Stock scams, boiler rooms, role of SEC By Mark Bower  Friday, February 25, 2005

A “boiler room” is a crooked brokerage house of any kind. The film of the same name shows shady brokers pushing stock in companies that don’t exist from an anonymous Long Island office, masquerading as a big name firm. They repeatedly swindle unsuspecting investors with their scams and aggressive sales tactics, but are finally shut down. The film (coincidentally released in February of 2000, just weeks before the NASDAQ top) provides a good approximation for what characterizes a boiler room.

There are a few qualities they have in common:

1) Little known firms or even fronts for other

2) They use highly aggressive tactics such as promising huge gains

3) They primarily push over the phone, and eschew meetings in person

4) They push stocks of dubious quality

Thus, to avoid being pulled in by a boiler room, let us recommend a few practices for investing that can counteract them

1) Deal with reputable firms with established brand names. Although we can’t guarantee dealing with Morgan Stanley brokers will be 100% successful, the firm has a well-established reputation and is certainly no boiler room.

2) Make sure the firm has a reputation by talking to current clients, some kind of credentials (NYSE membership, etc) and check with local government to see if it has any pending legal action.

3) Be wary of any newsletter or salesman over the phone promising huge returns.

4) Ask to meet your advisor in his/her office. One can tell a lot by the office.

5) Check up on the stocks that have been advised to you. If you haven’t heard of the company, at least make sure you can understand the business model or familiarize yourself with its products.

Another characteristic of boiler rooms is that they often push stock in companies that are fronts, shells or otherwise non-existent operations. These companies are scams with the sole purpose of defrauding investors by transferring wealth to insiders who issue stock. Even if you are dealing with a reputable firm, these situations can arise. They can come from newsletters, recommendations from friends, brokers, etc How can we go about avoiding a potentially disastrous scam? The scams pushed like this often have several characteristics to them that usually helps to weed them out

The stock scams almost always deal with small cap stocks, OTC Bulletin Board, or “Pink Sheets” listed stocks. The first step is to never trade OTC BB stocks. The exchange is the wild west of stock investing: companies have to file very little disclosure, there is hardly any market-making to make trades go through easily. If the company is listed on the bulletin board or the pink sheets, do not touch it. There are better opportunities in the regular exchanges and the bond markets. For non OTCBB or Pink sheet stocks, investigate them thoroughly. If it has analyst coverage, articles written about it, etc then the likelihood increases that it is a legitimate company. Again, there is no need to roll the dice on a company with no visibility, so investigate thoroughly.

Even assuming that is widely known, how do we know that the company is for real? Historically, stock scams have had many qualities in common to them. The first is an idea that is hard to understand or an esoteric technology. Technology and health care have attracted many scam artists, because it has always been difficult to understand what these companies do and what their competitive edge as a business is. Scams play off that to an unusual degree, with claims of revolutionary new products and patents, backed up by convoluted explanations or secrecy. As in all things, avoid a business whose competitive edge you cannot understand or whose business model is too confusing. Many people who were baffled at how Enron made money bought the stock because it was going up, and then got burned on the way down.

Another characteristic of scams is that they have a very promotional management team. In conference calls, in press releases, and in media exposure, they will hype, tout, and constantly make unrealistic future promises. They seem to spend far more time in outlining the potentials for their company than actually running them well. It is not uncommon for such companies to detail every minor business event in press releases to the public. Their annual reports will be zillion page compendiums of all these press releases, constant hosannas, and other such items that no serious company would want to include. These stocks will often resort to accounting tricks to inflate their results. Stay away from companies whose finances are hot air and not real results.

Finally, they attract a cultish following. Cheerleaders throng the message boards, believing every word dribbled out by the management, and they occasionally try to run the stock up to absurd heights. Anyone who sells the stock short is demonized and blamed for manipulating the price. The stock will often swing with the animal spirits of these investors, given to quick collapses and steep run-ups. This volatility, in addition to the financial and corporate red-flags, is the final reason to steer clear of such stocks.

The SEC (Securities & Exchange commission) was initiated in 1933-4 to stamp out precisely the above behavior. They have power to prosecute companies under several different laws. First is fraud, which is misrepresenting the businesses’ results or prospects with intent to deceive. Secondly, the SEC can go after insiders for insider trading, especially if it takes place during a “pump and dump” scheme. That is a scheme to promote a fictitious business and then unload the stock into the rally before a collapse. The SEC has prosecuted many of these cases, and its presence serves to deter more of them from occurring. The SEC also prosecutes stock manipulation, which is trying to suppress or control trading in a stock in order to enhance one own’s returns from it. Many boiler rooms have tried to do this and been prosecuted as a result. Finally, new SEC laws prevent companies from giving selective disclosure of key information to close associates or to large investors. Known as Reg FD (full disclosure) it mandates that all information be disseminated to all investors, big or small. This law serves to prevent management from feeding certain groups that could use it to profit maliciously. With its broad powers to enforce laws and punish wrong doers, the SEC can protect investors from would be deceivers and defrauders.