Cannabis Stocks and the Old Pump and Dump

People seem to hate me when I state the simple truth that cannabis  is illegal everywhere in the US. The Obama Administration decided to focus its drug enforcement budget on the cartels and large suppliers and not on small retail dealers.  Deciding not to bust small dealers did not make cannabis legal anywhere in the US.  Just because the federal government will not spend money to send 20 officers to kick down the door of a small dealer, they will still charge you with “intent to sell” if they find a few pounds of cannabis in the trunk of your car.

The former US Attorney General, Jeff Sessions was fairly clear that he wanted to keep cannabis illegal. What the incoming Attorney General will do is anyone’s guess.  The one clear truth is that action by states purporting to make cannabis legal within their borders does not actually make it legal anywhere under federal law.

Notwithstanding,many people seem to believe that there is a “legal” market for cannabis and a lot of people are finding ways to cash in believing that the federal government will continue to look the other way. That has encouraged the flow of a lot of new money into the “new” cannabis marketplace. As these cannabis companies are new, small and somewhat precarious given they often cannot get a bank account,some companies have sought funding in the microcap stock market where small companies can go public.  

Few investors come in contact with “microcap” or “penny stocks”.   Many of the very large brokerage firms will not touch very low priced shares and certainly will not recommend them.  Fewer investors are the victims of the “pump and dump” schemes that plague this portion of the marketplace. Even fewer investors actually understand how a pump and dump works or how to spot one.

The  blueprint for these pump and dump scams is often the same. These scams will often start with a “shell” corporation, a public company with few assets and minimal operations.  In a typical scenario a public “shell” corporation would acquire a private, ongoing business in exchange for stock.  There would be a press release, often several over the first few months that would begin to tell the story that the promoters wanted to tell, especially how this company was going to grow and grow.

The story would be told to thousands of investors through the stockbrokers who would be on the phones, cold calling people around the US with this week’s“tip”.  They would stay at it until enough people bought the stock to make the share price go up. There would often be subsequent acquisitions, subsequent press releases and subsequent hype.  All of the hype caused more people to buy the stock and the price to go further up.  As the price moved up, the insiders who bought for very little when the company  was still a shell could dump their shares.

This can be very lucrative for the people who bought the shares in the shell for pennies a share. It can also be lucrative for the brokers because getting the stock price up and then selling it to unsuspecting members of the public can mean a lot of transactions and a lot of commissions and mark-ups.  It is not unusual for even a small pump and dump scheme to net the promoters and brokers $10-$20 million or more. Consequently, people who pump and dump the shares of one company (often a team of promoters and stockbrokersfrequently do it repeatedly.

Organized crime settled into the stock brokerage industry in a big way by backing or owning a number of small brokerage firms in the 1980s and 1990s. Many of the firms were the quintessential boiler rooms like the ones depicted by Hollywood in The Wolf of Wall Street or BoilerRoom. By the early 1990s these boiler rooms proliferated in lower Manhattan, Long Island, New Jersey and Florida.  By 2000, the SEC was telling Congress that several of these firms were owned by or worked with the Bonanno, Gambino and Genovese crime families.  

A significant amount of regulatory scrutiny and regulatory actions followed,but that did not stop the billions of dollars of profit that was skimmed off by the miscreants.  The SEC closed down a few of those firms, barred a few people from the securities business and put a few of the people in jail.  But the beat goes on. 

Boiler  rooms are still active today and still working out of Manhattan, Long Island, New Jersey and Florida. They are still cold calling unsuspecting retail investors around the country. They are still using press releases and more recently “independent” fake investment newsletters to pump up what are essentially shell companies. 

In the 1990s the companies were “exciting” because they were going to capitalize in some way on the internet, a new and exciting technology that a lot of people believed could make a lot of money. People were happy to invest in every “internet” company that came along.Today, the pump and dumps have found cannabis stocks as a perfect substitute.   Which brings us to Aphria (NYSE:APHA). 

Aphria is a Canadian cannabis company that is trying to rapidly stake out its territory in new foreign cannabis markets. It traded over the counter in the US until November when it up listed to the NYSE.   The stock price has moved up as the company made a series of acquisitions and announcements in the last year. 

Last week it was the subject of a fairly scathing report by a research company and short seller that questioned whether the company had grossly overvalued some of those acquisitions.  Aphria has retorted that the company’s acquisitions were fine and properly valued and essentially that short sellers cannot be trusted.

Personally I thought that the research report was well written and seemed to have been well researched. There were photos of the headquarters and operations of some of the acquired companies that left a lot to be desired. There were copies of documents that supported the idea that insiders may be guilty of undisclosed self dealing. I thought that the valuations are clearly questionable and that alone was a big red flag. 

What got my interest and what troubled me the most was the discussion of who was involved with Aphria.The report goes out of its way to set out the facts and affiliations surrounding Andrew DeFrancesco who was apparently a founding investor and strategic advisor to Aphria. The report ties Mr. DeFrancesco to  several pump and dump schemes and affiliations with several pump and dump schemers.

These schemers include Paul Honig, John Stetson and John O’Rourke. The SEC brought an action against these three in September specifically charging them with operating pump and dump schemes in the shares of three companies.  I suspect there were other companies whose shares were manipulated by this group as well.  The report points out that in at least one company DeFrancesco’s wife was an early holder of cheap stock.

The report also ties DeFrancesco with a gentleman named Robert Genovese. In 2017,the SEC charged Genovese with operating a separate pump and dump scheme.  So if Aphria’s founding investor has connections with 2 separate pump and dump operators,, and has set himself up to benefit handsomely if Aphria’s stock price should be pumped up, what inferenc e would you make? 

The research report was published by a company called Hindenburg Investment Research. I have no affiliation with them whatsoever and I have never traded shares of Aphria either long or short.  Not surprisingly, a lot of market “experts” refuse to accept any information put into the market by any short seller.  That would be a mistake.

In addition to providing liquidity for the markets, short sellers provide a valuable service because the investment world is grossly overpopulated by“longs”.  The prospects for every company cannot always be rosy. If standard analysis can tell us when the price of a stock is likely to go up, that same analysis can tell us when the price is likely to come down. 

Short sellers truly love to spot scams. If this report is correct about Aphria and the company has grossly overvalued its acquisitions and is being pumped up only to have the insider’s shares dumped into the market, then sooner or later the stock may go to zero or very close to it. That is a win for any short seller.

There is more than enough information in the research report for any small investor who wants to invest in a cannabis company to make an intelligent decision not to invest in Aphria. But please do not think that Aphria is the only cannabis stock whose price may be the pumped up not because its prospects are actually good,but because someone has a lot of stock to dump into the market. As I was researching this article I saw at least a half dozen cannabis related microcap stocks that did not pass the smell test. There are undoubtedly more.

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