Internet Financial Chat Rooms Raise Concerns for Regulators, Companies
By Neil Hare
Corporate Law Weekly
December 1, 1999
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While the Internet has empowered American investors with easy access to information and low-cost online trading, the proliferation of false or misleading information in chat rooms and on financial Web sites has raised concerns for securities regulators and public companies.
In a Nov. 22 report on online trading, Commissioner Laura S. Unger of the Securities and Exchange Commission recommended that the agency conduct, or encourage researchers to conduct, a study analyzing the effect of chat room discussions on corporate stock prices.
Unger?s 95-page report summarized the findings from a series of online investing roundtables she conducted earlier this year, the commission explained in a press release. According to the release, the report also focused on issues of suitability, best execution, market data, systems capacity, investor education, privacy, and portals.
Unger remarked that the report "provides the Commission with a comprehensive examination of the critical issues to be addressed in the area of technology." Unger added, however, "it may still be premature for extensive rulemaking in this area."
ONE OF THE ?TOP ISSUES AROUND?
Unger is not the only SEC official to earmark chat rooms and online financial information as an area of concern. Brian Lane, the outgoing director of the SEC?s Division of Corporation Finance, stated Nov. 19 that protecting investors from misinformation online is "clearly one of the top issues around." Lane made his remarks at a meeting of the American Society of Corporate Secretaries held in Washington, D.C.
Lane explained that the commission?s main weapons against the dissemination of false information on the Web are the antifraud provisions -- Section 10(b) of the 1934 Securities Exchange Act, and Rule 10b-5 thereunder -- and the market manipulation provision, Section 9(a)(2) of the 1934 Act. Section 10(b) and Rule 10b-5 proscribe fraud in connection with the sale of a security while Section 9(a)(2) prohibits inducing others to purchase a stock in the hopes of manipulating the price of the stock.
The "problem," Lane remarked, is that both these provisions require a finding that the provider of the alleged false information "intended" to defraud the marketplace. The commission needs "clear evidence" of state of mind to prove market manipulation, Lane stated.
'NO SEC RULEMAKING POSSIBLE'
Harry Weiss, a partner at Wilmer, Cutler, & Pickering, Washington, and a former associate director of the SEC?s Enforcement Division told CLW Nov. 23 that the dissemination of financial information in chat rooms raises several issues for securities regulators and corporations. "I don?t think any SEC rulemaking in this area is possible," Weiss said, "because you don?t want a chilling effect on an open forum, unless, of course, someone is committing fraud. Investors sharing information is to be encouraged."
The only rule Weiss said could possibly address the issue would be for the commission to require companies to police the Internet in search of false information about them. Weiss finds it unlikely, however, that the SEC could impose such a rule.
Weiss explained that under current law, corporations do not have a duty to speak out if they see false or misleading information about them, unless it comes from someone inside the company. If, however, a corporation does respond to false or misleading chat room information, the corporation then has a duty to shareholders to correct the information.
Weiss, however, cautioned corporations against entering chat rooms or responding to false or misleading information disseminated elsewhere. "Once you step into a chat room, you create an expectation among shareholders that you will do it every time and you give investors the idea that you are policing the Internet."
Finally, Weiss predicted that the SEC would continue to enforce fraud and market manipulation on the Internet in hopes of educating investors and scaring off perpetrators of fraud. "The SEC must catch enough people to make an example and send a message: ?you will get caught,?" Weiss said.
SEC?S INTERNET ENFORCEMENT
In a Nov. 18 enforcement action, the SEC showed its willingness and ability to track Internet fraud, when Leszek Zbierajewski, of Chicago, agreed to a permanent injunction for allegedly posting a fraudulent press release on the Yahoo!Finance message board (SEC v. Zbierajewski, N.D. Ill., No. 99C-7539, 11/18/99) (see brief, In the Courts section). The message appeared to be a PR Newswire press release announcing a $89 million strategic alliance between Bid.com International Inc. and America Online, the commission reported Nov. 19.
According to the SEC, the phony message caused the price of Bid.com shares to increase from $8.50 per share to $9.00 per share. After, the hoax, was uncovered, the price of Bid.com returned to its original price, the commission reported.
The SEC?s most publicized Internet enforcement action involved Gary Dale Hoke and his bogus Bloomberg News Service Web page (SEC v. Hoke, C.D. Cal., No. 99-04262 (LBG) (Ex) (LR 16266), 8/30/99). In his remarks, Lane used the Hoke case as an example of the ability of the SEC and criminal prosecutors to show intent to manipulate the price of a security. In that case, Hoke, under an assumed name, posted a message on a Web page falsely reporting that an Israeli company was buying Hoke?s former employer, Pairgain Technology Inc., a publicly traded company. The posting also provided a direct link to the Bloomberg page fabricated by Hoke that announced the acquisition.
In its litigation release, the SEC explained that the publication of this false information created "significant trading activity" in Pairgain securities and caused the market price of Pairgain securities to increase substantially. Once the Web messages were exposed as false, the SEC stated, the price of Pairgain stock "declined precipitously."
Hoke pled guilty to the criminal charges against him in the U.S. District Court for the Central District of California, and received five months of home detention, five years of probation, and was ordered to pay $93,087 in restitution. Hoke also settled the SEC charges without admitting or denying the allegations, and was permanently enjoined from future violations of the antifraud provisions of federal securities laws.
BLOOMBERG V. HOKE
In addition to the federal charges, Bloomberg filed a Lanham Act trademark infringement action against Hoke. The case was settled shortly after the resolution of Hoke?s criminal case, with a court order enjoining Hoke, but without money damages, according to one of Bloomberg?s attorneys, Richard Klein, a partner at Willkie, Farr, & Gallagher, New York.
While Bloomberg was not entirely satisfied with the outcome because it could not recover the "tens of thousands of dollars" spent on investigating and pursuing Hoke, Klein explained that Bloomberg was not going to expend more resources trying to recover against an "empty vessel." Klein added that the Hoke case did show that people "erroneously assume" that they are anonymous when they post messages on the Internet.
Klein further remarked that the statutory and regulatory schemes that currently exist are "an adequate basis for enforcement" on the Internet, but the problem is that "the volume of information both real and fake dwarfs the enforcement resources currently available." Klein was adamant that there is "no hope that the SEC, the state regulators, or federal law enforcement can keep up with," the amount of information exchanged on the Internet.
Klein suggested that companies need to "be vigilant" and monitor what is being said about them on the Internet, and the SEC needs to "make glaring examples of people using the Internet for fraud," like Hoke.
Finally, Klein predicted that fraud on Internet message boards and chat rooms will remain "an ongoing problem."
MOMENTUM, RECOMMENDATION WEB SITES
While Hoke, notably, did not personally trade in Pairgain during the hoax, so-called momentum and stock pick Web sites do attempt to profit from the dissemination of securities information. Momentum and recommendation sites often host chat rooms in addition to providing investment information.
Momentum Web sites are used primarily by investors engaged in a day trading strategy. The sites suggest that investors purchase the same security on the same day and time; as a result, the price is driven up and the securities are sold at a profit.
Such sites can run afoul of federal securities laws by failing to disclose that operators are trading in the securities they discuss, and by falsely advertising their track records. Even if the site sponsors disclose that they are trading in the same securities, they can still violate the law if they sell stocks into their buy recommendations on a consistent basis.
Recommendation sites sell subscriptions to online newsletters dispensing investment advice, and invite investors into chat rooms. These sites are also required to disclose that they are trading in the securities they are recommending or that they are receiving compensation for touting the stocks. In addition, if the sites give advice tailored to individual investors, they can be considered investment advisers, and therefore, are subject to registration requirements.
According to a source inside the SEC?s Division of Enforcement, cases against momentum and recommendation sites are forthcoming. The SEC actions will probably range from market manipulation to inadequate disclosure of trading activity, the source said.
CHAT ROOMS ?UNREGULATED TERRITORY?
Frank Fernandez, the chief economist and director of research for the Securities Industry Association called financial chat rooms "unregulated territory."
According to Fernandez, the Unger report -- and a similar report released Nov. 22 by New York Attorney General Eliot Spitzer -- illustrate that regulators are finally "stepping up and dealing with technology." Fernandez said that the SIA has plans to form an ad-hoc committee to address some of the issues raised in the two reports, in the hope of educating investors.
Fernandez further explained that, traditionally, regulators watched brokerage firms and company insiders for market manipulation and fraud. With the advent of the Internet, regulators "have to watch everybody." According to Fernandez, the real challenge raised by the Internet is tracking the individuals perpetrating frauds, who often remain anonymous. "This places an increase on the burden of regulators," Fernandez said.
Indiana Securities Commissioner Brad Skolnik, who is also the new president of the North American Securities Administrators Association, also expressed concern that chat rooms are creating a new challenge for regulators. According to Skolnik, "regulators monitor these chat rooms and Web sites from time to time, but to be truly vigilant a lot more manpower is needed."
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