Janice, I am forwarding testimony of one of the Fools concerning a prank much like the FBN prank which cost you a lawsuit. The testimony was delivered in March '99 Are the FBNers interested in selling some toilets in Africa?
Testimony of
Thomas M. Gardner
Before the Permanent Subcommittee on
Investigations of the United States Senate
Committee on Government Affairs
My name is Thomas Gardner and I am a founder of
The Motley Fool, Inc. of Alexandria, Virginia. It is a
great honor for me to address the Senate Permanent Subcommittee on
Investigations. Fools do not often get the chance to speak in the U.S.
Senate.
I am particularly gratified to have the opportunity to address securities fraud
on the Internet. I believe that the main factor that permits Internet securities
fraud, indeed all securities fraud, is ignorance, and this sort of ignorance is
exactly what we founded The Motley Fool to combat.
We founded The Motley Fool in 1994 to "educate, amuse, and enrich" the
individual investor. Today, we have 1.2 million members of our Internet
service, we have an internationally syndicated newspaper column in over
150 newspapers, four best-selling books, a nationally syndicated radio
program, and all of it is borne out of our belief that individuals can and
should direct the management of their money. At The Motley Fool, we
recognize that technology, especially the Internet, now allows people
around the world to do just that by obtaining information that once was the
exclusive property of the financial-services industry. The general
inaccessibility of critical information coupled with the lack of financial
education in America has delivered an ignorance that is the very reason
we're meeting here today.
I. Bad Pennies
As this Subcommittee has previously learned, much of the securities fraud
that takes place on the Internet apparently involves microcap, or "penny"
stocks. Penny stocks are the stocks of small companies that don't qualify
for listing on any of our major exchanges but trade "over the counter."
These stocks generally trade at less than five dollars per share. Statisticians
note that 75% of all the companies whose stocks trade for less than $5 per
share go bankrupt over any ten-year period. These are the obscure
diamond miners in Zaire, the meat-packing business that just launched an
Internet service, the fingerprint-technology company that claims it will
provide the foundation for all transactions in the century ahead.
Now, because these companies do not trade on the major exchanges, they
often do not need to make comprehensive electronic or hardcopy filings
with the SEC. Further, because of their relative obscurity, many of these
public corporations lack liquidity. In many situations, the majority of the
shares in a penny stock company may be held by company insiders and/or
promoters. Obviously, not all, or even most, microcap companies are
fraudulent, and I'm not criticizing companies for failing to be Wal-Mart or
General Electric, but the cheapness and obscurity of penny stocks makes
them tremendous targets of fraud and manipulation.
Why, when they present such little opportunity to long-term investors, do
penny stocks still attract attention?
First, inexperienced investors may be attracted by the fact that they can buy
many shares for little money. To take an extreme example, $3,000 could
buy only one share of Warren Buffett's Berkshire Hathaway Class B stock,
but it could buy six thousand shares of, say, "Marginal Technology
Systems, Inc." at fifty cents a share. The combination of the opportunity to
hold large share positions and that appearance of unlimited upside draws
scads of new investors into this most highly speculative form of equities
ownership. After all, if the microcap stock goes up just fifty cents, the
stockholder would double his or her money. Never mind that the odds are
very remote that this penny stock will rise and then sustain its gains. Many
new investors will buy it up, not having been taught that bankruptcy and
micro-cap shares travel arm in arm. Penny stocks are the public market's
own brand of lottery ticket - the engine of financial dissolution among those
who have not been educated about their money.
Secondly, penny stocks are popular because, with little liquidity and a
limited float (few shares available for public trading), they do not demand
much popular interest to run higher, momentarily. The relative volatility of
microcap stocks re-creates the thrill of a gambling casino, where fortunes
can be won in an instant - yet where fortunes are clearly lost over the long
haul. What many penny-stock investors don't entirely grasp is that
manipulators and touts can pump up share prices with a promotional
campaign only to opportunistically dump their stock as the trading volume
levels out. Brokerage firms, newsletters, tip sheets, and company insiders
have driven this familiar scheme for years.
For all of these and other reasons, The Motley Fool abhors the dreaded
penny stocks. In our work, we've sought to teach people that penny stocks
are extremely risky and subject to manipulation. We do not report on
penny stocks, except to share horror stories. We will not open message
folders for our community members to discuss penny stocks. Instead, we
celebrate the unfortunate confessions of burnt penny-stock investors, which
litter our Dumbest Investments message folder at The Fool. Our chat hosts
will not discuss penny stocks. And when members of our community try to
discuss such stocks on our message boards or in chat rooms, our staff tries
to warn other readers of how little enduring reward chases this substantial
level of risk.
In excluding these stocks, we are certainly foregoing a line of business that
would have a substantial readership and drive considerable short-term
revenues for our company. But, in a free-market system, we believe that
the corporations that commit themselves to the greatest good of their
customers will flourish. Penny-stock ownership is not beneficial to
newcomers to our public markets, is absurdly comic to experienced
investors, and thus is not reported on by The Motley Fool.
Zeigletics
Penny stocks have given us great fun, though. I can't talk about them
without mentioning Zeigletics, the penny stock that never was. In 1994,
while my brother and I were cranking out our monthly newsletter, we were
also taking part in online discussions about stocks and investing. On
Prodigy and America Online we would join message board discussion
groups in the hopes of educating others and being educated ourselves. Our
comments, though, were quickly drowned out by the overwhelming noise
of penny stock hypesters screaming about Canadian mining companies at
twelve cents a share and how we had to "GET IN NOW!!!!" Thus, on
April 1st, we decided to play a practical joke by inventing a fictional
company with a fictional product, listed on a fictional stock exchange and
bearing a fictional ticker symbol. All we needed was a hypester.
Joey Roman was the name we gave to our penny stock superman. He
launched a massive propaganda blitz, just like all the other hypesters. But
Roman was better than all his competitors, even if he didn't have a real
company to hype. Joey Roman always bought all of the competitors' stocks
for a dime less, always pushed them up a few nickels higher, and he
claimed to enjoy the gushing admiration of the entire penny stock world. He
was, in short, a disgusting extreme.
We posted some fifty-odd messages on Prodigy over a one-week period
that were read by thousands of investors. Roman hyped our fictional
company, Zeigletics, Canadian manufacturer of linked sewage-disposal
systems for the Central African nation of Chad, and he hyped them on our
fictional Halifax Exchange.
In the first message we posted, Roman boasted of how Zeigletics was "a
HUGE bargain!" because it was trading at just 37 cents a share. The
company, Roman explained, had just introduced portable toilets
(Zeig-Lo-Pots) along with bathroom accessories to Chad. Roman further
hyped that "in Africa the name Zeigletics is virtually synonymous with
toilets. The company recently sponsored the Sudanese equivalent of the
Boston Marathon, where hundreds of fans were waving plungers at the
finish line!!!" In further messages we had Roman boasting of his success
with lines like, "This baby just tripled, in ONE DAY!!!?Our stocks never
go down. If you haven't bought Zeigletics yet (Halifax Canadian Exchange,
symbol ZEIG.H), you're no player at all."
As you might imagine, we got a great many responses from investors all
over the world. Some of them frantically posted questions and stated they'd
contacted their brokers to try to buy shares, but those brokers had never
heard of Zeigletics or the Halifax Exchange. The best message posted
serves as the best possible closing to this little episode. It comes from a Mr.
Hughes, whom we've never met, but he thinks as we do:
The point Joey Roman is making is pretty clear: It is so easy for a
fast-talking hypester to establish a position in a low-volume stock, rattle off
a bunch of crap that sounds plausible enough to convince a novice, let the
price pop due to uninformed amateurs flying in, and sell into the rise,
laughing all the way to the bank.
Dear people, learn to evaluate and think for yourselves. There are some
legitimate stock pickers on this board, and good ones at that, but please
check their records and do your own research before buying?
Ziegletics taught us several lessons, too. First, it demonstrated that there
was an audience for humorous material about personal finance. Second, it
showed that some people will believe just about anything they read, unless
they are educated on the subject, first. Third, it showed that many people
have not learned how to make informed decisions about their money for
themselves but will trade on tips, even ridiculous ones.
Education is critical to our nation's financial future.
II. The Problem of Securities Fraud On (and Off) the Internet
I'm often asked whether securities fraud on the Internet is a significant
problem. My answer is that securities fraud is a significant problem, and it
takes place on the Internet, over the telephone, in restaurants, on the
trading floors of the exchanges, and in boardrooms. As far as securities
fraud is concerned, the Internet is just another medium through which
people communicate with each other. Opportunists have used all advances
in communications, from the printing press, telegraph, telephone, and radio
to television, so it would be surprising if securities fraud was not taking
place online.
But the Internet does present some unique problems. Securities scams on
the Internet try to take advantage of how the medium makes it easy for
people to communicate across the world, instantly and inexpensively. The
best known activity, against which the SEC has conducted some
high-profile enforcement actions, occurs when a seemingly independent,
reporter, newsletter, newspaper, magazine, website or e-mail publication
publishes favorable stories about a penny stock company that it has been
expressly paid to promote, without disclosing this relationship. Sometimes
the company or its promoters even pay the touts with stock. After the
stock has been sufficiently "pumped," its promoters usually "dump" their
shares, leaving their victims with stock that is virtually worthless.
Other examples of securities fraud using the Internet have included:
Individuals soliciting for investors in companies that don't really exist, or that
exist on paper but are really scams. These con artists may use websites
elaborately designed to look like real businesses. In one example, a
"start-up" called Interactive Products & Services used a sophisticated Web
site to describe its "revolutionary" Internet technology (which didn't work),
based on a Microsoft partnership (which didn't exist), key employees (who
later denied any affiliation with the company), and SEC filings (which the
SEC had never seen). Before the scam was revealed, 150 people sent the
company $190,000, which - according to the SEC - the owner of the
company spent on groceries, clothing, and stereo equipment. Individuals or
groups, including brokers, may try to spread rumors or hype or smear
companies through posts in Internet message boards or live chat rooms. I
don't know of any prosecutions or enforcement actions based solely on this
sort of manipulation, but several companies have filed lawsuits alleging
"cyber-smears."
Some hypesters use mass emailings of unsolicited commercial email, or
"spam," to spread the word about the stocks they promote.
One of the most interesting characteristics of these investment scams is that
they are so uninteresting. They are the same scams that criminals have been
trying to perpetrate for decades, such as pumping and dumping, Ponzi
schemes, stock touting and hyping, and rumor mongering. Ill-intentioned
operators have always tried to sell nonexistent companies, or worthless
swampland, or the Brooklyn Bridge to unknowing individuals. Only the
mechanism of transmission is new, and more powerful. While the telephone
let schemers and low-grade salesmen contact individuals in their homes, the
Internet allows for instantaneous mass distribution into tens of millions of
homes around the world. Furthermore, people may be more likely to be
taken in by Internet scams than by scams via telephone or personal contact
because the Internet is essentially a text medium, and people may believe
what they read.
Thankfully, though, as the SEC's John Stark and we have noted, the
Internet can also make it harder for malefactors to get way unseen. Unlike
telephone or personal contacts, Internet scams leave themselves open for
rebuttal by others in communities online. It can be hard to hype a stock in a
chat room, for example, when hundreds of others of others can easily
challenge the promotion, demanding evidence and the source of that
evidence in their search for a hidden agenda. This is the role that our
community monitors play when, in online postings, promotion seems to
have supplanted education and curiosity. If every investor had access to
this public dialogue, made possible only by the Internet, I can assure you
that the misdeeds of criminal brokers, insurance salesmen, and realtors
would be fodder for the mockery of the people.
Perhaps most importantly, though, Internet messages leave "footprints" -
they can provide all the clues to a crime, clues that schemers can never be
sure that law enforcement will not obtain. Even the apparent anonymity of
cyberspace can work against the would-be con. A few years ago The New
Yorker magazine ran a cartoon declaring that on the Internet "nobody
knows you're a dog." Well, nobody online knows that you are a securities
regulator, either.
III. The Nightmare of Day Trading
The phenomenon of day trading, whereby individuals spend their days
trading securities, often holding them for only hours or even minutes, is also
not new. There have always been individuals who would spend their days
at brokerages or call their brokers dozens of times each day. There have
always been those who would risk their savings on short-term phenomena,
even when the odds and the costs associated with doing so pointed to
subpar returns. Nevertheless, the rise deep discount brokerages online and
even day trading "parlors" have contributed to a meaningful increase in the
number of people who, from their homes, offices, or rented desks and
terminals, may spend their days buying and selling ticker symbols. I have no
doubt this craze is only momentary. The poor economics of active day
trading cannot support its sustained, widespread use.
I do not have any data to support me on this, but the logical inference is
that the rise of day trading will increase the incidence of market
manipulation. The more that the public markets are used for short-term
speculation, the more frequently will its players attempt to fix prices in the
short term. Because rumors - stirred on every medium - can drive small,
quick moves throughout the market, a select group of daytraders can be
expected to use gossip across every communications and broadcasting
network to wiggle a stock that way or waggle it this.
It is important not to forget that the Internet didn't invent either day trading
or attempts at manipulation. But the sensitivity of short-term stock
movements to rumors, half-truths, and undigested data and the awesome
power of the Internet would seem to give day traders incentive to spread
misinformation online. That is one of the hundreds of reasons why The
Motley Fool advocates a less sexy strategy for buying and holding
companies listed on our major exchanges. In our attempts to coach
individuals into sound, inexpensive money management, we know that we
cannot convince everyone of the merits of that model. We believe, though,
that we're making a significant contribution to the reduction of financial
fraud throughout the world.
IV. Addressing Securities Fraud
a. Enforcement
Over the past year, the SEC has been particularly active in pursuing
securities fraud on the Internet. In October 1998 and again in February
1999, they announced a series of high-profile enforcement actions against
over fifty alleged fraudsters, most of whom were accused of promoting
penny stocks over the Internet in return for undisclosed payments by those
companies and their promoters.
These enforcement actions were reassuring because they showed that the
police were on the beat, ready to treat criminal activity online just as they
do that offline. That the NASD and the North American Association of
Securities Administrators are also active in addressing fraud on the Internet
is also good news.
In addition to its enforcement actions, the SEC last month announced some
regulatory amendments designed to increase the amount of information
available to microcap investors and address some loopholes that penny
stock issuers have used. I am hopeful that these reforms will help investors
make informed decisions about their investments. Certainly, though, their
adoption will not eliminate the misconduct I've discussed today.
Enforcement and monitoring of the Internet (and the securities markets,
including the microcap market) must continue, but will never stop all
misguided behavior, just as the regulators cannot catch every broker who
churns senior citizens' accounts nor every cold caller who sells a na‹ve
investor an unsuitable investment vehicle. Similarly, while the SEC's efforts
to make more information available about individual microcap companies
will shed light upon a shadowy corner of the securities markets, it won't
solve everything.
If government regulation and enforcement are medicine to cure the disease
of securities fraud, then the public needs pre-emptive immunization, too.
That immunization is education.
b. Education.
If people knew enough not to make investment decisions based upon tips,
rumors, and touts, but to do their homework, they wouldn't fall for most
stock frauds. The SEC has played an active role in trying to educate
investors. In truth, though, they have a gigantic task. They face massive
financial illiteracy in this country (though not nearly so substantial as that
across the world), because a great number of Americans are never taught
basic principles of personal finance in school or at home. For instance,
many people graduate from high school without understanding the effects of
compounding credit card debt (or investment returns), let alone how to plan
for retirement. What flows from that lack of training are savings and
investment plans that are either too risky (i.e., lotteries, casinos, sports
betting, options, futures, and commodities trading, or daytrading), or that
are too careful (i.e., 33% of all 401k plan money is sitting in money market
funds).
In addition, let me outline a few other facts that I think underline the lack of
fundamental financial knowledge in this country:
Money continues to pour into managed mutual funds, including energetically
managed funds with high fees that may turn over their portfolios like day
traders. This while more than 90% of all managed stock funds have
underperformed the stock market's average return in the 1990s. In short,
people are richly rewarding money managers for reducing their returns.
The average American family has $5800 of credit card debt at 19%
interest, even while increasing numbers of them are investing in stocks. With
that interest rate on their debt, individuals would have to make historically
unprecedented stock market returns over a long period of time just to stay
above water. The best investment these investors could make would be to
pay off their credit cards first.
If we, as a country, are concerned about citizens' ability to control their
own financial futures, to avoid fraudulent offerings, to sidestep poor
investment vehicles, and to rely less on government in the decades to come,
then this ignorance is our greatest obstacle.
At The Motley Fool we coach a few commonsense principles to help
individuals make sense of the money world. We advise that they do their
own homework, understand what they own, not act on tips, and not
instinctually believe the conventional wisdom that professionals in the
financial-services industry know what they're doing and have their clients'
best interests at heart.
If something sounds too good to be true, it probably is. If someone implies
that you must act now to win big, skip it. Finally, the only surefire way to
get rich is to be patient, to learn more about investments, to understand the
role of money in the world, and to know thyself. Though unoriginal, these
are principles that have served us and our community well.
c. The Future of Online Trading
Finally, I'm often asked what I make of the growth in online trading.
First, I'm certain that online trading represents the future of the securities
industry. Digital transactions are more efficient, more transparent, and less
expensive than their analog counterparts. More than half of all
discount-brokerage trades occur online today; over the next ten years, it's
clear that well more than half of all stock-market transactions will originate
on the Internet.
Because these transactions will occur on a medium that allows for greater
communication than any before it, I'm supremely optimistic about the
long-term effects of online trading. I believe that twenty years from now,
tens of millions of Americans will be in control of their money, and thus, in
control of their future opportunities.
But as happy as I am about the stock market's land rush online, I'm pleased
that this committee is paying attention to what will happen to investors once
they arrive in digital domains. If investors are not warned about the
potential pitfalls, many will suffer losses both trivial and tragic. Yet, also, if
online areas are not allowed to flourish without burdensome regulation, we
can expect nothing more than the same ignorance that has offered subpar
standards of living for tens of millions of people in what is certainly the most
prosperous nation on the planet.
Thank you for giving me the opportunity to address this Subcommittee. I
would be happy to answer any of the Subcommittee's questions.
Agree? Disagree? Talk about Tom's Testimony!
</SPECIAL FEATURE>
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