Beware the Pump and Dump Scheme

You may not have heard of the phrase “pump and dump.” I would be surprised, however, if you haven’t been personally solicited by a so-called investment advisory firm that was trying to sell you a penny stock.

What’s the connection? Pump and dump schemes, which are illegal, usually involve the heavy promotion of a penny stock by supposed investment advisors or corporate public-relations firms.

Are all stocks traded for less than $1 per share suspect? Absolutely not! But the average pump and dump scheme does involve some kind of penny stock.

Floats and Upsides

Let’s take a look at this phenomenon. First of all, it gets its name from unscrupulous people heavily promoting the stock of a small company that usually is in financial cardiac arrest. The stock commonly has a small float. In other words, it’s a thinly traded company with not many shares being actively bought and sold.

The people behind this scheme do their very best to “pump up” the price of the stock by intentionally providing inaccurate information on it. Once the stock reaches an artificially inflated high, the owners of the stock dump it. This scheme is also referred to as “hype and dump manipulation.”

In the short term, penny stocks have nowhere to go but up. If a stock is traded at 2 cents per share, it’s quite an easy jump to 4 cents or 5 cents, isn’t it? If it rises from 2 cents to 4 cents, that’s a 100 percent increase in value! One doesn’t normally see such price fluctuations on a national exchange such as the New York Stock Exchange.

The prices of these penny stocks that are being manipulated are extremely volatile. Because not many shares are being traded on any given day, the stock price can explode if demand is artificially primed.

This is a normal response to the laws of supply and demand. The inflated price cannot, however, be maintained for very long. Only good, basic fundamentals maintain and support the price of a stock.

Investor Holds the Bag

Greed, of course, is the motive of the manipulators who are driving up the price of the penny stock. The short-term upside is so great that one can see how this arena usually attracts unsavory characters.

The sad thing is that once the stock has achieved a lofty price level, the manipulators cut and run. This means that they sell out wholesale, thus driving down the price of the stock to where it was before they got involved — or possibly even lower. The unwary investor is left holding the bag.

The Securities and Exchange Commission is well aware of these schemes. But it can do only so much. The commission’s main duty is to assist the investor in avoiding the pitfalls of pump and dump schemes. Good information can be found on the SEC Web site.

You Are the Target

Just how do these operators contact you? They can call you on the phone with a “hot tip,” but my understanding is that the promoters aren’t using telemarketing as much as they have in the past.

The reason is that the federal government has now instituted the national Do Not Call Registry, which makes manipulators easy targets for those who file complaints with the registry. These schemers simply do not want that much exposure.

The more common method of contact is through your fax machine and your computer. For example, even though I have registered with the national do not call registry, these promoters are still sending me faxes.

I have found, however, that each fax does have a toll-free number that can be called to request removal from the list. I invariably call that number and, when I have the time, I report the fax to the registry.

Pump and Dump Spam

I also get spammed quite regularly by promoters of these schemes. In fact, I was spammed today.

At the end of the e-mail there was a disclaimer that said, among other things, that the promoter “discloses the receipt of Twenty-Thousand Dollars from a third party for the circulation of this report.”

It also stated that “all factual information in this report was gathered from public sources.” In other words, the promoter wanted nothing to do with the validity of the data that it was sending to you.

There was one more disclaimer. The promoter said that it could “make no guarantee as to the accuracy or completeness of the information.” And it had the audacity to say, “Use of the material within this e-mail constitutes your acceptance of its terms.” Honestly, I’m not making this up.

Take Action

What can you do if you think that someone is trying to make you the victim of a pump and dump scheme? You can call the SEC at 800-732-0330 or file a complaint at sec.gov/complaint.shtml.

Give the SEC as much identifying information as possible about the scammers — for example, the name of the company being promoted, the contact phone number that they provided you with (assuming that they did so), and even the date and time of the call.

So now we know, I hope, something about the pump and dump phenomenon. It’s going to be around for a while, so be cautious when you are buying penny stocks that are heavily promoted. If you’re not a professional, stick to the stock of conventional companies that have good track records. And good luck!