Pump and Dump: Avoiding an Illicit Money-Raising Scheme
One of the ways in which reverse mergers had had a bad rapport over the years is the often-repeated and sleazy practice of the typical pump-and-dump public offering. To the layperson, a pump-and-dump scheme likely sounds more complicated than it actually is. In most instances pump-and-dumps are as simple as running up the price of the stock and then selling off large blocks of the equities or convertible debt, driving down the value of the shares and sucking the money out from investors who placed money in during the pump phase. Let’s be completely clear: such shenanigans do not represent a zero-sum game or a victim-less crime. There are real winners and losers in the process–the winners win at the expense of the losers. The pump-and-dump itself is one of the classic methodologies that gives us movies like the Wolf of Wall Street and Boiler Room.
How to Spot a Pump & Dump
If you’re a business owner thinking of going public and a “consultant” comes to you offering his/her services to take your company public, it’s good to be leery of the potential to be taken advantage of. Luckily many pump-and-dump deals are orchestrated by con-artists who work with a group of close allies with a facade of a company. In the end their efforts can really screw investors, but they at least save a legitimate outside company from the perils of such financing.
The main feature of any pump-and-dump operation is control. If any single investor has majority control of a shell, then they have a greater ability to manipulate. That doesn’t mean every shell that is 99%+ delivered is a “bad” deal, but the likelihood is certainly higher and investors should have a bit more trepidation. Here are some other potential features that often get squeezed out if you’re doing some real due diligence on a potential investment:
- Promotable product. It may or may not be real, but it’s highly promotable. The key here is “pump”. Ask yourself, “would this product sell with ‘sizzle only’ without the steak attached?”
- Convertible debt. This is typically how the company is initially funded. Check on who owns the convertible debt. Are they insiders? Are they friends of the company? If so, could spell bad news.
- Large forward stock split. Doing so brings the share count up and the number of shares in the public float up as well, allowing for more shares to be sold in the “pump” phase.
- Press releases. To coincide with the large promotional campaign, there should be at least some chatter/noise in the online community through some good PR
- President and/or CEO. Take a look at who is president and CEO of the company. What relationship does this person have to others in the deal?
- Foreign. Sadly, there is a reason that many foreign-based deals have been spurned by the investor community. The instances of fraud and corruption have turned many investors off to the idea.
- Pink/gray sheets or non-reporting. Listed, trading firms that are not current on their financials should be a big immediate red-flag for a pump scheme.
If you’ve the wherewithal to spot a potential pump-and-dump, you’re likely smart enough to perform your own. It’s not rocket science, which is probably why more people engage in this form of investor-screwing than actually become real rocket scientists.
The Dump
“The dump” is a fairly simple concept. The stock is promoted to an unsuspecting investor public whilst the insiders prepare to sell into the flurry and heat of the stock run-up. In this process, the convertible debt-holders can also make out like bandits by converting and immediately selling their shares on the open market. The effective nature of a such activity typically reduces the stock to pennies from highs of $1+. It’s at least one of the contributing factors that many such deals are born and die as penny stocks.
If we’re being completely honest with ourselves every public offering has at least the “pump” component in their initial public offering. Moreover, the desire to pump up the value of the stock is a very natural and healthy thing, especially if the company has executable warrants in the public offering and is looking to raise some capital. The “dump” aspect comes in when market manipulators seek to short or naked short the stock or perhaps propagate a death spiral financing situation.
As one of the most recognizable methods for creating crooked wealth in the financial markets, it’s one of the reasons we still see the SEC’s prosecution of more pump-and-dump cases than perhaps any other. I also find it fascinating that those who orchestrate some of the most grandiose schemes try, in some way, to cover their tracks or think they’re going to get away with it. The temptation is too real because the money to be made is too tempting. This is one of the main reasons overseas deals represent an even higher risk to American investors: the perps are more difficult to track down and even harder to prosecute.
Even with all the right regulations in play, there are those who’ll find a way–somehow–to perpetrate their schemes before the right regulation comes in to cover some additional loophole the government may have failed to previously notice. And while we complain at the rules, many of them are in place to protect the unsuspecting public from the not-so-complicated financial wizardry of pump-and-dump schemers.
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