A "pump and dump" is an illegal scheme used to artificially boost the price of a stock by making false and misleading claims about a company's business prospects. Then, the shares are sold before the fraud becomes known, at which point the stock price usually plummets and the unsuspecting investors lose their money.
Pump and dump scams have been around for a long time but are now more commonly perpetrated on social media as well as on online stock market bulletin boards and chat rooms. Generally, the stocks being "pumped and dumped" are thinly traded penny stocks and other microcap stocks that trade well under US$1 or £1 per share on an over-the-counter (OTC) exchange.
According to the U.S. Securities and Exchange Commission, perpetrators of pump-and-dump schemes—they can be officers of the company or other paid promoters hired by the firm—tout the stock, often claiming to have inside information that will boost the price. If the "pump" part of the scheme is successful, the fraudsters then "dump" their shares, leaving investors holding the bag.
Examples Of Pump And Dump Scheme
There have been numerous examples of pump and dump scams over the years. The following two schemes—the RCA "Radio Pool" and Jammin' Java Fraud—demonstrate how these scams have been implemented since as early as the late 1920s.
The RCA "Radio Pool"
One of the earliest examples of a pump and dump involved Radio Corp. of America, better known as RCA, whose share price jumped to more than US$500 from less than US$100 before the stock market crash of 1929. A group of investors known as the "Radio Pool" bought and sold the stock among themselves to build a record of increasing volume and prices to sucker in other people.
The stock price then crashed to under US$10 a share, one of the triggers of the stock market debacle. At the time, this practice was legal before becoming outlawed in the 1930s after the crash and onset of the Great Depression.
The Jammin' Java Fraud
A more recent example occurred in November 2015, in which the SEC filed fraud charges against several people, and it gives another good example of how a scheme like this works.
According to the SEC, the perpetrators—including the company's CEO—sought to boost the price of the stock of Jammin' Java. The company operated as Marley Coffee and sold coffee products under the trademarked likeness of Bob Marley, the late reggae artist.
To inflate the stock price and to raise money for the company, the perpetrators "orchestrated a sham financing arrangement designed to create the false appearance of legitimate third-party interest and investment in the company," according to the SEC. They also "published false stock newsletters and took other steps to hype the stock and send the share price sharply upward."
At that point, the schemers sold 45 million shares "without registering the transactions, making at least US$78 million in illicit profits in the process." The stock price tanked after the company disclosed "that it became aware of an unauthorized and unaffiliated online stock promotion," falling further after it released disappointing financial results.
The SEC said the schemers "attempted to conceal their misconduct through complex offshore networks."
Red Flags Of A Pump And Dump
The Financial Industry Regulatory Authority (FINRA), a self-regulatory agency that monitors players in the U.S. financial markets, says there are several red flags that should alert investors to a pump-and-dump scheme.
"Be skeptical of press releases, spam emails and promotional materials such as newsletters and blogs from unknown senders," which often "come from paid company insiders or promoters," FINRA says. "Be wary if you are flooded with information over a short period of time, especially if the communications only focus on a stock's upside with no mention of risk."
Investors should also be on the alert for a reverse merger, in which a company merges with an existing public shell company.
That apparently happened in the Jammin' Java case, where the CEO took control of the company through Global Electronic Recovery Corp., a "publicly-traded shell company" for a "purported waste management business in Los Angeles."
According to the SEC, "many companies either fail or struggle to remain viable following a reverse merger," which are often the source of "fraud and other abuses."
FINRA says to also be alert to where the stock trades, noting that most pump-and-dump scams involve "low-priced, thinly traded stocks" that do not trade on the major registered national securities exchanges such as the New York Stock Exchange and NASDAQ. Rather, they trade on OTC penny stock forums.
A "pump and dump" is an illegal scheme to artificially inflate the price of a stock by making false and misleading claims about a company's business prospects. The perpetrators then sell their shares before the fraud becomes known, at which point the stock price usually plummets and unsuspecting investors lose their money.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…