On Securities

Cyberspace sometimes seems like the wild frontier of securities trading, because deceptive information can move so quickly over the Internet.  In one recent case, the stock of a company called Emulex dropped 62%, losing more than $2.5 billion of market capitalization, when a phony press release on the Internet claimed that its CEO was resigning as the result of an accounting scandal. A “pump and dump” scheme – fraudulently promoting a penny stock and then selling when the price rises – used to require a boiler room of fast-talking salesmen on the phone. Now it only requires a home computer and a modem.

THE LEBED CASE

Jonathan Lebed was 14 years old when he started committing securities fraud. He may have been a little nerdy, toting his black leather briefcase to school each day, but he already seemed to have a bright future on Wall Street. At the age of 12, he and two friends had placed fourth in a national stock-picking contest for students.

Jonathan used the computer in his bedroom to buy shares in thinly traded, over-the-counter stock. Then he sent hundreds of identical e-mails to various Internet chat rooms under fictitious names in order to tout the stock that he had just purchased. Meanwhile, he placed “limit orders” with his broker to sell his shares when the price rose to a designated point.  According to the SEC, his phony messages caused the price and trading volume of each touted stock to increase dramatically.  Jonathan would be in class when his profits rolled in, usually within 24 hours of his purchase.

When the SEC investigators caught up with him, Jonathan reportedly told them, “What’s the big deal? Everybody does this.” Nevertheless, he agreed to a consent decree to stop his scam and paid a penalty of about $285,000 based on his illegal profits and interest.

Unfortunately, the story doesn’t end there.  Jonathan went on “60 Minutes” to claim that he had done nothing wrong.  His lawyer added that Jonathan had done only “what is done every single day of the week on Wall Street” in promoting and then selling stocks.

Jonathan also got to keep most of his ill-gotten gains.  The SEC brought charges on only some of his suspicious trading, and Jonathan reportedly retained half a million dollars of other trading profits. His family also got to keep the Mercedes SUV that Jonathan had bought for them.  His classmates who spoke to the press seemed to think that Jonathan was some kind of hero and that manipulating stocks on the Internet was just the latest X-game.  Even worse, some older commentators who should know better have criticized the SEC for picking on a plucky kid.

It may be too much to expect remorse or rehabilitation from Jonathan or his friends and family.  But we can hope that his case will provide some benefit by helping to educate the investing public about how easily it can be fooled.

CYBER ENCFORCEMENT

The SEC has been working hard to bring law and order to the electronic frontier, establishing an Office of Internet Enforcement in 1998. It now has a “cyberforce” of more than 250 people nationwide who are specially trained for Internet surveillance, and each local office has its own Internet Enforcement Branch.

In the last few years the SEC has brought more than 180 Internet-related cases, usually in “sweeps” that bundle related enforcement actions for maximum publicity and deterrent effect.  In its most recent sweep, last September, the SEC accused 33 companies and individuals of using the Internet to drive up the prices of more than 70 micro-cap stocks with fraudulent Web sites, e-mails, and chat room postings.

Despite this effort, Internet stock fraud seems like a growth crime, and even garden variety stock fraud increasingly will leave some evidence in cyberspace.  According to one estimate, half of the securities-related messages posted in chat rooms are passing on false information. The good news is that, while securities fraud may be cheaper and easier to commit on the Internet, it is also easier to catch. Marc Fagel, head of the Internet Enforcement Branch in the SEC’s San Francisco office, points out that Internet frauds leave electronic tracks that more conventional scams don’t. For example, Mark Jakob was targeted within hours after he posted the phony press release about Emulex and was arrested within six days. Nevertheless, the sheer volume of Internet traffic will remain a challenge to the SEC.

In the final analysis, the best defense against Internet stock fraud is a sadder and wiser investing public.  The willingness to follow anonymous Internet tips should fade as investors realize that the market does not always go up and that anonymous tipsters probably have their own agenda and should not be trusted.  The proclivity to bet on such flimsy information someday may be seen as just another facet of the “irrational exuberance” that has driven the stock market in recent years.