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. Last Updated: 07/27/2016

Market Targets 'Small-Cap' Stock Fraud

NEW YORK -- Charges of fraud leveled against Sterling Foster & Co., a securities firm based in Melville, New York, are just the latest part of an ongoing U.S. crackdown on fraudulent sales of so-called "small-cap" stocks, regulators said.

The National Association of Securities Dealers, a self-regulatory organization, alleged in a disciplinary action announced last week that Sterling & Foster and 15 of its personnel made $53 million in illicit profits by defrauding people who invested in the initial public offerings of three small companies.

The fraud case is the largest ever brought by the NASD, according to Barry Goldsmith, executive vice president for enforcement at the association's regulatory arm.

Goldsmith said regulators believe stiff new rules regulating penny-stock sales, promulgated over the past several years by the U.S. Securities and Exchange Commission, may have led unscrupulous brokers to switch their sales efforts over to small-cap stocks. Because of that concern, a NASD task force consisting of 63 lawyers and examiners began investigating 13 dealers who specialized in such stocks, he said.

Penny stocks and small-cap stocks are distinguished by where they are traded, said Roger Sherman, director of the enforcement department at the NASD.

Penny stocks trade on non-Nasdaq markets such as the over-the-counter bulletin board or the so-called pink sheets containing wholesale-price quotations for brokers and dealers.

Small-cap stocks, which total about 1,400, trade on Nasdaq, the National Association of Securities Dealers Automated Quotations. Trade in this major stock market is conducted over computers and telephone networks rather than at a physical location such as the trading floor of the New York Stock Exchange.

Sterling & Foster's attorney has denied all of the allegations, which involve initial public offerings of Advanced Voice Technologies Inc., Com/Tech Communication Technologies Inc. and Embryo Development Corp. Shares in all three stocks fell heavily after the charges were announced.

Sterling & Foster is the third brokerage the task force has charged with stock manipulation so far. The other two brokerages are Stratton Oakmont of Lake Success, New York, against which the NASD filed two complaints last spring, and La Jolla Capital of San Diego, California, which the regulators have accused of fraudulent sales activities last January. Those cases, which both of the companies contest, are still in the hearing stage at the NASD. The cases also can be appealed to the SEC and the federal courts.

Sherman said that while "abuses can occur in any marketplace," small-cap stocks are more vulnerable to manipulation than issues of big companies because they are relatively new and thinly traded, meaning there often is a significant lack of information.

Since 1990, SEC rules have prohibited brokers from "cold-calling" customers to offer them penny stocks. Customers receiving such calls in which they are offered small-cap stocks can spot crooked brokers by listening for wild promises, Goldsmith said.

"A 'guaranteed' price prediction is something that people should look at with a grain of salt," he said. And if you get such a pitch, he added, "perhaps it's time to look elsewhere for a broker.''