This Shows How Massively Risky It Is to Buy Marijuana Stocks

By Todd Campbell Markets Fool.com

The U.S. Securities and Exchange Commission alleges that most of the revenue reported by the once fast-growing marijuana company Medbox was due to "sham transactions with a shell company."

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According to a complaint filed by the regulator last week, the company used illegal stock sales to boost the revenue it reported to investors. The revenue-boosting scheme serves as an important reminder why it's critical for investors to approach cannabis companies cautiously.

IMAGE SOURCE: GETTY IMAGES.

A fast-growing company? Nope.

Medbox's wanted its marijuana vending machines on every street corner, but its revenue growth came mostly from proceeds from stock sales, not marijuana sales.

At its height, the company, which traded on the unregulated over-the-counter stock market, saw its shares soarfrom $1 per share to as high as $200. Unfortunately, much of that run-up was due to investor enthusiasm sparked by revenue growth that the SEC alleges wasn't revenue at all.

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According to the SEC, Medbox was "falsely touting 'record' revenue numbers" and "claiming to be a leader in the marijuana industry while some of its earnings came from sham transactions with a secret affiliate."

Specifically, Medbox founderVincent Mehdizadeh formed a shell company -- New-Age Investment Consulting -- and installed his then-fiancee as its CEO. Afterwards, he reportedly transferred stock in Medbox to New Age that New Age later sold.

"As alleged in our complaint, investors were misled into believing that Medbox was a leader in the burgeoning marijuana industry when the company was just round-tripping money from illegal stock sales to boost revenue," said Michele Wein Layne, director of the SEC's Los Angeles regional office.

The SEC argues that proceeds from those illegal stock sales accounted for "nearly 90%" of Medbox's revenue in the first quarter of 2014. In a text message released by the SEC, Mehdizadeh seems to concede that misrepresenting the company's revenue to investors was part of his business strategy. In that text, he wrote:

The only thing we are really good at is public company publicity and stock awareness. We get an A+ for creating revenue off sheer will but that won't continue.

Mehdizadeh is settling the charges against him for $12 million, plus a promise never to serve as officer or director of a public company or participate in any penny-stock offerings in the future, but that's probably little comfort to investors who bought Medbox shares because of revenue reported in those press releases.

Spotting marijuana-stock manipulators

Like Medbox, most marijuana stocks trade over the counter (OTC) because they can't meet the financial and reporting requirements of major stock exchanges, like the New York Stock Exchange. For this reason, it's probably best to avoid over-the-counter stocks altogether.

However, here are some tips to help you spot a fraud, regardless of what stock exchange a company's shares trade on:

  • Ask "Why me?" If a marijuana stock is being recommended to you, keep in mind that you might be a target of someone who is being paid to sell that stock to you.
  • Use extreme caution with companies that seem to rely more on hype than on fact.
  • Research every company thoroughly, and don't invest a dime until you've done all your homework.
  • Dig into the details. If a company files its financials with the SEC, know that the SEC isn't responsible for making sure that information is true. Legitimate companies use top-shelf auditors from the country's biggest accounting firms, and it can pay to make sure one of them is signing off on the financials.
  • Consider the ancestry. If a company has unproven management, or its business model or name has changed multiple times in the past, then you might be best off taking a pass.

Looking forward

There's considerable momentum behind marijuana legalization, but the market is only in its earliest stage of evolution, and that means that there's likely to be far more failures than successes. The potential market opportunity, while large, brings with it the risk of scam artists eager to separate you from your hard-won money -- so make sure you approach these stocks with a very healthy dose of skepticism.

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