By Ian Lohr With John Lohr
If it didn’t start with Charles Ponzi in 1920, it was certainly perfected to an art form by him. Today, the predatory progeny of Ponzi rip off the American investing public to the tune of $5 billion annually. The prey ranges from the very young to the very old across all financial demographics, and the predators have it easier than ever to stalk their victims.
How Not To Get Ripped Off examines true stories of the historically famous investment scams and the most current schemes and frauds perpetrated by the prolifigate financial intermediaries of today. The book then gives simple prescriptions for investors to avoid the rip-off epidemic in the form of practical common sense mandates. It is targeted at the investing public, whether they have assets of $100 or $100 million.
The book differs significantly from Dearborn’s Brokerage Fraud by Tracey Stonewall in that How Not To Get Ripped Off gives war stories of the scams within their historical context, names the perpetrators, and tells how to avoid it. It is a more practical conversational book with a wider appeal.
Charles K. Ponzi was born in Italy around 1882 and emigrated to the USA in 1903 after having lived some time (and done some time, for petty forgery) in Canada. He became famous after he made $9,500,000.00 (current value about 45 million) in 1920 and 1921 in the investment industry, with no previous experience and without financial backing. He promoted a postage stamp trading service which promised a 50% return to investors by purchasing 2 cent stamps in Europe and selling them for 3 cents in America. Ponzi in fact did no such thing. He paid off old investors with the funds from new investors, pocketing a heavy percentage himself. He had previously served a prison term in Georgia for smuggling illegal immigrants. His namesake scheme made headlines in 1920 as the most lucrative investment in the country. Many persons and institutions were duped and cheated. For a few months it seemed he had developed the perfect crime, but such perfection eluded him. A perfect crime is never uncovered—and Ponzi’s house of cards fell soon enough. He was arrested, tried, convicted, and served four years in prison. Unreformed, he continued to make his living through questionable means, although less successfully. He was accused of running a real estate pyramid scheme in Florida during the thirties and nearly escaped to Italy before being captured by Texas police in New Orleans, extradited to Massachusetts, and deported. In his later life he migrated to Brazil where he died in 1949 with only $75.00 to his name, and was buried by the state. As a businessman and a criminal, Ponzi was a failure, however he has attained a dubious immortality by giving his name to the crime he refined.
Securities Fraud in the Digital Economy
The exponential advance of communications and information technology has reshaped the entire investment industry with wide-ranging consequences. The Internet Era of the past decade has facilitated the development of legitimate electronic-based business but also given unscrupulous individuals the technological capacity to violate the law on a scale that was previously impossible. The free-information aspects of the Internet provide vast opportunities to exploit communications technology for the artificial manipulation of stock value, insider trading, predatory marketing, and other illegal or unethical schemes. While a relatively new phenomenon, Internet fraud as related specifically to the securities industry is fast becoming a significant problem both for regulators and securities firms.
While the technology is new, the crime is not. Internet fraud is motivated by the same impulses as fraud of a more conventional variety. Often Internet Fraud is only one element of complex scam involving several parties or institutions; occasionally it is an isolated criminal activity. It is always lucrative (at least until the regulators catch up). The amount of fraudulent value created through market manipulation in the United States alone for the year 2000 was in excess of $2 billion resulting in illicit profits of more than ten million dollars.
According to SEC director of Enforcement Richard H. Walker, ”what used to require a network of professional promoters and brokers, banks of telephones and months to accomplish can now be done in minutes by a single person using the Internet and a home computer. Thinly traded microcap stocks are particularly susceptible to online manipulations.” Indeed, the use of electronic communications–including personal and bulk unsolicited email, online discussion forums, web sites, electronic newsletters and other means–to induce public interest in an essentially worthless security, raising the price, then selling out and allowing the value to collapse is one of the most common violations reported since 1997. This practice is known as a “pump and dump” scheme.
The most common violation however was on the part of stock promoters, both professional and amateur, with or without official qualifications, failing to disclose compensation received from companies they touted. This has proved a profitable criminal enterprise in many cases. In one case a school bus mechanic without professional qualifications or prior investment experience made illicit profits of more than $70,000.00 by distributing fraudulent information about securities he held, through electronic means.
Another common practice involves the sale and promotion of unregistered transactions. This includes transactions in unregistered securities (in some cases in securities which do not even exist), and transactions in registered securities at unregistered firms or by unregistered persons. In some cases the sale of unregistered securities is promoted as “free” stock despite hidden costs and risks.
Additionally, electronic communications have been used to promote traditional ponzi schemes, fraudulent transactions, and other scams. These scams often demographize their fraud, specifically targeting persons in various minority groups the perpetrators have identified as more vulnerable—Christian fundamentalists, African-Americans, and most tragically, the elderly. Additional Internet schemes and electronic scams investigated by the SEC include false promises of imminent IPO, baseless financial projections, false track records and resumes, analyst coverage promoted as “Bought and Paid For”, inflated performance claims and fake testimonials.
The ongoing development of Internet and advanced electronic communications in general have also increased the available facilities for making and disseminating false and misleading information about securities for fraudulent purposes. Both the Securities Exchange commission (SEC) and the National Association of Securities Dealers (NASD) have recently issued policy statements and enforcement reports detailing the scope and volume of the problem.
For each of the past four years the SEC has been conducting ongoing investigations of Internet securities fraud. Each year the number of violations has increased, as has the number of enforcement actions issued (from eight in 1997 to thirty-six in 2000 and a larger number, perhaps more than fifty, in 2001) and the amount of money involved. The SEC has made more than 200 Internet-related enforcement actions, nearly half of these in the last 18 months. These enforcement actions have involved a total of over 750 named individuals and entities, some of which are listed below. More than two dozen enforcement actions have been announced during the time that this article has been under revision, and more are expected before it goes to print.
Some outstanding examples of the misuse of electronic technologies in securities violations uncovered by the SEC and NASD since 1997 include the following cases:
Donald A. Baillargeon used his web site, print newsletter and cable television program “Emerging Company Report” to promote the stocks of companies from which he received compensation between $2,500.00 and $17,000.00 per month without full disclosure to clients or regulators.
Thomas Carter manipulated the prices of four securities he owned by disseminating a mass emailing from a fictitious securities firm to thousand of prospective investors in which he falsely indicated that he did not have a position in the securities in question resulting in price increases of between 10 and 100% and a criminal profit of more than $12,000.00.
Chidwhite Enterprises, Inc. and its sole shareholder and chief executive officer, Jerry L. Chidester, age 26, of Austin, Texas, used “spam” e-mail and a web page to defraud over 6,000 investors raising nearly $96,000 in the fraudulent offering of so-called “free” stock credits to those who paid an “administrative fee” of $10. Defendants claimed that investors could redeem their stock credits for common stock when Chidwhite Enterprises completed a purportedly imminent IPO. The defendants made numerous misrepresentations and omissions of material facts in connection with the offering, including that the SEC had approved the offering, that Chidwhite Enterprises would conduct an IPO upon completion of the offering, and that Chidwhite Enterprises stock would be valued at $20 to $50 per share at the time of its IPO. In fact, the SEC never approved the offering and Chidwhite Enterprises never undertook any meaningful steps to conduct an IPO. Moreover, Chidwhite Enterprises never established offices, never acquired any inventory, and never offered any products or services. Chidester misappropriated all of the administrative fees generated in the promotional offering and converted the fees to his own use.
Chill Tech Industries made numerous false and misleading statements (including identifying a product containing illegal toxic chemicals as “environmentally friendly”) through web sites, press releases, and phony unsolicited emails (“spam”) causing the price of Chill Tech Industries stock to increase 94% in the short term. The CEO of Chill Tech Industries personally sold 1,056,500 shares for an illicit profit of $277,136.00.
Trace Cornell offered “free” stock in the unregistered company Web Works Marketing, Inc., fraudulently claiming the stock was valued at $38.00 per share and making a baseless claim that the stock price would appreciate to $200.00 per share. A Web Works Marketing, Inc. web site claimed the company had 10,000 clients and a new contract with a major Virginia long-distance carrier when the company was in fact run from Cornell’s home, had 35 clients and $30.00 in operating capital.
Sloan Fitzgerald, a promoting company, disseminated more than 6,000,000 unsolicited emails touting two internet microcap stocks. This resulted in the largest number of complaints the SEC has ever received from a single criminal action by a member firm.
Scott Flynn, a former securities broker recently convicted of securities fraud in another matter, used unsolicited email (“spam”) and a web site to spread information about certain companies without disclosing his compensation of at least $183,200.00 in cash and an additional $360,000.00 in securities from these companies.
Michael E. Furr, a paid promoter of penny stocks, touted the stock of 26 issuers (whose stock he owned) on his free web site, where he made false and misleading claims regarding these securities, resulting in over-inflated price increases and a criminal profit of more than $3,400,000.00.
Future Securities, Inc. engaged in an ongoing pyramid scheme, recruiting through their web page and unsolicited direct email claiming an investor could make $116,400.00 with no risk from an initial investment of $120.00.
The Future Superstock (FSS), an internet newsletter published by Jeffrey C. Bruss recommended to its more than 100,000 subscribers the purchase of approximately 25 microcap stocks predicted to double or triple in the next three months; however FSS failed to disclose more than $1,600,000.00 in cash and an additional 2,000,000 shares of cheap insider stock in compensation from these companies, made false statements regarding their “independence” from these companies, falsely claimed to have performed independent research on these companies, and lied about profits received from prior recommendations.
Stephen Gaddis offered unregistered “free” stock in an internet based company, WowAuction.com, claiming the company would soon engage in a “direct public offering” during the third quarter of 1999.
Ricky Laine Gaspard, a former roofing contractor and sole owner and operator of WallStreet Prophet, a stock recommendation website, disseminated false and misleading statements on the website concerning WallStreet Prophet’s stock selection system, Gaspard’s investing experience, and his performance history in making successful stock recommendations. Gaspard claimed WallStreet Prophet’s system had “an 85% success rate” and that testimonials claimed returns of up to 860%. Gaspard has since acknowledged that his success rate claims were misleading or false and not supported by his track record. Gaspard also portrayed himself as an experienced trader with over 14 years of investing expertise, when he actually has very limited personal securities trading experience and has never received any formal securities training or license, and has never worked for a securities or investment firm.
Edgar Guilbreau of Houston Texans NFL Football Team Holding Co. sold shares of his company through the web site houstontexas-nfl.com which led potential investors to believe they were purchasing shares in the new Houston major-league professional football franchise, using NFL branded and copyrighted slogans and trademarks, although the enterprise was not in any way affiliated with the NFL or with Houston’s NFL franchise. The case was resolved with the assistance of the Houston FBI office. In addition to securities violations, Guilbreau was charged with copyright infringement and various other criminal offenses.
Hastings Communications, publisher of the Stockprofiles.com web site, promoted the stock of publicly traded companies on the Internet without disclosing that it was paid by these companies.
Christopher Hastings, a school bus mechanic with no experience in the securities industry, using the screen name “Stockpicks1” touted the stock of ten issuers through a free email newsletter, Internet message boards, and a personal web site, then sold the touted stocks resulting in a criminal profit of more than $70,000.00.
Heartsoft, Inc. issued a series of false press releases that were simultaneously posted to the organization’s web site resulting in an increase in stock price of more than 1500% and did not provide investors with accurate annual reports between 1997 and 1999. The principals of the company received a criminal profit of more than $160,000.00.
Internet Solutions For Business, Inc. (ISFB), a publicly traded Internet company located in Coventry, England, and its founder and CEO, Lawrence Shaw, engaged in widespread fraudulent promotion through various means. ISFB held itself out as a sophisticated, high-tech Internet company with new, cutting-edge products and profitable business relationships with established “blue chip” companies. ISFB hyped these products and relationships on its website, in press releases and through reports it paid to have published, all of which were authorized by Shaw. ISFB’s supposed cutting-edge products never reached the point of commercial viability. For example, a “$4.1 billion website audit service,” repeatedly hyped by the company, was nothing more than a concept which was never developed. Similarly, announcements of business relationships with “blue chip” companies were either outright lies or gross exaggerations. Further, ISFB’s stock price projections (300% increase over the mid- term) were without any reasonable basis and were made at a time during which the company was in a precarious financial position. Notwithstanding dire financial problems, ISFB’s stock price and trading volume substantially increased contemporaneously with the company’s fraudulent promotional activities.
In a related matter, the SEC found that Imcadvisors, a New Jersey corporation, and its owner, Stuart Bockler, violated the anti-touting provisions of the Securities Act of 1933 in the promotion of ISFB stock.
Steven A. King ran the internet touting service Stockstowatch.com out of his home, using the service to disseminate bulk email to more than 200,000 subscribers to artificially raise the prices of securities he owned, resulting in a criminal profit of more than $1,000,000.00.
Russel Klein, publisher of “Russ Reports” an investment newsletter, used this newsletter to promote the stocks of companies from which he received compensation.
Joe Luffborrow established several web sites claiming to offer “free” stock in American Space Corp., a company supposedly involved in lunar exploration, with a basis of $1.00 per share, when the company did not exist—it was never incorporated and had no officers, employees, or contracts.
Gursel Mandaci, a college student and taxi driver, used the Internet to inflate the price of securities he had purchased for short-term trading purposes. Mandaci purchased penny stocks with an online broker and made large numbers of Internet postings, including false information about the issuers and baseless price predictions increasing prices as much as 380% for a criminal profit of more than $23,000.00.
PinkMonkey.com, Inc., an online publisher, and Patrick R. Greene, its founder and controlling shareholder, issued a fraudulent press release that caused a 950% increase in the price of PinkMonkey’s common stock. The release announced the “launch” of a new website service that could “quickly reach a significant market share in the $400+ million” study aids market; however, according to the SEC’s complaint, the website was neither newly-launched nor likely to realize any significant market share. As of the date of the release, PinkMonkey had operated the website for 14 months and generated only $30 in sales. Furthermore, PinkMonkey and Greene actually anticipated needing one year to capture up to 5% of a market totaling only $160 million. Before the release, PinkMonkey’s stock was thinly-traded, at a price of $1.50 or less. Within an hour after the release, PinkMonkey shares traded for as much as $4.375 per share, on heavy volume. The price peaked two days later at $17 per share, a more than 1000% increase from just two days earlier, before closing at $13.50 per share. At its zenith, PinkMonkey’s market capitalization exceeded $200 million, although the company had only four full time employees and nominal sales. After PinkMonkey and Greene issued a clarifying press release, the company’s stock price fell to $7.25 per share by the close of trading that day. PinkMonkey has never realized significant revenues, and its stock now trades for about $0.20 per share.
Princeton Research, Inc. touted seven microcap companies while receiving 276,000 shares and 75,000 options from these companies. The enforcement action was resolved when the two principals involved agreed to pay a civil judgement of $40,000.00.
Torsten Prochnow and Dennis C. Haas (German citizens) touted the stocks of approximately 64 public companies under the screen name “Stockreporter.de” including baseless profit projections and misrepresentations as to the Long-term viability of the investments, through numerous press releases and postings on the Stockreporter.de web site, specifically targeting American investors resulting in price increases of up to 390% and traded these same stocks on at least 15 separate occasions for a criminal profit of more than $111,000.00.
PSA, Inc. realized more than $1,000,000.00 in criminal profits by promoting their stock by setting up an unregistered broker dealer and publicizing the stock over Internet, raising the price from $0.50 per share to $5.00 per share.
RCG capital Markets, Inc. engaged in similar practices, receiving between $3,350.00 and $5,850.00 per week in undisclosed compensation for a total criminal profit of more than $100,000.00 since 1998.
Michael D. Richmond fraudulently sold $8,000,000.00 in stock of Royal Meridian International Bank, an entity incorporated on the Island of Nauru with no assets, customers, or contracts, and used to proceeds for personal purposes. Richmond faces up to 20 years imprisonment and stiff fines. The case is still pending.
RumorSearch.com, a St. George, Utah company, that purportedly researches stock rumors for paying subscribers, and its principal, Jeremy Johnson, age 25, made false statements about, and touted the stock of, Far East Ventures, Inc. (FEVI). According to the complaint, Johnson profiled FEVI as RumorSearch’s “Stock Pick of the Month,” sent several emails to RumorSearch subscribers and others praising FEVI, and received a total of 95,000 FEVI shares in payment for the touting. In these touts, Johnson and RumorSearch misrepresented, or omitted to disclose, material information regarding FEVI, the reliability of reported information and Johnson’s receipt of compensation for the touting. While touting FEVI through his false and misleading releases, Johnson sold 66,500 FEVI shares at a profit of $315,848.
Donald Ruteledge and Gregory Skufca conspired to take public the development-stage company, Plus Solutions, Inc., without registering a public offering, through manipulative trading and postings to internet discussion groups, however the scheme was foiled by SEC investigators.
Kenneth W. Schilling disseminated false revenue and stock price projections on the Internet for iBIZ Technology Corp., a computer company headquartered in Phoenix, Arizona. Schilling, president of iBIZ, provided false financial projections to a purported analyst for use in research reports recommending the purchase of iBIZ stock, and placed 17 press releases on iBIZ’s website which contained direct hyperlinks to the analyst reports. In a press release, iBIZ characterized the analyst as “independent” even though iBIZ, through its investor relations firm, had agreed to pay the analyst 200,000 shares of iBIZ common stock for the report. The false financial projections, which appeared on the Internet, fueled a rise in both the price and the trading volume of iBIZ’s common stock.
Smart-Mart, Inc., its founder, Timothy A. McMurray, and its president, Bradley D. Woy, conducted a fraudulent securities offering in which they raised approximately $2.4 million from approximately 720 investors. Smart-Mart, McMurray and Woy knowingly made false and misleading statements to investors regarding a purportedly imminent IPO, the business prospects of the company, the use of investor funds, the liquidity of the investment and projected returns on investment. Despite these representations, Smart-Mart never took any significant steps to conduct an IPO and the company had only minimal business operations. Moreover, Smart-Mart’s financial and other business records reveal that McMurray and Woy used a large portion of investor funds for unauthorized business and personal expenses. In addition, McMurray failed to disclose critical information regarding his background, including his conviction on bank fraud charges for a check-kiting scheme in January 1993, for which he was sentenced to five years probation.
Theodore Sontarkis sold more than 200 shares of “free” stock in Kinesis International, an unregistered company, over the Internet.
Sunset Investment Group, Inc., James Brown, Pinnacle Capital Advisors, and Austin Tanner made false and misleading performance claims and testimonials that appeared on three different websites – OptionInvestor.com, SplitTrader.com, and NetBulls.com – and in press releases. All three sites provide stock and market analysis and publish a stock advisory newsletter offering stock analysis, trading strategies, and trading recommendations. All are operated by Sunset Investment Group and its president and sole shareholder, Brown. Tanner and his company, Pinnacle Capital, were hired by Brown to create the homepages of the websites. According to the complaint, OptionInvestor.com claimed actual returns ranging from 60% to 240% for subscribers who followed its trading philosophy and trading recommendations. These performance claims were hypothetical, not actual, and it was impossible for subscribers to achieve similar results. SplitTrader.com and NetBulls.com posted on their homepages false and misleading testimonials that praised the performance of the sites. These testimonials were copied almost verbatim from the OptionInvestor.com homepage and had nothing to do with the performance of either SplitTrader.com or NetBulls.com.
Thor Equity Group, LLC touted securities of CancerOption.com (in collusion with officers of that company) based on false financial and stock price information, sold large amounts of the stock at inflated prices for illicit profits of $180,000.00, posted the information to the web sites of both companies, and used the performance data to recruit more clients.
Jospeh Vertucci, a corporate insider, and Bruce Straughn, a registered representative, sold essentially worthless stock in a software developer, Interactive Media Publishers, Inc., which were not registered with the SEC, paid for favorable reports on the company to be published, used this information to boost stock prices, then sold the stock at a profit. The stock collapsed and the company ceased operations.
Rajiv Vohra, Sean Healey, Lantern Investments, Ltd. Lipton Holdings Ltd. and Beaufort Holdings, Ltd. engaged in several illegal schemes including “wash sales”, stock pooling, and publication of false and misleading information on the Internet regarding the stock of New Directions Manufacturing, Inc., while trading on the stock themselves for a criminal profit of more than $500,000.00
Ivan Webb and Donald Knight, executives of Broadband Wireless International Corporation, engaged in an ongoing scheme to inflate the value of their company’s stock through fraudulent claims as to the company’s impending acquisition of other companies in the industry, using the company’s web site and press releases, resulting in a dramatic increase in the price of the company’s stock. The scheme unraveled when the two began to squabble over the ownership the company and sued each other. Assets have been frozen by order of an Oklahoma Federal Court.
In addition, numerous other companies, including TKO Interntaional, Inc., Global Investment Services, Investment Hotlines, National Investors Council, The High Growth Publishing Group, IBJ Publications, Inc., ICS Communications, Inc., Starwood Media Group, Stock-Line.com used their web sites to promote the stock of various microcap companies without disclosure of the compensation they received from the same companies.
The problem of Internet fraud has not been reasonably affected by the current economic downturn. As this report was being prepared, NBC news featured an article detailing numerous abuses of the securities laws involving traditional and electronic means. Joseph Borg, director of securities for the state of Alabama cited the recent example of the firm MN Partners of Phoenix City, Alabama, where from a period of October 2000 to January 30th 2001 “without the benefit of radio, TV or advertising — just the Internet — 33,000 people from over 16 countries sent money.” The company claimed to have information from God as to the locations of exploitable mineral deposits in South America and promised salvation in addition to monetary gains. The perpetrators used invested assets to operate a traditional Ponzi scheme, laundering the profits offshore. This is only one of an increasing number of “faith-based frauds” specifically targeting the elderly, the gullible, and persons with little or no investment experience by identifying their investment programs as religious oriented and divinely influenced. These practices resulted in criminal profits that NBC estimated to be in excess of five hundred million dollars. State regulators have recovered some of these assets, Borg said, and “The return to investors will be approximately 72 percent”. Another fraud investigated by NBC news involved aggressive predatory marketing in the form of unsolicited emails targeting elderly minorities.
These cases represent only a small selection of a vast body of documentation detailing widespread criminal activity. The use of advanced communications technology for fraudulent, misleading, and unethical practices has unfortunately resulted in the loss of assets for many clients, and accounts for a significant amount of the illegal activity currently under investigation or censure by federal regulators.
While the bulk of responsibility in these circumstances falls to financial professionals, whose responsibilities to adhere to ethical business practices should not be disregarded, there is also a significant need for client awareness and responsibility. Fraud preys on the gullible, the greedy, and the inexperienced. Investors have the responsibility of verifying that their investments are sound, and consistent with their financial goals. A good rule of thumb is that if a prospective investment appears to good to be true, it is. While it is vitally important to keep this principle in mind when pursuing investment opportunities online, this principle can also be applied to traditional investments. The market is a complex system of risks and potential rewards. Future performance is difficult to predict and impossible to guarantee. Any attempt to downplay risks over rewards, and any promises of rewards without risks, should be viewed with suspicion and subject to intense scrutiny by potential clients.
According to the official SEC guidelines for avoiding victimization by Internet Fraud, “The Internet allows individuals or companies to communicate with a large audience without spending a lot of time, effort, or money. Anyone can reach tens of thousands of people by building an Internet web site, posting a message on an online bulletin board, entering a discussion in a live “chat” room, or sending mass e-mails. It’s easy for fraudsters to make their messages look real and credible. But it’s nearly impossible for investors to tell the difference between fact and fiction.”
The SEC guidelines against victimization in electronic fraud continue, giving special attention to specific strategies utilized by electronic fraudsters, examined in the following paragraphs. “Hundreds of online investment newsletters have appeared on the Internet in recent years. Many offer investors seemingly unbiased information free of charge about featured companies or recommending “stock picks of the month.” While legitimate online newsletters can help investors gather valuable information, some online newsletters are tools for fraud.” It is important to know who you are dealing with, where and how they get their information, and what compensation if any they receive in return for their recommendations. The concern for the investment professional should be for the financial situation of their clients, not their own financial situation. Honest disclosure on the part of investment professionals and investigation of potential financial service providers by clients is necessary in this regard.
“Some companies pay the people who write online newsletters cash or securities to “tout” or recommend their stocks. While this isn’t illegal, the federal securities laws require the newsletters to disclose who paid them, the amount, and the type of payment. But many fraudsters fail to do so. Instead, they’ll lie about the payments they received, their independence, their so-called research, and their track records. Their newsletters masquerade as sources of unbiased information, when in fact they stand to profit handsomely if they convince investors to buy or sell particular stocks.” This type of fraud can affect an investor in two ways. An client may lose money after buying into a fraudulent offering, or may become inadvertently involved in the fraud itself. Touting stocks online for compensation is sometimes marketed as a “work at home” opportunity. Frauds of this nature are an electronic variation on the famous “Pyramid Scheme”.
“Some online newsletters falsely claim to independently research the stocks they profile. Others spread false information or promote worthless stocks. The most notorious sometimes “scalp” the stocks they hype, driving up the price of the stock with their baseless recommendations and then selling their own holdings at high prices and high profits.”
“Online bulletin boards – whether newsgroups, usenet, or web-based bulletin boards – have become an increasingly popular forum for investors to share information. Bulletin boards typically feature “threads” made up of numerous messages on various investment opportunities.” The anonymity of Internet can allow fraudsters to avoid accountability, hiding behind multiple or false identities. This adds a measure of uncertainty to investing online. “While some messages may be true, many turn out to be bogus – or even scams. Fraudsters often pump up a company or pretend to reveal “inside” information about upcoming announcements, new products, or lucrative contracts.” Trading on inside information, however it is obtained, is illegal, and may constitute a serious crime. Any offer based on data presented as inside information should be avoided regardless of other issues involved. The SEC guidelines continue, “Also, you never know for certain who you’re dealing with – or whether they’re credible – because many bulletin boards allow users to hide their identity behind multiple aliases. People claiming to be unbiased observers who’ve carefully researched the company may actually be company insiders, large shareholders, or paid promoters. A single person can easily create the illusion of widespread interest in a small, thinly-traded stock by posting a series of messages under various aliases.”
Unsolicited email has proven to be one of the favoured tools of internet fraudsters (and a great way to distribute information quickly to people who may or may not want it, a technique guaranteed to effectively annoy total strangers). According to the SEC, “Because “spam” – junk e-mail – is so cheap and easy to create, fraudsters increasingly use it to find investors for bogus investment schemes or to spread false information about a company. Spam allows the unscrupulous to target many more potential investors than cold calling or mass mailing. Using a bulk e-mail program, spammers can send personalized messages to thousands and even millions of Internet users at a time.”
Having dispensed with some general comments and concerns, the SEC guidelines then offer specific instructions to the potential investor. “If you want to invest wisely and steer clear of frauds, you must get the facts. Never, ever, make an investment based solely on what you read in an online newsletter or bulletin board posting, especially if the investment involves a small, thinly- traded company that isn’t well known. And don’t even think about investing on your own in small companies that don’t file regular reports with the SEC, unless you are willing to investigate each company thoroughly and to check the truth of every statement about the company. For instance, you’ll need to:
- get financial statements from the company and be able to analyze them;
- verify the claims about new product developments or lucrative contracts;
- call every supplier or customer of the company and ask if they really do business with the company; and
- check out the people running the company and find out if they’ve ever made money for investors before.
“The difference between investing in companies that register with the SEC and those that don’t is like the difference between driving on a clear sunny day and driving at night without your headlights. You’re asking for serious losses if you invest in small, thinly-traded companies that aren’t widely known just by following the signs you read on Internet bulletin boards or online newsletters.”
As discussed above, internet fraud is often one element of a more complex fraudulent scheme, and, when perpetrated by otherwise qualified investment professionals, is almost always an outgrowth of some other fraudulent activity. “The types of investment fraud seen online mirror the frauds perpetrated over the phone or through the mail. Remember that fraudsters can use a variety of Internet tools to spread false information, including bulletin boards, online newsletters, spam, or chat (including Internet Relay Chat or Web Page Chat). They can also build a glitzy, sophisticated web page.” This is especially problematic, because web space is relatively cheap and web design is relatively simple (with a basic knowledge of the required programming languages). Since the Internet itself is a virtually inexhaustible resource. While growth has slowed from the explosive rate of a few years ago, new internet service providers and other electronic business support systems are arriving in the digital marketplace every week. “All of these tools cost very little money and can be found at the fingertips of fraudsters.”
The SEC report suggests that clients should consider all potential investments with skepticism. According to the SEC, investment frauds usually fit one of the following categories:
The “Pump And Dump” Scam
“It’s common to see messages posted online that urge readers to buy a stock quickly or tell you to sell before the price goes down. Often the writers will claim to have “inside” information about an impending development or to use an “infallible” combination of economic and stock market data to pick stocks. In reality, they may be insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by gullible investors. Once these fraudsters sell their shares and stop hyping the stock, the price typically falls and investors lose their money. Fraudsters frequently use this ploy with small, thinly-traded companies because it’s easier to manipulate a stock when there’s little or no information available about the company.” This scheme is illustrated in many of the cases listed above, including stockstowatch.com, and Broadband Wireless International Corporation, among others. Of special interest are cases such as those of Thomas Carter, Gursei Mandaci, and Michael Furr, who made significant illicit profits in pump and dump schemes despite having little or no experience in the investment industry.
The Pyramid
“Be wary of messages that read: “How To Make Big Money From Your Home Computer!!!” One online promoter claimed that investors could “turn $5 into $60,000 in just three to six weeks.” In reality, this program was nothing more than an electronic version of the classic “pyramid” scheme in which participants attempt to make money solely by recruiting new participants into the program.” The Pyramid scheme is perhaps the classic example of fraud. Internet related pyramids include the case of Future Securities, Inc. cited above.
The “Risk-Free” Fraud
“”Exciting, Low-Risk Investment Opportunities” to participate in exotic-sounding investments – such as wireless cable projects, prime bank securities, and eel farms – have been offered through the Internet. But no investment is risk-free. And sometimes the investment products touted do not even exist – they’re merely scams. Be wary of opportunities that promise spectacular profits or “guaranteed” returns.” The SEC report restates the familiar refrain once again: “If the deal sounds too good to be true, then it probably is.” Risk-Free frauds described above include the Chidwhite Enterprises, WebWorks Marketing, WowAuction.com, American Space Corp. and Kinesis International cases.
Off-shore Frauds
“At one time, off-shore schemes targeting U.S. investors cost a great deal of money and were difficult to carry out. Conflicting time zones, differing currencies, and the high costs of international telephone calls and overnight mailings made it difficult for fraudsters to prey on U.S. residents. But the Internet has removed those obstacles. Be extra careful when considering any investment opportunity that comes from another country, because it’s difficult for U.S. law enforcement agencies to investigate and prosecute foreign frauds.” Examples of offshore fraud cited above include the cases of stockreporter.de and Internet Solutions For Business (ISFB).
Another classification of Internet fraud, not specifically enumerated by the SEC, but prominent in their enforcement actions, is the practice of illegally touting securities without disclosure of compensation. This practice violates the standard ethical principles of the securities industry as well as fraud laws. Examples cited above include the cases of the Emerging Company Report, Sloan Fitzgerald, Hastings Communications, pinkmonkey.com, and iBIZ Technologies.
Yet another type of Internet fraud is the inventive use of electronic order systems to manipulate stock prices. In this scheme, a fraudster with access to client accounts and an electronic automatic order system will enter an artificially inflated bid on a security at the same time as a client has issued an order to buy at a price determined by the best available national bid. The fraudster then cancels their bid, executes the client’s order, reports the transaction to the client at the lower price, and pockets the difference.
There is a perception among many that the Internet is in a sense frontier territory, unencumbered by legal restriction, however this is not the case. The laws which protect the interests of use of the client in the traditional marketplace extend the same protection to the clients of the digital marketplace. Disseminating fraudulent materials is illegal no matter what the medium, and acting against the best interests of a client is unethical no matter what technology is involved. The problem is not going away any time soon, if the continuing litany of wrongdoing reported by regulators is any indication. Perhaps the most important question, for the investor and the investment professional, is how to avoid becoming involved in fraud.
Avoiding Internet Fraud
For Investors:
- Do your homework–perform independent research on all potential securities purchases, such as verifying that the security in question actually exists, is registered with regulatory agencies, is consistent with your financial goals, and has been presented to you, the prospective client, accurately. You may also want to verify performance claims, earnings reports, growth projections, and other financial data if possible.
- Do not do business with individuals or firms who are not licensed, and report all persons or firms operating without license or registration to the appropriate regulatory body and / or local or federal law enforcement agencies.
- Be wary of offers or investments with abnormally high returns and / or abnormally low risks. Be especially wary of offers of no cost or no risk investments.
- Do not take action on any supposed “insider information” you may encounter, especially in the form of unsolicited email or electronic bulletin board postings. Trading on insider information is a serious crime and should be avoided in any case.
- Always read the fine print including all disclosure statements– Be especially wary of offers where the offering party is receiving compensation from or has positions in the security they are recommending.
- When in doubt about an investment opportunity you have found out about online, consult with your financial advisor, accountant, or other financial services provider.
For Investment Professionals:
- Be certain you and your firm have all licenses and registrations required to operate your business, and that the securities you offer are also legally registered.
- Train your employees in ethical practices, especially employees with client contact.
- Review sales and marketing materials intended for public release including web pages and emails. Be especially alert for promises or guarantees of high returns and be certain all risks are fully disclosed in a manner that is clear to the client. Promising astronomical returns for almost no risk may seem to be an effective sales strategy, but misrepresenting the investments you offer your clients is not ethical.
- Keep in mind that, as a financial services provider, your concern should be for the best interests of your clients, and all investment decisions should be made with those interests in mind. Make sure you understand your client’s financial goals, and that your client is realistic about the risks involved and the probability of success.
- Discourage day-trading (many firms prohibit it altogether).
- Monitor all activities using automated or electronic order systems.
- Disclose in writing all compensation you or your firm receives (in the form of cash payments, securities holdings, options, or other compensation) from companies whose securities you sell, and provide accurate representations of past performance, estimated risks and potential returns to your clients. Many enforcement actions, accounting for hundreds of thousands of dollars in fines and numerous criminal proceedings, could have been avoided if compensation schemes, performance, and risks to investors were fully disclosed. Failure to disclose pertinent information on electronically distributed materials is the most common violation reported by regulators.
- If you have any doubts about materials you are providing to clients or prospective clients via electronic means, discuss the issue with your compliance department, legal counsel, or with representatives of the relevant regulatory agency.