Modern investors must be vigilant against various scams, including accounting scandals, insider trading, and other forms of fraud. One particularly deceptive scheme is the pump and dump scam.
In a pump and dump scam, stock investors heavily promote a company to create hype. Once the stock price is artificially inflated, these investors sell their holdings to unsuspecting buyers, causing the stock price to plummet. This leaves ordinary investors with substantial financial losses.
How pump and dump scams work
Creating hype
The initial phase involves existing investors spreading news and rumors about upcoming company announcements, promising significant increases in share prices. These announcements are presented as transformative events, designed to spark a surge in demand for the stock.
Attracted by the promising news, many investors purchase the stock, driving up its price in the short term.
Dumping the stock
After the stock price reaches a targeted high, the original investors begin selling off their shares to realize substantial profits. As the market catches on that these initial investors are exiting, the share price starts to fall.
New investors who bought into the hype are left facing significant losses. This strategy can be particularly harmful to inexperienced investors, leading to severe financial setbacks.
Example of a pump and dump scam
A notable example occurred in 2015 with the American firm Jammin’ Java. The company’s CEO and key promoters orchestrated a pump and dump scheme by disseminating false and misleading newsletters about the company’s prospects.
These newsletters quickly gained traction online, attracting a large number of new investors. The fraudsters also used complex offshore entities to conceal and move funds.
Before the scheme, Jammin’ Java’s stock was priced at $0.17 per share. After generating the hype, the price soared to an intra-day high of $6.35 per share. The perpetrators then sold their shares, reaping significant profits.
The securities and exchange commission (SEC) estimated that the fraudsters made around $78 million. The CEO and eight others faced civil charges from the sec.
Pump and dump scams can cause severe financial harm to investors. These schemes are often executed with such complexity that new investors may not realize they are being deceived.
The Jammin’ Java case highlights that even top management can be involved in such frauds. Investors should exercise caution before investing in overhyped stocks and conduct thorough research to protect themselves from these scams.
