The Securities and Exchange Commission

[thepennyking]

Where it's every investor for himself

On the free-wheeling OTC Bulletin Board, companies without much beyond a name and ticker symbol can make themselves seem like blue chips.

By Carrie Coolidge, Forbes

The investment sounded so good. New York-based 800America.com touted its Web sites, offering everything from online payment services to closed-out merchandise sales. Its site for teenagers, Youtopia.com, supposedly had up to 2 million members in North America. And 800America.com claimed to be pushing into fast-growing China with 150 independent sales reps.

This gem, however, traded in a nether region of the investing world called the OTC Bulletin Board, a newly popular electronic service that links market makers in the shares of small companies. Unlike the unregulated Pink Sheets, the Bulletin Board is policed by the Securities & Exchange Commission and surveilled by the National Association of Securities Dealers. And Bulletin Board companies must file audited financial statements with the SEC and comply with federal securities laws.

But don't be fooled: The filings can very well be garbage. The NASD has no real power over the 3,452 stocks listed on the system. The scams here are not of the magnitude seen at the New York Stock Exchange or Nasdaq (Enron (ENRNQ, news, msgs) or WorldCom (WCOEQ, news, msgs), for example), yet they are far more numerous.

"There are problems everywhere, but the Bulletin Board is the place they really fester," says Hartley Bernstein, a lawyer who pleaded guilty to conspiracy to commit securities fraud in 1999 (sentenced to probation). Bernstein now works the other side, running the Web site StockPatrol.com which alerts investors to fraud in the penny stock market.

A Web of deceit
Investors found to their dismay that 800America.com's biggest Web venture was the web of deceit it had spun. The company's chief executive, David Elie Rabi, portraying himself as a seasoned business leader, turned out to be an ex-con who had served a four-year term for previous securities fraud.Fast and easy.

Rabi was the subject of fresh fraud charges brought by the SEC, which declared that the balance sheet and income statements Rabi's company put out were fiction. The U.S. Attorney's Office for the Southern District of New York brought criminal charges against Rabi, and he was convicted on one count of securities fraud and one count of conspiracy to commit fraud. Rabi awaits sentencing. 800America.com is defunct. Its shares, which traded at $5 in 2000, are now worthless.

The horror stories are legion. Environmental Solutions Worldwide (ESWW, news, msgs) seems to have a good line of business making catalytic converters. But the SEC alleges this denizen of the Bulletin Board pumped the market with a fraudulent promotional campaign between 1999 and 2000. As a result, the stock bounced between $2 and $7. Meanwhile, company insiders dumped their stock on an unsuspecting market, profiting more than $15 million, according to the SEC. At the SEC's behest, the ex-chairman ended up paying a $25,000 civil penalty. The company insists this problem is in the past and there is new management. Environmental Solutions stock today bumps along at 72 cents.

In a similar case the SEC charges that Concentrax (CTRX, news, msgs), a manufacturer of vehicle-tracking systems, released inflated earnings projections, then raised $560,000 in a private stock offering. The chief executive paid a $35,000 fine. The company didn't return calls for comment. Its stock, which traded at a high of $3.15 in 2002, now goes for 20 cents.

Bullish on Bulletin Board
Despite all this unpleasantness, Bulletin Board stocks are in vogue lately, riding on the coattails of legitimate Nasdaq companies like Intel (INTC, news, msgs). In September, 41 billion shares traded on the Bulletin Board, up from 15.5 billion in September 2002. In share count, that put the Bulletin Board ahead of Nasdaq, at 40 billion, and the NYSE, at 29 billion. Of course, a lot less money changes hands on the Bulletin Board, where penny stocks litter the trading floor. On Oct. 29, diamond mining outfit Casavant (CMKM, news, msgs) traded 1.1 billion shares. At 1/100 of a penny each, that volume worked out to just $116,453.

Although you certainly can find good Bulletin Board stocks, such as upscale retailer Barneys New York (BNNY, news, msgs) and watchmaker Bulova (BULV), be warned that venturing onto the Bulletin Board requires immense due diligence. Many companies on the Bulletin Board are there after having been bounced from the major exchanges for failing to meet listing requirements: for falling below minimum market capitalization or for neglecting to mail out proxies. And even the best Bulletin Board stocks require patience. Barneys, once a private company, emerged from bankruptcy in 1999 and has slipped back into the red this year amid trying times for department stores. Bulova is solidly profitable but, while enjoying the security of being 97% owned by Loews Corp. (LTR, news, msgs), has a small public float.

Do your research before wading in
How do you separate the good from the bad? Read their filings, or even quiz companies directly. If you're interested in a bank or insurer, federal and state regulators can help. "Don't just buy a stock because a broker recommended it," says Walter Carucci, chief executive of Port Washington, N.Y.-based Carr Securities, an OTC market maker.

Walker's Manual, a 578-page book ($99 plus shipping at walkersmanual.com), contains research on Bulletin Board stocks as well as Pink Sheet names. The book's staff culls through thousands of companies to come up with high-quality selections. While chat rooms and message boards contain a lot of hype, you can gain good insights at such well-regarded sites as Motley Fool, Siliconinvestor.com and Ragingbull.com. And if you really want some dirt, go to Bernstein's StockPatrol.com.

The Bulletin Board was launched in June 1990 after Congress passed a law designed to clean up penny stocks. The hope was that the Bulletin Board would improve transparency and prevent rampant fraud among the OTC equities market, then trading only in the Pink Sheets.

And while the transparency helped raise the quality of trade execution, crooks used the false comfort of oversight as a way to market companies that had no value. "The Bulletin Board sounds like it's more of an institution than it really is," says veteran microcap investor James Mitchell of Mitchell Partners in Costa Mesa, Calif.

The system's weaknesses
Flabby rules. While Bulletin Board companies are required to file quarterly and annual reports, proxies and insider trading information to the SEC, neither the NASD nor the SEC checks to make sure filings are factual, and there are no minimums. "A company can qualify for the Bulletin Board if it has no assets, no revenues and no business -- provided it files regular reports," says Bernstein.

Unlike their brethren on the NYSE and Nasdaq, Bulletin Board companies aren't required to have corporate governance standards, independent audit committees or independent directors. Exchange-traded companies certainly have defrauded investors despite these safeguards, yet Bernstein argues that the absence of such strictures makes foul deeds easier to commit. Bernstein even has seen Bulletin Board company filings where the numbers are brazenly copied from quarter to quarter.

Lax oversight. The Nasdaq, charged by the SEC with operating the Bulletin Board, gets no listing fees from the companies there, as it does from its own listers. Hence there is little incentive for parent and regulator NASD to crack down, and it lacks the teeth to do so, anyway. NASD's jurisdiction extends only to the market makers and brokers who trade the stocks on the Bulletin Board. This isn't to say that the NASD isn't on the lookout for Bulletin Board fraud. It's simply that the NASD, lacking subpoena power, can only refer suspicions to the SEC. About the best NASD can do is attach the letter "e" to the ticker symbol of a delinquent Bulletin Board filer.

"Don't assume that because it has a four-letter ticker symbol, Cisco Systems (CSCO, news, msgs) and Joe's Auto have the same level of quality of regulation," says Stephen Luparello, executive vice president for market regulation at the NASD. He can compel the Nasdaq company executive to cough up even nonpublic information but has no similar clout with a Bulletin Board company. "He may say yes," Luparello notes, "but he might also tell me to get lost."

If the NASD's hands are bound, then why isn't the SEC calling for tighter controls on the Bulletin Board?The SEC says it has worked with the NASD in the past to improve standards, and they still continue to think of ways to improve regulatory structure. The agency may very well feel itself overburdened, as is. When SEC filings were first required for the Bulletin Board in 1999, commission staffers took at least a year simply to process all the new data. The SEC says that it has since adjusted its processes to accommodate filings from the Bulletin Board.

The BBX's failure. In fairness, Nasdaq did try to bring order to the freewheeling Bulletin Board -- and has taken a pratfall, recently scrapping the plan for the so-called Bulletin Board exchange. The BBX would impose corporate governance standards and -- ahem! -- charge listing fees. The top-tier OTCBB companies were supposed to sign up for the BBX. Trouble is, the Nasdaq had trouble enlisting enough support.

Vanishing market makers. Over the past few years many of the small-cap trading desks that made markets in Bulletin Board issues have been shut down or drastically reduced in size, including those run by Goldman Sachs (which bought Spear Leeds, the NYSE market specialist firm, in late 2000), Sherwood Securities and Fleet Securities. Herzog Heine Geduld's Bulletin Board trading desk was shut down shortly after the company was bought out by Merrill Lynch. In 1997 there were 430 marketmakers trading Bulletin Board stocks. Today there are 243.

The lack of dominant market makers has created less liquidity, more volatility and wider spreads for many Bulletin Board stocks. Some stocks have price swings of as much as 30% on a given day. For now, most Bulletin Board investors don't care. But if too many 800America.coms implode, they will.

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