Vol. 12, No. 2; Pg. 10
Tombstones: The Internet's Impact Upon SEC Rules of Engagement
By John Reed
Stark*
*John Reed
Stark is special counsel for Internet Projects in the Division of
Enforcement of the United States Securities and Exchange Commission (SEC) and is
in charge of the Division's Internet Program. He is also an adjunct professor of
law at Georgetown University Law Center where he teaches a course on the
Internet and the Securities Laws. The SEC as a matter of policy disclaims any
responsibility for any private publication or speech by any of its members or
staff. The views expressed herein are those of the author and do not necessarily
reflect the views of the SEC or the author's colleagues on the staff of the SEC.
All quotes in the section headings of this article, including the Epitaph (found
at Boot Hill Graveyard in
Tombstone, Ariz.), are from the film
Tombstone (Hollywood Pictures Corporation, 1993), produced by James
Jacks, Sean Daniel and Bob Misiorowski, directed by George Cosmatos and starring
Val Kilmer and Kurt Russell as the famed Doc Holiday and Wyatt Earp.
HIGHLIGHT:
The SEC enforcement program has always evolved to address the ever-changing
dynamics of domestic and global financial markets, and leaving a few
tombstones behind is really nothing new. Yet, the enforcement division
has never before experienced such a rapid and extreme transformation as the one
initiated by the Internet. This article discusses five illustrations of how the
Internet has transfigured SEC enforcement's rules of engagement, not only
changing what to enforce but also changing how to enforce.
"Here Lies Lester
Moore, Shot 4 Times With a 44, No Les, No More."
Interment is never an easy subject to discuss and does not typically fall within
the jurisdiction of the Division of Enforcement of the United States Securities
and Exchange Commission (SEC). But with the on-slaught of the Internet, old
concepts and notions of the traditional SEC enforcement paradigm continue to
sound their own death knell, leaving only
tombstones to mark their passage. As the Internet chisels the epitaphs on
these
tombstones, newborn principles and postulates infuse themselves into the
SEC enforcement program.
The five illustrations that follow demonstrate that the Internet continues to
change the playing field, requiring the SEC enforcement division to modify its
modus operandi and flex its regulatory muscle, to combat this nascent
and potentially dangerous threat to investors. n1 n1 For a thorough discussion
of the SEC's response to Internet fraud and other Internet-related threats to
investors, and an overview of the SEC enforcement division's Internet Program
see, Joseph J. Cella III and John Reed
Stark, SEC Enforcement and the Internet: Meeting the Challenge of the
Next Millennium A Program for the Eagle and the Internet, 52 Bus. Law. 815 (May,
1997).
"I'M Your Huckleberry And That's Just My Game"
The New Cyber Boiler-Rooms
Consider the fictional owner of an imaginary company called PhenomX, a
manufacturer of a purported cure for cancer. To date, PhenomX has not sold any
products, has not hired any employees, has not generated any income from
operations, has only nominal assets, and has just begun to be quoted on the OTC
Bulletin Board. PhenomX has just submitted its application for FDA approval of
its sole drug, which PhenomX's president knows the FDA will reject; he knows
this because the drug is merely coffee grinds in tablet form.
PhenomX's president, his family members and a few friends own all the ten
million shares outstanding. The president, a recidivist scam artist, wants to
pump up the price of PhenomX fraudulently, and sell his shares at the
artificially inflated price. The president has only limited resources to set up
a boiler room or to fund any other network of fraudsters; all he has is a little
capital, a home computer, some Internet-related software, and Internet access.
Unfortunately, that is all he needs. At almost no cost, the president can
conduct an international and sophisticated market manipulation over the Internet
from his own living room. All PhenomX's president must do is to take the four
following steps:
Step 1: The Phony Web Page
The first step for PhenomX's president is to set up a central location on the
Internet where potential investors can find out about PhenomX's miracle drug, in
an interactive and user-friendly environment. On the World Wide Web space
allocated to him for free by his Internet access provider, the president builds
a flashy and elaborate PhenomX Home page.
The page presents a wide range of bogus enthusiastic reports about PhenomX,
including a phony set of financial statements inflating the value of the
potential PhenomX drug's patent and documents bearing the FDA seal with the
actual names of FDA staff members asserting imminent FDA approval for the
PhenomX drug. Despite the president's lack of experience with computer
programming, he easily constructs the page with a simple Web page development
software package downloaded free of charge from the Internet.
The page incorporates graphics, sound and video, all obtained for free from the
Internet. The page even features a direct "video stream" that allows users to
watch live action of PhenomX scientists hard at work (the video is a phony
though users cannot tell the difference). In addition, the page contains all the
information necessary for the purchase of PhenomX shares, a chat area for
"real-time" talk about PhenomX, and a bulletin board allowing users to post
messages.
Step 2: Spam, Spam, and Spam
The second step is to use email, via a bulk-email or a spamming n2 program, to
contact as many potential investors as possible, about the fantastic investment
opportunity that PhenomX represents. The PhenomX president employs a "mining" or
"extractor" program that automatically collects email addresses from all over
the Internet. He also spends some time personally gathering email addresses from
the investment-related bulletin board systems, cyber message areas, newsgroups
and the various Web discussion forums dedicated to speculative investing and
unlisted securities. The president is relentless in developing an extensive
email list of potential victims.
n2 Spammers, who practice their art by transmitting an email message to email
lists (much like the junk mailer sends brochures, offerings and other
information via U.S. mail), combines the skills of a mass mailer with the hard
core pressure sales tactics of "boiler-room" cold-callers. Internet lore has it
that the term "spam" derives from a famous Monty Python skit, which featured the
word spam repeated over and over. The term may also have come from someone's
derision of the eponymous generic processed meat product, which some perceive as
lacking in substance or content. (Spam is a registered trademark of Hormel
Corporation.)
The president even collects a list of over 50,000 email addresses from sites
dedicated to discussing Comparator Systems Corp. and Systems of Excellence, two
of the most notorious stock manipulations involving the Internet -- both
companies the subjects of tens of thousands of Internet postings feverishly
hyping their respective stocks. n3 The president reasons that if these people
bought shares of Comparator and Systems of Excellence, they might purchase
shares of PhenomX.
n3 See, SEC v. Charles O. Huttoe, et al., Civil Action No. 96-CV-02543
(GK) (D.D.C.); SEC Litigation Rel. 15153 (November 7, 1996) and SEC v.
Comparator Systems, et al., Civil Action No. 96-3856 (JGx) (C.D. Cal.); SEC
Litigation Rel. No. 15056, 1996 SEC LEXIS 2478 (September 19, 1996). 96-3856 (LGB)
The president drafts a personalized note to explain that PhenomX represents an
exceptional buying opportunity and is poised to skyrocket in price. On the note
is a hyper-link to the PhenomX Web Site and a hyper-link to the page with all
the necessary purchasing information. Next, with the click of a mouse, the
president beams his personalized note to his private list of hundreds of
thousands (even millions) of potential victims.
For still greater distribution, the president hires a bulk emailer, an entity
that contracts to do mass mailings for a fee (typically about $ 100 per month)
to send the email to several million more potential victims. Cybermailers boast
that for every hundred emails sent out, seven responses result. This massive
global solicitation is no longer a matter of opening up the white pages of the
phone book and dialing every number -- this is a customized mailing list of
potential victims never before available to the average con artist.
Step 3: Begin the Buzz
Now PhenomX's president needs to create a "buzz" on the Internet about PhenomX.
The president utilizes several means to accomplish this goal. The president
smothers Internet forums with his spam (or some other marketing materials), by
posting it to newsgroups and Web discussion areas dedicated to investing.
The president also creates discussion forums dedicated to talking about PhenomX
while also posting his spam to discussion forums pertaining to other speculative
securities, the whole time hoping to snare a few victims into purchasing PhenomX
stock. The president responds to his own postings under various user names to
create the illusion that people are having a discussion, when in reality it is
just the president posting back and forth to himself, spreading more false
information about "PhenomX."
Step 4: Tout or Bribe a Touter
The fourth and final step makes the buzz more sophisticated by employing an
Internet investment newsletter. There are two options: the PhenomX president may
personally construct his own Internet investment newsletter to recommend PhenomX,
or, instead, bribe an unscrupulous online investment newsletter to feature
PhenomX as the "pick of the month" or some other sham promotion.
To build a personal online investment newsletter, he simply chooses a catchy
name, uses the same Web page building software employed for the PhenomX Web
site, and beams the newsletter out (or a spam with a link to the newsletter) to
the same list used for the PhenomX spam. The president posts the Internet
address of the investment newsletter in various investment newsgroups and other
online discussion forums that relate to investing. The newsletter, provided free
of charge, even picks a few recent winners in the market and boasts that these
stocks were prior newsletter picks. n4
n4 Section 17(b) of the Securities Act of 1933, often referred to as an
antitouting statute, clearly prohibits an Internet user from posting certain
promotional information and opinions concerning a security in an investment
newsletter without also disclosing the nature and substance of any consideration
received from the issuer of the company underlying that security.
There it is-four easy steps to a successful "pump and dump" scheme, courtesy of
the Internet. Don't doubt this four-step scenario. Record numbers of individuals
now own securities, and expect to receive double (and sometimes triple) digit
returns on stock investments. Hordes of neophyte investors have jumped head
first into the stock market, experienced the boom of the past few years, and are
hungry for more. This phenomenon exacerbates susceptibility to online fraud
schemes like the one promulgated by the fictional PhenomX company, and marks
this new crop of investors as potential targets for investment fraud.
"Are you gonna do
something or just stand there and bleed?"
The New Offshore Cyber Fraud
There was a time when the offshore orchestration of a fraud upon U.S. investors,
unless targeted towards the wealthy, was almost cost-prohibitive. Consider the
operation of an offshore boiler-room selling a fraudulent investment
opportunity. A boiler-room depends on two important elements for its success:
first, the ability to contact a large number of potential investors and, second,
the wherewithal to make the sale to the potential victim before the victim has
time to deliberate about the investment. Conflicting time zones, differing
currencies and most of all, the sheer costs of long distance telephone calls,
overnight mailings and other communication-related expenses all contribute to
hindering offshore fraudsters from preying on U.S. individual investors.
The Internet has, of course, changed all this. With the rapidly diminishing
costs of Internet access, computer hardware and Internet-related software, a
fraud emanating from the most remote emerging capital market costs about the
same as one that emanates from the house next door, perhaps even less.
International con artists can use Web pages, email, newsgroups, discussion
forums and chatrooms just as easily as anyone within the United States. The
obstacles created by differing time zones and other traditional notions of
borders disappear when it comes to the Internet, and soon, universal digital
legal tender may even reduce the problems caused by different currencies.
Internet offshore fraud may become the single greatest threat to U.S. investors.
It raises a myriad of complex issues and forces U.S. law enforcement to rethink
traditional notions of jurisdiction and sovereignty. When considering an
Internet fraud that involves a foreign jurisdiction, the enforcement division
must address issues associated with investigating and prosecuting foreign
entities and individuals, from serving subpoenas and criminal duality to
locating assets and extradition.
"What an ugly
thing to say."
The New Cyber-Defamation (of Character and Corporation)
Spurious rumor-mongering has always pervaded Wall Street, whether done for the
purposes of market manipulation or just for spite. Historically though, the
rumor mongers were usually limited in the numbers of individuals they could
reach. Now, with the availability of the Internet, spreading negative publicity
about a company or an individual has never been easier. Instantaneously,
efficiently, and at very little cost, individuals can use the Internet to cast
dispersions upon the most reputable of companies and individuals, reaching
millions.
The Internet has become saturated with negative deceptive information about
companies and their employees. The nefarious short-seller uses the Internet to
spread false information pertaining to a publicly traded company and the
treacherous promoter uses the Internet to advance false scuttlebutt about
competitors. Of course, many of these rumors and ramblings published on the
Internet strain credulity, and are simply ignored by users, but the accuracy of
some information is more difficult to discern, even when employing the highest
level of skepticism.
No subject is sacred, even SEC activities. In some Internet discussion forums,
for example, users gossip about an SEC investigation when no such investigation
exists. Hopefully, most individuals do not believe a false rumor about an SEC
investigation in such instances, particularly when the company or individual
loudly and flatly denies the existence of the investigation.
But what if the company or individual cannot make such a representation -
because, in fact, an investigation does exist. While pending, members of the
public inevitably learn some information pertaining to an SEC investigation,
typically from witnesses asked (or subpoenaed) to testify or produce documents
pursuant to that investigation. n5 Although an SEC investigation is not meant to
be an indication by the Commission or its staff that any violations of law have
occurred, or a reflection upon any person, entity or security, public
dissemination about an SEC investigation can still damage the reputation of an
individual and a company (even impacting the company's stock price). This is one
of the many reasons why the enforcement division maintains a long-standing
policy of confidentiality and deems nonpublic even the mere existence of an
investigation.
n5 When SEC enforcement staff contact a witness during an investigation,
enforcement staff must provide certain limited information to the witness, such
as the staff's principal purpose in requesting information from the witness, the
name of the investigation and, of course, the identity of the investigating SEC
enforcement staff. See The Privacy Act of 1974, 5 U.S.C. § 552a
(providing certain notice and protections to persons from whom the government
solicits information).
Before the Internet, witnesses seeking to propagate information about an
existing investigation were limited in the means used for dissemination -- they
could meet by the water-cooler, telephone, or use the mail to inform colleagues
and friends. Now, with the increasing ease of Internet use, individuals can
publish SEC correspondence and subpoenas, transcripts of testimonial
proceedings, even information about SEC staff, such as the staff's background or
possibly a home phone number. This could lead to even greater dangers. For
example, a corrupt short-seller might learn of an actual SEC investigation from
an Internet user, and then exploit the information, spreading a lie across the
Internet that SEC is about to file a civil enforcement action, when the SEC
staff are actually about to close the investigation.
"You look like
somebody just walked over your grave."
The New Cyber-Sleuths
Complaints and tips from members of the public have historically provided the
largest single source of investigative leads for the enforcement division. Thus,
it was only natural for the SEC to open its Enforcement Complaint Center (ECC)
(www.sec.gov/enforce/comctr.htm)
and expand the ways members of the public can contact the enforcement division
to report potential securities violations over the Internet (or any other
potential violation of the federal securities laws).
There is a genuine culture of vigilance and self-policing among Internet users,
and the enforcement division hoped to tap into that culture and further its
mission of protecting investors with the online construction of the ECC. The
ECC, which began operation on June 14, 1996, provides a variety of means to
contact the enforcement division, including an email box, toll-free number, fax
number, and mailing address. The ECC also provides a user-friendly form to
ensure that the complainant sends a complete report of the suspicious activity.
Thus far, returns from complaints made to the ECC have exceeded expectations.
From its inception, the ECC began receiving about 100 complaints a week, and now
receives more than 100 complaints each day. Not only does the ECC generate leads
about specific entities and persons, but the ECC also permits the enforcement
division to remain apprised of the latest trends and tactics of online riffraff.
Most startling is that complaints from Internet users are of a novel variety
never encountered before. Hence, the genesis of the "Cybersleuth." The
Cybersleuth reports more than just the fraudulent Web page or other potential
Internet securities violation. Cybersleuths meticulously trace the headers of
suspicious spams, relentlessly seeking to pierce any cloak of anonymity.
Cybersleuths take time to provide painstaking details of potential violations,
usually offering identifying information about themselves in case the SEC needs
to contact them. Cybersleuths even list the potential securities violations of
fraudsters by statute, rule and regulation, sometimes by precise citation.
Cybersleuths receive no reward or bounty for their benevolence, just the
satisfaction of helping to keep the Internet clean and safe for all investors,
and their numbers continue to swell.
"I am afraid we
must redefine the nature of our association."
The New Cyber-Investigation of the Internet 'Killer Application'
A "killer application" is generally defined as any product that overwhelms the
competition, significantly transforming a business - the first word processing
package was a killer application as was Lotus 1-2-3. Not a day passes without
business headlines announcing another company's progress in the hunt for the
Internet's next killer application. The word is out -- no arena is riper for the
next killer application than securities, investments and finance. The
enforcement division faces challenges on two fronts in this regard.
First, there are fraudsters who try to capitalize on the hype surrounding
technology, feigning discovery of the next killer application and then operating
a "pump and dump" scheme for their company's publicly traded stock. n6 Second,
there are those who will implement new technologies like online trading
facilities and Internet bulletin boards and unlawfully circumvent critical
customer protection provisions embedded into the federal securities laws.
n6 See note 4, supra.
No matter what the fate of these futuristic market appliances, the bottom-line
is that the enforcement division can no longer rely solely on its traditional
investigative methods and tools of yesteryear to police the next killer
application. The enforcement division now, more than ever, continuously updates
its own computer and Internet resources while also engaging in protractive
measures to take advantage of the Internet (and Internet killer applications)
for its own benefit.
The enforcement division, for example, in the Internet's discussion forums, not
only routinely announces SEC proceedings, such as trading suspensions, n7 but
also collects information from members of the public. n8 On the Web, the
Enforcement Complaint Center discussed above provides an interactive area for
investors to communicate with the enforcement division directly.
n7 See e.g., SEC postings on America online and on the Silicon Investor
announcing the trading suspension of Rocky Mountain International at
http://www.techstocks.com/wsapi/investor/reply?s=suspension+rocky+mountain&sreply=3021750.
n8 See e.g., SEC postings on The Silicon Investor at
http://www.techstocks.com
seeking information concerning SGA GoldStar prior publications.
The enforcement division also is constantly beefing up its technological
arsenal, maintaining all the necessary online commercial provider accounts, T1
lines n9 for direct Internet access, and also employing the latest browsing
software for viewing the Internet together with the powerful hardware necessary
to do the job right.
n9 T1 lines grant access at 1500 bits per second (more than 50 times faster than
the average high speed modem which only transfers 28.8 bits per second).
"So run you cur,
and tell all the other curs the law's coming ... you tell'em I'm coming and
Hell's coming with me you hear, Hell's coming with me."
Conclusion
As the rapid pace of technology continues to impact the SEC enforcement
division, the newly fashioned cyber transgressions of today could very well
shape the epitaphs on the
tombstones of the next millennium. Yet, one group of judicial precepts
will always remain notably absent from the list of
tombstones -- the powerful antifraud provisions of the federal securities
laws that have served the SEC so well since their inception. Historically, the
flexibility of the antifraud provisions has provided a statutory basis for the
enforcement division to prosecute offenses ranging from unlawful insider trading
to fraud in the sale of derivatives to pay-to-play municipal bond schemes.
Internet related securities violations do not require any new enforcement
statutes, rules or regulations; the present range of antifraud provisions
embodied in the federal securities laws more than suffice.
The Internet has created fantastic opportunities for companies, entrepreneurs,
brokers, dealers, exchanges, and every other participant in the financial
markets, and, in many respects, the investor has emerged as the biggest winner
of them all. Investors now have instantaneous financial information of almost
every variety at their fingertips -- all at little cost, at any time and from
the comfort and privacy of their own homes. Advanced concepts of electronic
disintermediation and cyber-commerce will undoubtedly lead to better access,
cheaper costs and fairer markets for all participants. The investor of today,
with the help of the Internet, has become more informed than ever before.
Unfortunately, the Internet has also spawned a new generation of scam artist --
a generation that aims to spoil the information superhighway, and contaminate
the exciting new financial emporium the Internet has created. These miscreants
believe that the Internet's uncharted territory provides the ultimate
opportunity to modify the investment playing field in their favor. These folks
are dead wrong.
Over the past 65 years, no matter where the arena, cyberspace or otherwise, the
SEC and its enforcement program has remained committed to stamping out fraud and
maintaining fair markets for all investors. In carrying out its mission, the
enforcement program has left a graveyard of
tombstones behind, continually adapting and modifying its own rules of
engagement whenever necessary. The Internet merely accelerates the changes,
because the
tombstones no longer creep up casually, they shoot up, right under your
feet.