Cyberspace Fraud and Abuse

Unwary investors are in danger today of being taken for a ride on the information superhighway. State securities regulators around the U.S. are concerned about the explosion in illicit investment schemes now flourishing on commercial bulletin board services and the informal web of computer networks that make up the Internet. An estimated four million U.S. households that already have access to the major online services are being exposed to hundreds of fraudulent and abusive investment schemes, including stock manipulations, pyramid scams and Ponzi schemes.

While the experienced pioneers who explored the online frontier are aware of some of the major rip-off techniques now in use, the investment fraud problem could reach epidemic levels over the next few years as several million unsophisticated newcomers crowd onto the information superhighway. Cyberspace, as the online world is known, has the potential to educate investors and help them to become better consumers. Today, any home equipped with a computer and modem is just a few keystrokes away from a wealth of instantly accessible research data and financial news. It will be a tragedy, however, if cyberspace comes to be regarded as a lawless "Wild West" haven for investment swindlers and, as a result, is shunned by the very financial consumers who could be empowered by it.

The States take on Cyber-Schemes

The Missouri Securities Division and the New Jersey Bureau of Securities announced on June 30, 1994, the first regulatory actions taken in the U.S. against online investment schemes. At least three other states currently have investigations underway involving suspected investment fraud and abuse in cyberspace. Here are the highlights of these and other key developments in known or suspected abuses in the online investment world:

According to a cease-and-desist order filed on June 30, 1994, by the Missouri Securities Division, a stockbroker unlicensed to do business in Missouri touted his own services and also made dubious claims for stocks not registered for sale in the state. The broker identified himself on one of the largest commercial online services in the U.S. as "A GOOD TRADER." In the online messages, the broker included his toll-free telephone number and an offer to provide more information by e-mail or regular mail. In an effort to entice customers, he made a number of dubious claims, implying in one case that Donald Trump was a major, behind-the-scenes player in a tiny cruise line with a thinly-traded stock. The Missouri action resulted in his employer, Investors Associates, withdrawing from the state of Missouri. The brokerage firm claimed to have been unaware of the suspect online promotion by the broker, who supposedly engaged in the activity after-hours from his home computer.
Investors were told "how to make big money from your home computer"` as part of the "Electronic Message"` scheme promoted by a San Antonio man and at least nine other individuals scattered around the U.S., according to a cease-and-desist action filed on June 30, 1994, by the New Jersey Bureau of Securities. In what might be referred to as an "e-mail chain letter," the promoter claimed that in exchange for five dollars, investors could earn a return of $60,000 in just three to six weeks. Participants were told to send one dollar to each of five people on an online list. Then, those who sent money were to add their own name to the list and post a message explaining the scheme on ten different computer bulletin board sites. In practice, the scheme amounted to a high-tech variation on the old pyramid scam, which is barred under federal and state laws.
The price of the shares of stock in another Canadian company, Wye Resources, Inc., which was reported to own a Zaire diamond mine where a major strike had been made, more than tripled in price in early 1994. After extensive online hyping, the stock, which was traded over-the-counter in Canada outside of an established exchange, collapsed. Authorities stepped in and called a halt to the trading. As one online observer of this apparent "pump and dump" scheme noted: "The company’s story was made to sound like the biggest get-rich-quick prospect this side of Mars, and a lot of naive investors began buying. The stock, as ALWAYS happens, went from 20 cents to $1.40 in a matter of a month, and the hypesters were talking about how great they all were ... until the Alberta Exchange halted trading on the stock the next day, investigating the manipulation of the share price...."(Emphasis in original.)

State securities regulators emphasize that the problem of illicit and abusive online investment schemes has the potential to spread like wildfire as the result of the increasing popularity of commercial bulletin board services and the Internet. "We are just now starting to get complaints, and a growing number of states and other regulators are in the first stages of focusing on this latest variation on the unending theme of investment fraud and abuse," explained Iowa Superintendent of Securities Craig Goettsch, who served as president of the North American Securities Administrators Association (NASAA) in 1994. "The states recognize the high value that is placed on privacy and minimal government intrusion in cyberspace, but the reality is that investment fraud is illegal and will be combated by the states wherever it takes place. We want to make sure that online investors know that they should proceed with extreme caution when traveling the information superhighway."

The Online World: A Primer

Cyberspace was once a place inhabited largely by government agencies and academics linked together through a decentralized collection of computer networks that came to be known as the "Internet." The late 1980s and early 1990s gave birth to a torrent of commercial entrants into cyberspace, with the way led by CompuServe, then Prodigy and America Online. By the end of 1994, some four million American households were online with these services. Additionally, hundreds of smaller companies also provided bulletin board services and local access to the Internet.

The result: cyberspace is no longer an ivory tower world. The number of Americans online jumped 90 percent from 1992 to 1994. Thanks to a new generation of sophisticated software programs that take much of the pain out of navigating the Internet, more and more of those who are online spend much or all of their time outside the confines of the commercial services.

For newcomers, cyberspace can be an enormously complicated and confusing place. But the appeal of the online world is easy to understand. Those who go online have opened up to them a dizzying array of computer bulletin boards (where messages can be posted under specific topic headings), live discussion groups (in which members have real-time "chats" through their keyboards), e-mail (the cyberspace equivalent of what is referred to as "snail mail"), information (in the form of research, newswires, and electronic versions of magazines), ways to buy goods and services (including airline tickets and office supplies), and games.

Investments Online: Not "Commercial Free"

Those who have never journeyed to cyberspace may be under the impression that the online world has not been "commercialized." This misunderstanding arises not only from the former "ivory tower" reputation of cyberspace, but also as a result of a few, widely publicized incidents in which commercial interests have attempted to advertise their services through indiscriminate use of e-mail messages and message-posting on multiple bulletin boards. Such individuals have been "flamed" (a sort of "hate e-mail"), with the result that some have been driven into silence or even out of cyberspace altogether.

There is little evidence of such anti-commercial sentiments when it comes to bulletin boards and discussion groups devoted to investing topics. Commercial bulletin board services offer special areas to subscribers on a wide range of professions and other interests, ranging from the law to romance. But one of the most powerful "magnets" drawing consumers to the commercial services and the "unmoderated" world of the Internet today is the growing number of bulletin boards and discussion groups devoted to investment tips, advice, and solicitations. Many of the investment-specific messages now appearing on commercial services and the Internet openly hawk brokers, investment advisers, financial newsletters, and specific investment deals.

Though many of the messages simply offer general stock-picking advice or mention other investment possibilities, others tout specific stocks, money-making enterprises, and service providers. Far from being free from commercialism, investment-specific bulletin boards are now littered with sales pitches, offers of details transmitted privately via e-mail and toll-free numbers. All three of the largest commercial computer bulletin board services also offer electronic trading links to major brokerage firms.

The Rise of Online Investment Schemes

Combine the circulation of the Wall Street Journal (1.8 million) and the USA Today (1.6 million) and you still fall short of the "self-publishing" reach available to someone who joins a few commercial computer bulletin board services. As one online investor has marveled: "With the online world growing quickly, we can all reach hundreds of thousands of people with a single (message) posting. With a few keystrokes, a couple of accounts, and a macro or two, I can make it appear that many people are posting on many different systems, all talking up a stock... never before has an individual been able to reach so many people, so easily, quickly, or inexpensively."

Just as investment con artists and other fast-buck operators wasted no time in taking advantage of the mails and the telephone as means by which to fleece large numbers of unsuspecting investors, so too have swindlers started in with a vengeance to exploit cyberspace. While many of those on bulletin boards dedicated to investment topics are interested in little more than swapping ideas about specific stocks and exchanging general financial advice, there is increasing evidence that a shady group of individuals are milking the online world in order to enrich themselves in what is often a blatantly fraudulent and abusive fashion.

State securities regulators have identified the following as being among the major investment scheme problems in the online world today:

Manipulation of obscure, thinly traded stocks. Most commercial bulletin board services allow individuals to post messages not only under an alias... but multiple aliases. Since it may be impossible for another subscriber to ascertain the true identity of the individual behind the message (or even if a series of messages are being entered by just one individual under various aliases), there is enormous potential for manipulation of little-known companies that have a small float (the number of shares available to be bought and sold). Acting alone or with accomplices, one company insider, broker, public relations executive or even just a large shareholder can leave numerous messages calculated to spark interest in an obscure stock. Once a "thread" (in this case, a series of related messages about a stock) is started, it will show up on the computer bulletin board and be readily accessible by anyone who enters the bulletin board.

Through a combination of puffery, speculation, and breathless claims of supposedly inside information about pending announcements, product innovations, and new contracts, the schemers seek to run up the price of the stock, which starts rising as unwary investors read of the "great opportunity" and buy shares. In response, the insiders take their shares ("bought at the low, "pre-hype" prices) and sell them into the rising market. As interest builds, dozens of messages may be posted about the stock. When the hype-fueled stock price falters, the promoters may blame unnamed short sellers. Sometimes, losses suffered by the unsuspecting are made even worse by ruthless promoters who urge victims to "dollar average" and keep buying shares, even at the falling prices. Talk of the stock then disappears from the board. Investors who are left holding the bag can do little more than post plaintive messages: "Whatever happened to Company X?" (See, "How a Typical Cyber-Scheme Works" below)
Misconduct by phony and unlicensed brokers/investment advisors. States are concerned that brokers may be attempting to drum up new business... without the supervision of their employers and while making liberal use of illegal assurances about the potential for profit in certain investments. The problem here goes far beyond the oral comments that an aggressive broker might make to a sophisticated client, since an online message is available to be read by, not one, but hundreds of thousands of investors. Additionally, states are concerned about brokers who may try to rope in new clients without regard for the clear state interest in keeping individuals with a history of fraud and abuse outside of their borders.
Undisclosed interests of promoters. The anonymity of cyberspace is exploited to the hilt by schemers who promote fraudulent and abusive investment schemes. In reading a bulletin board message about a stock, you have no way of knowing if the person involved is a company official, PR representative or market-making brokerage firm. Has the person hyping the stock been paid to do so and, if so, has that fact been disclosed? (In one instance, an individual running a private bulletin board disclosed there that he received compensation for his stock promotion activities, but did not make a similar disclosure when he posted messages on major commercial bulletin board services.) In some of these cases, the role of the person involved in the scheme is such that he or she is considered an "agent" of the stock issuer and, as a result, is subject to strict legal requirements about public statements, disclosure language and penalties for intentional "misrepresentations and omissions" intended to move stock prices.

How a Typical Cyber-Scheme Works

"Is anyone out there following Company X?"

"I heard that Company X is about to make a major announcement. E-mail me or call this toll-free number to get an information package."

"I spoke to Company X `s CEO who confirmed details of next month’s big news. I’ve bought 10,000 shares. Look for share price to double in next month! Get it now!"

"Big news is just around the corner. We hear from a friend who has visited Company X that is going to be even bigger than we thought. There’s still time to get in."

"Short sellers are in the market! Keep the faith... This will bounce back. The smart money will use the price as an opportunity to buy more and dollar average."

The original message in this hypothetical bulletin board "thread" might be posted by a company executive, public relations executive, market making brokerage firm or large, individual shareholder. Subsequent messages could be left by the same individual under an alias (or aliases) or by accomplices posing as unconnected outsiders. The goal would be to interest unwary investors, who then drive up the price of the stock through a surge in buying. The schemers stand to make substantial profits when they sell their cheap shares into the market. After the price collapses, talk of the company ceases and the schemers move on to hyping a new stock.

Promotion of "Exotic" Scams

The manipulation of the stock of publicly-traded companies and misconduct by professionals are just two types of problems that state securities agencies have detected on commercial bulletin board services and on the Internet. In hundreds of other cases, messages have been posted promoting a wide variety of highly suspect, unregistered investment deals (e.g., wireless cable television "build-out" schemes, ostrich farming, and viatical settlements), as well as flat-out rip-offs (e.g., pyramid schemes, including a number of twists on "chain e-mail letters," and Ponzi scams). These so called "exotic" securities may pose a greater threat to consumers than other cyber-schemes, since out-and-out scams often appeal to individuals who do not feel sophisticated enough to speculate in stocks. The experience of state securities regulators is that "exotics" are often just as costly to burned investors, since many schemes involve minimum investments of $5,000 or more.

Some of the investment fraud and abuse problems in cyberspace are indistinguishable from those that have been in circulation elsewhere for decades. But access to the online world represents an enormous advance in the ability of con artists to victimize the unwary. Even the fastest-talking boiler-room operator would be hard-pressed to make more than 150 "cold call" telemarketing pitches in one day, whereas the fast-buck swindler with access to Cyberspace can send e-mail to many thousands of individuals in less than an hour. The same con artist can then post a message that may be read in a matter of weeks by tens or even hundreds of thousands of individuals around the globe. As one veteran state securities agency official has observed about cyberspace: "In my 32 years of investigating fraud, this is by far the greatest money-making machine for scammers that I have ever seen."

Protecting Yourself Against Online Investment Schemes

What are the rules of the road for investors who decide to travel the information superhighway? Perhaps the most important thing to keep in mind is that there will never be enough "cybercops" to keep the online world free from fraud and abuse. Even though state securities agencies and other investment regulators have mounted serious efforts in recent months to spot and stop cyber-fraud, the simple truth is that there are far too many places in the online world (particularly in the almost entirely unregulated Internet) for swindlers to set up shop. Even if the several thousand people in the United States who work at the Securities and Exchange Commission (SEC), state securities agencies, National Association of Securities Dealers (NASD), and the stock exchanges were somehow able to put aside all other tasks in a massive bid to shut down online investment scams, it is doubtful that this problem could be stamped out altogether.

This does not mean that you should avoid cyberspace. Rather, it means that investors who venture into the online world should do so with caution, being mindful of the danger of fraud and abuse. The good news is that there are self-defense steps that you can take to fend off cyber-fraud:

Don't expect to get rich quick. The online world is filled with timely and accurate information that can help you become a smarter investor. Unfortunately, it also is home to a growing amount of investment fraud and abuse. The trick here is to keep your excitement and expectations about the promise of the online world in perspective. You have to evaluate the information you get online in the same way that you would any news magazine article, television report or whispered "hot tip." A failure to exercise the caution and skepticism that is a healthy response to all unfamiliar investment opportunities could be a fatal misstep here!
Don’t assume that your online computer service polices its investment bulletin boards. Most don’t. The vast majority of services take a "hands off" attitude to validating claims made in message postings. Even the ones that do minimal policing are swamped by the volume of postings, which add up to literally millions of messages each month. In the "wild and woolly" world of the Internet, just about anything goes. Nothing is in place to prevent a con artist from posting one (or dozens) of pitches for a swindle. In the unregulated environment of the Internet, often the only check on abusive messages is "flaming" by other users.
Don’t buy thinly-traded, little known stocks strictly on the basis of online hype. These are the stocks that are most susceptible to manipulation. Unlike blue chips and other stocks with substantial floats (the number of shares available to be bought and sold), the price of low-volume stocks can be moved through relatively small strategic trades. This is why online hype usually involves previously unknown securities, often for companies involved in mining or the world of high-tech. Even if a stock that is being hyped starts to move up, proceed with extreme caution, since this may just be part of the overall manipulation scheme. You could still end up holding the bag! Always take the time to do your own research using reputable resources, many of which are available online.
Don’t act on the advice of a person who hides his or her identity. Keep in mind that many computer bulletin board services allow people to use aliases and nicknames. Though this is intended to protect privacy, it also can be exploited by fast-buck artists. As a result, you may end up dealing with an undisclosed broker, investor, or company insider intent on driving up the price of a stock through false information or baseless speculation that is difficult or impossible to disprove. Don’t assume that two or more people talking up a stock are actually two or more different people! Review the motives of the person sharing investment opinions and information online and take the time to search out other information on your own before making an investment decision.
Don’t get suckered by claims made about "inside information," including pending news releases, contract announcements, and products. Investment bulletin boards and discussion groups are crammed with hot tips about impending developments sure to send a stock soaring in value. Just because these tips appear in cyberspace does not mean that they are exempt from federal insider trading laws and rules. It is extremely unlikely that genuine "insider information" is going to be publicly broadcast on an investment bulletin board.
Don’t assume that just because someone says that they have checked something out that they have actually done so. Online stock hypesters make all sorts of claims about visiting companies, inspecting mining operations, and having personal conversations with company officials. Keep in mind that you may not be able to verify who is making these claims much less whether any of the information is true or the supposed research ever took place. On a related note, keep in mind that an established tactic of investment schemers is to talk up mines and factories in remote corners of the U.S. (or elsewhere around the globe) where it is impossible for you to either visit in person or get meaningful information.
Don’t forget to always be on the look-out for conflicts of interest. A growing number of those who analyze stocks online are receiving cash or stocks in exchange for making glowing comments about the companies in question. Some of these individuals prominently disclose this fact, while others make little or no mention of the fact that they are paid touts. Make sure that you always know why someone is so "high" on an investment opportunity!
Don’t forget to first make sure that an investment opportunity and the person promoting it are properly registered with your state securities agency. Laws designed to protect small investors from fraud and abuse do apply in cyberspace. A failure by an issuer or broker to follow the state requirements here is often a major "red flag" of an investment scam.