Re: 2000 - Indiana Law Journal: "Click Here to Buy the Next Microsoft": The Penny Stock Rules, Online Microcap Fraud, and the Unwary Investor (Part 1 of 3)
"Click Here to Buy the Next Microsoft": The Penny Stock Rules, Online Microcap Fraud, and the Unwary Investor
KEVIN C. BARTELS *
I. INTRODUCTION
Investment fraud is a time-honored tradition. As far back as the 1700s, con artists on London's Exchange Alley were using a "pump and dump" scheme to defraud investors.[1] The "pump and dump" scheme used by con artists in eighteenth century London was simple but effective: the price of worthless shares of the "South Sea Bubble," a South American trading company, was inflated by false rumors of profitability spread about the company by owners of the shares, who then sold the shares at a substantial profit after the price of the shares increased.[2] The "pump and dump" scheme has since continued through the present day and has enriched a very few unscrupulous sellers at the cost of tens of thousands of investors.[3] Recently, though, the age-old schemes used by swindlers to sell phony or vastly inflated shares of stock have moved fully into the digital age: investors are now being duped over the Internet.[4] In fact, the number of fraudulent offerings of securities is predicted to grow as the number of investors trading online grows.[5] Historically, the existence of securities fraud in the United States has led to attempts by Congress to stem its growth, but what can or will be done about securities fraud conducted over the new medium of the Internet remains a matter of some speculation.
Indeed, much of U.S. securities regulation has focused on the prevention and punishment of fraud, and it was the abuses that contributed to the Stock Market Crash of 1929 that prompted Congress to enact the Securities Exchange Act of 1934 ("Exchange Act").[6] The Exchange Act attempted to curb securities fraud through the establishment of the Securities and Exchange Commission ("SEC") and the creation of a comprehensive regulatory scheme designed to manage and oversee trading on the stock exchanges.[7] The Exchange Act, fueled by congressional dissatisfaction over perceived speculation and manipulation of stock prices, provided restrictions on practices such as short selling and options trading, and, in § 9(a), prohibited specific manipulative practices in connection with stock exchange trading.[8] Additionally, the SEC was given its own enforcement tool to combat securities fraud in § 17(a), which prohibits fraud in "the offer or sale of securities."[9] Later, § 10(b) was added to the Exchange Act and it has since become the workhorse of the securities fraud regulation under the Exchange Act, since it is not explicitly connected to exchange-based trading and because so much of the activity associated with speculation and manipulation of securities occurs outside stock exchange trading.[10] But in 1990, Congress sought to expand the remedies under the Exchange Act for fraudulent activities made in connection with a stock sale or purchase due to the spiraling abuse of "penny" or "microcap" stocks.[11]
Traditionally, stock swindlers have preferred microcap or penny stocks for their offerings since microcap securities for little known, thinly traded companies are often difficult to research and their shares are frequently not quoted on a daily basis.[12] Congress, in 1990, attempted to deal with the problem of microcap securities fraud through the Securities Enforcement Remedies and Penny Stock Reform Act ("Penny Stock Act").[13] Pursuant to the Penny Stock Act, the SEC enacted the Penny Stock Disclosure Rules ("Penny Stock Rules"),[14] which require broker-dealers engaging in penny stock transactions to provide certain information about the nature and risks of penny stocks to their customers before completing any sale.[15] However, the Penny Stock Act has proven to be mostly a paper tiger since its provisions, as adopted by the SEC in the Penny Stock Rules, can be easily circumvented simply by evading the statutory definition of a penny stock as set forth in Rule 3a51-1. [16] Consequently, microcap securities fraud has continued more or less unabated through to the present day.
But the Internet presents an even more alarming scenario for investors: sites are springing up daily that are either completely fraudulent, as was the case with one site that proclaimed itself to be "‘[t]he next Microsoft,'"[17] or are materially misleading as to their expected profitability and stock value.[18] The prevalence of microcap, or penny stock, fraud on the Internet will likely assume greater significance in the future, as online trading is expected to grow substantially in the next few years,[19] which will make greater numbers of investors open to the types of online securities fraud that have previously ensnared relatively few investors. Accordingly, the Penny Stock Rules, as well as the antifraud portions of the Exchange Act, need to be rewritten specifically to include Internet offers and sales of securities in which issuers would be provided with firm guidelines and would be given substantial restraints on the method and manner of offering microcap securities, and to make those who commit fraud or make material misrepresentations of securities subject to stricter civil and criminal penalties.
This Note considers the growth of penny stock fraud conducted on the Internet, the response of the SEC as well as the response of individual investors in combating such fraud, and advances some possible solutions to the problem. Part I provides background on the explosive growth of online penny stock fraud, the response to the fraud by the SEC, and the reaction of groups of investors who, dissatisfied with the perceived ineffectiveness of the SEC, have taken the matter of policing the Internet for penny stock fraud into their own hands. Part II examines three possible solutions to the growth of online penny stock fraud and asserts that specific rules should be enacted by the SEC to govern online penny stock offers, sales, and trading, and that stricter civil and criminal penalties should be put in place to deter future instances of fraud. The Note then concludes that: (1) online penny stock fraud presents a serious threat to investor confidence in the medium of the Internet; (2) online penny stock fraud may ultimately undermine the stability of U.S. securities markets; and (3) online penny stock offerings must consequently be made under stricter regulatory control.
II. PENNY STOCK FRAUD ON THE 'NET, SEC ENFORCEMENT, AND THE "CYBERVIGILANTE" RESPONSE
The Securities Act of 1933 ("'33 Act")[20] and the Exchange Act were created to provide investors with enough information to make informed decisions when purchasing securities and to increase investor confidence in the securities markets.[21] Unfortunately, the lack of adequate regulation over Internet offerings and trading defeats the very purpose of the '33 Act and the Exchange Act due to the burgeoning amount of online securities fraud. According to John Stark, chief of Internet enforcement at the SEC, con artists are practicing every variety of fraud through the Internet, including "‘Ponzi schemes, pyramid schemes, public offerings, [and] oil and gas fraud.'"[22] Much of the fraud, according to the SEC, involves "small-time stock promoters" working out of their homes and small companies who hope to boost the share price of their penny stocks.[23] But while the types of fraudulent securities schemes are as diverse as they are proliferate, the victims of such schemes do not fit any one category.[24] Victims range from so-called "sophisticated" investors, including attorneys, to those who have little or no background or knowledge of securities trading or of investing generally.[25]
A. The Internet, Penny Stocks, and the Con Artist: A Growing Problem
Given the apparent failure of governmental agencies to stem the tide of Internet securities fraud over the Internet, one might conclude that no law or regulation applies to offerings or sales of securities conducted online. But the antifraud provisions of the '33 Act and the Exchange Act,[26] as well as the Penny Stock Rules,[27] do apply to Internet offers and sales of securities aimed at U.S. residents.[28] Arguably, the enactment of the Penny Stock Act put investors on notice of the very risky nature of microcap stocks because broker-dealers are required, under the Penny Stock Rules, to obtain an investor's signature to the Schedule 15G disclosure statement before a sale of a small-cap stock may be completed.[29]
But the Penny Stock Act, as interpreted by the SEC in the Penny Stock Rules,[30] has proven to be mostly a paper tiger due to the substantial loopholes available to sellers of microcap securities.[31] When the SEC enacted the Penny Stock Rules, it was apparently torn between two regulatory goals: (1) the need to combat microcap securities fraud; and (2) the need to ensure that its disclosure requirements were not overly cumbersome to issuers, particularly those issuers who are small, marginally capitalized companies.[32] Moreover, the Penny Stock Rules do not include any provisions for online trading of microcap securities nor do they impose any specific antifraud measures or penalties for the offering or selling of such securities. Accordingly, the application of the Penny Stock Rules, such as the requirement of the signing of the disclosure statement of Schedule 15G,[33] is problematic to enforce and virtually impossible to measure because Internet transactions may be conducted instantaneously and without the need for paper documents.[34]
The need for specific regulations for Internet solicitations and sales of microcap securities is underscored by the very nature of the Internet itself. The explosive growth of the Internet as a medium for commerce [35] is due, in part, to the ease with which products and services can be offered with relatively low cost to sellers.[36]
Consequently, stock promoters find it easy and relatively inexpensive, or even wholly without cost, to tout stocks in "pump and dump" schemes [37] or to give out supposedly impartial investment advice for microcap stocks for which the promoters have actually been paid substantial sums of money by the sellers of the stocks.[38] But the lack of appropriate regulation over the Internet not only causes an increased amount of outright securities fraud, which ultimately undermines investor confidence in the integrity of the securities markets, but also produces an increased amount of market volatility due to the presence of "day traders."[39] Such market volatility adversely affects the overall stability of the securities markets as well as investors who seek long-term investments in legitimate microcap securities.[40]
Currently, the SEC cannot keep pace with even a small percentage of the securities fraud taking place on the Internet.[41] In fact, since the SEC established its investor hotline on the Internet three years ago, the SEC has received about one hundred complaints per day, but only files, on average, one new charge per month against Internet securities promoters.[42] The perception among many investors is that the SEC is relatively ineffectual at combating fraud.[43] Clearly, the actions of the SEC in combating Internet securities fraud, while commendable, are not adequate to the task at hand. Consequently, the SEC needs to develop a more comprehensive approach that actually addresses how Internet securities offerings and sales of penny stocks should be conducted, along with increased penalties for committing fraud, as Internet securities trading grows.
B. The Response of the SEC to Fraud
The SEC, the Federal Trade Commission ("FTC"), the Commodity Futures Trading Commission ("CFTC"), as well as other organizations such as the North American Securities Dealers Administrators Association ("NASAA"), and the National Securities Dealers Association ("NASD"), have all taken action to warn investors of the hazards of trading online.[44] The SEC has also established an online investor hotline [45] and has very recently conducted an extensive enforcement action against several companies and individuals suspected of illegally promoting penny stocks over the Internet.[46] Additionally, the SEC has created a "cyberforce" of SEC investigators, whose task is to police the offering and trading of securities over the Internet.[47] Finally, while the SEC has yet to promulgate a change to the Penny Stock Rules specifically dealing with online trading of microcap securities, it has provided some guidelines regarding the use of Internet websites to offer, solicit, or advertise investment advice offshore.[48] The SEC has also issued an interpretative release detailing how broker-dealers, investment advisers, and transfer agents may satisfy their delivery requirements under the Exchange Act and the Investment Advisers Act of 1940 [49] ("Advisers Act") using electronic media.[50] Additionally, the SEC has indicated some guidelines for issuers in a series of no-action letters that may prove instructive to small companies wishing to offer and sell securities online.[51] However, these measures are, at best, stopgap and do little to stem the rising tide of penny stock fraud and manipulation over the Internet due to the fact that no clear guidelines are present to require broker-dealers, and not just issuers, to disclose the risks of such investments and to specify in what manner such disclosures should be effected.
1. The SEC's Attempt to Warn Investors
The SEC has not been lax in its attempts to warn investors of the hazards of purchasing penny stocks through online offerings or on the basis of recommendations and opinions found in online newsletters or websites.[52] For instance, the SEC has established a Web page that gives investors advice on the hazards of online investing and some practical tips on how to investigate a stock.[53] Additionally, the SEC has conducted town meetings in which it attempted to educate investors on recognizing securities fraud.[54] Moreover, investors can obtain information on issuers, such as a copy of a prospectus, registered under federal securities laws through the Electronic Data Gathering and Analysis ("EDGAR") system, which is available to the public over the Internet.[55]
The SEC's website alert on Internet securities fraud is instructive of the SEC's approach to warning investors of online trading. The site basically encourages investors to use caution when considering whether to invest in an "opportunity" discovered on the Internet.[56] The tips on how to spot fraud include viewing investment advice given in online investment newsletters, bulletin boards, and in e-mail "spams" with a skeptical eye.[57] Other advice given on the SEC website alert to investors suggests that investors "get the facts" before investing by obtaining financial statements from the issuer, verifying the accuracy of the new product claims, calling all the suppliers and customers of the issuer to find out if they "really do business with the company," and finding out if the "people running the company . . . [have] ever made money for investors before."[58] Additionally, the SEC recommends that investors check EDGAR to see if the issuer is registered with the SEC.[59] The site also encourages investors to check with state securities agencies to see if they can provide more information about a "company and the people behind it."[60] Finally, the site concludes with a brief description of the various types of securities fraud and a list of some of the enforcement actions recently conducted by the SEC.[61]
However, while the advice offered by the SEC on its website is generally sound, investors may not heed it or give it appropriate weight in making investment decisions.[62] In fact, the evidence of past SEC enforcement actions,[63] or of the stories of investors who have been defrauded,[64] suggests that investors will probably not take the time-consuming steps necessary to determine whether a given piece of investment advice is legitimate. The lure of making an easy profit seems, for many investors, to be the overriding concern in making investment decisions.[65] Additionally, as stated before, the ease with which con artists can set up detailed and seemingly legitimate websites tends to undercut any attempts to discern whether such sites are actually fraudulent simply by viewing them online.[66]
Accordingly, the only valid method for investors to determine whether a penny stock investment is legitimate is to follow the advice of the SEC website and verify new product claims by the issuer, review the issuer's financial statements, call the issuer's customers and suppliers to find out if they actually do business with the issuer, and check the EDGAR system for registration with the SEC.[67] Unfortunately for investors, however, the very steps recommended by the SEC are oftentimes extremely difficult or impossible to perform due to the very nature of penny stocks.[68] Additionally, as the SEC notes on its website, it may exempt some companies from registration requirements or require them to file only a "brief notice" that gives the names and addresses of stock promoters but "little other information."[69]
As stated earlier, the reason so much securities fraud involves penny stocks is because such stocks are very often difficult, or even nearly impossible, to research and investigate.[70] Stock promoters, whether operating out of a "boiler-room"[71] using a telephone and a scripted sales pitch or using a PC and a Web page, overwhelmingly prefer penny stocks for scams for the very reason that penny stocks oftentimes cannot be sufficiently researched by investors.[72] Consequently, investors are left to make an investment decision based only on the recommendation of the stock promoter's sales pitch or website. Finally, investors who place a phone call to a state securities office may discover little, as the resources of state securities divisions are often overtaxed in dealing with more conventional types of fraud and are generally unable to combat Internet fraud.[73]
2. The SEC's Enforcement Efforts
But the efforts of the SEC in combating online securities fraud are not limited to just investor education. Recently, the SEC completed an aggressive enforcement "sweep" against a variety of penny stock promoters which resulted in at least one criminal conviction and several large civil penalties.[74] The crackdown on Internet securities fraud, which consisted almost wholly of various penny stock promotion schemes,[75] stemmed from the SEC's "cyberforce" of investigators whose job is to police the Internet for potential violators of federal securities laws.[76] The Office of Internet Enforcement at the SEC ("OIE"), in addition to policing the Internet for potential cases of securities fraud, will also train law enforcement officials in other agencies to spot Internet fraud.[77] According to the OIE, the SEC receives about 120 complaints per day alleging securities fraud.[78]
Of course, the SEC is not able to act on all the complaints it receives even in a single day, even if each complaint proved to be factually accurate.[79] In the past year, the SEC was only able to bring thirty-eight actions against online stock promoters, which was a dramatic increase from the enforcement actions of previous years.[80] Given the increased amount of both online trading and online securities fraud, the SEC's Enforcement Division is likely to face considerable obstacles in attempting to respond to the numerous complaints from investors about suspected cases of illegal stock touting.
3. The SEC's Guidelines for Internet Offers and Sales of Securities
The SEC has also attempted to provide some guidance to issuers and broker-dealers who wish to offer and sell securities online. Initially, the SEC addressed the delivery of information by issuers, broker-dealers, and other "market participants" through a series of no-action letters.[81] An interpretative release from the SEC subsequently followed in October 1995, which detailed its views on the electronic delivery of prospectuses, proxy solicitation materials, and annual and semiannual financial reports.[82] In the release, the SEC acknowledged the '33 Act and the Exchange Act do not prohibit electronic delivery of information by market participants but that such delivery should include information equal to that found in paper-based mediums.[83] The SEC also indicated in the release that electronic delivery of information should provide "timely and adequate notice" to investors that such information is available, that access to such information should be as readily available in the electronic format as it is in the paper context, and that some evidence of the delivery of such information to investors through an electronic format should be provided.[84]
Additionally, the SEC issued another interpretative release in May 1996 that provided more guidance to broker-dealers, transfer agents, and investment advisers on how to use electronic media to comply with the delivery requirements of federal securities laws.[85] Essentially, the release emphasized the same requirements of the earlier release-notice of delivery to investors, comparable information available in a paper context, and some evidence of delivery to investors-but differed in a couple of important respects.[86] First, the May 1996 release specified that evidence of delivery could be established by obtaining the investor's "informed consent to electronic delivery . . . obtaining actual evidence of receipt through, for example, a return receipt electronic mail message . . . or . . . disseminating information through certain facsimile methods."[87] Moreover, the release stated that broker-dealers should take "reasonable precautions" to preserve the confidentiality of the personal financial information that they have collected on their customers.[88]
The SEC has also taken some tentative measures in a series of no-action letters to establish how securities may be distributed over the Internet as, for example, it did in the case of an initial public offering ("IPO") for a small, marginally capitalized issuer.[89] In the case of one small issuer, Spring Street Brewery ("Spring Street"), the SEC initially approved the issuance of its small-cap stock and also approved the creation of a bulletin board for Spring Street-Wit-Trade-which was to facilitate the trading of Spring Street stock.[90] The SEC, however, shut down Wit-Trade soon after it commenced operations but later allowed it to resume business after agreeing to disclose to investors that the trading of Spring Street stock by Wit-Trade was inherently risky due to the fact that the stock was speculative and relatively illiquid.[91]The SEC granted another no-action letter to IPONet, a Texas company that placed public offerings of securities on the Internet, in July 1996. [92] In its no-action letter, the SEC specified that IPONet was liable for any misstatements or omissions on its website.[93] IPONet responded to the SEC's restrictions by creating a system that permitted access through a password [94] to only those it deemed "sophisticated" investors.[95]
Finally, the SEC recently issued a release detailing the use of Internet websites to "disseminate offering and solicitation materials for offshore sales of securities and investment services."[96] The release provides the SEC's views on how U.S. federal securities laws apply to "broker-dealers, exchanges, and investment advisers" located outside of the United States who effect solicitation and sales of securities to U.S. residents.[97] The release states that the SEC interprets federal securities laws with regard to foreign offerings or investment advice directed at U.S. residents as not exempt from registration requirements,[98] and gives several suggested "precautionary" methods for foreign offerors to avoid targeting U.S. residents if the offerors do not wish to register with the SEC.[99] Additionally, as the SEC notes, although the release does not address the antifraud and antimanipulation provisions of federal securities laws, the antifraud provisions of federal securities laws will continue to apply to "all Internet activities that satisfy the relevant jurisdictional tests."[100]
While the guidance provided by the SEC has been somewhat helpful in establishing certain limitations for issuers wishing to offer and sell microcap securities online,[101] the no-action letters issued by the SEC as well as its interpretative releases are, at best, partial answers to the overall problem of how small-cap issuers should conduct offerings online. The guidelines provided by the SEC for offers or solicitations of securities made online, as of this writing, do not affirmatively address the prevention of fraud on the Internet other than to state that material misstatements or omissions make the market participant subject to liability under federal securities laws.[102] In fact, the distinct impression that one gets from the SEC's approach to dealing with the problems raised by Internet securities offerings and trading is that no clear consensus exists on how such offerings and trading should take place. At present, no provisions provide either issuers or broker-dealers a clear picture of how to conduct their activities in cyberspace. Without such provisions, legitimate issuers will have to engage in the time-consuming process of seeking a no-action letter in order to make their offering a possibility.[103] More importantly, the lack of guidance from the SEC on the prevention of fraud and the corresponding lack of adequate regulation over penny stock offerings made online will ensure that the instances of microcap fraud will continue to be difficult to recognize, as investors will not be able to refer to any benchmark for determining whether a given website offering or touting a penny stock is compliant with federal securities laws.
C. The "Cybervigilante" Response
Some investors are unwilling to wait for the SEC or other regulatory bodies to create a new set of rules and penalties for online securities fraud.[104] Instead, these investors have formed "cybervigilante" groups who alert other investors to instances of potential securities fraud.[105] These "vigilantes" warn other investors through establishing links at suspected sites or through e-mail sent to investors detailing the alleged fraud or shady nature of the offered securities.[106] Many of these self-styled "cybervigilantes" feel that the SEC oftentimes reacts too slowly to cases of alleged Internet securities fraud and thereby fails to recover the lost funds of investors in the majority of its enforcement actions.[107]
The lengths to which the cybervigilantes will go to expose potentially fraudulent online investments are impressive. For example, Silicon Investor features a link asking for submissions to the "Scammy Awards,"[108] which were billed as the awards for the Internet's most dubious investment opportunities.[109] On a more serious note, cybervigilantes have been targeting the purveyors of some of the Internet's more dubious investment offerings and advice and have established a "thread"-a series of posted messages-entitled "Stocks That Should Be Investigated by the SEC."[110]
One of the most visible of the cybervigilantes, Janice Shell, is especially notable for her devotion to exposing the various types of penny stock fraud conducted over the Internet.[111] After an Internet stock scam defrauded her a few years ago, Shell dedicated herself to pursuing Internet securities fraud and claims that she has exposed, over the past two years, "an investor relations director with a murder rap, a so-called biotech company that actually sold kitty litter, and a CEO who claimed to have run the largest corporation in Nevada but who was really the head of a two-man air-conditioning repair shop."[112]
But Shell recently took part in a scheme previously reserved only for Internet penny stock purveyors: she staged her own fraudulent Internet IPO on April Fools' Day 1997. [113] Shell's site was for "FBN Associates,"[114] which purported to offer a product called "NeuralNet 2000" that would cure the Year 2000 ("Y2K") bug in "one minute or less."[115] While such a scheme may sound outrageous in retrospect, it successfully generated a number of sincere responses,[116] and Shell claims to have been flooded with requests for prospectuses and additional information about the company.[117] While ostensibly created for satirical effect, Shell's FBN site aptly demonstrates the ease with which enterprising con artists can create sites that, even to a knowledgeable observer, appear perfectly legitimate. Moreover, the very existence of the "cybervigilante" groups points toward a need for more comprehensive regulation of Internet penny stock offerings by the SEC because these groups, who actively investigate and obtain detailed knowledge of various Internet penny stock scams, do not view the SEC's enforcement efforts as having the needed deterrent effect.[118]
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