for $111,704,230, which represented 90% of its total assets on March 31, 2000.
Interestingly, ZSUN’s market price on March 31, 2000, was $11.375, but the former OIA shareholders were willing to settle for $0.50 per share. They knew that there would be extreme difficulties in unloading 12 million shares on the open market for an obscure company like ZSUN. Therefore, $0.50 per share was a very good deal for them.
SLAPP LAWSUITS
Many critics posted negative statements about ZSUN’s controversial practices on Internet message boards. A now-defunct website publisher, StockDetective.com of Financial Web, posted an article about ZSUN’s various activities. Instead of changing its behavior, ZSUN filed strategic litigation against public participation (SLAPP) lawsuits against all the critics. Obviously, the primary purpose of these lawsuits was to silence the critics, because the chances of actually obtaining a financial judgment were virtually non-existent. Apparently, ZSUN believed that the individual critics had no resources to defend themselves. The idea was to force these critics to sign agreements not to post any negative comments.
ZSUN continued to issue exaggerated press releases in 1999 and 2000. It held itself out as a profitable leading Internet holding company, despite the fact that all its Internet holding units had produced little revenue and had all lost money. In reality, ZSUN was nothing but OIA in disguise. ZSUN was riding on the Internet fever. As long as it claimed to be an Internet business, gullible investors would bid up the price. If ZSUN had actually disclosed that the primary business was a traveling seminar firm, investors would have little interest.
PSEUDO-RESEARCHERS
ZSUN’s related parties then employed stock promoters, Security Capital Trading, Dirks and Associates, Access One Financial, and Stockreporter.de, to write pseudo-research reports and issue strong-buy recommendations with target prices as high as $36 between November 1999 and June 2000. The promoters all received ZSUN shares and cash for writing the research reports, but they never disclosed the amount of compensation, in clear violation of Section 17b of the Securities Act of 1933 and Section10b of the Securities Act of 1934.
Although there was no direct evidence that ZSUN paid for this pseudo-research, ZSUN used the promoters’ reports as its official press releases. The SEC later charged Stockreporter.de with violation of the Securities Act of 1933 for touting ZSUN without disclosing the amount of compensation.
EARNINGS REVISIONS
ZSUN started to file its first registration statement on September 16, 1999. The registration statement needed seven revisions to obtain final approval from the SEC. For unknown reasons, ZSUN constantly revised its revenues of 1998 downward. Sales went from $3,537,397 to $760,529. Net income was revised from $1,152,210 to $769,320.
A closer examination of ZSUN’s operating results reveals that ZSUN lost $201,729 from operations. The company generated $535,801 profit from realized gain on marketable securities and $712,438 profit from unrealized gain on marketable securities. These gains are clear evidence that ZSUN swapped its own stock with the stock of its related parties, DDD, TMOT, and LCAI to portray itself as a profitable Internet holding company.
Further examination of the financial statements of DDD, TMOT, and LCAI reveals that these companies also reported realized and unrealized gains from selling and holding ZSUN stock. Thus, as we have described before, by swapping stocks among themselves, each company was able to shift money from additional paid-in capital contributions on to the income statement. This accounting sleight of hand allowed these companies to conceal their operating losses.
CREATION OF A PHANTOM COMPANY
On December 23, 1999, ZSUN announced the sale of Asia4sale.com Ltd. to Internet Venture in Somoa, Indonesia, for $5 million and 300,000 shares of Internet Venture. Internet Venture had 1 million shares outstanding. Therefore, after the acquisition, ZSUN owned 30% of Internet Venture. Since Internet Venture owned 100% of Asia4sale.com Ltd., and ZSUN owned 30% of Internet Venture, ZSUN still owned 30% of Asia4sale.com Ltd., as well. Asia4sale.com Ltd. had a negative net worth of $6,986 as of December 31, 1999, with revenue of $70,024 and a net operating loss of $9,213 excluding goodwill amortization in 1999.
The casual observer might wonder why anyone would pay $5 million for an obscure company with few assets and a dead-end future; however, a closer examination of the people behind the scenes clarifies the madness. Internet Venture had a close connection with ZSUN’s insiders and related parties such as International Assets Management, Oxford International Management, and Capital Growth Report. Internet Venture raised the $5 million to pay for Asia4sale.com Ltd. from ill-informed Asian investors. Apparently, Internet Venture promised these naive investors that once Asia4sale.com started trading in the U.S., the investors would receive a more than 1,000% return. Internet Venture did not raise the capital in U.S., so it was beyond the reach of the SEC. It did not have to file registration statements with the SEC under the Securities Act of 1933. The company was based and located in Indonesia. It was beyond the reach of the regulatory agencies in other Asian countries as well.
$5 million is also an important figure to ZSUN. ZSUN’s final purpose was to send Asia4sale.com for quoting on the OTCBB. Under Section 3(b) of the Securities Act of 1933, the maximum amount of an offering exempted from registration is $5 million. Thus, the offering to the Asian investors by Internet Venture was not required to re-register under the Securities Act of 1933 when those securities started to circulate in the U.S.
We have already noted that the former OIA shareholders received $6 million to settle their claim on a bonus 12 million shares of ZSUN. We can almost be assured that ZSUN used the proceeds of $5 million from the sale of Asia4sale.com Ltd. to Internet Venture to pay most of the former OIA shareholders’ $6 million bonus.
On February 10, 2000, Internet Venture entered a reverse merger deal with Asia4sale.com Inc. in the U.S. Asia4sale.com Inc. was a company previously known as H&L Investment. H&L Investment was a shell corporation incorporated in September 1996 and quoted on the OTCBB. The company had no assets, and a negative net worth of $1,285, but it had 1 million shares of common stock outstanding. Out of those 1 million shares, 200,000 shares were tradable. Obviously, H&L had close connections with ZSUN insiders and other related parties.
Asia4sale.com Inc. issued an additional 9 million shares to exchange all 1 million shares owned by Internet Venture. The company then changed its ticker symbol from HLIN to AFSI. The ultimate result of these dealings transformed ZSUN’s Asia4sale.com Ltd. into an OTCBB company, Asia4sale.com Inc.—completely avoiding the registration process. Under Section 3(a)(10) of the Securities Act of 1933, securities being exchanged for mergers are exempt from registration. After the reverse merger, ZSUN’s ownership dropped to 27%; the naive Asian investors now owned 63%, and the original shareholders of H&L owned the remaining 10%.
Although 9 million shares were floating around, these were restricted for one year. In actuality, the float of tradable AFSI stock was only 200,000 shares. Market makers could easily manipulate the price. Before the merger, HLIN seldom traded on the OTCBB—but upon changing its name to AFSI, the first trade was for 800 shares at $10 a share. Trading volume had previously been extremely thin.
Out of nothing, AFSI created an absurd market value of $100 million—a dramatic value for a company with very little business activity, and that was virtually worthless before one simple name change.
A LIQUIDATION DIVIDEND AND EARNINGS MANIPULATION
On March 29, 2000, ZSUN announced that it would grant 800,000 shares of AFSI to ZSUN shareholders. ZSUN’s ownership in AFSI now dropped to 19%. ZSUN decided that it could now apply the cost method of accounting rather than the equity method of accounting for its ownership in AFSI, according to Financial Accounting Standards Board (FASB) Statement 115. The losses of AFSI would no longer be allocated to ZSUN. This change allowed ZSUN to use the absurd market value of AFSI to generate unrealized gains and to cover up the huge losses in stock investments and unprofitable Internet operations.
In its 10Q statement for the second quarter of 2000, ZSUN reported $3.8 million of unrealized gain from AFSI ($2 per share). Without this item, ZSUN would have incurred $471,661 of unrealized loss on marketable securities in that quarter. FASB Statement 115, however, allows an investor to report only the unrealized gain from “trading securities” on the income statement. Trading securities are debt and equity securities purchased with the intent of selling them in the near future. Trading involves frequent buying and selling of securities. Restricted shares of AFSI were not tradable. Thus, there could have been no intention of selling these shares. Shares of AFSI were extremely illiquid because of thin trading.
At best, ZSUN should have classified the shares of AFSI as available-for-sale securities. Unrealized gains from available-for-sale securities must be reported in the shareholders’ equity section, not on the income statement. ZSUN’s reporting of the unrealized gain on the income statement was a clear attempt to manipulate the EPS, in violation of generally accepted accounting principles.
In another twist, ZSUN valued AFSI at $2.0875 a share while the stock was quoted in the OTCBB at between $8.5 to $10.5. ZSUN never explained the basis for its valuation in the 10Q statement. Unfortunately for ZSUN shareholders, the company announced it was canceling the liquidating dividend of 800,000 shares on May 16, 2001. The shareholders were never able to realize this dividend, while ZSUN was able to take advantage of reducing its ownership of AFSI to 19%.
The absurd market capitalization served two other purposes. First, AFSI could tell the ill-informed Asian investors that their $5 million investment was worth an amazing $63 million. Second, AFSI used the absurd valuation to convince another group of naive investors to purchase 800,000 more restricted shares through a private placement at $2.50 per share.
The naive investors did not understand that when the restricted period expired, they were required to file Statement 144 to register their shares. Furthermore, the maximum shares disposed of cannot exceed more than 1% of the total outstanding shares in each quarter. Thin trading prohibited shareholders of AFSI from liquidating their positions at a reasonable price.
The final fate of AFSI was almost predictable. AFSI could not produce the 10K statement of 2000. The stock was removed from OTCBB system. It is currently quoted in the Pink Sheets at $0.01 per share, and has virtually no trading activity.
A NONSENSE ACQUISITION
On June 6, 2000, ZSUN announced the acquisition of Asia Prepress Technology for $100,000 cash, 100,000 restricted shares, and assumption of a loan of over $159 million. ZSUN also acquired Asia Internet Services for $200,000 cash and 150,000 restricted common shares.
Both companies had been operated by the same individual and used the same office as Momentum Asia, ZSUN’s Philippines subsidiary. Apparently, they had few assets or revenues but offered plenty of hope and promise. Why would ZSUN pay so much for companies doomed to fail?
KAMIKAZE INVESTMENT
On June 22, 2000, ZSUN announced that it had formed a McKenna-Ziasun Venture Fund (MKZ) with the McKenna Group of California. Under the agreement, ZSUN would contribute $15 million to MKZ. The McKenna Group would provide the management, consulting, and analysis services on behalf of the Venture Fund under the direction of an investment board made up of both ZSUN and the McKenna Group members.
ZSUN contributed 100% to MKZ but it would receive only 60% of the first $20 million of MKZ distributions, and the McKenna Group would receive 40% of such distributions. ZSUN would receive 51% of distributions above $20 million, and McKenna Group would receive 49% of such distributions.
A new business entity, McKenna Venture Accelerator (MVA), was formed to which ZSUN, through MKZ, was the sole contributor. Although the McKenna Group contributed no money, it held 25% of the ownership in MVA. The management team of MVA had 15% ownership; ZSUN’s MKZ had 60% of the ownership in MVA.
MVA invested in several extremely risky start-ups. ZSUN lost 40% of the $15 million immediately upon contributing the money to MKZ and then to MVA. If these ventures ever made a dime, ZSUN could enjoy only 60% of the return from MVA and lose another 40% or 49% through MKZ.
This investment makes no sense, if the purpose of the investment is to make money. The only explanation is that the money was diverted to start-ups that had connections with ZSUN’s insiders.
As of June 30, 2001, ZSUN had contributed only $7.5 million to MKZ. ZSUN reported a loss of $200,000 on MVA in 2000. It reported a loss of $474,603 on MVA in the first half of 2001. ZSUN paid 50,000 restricted shares to Bryant Cragun, former ZSUN CEO, and current advisor. ZSUN also paid 50,000 restricted shares to one of its directors, Hans Von Meiss, to arrange a deal that most people would have avoided.
EXPOSURE BY THE MAINSTREAM MEDIA
On August 16, 2000, the Wall Street Journal (WSJ ) reported stock scams perpetrated by International Assets Management (IAM) and Oxford International Management (OIM), which had been established and operated by ZSUN’s insiders or related parties in Europe and Asia. The Journal reported that legions of Europeans and Asians had developed a strong appetite for U.S. stocks because of the prolonged bull market and rising economy during 1990s. Unfortunately, neophyte investors often ventured into a grey area that national regulators are either unable or unwilling to police.
Outfits like IAM and OIM typically bought unregistered, illiquid penny stocks at significant discounts through Regulation S private placements. To elude the enforcement of a national regulatory agency, they operated in one foreign country to entice investors in another foreign country into buying these worthless stocks. Then, when investors discover they have been defrauded and complain to the SEC, they are told that the agency cannot help because the shares were issued under Regulation S. Investors frequently can neither receive their stock certificates nor sell their stocks. Often the broker would sell the shares only if the investors agreed to plow the proceeds into another obscure penny stock.
After the WSJ article, ZSUN realized that it had to put an end to its SLAPP actions. The management settled with all the critics on October 11, 2000. Since Financial Web had filed for bankruptcy under Chapter 7, ZSUN rescinded the lawsuit against it.
DIVESTMENT
On September 15, 2000, ZSUN announced that it was selling Momentum Internet back to its original owner, Vulcan Consultants, because Momentum Internet had not produced any significant revenues. The dream of becoming Yahoo! in Asia had suddenly vaporized. Vulcan Consultants returned 750,000 shares of ZSUN and paid back a $500,000 loan. Apparently, Vulcan Consultants knew this coming event. It started liquidating 250,000 shares at the then market price around $6 per share in June 2000 in order to pay back the $500,000 loan and make a handsome $1 million profit.
When a bear market arrived in Summer 2000, ZSUN encountered difficulty selling its high-priced investment seminars. Revenues and margin declined. Ironically, ZSUN was teaching people “how to invest,” but did not know how to handle its own money. ZSUN’s stock portfolio incurred significant amounts of realized and unrealized losses in 2000. The touting activities gradually waned.
ZSUN’s share price steadily declined. It dropped below $1 in the fourth quarter of 2000. By the third quarter of 2001, the stock had dropped below $0.40.
In the 10K statement of 2000, ZSUN announced that it was divesting all of its foreign Internet subsidiaries. On April 27, 2001, the former owners of Momentum Asia returned 200,000 shares of ZSUN for the subsidiary. ZSUN paid $50,000 to the former owners of Momentum Asia. On June 27, 2001, the former owner of Asia Prepress Technology and Asia Internet Services returned 200,000 restricted shares of ZSUN and agreed to pay ZSUN $200,000 over three years.
ZSUN decided to write off the entire ownership in AFSI. ZSUN also rescinded the promised liquidation dividends to its (once) gullible shareholders. The dream of becoming Amazon.com in Asia vanished.
ZSUN used the absurd valuation of AFSI to cover up the losses of its stock portfolio and the slowdown of its investment seminar business in its second and third quarter 10Q statements in 2001. When it wrote off AFSI in the 10K statement, it simply told shareholders that the writeoff was a one-time charge. ZSUN did not explain why its shares of AFSI jumped from 2.7 million shares to 5.4 million shares. Poor neophyte investors who bought the stock on misleading information now incurred huge losses.
The entire losing stock portfolio was pushed into the assets of discontinued operations. Apparently, ZSUN turned in the stock portfolio to Momentum Asia when that subsidiary was divested. After the divestment, ZSUN was equivalent to Online Investor Advantage, an investment seminar firm.
GETTING OUT OF THE SHADOWS
On May 16, 2001, ZSUN announced a merger with Telescan (TSCN), a Nasdaq firm that specialized in investment software. ZSUN and TSCN would change their names to Investment Tool Inc.
Telescan had provided financial information services to several Internet portal companies. After it lost contracts with two media giants, however, the stock tumbled from the mid $30s in December 1999 to 30 cents in September 2001.
Apparently TSCN was on the verge of bankruptcy and delisting from Nasdaq, so it had no choice but to agree to a merger with a company with a tainted past. And ZSUN’s management believed that by merging with a Nasdaq company, it might be able to participate in the mainstream financial market.
CONCLUSION
The majority of penny stocks follow the tactics used by ZSUN. These peddlers apparently have no difficulty attracting neophyte investors and duplicating the scheme. We can summarize the common tactics as follows:
Birth from a reverse merger. The acquiring company is typically a publicly held shell corporation that has been inactive for years; the acquired company is typically financially strapped or a conceptual company with phantom technology—normally a private company. As long as the SEC allows shell corporations with no assets, no capital, no employees, and no intention of doing meaningful business activities to register as publicly held companies, the door is left open to the potential of fraud. The existence of these corporations allows swindlers to orchestrate reverse mergers and defraud uninformed investors. Laws can be strengthened to require that a reverse merger follow the same registration process as a new public offering.
Regulation D or Regulation S offering. Microcap companies frequently raise additional needed capital through private placements to circumvent the registration process. Regulation D deals with domestic investors, while Regulation S deals with offshore investors. Regulation S offerings are used most often because the SEC has more difficulty enforcing the law in foreign countries.
Promotion of stocks by public relations firms. The public relations firms frequently masquerade as unbiased researchers. They often violate Section 17 (b) of the Securities Act of 1933, which requires disclosure of compensation for advertising. Ill-informed investors then buy the stock through boiler room operators and on the basis of these strong buy recommendations.
Participation in Internet chat rooms. This method is an easy and effective way to promote a stock without being suspected by naive investors. Promoters masquerade as innocent investors merely sharing information. Once the stock is pumped up, they simply dump their shares. When the naive investors discover that they have been deceived, the swindlers have disappeared. The investor’s lifetime savings suddenly vanish, with little recourse.
Exaggerated press releases. This tactic is essential to attract the naive investors. Many of these investors do not or cannot read the SEC filing. They tend to believe press releases from management. Managers know that as long as their press releases are half-true and tread a fine line, they can defend themselves against SEC probes. And they know that the mainstream media has little interest in reporting unethical behavior at obscure firms.
Changing core business constantly. Promoters of dubious ventures tend not to focus on one core business. They tend to search for the business that is hot in the current market environment. The managers, insiders, related parties, and promoters are more interested in manipulating the stock price than actually developing the business.
Establishing many subsidiaries. Microcap companies are small. The number of employees is never more than a handful. Because these companies are small, it surely does not make economic sense to have a lot of subsidiaries. But the misleading ventures do. Apparently, the operators of microcap companies believe they can easily put pieces together and easily break a company apart. They also use the subsidiary structure to manipulate their earnings.
Nonsense investment. Many microcap companies have little respect for the shareholders’ money. They frequently make investments that would benefit only the insiders and the related parties. They seldom regard shareholders as their business partners.
To order reprints of this article please contact Ajani Malik at amalik@iijournals.com or 212-224-3205.
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