Avoiding Boiler Room Scams
By: Jeff Brown

FBI agents recently raided an alleged “boiler room” in New York charging the firm had cheated investors out of at least $12 million over 10 years.

Compared to the multi-billion dollar Bernie Madoff scam, this one would be small potatoes if it turns out the FBI is right. The targeted company has denied wrongdoing. But the smaller, below-the-radar scams are a big deal for their victims, often the elderly and people of modest means.

Just what is a boiler room, and how can investors avoid this kind of scam?

Also known as “pump and dump” operations and “bucket shops,” these firms set up as brokerages and use teams of sales people armed with scripts to push worthless stocks on investors.

In the classic form, the company buys up shares in a small company that has essentially gone out of business but still has stock that can be traded. This company is then merged with an obscure, privately held company that has a product, or a product in development such as a new medication.

With the merger, the brokerage creates a publicly held company without having to jump through all the regulatory hoops involved when a private company wants to sell stock. The new company has a story that can be told to investors. The sales team can claim, for instance, that the drug is about to receive government approval, making the stock a good bet.

Typically, the brokerage owns the shares itself. Because the shares are rarely traded, the firm can artificially drive up the price by having its people offer gradually increasing prices on a series of trades.

Then the sales force hits the phones for the “pump” stage of the scam, telling investors news about the government approval is about to break, driving the share price up. Investors are sold shares out of the brokerage firm’s inventory, shares the firm originally bought for next to nothing. That’s the “dump” stage.

After all the shares are sold, the operation winds down, the stock price collapses, the investors suffer losses and the brokerage is left with big profits, the difference between what it paid for the shares and the prices it charged investors.

So, what are the warning signs?

Usually the first is a phone call from an unknown broker. Obviously, it’s foolish to trust your money to a faceless voice on the phone, but some people do.

The broker almost always urges very quick action, claiming some event is about to occur to drive up the share price. Any sensible investor would ask, “Why me? Why am I being offered this stupendous opportunity out of the blue?”

If the investor asks for time to do some research or check with a spouse, the salesman may accuse him of indecisiveness, of not having the stuff it takes to be a winner.

Later, when the stock price falls below what the investor paid, the broker will claim there’s been some sort of snag, like a temporary delay in the government’s drug approval, but that the stock is still promising. In fact, the broker may use the falling price to urge the investor to buy more shares.

Before doing business with any broker, even one from a reputable firm who you have met face to face, find out if the broker is properly licensed and has a clean disciplinary record. The North American Securities Administrators Association has instructions on its site.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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