You can buy like 30,000 shares with these.

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Penny Stock Pawnbroker Had a Clever Trick to Get Paid

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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A sign of a good scam is that it's hard to tell who's being scammed. So here is a charming little story about International Capital Group, which agreed to pay $4.3 million to the Securities and Exchange Commission to settle charges of penny-stock misbehavior. ICG basically ran a pawn shop for penny stocks. Lots of founders/promoters/chief executive officers of tiny public companies own lots of stock in their companies, and not much else. And some of them would like to turn that stock into money.

But controlling insiders can't sell their stock without registering the sales with the SEC. This requires things like, you know, audited financial statements, which can be a problem if you're a tiny company with dubious financials. Even more important, registration also means disclosure. And when the founder and chief executive officer and majority shareholder of a tiny company publicly announces that he's dumping all his stock, that ... tends to push the stock price down. The trick is to get money for your stock without telling anyone that you're selling.

So the insiders go to ICG and pawn their stock: They put up, say, $400,000 worth of stock, and get back, say, $200,000 of cash. In three years, they can repay the loan and get the stock back. Or, at any time before three years is up, they can stop paying interest, walk away and keep the money, while ICG keeps the stock.

Now. Let's say you are the chief executive officer of a tiny public company. Let's say that your company is not current on its SEC filings, so public disclosure about the company is hard to come by. Let's say your stock trades for 10 cents a share, and you have like 4 million shares, worth $400,000 or so. What are the odds that that stock will still be worth $400,000 in three years? That it will be worth $200,000? That it will still be publicly traded? That you'll want to pay back the loan? That you'll want to pay interest all along the way? Pretty low, right? Here is an artist's rendition of what happens to the stock price over those three years:

This is a classic market for lemons problem. If you are the chief executive officer of a tiny company that is not doing a very good job of meeting its public disclosure requirements, you know more about your company's prospects than any potential lender does. And if you're putting your stock in hock, it's probably because those prospects are dim. You'd sell the stock for $400,000 if you could, but you can't, so you "borrow" $200,000 against it instead. And then you walk away immediately:

Among the loan customers with the standard three-year loan term, a substantial majority made no more than a single quarterly payment.

This seems bad for ICG, right? It kept lending money to deadbeats who defaulted after one interest payment, leaving ICG with stock that collapsed and was worth less than what it loaned them. That's not much of a business model.

But that wasn't the business model at all! ICG had a simple -- illegal, but simple -- trick up its sleeve: It just sold the stock immediately, before it had a chance to go down. Actually "immediately" isn't strong enough; ICG sold the stock before lending the money:

On average, ICG began selling shares associated with each loan three days prior to loan closing and funding, and completed the sale of all remaining collateral within two weeks of receiving the stock from the customer. In many instances, ICG did not wire funds to the customer from its bank account until it had sold sufficient collateral shares in its brokerage account to generate an equivalent amount of proceeds.

Ha! ICG wasn't getting scammed by deadbeat debtors. It was scamming them. It set up the loans to make sure that they'd default, and then immediately dumped the shares to lock in its profit. It would lend money at 50 cents on the dollar, sell at 100(ish) cents on the dollar and keep the change when, inevitably, the loans defaulted:

ICG structured its loans to profit from the volatile nature of microcap securities. ICG’s master loan agreement generally did not allow the customer to repay the principal prior to the maturity date. Due to the volatile nature of the microcap securities that served as collateral, nearly all loans defaulted well before the end of the three-year term. Given the high rate of default, ICG rarely was obligated to redeliver collateral.

Obviously this plan is a disaster if any of ICG's customers strike gold. The thing about that trade is that if the stock goes up, and the client pays interest on time, then in three years he can come back to you, give you back your $200,000, and demand his 4 million shares back. If the stock is at $10, instead of $0.10, then you have to come up with $40 million worth of stock. But you already sold the stock. For $400,000. So you have a "he who sells what isn't his'n, must buy it back or go to pris'n" problem. In theory, ICG was short a lot of penny stocks.

But this wasn't a real concern, because, one, the loans were set up to make that unlikely: If the stock dropped before maturity -- pretty likely with volatile penny stocks -- ICG could demand additional collateral, which would probably lead to a default.  Two, the market-for-lemons problem worked in ICG's favor: If the CEO of a penny-stock company with bad disclosure comes to a shady broker to pawn his stock, that is not exactly a bullish sign. You'd feel pretty good betting against that stock.

And, three, the CEOs probably mostly knew what they were getting into. They didn't want a loan: They wanted to sell their stock without public disclosure, and they figured that a 50 percent discount on the market price was still a pretty good deal. They didn't want the stock back in three years, ICG didn't want to give it back and everyone was happy that ICG was dumping it on day one. Or day negative three. Whenever. 

The loan mechanics, then, probably had much less to do with anyone wanting a loan, and much more with creating a haze of deniability around what was really going on: Insiders were using ICG to dump their stock on the market without registration and disclosure. The insiders can say that they were just borrowing, not selling, and had no idea that ICG would be dumping the stock on the market. ICG can say that it wasn't selling on behalf of the insiders: It was just hedging its loan exposure by short-selling some of the stock it received as collateral.

This did not particularly persuade the SEC, nor should it have really, but I guess it was a good effort.  

That strikes me as the most plausible interpretation. But ICG did a lot of these trades, and I suppose in some of them ICG might have been putting one past the insiders, and in others the insiders might have been putting one past ICG. The important thing is that in all of them, ICG and the insiders were putting one past the public stock buyers -- the people who bought stock from ICG, without disclosure, just before it collapsed. Which can't really be a surprise. They bought penny stocks! That's a pretty foolproof way to get scammed.

  1. This story is based loosely on "Issuer A" in the SEC order, "which purportedly was engaged in the development and sale of alternative fuels and additives." 

  2. It's the chart of Alkane Inc., an alternative fuels penny stock that has certain similarities, let's say (but who really knows), to Issuer A in the SEC's order.

  3. From the SEC:

    The loans were nonrecourse: in the event of default, which could be triggered, inter alia, by a 60 percent decline in the price of the collateral stock, the debtor had the option to tender additional collateral or to forfeit the securities with no contingent liability.

    You can think of it as: The client has a call option on the stock, with a down-and-out knockout. (It's mostly nuts to post more collateral on a non-recourse loan after the stock has dropped by 60 percent -- at that point, the collateral is worth less than the loan.) On a very volatile stock, the knockout pretty much swamps the value of the call option.

  4. In fact, ICG did "block trades" at steep discounts that were explicitly this, as well as the margin loans that were just effectively this.

  5. As someone who once worked on margin loans for insiders, I can tell you that no one really thinks this excuse works: You can't just lend against restricted stock and then hedge your loan by selling stock. But it's a gesture in the direction of innocence. ICG made other such gestures, e.g.:

    According to brokerage forms submitted to transfer 2.5 million shares into ICG’s name, Affiliate A gifted the shares to Trust A in January 2009, and the shares were rendered unrestricted through operation of Rule 144. However, Issuer A’s transfer agent records reflect that the transfer from Affiliate A to Trust A took place on April 6 or 15, 2009 and that the shares were issued as restricted securities. Immediately following each transfer of stock, ICG sold the collateral shares, completing all sales from March 22 to April 14, 2010. However, because Issuer A was a non-current reporting issuer at the time, and the shares effectively were sold to ICG by an affiliate, ICG was required to hold the securities for one year prior to selling.

    The SEC is pretty sure that these shares belonged to the insider and were thus restricted, but there was some paperwork to the effect of "what, no, these shares? These shares are totally unrestricted."

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net