The White Rabbit

I would spend 55 minutes defining the problem and then five minutes solving it. (Albert Einstein)

Published on Thursday, 1 June 2023

Tags: investing2

Patterns of fraudolent stocks - Part I

Fraudulent patterns in the stock market can cost you money and ruin your investments. In this post I am going to explore one of this patterns in 6 different phases.

If you are interested in investing in the stock market, you should be aware of the possibility of fraud and market manipulations. Fraudulent patterns are deceptive practices that aim to create a false impression of the value or demand of a security, and to profit from it at the expense of other investors.

Here I'm going to discuss about a pseudo fraudolent pattern I've seen for publicly traded companies, which only drains investors resources without producing any value.

Phase 1

The company is trading as a penny stock (at low share price), declining over time.

Phase 2

Suddenly, shareholders get an exchange offer from their banks on behalf of the company. In a nutshell, the company offers to exchange existing common shares to preferred ones, with a very attractive premium. We know that preferred shares will also provide certain advantages such as priority in receiving dividends and liquidation proceeds.

Phase 3

Many investors accept the offer because of the favorable premium and conditions. Now, the total number of common shares owned by invstors is reduced and the CEO owns a bigger piece of the cake, giving him more voting rights. Why does he want more voting rights? There can be many reasons, but let's see what happens next...

Phase 4

Some time later, a reverse stock split is approved during a special stockholders meeting. The CEO wanted to do that and hoped to increase the likelihood of this outcome by gaining more voting rights (see Phase 3).

Phase 5

A reverse stock split is when a company reduces the number of outstanding shares by consolidating them into fewer ones. The CEO goal of a reverse split is - in our case - to increase the stock price, but keeping the same market capitalization (i.e. no need to create real "value"). And why does the CEO aim to increase the price if the market capitalization does not change? Well, do you remember that it was a penny stock with low price? Well, since some stock exchanges require stock prices to stay above some threshold, rising the price through a stock split will imply less risk for delisting.

Other possible side-effects that the CEO wants:

  • Blind investors that look at the stock price going up and think it will be a great idea to follow the "uptrend".
  • After the next earning call date, the EPS will suddenly look better thanks to two contributions: one from reducing the number of shares because of the exchange offer (see Phase 2), and the other from the reducing them because of the reverse stock split. This will hopefully help the company look better.

Phase 6

Now the price is high again, so the CEO can slowly start again to issue new shares (dilution) to raise new capital and take money from investors until the Phase 1 starts over.