Blog : Tired of Pump & Dump? Try Dump & Pump

by Ed Zwirn on April 17th, 2013

By Ed Zwirn

Has your penny stock been subject to massive insider selling followed by good earnings news? It so, the insiders selling your penny stock may not be as stupid as they would appear but trying to distance themselves from litigation.

Managers of penny stock companies about to go under often may be thought of as keen on pumping up earnings before dumping their own shares.

But recent research shows that these penny stock company managers have a strong incentive to forgo pump-and-dump personal profits, and instead to distance themselves legally from the consequences of default.
 
The University of Indiana's Messod D. Beneish, in a paper he co-authored with Temple University's Eric Press and Drexel University's Mark E. Vargas, investigated insider trading incentives for income-increasing earnings management in a sample of 462 firms that experienced technical default from 1983 to 1997.
 
It was Beneish who in the 1990s introduced to academia a set of indicators useful for earnings management detection, and who achieved prominence when these were used to flag the Worldcom debacle. His latest findings should be required reading for penny stock investors.
 
In this paper, the authors find that while more than half (57%) of the companies they looked at saw their managers refrain from both insider trading and earnings management prior to default, most of the remainder were found to trade "at a distance from default and contemporaneously increase earnings."
 
Pumping up earnings numbers well after dumping penny stock shares means that these managers see their firms "experience no stock market losses in the period preceding default, which makes litigation less likely."
 
Beneish, Press and Vargus pointed to this tendency to "dump and pump" as a "possible unintended consequence" of legal provisions that require disgorgement of bonuses and trading profits "following misstatements," because managers may seek to avoid legal trouble by creating a "one-year buffer" between their selling and future bad news.
 
"The finding that abnormal selling can be contemporaneous with - rather than subsequent to earnings management suggests that Section 304 of the Sarbanes-Oxley Act may not be an effective deterrent in firms with deteriorating performance," they write.
 
"Earnings management in distressed firms is more likely to reflect a desire to avoid litigation ('dump and pump') rather than to sell at higher prices," they add. This is why "abnormal selling" in these firms occurs before rather than after earnings management.

The authors saw that there were two distinct trading strategies in these firms, each associated with a unique earnings management strategy. On the one hand, some managers were found to have sold out and pumped up earnings at the same time to distance their trades from the eventual announcement of default. On the other hand, some managers traded in close proximity to the default but kept their earnings clean.

Penny stocks in precarious financial condition will always pose challenges to those trying to determine which stocks to buy and sell, and when. With smaller companies, it is important to get a handle on what the management is up to, and looking at your penny stock in terms of whether or not one of these scenarios is being played out is part of getting this handle.