Paul Allen understands all too well the pitfalls of purchasing
. Last spring, Allen, a 65-year-old retiree from Boston, invested
in Vapor Hub International (symbol
) after receiving a flood of e-mails suggesting that shares of the
e-cigarette company were about to take off. He quickly lost 80% of
Allen won't be the last investor to suffer such a fate. The
possibility that a stock will soar from a few pennies a share to a
few dollars, or more, is too tempting to ignore, even if the
potential for fraud is great.
Consider how investors got sucked into a company called Cynk
). Cynk, which had no revenues and just one employee, briefly
enjoyed a market value of more than $6 billion, thanks to a
promotional blitz that started in June and sent the shares soaring
from 6 cents to nearly $22 in just a few weeks. The Securities and
Exchange Commission ended the party by suspending trading in the
stock on July 11. When the SEC lifted the suspension on July 25,
the stock sank 96% in two days.
Encouraged by a bull market and the exorbitant prices companies
are paying to buy start-ups, more and more people are hoping to
make a killing with penny stocks. According to OTC Markets Group,
where many tiny companies trade, some $26 billion in penny stock
shares changed hands in 2013, up 46% from the previous year's
The apparent manipulation of Vapor Hub's stock was typical.
Vapor Hub operates two retail shops in the Los Angeles suburbs
where you can try different e-cigarette flavors. According to its
March 31 financial statements, the company lost $6,048 in its first
nine months of operation. And its survival depends on its ability
to raise more capital--a prospect so uncertain the firm said its
ability to stay in business was in doubt.
But in April, two newsletters,
received $65,000 to promote Vapor Hub and began sending out
rapid-fire e-mails about their top pick in the e-cigarette sector.
The shares doubled in a matter of days, convincing Allen he needed
to act fast. The stock, which hit 87 cents in early April, closed
at 11 cents on July 31.
Fraud risk. The SEC, which defines penny stocks as those that
trade for less than $5 per share, says this market is unusually
vulnerable to fraud for a variety of reasons: Few seasoned analysts
follow penny stocks, financial information is scarce, and many
supposedly unbiased reports are actually written by paid promoters.
The SEC doesn't list enforcement actions based on market
capitalization, but the agency has shut down hundreds of suspicious
stocks in the past year.
Of course, plenty of legitimate outfits with tiny share
prices--so-called micro caps--eventually grow into bigger concerns
and reward shareholders. On average, about 50 firms graduate to
larger exchanges each year, says Cromwell Coulson, CEO of OTC
Markets Group. He says his exchange tries to curb fraud by making
financial information more readily available and by adding a
skull-and-crossbones warning to a company's listing when the
exchange learns that the stock is the subject of an e-mail
But the warnings often come too late for individual investors
such as Allen. The best way to avoid penny stock scams is to do
independent research, says Ken Springer, a former FBI agent who
conducts investigations for institutional investors.
Start by visiting the
SEC's Web site
. Look at a company's 10-K annual report, 10-Q quarterly reports
and Form 8-K filings, in which companies report "material" events.
Checking out promoters can be tougher, but some telltale signs are
readily available. For example, disclosures on the Web sites of
revealed that they had received payments from Vapor Hub. Says
Allen: "I've been torturing myself over this. It's not that I
didn't know the right questions to ask. It's that I invested before
I asked the questions."