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DANGEROUS DEALS: A special report - Penny Stock Fraud Is Billion-Dollar Game

The following article is based on reporting by David Barboza, Leslie Eaton and Diana B. Henriques and was written by Ms. Eaton.

Most Americans may not know it, but there are really two Wall Streets.
One is the Wall Street of the New York Stock Exchange closing bell, of brash stockbrokers and hair-trigger traders, of big deals and big fortunes, of Microsoft and mutual funds.
But in the crooked alleys of Lower Manhattan flourishes another Wall Street. This is a world of low-priced stocks and high-priced dreams, of grimy offices and sham companies, of swindlers and touts who prey on average people trying to grab the brass ring in the greatest bull market in American history.
Like the world of organized crime, with which it increasingly overlaps, it is a violent place full of colorful characters and arcane lingo, of ''naked shorts'' and ''pump 'n' dumps.'' And it specializes in creating illusions that are as complex as a Broadway play -- and as simple as a game of three-card monte.
It was in this world that Albert Alain Chalem and Maier Lehmann lived -- and died. The men, who were promoting stocks over the Internet together, were both shot in the head on Oct. 25 and left to die on the marble floor in the $1.1 million home in Colts Neck, N.J., where Mr. Chalem lived.
Their world might seem arcane -- except that its denizens bilk Americans out of roughly $2 billion a year, securities regulators say. The problem is so severe that regulators and prosecutors have made it one of their chief goals to crack down on what they used to dismiss as ''penny-stock fraud,'' before it became clear that the money involved amounted to many billions of pennies.
''A sustained, prolonged bull market really does bring out the crustaceans from the bottom of the sea,'' said Richard H. Walker, director of enforcement for the Securities and Exchange Commission. ''They're attracted to the money.''
While the enforcement effort has closed down many of the big brokerage operations that pushed shady stocks over the telephone, Mr. Walker said, many people who were kicked out of the securities business have moved their schemes into cyberspace. ''That's where the action is now,'' he said.
And that is where Mr. Chalem and Mr. Lehmann were before they were killed. In addition to running a Web site, Mr. Chalem was trading stocks electronically, and may have had an account under an assumed name at a Manhattan firm called Harbor Securities. Investigators are examining whether he traded there, and if it was linked to his death. [Page B6.]
From the very first, investigators have suspected that the slayings somehow involved the two men's financial dealings, rather than their personal lives. And, although the investigation remains in its early stages, law enforcement officials have clearly not changed their minds.
On the surface, Mr. Lehmann, 37, seems to have had the more troubled work history. He had pleaded guilty to mail fraud in an insurance scheme and settled civil securities-fraud charges. Before his death he told Barron's magazine that he had secretly worked at Patterson, Travis Inc., a small brokerage firm with a history of regulatory troubles; company officials said yesterday that they had no record of his having worked there.
In fact, Mr. Lehmann was more than willing to talk. He told reporters, regulators, prosecutors and, apparently, anyone who would listen about what he said were various schemes and swindles.
But it was Mr. Chalem, 41, who cast the longer shadow in the world of shady stocks, and it is Mr. Chalem who is increasingly the focus of investigators. He had worked at a brokerage firm, A. S. Goldmen & Company, that prosecutors contend was a criminal enterprise -- a charge that the firm denies. He also worked secretly at a firm called Toluca Pacific Securities, according to several people who knew him. Toluca, which is defunct, had a long history of regulatory run-ins and had links to career felons and to organized crime.
Mobsters have increasingly turned up in stock swindles. In January, two men whom prosecutors said were tied to the Bonanno and Genovese crime families pleaded guilty to federal charges that they participated in a conspiracy to manipulate the stock of an Arizona company that owns a health club; the president of the company was convicted of related charges in May in Federal District Court in Manhattan.
In June, federal prosecutors in Brooklyn indicted a group they said included members of the Colombo crime family and an associate of the Bor organized crime group of Russian immigrants.
The men, who prosecutors said ran rogue brokerage firms that manipulated stock prices, were charged with conspiracy, securities fraud and money laundering; they pleaded not guilty.
Mr. Chalem was widely believed, in the penny stock world, to have dealings with Russian organized crime and to be ''a protected guy,'' as one lawyer put it.
New information is coming to light about his activities in the weeks before his death. Last week, federal prosecutors served subpoenas to retrieve trading records, which may be linked to Mr. Chalem, from Harbor Securities, which catered to self-employed day traders. Heavy financial losses recently forced the firm to close.
Whether Mr. Chalem's trading had anything to do with his death remains unclear. What is clear is that he and Mr. Lehmann were more accustomed to being predators than to being prey in the dangerous world they inhabited.

The Performance
Everything Fake Except the Money

Their alternative Wall Street is not a big place; its players, who all seem to know each other, cluster in just a few spots: San Diego and La Jolla in Southern California, Boca Raton, Fla., Vancouver and New York, the ground zero of stock fraud.
To be successful, stock frauds must look a lot like legitimate deals. But in reality, they are elaborately choreographed performances, in which everything is fake except the money the audience will lose when the play is over.
Fraudulent companies issue fraudulent press releases touting fraudulent products; fake newsletters make fake recommendations about fake stocks; phantom investors make phantom trades to push up the price of these phantom stocks. A small claque in the audience may be tossing tomatoes, but these skeptics -- known as short-sellers -- can often be bought off by the show's producers.
Between them, Mr. Chalem and Mr. Lehmann seem to have played every possible role in such productions. Behind-the-scenes operators, they did business over cellular phones and computers, from so-called boiler rooms full of phones and fast-talking salesmen, and most recently, on the Internet.
To understand how thousands of Americans get taken in by these shows, it helps to know a little bit about the legitimate side of Wall Street -- and about how the real thing differs from its evil twin, as described in court documents, in interviews with regulators and prosecutors, and in discussions with people in the stock business.
In the real Wall Street, new companies that want to raise money pay investment firms a fee to sell shares of stock. In the shady Wall Street, almost none of the money raised from investors goes to the company; rather, it lines the pockets of brokers and promoters and their pals. In one case analyzed by state regulators in Alabama, a New York company raised $12.5 million from investors; $11 million of that went to insiders and brokers.
In the real Wall Street, public companies are vetted by accountants and auditors and lawyers and investment firms, all of them supervised by regulators. Companies that have stock outstanding must file quarterly financial reports with the Securities and Exchange Commission, and keep investors informed of major changes in their businesses.
In the ersatz Wall Street, companies avoid filing regulatory reports -- lying on such reports is a crime -- and communicate almost entirely by news releases, the more hyperbolic the better. (Without admitting or denying wrongdoing, one Florida executive recently settled regulatory charges over his press releases. These falsely claimed that the Moscow Ministry of Finance and Walt Disney World were negotiating to buy his company's process for turning scrap tires into oil.)
At legitimate companies, insiders, like executives and directors, must report, publicly, any time they buy or sell their own stock. People who own even 5 percent of a company must also reveal that through filings.
In the fake Wall Street, insiders use false names and dummy accounts to hide the fact that they control almost all of a company's stock that is available for trading. In one regulatory case recently filed in Federal District Court in Brooklyn, the S.E.C. contends that a group of stock promoters controlled as much as 95 percent of the tradable shares in several companies.
Though the real stock market is a complicated place, particularly in the short run, over the long haul a company's stock price rises when investors are optimistic about its future sales and profits; the stock price falls when investors worry that the company's business is in trouble.
In the false Wall Street, a stock rises like Peter Pan in the stage play, not because he is thinking merry little thoughts, but because he is attached to a wire strung from the theater's rigging. (Aptly, these manipulated stocks are called rigs.)
The stage for these stocks is usually the O.T.C. Bulletin Board, a trading network run by the National Association of Securities Dealers, which also runs Nasdaq. But unlike the real Nasdaq market, the bulletin board will trade the stock of almost any company, no matter how small, secretive or downright preposterous.
Regulators predict that more than half of the roughly 6,000 companies that were trading on the bulletin board last year will be removed by next June, under new rules that require them to file current financial statements with regulators.
The cast of characters includes the promoters, who are often stockbrokers barred from the securities business, their lawyers and public-relations advisers. The production also needs someone still in the securities business who can execute trades. Other starring roles usually belong to corporate executives, who are mostly in on the rig, though sometimes they are innocents desperate to raise money for their companies.
And then there are short-sellers, who are people who bet that share prices will fall (and make a profit when that happens). In some cases, they are doing all they can to make sure the production is a flop.
The production may call on the brokers and cold-callers to unload shares on the public, although the Internet is making such brokers increasingly unnecessary; now, investors can be persuaded to buy stock electronically. ''The Internet has put this type of fraud on steroids,'' said Cameron Funkhouser, vice president of market regulation for the National Assocation of Securities Dealers.

The Choreography
Hyped-Up Ideas, Controlled Stock

The plot of the play always begins with the company. The ideal stock-fraud company has some whiz-bang new product that will excite investors, like a self-chilling beer can, springy shoes for race horses, or a cure for baldness or for tooth decay. Also popular are gold mines in obscure locations, theme restaurants in Las Vegas and anything in cyberspace with a .com after it.
Sometimes the purported business will change in the course of the scheme; according to a ruling in a federal lawsuit, one outfit called Sky Scientific claimed at various times to be running gold mines, a financial services company and the first riverboat casino in Moscow. Occasionally the company is a small operation that has a real product, but it is just not as thrilling as the company's public relations makes out. (The vitamins do not really cure cancer; the Internet service has not really signed up every household in Peru.)
One company Mr. Lehmann was involved with, Electro-Optical Systems, claimed to be developing a computer gizmo that would read fingerprints, so that users could sign in without having to remember pesky passwords.
His original role was to hook up the would-be inventor of the product with the ''investment bankers'' who were supposedly raising money for the company, according to a decision in a lawsuit filed last year by the S.E.C. in Federal District Court in Manhattan. The inventor was not named as a defendant in the case, which is now dormant while a criminal investigation continues. Mr. Lehmann settled the regulators' charges and paid $630,000 in fines and restitution.
The key, from the con artists' point of view, is to get control of the shares of stock, which might be called Act 1. Sometimes shady brokerage firms stage ''initial public offerings,'' but a faster and cheaper method -- the one Mr. Lehmann's group used -- is to merge the company with a shell corporation, which has stock outstanding but no business.
Almost everyone involved in the scheme is paid with stock; the promoters usually control huge blocks in accounts with false names, often overseas.
They all make money by making the shares rise in price. They often do this in part by making fake trades at arbitrary prices. In the case of Electro-Optical, regulators contend that the promoters put in an order to buy shares at $7 each, far above the 20 cents for which shares had last changed hands before the promotion began.
Once the stock price has been pumped up, it is time to lure outsiders into buying the shares. Mr. Lehmann helped out with the public relations. He got an an Internet newsletter to choose Electro-Optical as its ''pick of the year''; the newsletter's owner was later sued by the S.E.C., which accused him of secretly taking stock and cash from companies in exchange for recommending their stocks; he is contesting the charges.
Mr. Lehmann also approved a press release that claimed, falsely, that Electro-Optical had just received a big order for its products. (Neither order nor products existed.) Investors, entranced with the concept and the rising stock price, began to buy the inflated stock.
After the pump comes the dump. Those in the know sell their shares to unsuspecting investors. Mr. Lehmann had received 100,000 shares, for which he paid nothing and which he put in an account in his wife's name; when he sold, he made about half a million dollars. All told, regulators say, those involved in the Electro-Optical rigging made $12 million by dumping their shares.
Once the promoters stop pumping the stock, its price usually plunges. Anyone who wants to buy Electro-Optical today can get 10 shares for a penny.

Bailing Out
Special Handling For Short Sellers

Some inventive stock promoters find a way to make money on the falling price, too, by selling short. To do this, a short seller simply borrows some shares from a brokerage house, promising to replace them later, and then sells them. If the trader has guessed right and the stock's price later falls, he can replace the borrowed shares -- a step known as ''covering'' -- by buying shares at the new, lower price.
His profit is the difference between the price at which he sold the borrowed shares and the price at which he bought the replacements. But if the share price rises, he can easily lose his entire investment.
While short selling can be a legitimate practice, it can also be abused. Mr. Chalem's friends and former business allies say he practiced a more aggressive form of short-selling, called naked shorting. Brokerage houses that deal in a particular stock can short it without borrowing the shares first. Going through those cooperative brokers, speculators like Mr. Chalem sell, and sell and sell -- thereby guaranteeing that the stock's price will plummet.
A year or two ago, Mr. Chalem's associates say, he was shorting the stock of the Quigley Corporation of Doylestown, Pa., which makes zinc lozenges that it says relieve common colds. The company blamed short-sellers for the decline in its stock, which has dropped from $23 in the fall of 1997 to about $3 today. Skeptics said the company's share price was too high and, indeed, sales of the lozenges have been falling.
But a debate over the true merits of most penny stocks is pointless; in many cases, both the promoters and the short sellers know that the stocks are rigged. Then, the question is simply who has enough power -- and money -- to prevail in what is really trench warfare.
Promoters may try to make short-sellers go away by giving them free shares that the short-sellers can use to cover and close out their positions with big profits. This has caused some prosecutors to believe that this sort of short-selling is really a kind of extortion, though that is hard to prove.
Both sides use rough tactics in their efforts to win. They try to plant stories in the press. They call regulators and prosecutors to inform on each other.
And they threaten each other with physical harm, backed up by visits from burly men. John Fiero, a prominent short seller and president of the firm Fiero Brothers in Manhattan, has repeatedly complained to the police about the threats he has received.
And that violence may ultimately be the biggest difference between the real Wall Street and the parallel universe inhabited by people like Mr. Chalem and Mr. Lehmann.
Real Wall Street takes a lot of financial risks. But the crooked Wall Street ''is not just a financially dangerous world,'' said Stephen Luparello, a senior vice president of the N.A.S.D. ''It's also a physically dangerous world.''

1. THE RIG Stock promoters buy an inactive company that has already publicly issued shares. The fraud is set up ... The broker can also start a company and stage an initial public offering based on exaggerated financial statements.
2. Those shares are transferred to whomever the promoters specify, typically those who are in on the deception. The broker may also put the shares into brokerage accounts set up in the names of others, who may not even know of their role in the scheme.
3. THE PUMP The promoters begin to trade the shares among themselves, simulating actual investment interest and artificially inflating the price. ... Then public investors are pulled in. The promoters then start to circulate exaggerated or false press releases, and use Internet sites and chat rooms to promote the stock.
4. THE DUMP Public investors who believe the hype start to buy in, and the promoters gradually unload their shares by selling to the public. Without the support of the promoters' artificial trading, public shareholders usually find no buyers if they try to sell, and the stock's price plummets. (pg. B6)

SOURCE:
http://www.nytimes.com/1999/11/19/nyregion/dangerous-deals-a-special-report-penny-stock-fraud-is-billion-dollar-game.html?scp=1&sq=penny-stock%20fraud%20is%20billion-dollar%20game&st=nyt&pagewanted=1