Interesting story from business week re: spreads in small stocks:part 1 of 2...
INVESTORS BEWARE:
CHOP STOCKS ARE ON
THE RISE
An inside look at how scamsters are taking billions from
small investors
It has become almost routine. On Nov. 13, the U.S. Attorney in Brooklyn
charged 13 people--brokers, Mob associates, and officials of two
brokerage firms--with manipulating the prices of thinly traded micro-cap
stocks. On the same day, in New Jersey, federal authorities announced
a similar indictment. And then, on Nov. 25, came this bombshell: A
federal grand jury in Manhattan handed up an indictment charging 19
people with multiple counts of racketeering and securities fraud.
Among the accused were stock promoters, alleged mobsters,
corporate officials, and six brokers at a firm that had managed to avoid
the limelight, Meyers Pollock Robbins Inc. Not since the insider-trading
scandals of the 1980s has Wall Street faced such a sustained legal
juggernaut.
Throughout the multitude of charges in the assault on fraud in micro-cap
stocks, there is one common theme. It's not just ''pump and dump''
stock-rigging schemes, or financial-statement fraud, or profiteering on
hot initial public offerings. Nor is the problem confined to what the
public experiences--the ubiquitous, forked-tongue cold-callers. Bribery
is another element, but not the crucial one. Neither is the Mob the
common factor, though it feasts on this corner of Wall Street.
Behind all the charges lies a simple fact that has received surprisingly
little attention--even from regulators. Vast, interlocking networks of
brokers are managing to obtain shares in hundreds of companies at
dirt-cheap prices and are unloading them on the public. Among the
people who make their living by pushing them on the public, the rogue
brokers and stock promoters and mobsters, there's a name for these
stocks. It is brutally simple: chop stocks.
''Chop'' is slang for spread--the difference between the prices the
brokerages pay for stocks and the prices at which they are sold to the
public. In the world of the ''chop houses'' that sell these stocks, the real
spreads often bear no relation to the numbers that appear on
stock-quote machines. Often the stock is obtained by the brokers from
corporate insiders or offshore accounts at a fraction of the price listed
on the quote terminals. They then sell it to the public, illegally, at
massive, undisclosed markups. It's fraud of the most fundamental kind.
The public doesn't know that they are buying stocks that are worth
nothing more than the pennies shelled out by their brokers.
To regulators, this is a small if troublesome fringe of the securities
industry. Even Mob infiltration, they assert, is ''relatively isolated, and
does not threaten the overall stability of our markets,'' as U.S. Attorney
Mary Jo White maintained in a press conference on Nov. 25. But this is
a problem that goes well beyond the Mob on Wall Street.
LOW RISKS. In fact, BUSINESS WEEK has found that chop stocks
constitute a vast underworld of the securities markets--a $10
billion-a-year business that regulators and law enforcement have barely
dented in their recent prosecutions. Chop stocks are increasingly
exploited by organized crime, and for a good reason: The profits are
huge, the chances of incarceration low. Guaranteeing the ''chop''--the
immense profit margins--requires cooperating networks of brokerage
firms employing uncounted thousands of cold-callers that are the
public's main exposure to this world. Behind the cold-callers are an
array of stock issuers, offshore accounts, and the barred brokers and
stock promoters who are the middlemen between brokers and
companies.
How serious is this problem? How is it being handled by regulators, in
their well-publicized assault on small-stock fraud? Who are the
players--the brokerages and stocks involved and the stock promoters
who bring them together? BUSINESS WEEK sought answers to these
questions in a six-month investigation involving interviews with present
and former chop-stock brokers and customers, review of massive
quantities of public documents and internal records and tape
recordings, and interviews with traders, clearing-firm executives, and
current and former securities regulators and law-enforcement officials.
BIG NAMES. One former chop-house exec, who requested anonymity,
shared a graphic tale of illicit trading and payoffs--including a bribe that
he said was paid to a National Association of Securities Dealers
examiner (page 118). Another broker provided BUSINESS WEEK with
a rare account of what he asserts was the purchase of a hidden stake
in his firm by a leading behind-the-scenes power in the chop-house
business--Jordan Belfort, former head of the now-defunct Stratton
Oakmont Inc. penny-stock house. Sources also painted a disturbing
picture of alleged customer overcharges and trading abuses at
Paragon Capital Corp., one of the largest dealers in micro-cap stocks.
And other sources maintain, in allegations being probed by regulators
and state and federal law enforcement, that stock promoters dominated
a Florida cold-calling operation run by the president of Meyers Pollock
Robbins, the large micro-cap brokerage whose brokers were indicted
on Nov. 25. Meyers Pollock declines comment on the indictments.
What emerges is a shocking picture of a problem that has spun out of
control. Among BUSINESS WEEK's findings:
-- The bull market in chop stocks has spawned a new generation of
stock promoters, some still in their early 30s, replacing the Meyer
Blinders and Robert Brennans who dominated the heyday of penny
stocks during the 1980s. The new promoters gain control over cheap
stock, or dominate the markets for thinly traded stocks, and then push
them on the public, using crews of brokers reporting to them.
-- The NASD and Securities & Exchange Commission's highly visible
campaign against small-stock abuses and the recent spate of criminal
prosecutions have failed to have a significant impact on chop houses.
Although regulators have shut down a handful of cold-calling
powerhouses, the vast majority of questionable firms--totaling perhaps
200 nationwide, according to state securities regulators--remain
untouched.
-- Although officials have downplayed Mob infiltration of Street firms, the
Mob remains a troublesome presence on Wall Street (page 130).
-- Payoffs to brokers have emerged as a commonplace method of
bringing chop-stock companies into the marketplace. Some of the
stocks that BUSINESS WEEK has identified as recent subjects of
broker payoffs are listed here (table). None have been named in the
recent prosecutions.
-- Some of Wall Street's best-known firms--notably Bear, Stearns & Co.
and Schroder Wertheim & Co.--clear trades for chop houses,
processing trading records that sometimes show massive
commissions and excessive price markups.
At the NASD and SEC, officials say they are hard at work addressing
the problem of small-cap fraud. And, they say, they have made great
strides--particularly in eliminating the large firms that used to be a major
source of small-stock abuses. Testifying before the Senate
investigations subcommittee late in September, NASD Regulation's
head of enforcement, Barry R. Goldsmith, said he would ''readily
acknowledge that there are some dishonest individuals and firms in the
securities business today.'' But they also have systematically minimized
the problem. In his Senate testimony, Goldsmith asserted that ''the
problem firms represent a tiny portion of the more than 5,500 securities
firms.''
By contrast, BUSINESS WEEK's investigation shows that chop stocks
are a vast and growing industry. The NASD and SEC won't even
hazard a guess on the scope of the problem. But according to people
familiar with the business, chop stocks make up perhaps half the 85
million-share daily volume of the OTC Bulletin Board, plus dozens of
stocks on the NASDAQ Small Cap Market. By that reckoning, there
would be perhaps 700 actively traded chop stocks on the OTC Bulletin
Board alone, and perhaps another 200 NASDAQ Small Cap stocks.
With dollar volume of trading in domestic OTC Bulletin Board
stocks--the shares not traded on NASDAQ or the
exchanges--exceeding $20 billion a year, the portion consisting of chop
stocks might well exceed $10 billion.
COLD-CALLERS. Cheap stock is fueling the chop-stock explosion.
Restricted or ''letter'' stock, issued under Rule 144 of the securities
laws, is commonplace at many perfectly legitimate companies as a
way of rewarding key employees and giving them an equity
interest--often in lieu of a high salary. Stock and warrants are also
issued to compensate consultants in lieu of cash. And stock issued
overseas, under Regulation S of the securities laws, is a widely
recognized way of raising capital for emerging companies. Reg. S
stock is cheap for a simple reason: Since it cannot be legally traded for
two years, it is commonly issued at a steep discount. Rule 144 stock is
cheap because it is usually issued at little or no cost and also must be
held for one or two years.
The chop houses make their profits by simply breaking the law and
getting that stock on the market immediately. ''People violate the
restriction. [They] basically launder it and dump it,'' says the SEC's
enforcement chief, William R. McLucas. Another form of abuse, he
notes, involves misuse of the rule allowing companies to compensate
consultants with stock instead of cash--a rule that was put in place to
help cash-poor high-tech startups. The ''consultants'' are often stock
promoters. The Meyers Pollock indictment, for example, alleges that
stock- promoter ''consultants'' were issued shares and warrants in one
chop stock, much of which was immediately dumped on the public.
How does cheap stock make its way to the cold-callers? As told by
chop-house brokers, one common method is simple enough:
Rule 144 stock certificates carry a legend marking it restricted stock,
and the legend can only be legally removed at the end of the holding
period. Among the chop houses, however, the restrictions are often
ignored and the ''legend stock'' is traded in an illicit black market. The
stock is available at a cut rate because it cannot be legally sold to the
public. If the stock is trading at $6 a share, the chop-stock house may
buy it at $2.50--never reporting it in the daily runs to NASDAQ. They
can swiftly trade it to another chop-stock house at $3, making a swift
profit.
STRIP BARS. When the legend stock is sold to the public, chop
houses go for big profits. The price to the customer might be, say, $7 a
share. The official bid would be $6 bid and $7 asked. But the actual
cost to the brokerage is $2.50. The real, humongous spread never
appears on the stock-quote machines.
If customers were to see the stock, they might realize that it's not
supposed to be sold to the public. So the chop houses have a simple
solution: They don't show the customers the stock. The shares are only
a book entry.
The illicit nature of the stock is one reason shady brokers are
notoriously reluctant to execute sell orders. If the customers want to sell,
or obtain the certificates, or transfer the shares to another firm, they are
discouraged. If the customer insists on selling, the firm simply does
another book entry and ''washes'' the stock into another account--the
brokerage's own ''house'' account, or sells it to an allied firm.
Whether the cheap stock originated overseas or from insiders, the
procedure for getting it to the public is the same (chart). According to
brokers familiar with the process, the massive profits are often split--in
cash--between the brokerages involved. And the payments are often
made in strip bars and other nontraditional Wall Street locales.
BALM. Warrants are the other major chop-stock money-making
machine. Because of the leverage they afford, they become gold mines
when the underlying stock is manipulated upward. They are often
issued for pennies or no cost at all, making warrants a cheap way of
compensating brokers and stock promoters. Warrants are also
provided to favored investors in chop-stock deals, and sometimes are
used to mollify unhappy chop-house customers.
That is what allegedly happened a couple of months ago to a customer
of a New York-based firm named PCM Securities Ltd. The customer, a
California resident who asked that his name not be used, had been in
another stock sold to him by PCM that was a disaster. To make up for
some of his losses, he says, PCM offered him warrants in an outfit
called Medley Credit Acceptance Corp., which has filed for an initial
public offering of its stock but has not yet gone public. The broker, he
says, offered him the opportunity to buy the warrants, when the
company went public, for 15 cents--and assured him that the warrants
would then be sold at $3. The customer says he was offered 15,000 to
20,000 warrants--a guaranteed profit of $45,000 to $60,000. PCM
officials did not return repeated calls requesting comment. The Miami
phone number for Medley--whose president is a PCM officer--has been
disconnected.
For chop houses, warrants are a form of cheap currency. But in order
for them to have any future value, the underlying stock has to climb. In
the case of the Medley deal, the stock would have to rise from its initial
price of $5.50 to $8.65 a share. The ability to drive up share prices is
crucial. That is where the stock promoter comes in.
Stock promoters are the middlemen and fixers of the chop-stock world.
Investors rarely have contact with them. They put stock in the hands of
brokers, and on occasion they perform old-fashioned investor
relations--the ''promote'' in stock promoter. But when Carol Ann
Kandell, a bookkeeper at a college in Colorado, bought a stock called
Java Centrale in 1995, she didn't come into contact with a promoter. It
was simply on the sell list of her broker in a Long Island (N.Y.) office of
Meyers Pollock Robbins--the 160-broker national firm that had
escaped attention until the Nov. 25 indictments.
''GOOD STUFF.'' Java was not a penny stock--it went public at $6 a
share, $1 above the official definition of a penny stock. The broker ''was
always pitching that it was really good stuff,'' says Kandell. And
then--guess what? The stock price dropped into pennies in the months
that followed.
Investors had no way of knowing that a stock promoter was pushing
Java and a host of other stocks destined for the cellar. According to
sources familiar with his activities, the promoter was James Peter
Minsky. In his file in the NASD's Central Records Depository (CRD),
the 30-year-old Minsky has a typical record for a low-level chop-house
broker. Minsky worked at 16 brokerages over a four-year time span,
ending with a one-month stint at Westfield Financial Corp. in early
1994. Among the firms where Minsky worked was Joseph Roberts &
Co., a Chicago-based firm where, one former regulator notes, he
worked closely with Claudio Iodice--one of the stock promoters indicted
on Nov. 25. Efforts to reach Iodice and officials of Westfield and
Joseph Roberts for comment were unsuccessful.
Meyers Pollock appears nowhere in Minsky's CRD record. But
according to people familiar with his activities, by 1995, Minsky was
working at Meyers Pollock, pushing marginal stocks through Meyers
Pollock brokers reporting to him. In the chop-stock world, stock
promoters are an intriguing amalgam--part investment banker, part
stock retailer, and part investor-relations publicist. They often have
''crews'' of brokers working for them and often work closely with
chop-house execs. In Minsky's case, the venue in 1995 allegedly was
the Fort Lauderdale office of Meyers Pollock, which was run by the
president of the firm, Michael Ploshnick. Also working there, sources
have told investigators, were two allied stock promoters--W. Fred
Ballou and Leonard Ruge. |
