OTCBB General Discussion

[Anthony M]

Background Information On Microcap Fraud

What is a Microcap Company?

Microcap companies are typically thinly capitalized and are often not required to file periodic reports with the SEC. Securities of microcap companies may be quoted on the Over-the-Counter Bulletin Board operated by the National Association of Securities Dealers, Inc., in the Pink Sheets operated by the National Quotation Bureau, and on the Nasdaq Small Cap Market. In any of these trading mediums, public information is limited and a small number of brokers control the market.


The Nature of Microcap Fraud

Microcap fraud typically takes one of two forms. The first – the "pump and dump" scheme – often involves fraudulent sales practices, including high pressure tactics from "boiler room" operations where a small army of sales personnel cold call potential investors using scripts to induce them to purchase "house stocks" – stocks in which the firm makes a market or has a large inventory. The information conveyed to investors often is at best exaggerated and at worst completely fabricated. Increasingly, these stocks also are being touted on the Internet by unregistered promoters. The promoters of these companies, and often company insiders, typically hold large amounts of stock and make substantial profits when the stock price rises following intense promotional efforts. Once the price rises, the promoters, insider and brokers sell, realizing their profits.

Second, as part of the "pump and dump," unscrupulous brokers often employ a variety of fraudulent sales practices including "bait and switch" tactics, unauthorized trading, "no net sales" policies (where investors are discouraged or actually prevented from selling their stocks) and churning (excessive trading in their accounts in order to generate commissions for the broker).


The SEC's Response to the Problem

The Commission has a four-pronged approach to attacking microcap fraud: enforcement, inspections, investor education and regulation. The Commission's efforts devoted to fighting microcap fraud are described below.


Detection of Microcap Fraud – Office of Compliance Inspections and Examinations

Examinations are an important prong in the Commission's approach to microcap fraud. On-site examinations of regulated entities are often the earliest indications of changing industry practices and the techniques utilized by broker-dealers, salespersons, and issuers to skirt the federal securities laws and to defraud investors.

Microcap examinations of broker-dealers have been focused in the New York, South Florida, and Colorado/Utah areas, where the greatest concentration of fraudulent microcap activity is found. In fiscal year 1997, over 70 examinations of microcap firms were conducted in these regions, representing about 43 percent of all cause examinations conducted there. More than two-thirds of these microcap examinations were referred to the Commission's Division of Enforcement or to the NASDR for further investigation. The most common violations found were fraudulent misrepresentations, unsuitable recommendations, unauthorized trading, market manipulations and unregistered offerings.

Commission examiners are also scrutinizing the records of microcap issuers maintained by registered transfer agents, located predominantly in Utah and Nevada, to detect irregularities in the issuance and transfer of shares which typically accompany frauds on investors.

In January 1998, we initiated an examination sweep of several firms that are players in the microcap market. These firms had all of the "red flags" of fraudulent microcap activity, such as customer complaints, significant profits from underwriting and subsequent aggressive market making of illiquid microcap securities, registered representatives or principals previously associated with disciplined microcap firms, and large pools of inexperienced cold callers. Examiners conducted a complex and resource-intensive review of these firms' records for evidence of the hallmarks of microcap fraud: patterns of "bait and switch" sales techniques, misrepresentations and exaggerated claims of performance, unauthorized trading and refusals to sell securities, market manipulation and lax or nonexistent supervision.

As the Commission considers the proposals released today, and as regulatory reform progresses, the Commission's exam program will continue to focus attention on problem microcap firms and to identify any new methods used to circumvent statutory obligations to investors. These firms should be on notice of the certainty of examination scrutiny.

Division of Enforcement Combats Microcap Fraud

The SEC has increased its focus on microcap fraud in the Division of Enforcement in Washington, DC, and in the regional and district offices around the country, to bring actions against fraudulent microcap companies, promoters and brokers. In these microcap cases the SEC seeks immediate relief, such as temporary restraining orders and asset freezes, as well as strong remedies such as permanent industry bars, registration revocations and fines. In addition, the SEC has increased its use of trading suspensions to minimize investor harm by intervening early in ongoing market manipulations when there is misinformation about the issuer in the market.

In many of these cases the SEC has leveraged its resources by working closely with the criminal authorities, and, in many of the cases described below, has assigned SEC staff to devote full time effort to work on the parallel criminal investigations. Our close collaboration with the criminal authorities is an essential component of our enforcement program, given that a large number of recidivists - with little respect for civil proceedings - engage in microcap fraud.


Full Link on SEC site...

http://www.sec.gov/divisions/enforce/microcap.htm