Illustration: Binay Sinha
The Securities Exchange Board of India (Sebi) on June 1 imposed a fine of Rs 7.75 crore on 11 people for allegedly operating a ‘pump and dump’ scheme in Svarnim Trade Udyog’s scrip.
The pump and dump system was carried out through recommendations shared through Telegram channels, which led to public shareholders buying the shares at a high price.
In November 2022, the market regulator indicated it was drafting rules to govern the growing base of financial influencers on social media, to strengthen the regulatory regime on tipping from unregistered persons.
So what is the pump and dump system and why should investors be aware of it?
While many participate in the stock market for the purpose of long-term investment or legitimate trading, some exploit the market. One of these stock manipulation activities is known as a ‘pump and dump’ scheme. This practice is illegal and can have serious consequences for investors and the integrity of the market.
What is a pump and dump scheme?
In the stock market, a pump-and-dump scheme is a type of manipulation activity that involves artificially inflating the price of a stock through false and misleading information, then selling the stock at the high price and leaving investors with significant losses to let. This manipulative tactic is especially prevalent in the micro and small cap sectors, where companies often have limited public information and trading volumes are lower.
How does pump and dump work?
This process involves several steps:
First, a significant amount of stock in a relatively small or thinly traded company is acquired. These stocks are often referred to as ‘penny stocks’ because they trade at low prices and are more susceptible to price manipulation due to low trading volumes.
The stock is then aggressively promoted to create buzz and attract investors. This promotion can take several forms, including sending mass emails or newsletters with exaggerated claims about the company’s prospects, as well as misleading social media posts. Promoters aim to create buzz and increase interest in the stock.
As the promotion gains momentum, more investors buy into the stock, causing the price to rise due to increased demand. Sometimes fraudsters may also engage in coordinated purchasing to further increase the price. During this phase, the stock often experiences rapid and significant price increases, creating the illusion of an attractive investment with high potential.
Once the stock price is inflated enough, the sell-off at the inflated prices begins. This selling pressure causes the stock price to plummet, often leaving unsuspecting investors with significant losses as the stock returns to its true value or even lower.
Impact on investors and the market
Those who joined in the hype and bought the shares at high prices typically face significant losses when the stock price crashes. These schemes undermine confidence in the financial markets, making legitimate investors wary of potential fraud.
Participants in pump and dump rigging may face severe legal penalties, including fines, lost profits and imprisonment.
Regulations surrounding pump and dump
As per the Securities and Exchange Board of India (Sebi) guidelines, pump and dump systems are completely prohibited.
On March 2, a crackdown on a YouTube-run stock pump-and-dump operation was ordered, a precursor to the financial influencer regulations that the watchdog is in the process of enacting.
The steady rise of influencers in India providing financial and investment advice without being qualified has sometimes been damaging, especially in the case of recent stock market listings of start-ups. And with the proliferation of social media channels on platforms like Telegram and Instagram etc., the task has fallen away from the regulators.
Recently, the market regulator also took action against popular Bollywood actor Arshad Warsi and his wife, categorizing them as volume makers. They bought and sold shares, helping to boost trading volumes and interest in the scrip. Their method involved buying thinly traded stocks and then publishing videos on the platform spreading false information.
How can investors protect themselves?
Experts suggest that investors should be cautious of unsolicited investment offers from unknown sources as these often indicate a ‘pump and dump’ scheme. Investors should do their research before investing in the stock market. Blindly following celebrities and promoters can lead to significant financial losses.
Investors should be careful with investments that promise unusually high returns or investments that are promoted in an unsolicited manner.
They also suggest that regulators should stay one step ahead of the scammers by using social media oversight mechanisms to protect the public’s hard-earned money.
First print: June 5, 2024 | 12:04 pm IST