An uphill battle: the difficulty of deterring and detecting perpetrators of Internet stock fraud.

• Author: Hittle, Byron D.

1. INTRODUCTION

   When fifteen-year-old Jonathon Lebed of New Jersey was convicted of securities fraud through the Internet by the Securities and Exchange Commission ("SEC") in September of 2000, it brought national attention to an already existing question in the investment world. (1) That is, "Where is the boundary line between legal promotion of stock and illegal misrepresentation of stock?" Unfortunately, there is no clear answer, and as investing online through the Internet allows for increased communication among all potential and actual investors, perpetrators of Internet stock fraud will continue to take advantage of the blurry distinction.

   Undoubtedly, advancements in technology and increased access to the Internet have allowed the securities industry to go "online." (2) Not only has the Internet increased the number of traders and investors in securities, it has dramatically increased the amount of information available to investors. (3) Because the securities market is essentially driven by information about securities, it is no surprise that the securities market has embraced and exploited the information capabilities of the Internet. (4) But increased information and trading online has also given criminals new means of perpetrating stock fraud to unsuspecting investors. "The Internet has opened new avenues for securities fraudsters to swindle the investing public." (5)

   Responsible for regulating the securities market, the SEC is aware of the current and future threats posed by Internet fraudsters. Richard Walker, director of the Enforcement Division of the SEC, recognized that "[w]hile insider trading was top priority for the agency in the past decade ... policing the Internet `is unquestionably our greatest enforcement challenge today.'" (6)

   In addition to the efforts of the SEC, other sources of protection from, and enforcement against, securities violations exist. Federal statutes give defrauded investors private causes of action for illegal misrepresentation, and state enforcement agencies that monitor the securities markets offer some protection against Internet fraud. But due to the vastness of both the securities markets and cyberspace, these protections fall woefully short of successfully curbing Internet fraud. Despite the seemingly successful and much publicized SEC sanctioning of the teenage fraudster, Lebed, the SEC and other enforcement agencies face an uphill battle as they attempt to deter and detect perpetrators of Internet stock fraud in their attempt to secure the integrity and legitimacy of securities traded online.

   This Note argues that because of the limited resources of the SEC, the demanding requirements to prove misrepresentation, the current lack of cooperation between federal and state securities regulators, and a perverse admiration for fraud masterminds, illegal stock price manipulators like Lebed will continue to profit from unsuspecting investors. Various measures to curb Internet fraud, however, are currently being pondered by industry experts. Among the most effective and realistic are, in order: increasing investor education and awareness, (7) increasing the SEC's "firepower," (8) increasing penalties and jail time for offenders, furthering coordination of federal and state efforts, (9) and creating a "seal of approval" for traders and brokers. (10) Absent an increased effort in a combination of some or all of the proposed solutions, Internet stock fraudsters will continue to exploit the "easy pickings" created by Internet investors.

2. TYPES OF INTERNET FRAUD

   Unfortunately for both investors and the SEC, it is not easy to discern if online advisors and promoters are acting within the law. (11) "Telling the difference between what's legal and what's not has always been tricky, and it's getting more complicated in the Internet age, where opinion and fact and hype are combined in a volatile mixture." (12) Individuals may legally tout or promote a stock if they actually believe in the value of it, and much of this sort of communication is harmless because no one believes it. (13) But problems arise when information posted on Internet message boards, chat rooms, and e-mail possesses enough information and apparent authenticity so that a reasonable investor cannot distinguish it from traditional "puffing" of stock. (14) Alan Bromberg, a securities expert, explains that "[t]he Internet `amplifies the fuzziness because there is so much chitchat.... You've got anonymity and glibness and mixed motives, and all the uncertainty that goes with it.'" (15) Even if an investor unknowingly relies on misleading information about a stock, whether the author or creator of the information intended for others to be deceived by his action is not always clear. (16)

   Regardless of whether a stock manipulation scheme in action is easily detectable or not, there are three general ways in which manipulators defraud investors: sham offerings, "pump and dump" schemes, and illegal touting. (17) Securities experts and SEC officials agree that these methods are not new to the industry, but the medium in which they are now performed, the Internet, is both a novel and powerful tool. (18)

   As far as securities fraud is concerned, the Internet is just another medium through which people communicate with each other. Bad people have used all advances in communications, dating from the printing press, telegraph, telephone, and the radio, so it would be surprising if securities fraud was not taking place on the Net. (19) The first of the three traditional types of fraud is the sham offering. This involves perpetrators creating sophisticated Web sites and/or masse-mails that offer securities that either do not exist or are misleading. The subject matter of these offerings tends to be exotic, offering interests in, for example, eel farms, coconut plantations, and projects to explore near earth asteroids. (20) With the availability of advanced, yet inexpensive, software through retail outlets and increasingly through the Internet, fraudsters can create sophisticated Web sites that present the facade of a legitimate investment opportunity. An army of telemarketers or an actual "boiler room" full of fraudsters is no longer necessary to create sophisticated scams. For example, in October of 1998, a solo California scam artist was convicted on fifty-four felony counts by offering stock entirely over the Internet. (21) The promoter raised over $190,000 from 150 investors, using the money to purchase groceries, clothing, and stereo equipment. (22)

   The second category of fraud perpetrated on the Internet is market manipulation, usually in the form of "pump and dump" schemes. In this case, fraudsters use the Internet to circulate widely false and misleading information on message boards, chat rooms, and through mass e-mails to drive up a stock's price. Internet bulletin boards and chat rooms devoted to investing often foster a false sense of community and trust among their readers, causing unwary investors to react and revest. (23) Because messages may be posted anonymously, an individual, through multiple pseudonyms, can create the impression that such information is being relied upon by many different investors. (24) The perpetrator then unloads his holdings at the artificially high price. Once the scheme is complete, the price of the stock usually collapses, with the legitimate investors suffering the loss. (25)

   Perhaps the most widely known "pump and dump" schemes were those perpetrated by Jonathon Lebed. He targeted penny stocks and companies with low price and trading activity because it was easier to manipulate the price of smaller, lesser-traded companies. Once he identified his target company, he would buy upwards of 20,000 shares of its stock. Using various message board names on Silicon Investor and Yahoo!, Lebed posted messages such as "next stock to gain 1,000%," and "This stock will explode this week." By unloading his shares after the price rose, Lebed netted around $800,000. (26)

   Short sellers of stock can also inversely manipulate the market by a practice called "cybersmear." (27) Internet communication is used to drive a stock price down by using negative, false information. Short sellers then profit by covering their short sales at artificially deflated prices. (28)

   Ironically, anonymous messages on the Internet are not always false. A study presented at the 1998 Summer Symposium on Accounting Research suggested that anonymous forecasts appearing on the Internet were better predictors of the performance of technology companies than were the traditional analysts' forecasts appearing in the electronic First Call Network. (29) The existence of legitimate information on chat rooms and message boards favors Internet fraudsters because investors will not necessarily dismiss all Internet opportunities as fraudulent. Hoping to find the legitimate "hot tip," investors can easily fall prey to savvy Internet fraudsters.

   The third category of fraud on the Internet is illegal touting. This occurs when seemingly independent newsletter Web sites or e-mail publications are paid to report favorably upon a stock, but the online promoter does not disclose the fact that it is being paid to do so. Often, the company or its promoters pay the online promoters with stock. (30) With the increased amount of information available on the Internet, the reliability of information has become increasingly important. Richard Walker of the SEC has stated that investors have a right to know if the promotional information they see on their computer screens is really just a paid advertisement, like the sort of notice commonly found in magazines and newspapers. (31) In October of 1998, an SEC-conducted Internet fraud sweep that focused on illegal touting revealed that nearly $7 million in cash and over two million shares were garnered by just forty-four illegal touters. (32)

   The stock fraud schemes may be old news, but the...