Brian Smiley quoted in Atlanta Journal Constitution on broker’s duties.
Investors who sank their savings into a Florida company named Venus Cruise Line in 1985 and 1986 are still waiting for their ship to come in.
Or go out.To the chagrin of the company’s 447 shareholders of record, no Venus Cruise Line ship ever set sail, or even touched Water.
Venus, the nation’s first publicly owned cruise line, was a cruise line without a ship. Today it doesn’t even have an office, yet its stock is still available to anyone who wants to buy it, for 2½ cents a share.
In the multibillion-dollar world of penny stocks, where companies don’t need earnings or assets as much as avid promoters, regulators say thousands of Americans are grasping at such investment opportunities that in reality are little more than straws.
No one knows precisely how much money investors are losing on the “pennies,” but estimates start at $500 million a year.
Before last fall’s stock market crash, securities regulators in Georgia and other states had begun to scrutinize the industry more closely because of a rising tide of complaints against penny salesmen during the 1982-87 bull market. But since Oct. 19, regulatory efforts have been slowed by a flood of investor complaints against stockbrokers of all kinds.
Meanwhile, because jittery, small investors have all but stopped buying stocks, brokers have become more aggressive in an effort to maintain their livelihoods and help their firms offset flagging revenues, according to Scott Stapf, education director for the Washington-based North American Securities Administrators Association, an alliance of state securities regulators.
Regulators say complaints against penny brokers began pouring in early last year when investors noticed their stocks were not keeping pace with the Dow Jones industrial average.
Even in bull markets, penny stocks seldom go up, and those whose prices do rise rarely stay up long, according to Stapf, state and federal regulators and other industry experts. Moreover, according to these experts, securities lawyers and more than a half-dozen former penny brokers, the penny pitchers seek out small, unsophisticated investors who are unfamiliar with the workings of Wall Street.
“Traditionally, the stock market was a place for sophisticated investors, but now [penny brokers] are reaching out to less sophisticated people who cannot afford to lose money,” said H. Wayne Howell, head of the securities division in the Georgia secretary of state’s office.
He added: “There’s nothing per se wrong with penny stocks. The problem is that people aren’t told they’re essentially doing the same thing as putting a quarter in a machine in Las Vegas”
But Howell, other state regulators and federal investigators say they suspect the penny market may not even be that fair.
Nine Cobb County residents filed suit in Superior Court in Marietta last month against Denver-based Stuart-James Co., claiming among other things that the investors had been cheated and that prices of stocks they purchased and sold had been manipulated. They also charged that transactions had been made in their accounts without their approval and that they were “unsuitable” for risky investments in any case.
Mark Geman, attorney for Stuart-James, said the broker of the plaintiffs was no longer with the company but that investors are warned that penny stocks are highly risky and that “there is no fixed definition of suitability.”
Such investor complaints, however, have led to a new state investigation into the pricing practices of Stuart-James and at least two other major Denver penny stock concerns, Power Securities Corp. and Blinder, Robinson & Co. Inc., according to sources close to the probes.
Among complaints being examined, the sources said, are allegations that stock prices are controlled and manipulated not only by penny brokerage firms and their executives, but by individual brokers, that unauthorized transactions are routinely made in consumer accounts and that penny brokers “regularly” employ a price-manipulative maneuver called “cross trading,” which is known in the business as a “simultaneous transaction.”
In a “cross,” according to ex-brokers and regulators, one customer is told to sell a certain stock while another is told to buy it, in identical amounts. Thus, the regulators say, customers get conflicting recommendations and brokers get bigger commissions.
Executives for the firms say that Stuart-James has 70 brokers in three offices in Atlanta, Power employs 82 brokers in its Gwinnett County office and Blinder has 50 brokers in three offices.
According to the sources, the Securities and Exchange Commission (SEC) also has launched an investigation of Stuart-James’ Georgia operation, and taken depositions so far from more than two dozen people, mostly former brokers.
Last fall, less than two weeks before the stock market crashed, Georgia Secretary of State Max Cleland reprimanded Stuart-James and placed the firm on administrative probation for two years for violating state securities laws.
Stuart-James was made to pay $75,000 to cover the state’s expenses in the probe and was ordered to prevent its brokers from making unauthorized trades in the future. The state found that Stuart-James brokers had made false representations to clients about stocks, and had failed to disclose to customers that an Atlanta company whose stock they were selling — Adcor Electronics — was on the verge of bankruptcy.
Neither Cleland nor Howell, his deputy, would confirm the existence of the probe of Stuart-James, Power Securities or Blinder, Robinson. But Howell acknowledged that his office is “keeping a close eye” on all penny stock firms doing business in the state, including the three mentioned. Spokesmen for the three firms said they were unaware of any investigations.
The National Association of Securities Dealers (NASD) recently fined Blinder $250,000 for marking up stocks by “excessive and fraudulent” amounts and last year censured and fined Stuart-James for “failing to segregate customer funds” and providing false volume information to NASD, said spokesman Enno Hobbing. Blinder currently is being sued in federal court in Philadelphia by investors who charge they were sold nearly worthless stock at high prices.
At the heart of the disputes between the regulators and penny firms is whether the brokerages’ pricing practices are fair, and if fair, whether the manner in which stocks are priced is adequately explained to investors.
Stocks that are not listed on a major exchange such as the New York Stock Exchange (NYSE) or the American exchange are traded in the over-the-counter (OTC) market, which is regulated by the NASD.
Stocks that are traded on the NYSE or the Amex are bought and sold in an auction market to the highest bidder. But stocks traded OTC are bought and sold in a different way, through market makers: companies that stand ready to buy or sell certain securities.
Such market makers are allowed to levy “spreads” on stocks to cover their costs and risks. The spread is the difference between the price a market maker will charge and the price it will pay. Theoretically, spreads narrow or widen according to the supply and demand for the stock being traded.
For instance, the stock of Atlanta-based Management Science America is traded over-the-counter. Recently the stock’s “bid” price, or what an investor could sell it for, closed at $8.37. The “ask” price, what an investor would have to pay for it, was $8.50. That was a spread of 1½ percent of the bid price.
But spreads on penny stocks frequently can be as high as 300 percent. A spread that big — or even bigger — is not illegal, but regulators charge that penny brokerages, and individual brokers, often fix prices more by whim than by supply or demand. In the penny industry, there are fewer market makers and sometimes only one for a particular issue.
Blinder, Robinson Vice President Steven B. Theys said spreads are fair and legal – “the amount of compensation that a broker-dealer market maker will receive for putting his capital at risk to maintain a liquid market.”
But Steven J. Gard, a partner in the Atlanta law firm Page Gard Smiley Bishop & Porter , which is representing the Cobb Countians in the suit, alleges that “the prices at which these stocks are bought and sold has no more connection to reality than the man in the moon.”
Howell and other regulators, however, say proving the prices are unfair is another matter.
“You can’t tell on one transaction,” said Howell, whose agents make spot checks from time to time on brokerage operations. “In order to trace these things, you’ve got to go to each point of the transaction. You’ve got to be able to prove where a [purchased] share of stock came from.”
But short of infiltrating various brokerages with undercover agents, price manipulation will remain difficult if not impossible to prove, according to Howell. Ex-brokers and regulators say cross trades have the effect of bidding prices up artificially — making the stocks easier to sell again.
“Once you get the buy, you go through your book and find clients that have it to sell,” said one broker named Mark who did not want his last name used. “It’s a lot harder to find a buyer than a seller.”
The brokerage firm’s incentive to encourage such maneuvers is that it doesn’t want a stock it underwrites, or initially sells to the public, to drop below its offering price “because it makes it harder for them to find other companies to underwrite,” said Stewart Winograd, managing editor of the OTC Stock Journal in Denver, one of the bibles of the industry.
Some investors do make money on pennies according to Winograd, ex-brokers and regulators. The likeliest way is through the purchase of “new issue,” or initial public offerings of stock.
But penny stock critics say few investors manage to sell even their “new issue” at more than a small profit. According to regulators, ex-brokers and former clients, customers are urged to sell their “new issue” quickly, for a small profit, so the underwriter can resell the stock at big spreads.
“If I made you a couple grand overnight, you’d do anything I told you to do,” said a former broker named Jim who did not want his last name used. “You’d be hooked.”
Another broker, Mark, agreed in a separate interview. “I say, ‘Look, I made you this much money, just think about what I could do if I had some more money to play with.'”
Another ex-broker, Bill, now with a mainstream Wall Street firm, said that of 300 former clients, fewer than 10 were in the black when he quit.
The former brokers said salesmen are taught not to tell customers what stocks sell for — only the price it would cost to buy them.
“You’re not going to tell them that the first day you buy a stock, you’re automatically down 30-40-50 percent,” said one former broker. “Nobody would ever buy anything if you did.”
Brokers are legally prohibited from making unrealistic promises, executing unauthorized trades, charging arbitrary prices, or from investing their clients’ funds unsuitably, according to Brian N. Smiley, a partner in the Atlanta law firm Page Gard Smiley Bishop & Porter , which specializes in securities cases.
But with production “the name of the game, and these young kids seeing dollar signs in their eyes,” complete candor often proves impossible, said J. Boyd Page, senior partner in the firm. Gard added: “The penny brokers operate on the mushroom principle: They keep their clients in the dark and they feed them manure.”
Hugh Helmly, Blinder’s former divisional manager in Atlanta, said: “There should be warnings on this stuff like on cigarette packages.”
“A penny stock firm basically has a license to steal in that they do not have to disclose the amount of spread or discount between the bid or ask of a given stock.”
Helmly, president of his own fledgling company called Atlanta Oil and Gas Investments Inc., added: “Until the brokerage firms have to disclose their market maker spread to the customer on the confirmation [trading statement], the customer will be in the dark. With that information, if the customer really believed in a penny stock, he’d be fully armed.”
A well-known law, rule 10b5 of federal securities statues, requires brokers to disclose when their companies are market makers and explain what that means. But, said Page Gard Smiley Bishop & Porter attorney Robert C. Edwards, “The only thing that these brokers know about SEC rule 10b5 is, you give us $10 today, it’ll be 5 tomorrow.
By Bill Hendrick
