Penny-Stock Fraud Is Billion-Dollar Game
November 19, 1999
NEW YORK TIMES
Penny-Stock Fraud Is Billion-Dollar Game
The following article is based on reporting by David Barboza, Leslie Eaton
and Diana B. Henriques and was written by Ms. Eaton.
Most Americans may not know it, but there are really two Wall Streets.
One is the Wall Street of the New York Stock Exchange closing bell, of brash
stockbrokers and hair-trigger traders, of big deals and big fortunes, of
Microsoft and mutual funds.
But in the crooked alleys of Lower Manhattan flourishes another Wall Street.
This is a world of low-priced stocks and high-priced dreams, of grimy
offices and sham companies, of swindlers and touts who prey on average
people trying to grab the brass ring in the greatest bull market in American
history.
Like the world of organized crime, with which it increasingly overlaps, it
is a violent place full of colorful characters and arcane lingo, of "naked
shorts" and "pump 'n' dumps." And it specializes in creating illusions that
are as complex as a Broadway play -- and as simple as a game of three-card
monte.
It was in this world that Albert Alain Chalem and Maier Lehmann lived -- and
died. The men, who were promoting stocks over the Internet together, were
both shot in the head on Oct. 25 and left to die on the marble floor in the
$1.1 million home in Colts Neck, N.J., where Chalem lived.
Their world might seem arcane -- except that its denizens bilk Americans out
of roughly $2 billion a year, securities regulators say. The problem is so
severe that regulators and prosecutors have made it one of their chief goals
to crack down on what they used to dismiss as "penny-stock fraud," before it
became clear that the money involved amounted to many billions of pennies.
"A sustained, prolonged bull market really does bring out the crustaceans
from the bottom of the sea," said Richard H. Walker, director of enforcement
for the Securities and Exchange Commission. "They're attracted to the
money."
While the enforcement effort has closed down many of the big brokerage
operations that pushed shady stocks over the telephone, Walker said, many
people who were kicked out of the securities business have moved their
schemes into cyberspace. "That's where the action is now," he said.
And that is where Chalem and Lehmann were before they were killed. In
addition to running a Web site, Chalem was trading stocks electronically,
and may have had an account under an assumed name at a Manhattan firm called
Harbor Securities. Investigators are examining whether he traded there, and
if it was linked to his death.
From the very first, investigators have suspected that the slayings somehow
involved the two men's financial dealings, rather than their personal lives.
And, although the investigation remains in its early stages, law enforcement
officials have clearly not changed their minds.
On the surface, Lehmann, 37, seems to have had the more troubled work
history. He had pleaded guilty to mail fraud in an insurance scheme and
settled civil securities-fraud charges. Before his death he told Barron's
magazine that he had secretly worked at Patterson, Travis Inc., a small
brokerage firm with a history of regulatory troubles; company officials said
yesterday that they had no record of his having worked there.
In fact, Lehmann was more than willing to talk. He told reporters,
regulators, prosecutors and, apparently, anyone who would listen about what
he said were various schemes and swindles.
But it was Chalem, 41, who cast the longer shadow in the world of shady
stocks, and it is Chalem who is increasingly the focus of investigators. He
had worked at a brokerage firm, A. S.
Goldmen & Company, that prosecutors contend was a criminal enterprise -- a
charge that the firm denies. He also worked secretly at a firm called Toluca
Pacific Securities, according to several people who knew him. Toluca, which
is defunct, had a long history of regulatory run-ins and had links to career
felons and to organized crime.
Mobsters have increasingly turned up in stock swindles. In January, two men
whom prosecutors said were tied to the Bonanno and Genovese crime families
pleaded guilty to federal charges that they participated in a conspiracy to
manipulate the stock of an Arizona company that owns a health club; the
president of the company was convicted of related charges in May in Federal
District Court in Manhattan.
In June, federal prosecutors in Brooklyn indicted a group they said included
members of the Colombo crime family and an associate of the Bor organized
crime group of Russian immigrants.
The men, who prosecutors said ran rogue brokerage firms that manipulated
stock prices, were charged with conspiracy, securities fraud and money
laundering; they pleaded not guilty.
Chalem was widely believed, in the penny stock world, to have dealings with
Russian organized crime and to be "a protected guy," as one lawyer put it.
New information is coming to light about his activities in the weeks before
his death. Last week, federal prosecutors served subpoenas to retrieve
trading records, which may be linked to Chalem, from Harbor Securities,
which catered to self-employed day traders. Heavy financial losses recently
forced the firm to close.
Whether Chalem's trading had anything to do with his death remains unclear.
What is clear is that he and Lehmann were more accustomed to being predators
than to being prey in the dangerous world they inhabited.
The Performance: Everything Fake Except the Money
Their alternative Wall Street is not a big place; its players, who all seem
to know each other, cluster in just a few spots: San Diego and La Jolla in
Southern California, Boca Raton, Fla., Vancouver and New York, the ground
zero of stock fraud.
To be successful, stock frauds must look a lot like legitimate deals. But in
reality, they are elaborately choreographed performances, in which
everything is fake except the money the audience will lose when the play is
over.
Fraudulent companies issue fraudulent press releases touting fraudulent
products; fake newsletters make fake recommendations about fake stocks;
phantom investors make phantom trades to push up the price of these phantom
stocks. A small claque in the audience may be tossing tomatoes, but these
skeptics -- known as short-sellers -- can often be bought off by the show's
producers.
Between them, Chalem and Lehmann seem to have played every possible role in
such productions. Behind-the-scenes operators, they did business over
cellular phones and computers, from so-called boiler rooms full of phones
and fast-talking salesmen, and most recently, on the Internet.
To understand how thousands of Americans get taken in by these shows, it
helps to know a little bit about the legitimate side of Wall Street -- and
about how the real thing differs from its evil twin, as described in court
documents, in interviews with regulators and prosecutors, and in discussions
with people in the stock business.
In the real Wall Street, new companies that want to raise money pay
investment firms a fee to sell shares of stock. In the shady Wall Street,
almost none of the money raised from investors goes to the company; rather,
it lines the pockets of brokers and promoters and their pals. In one case
analyzed by state regulators in Alabama, a New York company raised $12.5
million from investors; $11 million of that went to insiders and brokers.
In the real Wall Street, public companies are vetted by accountants and
auditors and lawyers and investment firms, all of them supervised by
regulators. Companies that have stock outstanding must file quarterly
financial reports with the Securities and Exchange Commission, and keep
investors informed of major changes in their businesses.
In the ersatz Wall Street, companies avoid filing regulatory reports --
lying on such reports is a crime -- and communicate almost entirely by news
releases, the more hyperbolic the better. (Without admitting or denying
wrongdoing, one Florida executive recently settled regulatory charges over
his press releases. These falsely claimed that the Moscow Ministry of
Finance and Walt Disney World were negotiating to buy his company's process
for turning scrap tires into oil.)
At legitimate companies, insiders, like executives and directors, must
report, publicly, any time they buy or sell their own stock. People who own
even 5 percent of a company must also reveal that through filings.
In the fake Wall Street, insiders use false names and dummy accounts to hide
the fact that they control almost all of a company's stock that is available
for trading. In one regulatory case recently filed in Federal District Court
in Brooklyn, the S.E.C. contends that a group of stock promoters controlled
as much as 95 percent of the tradable shares in several companies.
Though the real stock market is a complicated place, particularly in the
short run, over the long haul a company's stock price rises when investors
are optimistic about its future sales and profits; the stock price falls
when investors worry that the company's business is in trouble.
In the false Wall Street, a stock rises like Peter Pan in the stage play,
not because he is thinking merry little thoughts, but because he is attached
to a wire strung from the theater's rigging. (Aptly, these manipulated
stocks are called rigs.)
The stage for these stocks is usually the O.T.C. Bulletin Board, a trading
network run by the National Association of Securities Dealers, which also
runs Nasdaq. But unlike the real Nasdaq market, the bulletin board will
trade the stock of almost any company, no matter how small, secretive or
downright preposterous.
Regulators predict that more than half of the roughly 6,000 companies that
were trading on the bulletin board last year will be removed by next June,
under new rules that require them to file current financial statements with
regulators.
The cast of characters includes the promoters, who are often stockbrokers
barred from the securities business, their lawyers and public-relations
advisers. The production also needs someone still in the securities business
who can execute trades.
Other starring roles usually belong to corporate executives, who are mostly
in on the rig, though sometimes they are innocents desperate to raise money
for their companies.
And then there are short-sellers, who are people who bet that share prices
will fall (and make a profit when that happens). In some cases, they are
doing all they can to make sure the production is a flop.
The production may call on the brokers and cold-callers to unload shares on
the public, although the Internet is making such brokers increasingly
unnecessary; now, investors can be persuaded to buy stock electronically.
"The Internet has put this type of fraud on steroids," said Cameron
Funkhouser, vice president of market regulation for the National Assocation
of Securities Dealers.
The Choreography: Hyped-Up Ideas, Controlled Stock
The plot of the play always begins with the company. The ideal stock-fraud
company has some whiz-bang new product that will excite investors, like a
self-chilling beer can, springy shoes for race horses, or a cure for
baldness or for tooth decay. Also popular are gold mines in obscure
locations, theme restaurants in Las Vegas and anything in cyberspace with a
.com after it.
Sometimes the purported business will change in the course of the scheme;
according to a ruling in a federal lawsuit, one outfit called Sky Scientific
claimed at various times to be running gold mines, a financial services
company and the first riverboat casino in Moscow. Occasionally the company
is a small operation that has a real product, but it is just not as
thrilling as the company's public relations makes out. (The vitamins do not
really cure cancer; the Internet service has not really signed up every
household in Peru.)
One company Lehmann was involved with, Electro-Optical Systems, claimed to
be developing a computer gizmo that would read fingerprints, so that users
could sign in without having to remember pesky passwords.
His original role was to hook up the would-be inventor of the product with
the "investment bankers" who were supposedly raising money for the company,
according to a decision in a lawsuit filed last year by the S.E.C. in
Federal District Court in Manhattan. The inventor was not named as a
defendant in the case, which is now dormant while a criminal investigation
continues. Lehmann settled the regulators' charges and paid $630,000 in
fines and restitution.
The key, from the con artists' point of view, is to get control of the
shares of stock, which might be called Act 1. Sometimes shady brokerage
firms stage "initial public offerings," but a faster and cheaper method --
the one Lehmann's group used -- is to merge the company with a shell
corporation, which has stock outstanding but no business.
Almost everyone involved in the scheme is paid with stock; the promoters
usually control huge blocks in accounts with false names, often overseas.
They all make money by making the shares rise in price. They often do this
in part by making fake trades at arbitrary prices. In the case of
Electro-Optical, regulators contend that the promoters put in an order to
buy shares at $7 each, far above the 20 cents for which shares had last
changed hands before the promotion began.
Once the stock price has been pumped up, it is time to lure outsiders into
buying the shares. Lehmann helped out with the public relations. He got an
an Internet newsletter to choose Electro-Optical as its "pick of the year";
the newsletter's owner was later sued by the S.E.C., which accused him of
secretly taking stock and cash from companies in exchange for recommending
their stocks; he is contesting the charges.
Lehmann also approved a press release that claimed, falsely, that
Electro-Optical had just received a big order for its products. (Neither
order nor products existed.) Investors, entranced with the concept and the
rising stock price, began to buy the inflated stock.
After the pump comes the dump. Those in the know sell their shares to
unsuspecting investors. Lehmann had received 100,000 shares, for which he
paid nothing and which he put in an account in his wife's name; when he
sold, he made about half a million dollars. All told, regulators say, those
involved in the Electro-Optical rigging made $12 million by dumping their
shares.
Once the promoters stop pumping the stock, its price usually plunges. Anyone
who wants to buy Electro-Optical today can get 10 shares for a penny.
Bailing Out: Special Handling for Short Sellers
Some inventive stock promoters find a way to make money on the falling
price, too, by selling short. To do this, a short seller simply borrows some
shares from a brokerage house, promising to replace them later, and then
sells them. If the trader has guessed right and the stock's price later
falls, he can replace the borrowed shares -- a step known as "covering" --
by buying shares at the new, lower price.
His profit is the difference between the price at which he sold the borrowed
shares and the price at which he bought the replacements. But if the share
price rises, he can easily lose his entire investment.
While short selling can be a legitimate practice, it can also be abused.
Chalem's friends and former business allies say he practiced a more
aggressive form of short-selling, called naked shorting. Brokerage houses
that deal in a particular stock can short it without borrowing the shares
first. Going through those cooperative brokers, speculators like Chalem
sell, and sell and sell -- thereby guaranteeing that the stock's price will
plummet.
A year or two ago, Chalem's associates say, he was shorting the stock of the
Quigley Corporation of Doylestown, Pa., which makes zinc lozenges that it
says relieve common colds. The company blamed short-sellers for the decline
in its stock, which has dropped from $23 in the fall of 1997 to about $3
today. Skeptics said the company's share price was too high and, indeed,
sales of the lozenges have been falling.
But a debate over the true merits of most penny stocks is pointless; in many
cases, both the promoters and the short sellers know that the stocks are
rigged. Then, the question is simply who has enough power -- and money -- to
prevail in what is really trench warfare.
Promoters may try to make short-sellers go away by giving them free shares
that the short-sellers can use to cover and close out their positions with
big profits. This has caused some prosecutors to believe that this sort of
short-selling is really a kind of extortion, though that is hard to prove.
Both sides use rough tactics in their efforts to win. They try to plant
stories in the press. They call regulators and prosecutors to inform on each
other.
And they threaten each other with physical harm, backed up by visits from
burly men. John Fiero, a prominent short seller and president of the firm
Fiero Brothers in Manhattan, has repeatedly complained to the police about
the threats he has received.
And that violence may ultimately be the biggest difference between the real
Wall Street and the parallel universe inhabited by people like Chalem and
Lehmann.
Real Wall Street takes a lot of financial risks. But the crooked Wall Street
"is not just a financially dangerous world," said Stephen Luparello, a
senior vice president of the N.A.S.D. "It's also a physically dangerous
world."
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