The Penny Stock Parallel
Copyright 1999, Robert L. FitzPatrick
Each decade seems to have its own business hoax. The schemes develop ingood times and bad and adapt to the special conditions of each era. Withthe benefit of experience and hindsight, the hoaxes appear obviously asfrauds, but in the context of their period, they are seen as believableand beguiling. They inspire hope and excitement and they attract millionsof followers.
A common thread of many of these hoaxes is the pyramid scheme. The insidious,underlying flaw in the pyramid scheme is its denial of the future. Its allurementis the promise of immediate enrichment. It most destructive impact is notfinancial but communal. Pyramid schemes enroll large numbers of people ina plan to defraud larger numbers of others. The most recent and dramaticconsequence of this communal damage was seen in Albania where the collapseof a large-scale pyramid scheme brought down a national government and causedchaos and anarchy.
In the 20's when the economy was roaring, there was the delusion of purchasingstock `on margin,' that is, buying stock with borrowed money. The stocksrose continuously as did the attached debt. When the stock market droppedsuddenly, the debt on the formerly high priced stocks, not the drop in stockvalue, wiped out many investors.
Also during the 20's the famous Ponzi scheme occurred. High interest paymentswere offered to investors. The plan appeared feasible as early investorsreceived their extraordinarily high interest payments. Soon, however, itwas discovered that the payments were being made from funds provided bylater investors, not from any other business activity. Continuous new investorenrollment was required for the scheme to continue, just as debt on stockworked only as long as the stock grew in value.
During the Depression that ensued in the 1930's, the chain letter maniaoccurred. Investors were urged to send dimes in the mail to lists of peopleon the letter they received and then draw up more names and continue tocirculate the letter. Eventually, they were promised, millions of dimeswould pour in. At one point the US Mint ran short on dimes due to the widespreadcirculation of these chain letters.
The business hoax of the 1980's was known as "penny stocks." Pennystocks rode the wave of a blind optimism that swept over the country inthe early and mid-80's before the crash of 1987 brought many investors backto their senses. This business system is still in operation although greatlyreduced and more carefully monitored by the Securities & Exchange Commission.
To better understand our era's current business hoax - multi-level marketing- a look back at the penny stock phenomenon can be instructive. Penny stocksplayed upon unbridled optimism. It fooled investors into believing theywere going to cash in on the stock of an unknown but `hot' new company.MLM capitalizes upon economic fear and insecurity. It fools investors intobelieving they will be delivered from downsizing, debt and global competitionby this `hot' new sales system.
Some of the major penny stock firms were shut down by state and federalregulators by the end of the decade. Others are still in business oftenunder new names. Some executives went to jail, paid large fines or wereofficially banned from the securities business. Yet some others came throughmostly unscathed and are enjoying their riches from the fraud. The individualsand the specific companies are not the story. As in MLM, the key to reformand to avoiding being duped is to understand the system. Few peopleunderstood penny stocks just as few investors understand the mathematicsand economics of MLM. For penny stock telemarketers, as for today's MLMupliners, public ignorance presents a very lucrative and vulnerable marketto exploit.
Here's how a typical penny stock scheme worked, although there were manyother variations on this theme.
A stock brokerage company makes a deal with a small group of investors tosell stock in a newly formed public company and then to merge this new companywith an existing privately held one. The new public company will have noproduct, no history, no experience, nothing. Shares will be sold to thepublic on the story that this is a `blind pool.' or `shell,' that is, thenew public company will have the structure of a publicly traded companywhich allows investors to buy and sell shares and better enables the companyto gain new capital. It will also have cash available from the initial sharesits sells. When the initial stock is sold, it will have a public structureand a large bank account without debt, nothing more. Then, it will mergewith the private company which is engaged in some enterprise or anotherand thereby fold the private company into the public structure.
This process is a cheaper and easier way for the private firm to becomepublicly traded without the federal or state regulators, journalists orshareholders ever examining its viability. The shell will be sold boldlyas just a new company with a bank account but one that has great `potential.'Shareholders are told that an impending and portentous merger will sendthe stock skyward.
As in MLM, the penny stock investor is really buying a `future.' The shellby itself, like the MLM distributorship that just retails products to friendsand neighbors, is an unattractive business proposition indeed. But its potentialis great due to possible subsequent events. This impeding event in the pennystock scheme is the much heralded `merger' leading to subsequent resellof the stock at a big profit. In the MLM scenario, the future is based uponthe potential of huge downline development which will provide lifetime annuities.
Now comes the mathematical trick common to all pyramid schemes. In MLM thetrick is to offer the possibility of exponential expansion of the downline.You enroll just five distributors and they each recruit five and they inturn enroll five each. Investors do not realize that if this expansion continuedonly 12 more times the number of distributors required would exceed thepopulation of the earth. Nor do they know that because endless expansioncannot be achieved, 99% must fail in the business. They simply cannot seethe inherent limit on the number of `winners' in this scheme. They do notrealize that the real business is to continuously enroll replacements forthe failures. They become convinced they will be one of the winners andso they ignore the overall picture. They also turn their heads away fromthe idea that they might profit from so many others' losses. MLM promotersplay upon the greed, ignorance and the tinge of larceny in the heart ofeach new investor. Remember, MLM operates in an environment of personalfear and insecurity. People are investing in hope.
In penny stocks, the math is spelled out in the prospectus sent to eachshareholder but is usually ignored or not understood by the investors. Pennystocks operated in a booming economy. Anything seemed possible. Peoplewere investing in greed which had been declared good. Remember? So,why bother to pore over the tortuous language of the prospectus?
Millions of shares are issued but only 20% are actually sold to the public.One or more people control the other 80% even though they may have investedlittle or no money of their own. This ensures massive profits to the insiders,including the company waiting in the wings for the merger, and to preventany interference from those who actually put up the money.
The stock is sold for one penny a share. Investors believe this is verycheap and they are getting a bargain. Brokers hint that the stock couldgo to a dollar! They are getting in on the ground floor. This shellwill soon merge with a company that has explosive potential for growth.This is a chance of a lifetime!
If the total number of outstanding shares are divided into the total dollarsin the shell's new bank account, the true value of a share of stock is revealedto be perhaps 1/20th of one penny. Far from a bargain, at one penny a sharethe shareholders actually bought stock that is grossly overpriced.Further, the insiders who own 80% of the shares have become instantly wealthywith the initial sale of shares. If $500,000 of stock are sold to 500 shareholders,each buying about $1,000 of stock, then the day after the offering, theinsiders gain $400,000 (80% of the net worth of the company).
Like the MLM recruit who enters the system years after the MLM company wasfounded and faces extraordinary odds against success, the penny stock investorswere effectively beaten even before the company got off the ground. Or werethey? Like the MLMer who has a losing business unless he is able to recruitmany others below him and earn overrides from their losing investments,the penny-stocker can redeem his position handsomely if he can unload thestock at a profit to another investor behind him, the "bigger fooltheory" as it is called in stock broker circles. Meanwhile those atthe top of both types of schemes, the brokerage company and insiders inthe penny stock deal, the founders and first top-line distributors in theMLM, pull the strings and profit accordingly.
As in MLM, some winners are needed to convince many more hopefulsto invest. Evidence must given to entice others, even if the evidence isbogus. In MLM, the lives of the wealthy upliners are presented as proofthat the system works and the opportunity for success is available to all.The system functioned similarly in penny stocks. The first level of investorsis offered the chance to sell its shares at 1 1/2 cents a share, a 50% profitin only one or two weeks! The brokerage company that is `making the market'buys back the shares, but unknown to the sellers, the brokerage companyhas already lined up twice as many people to buy these same shares at 2cents a share. The brokerage company makes as much as 60% commission plustransaction fees on the `spread' between one and two cents, thus makingmore profit than the initial shareholders. Additionally, insiders are positionedto buy and resell the stock themselves in the artificially skyrocketingmarket. The buy/sell transactions are conducted on the same day.
As in MLM, the penny stock system works by getting investors to make relativelysmall investments, usually $500 to $5000. Each level of shareholders thatis sold stock, therefore must grow in numbers of people to account for thehigher priced shares. If five hundred were needed to buy the shares at onepenny a share, with each investing an average of $1,000, then one thousandmore investors are needed to make similar size investments when the stockis at two pennies a share. The base of the pyramid must now continuouslyexpand to keep the entire structure from toppling. The rumored merger ismade with the phantom company. Newsletters and phones calls pour forth fromthe brokerage company to trumpet the good news.
The merger of the shell with a private company provides the penny stockscheme with a certain validity. An empty shell was taken public; peopleinvested; shares are bought and sold on the basis of this future transaction.But, in reality, the merger itself was as worthless to shareholders as theoriginal shell. Its only purpose was to excite investors. The real moneyis to be made in the buying and reselling of the stock, not in any tangiblebusiness activity of the merged company itself.
This aspect is closely analogous to MLM's sales of products which are sometimesheralded as miracle cures or technology breakthroughs. Whatever they are,they are not the essential business of the enterprise. Continuously resellingdistributorships in an ever expanding chain is the real business. Few peopleother than new distributors ever buy these products and most are sold aspart of the investment scheme which is also contingent on future transactions.Products provide a fig leaf of validity and often keep regulators at bayjust as the mergers did for penny stock promoters. If the newly formed pennystock company does not merge with another enterprise, it can be reclassifiedas an investment or banking company and fall under new and different regulations.
As more penny stock investors are solicited, the stock keeps rising. Soonthe stock goes to five and then seven and perhaps eventually to twelve!For those on the inside, this is a veritable gold mine. For some shareholderswho invested early, the program appears to be a wonderful and fully legitimateinvestment. Who can argue with making money by buying and selling stock?It's as American as apple pie. It's legal. It's just supply and demand.This is capitalism at its finest. What a system! The brokerage house hasbeen earning huge commission rates on trades with stock rising at 50, 100and 200% increments. The inside investors associated with the brokeragefirm have been reaping massive profits.
But the bonanza does go not forever. The stock is astronomically overpricedrelative to the assets of the company. Further, the number of investorsneeded to keep the stock propped up is becoming impossible to recruit. Someshareholders are beginning to ask questions about the actual business ofthis merged company. A point is reached at which the stock cannot be resoldat a higher price. The collapse begins. Those holding the stock at thispoint suffer major losses on their investments. The real value of the stockis now revealed to be what is what it was all along, a small fraction ofa penny or perhaps nothing at all.
The penny stock brokerage firm, it should be remembered, is not in any wayharmed when the stock collapses. Only the most recent investors lose. Thefirm can move forward to create yet another similar scheme. It could alsorepurchase the shares from the losers and begin the entire process againwith yet another "story" about the firms great potential.
Likewise, the MLM does not collapse by continuously enrolling distributorswho lose their funds. The brunt of "collapse" is borne continuouslyby the new recruits. The systems rolls on as long as more recruits can beenrolled to replace those who lose their money and drop out.
Finally, it should be noted that taking companies public with very low stockprices and even using the merger with a blind pool or shell is not inherentlyfraudulent. It can be a valid method of helping a new company grow rapidly.Rather, it was the selling of grossly overpriced stocks (even though theselling price was only one penny a share) and then manipulating the priceto entice more shareholders into schemes in which most were destined tolose money that constituted the fraud.
Likewise, a distribution system that allows distributors to appoint sub-distributorsis not inherently fraudulent. It becomes fraud only when the company andthe upliners place the majority of their efforts on recruitment of distributorsrather than sales of products. Unfortunately, this kind of abuse pervadesand characterizes the MLM industry.
When Securities & Exchange Commission and some state regulators closedin on the penny stock firms they were charged with `stock manipulation,'an accusation analogues to that of many former MLMers who have charged theiruplines and MLM companies with `distributorship manipulation.' In MLM, notonly are the distributorship investments manipulated, but the distributorsthemselves can also be taken for still more money by selling motivationand marketing material which they are told will help them succeed.
The MLM industry operates under the thin protection of a 20-year old rulingby an FTC judge that declared the basic business model legal. However, unlikethe penny stock business, MLM does not have a federal or even state agencythat specifically oversees its operations. There is no testing or certificationfor distributors. Companies do not register with any MLM regulatory bodyor send quarterly reports of sales activities as did the penny stock brokers.Even when an MLM company sells stock to the public, its day-to-day salesand marketing activities are not regulated, only its stock sales.
Some analysts have argued that MLM distributorships are, in fact, securities.They are bought on speculation. Their value rests on future transactionsof dowliners and are promoted this way. Buy in now! Get in on the groundfloor! One of your dowliners may become a superstar and take you to unimaginablewealth! The MLM industry naturally opposes this regulation. Few people favorgreater government regulation of any business. Yet, regulation normallyoccurs only where abuse has been rampant. Until the MLM business goes backto selling products rather than making its money by using new distributorsas its unwitting customers, the call for regulation will grow.
Robert FitzPatrick is co-author with Joyce K. Reynoldsof the recently published book, False Profits: Seeking Financial andSpiritual Deliverance in Multi-level Marketing and Pyramid Schemes (ISBN:0-9648795-1-4).
He has been a guest on many talk radio shows onthe subject of the marketing practices of the multi-level marketing (MLM)industry. He has been interviewed and quoted in numerous newspapers andmagazines, including Money Magazine and the National BusinessEmployment Weekly, on the subject of MLM. He is a nationally recognizedconsultant, speaker and author on trends in distribution and measures forincreasing productivity in the manufacturer/distributor relationship.
Robert L. FitzPatrick is the co-editor and publisherof THE EAGLE, a quarterly journal on distribution-related issues in thedigital imaging industries. He is the author of numerous articles and monographson distributor marketing which have appeared in trade journals in the graphicarts, food processing, materials handling, wholesale florist and digitalimaging trade journals among others. He provides direct consulting servicesto major manufacturers and distributors. He is a regular speaker at theannual conferences of several national trade associations and the co-founderof International Power Connexions, a series of global networkingconferences held in Fort Lauderdale, Antwerp, and Guadalajara. Robert FitzPatrickcan be reached at 1235-E East Blvd. #101, Charlotte, NC 28203, Fax: (704)334-0220,email: email@example.com, website: http://www.falseprofits.com.
The book, False Profits, is available inbookstores nationwide, at Amazon.com or from the publisher at 888-334-2047or at http://www.falseprofits.com.