Blind Pools: A Risky Play : Investors Not Told Where Funds Will Go

Charles D. Weller is not exactly setting out to attract customers when he describes the wisdom of investing in Coastal Financial Corp., the capital pool of which he is corporate secretary:

“It states very clearly in the prospectus that if you invest in this, you need to see a psychiatrist.”

But that is simply how the principle of full disclosure works as applied to penny-stock blind investment pools such as Coastal. When Weller and his partners proposed earlier this year to sell stock at a nickel a share for their venture, their offering documents vaguely described the firm’s purpose as “to take advantage of business opportunities . . . which arise from time to time.”

The prospectus went on to warn that even if the stock offering brought in the maximum of $637,500, the sum would be “insufficient to conduct more than limited operations,” that the company “will continue to be an insignificant participant in the business of seeking business opportunities” and that its officers might be engaged in potential conflicts of interest.

Furthermore, because Coastal’s founders and organizers awarded themselves controlling stock rights, outside investors would be contributing 98% of the firm’s total capital but would own only 48% of the stock.

“It’s a double whammy,” Weller acknowledged. “You have to be prepared to lose all your money.” But for all that, the offering was sold out.

Investment solicitations like Coastal’s are known as “blind pools” or “blank checks” because investors are given no idea of how their money is to be used, a situation that requires blind faith in the honesty and ability of the pools’ promoters.

With the surge in stock market prices luring investors to buy almost anything that resembles an equity, securities authorities say that these issues, most of which reach market through brokers in Denver, Salt Lake City and other places where penny-stock trading is concentrated, have been proliferating wildly.

So has the business of regulators, who are wary of the blind pools’ habits of disguising the identities of their true promoters, often to shield those with disciplinary records, and of some promoters’ skill at rigging the market for their stocks in order to produce swift profits for some investors but illusory ones for most.

Securities and Exchange Commission officials in Denver, for instance, recently suspended the stock registrations of four related blind pools seeking a total of more than $300,000 in investments for failing to disclose that their controlling investor was one George Norman III, who had been charged with stock manipulation in the 1970s and enjoined from further securities law violations. More such actions are pending, officials say.

“These are pure, speculative, garbage situations,” said Norman Fosback, a stock market analyst whose newsletter, New Issues, tracks penny stocks as well as other public offerings. “When somebody sells stock for pennies, they’re appealing to the darkest side of the investor. And it’s just bad practice to give money to anybody who doesn’t tell you what he’s going to do with it. Since most of these offers are designed to raise only $200,000 to $400,000, you have to ask yourself what anyone can hope to do with such an amount.”

Clearly the answer is not much. Most blank check pools, according to state and federal regulators in Utah and Colorado, are aimed not at finding and developing new business but in becoming vehicles--”shells”--through which second companies can go public.

The process works because of Rule 504 of the Securities and Exchange Commission. This regulation allows companies going public with less than $500,000 in capitalization to remain exempt from the SEC’s more stringent rules governing the stock offer as long as they register their offering in a state whose own rules require delivery of a prospectus to investors.

Minimal Assets

Customarily, the blind pool goes public with minimal assets. After depleting those it has, its promoters have a “clean shell” that they can offer to private companies whose owners want to go public themselves--also without submitting to the SEC’s complex and costly disclosure rules and stock restrictions. The private company merges into the shell and de facto becomes a public company.

Sometimes this process produces big gains for holders of the shell’s stock--in fact, that is what most knowledgeable investors are hoping for.

But often the shell company’s assets have been long since depleted or appropriated and the original buyers of the penny stock--a term that generally defines any issue selling initially for less than $1 per share--are wiped out. One regulator said the blind pool promoters often take a finder’s fee for completing the merger equal to whatever portion of the initial investors’ funds are left in the shell.

Gale Weggland, the SEC’s district director in Salt Lake City, said: “A lot of these were pretty much created to go broke so they could be used as a shell. That isn’t too difficult in the imaginative minds of their promoters.”

Many promoters, he adds, “don’t want to come in and face the SEC themselves, so they get hairdressers or ski instructors to come in as the person in charge.”

In the past, blind pool operators have thrived in Denver and Salt Lake City, where investors were accustomed to playing the penny-stock markets like a row of 25-cent slot machines. People could scarcely muster much concern about issues that came on the market for a nickel a share and enjoyed a volatile ride into the dollars on pure speculation before vanishing for good.

“If you buy for 5 cents and sell for $5, you don’t care if it’s based on substance or not,” said Royce Griffin, Colorado’s chief securities regulator and president of the North American Securities Administrators Assn., an organization of state and provincial securities regulators.

There are many in the penny-stock market who argue that shell transactions serve an important market function.

States Begin to Crack Down

“If the funds are properly handled, someone who wants to go public can do it without a lot of red tape,” said John Potter, head of Potter Securities, a Salt Lake City brokerage. “But the main question is the credibility of the people behind them.”

The states have begun to crack down, with Utah in the vanguard. That state this year sharply tightened its standards for blank-check offerings. In the past, a promoter could register such an issue for any amount; now the minimum issue must be $75,000, on the reasoning that anything larger is more difficult to manipulate.

More important, Utah now requires promoters to place their initial investors’ funds in escrow until the company finds a merger partner or a line of business. At that point, the investors have the right to rescind their purchases.

“That’s thrown fits into the penny-stock community,” observed Nicholas Hales, an assistant Utah attorney general involved in market regulation. Promoters knew that the rules would effectively shut them down: In the two months before the regulations took effect Feb. 15, the promoters filed registrations for 98 blank-check offerings. Since then, Hales said, there has been none.

Colorado’s Griffin said the SEC could help by tightening its own rules. “If the SEC would restrict the merged company’s stock for two years (that is, prevent insiders from putting it back on the public market) or prevent Rule 504 companies from merging for a year (after they go public), that would make a lot of difference,” he said.

Blind pools have such an attraction these days for players in the penny-stock markets, however, that even those restrictions might not dissuade some of the business’ more sophisticated operators. Utah authorities in March moved against one particularly elaborate scheme of a variety known as a “box job.”

The subject in that case was a company called Freedom Coin Co., which was created in 1984 not as a blind pool but as a wholesale and retail coin dealer. Shortly after it registered to raise $25,000 in the penny markets, according to a lawsuit filed by the Utah attorney general’s office, a Salt Lake City stockbroker named Kenneth Brailsford took control by purchasing all of its “investor stock”--that is, stock owned by insiders.

Brailsford, the state charged, then used Freedom Coin as the vehicle for a stock manipulation scheme based on the public’s admiration for blind pools.

First, Brailsford began a public offering of the stock by selling it to 38 private investors, most of them contacts of an associate named Lynn Clingo. They were told that they would be loaned the money to buy the stock and it would be repurchased from them at a small profit--as little as $25 to $50 in some cases.

This was necessary because securities laws require initial public offerings to be accomplished in two steps: First, there must be a subscription by a limited number of investors. Once they have been signed on, their subscriptions are filed with state officials, who clear the stock issue for full-scale trading.

“These were unsophisticated individuals who had never done a stock transaction in their lives,” said Mark Griffin, a Utah securities regulator. “They were just being paid for their name.”

The promoters appear to have let little stand in their way toward getting prospects’ names on the stock. Roger Grooms, a contact of Clingo’s, said: “I was going to buy some, but I didn’t get some money I’d been planning on. He said he’d go ahead and get me the stock anyway. Then I just signed it over to him.”

Artful Rumors

The stock having been issued by subscription, the initial offering was officially closed. Soon after that, the state said, the promoter had paid back the subscribers and had 98% of the stock back in his hands. (Hence the term “box job.” Griffin explained: “it means somebody has a shoe box full of stock.”)

Now, the state charged, Brailsford promoted the sale of the stock to the public through some friendly brokers who understood that one person controlled most of it. While investor interest was drummed up by artful rumors that Freedom Coin had invested in offshore gold mines, the state said, Brailsford’s agents dribbled the shares onto the market, pushing up the price of the meager supply. In all, Brailsford and his associates are said to have made more than $123,000 by selling the stock this way.

In June, 1985, the stock was quoted over the counter at 7 cents a share. By August it was up to $1.10. The stock finally peaked at $1.18 before heading down. At that point investors began complaining to regulators, who quickly discovered the loans to the initial investors and concluded that the offering was fraudulent.

Utah officials have since suspended Freedom Coin and extracted a settlement from Brailsford’s employer, Equity-One Corp., requiring the brokerage to pay $75,000 to help repay investors. Brailsford is negotiating with officials to settle the case against him.

As for Freedom Coin, regulators are hoping to rehabilitate it enough to place it back on the market--as a shell corporation.