Witness Tells of Mob Influence in Penny Stocks

WASHINGTON —  An admitted penny stock scam artist, wearing a hood to conceal his identity, told a House subcommittee Thursday that penny stocks traded over the counter are often controlled by organized crime.

Lorenzo Formato, a former broker and promoter of the inexpensive but highly risky securities known as penny stocks, testified that “organized crime has their hand on the shoulder of someone inside any (over-the-counter) brokerage that’s making money.”

Formato is now in the federal Witness Protection Program.

He told the Energy and Commerce subcommittee on telecommunications and finance that although there are legitimate companies offering their stocks over the counter, the issues are often manipulated by brokers, promoters or salesmen.

Although their price--a few cents up to a few dollars a share--makes penny stocks attractive to small investors with limited funds, many are prone to abuse because information about the issuing company often is hard to obtain and fraudulent claims are difficult to dispute.

Small or young companies, or those that trade infrequently or in a limited area, are often listed only on so-called pink sheets rather than with larger and more stable companies. Brokers and investors must call a broker that deals in a specific company’s shares to get a price quote.

Top Threat to Investors

According to a survey by state securities regulators, American investors have been cheated out of at least $2 billion a year by crooked schemes involving penny stocks.

The National Assn. of Securities Dealers, a self-regulating organization that oversees over-the-counter stock brokers, said any investigation of organized crime links to the industry was in government hands.

“We’re cracking down hard on unscrupulous penny stock brokers, but we’re not Elliott Ness,” said Robert Ferri, a NASD spokesman. “If an investigation has to go farther than our purview, the law enforcement agency we’re dealing with will take it from there. And that’s quite often the FBI or the Justice Department.”

“Penny stock swindles are now the No. 1 threat of fraud and abuse facing small mom-and-pop investors in the United States,” said Rep. Edward J. Markey (D-Mass.), the subcommittee chairman. He called Formato’s testimony “a blistering, scalding indictment of the entire penny stock market.”

Formato entered the crowded congressional hearing room surrounded by federal marshals and wearing a gray hood with holes for his mouth, nose and eyes. He testified from behind a screen with his voice altered to protect his identity.

He said he got involved with the mob in his native New Jersey to prevent competitors from trying to undercut him.

“I needed the protection. I needed the strength of organized crime,” he said.

But Formato, who is serving a six-year prison sentence, declined to say what organized crime family he was involved with.

Was Key Witness

He pleaded guilty in 1987 to charges of income tax evasion, mail fraud and interstate transportation of money taken in stock fraud, according to Robert Warren, a federal prosecutor in Newark, N.J.

Formato was the government’s key witness at the trial of five people later convicted of participating in a penny stock fraud involving a bogus company, Laser Arms Corp., that purported to have developed a self-chilling beverage can.

Formato was described at the trial as one of the masterminds behind the scam. In addition to the five convicted at trial, nine other people pleaded guilty to charges involving Laser Arms.

Formato gave several recommendations for cleaning up the penny stock market, especially tougher penalties.

He said he used to laugh at the Securities and Exchange Commission, the watchdog of the stocks and bonds markets, because it did not have the authority to put him behind bars.

‘Truly National Proportions’

“I did not fear the Securities and Exchange Commission,” Formato said. “They could only attack me on a civil basis. The people who bought the stocks lost their money.”

“There are thousands of people making millions of dollars doing what he did,” said John Baldwin, director of the Utah Division of Securities.

Baldwin is also president of the North American Securities Administrators Assn., a Washington-based organization of state securities regulators.

“The evidence is clear and convincing: Penny stock fraud has evolved into a problem of truly national proportions,” Baldwin said.

A report on NASAA’s 50-state survey of securities regulators noted that investors in legitimate penny stocks “are believed to lose all or some of their investment 70% of the time and the presence of fraud pushes up that figure to 90%.”

The SEC has created a Penny Stock Task Force and has adopted rules that will make it tougher to sell penny stocks over the telephone.