From the SEC: Micro-Cap Fraud

    Information is the investor's best tool when it comes to wise investing. But accurate information about "micro-cap stocks"—low-priced stocks issued by the smallest of companies—may be difficult to find.

    Many micro-cap stocks trade in the over-the-counter market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the Pink Sheets.

    But many micro-cap companies do not file financial reports with the SEC, so it's hard for investors to get the facts about the company's management, products, services, and finances. And while many of the companies that don't file reports with the SEC are legitimate businesses with real products or services, the lack of reliable, readily available information about these kinds of companies can open the door to fraud.

    Spreading False Information

    Micro-cap fraud depends on spreading false information. Here's how this false information is often distributed:

    • E-mail Spam: Fraudsters distribute junk E-mail or "spam" over the Internet to spread false information quickly and cheaply about a micro-cap company to thousands of potential investors. Spam allows the unscrupulous to target many more potential investors than cold calling or mass mailing.

    • Internet Fraud: Fraudsters often use aliases on Internet bulletin boards and chat rooms to hide their identities and post messages urging investors to buy stock in micro-cap companies based on supposedly "inside" information about impending developments at the companies.

    • Paid Promoters: Some micro-cap companies pay stock promoters to recommend or "tout" the micro-cap stock in supposedly independent and unbiased investment newsletters, research reports, or radio and television shows. Paid promoters are generally behind the unsolicited "junk" faxes you may receive that tout a micro-cap company. The federal securities laws require the newsletters to disclose who paid them, the amount, and the type of payment, but many fraudsters fail to do so and mislead investors into believing they are receiving independent advice.

    • "Boiler Rooms" and Cold Calling: Dishonest brokers set up "boiler rooms" where a small army of high-pressure salespeople use banks of telephones to make cold calls to as many potential investors as possible. These strangers hound investors to buy "house stocks"-stocks that the firm buys or sells as a market maker or has in its inventory.

    • Questionable Press Releases: Fraudsters often issue press releases that contain exaggerations or lies about the micro-cap company's sales, acquisitions, revenue projections, or new products or services. These fraudulent press releases are then disseminated through legitimate financial news portals on the Internet.

    The Schemes

    Micro-cap fraud schemes can take a variety of forms. However, the two most common are the classic "pump and dump" scheme, and the off-shore scam.

    Pump and Dump
    It's common to see messages posted on the Internet that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have "inside" information about an impending development or to use an "infallible" combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create.

    Once these fraudsters sell their shares and stop hyping the stock, the price typically falls, and investors lose their money.

    The Off-Shore Scam
    Under a rule known as "Regulation S," companies do not have to register stock they sell outside the United States to foreign or "off-shore" investors.

    In the typical off-shore scam, an unscrupulous micro-cap company sells unregistered Reg S stock at a deep discount to fraudsters posing as foreign investors. These fraudsters then sell the stock to U.S. investors at inflated prices, pocketing huge profits that they share with the micro-cap company insiders. The flood of unregistered stock into the U.S. eventually causes the price to plummet, leaving unsuspecting U.S. investors with enormous losses.

    Red Flags

    To avoid micro-cap fraud, the SEC recommends that investors watch out for these "red flags":

    • SEC Trading Suspensions: The SEC has the power to suspend trading in any stock for up to 10 days when it believes that information about the company is inaccurate or unreliable. Think twice before investing in a company that's been the subject of an SEC trading suspension. You'll find information about trading suspensions on the SEC's Web site at

    • Assets Are Large But Revenues Are Small: Micro-cap companies sometimes assign high values on their financial statements to assets that have nothing to do with their business. Find out whether there's a valid explanation for low revenues, especially when the company claims to have large assets.

    • Odd Items in the Footnotes to the Financial Statements: Many micro-cap fraud schemes involve unusual transactions among individuals connected to the company. These can be unusual loans or the exchange of questionable assets for company stock that may be discussed in the footnotes.

    • Unusual Auditing Issues: Be wary when a company's auditors have refused to certify the company's financial statements or if they've stated that the company may not have enough money to continue operating. Also question any change of accountants.

    • Insiders Own Large Amounts of the Stock: In many micro-cap fraud cases—especially "pump and dump" schemes—the company's officers and promoters own significant amounts of the stock. When one person or group controls most of the stock, they can more easily manipulate the stock's price at your expense. You can ask your broker or the company whether one person or group controls most of the company's stock, but if the company is the subject of a scam, you may not get an honest answer.
    Additional red flags:

    High Pressure Sales Tactics: Beware of brokers who pressure you to buy before you have a chance to think about and investigate the "opportunity." Dishonest brokers may try to tell you about a "once-in-a-lifetime" opportunity or one that's based on "inside" or "confidential" information. Don't fall for brokers who promise spectacular profits or "guaranteed" returns. These are the hallmarks of fraud.

    No Written Information: Don't deal with brokers who refuse to provide you with written information about the investments they're promoting. Never tell a cold caller your social security number or numbers for your banking and securities accounts. And be extra wary if someone you don't know and trust recommends foreign investments.