Avoiding Boiler Room Scams

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.

If you liked this article you might like

Why You May Not Want to Pay Cash, Own Your Home Free and Clear

Now You Can Get That Home Equity Loan in a Comfortable Hybrid

If Retirement Health Care Costs Look Scary, Try These Tactics

Why Buying Bonds With Negative Yield Isn’t as Weird as It Sounds

Investors Turning to Dividend-Paying Stocks See Benefits of Buybacks, But Must Heed Caveats