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An In-Depth Examination of Pump and Dump Schemes in the Microcap Markets

So-called "pump and dump" schemes continue posing major risks in the microcap markets. These illegal schemes to manipulate share prices remain an area of aggressive enforcement by the Securities and Exchange Commission (SEC), Department of Justice (DOJ), and other authorities. This article provides an in-depth overview of how pump and dumps work, what makes microcap companies vulnerable, and the severe legal consequences for participants when uncovered.

What are Pump and Dump Schemes?

Pump and dump schemes aim to artificially inflate, or “pump up,” the price of a stock through misleading promotional efforts. The fraudsters then sell, or “dump,” their shares when prices peak to lock in profits before the deception is exposed. These manipulative schemes undermine market integrity and harm ordinary investors for the perpetrators’ gain.

In the microcap context, the basic blueprint involves obtaining a substantial position in a thinly traded microcap issuer with limited public information. This is often achieved through toxic financing deals that provide shares or warrants via private placements and convertible instruments. Promotional materials are then created containing exaggerated or outright false claims about the company’s operations, products, financials, management team, or growth prospects.

Aggressive promotional campaigns publish these misleading materials through vehicles like press releases, blast emails, social media, and paid stock touts. The goal is generating buying interest that drives up the stock price. When share prices are successfully “pumped up” to artificial highs, the fraudsters dump their positions to profit. The selling pressure eventually deflates the price, burning unwitting investors who bought during the false run-up.

Warning Signs of Potential Pump and Dump Targets

Certain attributes make microcap companies ripe targets for pump and dump schemes. Warning signs include:

• - Thinly traded, low float shares with limited public financial information that can be easily manipulated
• - Templated SEC disclosure with little transparency about operations, financials or management
• - Frequent name changes, forward stock splits, or unnecessary corporate restructurings
• - Promotional press releases, social media or mailers focused on share price or touting the “next big thing”
• - Material third-party service providers or financiers with checkered reputations

Microcap companies exhibiting these red flags should be vigilant for any indications their firm is being targeted for manipulation.

Role of Shell Companies and Reverse Mergers

One common tactic to facilitate pump and dumps is using shell companies set up for this unlawful purpose. The schemers take controlling interest in an inactive public reporting shell corporation with no actual underlying business. They then orchestrate a reverse merger with a private operating company, injecting it into the shell’s public listing.

A reverse merger into the clean shell evades the extensive disclosures and scrutiny of an IPO. With a public listing achieved virtually overnight, the schemers then implement pumps through misleading campaigns about the private entity’s operations acquired via the shell. Securities obtained cheaply pre-merger are dumped into the false market excitement.

This shell creation and reverse merger process enables fraudsters to engineer pump and dump schemes in new public vehicles with speed and minimal transparency. Shells used for unlawful purposes may see frequent name and ticker symbol changes as each scheme runs its course. But lack of actual business or assets is the common denominator.

SEC and Criminal Enforcement Remedies

Pump and dump schemes have long drawn aggressive SEC enforcement under the antifraud provisions of the federal securities laws. These cases generally charge violations of Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder. The antifraud provisions make it illegal to use deceptive devices, schemes or artifices to defraud in connection with purchases or sales of securities. The SEC often couples these with charges for false SEC filings, misleading investors, and market manipulation.

On the criminal side, the Department of Justice and U.S. Attorneys typically prosecute pump and dump cases using the mail and wire fraud statutes, 18 U.S.C. § 1341 and 18 U.S.C. § 1343. These criminalize using the mails or interstate wires to execute schemes to defraud or obtain money or property under false pretenses. DOJ also commonly adds money laundering charges.

Boiler room operations promoting schemes often lead to ancillary civil and criminal charges for broker-dealer registration violations. The SEC and FINRA regulate who can sell or promote securities to prevent unregistered distribution channels. Violations can trigger severe sanctions against broker-dealers, bars against individuals, and rescission rights for investors.

Penalties for Pumps - And Advice for Avoiding Exposure

The SEC, DOJ, and state authorities rigorously pursue pump and dump cases using all available remedies. Recent SEC actions have targeted schemes involving companies across sectors like biotech, cryptocurrency, cannabis, and food and beverage. Civil penalties, disgorgement, and injunctive relief are routinely obtained, coupled with industry and penny stock bars against individuals. On the criminal side, recent years have seen lengthy prison sentences for scheme masterminds.

Issuers and gatekeepers must be vigilant for red flags that their firms or services could facilitate manipulation. Robust compliance policies and practices are essential, along with data-driven monitoring for irregular trading patterns. Contact experienced securities counsel at Lucosky Brookman if you have concerns your company may be at risk or need guidance strengthening protections against pump and dump schemes in the microcap space.