DOB: Investor Alert: Phone Hucksters Target Micro-cap Investors

INVESTOR ALERT {traffic light with red stop signal displayed}

{ } Phone Hucksters Target Micro-Cap Stock Investors

May 1997 -   "You've got to understand," said the voice on the other end of the telephone. "Typically, I don't make these type of calls. I've got people to do that. I've got 11 years in this business and worked my way up to senior vice president with 400 clients and $40 million dollars under management. I don't need this account, but I want it."

The caller was attempting to close a deal for an unknown small-cap stock by trotting out some of his most impressive facts. But it was all a lie. In fact, he had been on the job for less than a month and was reading from a script supplied by his employer.

"Perhaps a return of 100 percent in 20 minutes sounds a bit unrealistic," the scam artist continued. "But that's exactly how all our initial public offerings trade. We did three deals last year yielding collectively 34 points within the first ten days of trading. That's a fact! All I ask for is your vote of confidence this one time. I won't let you down."

Taken from an actual script seized by state securities examiners in February 1997 from a working boiler room, these words encapsulate the danger faced today by investors who purchase shares of stock in unknown companies over the phone from people they don't know. Although the companies are all small, it is not their size that is dangerous, but the dishonest way that the stock is manipulated and sold by others. Unfortunately, far too many investors are falling for the lure of this latest trend in boiler room scams. Telemarketers, playing upon people's desire for ever-greater financial returns, have been running away with millions of dollars of hard-earned-money.

Among the victims: An elderly Connecticut man who was swindled out of $40,000 and suffered a stroke that his wife claims was directly tied to the loss. A Utah man in his forties who lost $11,000 through the payment of commissions after being promised that his transactions would be commission-free. A 78-year-old Missouri man, who originally purchased $6,000 of stock, incurred a loss of $24,000 after his broker executed six trades without his knowledge or consent.

The States Take Action

In response to a growing pattern of investor complaints against a dozen small, broker-dealer firms, the North American Securities Administrators Association, Inc. (NASAA) authorized a special project. The mission was clear: To address the problem of fraudulent sales practices in the small-cap marketplace.

In January 1997, NASAA created a task force comprised of representatives from 12 states. The task force was divided into five teams, each targeting the headquarters of a particular firm. In addition, branch offices in several other states were also scheduled for coordinated audits.

Examinations of four of the five firms revealed four systematic abuses. They include:

Evasion of broker-dealer registration requirements. Stockbrokers and the firms that employ them are required to register in the state in which they do business. This requirement serves several important purposes: To allow state securities officials to monitor the activities of the firms in order to insure compliance with laws designed to protect investors. In addition, registration also ensures that representatives meet minimal knowledge requirements through a requirement that potential registrants first pass an examination. When a broker-dealer or its representative is not properly registered, its a sure sign that something is wrong. Most of the firms that were examined were found to be employing unregistered agents. Other requirements triggered by registration include keeping proper books and records and supervision of employees. One firm kept no customer or trading records at its principal office and claimed that its branches were franchises in order to evade state securities laws.

Failure to report investor complaints. Most of the offices failed to have centralized procedures for handling and reporting customer complaints. Examiners found forms to respond to unauthorized trade complaints with blanks to be filled in with the name of the stock, its value, and the reason for the unauthorized trades. At several firms, complaints were found stuffed in customer files, inquiry files, correspondence files and stock jacket files. One branch office had reported only one complaint to the National Association of Securities Dealers (NASD) since July 1, 1996, yet over 90 complaints were recovered on-site by examiners. Another firm had no complaints on file with the NASD, but state officials found over 300 complaints throughout the office. The following pattern of abuse emerged: After receiving a complaint of an unauthorized trade, a registered representative called the investor and convinced that person to hold onto the stock, usually telling the investor that the stock had already appreciated in value. The investor was requested to fax a note that indicated the unauthorized trade was accepted. If the investor later changed his or her mind, the rep claimed otherwise. Records of unreported settlements were documented as "clerical errors" without any back-up documentation.

Abusive cold calling practices. All of the firms and branches relied on high-pressure, scripted telephone "cold calling" practices. Many were classic boiler room operations with long tables and up to seven phone stations per table. These operations were very busy, with as many as 60 cold callers each making several hundred phone calls daily. At one firm, all the cold callers were on the first floor without any supervision. They "qualified" clients by determining their market assets and interest in the stocks that the firm was pushing. Average pay for cold callers is $200 per week.

"I sense you like to make money and you think it's a compelling buy, but I think there is another factor here. A psychological comfort factor... I'm a stranger asking you for an order. Let me address that because it's our biggest problem. It's like the first kiss. We're not day traders. We position stocks for the long term." (From an actual script found during an examination.)

Clients of several companies were able to recall and identify unregistered cold callers, but had no recollection of speaking or trading with the licensed registered representative who allegedly signed off on the accounts. At one firm, there was a score board listing stocks, customers, and other production information. No one at the firm could explain its use to state examiners or the information listed on the board. A registered rep told an examiner that he made 250 calls on a good day; 70 on a bad day. All of his calls had been previously "qualified" by an unregistered cold caller.

Sales practice abuses. Unauthorized trading was rampant at all of the firms. Firm and branch records were falsified. Customer account forms were marked with the number of the registered representatives whom the clients insist they had never spoken to or traded with. Failure to execute sell orders was a common stated problem. No commission is paid on a sell order and there is no market until the next victim is found. Unsuitable recommendations and other unethical practices were common customer complaints. At one firm, a review of a thousand customer accounts showed that all of the clients had bought only one or two stocks -- stocks that only that particular firm was selling to the public. At a time when the Dow Jones Industrial Average was being driven by the S&P 500, these firms' clients were investing solely in unknown small-cap companies.

A Changed Marketplace

In the late-seventies and early 1980s, so-called "penny stock" frauds were rampant in Colorado and Utah until state securities officials moved in and shut them down. Although the scams of today are similar to the swindles of that earlier time, there are significant differences.

The most obvious difference is the marketplace itself. Today, there are far more mid-income retail investors than ever. One in three U.S. households now owns securities, compared with one in 17 households in 1980. Products are more sophisticated and choices have multiplied. Due to the growth of 401(k) plans and other self-directed retirement programs and fears about the future of Social Security, people are encouraged to be more "aggressive" in their investments. The marketers of the most legitimate firms down to bottom-dwelling perpetrators of fraud are singing the same siren song: "You've got to be in the market or you're going to be left behind." The message is everywhere. It's hard to pick up a magazine or watch television or listen to the radio without hearing advertisements for mutual funds or other securities products.

There has also been a general assault on regulation as portions of industry, some elected officials, and large sectors of the media question its effectiveness. Intertwined with the current bull market is an undercurrent that declares state licensing procedures inefficient and a tax on capital. Unfortunately, this rhetoric helps provide the necessary cover for scam artists and crooks.

To avoid becoming a victim...

1. Ask the Department of Banking for help. When you are contacted by a securities industry representative, particularly if you do not know this person or have not heard of the firm, contact the Securities Division to learn more about the caller and the firm. The simplest inquiry is to ask if they are registered to do business in Connecticut. But you should also ask about the record of the firm and its representative. Are there any past reportable disciplinary events? How long has the salesperson been in the securities industry? The majority of this information is available if you only ask.

2. Ask questions. Even if everything checks out with the state, don't rely on a company's glossy brochure. You need to ask about the investments themselves. Where is the company traded? Is it listed in the stock tables printed in your local newspaper? Investigate its trading history. Make phone calls. Find out more about it. Read the prospectus. Ask the salesperson -- who is making a market in the stock? Who else is buying in your area? Is the salesperson's firm making a market in this company? The reason you want to ask is that they might be the only market maker. And they might be using cold calling techniques to create a buy demand for a stock that insiders will sell when the price is driven high enough. Don't let the salesperson intimidate or pressure you. If uncertain, say that you want to check into the stock further.

It is not uncommon for some salespeople to attempt to make you look foolish if you ask for additional information. In one script picked up by Connecticut examiners, salespeople were trained to respond to individuals seeking background information as follows:

Dear Customer, do you mind if I ask you a question? When you go on an airplane -- with your most prize possessions -- the lives of your family and yourself, do you ask to see the pilot's credentials or those of the riveters or welders? Which is obviously a much bigger decision than the one I'm asking you to make today. No! Why? Because of the reputation of the entire airline company.

3. Send copies of your complaints to regulators. When you have problems with a firm, immediately put your problem down in writing and send a copy of your complaint to the Department of Banking's Securities Division as well as to the NASD. Examiners in the February sweep found hundreds of complaints that individual investors wrote to the firms that were never passed on to regulators. Failing to forward a complaint to the appropriate regulator is a violation of the rules for firms. But if they have stolen your money, what good does that violation do for you? If you call to inquire about a firm, and a previous customer's complaint never made it into the system, you won't be protected. So never forget to send a copy of your complaint to the regulators as well.

For more information...

If you suspect that you may be the victim of investment fraud, contact the Department of Banking.

The oldest international organization devoted to investor protection, the North American Securities Administrators Association (NASAA) was organized in 1919. It is a voluntary association with a membership consisting of the 65 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, Canada, and Mexico. In the U.S., NASAA is the national voice of the 50 state securities agencies responsible for the promotion of efficient capital formation and investor protection.


What Every Investor Should Know