upside.com
September 25, 1998
By Geoffrey James
Scams on the Internet
The Internet and the online trading environment it supports put enormous power in the
hands of entrepreneurs and investors: Entrepreneurs can make customers immediately
aware of their companies and products, and investors can quickly and easily put their
money into stocks and investments that might otherwise be neglected.
But trouble is brewing in this fiscal paradise as growing numbers of criminals are using
the Internet to promote fraudulent stock schemes and encourage investors to make
questionable investments. Such nefarious dealings may in the long run injure the
legitimate market for online securities trading and e-commerce.
"The Internet is a cheap and efficient way to reach a large number of people quickly,"
explains Erich Schwartz, assistant director of enforcement at the Securities and
Exchange Commission (SEC). "And there are people who are going to take advantage
of those efficiencies to carry out securities fraud."
The problem has grown so large, in fact, that the Federal Trade Commission (FTC)
receives as many as 1,500 complaints a day, and that number is increasing, according
to Paul Luehr, chairman of the FTC's Internet Coordinating Committee. To make
matters worse, a disproportionate number of complaints center around bogus high-tech
companies, which may make it difficult for high-tech startups to use the Web to attract
and retain new investors.
A 'SEXI' deal
Make no mistake, criminals are entrepreneurs. And, like other business people, they
understand the huge growth potential the Internet offers for their "businesses."
Because it's easy to set up and publicize a stock offering on the Internet, criminals can
mount a stock scam at a fraction of the cost it would take to do so via traditional
methods. They can pepper the Web with bogus press releases, product catalogs,
investor endorsements, analyst white papers and all the trappings of a legitimate
investment opportunity. "The crimes are the same, and crooks are the same," says John
Reed Stark, chief of the office of Internet enforcement at the SEC. "But the new
medium allows them to commit their crimes cheaply, immediately, efficiently and
worldwide--right from their living rooms."
This comes as no surprise to veteran stockbroker Kevin Ameling. After hearing about
a McLean, Va.-based company called Systems of Excellence Inc., Ameling logged
onto the Web and discovered that the company (which traded on Nasdaq under the
symbol SEXI) was getting plenty of positive buzz in discussion groups. Postings
claimed SEXI had the most efficient, cost-effective videoconferencing
software/hardware on the market, comparing it favorably to competitive products from
Intel Corp., PictureTel Corp. and Sun Microsystems Inc. The stock was also highly
recommended on what appeared to be an online investors' newsletter called SGA
Goldstar Whisper Stock. On the strength of all this information, Ameling shelled out a
big chunk of cash to buy shares in what promised to be (as some of the postings put it)
"the next Microsoft."
Unfortunately for Ameling (not to mention hundreds of other investors), SEXI didn't
have a salable product. According to SEC documents, former Systems of Excellence
chairman Charles Huttoe had been allegedly issuing bogus press releases to create a
positive impression of the company. The SEC also alleged that Huttoe gave free SEXI
stock to Theodore Melcher, publisher of SGA Goldstar Whisper Stock, in return for
his glowing endorsement. As the price of SEXI stock rose on the basis of fake news
and rosy recommendations, the value of the shares held by Huttoe and Melcher kept
rising.
The stock eventually tumbled from a high of $4.70 in June 1996 to a low of about a
penny per share in April 1997. Ameling was lucky: He got out early (losing $5,000).
Other investors, however, lost everything they had put into the company.
In November 1996, Huttoe pleaded guilty to money laundering and violation of
securities laws, and received a 46-month prison sentence. Melcher pleaded guilty to
stock fraud and was sentenced to a year in prison and fined $20,000 by a federal
judge in September 1997--this despite the fact that SGA Goldstar has published a
disclaimer for the past several years stating that it's not an investment adviser. (SGA
Goldstar management maintains that had they known SEXI was issuing false press
releases, they would never have recommended purchasing the stock.)
Pump and dump
The Systems of Excellence debacle is the high-tech version of the infamous (and
age-old) "pump and dump" routine. Traditional pump-and-dump operations are run out
of "boiler rooms" filled with telemarketers who use high-pressure sales tactics to get
regular folks to buy questionable stock. The artificial demand they create causes the
stock price to rise, at which point the investors who are "in the know" sell their shares,
and the investors who bought from the boiler room are left with a portfolio of toilet
paper.
Systems of Excellence, however, was never pumped up by a boiler room operation.
"Unsolicited phone calls from brokers were not a significant portion of the sales of this
stock," explains the SEC's Schwartz. Instead, SEXI was promoted--at far less
cost--directly over the Internet. Furthermore, the scam benefited from the ready
availability of online trading, which made it all too easy for Web-enabled investors to
buy SEXI shares.
"Systems of Excellence is the poster child for Internet hype," says the SEC's Stark.
"Here you have a company that never sold a product that suddenly achieves a market
capitalization of $350 million, mostly because of promotion on the Internet."
Buy now, cry later
Unfortunately, Systems of Excellence is far from unusual, according to Stark, who also
cites the case of Acton, Mass.-based Electro-Optical Systems Corp., which professes
to have developed an advanced methodology for computerized fingerprint verification.
This company, traded on the over-the-counter market under the symbol EOSC,
appears to be an excellent example of how online trading makes it easier for
prospective investors to get wrangled into pump-and-dump fiascoes.
According to Stark, Electro-Optical Systems issued false information, claiming deals
with nonexistent customers. This, in turn, inflated the company's share price to a high of
nearly $7 in February 1998. At that point, former company officers dumped about 2
million shares of EOSC stock onto the market. According to Stark, small investors
used online broker accounts to snap up most of these overpriced shares. Needless to
say, the majority of these investors lost their money. (In mid-August, EOSC shares
were trading at 37 cents.)
On March 13, the SEC filed a complaint in the U.S. District Court for the Southern
District of New York, alleging the defendants defrauded investors under the Securities
Act of 1933. The same day, Judge Denise Cote signed a temporary restraining order
freezing the company's finances and blocking the sale of any shares held by the
defendants. On April 20, the judge entered a preliminary injunction extending the
company-asset freeze. In the April 20 court filings, Judge Cote said the defendants "set
in motion a plan that had little to do with raising funds" for the company but instead
"was designed to line their pockets."
An Electro-Optical Systems official, who declined to be named, points out that the
stock owned by employees, officers and directors (unlike the stock owned by the
former directors) is "restricted," meaning it can't be sold for two years. This makes it
unlikely that current EOSC employees will profit from stock manipulation. SEC
officials, however, say they intend to prove that EOSC management was in on the
scheme because they issued the false press releases that caused the stock to rise so
rapidly.
Geoffrey James (www.businesswisdom.com) is a frequent UPSIDE contributor and
the author of the book Success Secrets from Silicon Valley (Times Books, 1998).
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