The wiki article on share dilution scams says

A share dilution scam happens when a company ... repeatedly issues a massive amount of shares into the market (using follow-on offerings) for no particular reason, considerably devaluing share prices until they become almost worthless, causing huge losses to shareholders.

Then, after share prices are at or near the minimum price a stock can trade and the share float has increased to an unsustainable level, those fraudulent companies tend to reverse split and continue repeating the same scheme.

How does this make money for the people at the company? Do they dilute the shares so that they become worthless, buy a lot of them at cheap prices, hype/pump and dump their company so the prices increase, then repeat the process? I feel like the wiki article is missing the actual reason for why a company would do this.

up vote 5 down vote accepted

For this to work, those who control the dilution must also control their salaries because the only way for them to be paid off when it's the corporation itself selling is to gain access to the proceeds.

When a corporation sells newly issued equity, the corporation itself owns the money. To at least have the appearance of propriety, the scammers must be paid those proceeds. Both actions imply that the board is captured by the scammers.

There are many corporations that seem to do this even with persistently large market capitalizations.

The key difference between this and pump-and-dump is that its a fraudulent group of investors selling in this case instead of the corporation itself.

A detailed simple example

Corporations are mandated by law to be little oligarchies; although, "republic" is now becoming more appropriate with all of the new shareholder rights. A corporation is controlled at root by the board of directors who are elected by the shareholders. The board has no direct operational control, as that is left to the "king", the CEO; however, the board does control what everyone wants access to: the money.

Board members have all sorts of legal qualitative mandates on how to behave, and they've functioned fairly decently efficiently over the long run, but there are definitely some bad apples.

Boards are somewhat intransigent since it's difficult to hold board elections, and usually only specific board members are put up for election by a shareholder vote, so a bad one has the potential to really get stuck in there. Once a bad one is in there, they don't care because they know it will be tough to get them out, so they run roughshod over the company's purse.

Only the board can take action on major funding such as the CEO's operating budget, board compensation, financing, investment, etc, some with shareholder approval, some without. The corporation itself owns all of those assets, but the board controls them.

In this example, they scheme with most likely the top executive, but a rubber stamp top executive could allow a lower rung to scheme with the board, but the board is always constant until the law is changed.

Because there's no honor amongst thieves, the board votes which can require some combination of executive and shareholder approval are taken very close together: sell shares, increase salaries to key executive schemers, increase board compensation. The trusting shareholders believe this is in the best interests of the company at large so go along.

So the money flows from existing & new shareholders to the corporation now controlled by a malicious board and then finally to the necessary malicious executive and the vital malicious board.

  • oh so the company (and therefore the scammers running the company) make money with every sale of shares to the public? – Michael A Feb 21 '14 at 19:39
  • @BenK Exactly! The corporation owns the proceeds of any new issuance of equity. The only way for the scammers to have access is to get those proceeds paid out as salaries, bonuses, etc. I'll edit... – user11865 Feb 21 '14 at 19:45

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