has another criminal been unearthed? Once had one making illegal telephone recordings, now have one who takes parts of copyrighted works, switches and borrows whole paragraphs at times, and then tries to pass it off as his own. Hum..wonder who really wrote the essay a short time ago? Hum...does this come as a surprise to anyone???
The Penny Stock Parallel
Copyright 1999, Robert L. FitzPatrick
Each decade seems to have its own business hoax. The schemes develop in good times and bad and adapt to the special conditions of each era. With the benefit of experience and hindsight, the hoaxes appear obviously as frauds, but in the context of their period, they are seen as believable and beguiling. They inspire hope and excitement and they attract millions of followers.
A common thread of many of these hoaxes is the pyramid scheme. The insidious, underlying flaw in the pyramid scheme is its denial of the future. Its allurement is the promise of immediate enrichment. It most destructive impact is not financial but communal. Pyramid schemes enroll large numbers of people in a plan to defraud larger numbers of others. The most recent and dramatic consequence of this communal damage was seen in Albania where the collapse of a large-scale pyramid scheme brought down a national government and caused chaos and anarchy.
In the 20's when the economy was roaring, there was the delusion of purchasing stock `on margin,' that is, buying stock with borrowed money. The stocks rose continuously as did the attached debt. When the stock market dropped suddenly, the debt on the formerly high priced stocks, not the drop in stock value, wiped out many investors.
Also during the 20's the famous Ponzi scheme occurred. High interest payments were offered to investors. The plan appeared feasible as early investors received their extraordinarily high interest payments. Soon, however, it was discovered that the payments were being made from funds provided by later investors, not from any other business activity. Continuous new investor enrollment was required for the scheme to continue, just as debt on stock worked only as long as the stock grew in value.
During the Depression that ensued in the 1930's, the chain letter mania occurred. Investors were urged to send dimes in the mail to lists of people on the letter they received and then draw up more names and continue to circulate the letter. Eventually, they were promised, millions of dimes would pour in. At one point the US Mint ran short on dimes due to the widespread circulation of these chain letters.
The business hoax of the 1980's was known as "penny stocks." Penny stocks rode the wave of a blind optimism that swept over the country in the early and mid-80's before the crash of 1987 brought many investors back to their senses. This business system is still in operation although greatly reduced and more carefully monitored by the Securities & Exchange Commission.
To better understand our era's current business hoax - multi-level marketing - a look back at the penny stock phenomenon can be instructive. Penny stocks played upon unbridled optimism. It fooled investors into believing they were going to cash in on the stock of an unknown but `hot' new company. MLM capitalizes upon economic fear and insecurity. It fools investors into believing they will be delivered from downsizing, debt and global competition by this `hot' new sales system.
Some of the major penny stock firms were shut down by state and federal regulators by the end of the decade. Others are still in business often under new names. Some executives went to jail, paid large fines or were officially banned from the securities business. Yet some others came through mostly unscathed and are enjoying their riches from the fraud. The individuals and the specific companies are not the story. As in MLM, the key to reform and to avoiding being duped is to understand the system. Few people understood penny stocks just as few investors understand the mathematics and economics of MLM. For penny stock telemarketers, as for today's MLM upliners, public ignorance presents a very lucrative and vulnerable market to exploit.
Here's how a typical penny stock scheme worked, although there were many other variations on this theme.
A stock brokerage company makes a deal with a small group of investors to sell stock in a newly formed public company and then to merge this new company with an existing privately held one. The new public company will have no product, no history, no experience, nothing. Shares will be sold to the public on the story that this is a `blind pool.' or `shell,' that is, the new public company will have the structure of a publicly traded company which allows investors to buy and sell shares and better enables the company to gain new capital. It will also have cash available from the initial shares its sells. When the initial stock is sold, it will have a public structure and a large bank account without debt, nothing more. Then, it will merge with the private company which is engaged in some enterprise or another and thereby fold the private company into the public structure.
This process is a cheaper and easier way for the private firm to become publicly traded without the federal or state regulators, journalists or shareholders ever examining its viability. The shell will be sold boldly as just a new company with a bank account but one that has great `potential.' Shareholders are told that an impending and portentous merger will send the stock skyward.
As in MLM, the penny stock investor is really buying a `future.' The shell by itself, like the MLM distributorship that just retails products to friends and neighbors, is an unattractive business proposition indeed. But its potential is great due to possible subsequent events. This impeding event in the penny stock scheme is the much heralded `merger' leading to subsequent resell of the stock at a big profit. In the MLM scenario, the future is based upon the potential of huge downline development which will provide lifetime annuities.
Now comes the mathematical trick common to all pyramid schemes. In MLM the trick is to offer the possibility of exponential expansion of the downline. You enroll just five distributors and they each recruit five and they in turn enroll five each. Investors do not realize that if this expansion continued only 12 more times the number of distributors required would exceed the population of the earth. Nor do they know that because endless expansion cannot be achieved, 99% must fail in the business. They simply cannot see the inherent limit on the number of `winners' in this scheme. They do not realize that the real business is to continuously enroll replacements for the failures. They become convinced they will be one of the winners and so they ignore the overall picture. They also turn their heads away from the idea that they might profit from so many others' losses. MLM promoters play upon the greed, ignorance and the tinge of larceny in the heart of each new investor. Remember, MLM operates in an environment of personal fear and insecurity. People are investing in hope.
In penny stocks, the math is spelled out in the prospectus sent to each shareholder but is usually ignored or not understood by the investors. Penny stocks operated in a booming economy. Anything seemed possible. People were investing in greed which had been declared good. Remember? So, why bother to pore over the tortuous language of the prospectus?
Millions of shares are issued but only 20% are actually sold to the public. One or more people control the other 80% even though they may have invested little or no money of their own. This ensures massive profits to the insiders, including the company waiting in the wings for the merger, and to prevent any interference from those who actually put up the money.
The stock is sold for one penny a share. Investors believe this is very cheap and they are getting a bargain. Brokers hint that the stock could go to a dollar! They are getting in on the ground floor. This shell will soon merge with a company that has explosive potential for growth. This is a chance of a lifetime!
If the total number of outstanding shares are divided into the total dollars in the shell's new bank account, the true value of a share of stock is revealed to be perhaps 1/20th of one penny. Far from a bargain, at one penny a share the shareholders actually bought stock that is grossly overpriced. Further, the insiders who own 80% of the shares have become instantly wealthy with the initial sale of shares. If $500,000 of stock are sold to 500 shareholders, each buying about $1,000 of stock, then the day after the offering, the insiders gain $400,000 (80% of the net worth of the company).
Like the MLM recruit who enters the system years after the MLM company was founded and faces extraordinary odds against success, the penny stock investors were effectively beaten even before the company got off the ground. Or were they? Like the MLMer who has a losing business unless he is able to recruit many others below him and earn overrides from their losing investments, the penny-stocker can redeem his position handsomely if he can unload the stock at a profit to another investor behind him, the "bigger fool theory" as it is called in stock broker circles. Meanwhile those at the top of both types of schemes, the brokerage company and insiders in the penny stock deal, the founders and first top-line distributors in the MLM, pull the strings and profit accordingly.
As in MLM, some winners are needed to convince many more hopefuls to invest. Evidence must given to entice others, even if the evidence is bogus. In MLM, the lives of the wealthy upliners are presented as proof that the system works and the opportunity for success is available to all. The system functioned similarly in penny stocks. The first level of investors is offered the chance to sell its shares at 1 1/2 cents a share, a 50% profit in only one or two weeks! The brokerage company that is `making the market' buys back the shares, but unknown to the sellers, the brokerage company has already lined up twice as many people to buy these same shares at 2 cents a share. The brokerage company makes as much as 60% commission plus transaction fees on the `spread' between one and two cents, thus making more profit than the initial shareholders. Additionally, insiders are positioned to buy and resell the stock themselves in the artificially skyrocketing market. The buy/sell transactions are conducted on the same day.
As in MLM, the penny stock system works by getting investors to make relatively small investments, usually $500 to $5000. Each level of shareholders that is sold stock, therefore must grow in numbers of people to account for the higher priced shares. If five hundred were needed to buy the shares at one penny a share, with each investing an average of $1,000, then one thousand more investors are needed to make similar size investments when the stock is at two pennies a share. The base of the pyramid must now continuously expand to keep the entire structure from toppling. The rumored merger is made with the phantom company. Newsletters and phones calls pour forth from the brokerage company to trumpet the good news.
The merger of the shell with a private company provides the penny stock scheme with a certain validity. An empty shell was taken public; people invested; shares are bought and sold on the basis of this future transaction. But, in reality, the merger itself was as worthless to shareholders as the original shell. Its only purpose was to excite investors. The real money is to be made in the buying and reselling of the stock, not in any tangible business activity of the merged company itself.
This aspect is closely analogous to MLM's sales of products which are sometimes heralded as miracle cures or technology breakthroughs. Whatever they are, they are not the essential business of the enterprise. Continuously reselling distributorships in an ever expanding chain is the real business. Few people other than new distributors ever buy these products and most are sold as part of the investment scheme which is also contingent on future transactions. Products provide a fig leaf of validity and often keep regulators at bay just as the mergers did for penny stock promoters. If the newly formed penny stock company does not merge with another enterprise, it can be reclassified as an investment or banking company and fall under new and different regulations.
As more penny stock investors are solicited, the stock keeps rising. Soon the stock goes to five and then seven and perhaps eventually to twelve! For those on the inside, this is a veritable gold mine. For some shareholders who invested early, the program appears to be a wonderful and fully legitimate investment. Who can argue with making money by buying and selling stock? It's as American as apple pie. It's legal. It's just supply and demand. This is capitalism at its finest. What a system! The brokerage house has been earning huge commission rates on trades with stock rising at 50, 100 and 200% increments. The inside investors associated with the brokerage firm have been reaping massive profits.
But the bonanza does go not forever. The stock is astronomically overpriced relative to the assets of the company. Further, the number of investors needed to keep the stock propped up is becoming impossible to recruit. Some shareholders are beginning to ask questions about the actual business of this merged company. A point is reached at which the stock cannot be resold at a higher price. The collapse begins. Those holding the stock at this point suffer major losses on their investments. The real value of the stock is now revealed to be what is what it was all along, a small fraction of a penny or perhaps nothing at all.
The penny stock brokerage firm, it should be remembered, is not in any way harmed when the stock collapses. Only the most recent investors lose. The firm can move forward to create yet another similar scheme. It could also repurchase the shares from the losers and begin the entire process again with yet another "story" about the firms great potential.
Likewise, the MLM does not collapse by continuously enrolling distributors who lose their funds. The brunt of "collapse" is borne continuously by the new recruits. The systems rolls on as long as more recruits can be enrolled to replace those who lose their money and drop out.
Finally, it should be noted that taking companies public with very low stock prices and even using the merger with a blind pool or shell is not inherently fraudulent. It can be a valid method of helping a new company grow rapidly. Rather, it was the selling of grossly overpriced stocks (even though the selling price was only one penny a share) and then manipulating the price to entice more shareholders into schemes in which most were destined to lose money that constituted the fraud.
Likewise, a distribution system that allows distributors to appoint sub-distributors is not inherently fraudulent. It becomes fraud only when the company and the upliners place the majority of their efforts on recruitment of distributors rather than sales of products. Unfortunately, this kind of abuse pervades and characterizes the MLM industry.
When Securities & Exchange Commission and some state regulators closed in on the penny stock firms they were charged with `stock manipulation,' an accusation analogues to that of many former MLMers who have charged their uplines and MLM companies with `distributorship manipulation.' In MLM, not only are the distributorship investments manipulated, but the distributors themselves can also be taken for still more money by selling motivation and marketing material which they are told will help them succeed.
The MLM industry operates under the thin protection of a 20-year old ruling by an FTC judge that declared the basic business model legal. However, unlike the penny stock business, MLM does not have a federal or even state agency that specifically oversees its operations. There is no testing or certification for distributors. Companies do not register with any MLM regulatory body or send quarterly reports of sales activities as did the penny stock brokers. Even when an MLM company sells stock to the public, its day-to-day sales and marketing activities are not regulated, only its stock sales.
Some analysts have argued that MLM distributorships are, in fact, securities. They are bought on speculation. Their value rests on future transactions of dowliners and are promoted this way. Buy in now! Get in on the ground floor! One of your dowliners may become a superstar and take you to unimaginable wealth! The MLM industry naturally opposes this regulation. Few people favor greater government regulation of any business. Yet, regulation normally occurs only where abuse has been rampant. Until the MLM business goes back to selling products rather than making its money by using new distributors as its unwitting customers, the call for regulation will grow.
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