Definition of Blue Sky Stocks

Every investment in the stock market involves some level of risk, and some stocks are inherently riskier than others. Then there are those investments that simply appear to be too good to be true -- because they are. Stock scams and swindlers are not a new phenomenon. Ponzi schemes and pump-and-dump perpetrators have been around for generations, offering fantastic returns on what amounts to nothing more than a patch of blue sky.

Origination of the Term

Joseph McKenna, a Supreme Court justice in the early years of the 20th century, is credited with originating the term "blue sky stock," to refer to speculative schemes that have no real value for investors. In his opinion in the 1917 case of Hall vs. Geiger-Jones Co., McKenna wrote that such investments had "no more basis than so many feet of blue sky."

Famous Stock Scammers

Sheldon and Eugene Burr, commonly referred to as the Burr Brothers, were among the more infamous of early 20th-century blue sky stock swindlers. The brothers set up shell companies purportedly involved in oil wells, gold mines and railroads, then sold stock in those companies promising that a $50 investment would return $1,500. The brothers sold more than $30 million worth of fraudulent stock before the U.S. Postal Service shut them down for mail fraud in 1910. Although Bernie Madoff is famous for using new investor money to pay previous investors to create the illusion of excellent returns, the scheme was actually invented by Charles Ponzi in the early 1900s. Ponzi, whose name is now synonymous for such scams, bilked hapless investors out of more than $7 million.

Blue Sky Stock Characteristics

You can protect yourself from blue sky stock scams by doing some due diligence before you invest. Request an annual report and check out the company's financial reports -- blue sky stocks frequently have sketchy or unaudited financials. Vast amounts of positive self-promotion and a barrage of glowing "buy" recommendations from unfamiliar sources should be a tip-off that something is amiss, particularly if the seller insists you must buy now or you'll miss out. A sudden surge in share trading volume should be another warning sign -- pump-and-dump stock scams work by generating a false sense of urgency that drives the stock's price up. Insiders dump their shares once the price peaks, then leave the rest of the investors with near worthless stock.

If You've Been Scammed

Anyone can fall victim to an investment scam, but you don't have to remain a victim. Federal securities laws and state "Blue Sky" laws provide a certain level of protection against swindlers. If you suspect you have been scammed, contact your local state securities commissioner, the U.S. Securities and Exchange Commission or the FBI. If the offer to sell such securities came through the mail, you may be able to get the U.S. Postal Service involved. In 2010 the FBI reported its Operation Shore Shells investigation resulted in 100 seizures, forfeitures of more than $70 million in cash and property and restitution of more than $130 million.