This note was originally published June 03, 2013 at 14:38 in Compliance
Like the US economy, the SEC appears to be recovering from the depths to which it had sunk. While it is premature to determine the scope of the “new” Commission under Mary Jo White, a number of recent actions show increased diligence in certain key areas.
This morning the SEC Tweeted piece news on a corner of the business which has seen more than its share of financial hanky-panky.
First, though, you may be amused to learn that the SEC tweets. In fact, the SEC has three separate Twitter offerings: SEC News, SEC Investor Ed, and SEC Careers. SEC News has over 192,000 followers, while the investor education stream has only some 35,000, and Careers around half that – about 18,000.
We think it’s important to follow the Commission’s work – and “following” the SEC gives you up to date information on what the SEC is up to. It also tells you what the SEC itself believes is important to burnishing its public image – a task that still has a way to go.
Today’s tweet reads: “SEC Suspends Trading of 61 Companies Ripe for Fraud in Over-The-Counter Market,” a follow-up on a major action last May when the Commission’s Microcap Fraud-Fighting Initiative suspended trading in 379 dormant “shell” companies (SEC Release 2012-91, May 14, 2012).
Shell Companies – In a typical organization, John Smith starts work at Your Company, Inc, and is assigned firstname.lastname@example.org. Using this email address, he proceeds to do business on your behalf. Since you want John to start doing business right away, it’s a priority for your tech team to set up his email, phone extension and voice mail-box. But when John leaves your employ, are you equally diligent in disabling his communication abilities? John may move on to his new endeavor with nary a backward look. But just imagine how much trouble might be created by someone surreptitiously using John’s email to create a false set of business transactions. Managers think that “discontinued” means “gone” – but not in the world of communication technology.
This internal miscreant could attempt to place buy and sell orders on behalf of Your Company, to move money out of bank accounts, to shift assets around – in short, they could do a whole lot of damage. Since John is no longer with you, you wouldn’t ever think of monitoring communication over his email address. By the time you figured out where the problem was coming from, it could be too late.
So the first lesson is: make sure your IT department disables those unused email accounts. Just because there’s no one there to use them officially, doesn’t mean there’s no one using them at all.
How does this relate to stock trading?
Announcing the result of last year’s “Operation Shell-Expel,” then-director of Enforcement Robert Khuzami said “Empty shell companies are to stock manipulators and pump-and-dump schemers what guns are to bank robbers.” In a Pump-N-Dump scam, fraudsters acquire the stock of a dormant microcap company. Stock of companies that have ceased doing business can reside in any of a variety of “inactive securities” accounts at a brokerage firm – which would be only too happy to clear it off their books for a nominal fee. Scammers can often acquire over 90% of the stock for a couple of hundred thousand dollars. They then launch a promotional blitz to get people like you to buy as much stock as possible, as quickly as possible.
If you receive an email promising you the equivalent of “major new find to cure cancer, incredible opportunity in low-priced stock!!!” you are probably on the receiving end of a shell-company scam.
What’s Different Today? – The SEC’s mandate is based on a “disclosure regime,” requiring companies that want access to the public marketplace to fully disclose all material information about their business. As with the prospectus for a new securities offering – the Disclosure Document extraordinare – the SEC passes on the Completeness of the information, but not on its Accuracy. There lies the rub.
For years, when dormant “shell” companies started trading again, SEC disclosure rules required them to bring their filing information up to date – but not to verify whether it was true. In fairness, the SEC are not detectives – nor do they have the staff to send inspectors to interview the executives of every fly-by-night operation that tries to sell you stock.
It’s very much like having a membership in an exclusive club. John Smith, member of the Club of One Hundred (so called because it is limited to one hundred members, each one of which is pledged to give full financial support to any other) dies. His death is not reported to the Club. Three years go by, and someone else finds John’s membership card among his cast-off effects. The impostor shows up at the Club and produces the card. “Ah, Mr. Smith!” he is told. “We would love to welcome you back. But you see, your membership has lapsed because your dues have not been paid for three years.” At $100 a year, it will cost $300 to re-activate the membership – which sum the impostor gladly hands over. The Club does not ask for any verification of his identity, and by the time the members learn of the previously unreported demise of their lamented former member, the false “John Smith” is on a tropical island spending his ill-gotten millions.
For years, all the SEC required was that the public reporting documentation be filled out in full. To facilitate capital formation, smaller companies were permitted to register and report directly on EDGAR, the Electronic Data Gathering, Analysis and Retrieval system set up by the SEC in the mid-1990s, bypassing the manual review process.
Pump-N-Dump schemes tend to run very quickly, which means that by the time you realize what’s going on, you’ve already been scammed. Stock is handed out liberally to small shady operators, who mix it in with the stock they sell for the promoters, as those at the head of the Pump-N-Dum pyramid are known. This way everyone gets paid. Except you. For more about the world of stock scammers, and other depressing insights, read our Hedge e-book Fixing A Broken Wall Street, available at http://tinyurl.com/cqgter9.
The SEC suspends trading in a stock when there is a lack of adequate up to date information, when the Commission has serious doubts about the accuracy or truthfulness of the company’s public information, or when there are concerns that the stock is being manipulated. This initiative to track down and prevent trading in ripe-for-fraud shell companies is an important step. Under the Commission’s own rules, they can’t just pull these stocks from circulation. The suspensions are set to run for ten days and should be a first step towards de-listing these issues before they rise, zombie-like, to eat the living flesh of your portfolio.
Protect Us From Ourselves? – Investor Protection is not adequately served by mere warnings about risks. See, for example, the NY Times, 24 May, “Growth in Options Helps Brokers But Not Small Investors.” Brokers are required by law to warn investors about the risks of options trading. But the warnings only seem to make investors more keen to trade exotic instruments. According to the Times, options trading has risen to nearly a quarter of customer business in some areas – but options investors’ returns are only about 20% of the global returns for stock and bond investors. “Buyer Beware” is a joke. In the financial markets, people believe that they are told not to do something because some Really Smart Guys want all the profits for themselves.
The SEC, by taking the extra step of actually digging into the information, and putting the regulatory kibosh on trading, is doing something they haven’t been known for of late: making the markets safe for investors.
Managing Director / Chief Compliance Officer