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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.