Pump and dump is a securities’ fraud or a scheme that involves the inflation of the price of security through misleading, false or statements that exaggerate the stock’s price (Pump). The person attempting this fraud will benefit from this boost in the price by selling the securities at a high price quickly (Dump). This practice is illegal and can lead to heavy fines based on securities law.
How does it work?
This scheme involves manipulation of microcap or penny stocks. These are usually the stocks of companies with small market capitalization. These stocks are generally traded over the counter at an extremely low price. They do not stick to the requirements for public listing. Hence, the information about these securities can be manipulated by fraudsters easily. Unavailability of public information creates favorable conditions for fraudsters as the potential investors do not have enough sources of information about these companies. In addition to that, it does not take many buyers or too much money to push the stock price higher because of the small float of these types of securities.
Pump and dump scheme was initially done via cold calling. But with the advancement of technology and internet facilities, this practice has become more prevalent. These scammers post messages online that attract investors to purchase a stock quickly, with claims like some development will result in an upswing in the stock’s price. Once the buying starts, the fraudsters sell their shares, which leads to a price drop. New investors now lose their money.
The different types of Pump and Dump Schemes:
1. Classic scheme
This scheme involves any kind of manipulation of information regarding a company or its stock. It includes stock pitches through cold calling, releasing fake news, and distribution of “inside” information that might boost the share price.
2. Boiler room
Boiler room is a very small brokerage firm that employs brokers who use dishonest practices to sell questionable stocks to investors. These brokers sell midcap stocks that the firm sells or buys as a market maker via cold calling. These brokers working at boiler rooms attempt to sell as many stocks as possible thus inflating the price of the stocks.
3. Wrong number
The ‘wrong number’ scheme is a new method. People receive voicemails from strangers with tag lines like ‘hot investment tip to a friend’. However, this is a target action to attract potential investors to a particular company’s stock and increase the demand for it.
Avoiding Pump-and-Dump Schemes
Scrutinizing the Source
It is important to examine the source of information. With the advent of the internet, pump and dump schemes have become very prevalent. One should double check before investing in stocks based on advertisements available online. A simple internet search with the product name will give a number of results if the product is indeed a scam.
Verifying the Stock Independently
Every company claims its stock to be the best investment. Any scammer can pay the promoters to give good reviews. Before one makes an investment, it is advised to verify the claims made about the stock. It could be through Internet research or simply calling different financial professionals or the state securities regulator. If a newsletter or an email only speaks about the hype and does not mention any risk, it is probably a scam
Avoiding Red Flags
If any stock’s promoter is using really high pressure sales techniques and tactics to make a sale, odds are that they stand to gain much more than the buyer. Before buying, It is important to ask for (or read) the company’s financial statements or the investment’s prospectus.
Seeking legal help
If one thinks that they might be the victim of any pump and dump scheme, he/she may be entitled to recover the losses. People who are found guilty of pump and dump schemes are subject to heavy fines.
Reporting to regulator
It is also important to share information with SEBI in case of any wrongdoing or potential fraud by the brokers or the company itself. Savart is proactive in identifying & educating investors on avoiding these companies. However, it would take your help to do it better! If you know of any such companies or are concerned about their activities, let us know and we shall do our best.
In general, these are the stocks that come out of nowhere that shoot up like a rocket only to crash in a flash. It is important to investigate thoroughly to avoid pump and dump investments as they have now become really common. A few key rules like ‘never investing in a company before reading annual reports’, ‘setting a minimum threshold of market capitalization for exploring investment’ can help solve most of the problems and avoid these low-quality companies or sometimes the low-quality people around the companies.