Monday, March 23, 1998

Small-stock fraud is a big-time problem
Unscrupulous promoters take advantage of a loosely regulated marketplace to cheat investors

by JULIE TRIPP

The great roaring bull of a stock market has brought along an unwelcome passenger as it charges through this decade: an unprecedented boom in securities fraud.

The abuses cost investors $6 billion annually, triple the rate during the heyday of penny stocks in the '80s, according to industry estimates.

This column gives an overview of stock fraud and what regulators and legislators are doing, or not doing, about it. We also give investors advice about what they can do to prevent becoming a fraud victim.

Next week's column looks at a specific proposal to limit listing on the over-the-counter "bulletin board'' exchange to companies that file periodic reports with regulators. Only about half of the 6,800 companies file anything more than token reports. That's also the exchange where much of the fraud occurs, regulators say. More than a dozen Portland-area public companies are listed on the bulletin board.

About $580,000 of that $6 billion mountain of investor losses once belonged to an 86-year-old Oregon man and his wife. How they parted with their money is a textbook example of "microcap'' stock fraud, says their Portland attorney, Robert S. Banks Jr.

The Oregon man, who doesn't want to be identified, is the retired owner of a small business and regarded himself as a conservative investor. He got an unsolicited call from a New York stockbroker -- a "cold call'' -- in the spring of 1995.

The salesman chatted with him, sounded knowledgeable and suggested the man buy McDonalds Corp. and Merck & Co., two blue chips on the Dow Jones average that are above question when it comes to pedigrees. The man opened an account and bought stock.

The investments weren't spectacular, but they were solid. That was the point.

After the broker primed the investor to gain his confidence, he called again. He pointed to his previous blue chip recommendations and then sold the man hard on some new ones.

The investor and his wife invested heavily in three companies the broker talked up as big in the entertainment, computer and cosmetic marketing businesses.

The man didn't know it then, but he had just become a victim of the "Stratton Two-step,'' a technique named for Stratton Oakmont brokerage, which used it to great effect before being expelled from the securities industry in December 1996.

The couple's stocks dropped and kept dropping. The couple were assured they should hang on.

The "momentary blip'' became an extended free fall that ate up most of their investment.

In a fraudulent scheme, the stock drops because at a certain point the broker and brokerage unload their own portion of shares. As they sell to cash in on the high price, their sales drive down the price.

The Oregon couple's case is pending arbitration with the National Association of Securities
Dealers, Banks says.

Microcap stocks such as the ones in which they invested are the penny stocks of the '90s, but the stakes are greater. The securities industry considers microcaps to be companies with market capitalizations of less than $300 million -- small by Wall Street standards. Most penny stocks, generally those that trade for less than $5 a share, fall within that definition.

The microcaps that raise regulators' eyebrows are those that don't regularly trade many shares or are start-up companies with little or no earnings. They generally cost $8 or less on small, loosely regulated exchanges, where it is easier to manipulate their price.

"There has been a significant increase in microcap complaints'' in the United States and Oregon, says Dave Tatman of the Oregon Division of Finance and Corporate Securities. He doesn't keep comparative complaint numbers, but he says he opens between 75 and 100 investigations a year.

"It's very similar to what we saw in the 1980s when penny stock fraud was at its height,'' he says, "but it's a higher-priced form.''

Banks says securities fraud cases have grown to make up half his caseload.

"They used to be $50,000 losses; now it's several hundred thousand. I have nearly $2 million in losses now,'' he said, toting up his clients' aggregate losses.

The bull market in stock fraud springs from several factors. Legitimate investment returns have been so remarkable in recent years that it is easier to sell investors on the promise of wildly unrealistic returns; baby boomers who haven't saved enough for retirement may want to play catch-up with riskier investments; and older Americans trying to live on fixed incomes in a lowinterest rate environment may be more easily tempted with cunning pitches.

The result?

"It's like tinder and a match,'' said Arthur Levitt, chairman of the U.S. Securities and Exchange Commission, at a town meeting for investors last summer in Tulsa, Okla. ``As SEC chairman, I've seen too many people's life savings go up in smoke.''

Although state and federal regulators and the NASD are responding to the crisis by proposing tighter reins on microcaps, Congress and the courts are headed in the other direction, say Banks and another Portland securities attorney, Gary Berne.

Federal laws protecting investors from stock fraud have been weakened, and Congress is considering legislation that would pre-empt stronger state laws such as Oregon's.

With the "eviscerated'' federal law, state law becomes ever more important, Berne and Banks say.

"Unfortunately,'' Banks writes in a seven-page report to the Oregon congressional delegation, "the assault of investor rights is continuing, and it now threatens to destroy the last statutory bastion of hope for investors, the state securities laws.''

The most of the three bills, HR1653, would pre-empt the use of state law in private lawsuits
alleging misrepresentations and omissions in securities cases.

"If this bill were to pass, my clients would have no statutory recourse against the scam artists who stole their money,'' Banks writes. The other two bills, HR1689 and SB1260, aren't as comprehensive but represent "a further slide down the slippery slope of evisceration of investor rights in favor of the empowerment of scam artists and criminals.''

As of last week, Earl Blumenauer was the only Oregon representative to have responded to the February letters from Banks and Berne. In his one-page letter to Banks, he addressed one of the lesser proposals, HR1689, which is designed to establish uniform national standards in securities fraud class actions.

The intent is to develop a narrowly tailored bill to affect only those suits traditionally filed in federal courts, Blumenauer wrote. He added that it's not clear when the legislation will be considered by the full House, "but I will certainly keep your views in mind at that time.''

Meanwhile, concerns continue to pile up at regulators' doors.

Last year, a joint sweep by regulators in 12 states revealed "a disturbing cottage industry of coldcallers, boiler rooms and nonexistent analyst reports used to hype microcap stock,'' a state regulator from Texas told John D. Dingell, D-Mich., in a special report this year. Dingell is his party's ranking member of the House Commerce Committee.

The top abuse reported was "high-pressure, scripted telephone cold-calling.'' Auditors who crashed the boiler-room operations found telemarketers reading from scripts who weren't registered to sell securities.

"Perhaps a 100 percent return in 20 minutes sounds a bit unrealistic,'' one script says, "but I assure you that's exactly how all of our IPOs (initial public offerings) trade.''

If investors resisted the silver-tongued telemarketers enough to do minor checking, losses could be greatly reduced.

For instance, if you're even thinking about investing over the phone with a broker you don't know, promise yourself you'll do a couple of things first:

• Call the National Association of Securities Dealers (1-800-289-9999) to request a copy of the disciplinary history of the caller and his firm;
• Ask the caller for his and his firm's CRD (Central Records Depository) number and let him know you're going to do a background check before you invest. If he balks, he probably has a history.

"I do this for fun when I get cold calls,'' Banks says, "and the broker usually hangs up the
telephone.'' May we all be so blessed.