Avoiding Pump-and-Dump Scams

Pump-and-dump stock scams are nothing new. These scams have been a mainstay of financial fraudsters for centuries. And while technology has changed the way they operate, the underlying principles and motivations of these unlawful practices remain the same.

The Elements of a Pump-and-Dump

In a pump-and-dump scheme, fraudsters will first accumulate a large position in a stock. Generally, they'll restrict themselves to low-priced securities, often known as "penny stocks" or "microcap stocks."

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These smaller stocks may trade either over-the-counter (OTC) or on an exchange. Those that trade in the OTC market aren't required to meet the listing standards imposed by exchanges; however, even listing standards don't guarantee that low-priced stocks trading on exchanges are safe investments.

There's often little publicly available information about these smaller stocks, which can make them targets of market manipulation schemes. And fraudsters can control the number of shares of a company's stock available for public trading by investors, known as the public float, thereby giving them control of the market.

Next, fraudsters will engage in various tactics to "pump" up a low-priced stock. This could include publicly promoting, sometimes through email or newsletter campaigns, stories that claim bullish news for the company is imminent, such as an announcement of a technology breakthrough or major contract. In the past, fraudsters typically reached out to targets via word of mouth or cold telephone calls. Today fraudsters often communicate away from public attention through encrypted social media platforms. For example, bad actors might purchase social media advertising for an investment club directing interested investors to an encrypted group chat through which the bad actors then promote -- and ultimately manipulate the demand for and price of -- the small-cap stocks they acquired.

These efforts might help the stock rise quickly and substantially. This not only increases the value of the fraudsters' initial investment but also seemingly reinforces the accuracy of the story and creates buzz beyond their initial efforts, potentially making the stock more attractive to investors. Unaware of the scam, some investors, such as those who follow a momentum investing strategy, might buy and promote the stock based solely on its rapid advance. Given how fraudsters often control the float of the low-priced stocks they target, though, these investors might find themselves unable to sell when they want to.

At some point after the stock rises, the fraudsters will begin to sell or "dump" their shares. Absent a flood of fresh buyers, this sudden selling in an illiquid stock will likely make it difficult for the remaining shareholders to sell, causing the price to drop rapidly.

FINRA and other securities regulators have also called attention to ramp-and-dump schemes, a newer twist on the classic pump-and-dump scheme, in connection with some small cap stocks listed on exchanges.

The Power of FOMO

Pump-and-dump operators rely on the fear of missing out (FOMO), which they recognize as a powerful motivator for many investors. They generally include a time component to their pitch, stressing that if you don't act immediately, you'll never get another chance. And if the pump part of the scam is successful and moves the target stock substantially, this might amplify the sense of FOMO and generate even more buying.

How to Recognize a Potential Pump-and-Dump Scheme

While it might be difficult to distinguish a pump-and-dump from enthusiastic, legitimate investment advice, there are ways to protect yourself:

• Don't accept investment advice from strangers. A stranger might "accidentally" contact you on social media or an encrypted messaging app. After befriending you, they might quickly turn the conversation to a "can't lose" investment. In these situations, it's best not to engage.
• Be cautious of social media ads. Social media platforms often contain ads for investment products or investment clubs promising high returns. While there might be legitimate clubs placing ads, others are merely seeking more participants for their pump-and-dump schemes. Do your own research on those promoting investment opportunities, including checking their background and experience on FINRA BrokerCheck. You might also call the phone number listed for them in BrokerCheck to confirm their identity.
• Be wary of stories promoting small-cap securities you've never heard of. In many cases, investment club schemes initially promote better known investments before pivoting to less familiar low-priced stocks. Ignore suggestions that you borrow money, such as through a home equity line of credit (HELOC), to obtain additional funds for investing in these assets.
• Watch for shares that are extremely volatile. Volatility can stem from sudden interest in a normally illiquid stock. You might have stumbled upon a pump-and-dump in progress. Bad actors often use short-term, upward-trending trading data to persuade investors to buy. Be sure to use FINRA's Market Data tool to view price and volume trends over longer periods -- over months and years -- and to research the company's financial health.
• Don't give out personal or investment information to strangers. The more that bad actors know about you, the greater their opportunity to commit fraud.

If you think you've been a target or victim of a pump-and-dump or other stock manipulation scheme, submit a regulatory tip to FINRA.

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