Digitalwisher Pump-and-Dump: Definition, How the Scheme is Illegal, and Types

Pump-and-Dump: Definition, How the Scheme is Illegal, and Types

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 Unmasking Pump-and-Dump Schemes: Learn how to spot, avoid, and protect your investments from these illegal tactics. Safeguard your financial future.


Pump-and-Dump: Definition, How the Scheme is Illegal, and Types

Pump-and-Dump: Definition, How the Scheme is Illegal, and Types


Understanding Pump-and-Dump

Pump-and-dump, a deceptive manoeuvre, seeks to artificially inflate the value of a stock or security through fraudulent endorsements. These endorsements are constructed upon deceitful, misleading, or grossly exaggerated information. Perpetrators behind pump-and-dump schemes typically maintain substantial holdings in the company's stock, strategically divesting their shares once the artificially generated hype drives up prices.


This nefarious practice finds itself firmly on the wrong side of securities law and carries severe financial penalties. The surge in popularity of cryptocurrencies has witnessed a surge in pump-and-dump schemes within this burgeoning industry.


Key Insights

  • Pump-and-dump entails illicit efforts to inflate a stock or security's value via deceptive statements.
  • Primarily, micro- and small-cap stocks fall prey to pump-and-dump schemes.
  • Perpetrators of pump-and-dump schemes face substantial fines.
  • These schemes have found a breeding ground in the cryptocurrency sphere.


The Mechanics of Pump-and-Dump

Historically, pump-and-dump schemes thrived through cold-calling tactics. However, the digital era has shifted the bulk of these activities online. Fraudsters now have the ability to inundate unsuspecting targets with hundreds of thousands of emails or online messages, enticing investors to rapidly invest in a particular stock.


Typically, these messages peddle inside information regarding an imminent development expected to trigger a substantial uptick in share prices. As soon as investors flock in, driving the stock's price considerably higher, the perpetrators of the pump-and-dump scheme offload their shares. In such instances, the volume of share sales often reaches significant proportions, leading to a precipitous drop in stock prices, leaving many investors nursing substantial losses.


Pump-and-dump schemes frequently zero in on micro- and small-cap stocks traded on over-the-counter exchanges, which feature less stringent regulations compared to traditional exchanges. Micro-cap stocks, and occasionally small-cap ones, are favoured for such manipulative activities owing to their susceptibility to manipulation.


The Evolution: Pump-and-Dump 2.0

Today, anyone with access to an online trading account and persuasive skills can execute a pump-and-dump scheme. The schemer initiates the action by making substantial purchases of stock with low trading volumes, inflating the price.


This price action attracts other investors, resulting in a further surge in share prices. The schemer can exit the market at any point when they sense waning buying pressure, thus securing substantial profits.


Pump-and-Dump in Popular Culture

The pump-and-dump scheme has served as a central theme in two widely acclaimed movies, namely "Boiler Room" and "The Wolf of Wall Street." Both films depicted telemarketing stockbrokers working in a warehouse setting, aggressively promoting penny stocks. In both cases, the brokerage firms acted as market makers, holding significant volumes of shares in companies with dubious prospects. Brokerage leaders incentivized their brokers with hefty commissions and bonuses for placing these stocks in as many customer accounts as possible. Consequently, the brokers artificially inflated the stock prices through massive volume selling.


Once the selling reached a critical mass with no more buyers, the firms promptly divested their shares, reaping substantial profits. This led to a sharp decline in stock prices, often plunging below the initial selling prices, resulting in substantial losses for customers who couldn't offload their shares in time.


Safeguarding Against Pump-and-Dump Schemes

The Securities and Exchange Commission (SEC) offers valuable guidance to safeguard against falling victim to pump-and-dump schemes. Here are some key points to remember:


1. Exercise Caution with Unsolicited Investment Offers

Exercise extreme caution when receiving unsolicited communications about "investment opportunities." The plethora of virtual communication channels enables dubious investment pitches to reach you through various avenues, including emails, social media comments, direct messages, or cellphone calls or voicemails. It's advisable to disregard such messages, as acting on them can lead to substantial losses, rather than the promised massive gains.


2. Be Alert to Obvious Red Flags

Are the purported investments appearing too good to be true? Do they promise guaranteed astronomical returns? Do they pressure you to invest immediately, lest you miss out on a skyrocketing stock? These are common tactics employed by stock touts and unscrupulous promoters and should serve as glaring red flags for investors.


3. Beware of Affinity Fraud

Affinity fraud revolves around investment scams targeting identifiable groups, such as religious or ethnic communities, seniors, or professional groups. An investment pitch from someone affiliated with your group may lend an air of credibility to the scheme. However, it's vital to recognize that the member may have unknowingly fallen victim to a fraudulent investment scheme, falsely endorsing its legitimacy.


4. Conduct Thorough Research and Due Diligence

Before parting with your hard-earned money, engage in thorough research and due diligence. The Internet offers a wealth of information on legitimate companies, covering aspects like business prospects, management, and financial statements. The absence of such information can often signal a potential red flag.


The Rise of Pump-and-Dump 3.0

The cryptocurrency arena has emerged as the latest frontier for pump-and-dump schemes. The phenomenal gains witnessed by Bitcoin and Ethereum have ignited immense interest in cryptocurrencies of all kinds. Unfortunately, cryptocurrencies are particularly susceptible to pump-and-dump schemes due to the lack of regulatory oversight, opacity, and technical complexity surrounding these digital assets.


A study conducted in 2018 scrutinized the prevalence of pump-and-dump schemes in the cryptocurrency market. Over a mere six months, researchers identified more than 3,400 such schemes, primarily observed across two group messaging platforms popular among cryptocurrency enthusiasts.


In March 2021, the U.S. Commodity Futures Trading Commission (CFTC) cautioned against pump-and-dump schemes, especially in thinly traded or new cryptocurrencies. The CFTC also introduced a program offering monetary rewards, ranging from 10% to 30%, to whistleblowers who expose original enforcement actions leading to monetary sanctions exceeding $1 million against pump-and-dump schemes.

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