Re: 2000 - Indiana Law Journal: "Click Here to Buy the Next Microsoft": The Penny Stock Rules, Online Microcap Fraud, and the Unwary Investor (Part 2 of 3)
III. THE NEED FOR BETTER REGULATION: THREE SCHEMES
However, the question of what exactly should be done with regard to regulation of online penny stock offerings is not easily answered. Investors, such as Janice Shell, may wonder whether any measures taken by the SEC or any other regulatory body will ever prove effective enough to prevent or stop the "exploding" phenomenon of online penny stock fraud.[119] Additionally, the prevalence of microcap fraud over the Internet may create the impression among investors that all online penny stock offerings are illegitimate, thereby damaging an important source of capital for small companies.
Finally, investors may begin to view the Internet as inherently risky for investing if sufficient safeguards against microcap fraud are not implemented, and such a perception may extend to other areas of business which could ultimately hinder the growth of the Internet as a vehicle for commerce.[120] But whatever the measures taken by regulatory agencies to combat Internet microcap securities fraud, the regulations must not be so cumbersome as to impede the development and emergence of small companies whose plans for growth, expansion, or simple survival hinge on the speculative capital investments that investors can provide.
Consequently, the SEC and other regulatory bodies have the task of determining what to do to stem the present tide of penny stock fraud being conducted over the Internet. One viable option that the SEC, the FTC, and the NASD have already implemented, in part,[121] is to conduct a national public relations campaign to educate investors about the risks of investing online and what to do to protect themselves from becoming victims. Another possibility for combating Internet fraud would be to halt, at least temporarily, all online trading in penny stocks as penny stocks are defined in the Penny Stock Rules.[122] While the halt in trading would not entirely prevent penny stock fraud, it would stop at least some of the fraud and alert investors of the risks of penny stock investing over the Internet. Finally, the SEC could amend the Penny Stock Rules to specifically address the issue of Internet penny stock fraud, to eliminate the loopholes in the rules that permit broker-dealers to easily circumvent their requirements,[123] and Congress could significantly expand the penalties for making materially false or misleading statements or omissions.
A. Public Information: Getting the Word out
It would not be difficult to conclude from the multitude of penny stock scams present on the Internet [124] and the corresponding number of victims [125] of such scams that investors have had little or no warning about the dangers of investing in penny stocks offered online. However, the SEC, the FTC, the NASD, and NASAA have all taken steps to advise caution to investors and have provided investors with a variety of tips on how to research an online offering of a penny stock.[126] What is not certain is how widespread the warnings need to be in order to be effective.[127] Given the amount of penny stock fraud presently occurring on the Internet, investors are obviously not educated enough to avoid the risks of investing online.
Accordingly, as one possible solution to the burgeoning amount of penny stock fraud occurring online, the SEC could launch a national public relations campaign to educate investors about Internet penny stock fraud and to encourage them to take the affirmative steps necessary to prevent themselves from becoming victims. The program would have the advantage of being relatively simple to implement, provided that the SEC and other regulatory bodies could arrange for the funding to be allocated, and would constitute a proactive step that would alert all potential investors rather than the purely reactive stance that the SEC has taken thus far.[128] Additionally, a nationally conducted education campaign for investors, if conducted via print, television, radio, as well as the Internet, would have the desired effect of alerting the public at large to the risks of penny stock investing over the Internet. Finally, a national education campaign would not require any substantial rewriting of federal securities laws or regulations to accommodate the Internet as a new medium for offers, sales, and trading of penny stock.
But even if such a campaign succeeded, it might not wholly serve the purpose of federal securities laws, which were created to protect investors and to increase investor confidence in the U.S. capital markets.[129] In other words, the '33 Act was enacted with the "orientation [of] disclosure,"[130] while the Exchange Act was created as "a laundry list of problems for which Congress articulated neither the means nor the end objective" and instead "created the [SEC] and delegated to it the task of grappling with the problem areas."[131] Consequently, while a national investor education campaign on the part of the SEC and other regulatory bodies may increase overall investor awareness of the instances of penny stock fraud being conducted over the Internet, the campaign would not address disclosure by the small companies issuing penny stock nor would it address the issue of investor confidence in U.S. capital markets. As Chairman Levitt has stated, "[t]he SEC's mission is to protect investors,"[132] and that mission would not necessarily be served through alerting investors to the hazards of investing in small-cap stocks on the Internet.
At the very least, however, a public relations campaign could slow down, if not halt, the effectiveness of many of the fraudulent schemes present on the Internet. As Chairman Levitt stated, while speaking of the feasibility of allowing social security funds to be invested in the stock market,[133] investors need to understand "one word . . . and that is risk."[134] Additionally, as Chairman Levitt noted, "a great influx of new investors can sometimes test [the] integrity [of U.S. capital markets] by providing more opportunities for fraud."[135] Certainly the influx of investors onto the Internet has created a multitude of opportunities for fraud and the Internet's current popularity with investors accounts for at least some of the Internet's popularity with penny stock promoters.[136] Consequently, while an investor education campaign may not serve the ostensible goals of federal securities laws or completely halt the amount of securities fraud taking place on the Internet, it may constitute an important first step in educating investors to use considerable caution when investing online in penny stocks.
B. A Temporary Halt in Trading: Drastic Measure or Proportional Response?
The data on Internet penny stock fraud is not entirely reliable, as figures are subject to constant change, but the number of complaints made to the SEC each day,[137] as well as the numerous stories of investors who have been defrauded, suggest that the problem of Internet penny stock fraud is spiraling out of control.[138] If Chairman Levitt is correct in saying, while speaking of the proposed investment of social security funds in the stock market, that "novice investors are our society's most vulnerable citizens,"[139] then perhaps the drastic measure of having the SEC temporarily halting online trading in penny stocks, as they are defined in the Penny Stock Rules,[140] is warranted.
While the prospect of halting online trading in small-cap stocks may seem excessive to those unacquainted with the growing problem of Internet securities fraud, the current regulatory actions by the SEC and the FTC, as well as by self-regulatory agencies such as the NASD, are not effective.[141] In fact, the goal of creating and maintaining investor confidence in U.S. capital markets has already fractured, as can be seen, for example, in the formation of "cybervigilante" groups who police the Internet themselves.[142] Additionally, in light of the disparity in investor complaints to the SEC and the number of enforcement actions against online stock promoters that the SEC pursues, it seems evident that the SEC cannot meet its obligation to protect investors.[143]
A temporary halt in online trading would draw attention to the problem of Internet securities fraud in a dramatic fashion, and would also allow regulatory agencies to address the backlog of cases that may have accumulated and to devote more resources to investigating and prosecuting investor complaints. Second, a temporary halt in online trading would deprive penny stock promoters of their most needed resource: capital from unwitting investors. Third, a move of this sort may very well send a message to investors that the SEC and other regulatory bodies are taking appropriate steps to restore investor confidence in online trading.
Of course, regulators will not likely implement such a draconian solution for a variety of reasons. Principally, regulators would most likely fear the damage that would be done to legitimate small issuers whose survival depends on the speculative capital provided by investors. Such small companies might have to suspend or downsize their operations if investors were suddenly prohibited from making online trades. Moreover, as this Note discussed,[144] the many investors who trade over the Internet trade heavily in the stocks of small issuers,[145] although the overall benefit to capital markets of increased trading in penny stocks is somewhat questionable.[146] Another factor that the SEC and other regulatory bodies must consider is competition from the capital markets of other countries.[147] A halt in online trading by the SEC could necessarily only apply to the territorial boundaries of the United States, which would mean that penny stock offerings from other countries would continue unabated. An additional concern is that U.S. regulatory agencies could garner a reputation-particularly outside of the United States-for enforcing even more stringent and paternalistic regulations than are presently in place,[148] and such a perception among foreign issuers could dampen their willingness to trade on U.S. exchanges.[149]
Furthermore, the SEC might very well find its backlog of complaints from investors actually increasing from a temporary halt in online trading because not all issuers or promoters would stop offering penny stocks to investors. Con artists such as Matthew Bowin [150] routinely operate outside the boundaries of federal securities laws and apparently are undeterred by the possibility of civil and criminal penalties.[151] Likewise, penny stock promoters may simply change their offerings enough to evade the definition of penny stock as found in the Penny Stock Rules [152] and so evade any outright violation of a mandatory halt in trading.
Ultimately, then, while a halt in Internet trading of penny stocks may be desirable from an enforcement standpoint, the logistical and practical difficulties of such an action by the SEC would likely render it impossible to carry out. Therefore, the question of what to do about the explosion of penny stock fraud on the Internet still remains unanswered.
C. New Regulations and Strict Liability
If a campaign to educate investors is unlikely to stop them from purchasing penny stocks of questionable value, and a halt in online trading of penny stocks is impractical or impossible to execute, another solution must be contemplated. When the SEC enacted the Penny Stock Rules, the medium for trading such securities was the over-the-counter market.[153] At that time, very little securities trading took place online compared to the present, and the Internet had yet to assume its current commercial importance.[154]
The massive growth of the Internet as a commercial tool necessitates reevaluating how the SEC should regulate Internet stock trading in order to protect consumers. For offers, sales, and trading of securities, such a reevaluation means creating rules that are specifically tailored to the Internet and that address how investors should be protected in this new environment. Traditional, paper-based disclosure methods will be ineffective as will mandates that state that electronic submission of such forms will satisfy disclosure requirements because it is impossible to know if investors have actually received them since there is neither physical, tangible proof of their delivery nor is there any way to know if they will be delivered in time for investors to peruse them before making an investment decision.
What is needed is a set of specific rules that address how online buying and selling of securities should take place, which method for disclosure of information over the Internet should be used, what safeguards should be in place to protect investors, and how a stricter set of penalties for violations of federal securities laws should be implemented. Such a solution will not, of course, completely prevent fraud from occurring on the Internet, but the enactment of these types of provisions would at least provide mechanisms that would reduce the amount of fraud by making it harder to commit and by adding a deterrent effect that so far has been missing from federal securities laws.
1. Penny Stocks: Who Should Sell and Who Should Tell
One of the most problematic areas of the Penny Stock Rules is actually not found in the "Penny Stocks" section of the Exchange Act [155] but is instead located within the definition of penny stocks themselves along with a corresponding list of exemptions.[156] The difficulty with the list of applicable exemptions for penny stocks is that issuers and broker-dealers find it relatively easy to avoid their provisions, thereby divesting the Penny Stock Rules of much of their regulatory importance.[157] As O. Douglas Hernandez, Jr., points out, the definition of penny stocks leaves substantial gaps through which unscrupulous stock promoters may slip while defrauding investors:
Penny Stock Rule 3a51-1 modifies the definition of penny stock by exempting certain kinds of equity securities from the definition. The purpose of Rule 3a51-1 was to limit the heightened disclosure requirements under the [Penny Stock Act] to those low-priced, lightly-traded securities that have proven most susceptible to fraudulent sales practices.
. . . .
The SEC's narrowing of the definition of "penny stock" is problematic for two reasons. First, broker-dealers can circumvent the protections enacted under the Penny Stock Rules by simply issuing securities that do not fall within the scope of the narrowed definition. . . . Second, securities priced at any level may be subject to market manipulation by broker-dealers. For these reasons, the SEC should have utilized a net capital standard . . . to define a penny stock, rather than the per-share price of an issuer's security.[158]
According to Hernandez, the solution that the SEC ought to have enacted would be to define a penny stock by the "net capital" of its issuer, which would presumably allow the SEC greater flexibility in identifying thinly capitalized issuers who are likely to be used in a market manipulation scheme.[159] With such a definition for penny stocks, issuers cannot as easily evade SEC disclosure requirements, which were principally the focus of the Penny Stock Act.[160]
But a change in the definition of a penny stock is only a beginning in making disclosure requirements for penny stock promoters less easy to evade. In the context of offerings made over the Internet, issuers, broker-dealers, and other market participants should not be permitted by the SEC to make any solicitation or accept "buy" offers from investors until the full disclosure intended behind Schedule 15G of the Penny Stock Rules [161] is delivered to prospective purchasers of a security. Such a disclosure could be accomplished by requiring "pop-up" screens [162] to appear before investors could make a purchase, as one possibility. Or, as another possibility, the SEC could require investors to click on a "link" that would take them to a website maintained by the SEC or one of the self-regulatory agencies, such as the NASD, before completing a purchase of penny stock. Yet another possibility would be for offerings to be conducted through a broker-dealer or issuer who has established a "password" system [163] that would certify that investors had been provided with the necessary disclosure documents and had still elected to purchase penny stocks. By enacting such steps, and taking advantage of the technology that the Internet offers, rather than attempting to make the antifraud provisions of the '33 Act and the Exchange Act fit, however awkwardly, into the present state of Internet offerings and trading of securities, the SEC could more effectively ensure that investors have all the necessary data to make an informed investment decision.
Effectively, then, the SEC would make penny stocks a "controlled" security, in the context of the Internet, insofar as investors would need to complete a series of steps in which disclosure documents were provided that would advise them of the potential risks involved before they could complete a purchase. Such provisions for Internet delivery of disclosure documents would follow the general mandate of Penny Stock Rule 15g-100, [164] but would provide some specific guidance for Internet penny stock offerings. The provisions also would specify the method of delivery over the Internet, which is important due to the problem of e-mailing disclosure statements, which could prove difficult for issuers to prove in retrospect and easy for investors to ignore given the amount of "spam" (junk e-mail) currently sent over the Internet.
The foregoing does not mean that investors would not still make purchases of penny stocks or that such purchases would result in financial losses to the investors. But, at the very least, investors would actually have received disclosure documents such as Schedule 15G [165] before making the decision to purchase a penny stock online. The SEC could further protect investors by simply narrowing the types of broker-dealers or issuers who may offer securities over the Internet. A restriction specifying that only issuers who, say, agree to only solicit for a specific dollar amount within a given year [166] after they have been given an effective registration statement by the SEC [167] before they can solicit for penny stock online would help reduce the incentive that many "boiler-room" firms have to make a large profit at the hands of unsophisticated and inexperienced investors. Other issuers who wished to solicit more than the annual dollar cap would need to seek a no-action letter from the SEC before they could proceed with an offering. Broker-dealers who wished to solicit investors online for penny stock offerings could be required by the SEC to meet a higher than usual professional standard and to not have been the subject of any enforcement proceedings by the SEC under the SEC's broker-dealer standard setting authority in § 15(b)(7) of the Exchange Act.[168] The imposition of stricter requirements for the types of issuers and broker-dealers who are able to effect penny stock transactions online, as well as more specific methods for online disclosure, would enable the SEC to make the Internet safer for would-be investors in the small-cap market.
2. Strict Liability for All and Heavier Penalties
In addition to policing the types of issuers and broker-dealers who wish to offer penny stock online, and specifying the methods by which penny stock may be offered online, the penalties for committing fraud need to be more substantial in order to have the desired deterrent effect.[169] Also, the imposition of strict liability for anyone who stands to benefit financially, directly or indirectly, from the activities of penny stock promoters could potentially expand the class of defendants against whom an action may be pursued. Presently, the liability for material misstatements or omissions in a registration statement, for instance, subjects only the issuer to strict liability.[170] Expansion of strict liability to anyone connected with preparing the registration statement when made via the Internet would create a greater incentive on the part of those preparing the registration statement to avoid being involved in the creation of shell companies that are the preferred issuer of penny stock promoters.
Moreover, the imposition of a "scienter" requirement for Exchange Act Rule 10b-5 by the Supreme Court in Ernst & Ernst v. Hochfelder [171] necessitates a rethinking of the language in § 10(b) of the Exchange Act [172] on which the Hochfelder Court premised its decision.[173] Obviously, the imposition of a scienter requirement by the Hochfelder Court makes an action against a penny stock promoter, for example, harder to pursue because satisfying that a promoter had "a mental state embracing intent to deceive, manipulate or defraud"[174] is clearly quite difficult to prove in retrospect because such a required mental state is necessarily a nebulous and subjective standard which cannot be established except through inference or confessions of guilt by the accused. This is particularly the case in the context of the Internet, where evidence of communications that might demonstrate such a mental state may prove impossible to obtain in any tangible, permanent form, given the transitory nature of e-mail and other Internet communications. A redrafting of the language in § 10(b) of the Exchange Act [175] that specifically did not use the term "employ" might allow the SEC to institute an action under Rule 10b-5 that did not require scienter.[176]
Criminal sanctions should likewise be easier for prosecutors to bring against Internet penny stock promoters. For instance, under the wire fraud statute,[177] "the government must establish that the defendant had knowledge of a scheme to defraud."[178] As Cox points out, a scienter requirement for the wire fraud statute may allow salespersons who sell fraudulent investments to evade criminal sanctions if the government cannot prove that the salespersons knew that the investments were fraudulent.[179] In the context of Internet penny stock promoters, it may prove very difficult indeed to demonstrate that the salesperson was aware or should have been aware [180] that the scheme was fraudulent since the communication from salesperson to investor may consist of e-mail or other electronic communications that are not tangible and permanent in nature. Web pages, links, and online "newsletters" present even trickier questions, because they only give out information or advice that the creators of such pages may assert was provided to them by a third party and so escape criminal penalties under the wire fraud statute.
Overall, a redrafting of the securities laws establishing strict liability in the context of Internet offerings would offer a relatively streamlined system for pursuing enforcement actions as well as deterring future violations of securities laws by expanding the potential class of defendants in enforcement proceedings. While such harsh penalties may not be appropriate for paper-based penny stock promotions, the Internet facilitates such promotions and greatly expands the potential number of victims exposed to penny stock schemes. Given the fact that Internet use for securities trading is relatively still in its infancy but is expected to more than triple in use over the next few years,[181] Congress and the SEC need to enact a more readily applicable set of penalties to discourage Internet stock fraud.
Clearly, then, the Internet presents a unique challenge to enforcement of federal securities laws that is unlike any previously faced by the SEC and federal prosecutors. A fundamental rethinking of the sanctions, burdens of proof, and the liability for the commission of securities fraud is necessary if the enforcement actions against Internet penny stock promoters are to be successful enough to provide the needed deterrent effect on potential future violators.
IV. CONCLUSION
Penny stock fraud over the Internet potentially presents one of the most serious threats to the stability of U.S. securities markets that has yet been encountered, due to the ease with which penny stock promoters may reach substantial portions of the U.S. population. Currently, penny stock promoters freely operate in an environment that poses little real risk or cost-financial or otherwise-to themselves while the funds of thousands, potentially millions, of ordinary investors are continually drained away by the promoters' fraudulent schemes. While the SEC and other regulatory bodies have taken commendable steps to educate and protect investors, the sad fact is that by the time action is taken against a penny stock promoter, the funds of investors have disappeared without a trace. In order to ensure investor confidence in the Internet as a medium for investing, and to protect the funds of investors from fraudulent schemes that may leave such investors penniless, the securities laws must reflect a newfound intolerance for securities fraud conducted through the Internet.
(continued...) |
