sec.gov
About Microcap Fraud
I. Background Information
On Microcap Fraud
What is a Microcap Company?
Microcap companies are typically thinly capitalized and are often not required to file periodic reports with the SEC. Securities of microcap companies may be quoted on the Over-the-Counter Bulletin Board operated by the National Association of Securities Dealers, Inc., in the Pink Sheets operated by the National Quotation Bureau, and on the Nasdaq Small Cap Market. In any of these trading mediums, public information is limited and a small number of brokers control the market.
The Nature of Microcap Fraud
Microcap fraud typically takes one of two forms. The first – the "pump and dump" scheme – often involves fraudulent sales practices, including high pressure tactics from "boiler room" operations where a small army of sales personnel cold call potential investors using scripts to induce them to purchase "house stocks" – stocks in which the firm makes a market or has a large inventory. The information conveyed to investors often is at best exaggerated and at worst completely fabricated. Increasingly, these stocks also are being touted on the Internet by unregistered promoters. The promoters of these companies, and often company insiders, typically hold large amounts of stock and make substantial profits when the stock price rises following intense promotional efforts. Once the price rises, the promoters, insider and brokers sell, realizing their profits.
Second, as part of the "pump and dump," unscrupulous brokers often employ a variety of fraudulent sales practices including "bait and switch" tactics, unauthorized trading, "no net sales" policies (where investors are discouraged or actually prevented from selling their stocks) and churning (excessive trading in their accounts in order to generate commissions for the broker).
The SEC's Response to the Problem
The Commission has a four-pronged approach to attacking microcap fraud: enforcement, inspections, investor education and regulation. The Commission's efforts devoted to fighting microcap fraud are described below.
II. Detection of Microcap Fraud –
Office of Compliance, Inspections and Examinations
Examinations are an important prong in the Commission's approach to microcap fraud. On-site examinations of regulated entities are often the earliest indications of changing industry practices and the techniques utilized by broker-dealers, salespersons, and issuers to skirt the federal securities laws and to defraud investors.
Microcap examinations of broker-dealers have been focused in the New York, South Florida, and Colorado/Utah areas, where the greatest concentration of fraudulent microcap activity is found. In fiscal year 1997, over 70 examinations of microcap firms were conducted in these regions, representing about 43 percent of all cause examinations conducted there. More than two-thirds of these microcap examinations were referred to the Commission's Division of Enforcement or to the NASDR for further investigation. The most common violations found were fraudulent misrepresentations, unsuitable recommendations, unauthorized trading, market manipulations and unregistered offerings.
Commission examiners are also scrutinizing the records of microcap issuers maintained by registered transfer agents, located predominantly in Utah and Nevada, to detect irregularities in the issuance and transfer of shares which typically accompany frauds on investors.
In January 1998, we initiated an examination sweep of several firms that are players in the microcap market. These firms had all of the "red flags" of fraudulent microcap activity, such as customer complaints, significant profits from underwriting and subsequent aggressive market making of illiquid microcap securities, registered representatives or principals previously associated with disciplined microcap firms, and large pools of inexperienced cold callers. Examiners conducted a complex and resource-intensive review of these firms' records for evidence of the hallmarks of microcap fraud: patterns of "bait and switch" sales techniques, misrepresentations and exaggerated claims of performance, unauthorized trading and refusals to sell securities, market manipulation and lax or nonexistent supervision.
As the Commission considers the proposals released today, and as regulatory reform progresses, the Commission's exam program will continue to focus attention on problem microcap firms and to identify any new methods used to circumvent statutory obligations to investors. These firms should be on notice of the certainty of examination scrutiny.
III. Division of Enforcement
Combats Microcap Fraud
The SEC has increased its focus on microcap fraud in the Division of Enforcement in Washington, DC, and in the regional and district offices around the country, to bring actions against fraudulent microcap companies, promoters and brokers. In these microcap cases the SEC seeks immediate relief, such as temporary restraining orders and asset freezes, as well as strong remedies such as permanent industry bars, registration revocations and fines. In addition, the SEC has increased its use of trading suspensions to minimize investor harm by intervening early in ongoing market manipulations when there is misinformation about the issuer in the market.
In many of these cases the SEC has leveraged its resources by working closely with the criminal authorities, and, in many of the cases described below, has assigned SEC staff to devote full time effort to work on the parallel criminal investigations. Our close collaboration with the criminal authorities is an essential component of our enforcement program, given that a large number of recidivists - with little respect for civil proceedings - engage in microcap fraud.
Some of the SEC's most significant microcap enforcement actions include the following:
August 3, 1999 – Eighty-two individuals and companies charged in 26 actions involving more than $12 million in second nationwide microcap sweep: The Commission announced the filing of 26 enforcement actions against 82 defendants and respondents across the country for engaging in fraudulent microcap schemes from which they profited by over $12 million. The actions charged all of the participants, including issuers, officers, directors, promoters, accountants, attorneys, broker-dealers and transfer agents, in a wide range of microcap fraud cases. In four cases, investors were lured into the market for a manipulated stock by false information communicated on the Internet.
July 8, 1999 – SEC and New York County District Attorney charge brokerage firm and principals with massive microcap fraud: The SEC instituted administrative proceedings against registered broker-dealer A.S. Goldmen & Co., its president Anthony J. Marchiano and seven other people associated with the firm. The SEC charged the respondents with engaging in fraudulent sales practices and market manipulation in five interrelated microcap fraud schemes. Also on July 8, 1999, the New York County District Attorney's Office indicted A.S. Goldmen, Marchiano and thirty-two other individuals, charging them with participating in a pattern of massive securities fraud which cheated thousands of investors out of almost $100 million.
June 16, 1999 – SEC and United States Attorney charge microcap stock manipulator with making $18 million in illegal profits: The SEC filed a complaint in federal court against David Houge, an undisclosed owner of defunct broker-dealer First National Equities , Inc., for his role in manipulating three microcap stocks, Auxer Industries, Inc., Legend Sports, Inc. and Orlando Super Card, Inc. From 1995 to 1998, Houge's schemes generated illegal proceeds totaling $18 million, 50 percent of which he paid in kickbacks to salespeople which were never disclosed to retail customers. Houge consented to a permanent injunction and a bar from serving as an officer or director of any public company. Also on June 16, 1999, the United States Attorney's Office for the Eastern District of New York named Houge as an unindicted co-conspirator in its indictment charging 89 defendants with manipulating twenty microcap stocks.
October 27, 1998 – SEC charges 44 on-line stock promoters with securities violations: The SEC filed 23 enforcement actions against 44 individuals and entities who touted microcap stocks over the Internet without disclosing adequately the compensation they received from the issuers of those stocks. The SEC alleged that defendants purported to be giving independent stock recommendations in on-line newsletters, spams (Internet junk e-mail), message board postings, and websites, when, in fact, their opinions had, been bought and paid for. The promoters are alleged to have received over $6.3 million and nearly two million shares of cheap insider stock and options from the companies whose stocks they touted. In some instances, promoters sold their own stocks immediately after recommending that investors purchase them -- a deceptive practice referred to as "scalping". On February 25, 1999, the SEC announced that it filed four additional cases against Internet stock promoters for illegal touting of microcap stocks.
September 24, 1998 – Thirty-eight people charged in twelve actions involving microcap "pump and dump" schemes: The SEC announced the filing of twelve enforcement actions against thirty-eight defendants across the country for their involvement in microcap fraud, bilking investors of more than $25 million. In nine injunctive actions and two administrative proceedings the SEC alleges that the defendants violated the antifraud provisions of the federal securities laws by manipulating thirteen microcap stocks. The defendants engaged in "pump and dump" schemes and manipulated the stock price of microcap companies by disseminating materially false and misleading information about the financial condition, business relationships and future stock price of those companies, among other things. The defendants in these cases profited from the fraud, often by selling cheap insider stock after pumping up the stock price, receiving a total of over $25 million in ill-gotten gains. In a separate administrative proceeding, the Commission charged a former branch manager at Datek Securities Corp. with failing to supervise former Datek broker, Sheldon Maschler, who participated in the unregistered distribution of microcap stock in a "pump and dump" scheme.
March/April 1998 – Market manipulation in Electro-Optical Systems Corporation yields over $10 Million in about three months: The SEC suspended trading and obtained a TRO, asset freeze and preliminary injunction based on a market manipulation scheme in the stock of Electro-Optical Systems Corporation. The scheme included the dissemination of false and misleading information over the Internet, and purchased of stock by investors directly over the Internet. The defendants caused the stock price to rise more than 1,000% in one day and raised over $10 million in about three months through this manipulation scheme.
December 18, 1997 – Fifty-eight individuals charged in five SEC enforcement actions: The SEC filed five civil injunctive actions charging fifty-eight defendants with manipulation of the over-the-counter markets for microcap securities. The five actions were the result of an undercover investigation into illegal practices in the OTC securities markets conducted by the United States Attorney's Office for the Southern District of New York and the Federal Bureau of Investigation, with assistance from the SEC and the National Association of Securities Dealers Regulation. On October 16, 1996, this same undercover operation led to the arrest of forty-six individuals and the institution of administrative proceedings by the SEC against twenty-nine of the individuals arrested.
November 25, 1997 – Seventeen individuals indicted for stock fraud:The SEC suspended trading in the stock of HealthTech and obtained an injunction requiring correction of the company's fraudulent financial statements. The SEC staff also worked with the U.S. Attorney in indicting seventeen individuals associated with the brokerage firm Meyers Pollack, including two high-level members of organized crime families, for securities fraud by the company and several brokers.
May 13, 1997 – Brokerage firm and principals indicted: The SEC brought emergency administrative action against the firm A.R. Baron for fraudulent sales practices, revoked Baron's broker-dealer registration and recovered significant investor funds. The Manhattan District Attorney's Office subsequently indicted A.R. Baron and thirteen individuals associated with Baron, including the firm's principals.
February 1997 – Thirty-two defendants pled guilty to criminal charges:The Nevada U.S. Attorney obtained guilty pleas from thirty-two defendants on charges of racketeering, securities fraud, money laundering, illegal structuring of monetary transactions and conspiracy to commit securities fraud and wire fraud charges in connection with the sales of the stock of three microcap issuers. To date, the SEC has brought enforcement cases against a total of nineteen respondents in connection with undisclosed payments on the stocks that were involved in these criminal proceedings.
October/November 1996 – Market Manipulation by Systems of Excellence:The SEC suspended trading and obtained a TRO and asset freeze based on a market manipulation scheme in the stock of Systems of Excellence. The scheme, which involved the abuse of Form S-8, included bribes paid to newsletter writers to promote and disseminate misleading information about the company over the Internet. Six individuals have pled guilty to criminal charges.
February 1996 – Abuses of Regulation S:The SEC instituted and settled proceedings against Candie's Inc., Salvatore Mazzeo and others based on their use of Regulation S in a scheme to evade the registration requirements of the securities laws.
The SEC's Enforcement Division has dedicated certain staff almost exclusively to coordinate its nationwide enforcement effort to address microcap issues. The goals of this group, which works closely with the Commission's field offices, are to: intervene in microcap frauds at the earliest point possible to minimize investor harm, to enhance surveillance and coordination with the SEC's operating divisions as well as the NASD, and to coordinate a nationwide approach to microcap fraud with other state, federal and industry regulators.
In addition, the SEC is cracking down on individual brokers who engage in fraudulent practices which impact the microcap market. For instance, in November 1995 and May 1997 the SEC and the Department of Justice filed charges against twenty-eight rogue brokers throughout the country for engaging in a wide range of fraudulent conduct, including forging investor checks, engaging in unauthorized transfers of client funds, selling securities of nonexistent companies and creating false account statements.
IV. Summary of Regulation S Amendments
Regulation S provides a safe harbor from the registration requirements of the Securities Act for offers and sales of securities by both foreign and domestic issuers that are made outside the United States. It was adopted on the premise that the registration provisions under U.S. law should not apply to placements of securities that are truly offshore. Instead, the laws of the foreign jurisdiction regulating public offerings of securities would protect investors in that market.
Although Regulation S has proved successful for many types of offerings, abuses in connection with sales of equity securities, particularly with respect to equity securities of domestic issuers, have been widespread. Issuers, affiliates and others involved in the distribution process have used Regulation S as a guise for distributing securities into the U.S. markets without the protections of registration under the Securities Act.
On February 20, 1997, the Commission proposed for comment certain amendments to Regulation S designed to curb abuses of that rule. As a result of these amendments, securities sold by domestic issuers pursuant to the Regulation S exemption will be treated in a manner similar to securities sold under the Regulation D exemption from registration.
On February 10, 1998, the Commission adopted final amendments to Regulation S, which include the following changes:
Equity securities placed offshore by domestic issuers under Regulation S will be classified as "restricted securities" within the meaning of Rule 144, so that resales without registration or an exemption from registration will be restricted. Rule 905, which classifies these securities as "restricted securities," will not be applied retroactively;
To avoid confusion between the holding period for "restricted securities" under Rule 144 and the "restricted period" under Regulation S, the term "restricted period" will be renamed the "distribution compliance period";
The distribution compliance period for these domestic equity securities will be lengthened from 40 days to one year;
Certification, legending and other requirements will be imposed on these equity securities; and
Domestic issuers will be able to report sales of equity securities pursuant to Regulation S on a quarterly basis, rather than on Form 8-K.
V. Summary of Form S-8 Amendments and Proposals
Form S-8 is the short-form Securities Act registration statement for offers and sales of securities to employees. Unlike other Securities Act registration forms, Form S-8 does not contain a separate disclosure document called a "prospectus." Instead, Form S-8 relies on documents otherwise provided by the employer to satisfy the disclosure obligations of the Securities Act. This abbreviated disclosure is available for offers and sales of securities to employees because of the compensatory nature of these offerings and employees' familiarity with the company's business due to the employment relationship. In 1990, the Commission expanded the employee concept to permit Form S-8 to be used for offers and sales to consultants or advisors who provide legitimate services to the issuer that do not involve the offer or sale of securities in a capital-raising transaction.
Since adoption of the 1990 revisions, some companies have used Form S-8 improperly to compensate consultants whose service to the company is promotion of the company's securities. This practice has been used in fraudulent promotions of microcap securities. In other cases, Form S-8 has been used to distribute securities to public investors through so-called "consultants" whose service to the issuer is selling the securities. This practice, which deprives public investors of the benefits of Securities Act registration, has been the subject of several Commission enforcement actions.
In February 1998, the Commission proposed for comment amendments to Form S-8 designed to curb these abuses. On February 19, 1999 the Commission adopted some of these proposals, amending:
Form S-8 and related rules to make the form unavailable for sales to consultants and advisors who directly or indirectly promote or maintain a market for the company's securities; and
the Securities Act rules, so that registration statements, such as Form S-8, that "go effective" automatically upon filing will not be presumed to be filed on the proper form.
On the same date, the Commission proposed new amendments to Form S-8 that are designed to deter the same abuses. These new proposals would amend the Form S-8 eligibility standards to:
require any company to be timely in its Exchange Act reports during the 12 calendar months and any portion of a month before the Form S-8 is filed; and
require a company formed by a merger of a nonpublic company into an Exchange Act reporting "shell" company to wait until it has filed an Exchange Act annual report containing audited financial statements reflecting the merger before filing a Form S-8.
The Commission continues to consider the 1998 proposal to require disclosure in the Form S-8 of the names of any consultants and advisors who will receive securities under the registration statement, as well as the amount of securities to be offered to each and the nature of the consulting or advisory services, and related comment requests. The Commission has extended the comment period on these matters for the duration of the comment period on the new proposals. The Commission may adopt any combination of the 1998 proposal, the related comment requests and the new proposals.
Although Form S-8 has been misused in microcap fraud schemes, most Forms S-8 are filed for legitimate employee compensation purposes. The Commission also adopted amendments to simplify registration of securities underlying employee benefit plan stock options. Because these options have become an increasingly important component of employee compensation, employees are more likely to face circumstances - such as estate planning and property settlements in connection with divorce - that may require the transfer of options to their family members. Form S-8 appears suitable for the exercise of employee benefit plan stock options by employees' family members because of the continuing compensatory nature of the transaction. The amendments make Form S-8 available for these exercises, and clarify how options that have been transferred to family members should be disclosed in SEC filings.
VI. Summary of Amendments to
Rule 504 Of Regulation D
Rule 504 of Regulation D allows non-reporting companies to raise up to $1 million per year in "seed capital" without complying with the registration requirements of the Securities Act. On February 19, 1999, the Commission adopted changes to Rule 504 to limit the availability of the exemption from registration in light of disturbing developments in the secondary markets for some securities initially issued under Rule 504, and to a lesser degree, in the initial Rule 504 issuances themselves. These offerings generally involved the securities of microcap companies. Recent market innovations and technological changes, most notably, the Internet, created the possibility of nation-wide Rule 504 offerings for securities of non-reporting companies that were once thought to be sold locally. In some cases, Rule 504 offerings have been used in fraudulent schemes to make prearranged "sales" of securities under the Rule to nominees or promoters in states that do not have registration or prospectus delivery requirements. As a part of these arrangements, the securities would then be placed with broker-dealers who used cold-calling techniques or with promoters who used the Internet to sell the securities at ever-increasing prices to unknowing investors.
The amendments recently adopted by the Commission limit the circumstances where general solicitation is permitted and "freely tradable" securities may be issued in reliance on the Rule to transactions that : 1) are registered under a state law requiring public filing and delivery of a substantive disclosure document to investors before sale, or 2) involve securities issued under a state law exemption that permits general solicitation and advertising, so long as sales are made only to accredited (meaning, generally, sophisticated and/or experienced) investors as that term is defined in Regulation D. For sales to occur in a state without this sort of provision, the transaction must be registered in another state with such a provision and the disclosure document filed in that state must be delivered to all purchasers before sale in both states.
Private offerings under Rule 504 will continue to be permitted for up to $1 million in a 12-month period, but now the securities in these offerings will be restricted, and these offerings may not involve general solicitation and advertising.
VII. Summary of Rule 15c2-11 Reproposal
Problem
Quotations can be integral to fraudulent schemes involving microcap securities. Retail brokers "hyping" a microcap security may refer to a market maker's quotation when representing the security's value to a potential customer. The Commission is concerned that many market makers for unlisted securities may publish quotations without reviewing current financial and other information about the issuer.
Microcap securities often are thinly traded and their issuers have minimal or no assets. Many of these securities trade in the unlisted over-the-counter market, i.e., they are not listed on an exchange or Nasdaq, but are quoted in systems like the NASD's OTC Bulletin Board or the National Quotation Bureau's "Pink Sheets."
Response
In February 1999, the Commission reproposed amendments to Rule 15c2-11 under the Exchange Act to help curtail abuses in the offer, sale and trading of microcap securities. The amendments are intended to have broker-dealers review fundamental information about the security's issuer before they publish quotations. The amendments also will help to improve the quality of information about smaller, lesser-known issuers and foster greater access to this information by investors. A prior version of the amendments was proposed in February 1998. The comment period for the reproposal expires 30 days after its publication in the Federal Register.
How Rule 15c2-11 Works Now
Rule 15c2-11 requires broker-dealers to review current information about the issuer before publishing quotations for that issuer's securities. Broker-dealers must have a reasonable basis for believing that the information is accurate and was obtained from a reliable source. After one broker-dealer has published quotations for a security for at least 30 days, other broker-dealers can publish quotations for the security without reviewing information about the issuer (i.e., they can "piggyback" onto the quotes of the first market maker). Broker-dealers thereafter can quote indefinitely without reviewing any issuer information (unless the Commission suspends trading in the security).
Reproposed Amendments
The reproposed amendments make significant changes to the scope of Rule 15c2-11 to focus on the type of quotations and securities that are used in fraud schemes. For example, the reproposal will require the first broker-dealer to review the specified issuer information before initiating a priced or unpriced quotation for an unlisted OTC security. Thereafter, any broker-dealer publishing a priced quotation for the security for the first time must review current information about the issuer (i.e., "piggybacking" will be eliminated). A broker-dealer publishing priced quotations also will have to review the issuer information annually. The reproposal will require broker-dealers to document their Rule 15c2-11 review and make a record of any significant relationships they have with the issuer or others, including the receipt of any compensation to make a market. Also, the reproposal focuses Rule 15c2-11 on OTC microcap securities by excluding the securities of larger issuers.
The information that broker-dealers must review covers issuers that file periodic reports with the Commission (i.e., reporting companies), those issuers that file periodic reports with other government agencies, and those issuers that do not file any periodic reports (i.e., non-reporting companies). The information about reporting companies is readily accessible through the Commission's EDGAR system. For non-reporting companies, broker-dealers will have to obtain more information than Rule 15c2-11 currently requires, including more information about the issuer's insiders, control persons, and promoters, and about recent significant events involving the issuer. Broker-dealers will have to provide the information to customers and other broker-dealers upon request, as well as to any information repository. The reproposal establishes a procedure for recognizing information repositories to collect and distribute Rule 15c2-11 information.
The reproposal targets the unlisted microcap securities market. By enhancing the information reviewed by market makers and narrowing the scope of the Rule, the reproposal should provide more efficient and effective mechanisms to deter fraud and manipulation in the OTC market.
VIII. How to Avoid Micro-Cap Fraud:
Office of Investor Education and Assistance
The SEC's Office of Investor Education and Assistance strongly believes that an educated investor provides the best defense against securities fraud. Investors who know what questions to ask and how to detect fraud will be less likely to fall prey to con-artists. And, because they are more likely to report wrong-doing to the SEC and their state securities regulators, educated investors serve as an important early warning system to help regulators fight fraud.
We educate investors on how to invest wisely and protect their savings from fraud in all markets. Our programs include:
Free Publications We distribute more than a dozen free brochures that explain in plain English how the securities industry works, how to invest wisely, and what to do if something goes wrong. These include
Microcap Stock: A Guide for Investors – In the battle against microcap fraud, the SEC has toughened its rules and taken actions against wrongdoers, but we can't stop every microcap fraud. Before you consider investing in a microcap company, arm yourself first with information. This brochure tells you about microcap stocks, how to find information, what "red flags" to consider, and where to turn if you run into trouble.
Cold Calling Alert – Cold calls can serve as a legitimate way for brokers to find new customers. But some dishonest brokers use the telephone to pressure investors to buy risky investments, including microcap securities, that may be part of a scam. Cold Calling tells investors about their legal rights, how to deal with cold calls, how to stop them, and how to evaluate investment opportunities that come over the telephone.
Internet Fraud: How to Avoid Internet Investment Scams – Unwary investors may be lured by the vast array of investment opportunities on the Internet. But not all are legitimate. Online scams abound, and many involve small, microcap companies. This alert tells you how to spot different types of Internet fraud, what the SEC is doing to fight Internet investment scams, and how to use the Internet to invest wisely.
Ask Questions – This brochure lists the questions investors should ask about their investments and the people who sell them and tells investors what to do if they run into problems.
Invest Wisely: Advice From Your Securities Regulator – Learn how to choose a broker, pick an investment, and look out for trouble.
SEC Website The "Investor Assistance" pages on the SEC's website – www.sec.gov – feature "investor alerts" on various investment scams, updates on significant enforcement cases, and all of our publications.
"Facts on Saving and Investing Campaign" The SEC, the North American Securities Administrators Association, and the Council of Securities Regulators of the Americas recently launched an ongoing, hemisphere-wide "Facts on Saving and Investing Campaign" to educate the public about the importance of saving, investing, and avoiding securities fraud.
Investors' Town Meetings We've held 27 Investors' Town Meetings to educate investors and respond to their concerns.
Toll-free Information Line Investors can use our 24-hour, toll-free information line – (800) SEC-0330 – to order free publications and get updates on fast-breaking cases.
Complaint Tracking Our office analyzes data from investor complaints to track trends. We also monitor broker migration. These activities help us to identify problem brokers, firms, or sales practices so that the SEC's enforcement and inspections resources can be directed to the areas of greatest need first.
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Last update: 08/03/1999
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