Cracking Down on Corruption SEC Chairman Arthur Levitt Speaks Out on the BurgeoningProblem of Micro-Cap Fraud

Just as the numbers of individual Americans investing in stocks and bonds has increased to record levels, so has the number of scams.

In fact, for the first time, Americans have more money in mutual funds--about $3.5 trillion--than in deposits with commercial banks. But more people, especially in Southern California, are seeing their life’s savings disappear in the hands of unscrupulous financiers and stockbrokers pitching stocks of small companies. While there are no data tracking the exact scope and depth of investment fraud nationwide, complaints and investigations are dramatically increasing, according to the National White Collar Crime Center, a federally funded nonprofit group.

This type of fraud often starts with the cold call, a telephone pitch you haven’t requested from a broker you’ve never met.

That’s why Arthur Levitt, chairman of the Securities and Exchange Commission, is cracking down on fraud in small-company stocks. The SEC has formed a task force to deal with so-called micro-cap fraud, and Levitt has been on tour around the country, speaking at 21 town hall meetings in recent months on the subject. Levitt, who had a long career on Wall Street and was chairman of the American Stock Exchange before he joined the SEC in 1993, knows all too well the potential for abuse in the public markets.

The regulatory chief, who will be the featured speaker at Sunday’s early general session (8:30 to 10:15 a.m.) at the Los Angeles Times Investment Strategies Conference, was interviewed from his New York offices. Members of the public can hear Levitt free of charge in West Hall A Annex of the Los Angeles Convention Center on a space-available basis.

Times: Fraud in small-company stocks has been around for a long time. Why is this area suddenly a priority for the SEC?

Levitt: It’s a top priority because when the market is at high levels, it brings out the worst in people. There’s been a sharp increase in fraud primarily in stocks on the bulletin boards, the pink sheets [companies that aren’t listed on any formal exchange] and the Nasdaq small-cap market.

When you see a sharp increase in underwriting activity and IPOs, it increases public appetite, and judgment often takes a back seat to emotions such as greed. When you hear your neighbor at the country club got an IPO that doubled after the first day, you want something equally exuberant.

Times: What exactly is micro-cap fraud and why is it increasing, especially in Southern California?

Levitt: Generally, there appears to be more fraud in Southern California and in southern Florida than in other areas. There is a correlation in the amount of micro-cap fraud and the amount of underwriting being done in the country. The new-issues game is a risky game that should supplement or complement an investment strategy rather than form the basis of someone’s investment portfolio.

This type of fraud follows a fairly predictable pattern. You’ll see high-pressure brokers, abusive cold-calling and unauthorized trading. There will be manipulation of micro-cap stocks by brokers and company insiders. The job of the commission is to try and control this type of fraud without compromising the market for securities issued by small business.

Times: How can investors protect themselves?

Levitt: Nobody can protect investors better than they themselves can. We’ve had 21 meetings around the country about this. And we are organizing right now a major campaign to educate investors. The mileage we get on one dollar educating investors is much greater than the mileage we get on one dollar cracking down on these people.

Investors can ask questions. Take nothing for granted. They should not be afraid of their own inadequacies to understand. If they can’t understand it, they shouldn’t invest in it. They shouldn’t do anything on the basis of a telephone call. It’s important to eyeball someone. If something doesn’t pass the smell test, if it sounds too good to be true, it is. They should do their homework in determining what their own tolerance for risk is. If they need solid income, they might not want to buy new issues.

Times: Aren’t these types of fraud even more prevalent when it comes to the elderly?

Levitt: It happens most often with the elderly. They need self-awareness and focus. Investors who lose sight of what their goals are will be hurt in this market. They are just bound to fall prey to a sloppy broker. And investors must remember they can get hurt from an honest broker as well as a problem one. They just need to keep sight of their goals.

Times: Shouldn’t you just hang up on these cold callers?

Levitt: It depends on what you are doing when they call and what time of day they are calling. They can call only from 8 a.m. to 9 p.m. Never do business with someone you have met only on the phone. I wouldn’t do business with anyone until I’ve sat down and looked him in the eye and knew that he understood what my tolerance for risk was.

In fact, I had a cold call last night.

Times: How do you handle cold calls?

Levitt: I always talk to salesmen. It was a broker from a San Francisco firm calling my house at 10 p.m. my time. He had no idea who I was. He was going to get back to me with some new IPO that would give me excellent results.

Times: What about investors who think they’re safe if they put their money in mutual funds? Can names sometimes be deceiving?

Levitt: Very often funds are called “the Safety Fund,” “the Government Fund.” I don’t care if they are called “U.S. Government Safety Fund,” you can lose money in any fund. Investors can’t depend exclusively on past performance; they need to see where a fund is going. Is its aim to take risks or is it to preserve capital? Is it investing on qualified research or does it base itself on a trend? Still, an investor who is unwilling to do his or her own homework or doesn’t have a history and good relationship with a broker would do better to consider a fund.

Times: We’ve seen investment in the nation’s securities markets explode in just the last two decades, meaning more Americans are investing than ever before. Yet resources devoted to enforcing the integrity of the markets haven’t been increased proportionally. Isn’t this dangerous?

Levitt: I don’t think any regulator can ever have sufficient resources to assure that all graft and corruption will be uncovered. Still, in many areas the resources for the commission are really being strained. I think that we just have to make use of what we have, but clearly we need more.

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Fraud-Fighting Tips for Investors

Fraud in small-company stocks typically begins with a phone call from a very aggressive brokers touting an investment. For many people, the result is serious financial loss. Here are some things investors, especially those in Southern California, should remember in handling such calls:

* Ask anything you want.

* If it sounds too good to be true, it probably is.

* Don’t buy anything over the phone.

* Don’t let anyone bully you.

* Watch out for mention of spectacular profits or “guaranteed returns.”

* Watch out for the three-call technique. The first call is a setup, the second is to tell you about a fabulous deal, and the third is the close the deal.

* Watch out for the bait-and-switch, in which a broker entices you with blue-chip stocks and then pressures you to invest in small, unknown company.

* Watch out for brokers selling the “house stocks” of companies they took public at high prices.

* Hang up.

* Send complaints to the Securities and Exchange Commission or state regulators.

Sources: Securities and Exchange Commission, Times research