BOILER ROOMS/COLD CALLING

Prepared for

APEC Regional Training Program Regional Seminar on Investigation, Enforcement and Prosecution Melbourne, Australia September 2-5, 2002

By Michael Hubley Assistant Manager, Investigations Ontario Securities Commission Canada

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors or the governments they represent. ADB makes no representation concerning and does not guarantee the source, originality, accuracy, completeness or reliability of any statement, information, data, finding, interpretation, advice, opinion, or view presented.

INTRODUCTION
As securities regulators from Canada, we think we can provide a unique perspective regarding penny stocks and Acold calling@ schemes. Regrettably, Canada has a disturbing record in respect of the involvement of some of our citizens in boiler rooms and stock frauds. Our notorious reputation in this respect is worldwide. I understand that last year, Canadian citizens were arrested in the Philippines in connection with at least two boiler room operations Pryce Richardson and Evergreen. In January of last year, a Belgian judge sentenced long-time boiler room fraudster Canadian Jack Kronis to seven years in prison for his role in running a fraudulent securities ring out of Holland. He and thirteen other scammers, who got sentences ranging up to ten years were also ordered to repay the $33 million defrauded from 280 investors of Grimaldi Hofmann and Co.

Kronis previously had a role in other such stock scams while working at Durham Securities in Canada where 827 people lost $5 million. For that he served six months and was ordered to pay restitution after pleading guilty to four counts of fraud.

In 1993 staff of the OSC submitted a report that outlined the nature and impact of the sale of penny stocks in Ontario. The report identified that: The average penny stock investor has little or no investment experience. Most investors do not understand the speculative nature of penny stocks, including the real possibility that their entire investment could be lost. Salespeople in the industry routinely target men because they believe men are less likely than women to complain if they lose money.

Throughout the 1990's and into this century, the Enforcement Branch of the Ontario Securities Commission has committed substantial time, energy and resources into reviewing certain abuses that have occurred in respect of the sale of penny stocks to investors. The focus of the allegations in a number of early cases dealt with the various high pressure sales techniques that the Commission considered to be abusive.

This presentation will cover: Anatomy of a boiler room Boiler room marketing strategies OSC investigative strategies Future of telemarketing frauds What the OSC is doing

ANATOMY OF A BOILER ROOM

The recent movie Boiler Room provided a reasonably realistic representation of a boiler room operation. Although the movie provided a set that was somewhat more attractive than most boiler rooms, the basic setup is the same telemarketers lined up on banks of telephones, cold calling prospective marks and hustling them using prepared scripts. The movie is representative of the penny stock dealers (known as broker-dealers) that were once prevalent in Ontario and still exist in the United States. These are licensed firms that are predominantly involved in the sale of unlisted securities. The most common market being used by these dealers today is the OTC Bulletin Board in the U.S., run by NASDAQ. The other types of boiler rooms are the unlicensed firms, which tend to operate in much less luxurious surroundings and often sell totally fictitious securities or securities-like products such as prime bank instruments. The advances in technology over the past decade have provided an additional cushion of anonymity for the boiler room operator. Such technology now allows these unscrupulous individuals to use call-forwarding to give the appearance that they are calling from Switzerland while sitting in a dingy basement room in Manila or Bangkok or Toronto. They route payments through offshore banks or use mail drops to collect the victims money. The advent of the Internet allows them to publish fancy official-looking websites which tend to give them credibility with their unsuspecting victims. Their names almost always have a familiar ring associated to well-known financial entities. Names like Price Warner, Morgan Pacific Capital and Gerson-Lehman Inc. are just some examples. Usually, before the authorities figure out where they are and what they are doing, they have taken their ill-gotten gains, packed up and moved to another location. 2

THE BOILER ROOM MARKETING APPROACH

The typical boiler room operation will use a staged marketing approach:

Stage one:

Telemarketers, commonly known as qualifiers, cold-call prospective customers, known as leads. After identifying themselves, qualifiers ask leads if they would like a copy of their firm=s newsletter. If the answer is yes, their name and address are taken. The lead is then advised that nothing is being offered immediately, but a number of possibilities are being monitored.

Stage two:

Junior salespeople, known as openers, call three to six weeks later indicating a few special situations look promising, and imparting a sense of urgency about getting in now.

If the leads balk, openers recommend monitoring the price of one of the stocks in the newspaper. When the price of the stock rises and it usually does when a broker/dealer sells a position from its inventory at a considerable markup openers call back and are told how much money they would have made if they had bought in.

Stage three:

After the first, usually small, purchases are made and stock prices have risen, stage three involves senior salespeople, referred to as loaders calling back to point out that more profits can be made. The loaders will use any, or all, of the following high pressure sales techniques to clinch a deal:

Optimistic predictions on the future value of a stock; False representations about the market for the stock; Pressure to act quickly; 3

Misrepresentation of assets or prospects of the company; Promises of great rates of return; Claims of little or no risk; Offers of discount commissions; and Suggestions of insider information

Stage four:

After the sales have been made and the client has no money left, the firm will use many different techniques to ensure the client is unable to sell their stock. The firm will often have a specialist called a cooler to ensure the order never gets processed.

Stage five:

After a period of time has gone by normally enough time that allows the victim to accumulate savings they may be contacted again in a recovery scam. In that case, the same people or others who have purchased the sucker list from the original operators, will contact the victim and offer them an opportunity to unload their losing stock and replace it with blue chip securities. The only catch is that there will be a delay in closing the transaction and some good faith money is required to hold the deal. Once the investor parts with more money, they may never hear from the operator again.

OSC INVESTIGATIVE APPROACHES

Registered Dealers During the course of our investigations into abusive selling practices by our registered broker/dealers, OSC staff developed concerns that the manner in which certain issues were acquired and subsequently priced were in and of themselves abusive to the capital markets. Staff=s concerns were echoed in two decisions of the OSC.

In Re E.A.Manning Ltd. (1995), 18 O.S.C.B. 5317, the Commission stated: The Penny Stock (E.A. MANNING) dealer acquired a sufficient position in the outstanding shares of a small issuer to effectively give it control over the market for the securities of that issuer. These shares would have little intrinsic value. So far as we were able to tell from the evidence, none of these shares would be listed on a stock exchange. After its purchase, Manning would effectively represent the only market for the purchase and sale of the shares, enabling it to set the price at which the shares would be sold or repurchased. It did set the selling price, at a very substantial mark-up from its cost, moving the selling price to customers gradually up until its inventory had been disposed of, and then letting it drop. The evidence indicates that on occasion the process would be repeated more than once. Manning discouraged its customers from reselling the shares, since in reality it would be the only purchaser and its goal was to get rid of its inventory, not to increase it. At the end of the day the customer would be left with shares which had little or no value, and for which there was no real market. In Re Marchment & MacKay Ltd. (1999), 22 O.S.C.B. 4705, the Commission stated:

Although Marchment's clients are led to believe that they can count on the firm to provide investment advisory services to them, in reality, Marchment's real interest lies in disposing of large positions that it has acquired in low-cost stocks to its customers at a substantial markup and then ensuring that the customers hold on to these securities until the campaign is over.... We find that Marchment recommended that its clients acquire (a certain issuers) shares at prices that were dictated solely by its own selling campaign and which bore no relation at all to the appraised value of the securities or to any independent market price. As a result of staff inquiries into the sale of penny stocks and as a result of comments the Commission had made in both the Manning and Marchment matters, the Enforcement Branch, in cooperation with the IDA and TSE initiated an investigation and determined that the campaign identified was not unique to the these two firms and that this scheme was systemic to the penny stock industry in Ontario.

To this end, staff of the Enforcement Branch are investigating the penny stock industry to determine if a dealer or certain dealers repeatedly engage in the activities identified by the Commission. 5

A typical example of these activities is as follows:

1. An issuer is formed by a reverse takeover or amalgamation with a company quoted on an OTC market which has little assets or liabilities. Shortly after the reverse takeover/amalgamation, the Issuer=s shares begin trading on OTC market;

2. A dealer enters into option agreements which entitle it to purchase a significant percentage of the shares;

3. The dealer exercises the options and accumulates shares from insiders at a premium to what the insiders paid (the "Accumulation Phase"). There is no obvious economic rationale for such premium as the Issuer had not engaged in any apparent economic activity since the reverse takeover/amalgamation;

4. Trades during the first 2 4 months after the shares are quoted on the OTC market (the "Buildup Phase") are dominated by insiders of the Issuer or associates of the dealer. Such persons are associates due to their connection with other issuers traded by the dealer. Trading volume during the Buildup Phase is low, with typically less than 100,000 shares traded during the entire Buildup Phase. The price of the shares increases dramatically during this phase;

5. Once it has accumulated a substantial inventory of the shares, the dealer sells shares from its inventory (the "Selling Phase") to its customers. The sales are made at prices 100 200% higher than what the dealer paid. The dealers first selling price is often at or near the quoted market price at the end of the Buildup Phase. As the dealer continues to dispose of its inventory, the price at which it sells the shares increases, again without any obvious business reason. There is a high correlation between the trading volume and the number of shares the dealer acquired during the Accumulation Phase;

6. During the Selling Phase, the dealer continues to acquire shares from insiders. Despite the fact that sales are made to clients of the dealer at the post-Buildup Phase price, the dealer is still able to acquire additional shares for their own inventory at or about the same prices it paid during the Accumulation Phase;

7. The dealer is responsible for a substantial portion of the trading volume of the shares during the Selling Phase; and

8. The Selling Phase ends after a period of six months to two years, when the dealer has sold from its inventory all or substantially all of the shares. The price of the shares drops significantly and trading volume is virtually nil.

In 1999 when we began our investigation into the methods the dealers used to acquire stock, there were eleven penny stock dealers in Ontario with sales in excess of $100,000,000 annually. Today, there are none left. That does not mean that the problem has disappeared it has merely moved underground or has become virtual.

Unregistered Boiler Rooms We are convinced that the only way to combat the unregistered boiler rooms is through cooperative investigations with our criminal law enforcement agencies. Recently, staff of the OSC worked in conjunction with the RCMP and the FBI to investigate and shut down an international boiler room operating out of Toronto targeting overseas investors. The operators made promises of great returns by investing in a NASDAQ OTC bulletin board stock. The scheme was designed as follows:

1)

Individuals with ties to organized crime were able to obtain a substantial block of Regulation S stock which traded on the OTC Bulletin Board.

2)

A boiler room operation was established in Toronto that operated between 2 A.M.

and 9 A.M. targeting investors in Europe. The targets thought they were dealing with a legitimate investment house operating out of Switzerland.

3)

Investors were sold shares in the OTC Bulletin Board stock at highly manipulated prices in a pump and dump scheme.

4)

Investors were told to make their cheques payable to a Swiss bank. This of course provides protection for the fraudsters by depositing the funds in a strict bank secrecy regime.

5)

A rogue trader in a legitimate firm was compromised into processing trades and to provide greater legitimacy to the scheme.

6)

Once the value of the shares plummeted, the investors were victimized again in a recovery scam.

The case was somewhat unusual in that investigators completed the task without the use of intercepted communications or undercover operations. The investigators used old-fashioned physical surveillance of known mail drops to begin the investigation. They were able to identify the main suspects who were known to them previously as boiler room operators by connecting them to the mail drop couriers. Search warrants were used to obtain banking and telephone records as well as records of emails and websites being used by the suspects.

The investigation resulted in the arrest of eight individuals. Three of the suspects have been sentenced to jail terms ranging from 18 to 28 months. The others have yet to go to trial. Victims of this fraud, many from Australia and New Zealand, are believed to have lost over $4 million dollars.

THE FUTURE OF TELEMARKETING FRAUDS

We are seeing greater involvement of traditional and new organized crime groups in funding and running boiler rooms and stock frauds, whether for the lucrative profits or as vehicles to launder proceeds of criminal activities.

Even when boiler room operations are shut down, the staff and sucker lists are shared with other organizations in the same or different jurisdictions.

Increased Internet access throughout the world has provided a new vehicle for the scam artist. Rather than employing 20 or 30 people to work the phones and contact perhaps hundreds of potential victims, thousands can be reached with the push of a button. We expect to see continued increases in the use of the Internet for fraudulent activities.

WHAT IS THE OSC DOING?

1. Commission staff are attempting to identify cases that we can prosecute under the Ontario Securities Act and seek jail terms and fines.

2. The federal government has recently enacted new legislation that makes deceptive telemarketing a criminal offence and allows law enforcement to obtain judicial authorization to wiretap in situations of deceptive telemarketing.

3. The Ontario legislation has recently strengthened the administrative sanctions available to the Commission to deal with serious breaches of Ontario Securities law.

4. Staff of the Commission are currently in negotiations with various law enforcement agencies to enhance our partnership arrangement by making more resources available to gather real time intelligence on criminal activities and provide more trained staff to investigate telemarketing schemes. 9

5. We continue to develop and enhance our relationships with foreign regulators to enable us to detect and prevent telemarketing schemes.

6. The Commission has a strong investor education program and staff of the Enforcement Branch take an active role in this area. We work closely with senior citizen organizations, as seniors are most susceptible to this type of fraud.

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