A nice little article...
SEC Proposes New Measures to Combat Microcap Fraud
By Rusty Szurek - 2/21/98
Over the past several years, the Internet has evolved into a powerful medium
for the personal investor. Through Internet message boards, microcap stocks
and many others have gained large followings. Unfortunately, some individuals
have abused message boards and other Internet resources to hype and
manipulate these types of stocks. In an attempt to combat these fraudulent
practices, the Securities & Exchange Commission recently proposed several
regulatory measures. What are the possible implications of these regulations?
Overview
Microcap companies are predominantly thinly capitalized stocks that are often
not required to file periodic reports with the SEC. The securities of these
companies are quoted on three mediums: the Over-the-Counter Bulletin Board
(OTC BB) under the supervision of the National Association of Securities
Dealers, Inc. (NASD), in the Pink Sheets under the supervision of the National
Quotation Bureau, and on the Nasdaq Small Cap Market. Microcaps, because
of infrequent press releases and hype, often trade on high volumes with large
price spreads and fluctuations. The SEC has recently become more concerned
about microcap fraud as the aforementioned trading mediums have assisted
individuals, brokers, and companies in their efforts to control the markets for
these securities.
The "pump and dump" scheme is one of the most common types of microcap
fraud. Brokerage firms use their personnel to "cold call" potential investors to
purchase "house stocks" (stocks in which the brokerage firm holds a large
inventory or makes the market). Often, the information disclosed to investors is
slightly exaggerated, or it can be completely fabricated. Message boards on the
Internet have made it very easy for "pump and dump" schemes to operate.
Promoters or insiders of a company, holding many shares, commonly post
messages citing the great potential for a company on these boards. After
investors "pump" up the stock, the insiders and promoters "dump" their shares,
realizing healthy profits.
An example of this scheme involves the security, Systems of Excellence
(SEXI). The CEO, Charles Huttoe, was convicted of paying an electronic
newsletter to hype his company's stock. Huttoe pleaded guilty to making $12
million in illegal profits, and he is currently serving a 46-month sentence.
The SEC recently made the following proposals aimed to decrease fraudulent
scams similar to the "pump and dump" schemes in microcap trading:
NASD Surveillance Proposal
The most recent proposal by the SEC is to have the NASD implement an
automated surveillance system that will search Internet message boards,
company home pages, investment sites, and other on-line sources for fraudulent
claims about Nasdaq and OTC securities. The NASD plans to investigate
companies with large message followings, suspect postings, and large fluctuation
in daily closes. The surveillance system has taken a year to develop, and it will
alert the NASD to certain phrases like "the next Microsoft, hot tip, etc." posted
on the Internet. After being alerted, the NASD will investigate those companies
it feels may be fraudulent. Mary Schapiro, President of NASD Regulations, has
said that an "automated technology might have raised earlier red flags about
Comparator Systems Corp., whose stock rose thirty-fold in a three-day period in
May 1996 before it collapsed."
However, the NASD does see two problems with this new system. First, the
anonymity of those posting the messages, and second, the vastness of the
Internet. Despite these fears, the SEC feels that this system will allow them a
better opportunity to alert the public and brokerages of possible scams even
though it may not know who exactly is posting the fraudulent information. The
SEC's enforcement director, William McLucas, has said "investors need to be
just as wary of the information they read electronically as they are about a flier
they are handed on the street."
Form S-8 Proposal
Form S-8 is used to register securities for offer and sale to employees of the
issuer in a compensatory or incentive context. Revised in 1990, the form has
since been used improperly as a means to sell securities to the public without the
correct investor protections outlined in Section 5 of the Securities Act. Fraud
occurs in the following manner: The issuer of Form S-8 registers the securities
to consultants or market-makers (market-makers: dealers who match buyers
and sellers and help finance trades) who then act as statutory underwriters to
sell the securities to the general public. As compensation, the registrant issues
the consultants securities for promoting or hyping the registrant's securities.
This practice promotes fraud by compensating market-makers who hype the
issuer's stock. A secondary problem is that often times the market-makers
know little or nothing about the security they are trading and as a result provide
a disservice to the investor.
The SEC proposals would deter Form S-8 abuse by:
Clarifying that Form S-8 status is not available for sales to market-makers
who directly or indirectly promote or maintain a particular company's securities.
Disclosing to the public those advisers who are receiving stock from Form S-8
clauses.
Microcap Capital Raising Proposal
Although nothing has been formally proposed yet, SEC officials are seriously
considering regulating ways in which small companies raise seed capital by
selling their companies securities privately to friends and family. The current
rule, 504 of Regulation D, allows public and private companies to sell as much
as $1 million worth of stock without registering the securities with the SEC. The
SEC added this rule to Regulation D to help small companies raise capital
without having to pay the expensive costs of federal registration.
The SEC plans to amend this rule by forcing companies that avoid federal
registration of the security to register the stock sale with a state's security
regulator. This proposal would also require companies to file financial
statements with state regulators. The proposal would also recommend that the
owner of the shares be required to hold the securities for one full year before
any of them can be traded, and two years before all of the securities can be
sold. Under current SEC law, the securities can be sold immediately and
investors have no access to a company's financial information.
How will these regulations affect Investors?
Although the Internet provides a wealth of information, investors should realize
that much of the information can be false, and that they themselves, should
confirm any claim made on the Internet. If passed, these new regulations will
help the personal investor. It should help remove some of the fraudulent
microcaps and hopefully lessen the hype found on message boards. However,
because the Internet is so vast it is impossible to curb all fraudulent schemes.
The new regulations should not be cumbersome for legitimate small companies.
Stanley Keller, co-chairman of the American Bar Association's task force of
small issuers said, "This won't be particularly burdensome to small companies
and shouldn't interfere with legitimate small-business financing efforts."
Investors should realize that the SEC does not require companies that are
raising less than $1 million to formally register with the SEC. Therefore, these
companies do not have to file reports with the SEC. Investors should be extra
careful with companies that fit this description.
Investors should research as much as possible about a company before they
invest. Never rely solely on information from on-line sources to make an
investment decision.
Investors interested in visiting the SEC's guidelines to "INVESTigating before
you INVEST" should visit: sec.gov.
Note: It was not the aim of this article to slander any of the companies
originally mentioned in the opening paragraph. The author, Rusty
Szurek, was only trying to express to the readers that microcap stocks
like the securities listed have gained a larger following facilitated by the
Internet. He used the large following on Silicon Investor and Yahoo
message boards as evidence of his statement. The current financial
position and standing of the companies was of no consideration to the
author. He apologizes to those shareholders and employees of any of
the named companies who feel that they may have been slandered
through "guilt by association." |
