Market Manipulation

Internet stock fraud essentially takes the form of "market manipulation" (i.e., the use of devices intended to mislead investors by artificially affecting market activity). See Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476, 51 L. Ed.2d 480, 493-94 (1977). The advent of the Internet has merely increased the rate at which market manipulation occurs by using such schemes as "pump and dump" and illegal "touting" of stocks.

Congress and the SEC has been dealing with stock fraud since well-before the enactment of The Securities Act of 1933 (the "1933 Act") and The Securities Exchange Act of 1934 (the "1934 Act"). The 1934 Act crystalized Congress and the SEC's attack on stock fraud to protect the investing public. Though market manipulation often involves Sections 9, 10, 14(e), and 15(c) of the 1934 Act, this article focuses solely on Section 10 of the 1934 Act and Rule 10b-5 promulgated thereunder-the most overreaching, "catchall" section dealing with market manipulation.

Section 10(b) of the 1934 Act provides that:

It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchanges-

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.

See 15 U.S.C. § 78j

Rule 10b-5, promulgated by the SEC under the 1934 Act proscribes that:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statements of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

See 17 C.F.R. § 240.10b-5 (1993).

Pump and Dump Stock Fraud

The "pump and dump" scheme is nothing new to the world of stock fraud. What used to take place in "boiler-rooms" with maybe twenty to thirty cold callers has now become a much more efficient and sophisticated scheme via on-line spam e-mail messages. Spam messages are basically the Internet's version of junk mail, and defrauders can easily purchase an e-mail list of likely victims. There even exists a website instructing potential defrauders how to nab unsuspecting investors in a pump and dump scheme.

In the "pump and dump" scheme, the defrauder first accumulates a substantial position in a company trading on the NASDAQ OTC Bulletin Board, for example. Most often this includes creating a position in microcap stocks. What makes microcap stocks so vulnerable to manipulation is that they are, by definition, sensitive to wide stock price swings because they are companies with low or "micro" capitalizations, typically with limited assets, low trading prices, and little publicly available information. See Microcap Stock: A Guide for Investors, Feb. 1999. It is the lack of wide-spread publicly available information which fuels the engine of stock fraud, thus limiting the ability of traders to carefully filter out false information on the Internet. Then, after the close of the market and through the opening of the market the following trading day, the defrauder uses alias screen names to post hundreds of messages about the targeted microcap company on Internet message boards, and send hundreds of "spam" e-mail messages with identical messages. The spam messages and e-mails falsely tout positive things about the microcap company (i.e., that the company is about to be acquired by a well-known blue-chip company at a premium over its current market price.). If the scheme goes as planned, this will cause a surge in the price and volume of the microcap company's stock. When the price has skyrocketed, the defrauder sells his shares in the market he has created, realizing substantial profits per share. This typical "pump and dump" process was adapted from the facts of SEC v. Hogan, No. 00c5637 (N.D. Ill. Sept. 14, 2000).

This scheme takes the "buy low, sell high" theory, combines that with the Internet's graphic ability to make anything look authentic, and packages that together with the seeming ability to remain unidentifiable while simultaneously transmitting information to hundreds of people. In the context of the Internet, this scheme can be seductive to the investing public, for the information at least appears authentic and very official.

Recent Pump and Dump Schemes

Over the past few years, there have been numerous pump and dump schemes on the Internet. Some of the most notable instances, in which the SEC has taken center stage to mount attacks against them, provide good illustrations as to the magnitude of this growing problem and the SEC's response to make the investing public feel comfortable.

Georgetown Law Students

In February and March 1999, a Georgetown University Law School student, Douglas W.Colt, created a scheme to manipulate the shares of four stocks using a free subscription internet site entitled "Fast-Trades.com," increasing the short-term price of each stock by as much as 700%. See SEC v. Colt, Civ. No. 00423 (D.D.C., Mar. 2, 2000). Colt and others targeted and purchased shares of four microcap companies, knowing that his trading activity and that of his subscribers would artificially increase the price. The Defendants purchased shares shortly before the website made its recommendations to its subscribers. Then, according to the SEC, Colt's online stock subscriber site recommended subscribers purchase shares in the companies in which Colt had just purchased shares. As the recommendations drove up the price of the stock, Colt's previously placed stop limit orders kicked in, triggering a sale of his and the other defendants' shares, thus reaping profits of around $345,000. Profiting from the scheme were Colt, his mother, and two of Colt's law school mates. Simultaneous with the filing of the complaint, Colt entered into a final judgment permanently enjoining him from such violative conduct. Based on his alleged financial inability to pay, the Commissioner waived the disgorgement and prejudgment interest and did not seek the imposition of a civil monetary penalty. See SEC v. Colt, Civ. No. 00423 (D.D.C., Mar. 2, 2000), Litig. Rel. No. 164461, 3/2/00.

Manipulation of Pairgain Technologies

In August 1999, Gary D. Hoke, Jr., a former engineer for PairGain Technologies ("PairGain"), who at the time owned shares of PairGain, signed onto the Internet under a false name and posted false messages reporting that publicly traded PairGain was being purchased by an Israeli company. SEC v. Hoke, Civ. No. 99-04262 (C.D. Cal.), Litig. Rel. No. 16266, 8/30/99. Hoke's posting was presumed legitimate because, ingeniously, he provided a direct link to what appeared to be a Bloomberg News Service page containing an announcement of the acquisition, but was really a fabrication by Hoke. Hoke's false reporting created a trading activity in PairGain, substantially pumping up the market price. Hoke settled, agreeing to be permanently enjoined from future violations of the Exchange Act. The proposed final judgment relieves Hoke of all obligations to pay based on a sworn statement of his inability to pay. The most interesting fact is that Hoke allegedly never actually traded his own shares or encouraged others to do so. Peter Ramjug, Reuters,"PairGain Web Hoax: Hoke Grounded," Aug. 30, 1999.

NEI Webworld Pump and Dump

In November 1999, three "twenty-somethings" in California participated in a standard pump and dump scheme when they first accumulated large blocks of NEI Webworld, Inc. ("NEI") for merely pennies a share. SEC v. Aziz-Golshani, et. al., Civ. No. 99-13139 (C.D. Cal. Dec. 15, 1999), Litig. Rel. No. 16391, 12/15/91. At the time, NEI had no assets and was in bankruptcy liquidation. The defendants used computers at UCLA to create numerous Internet message board accounts. Throughout the weekend following their accumulation, the defendants began pumping up the price of NEI by posting false statements that NEI would be acquired by privately held LGC Wireless, Inc., and that the target price was between $5--$10. Their other accounts were used to give the appearance of third party comments regarding the acquisition. Shares of NEI rose from $.13 per share to over $15 per share during the first hour of trading, before subsequently dropping. The defendants allegedly realized approximately $364,000 in profits. In July 2000, an amended complaint broadened the charges to include price manipulation in eleven other companies. See SEC v. Aziz-Golshani, et al., Civ. No. 99-13139, (C.D. Cal. Dec. 15, 1999), Litig. Rel.No. 16620, 7/6/00.

In late January 2001, two of the defendants (Hootan Melamed and Allen Derzzakharian) settled with the SEC, agreeing to surrender substantially all of their illegal trading profits (approximately $211,000) and consenting to the entry of permanent injunctions from future violations of Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Act and Rule 10b-5 thereunder. See SEC v. Aziz-Golshani, et al., Civ. No. 99-13139 (C.D. Cal. Dec. 15, 1999), Litig. Rel. No. 16867 (1/23/01). The SEC civil case against Aziz-Golshani is still pending as well as criminal charges against him by the United States Attorney.

"AOL Investment Snapshot" Scam

James Sheret, Jr. and Glenn E. Conley allegedly disseminated false spam messages fraudulently manipulating the share price of 57 thinly-traded companies. See SEC v. Sheret, Civ. No. 1411 (S.D.N.Y.), Litig. Rel. No. 16453, 2/24/00. The messages prepared by Sheret and Conley misrepresented that they emanated from or were endorsed by America Online, Inc. After the prices of the shares rose, the defendants sold their personal holdings allegedly making profits of approximately $330,000. In addition to civil charges alleging violation of Section 10(b) of the 1934 Act, the U.S. Attorney for the Southern District of New York also filed criminal charges alleging securities fraud.

Gursel Mandaci Scheme

In yet another pump and dump scheme, twenty-five year old Mandaci purchased thinly-traded penny stocks through an online broker. Then, in keeping with the typical pump and dump technique, he logged onto the Internet and posted several messages using three different identities-to give the impression of widespread interest in the stock. The messages allegedly contained false information and baseless price predictions. Following a run-up in the stock, Mandaci sold, making more than $23,000 in six stocks he manipulated. SEC v. Mandaci, Civ. No. 00-CIV-6635 (S.D.N.Y. 9/5/00), Litig. Rel. No. 16682 (9/6/00).

TnTStock.com Scheme

In a recent SEC litigation release, the SEC indicated it filed a complaint against brothers Byron and Jared Leisek (ages 22 and 25, respectively) for market manipulation resulting from their stock picking website, TnTStock.com. According to the SEC, the defendants purchased shares in profiled companies, placed limit orders to sell the shares at higher than then-current market prices, and then issued recommendations for such stock on their website. The defendants allegedly made close to $200,000 in profits from this scheme. See SEC v. Leisek, et. al., No. CV 01-6084 (AA) (D. Or.), Litig. Rel. No. 16921, 3/01/01. The defendants allegedly sold their shares within thirty minutes of the release of their recommendations.

Emulex Pump and Dump

In perhaps one of the most widely publicized, broad reaching pump and dump scams to date, defendant Mark S. Jakob first sold short Emulex stock on August 17 and 18, 2000, in anticipation of its decline. However, within a week, the stock rose $33 per share above the short-sale price, resulting in over $97,000 in unrealized losses for Jakob. In a scheme to reduce the share price of Emulex, Jakob used an alias and purported to act on behalf of Emulex by sending e-mail instructing Internet Wire (a web-based news-release service for which Jakob was formerly employed) to issue an attached press release that Emulex was under SEC investigation, that its CEO resigned, and that it would revise its earnings to report a loss instead of a profit. See SEC v. Jakob, Civ. No. EDCV-00-687 VAP (C.D. Cal.), Litig. Rel. No. 16671, 8/31/00. The presumably official press release wreaked havoc on Wall Street, initially dropping Emulex shares almost $61 in just 16 minutes of trading (resulting in a $2.2B loss in market capitalization). Followings the issuance of the false press release, Jakob covered his short position, wherein he realized a profit of over $240,000. The word spread rapidly due to news casts on CNBC-TV and Bloomberg News as well as internet postings on Yahoo! Finance and RealMoney.com (posted by the well-renowned market-maker James Cramer). See Erin White and Aaron Elstein, "Bogus Report Sends Emulex on a Wild Ride," The Wall Street Journal, Aug. 28, 2000, C1. It was the wide-spread reporting which added the assumed truth to such statements. The SEC's complaint alleged Jakob's violation of Section 10(b) and Rule 10b-5 of the 1934 Act and section 17(a) of the 1933 Act.

In a matter separate from the civil action, Jakob pleaded guilty on December 29, 2000, to criminal charges of two counts of securities fraud and one count of wire fraud for creating and distributing false Emulex press releases over the Internet. See SEC v. Jakob, CR 00-1002-DT (C.D. Cal.), Litig. Rel. No. 16857, 1/8/01. Under the guilty plea, Jakob is subject to a maximum of 25 years in prison, a maximum fine equal to two times the $110 million in investor losses and an order of restitution up to $110 million payable to the victims he defrauded.

Separate from either of the above actions, a class action suit was also filed on behalf of defrauded investors against Internet Wire, Inc. and Bloomberg, L.P. in connection with alleged reckless dissemination of the false information. See Hart v. Internet Wire, Inc., et al., (S.D.N.Y. Aug. 31, 2000).

Jonathan Lebed's Pump and Dump Scheme

The most recent high-profile SEC crackdown of internet stock fraud came in September 2000. Allegedly, from August 1999 to February 2000, teenager Jonathan G. Lebed used the Internet to manipulate shares in microcap stocks. Lebed first purchased a large block of thinly-traded micro-cap stocks. Lebed then sent several false and/or misleading "spam" messages to various Yahoo! Finance message boards wherein Lebed pumped up the price of the stock he had recently purchased. Then, when the price rose, Lebed sold all of his shares at a proft. The posting of the "spam" messages, which were through several fictitious author names, specifically included baseless price predictions, some of which claimed that a company's stock would rise from $2 per share to more than $20 per share "very soon." See "SEC Brings Fraud Charges in Internet Manipulation Scheme: Settlement Calls for Return of $285,000 in Illegal Gains," Rel. 2000-135. The case was settled without admitting or denying liability whereby Lebed agreed to an administrative cease and desist order, agreeing to return $285,000.

The Internet: A Breeding Ground for Stock Fraud

The interesting and perhaps unusual facts in the Emulex, PairGain, and Lebed scams, for example, were that it was the Internet which made it rather easy for the defendants to make the false message look very official and believable, based on the defrauders' skills at manipulating information on the Internet, and the Internet's ability to graphically package anything as authentic coupled with the day-trader's need to act quickly.

So much was this the case in the Emulex scam that even CNBC-TV was lured into believing that the information was real. In the case of Johnathan Lebed, the Internet allowed one person, a teenager at that, to sit in his bedroom and manipulate the market through a well-thought-out pump and dump scheme.

No longer is it necessary to rent office space on Long Island and hire twenty or thirty people to cold call senior citizens in a pump and dump scheme. Lebed proved that with the Internet's ability to at-least-initially conceal identities and send messages to hundreds of people, anyone can participate in stock fraud, at a much lower transaction cost.

The ability initially to mask identity works like this: the defrauders use multiple Internet service-providers ("ISPs"), some of which are oversees, and they bounce information from one place to another, obscuring the transmission's place of origin. Kevin Cool, Internet Enforcer: Christopher Painter Chases Criminals Through the Dark Alleys of Cyberspace," Stanford Lawyer, Iss. 57, Spring 2000. While it is possible to track down the original source of the information, which the SEC eventually does, locating the source takes time and technical know-how by sophisticated enforcers.

Illegal stock touting on the Internet involves, among other things, fraudulent spam messages, online newsletters, message board postings and web-sites which, among other things, lie about the companies (often in connection with a pump and dump scheme), lie about the touter's independence from the company which they are touting, and fail to adequately disclose the nature, source and amount of compensation they receive from the companies. See "SEC Charges 44 Stock Promoters in First Internet Securities Fraud Sweep," Rel. No. 98-117 .

Federal and Local Government Enforcement

Over the past three years, the SEC, under Chairman, Arthur Levitt, went to great efforts to mount a public attack against Internet stock fraud, which may or may not result in adequate enforcement. At the same time, investors who have been defrauded often consider a private right of action against the defrauder.

Enforcement Measures

In July 1998, the SEC formed an Office of Internet Enforcement to combat on-line stock fraud. The Office is comprised of a "Cyberforce," a team of 135 staff members (as of 4/5/99) who spend time each week surfing the web in search of securities fraud. See "A Bull Market in Securities Fraud?" Remarks of Richard Walker.

Conceding that the SEC's net is not expansive enough to monitor every corner of cyberspace, the SEC has undertaken a web-based counter-attack of effective investor education. For example, the SEC's website includes materials such as:

1. Internet Fraud: How to Avoid Investment Scams, Oct. 1998;

2. "Plain Talk About On-line Investing";

3. "Pump&Dump.con: Tips for Avoiding Stock Scams on the Internet" ; and

4. "Microcap Stock: A Guide for Investors," Feb. 1999.

In addition to the educational program, the SEC has held several town meetings across the country where they have met with investors and helped them understand the schemes and detect warning signs. In all fairness to the SEC, these initiatives have made stock fraud information widely available to the investing public. But it is questionable whether the SEC's actual enforcement is much more than rhetoric.

On the state level, New York Attorney General Elliot Spitzer created an eight-person Internet Bureau to investigate securities issues relating to the Internet. See Lisa I. Fried, "'New Age' Cops Patrol Internet," New York Law Journal, Sept. 27, 1999. The Attorney General's website even contains brochures relating to protection against securities fraud. See "Protection Against Fraud" and "Report on Micro-Cap Stock Fraud".

Adequate Enforcement for the Savvy Defrauder?

Despite the SEC's claims of tough enforcement, its actions suggest it is content mostly with press releases, the theory being that enforcement in a few high-profile cases will deter future acts by many potential defrauders considering "pump and dump" schemes.

The SEC determined in the Colt matter that Colt, his mother, and law school classmates were "financially unable" to pay back their gains. The SEC's complaint sought to require Colt to disgorge his illicit profits, with interest. However, according to The Wall Street Journal, Mr. Colt comes from a prominent Colorado Springs family. See "Georgetown Students Draw Web Investors and an SEC Bust: How Founders of Fast-Trades Reaped Speedy Profits; 'Boiler Room' in a Dorm Room?" The Wall Street Journal, at 2000 WL-WSJ 3020227, March 3, 2000. How could both Colt and his mother have been deemed "financially unable" to pay? Why didn't the SEC simply obtain a judgment and wait until Colt is financially able to pay?

In the Jonathan Lebed case, the SEC carefully reported that the case was settled and Lebed was required to return $285,000 in profits. While appearing to be the saviors of the investing public on the one hand, Lebed allegedly was able to keep $500,000 in profits, on the other hand. See Michael Schroeder and Ruth Simon, "Teenager in Stock-Fraud Case Kept $500,000 in Profits: SEC Didn't Pursue Gains From 16 Trades That Seem Similar to the Illegal Ones," The Wall Street Journal, at 2000 WL-WSJ 26613947, 10/20/00. According to The Wall Street Journal, there were sixteen trades the SEC decided not to prosecute on which resulted in approximately $500,000 in profits, as the SEC alleged wrongdoing only in the cases they felt they had abundant evidence, where violations were clear instances of fraud. Presumably, the SEC could have used its leverage to force Lebed to disgorge all his profits.

The argument can be made that the SEC was merely looking to make an example, without having to expend substantial resources. The SEC's example is that stock manipulation is just as much of a violation when done by a teenager or twenty-five year old as when it is committed by a fifty year old on Wall Street. The Wall Street Journal reported that a former SEC general counsel noted that "almost every case the SEC brings is a message case."

Private Remedy

Of course, the investing public is not required to solely rely on SEC enforcement actions. A private right of action under Section 10 of the 1934 Act exists against those who commit a manipulative or deceptive act in connection with the purchase or sale of securities. See Santa Fe Indus., Inc., 430 U.S. at 475. More specifically, the stock manipulation must constitute: (1) a scheme relating to the purchase or sale of stock, which includes (2) mistatements or omissions, (3) of material facts, (4) made with scienter, (5) upon which [the plaintiff] relied, (6) causing [plaintiff's] injury, and (7) touching upon the loss in value of the stock. See Huddleston v. Herman & Maclean, 640 F.2d 534, 543 (5^th Cir. 1981). See also, Chemetron Corp. v. Business Funds, Inc., 718 F.2d 725, 728 (5^th Cir. 1983).

The defendant in a Section 10 claim is not also required to be a purchaser or seller of the securities in question. See Basic, Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988), on remand 871 F.2d 562 (6th Cir. 1989). Thus, the defendants could merely be (and sometimes are) kids having a good time on the Internet, or disgruntled people seeking to manipulate shares without actually purchasing or selling shares themselves. In the PairGain scheme the defendant made no trades.

Without addressing each element of stock fraud here, it is at least worth noting that the determination of liability is very fact-sensitive and could at least hinge on the circumstances surrounding the "materiality" requirement.

Materiality

Perhaps the "materiality" standard provides the best argument for shielding Internet manipulators. The materiality standard requires that "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." See TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 96 S.Ct. 2126, 48 L.Ed.2d 757, 766 (1976); and Basic, Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988).

The SEC warns that an investor should "never, ever, make an investment based solely on what [he] read[s] in an online newsletter or Internet bulletin board, especially if the investment involves a small, thinly-traded company that isn't well known." See "SEC Charges 44 Stock Promoters in First Internet Securities Fraud Sweep," Rel. No. 98-117. From this premise, it is arguable that a reasonable investor would not have been swayed by the false or misrepresented information and therefore, the information is immaterial as a matter of law. See Parnes v. Gateway 2000, 122 F.3d 539, 546 (8^th Cir. 1997).

As silly as this sounds, many online traders log-on to chat-rooms for their investing advice. Would a reasonable investor really do such a thing? It is seemingly absurd for investors to rely merely on Internet chat-room messages as their "total mix" of information, particularly where the stock of public company is involved.

In cases of small cap stock fraud, given the limited total mix of information, a purchase or sale based on Internet manipulation is arguably more reasonable than fraud involving large-cap stocks. In the case of large cap public companies where information is widely available, liability for investors' losses should not be solely placed on the alleged market manipulator.

There are types of statements and omissions, where a defrauder might possibly be able to manipulate the price of a stock without such manipulation being deemed "material" and thereby subjecting the manipulator to liability. For example, vaguely optimistic false statements on which a reasonable investor would not rely are not material. See Raab v. General Physics Corp., 4 F.3d 286, 289-90 (4^th Cir. 1993); and Picard Chem., Inc. Profit Sharing Plan v. Perrigo Co., 940 F. Supp. 1101, 1122 (W.D. Mich. 1996). It appears that this is what was going on in the Lebed and Georgetown Law Student cases.

Conclusion

As investors log onto the Internet and point and click their way through cyberspace in search of the next big stock tip, they should keep in mind the absurdity in relying solely on Internet chat-room advice in purchasing securities, and they should be generally cautious of information contained in online newsletters. Absent such precautions, the parties on whom to place most of the blame may be those eager investors who turn a blind-eye to the total mix of information and merely rely on information that is arguably not "material" under the law.

Copyright © Ford Marrin Esposito Witmeyer & Gleser, L.L.P., 2001.

Last Updated May, 2001

http://www.fmew.com/archive/lies/