Internet stock scams

More On Internet Stock Manipulations; SEC v. Lebed (2000), revisited

Capital Markets, Investors, Issuers, Law , , ,


I was reminded recently of the story of Jonathan Lebed, a 14 year old kid from New Jersey who was investigated by the SEC for stock manipulation using the internet back in 2000.  This case was a big deal at the time, garnishing a segment on 60 Minutes and some interesting discussions in the financial and legal press.

Even though he was underage, with the help of his parents, Lebed had managed to open an account at one or two of the discount brokerage firms. He was apparently trading his accounts in low price stocks when the SEC came knocking on his parents’ door. 

It seems that in the course of trading Lebed liked to post positive comments about what he was buying on various websites, bulletin boards and chat rooms where people who might be interested in purchasing these stocks would see them.  This was in 2000 when the chat rooms were not sophisticated and the web reached a fraction of the people it reaches today. 

Lebed would buy a low priced stock and then say something nice about the company in a message that he posted in a chat room. Using multiple e-mail addresses he might get that same, positive message posted in 200 chat rooms.  Some of the people who saw his posts would re-post them again. 

Lebed knew that his simple postings would create significant interest in these shares and that the price would move up.  He commented that posting the messages with key words in all capital letters would actually get even better responses. 

Bringing a lot of attention to a more obscure, low priced stock can, indeed, lift the price. The SEC called it an intentional market manipulation.  Lebed said that he was only doing what the research analysts at the big firms did, publish their opinions about companies whose share price they wanted to go up. 

Lebed did all this out in the open. Several of his classmates and school teachers followed his leads and invested with him. They were willing to take a chance of doubling their money if the share price of one of these companies went from $.30 to $.60. 

Many of these investing neophytes did understand the positive effect that Lebed’s postings and his quasi investor relations campaigns had on these stocks.  They wanted to buy before he posted and get out as the buyers reacting to his posts pushed up the price.  

Lebed was not the only person or group at that time that was using the internet to enhance the price of shares of small public companies.  But he demonstrated that in the year 2000 the power of the internet to sell investments directly to investors was underrated.  In the almost 20 years since, the use of the internet to sell almost anything, including investments, has become much more powerful and pervasive. 

In the regulated financial markets the dissemination of information is encouraged, but it is also controlled.  Regulations require that information be accurate and complete. Public companies are required to report specific information about their business, to present that information in a specific manner and to release that information on a regulated schedule. 

For a licensed stock broker or investment advisor every e-mail, tweet, posting, comment and utterance about any investment is subject to the scrutiny of his/her employer and by regulators. The SEC depends on the market professionals and market participants to play by the rules. There are significant penalties for non-compliance. 

But Lebed was not a market professional. He was an outlier. He was an independent investor, not a licensed participant in the marketplace.  In the end the SEC let Lebed keep most of the money that he made from his trading as long as he promised to stop.  

At the time, no one really questioned the SEC’s jurisdiction over Lebed or what he was doing. Lebed was a US citizen, operating out of New Jersey. His posts were about US companies whose shares traded in the US markets. Many of his posts were made through a US based internet company (Yahoo Finance). 

In the ensuing 20 years, social media and on line platforms, publications and unregulated “experts” have demonstrated that they can easily sell investments directly on line to millions of investors.  Moreover they have demonstrated that they can disseminate information about public companies and new issues without regard to the truth of the information.  And they can do so without regard for regulations or national borders.

In the “direct to investors” investment world, social media “followers” has replaced “assets under management” as a measure of how many investors’ dollars a person can bring to an investment or new offering.  And you can buy people who have a lot of followers.

If I wanted to hype a stock, either a new issue or one that is already trading, I can make a financial arrangement with any number of independent “experts” who have a lot of social media “followers”.  Some may write articles for financial publications, some write books and blogs and many can be found going from conference to conference and podcast to podcast. 

Any financial “expert” can purchase the right to give the keynote speech at a conference and purchase any number of other speaking slots and sponsorships as well.   Anyone can buy interviews on financial websites, blogs and podcasts or pay for the right to create and distribute positive content on these sites.   

If you look at the numbers you can get an idea of how this works.  I can hire a financial “expert” to tout any stock that I wish. The “expert” will send his/her followers a series of e-mails, appear at a series of conferences and write a series of articles about that company. An expert with 1 million followers might reach 2 million other investors who see re-prints and references to it.

If only 10,000 investors of those followers invest an average of $1000 a new issuer can raise $10,000,000. That much new money coming into a thin trading market can often raise the trading price of the shares of a smaller company.  

There is no limit to the number of experts I can hire or the size of the e-mail lists I purchase for their use to augment their own list of followers.  If I hire multiple experts to hype the same stock, other experts who have not been paid may mention the company independently.  And before you say that this type of scheme using paid experts to hype the stock may be questionable under US law, who said that US law applied?   

If you solicit investors in the US for a new issue the offering is subject to US law.  That would require full and fair disclosure to investors in the US and provide for government penalties for non-disclosure.  But what if you donot make the necessary disclosures and you only solicit investors in other countries? 

The capital markets are regulated country to country.  Each country has its own rules which apply to financial transactions involving its citizens and issuers.  Each has rules governing transactions executed on the exchanges domiciled in their country. The laws of the country where the issuer is domiciled, the exchange is located and where the investors reside may all apply to a single transaction.  An overriding question with the direct to investor market is which country has jurisdiction and over what actions and activities.

If an article about a company’s share price or prospects from a European website gets republished or re-distributed in the US is the author subject to US law? What if the author knew the information in the article was false; do US investors have any recourse?  Does it matter if the author got a royalty for the re-print?

Would the answer be different if the false information originated with just one shareholder who bought a large block of shares cheap and now wants to pump up the price?  Does it matter if that person is in a country other than where the shares trade or the articles originate? 

I recall that when the Lebed case was discussed a lot of people thought that the internet would change and globalize the capital markets. It clearly has.  

I think that there is still a lot of discussion that needs to be had and a lot of questions that need to be asked and answered.  In the meantime, it should be obvious that the current international regulatory scheme does not overlap as well as it could.   

The current and expanding global reach of social media create opportunities and but also highlights problems.  The flow of capital and information continue to globalize. At the same time I am certain that it would is a lot easier today for a 14 year old to manage a single successful, global stock manipulation.    

Remembering Bre-X- The First Big Internet Stock Scam

Issuers, Law , ,

It has been 20 years since the Bre-X stock scam.  It may not be completely accurate to call it the first internet stock manipulation, but it was certainly the largest for its time. The scam was based upon false information that the company originally circulated on the internet. After a while large companies and the mainstream media jumped on the bandwagon. Then large investors followed.

Bre-X was a Canadian penny stock company whose share price went from about $.30 per share in 1993 to over $250 in 1997. The stock was originally traded on the Alberta Stock Exchange and later the Toronto Exchange and then moved to NASDAQ.

At the end, it took only about one month or so for Bre-X to unravel completely.  When the stock collapsed, investors had lost somewhere in the neighborhood of $5-$6 billion.

Bre-X has a fairly simple story. The company claimed to have located a huge deposit of gold, perhaps the largest single deposit ever discovered, deep in the jungle on the island of Borneo which is part of Indonesia.

People have been scamming investors with claims of huge gold discoveries for a long time. And as they say “greed is a powerful motivator”.

As far as anyone knows the entire a scam was the product of no more than 3 people.  The primary players were David Walsh the founder and largest shareholder of Bre-X, John Felderhof the chief geologist and Michael de Guzman the on-site geologist in Borneo.

Walsh purchased the property located in the middle of a jungle in 1993 on the advice of Felderhof.  The on-site geologist, de Guzman, took samples which were assayed. He initially estimated that the deposit was equal to 2 million Troy ounces of gold. The estimate of the site’s size and worth increased over time. In 1995 the estimate was raised to 30 million ounces, in 1996 it was raised to 60 million and finally in 1997 the estimate was 70 million ounces.

There was actually no gold at the site. It was later revealed that de Guzman was “salting” the samples he was sending to be assayed, i.e. he was adding gold shavings to the samples.  There is nothing particularly new about this scam. People had salted gold and silver mines to gain investors before. What was new is that the fake information was disseminated over the internet.

The internet in 1994-1997 was very different than it is today. Computer screens still had no color. You could not upload or attach documents. There were no search engines.  E-mail was primitive and very few people had an e-mail address. There were 3 primary services that you could use for internet access; America On-Line, Prodigy and CompuServe.

I was an early CompuServe user. I say early because my account number had only six digits. I would usually access CompuServe in the evenings via my dial-up modem.  It was primarily a collection of forums and primitive chat rooms where users could swap information and discuss various subjects.  There was a section dedicated to stocks.

Bre-X was certainly one of the most often talked about stocks during this period. There might only be one or two dozen people who left comments but you knew that many more were silently lurking and reading them.  I was reading the comments late in the evening on the West Coast. There were certainly people who were writing comments and other people reading them on the East Coast the next morning.  There was a lot of information about Bre-X to post and discuss.

As new assays were supposedly being taken and the estimates about the size of the potential strike went up and up, larger players tried to put their hand into the cookie jar.

First there was a failed take-over attempt by Placer Dome which was a much larger mining company. Next, the government of Indonesia (then a corrupt dictatorship) tried to bring Barrick Gold on board. The government claimed to be concerned that a small company like Bre-X might not be able to handle a large mining operation,

Later, the government brokered a deal whereby Freeport-McMoran a third large mining company, would have a majority interest and run the mine.  Members of Indonesian President Suharto’s family and their cronies got a cut of that deal as well.

Once the shares were on the NASDAQ in 1996, Lehman Brothers and other big firms started to follow the stock. There were articles about it in the Wall Street Journal and the mainstream media.

Everyone seemed to think that the gold deposit that had been discovered in the middle of the jungle on Borneo might be larger than expected and that other sites in the jungle might be the next to be explored.  The “smart money” seemed to think that it was only a matter of time before more gold was discovered.

Freeport-McMoran began its due diligence by drilling samples in early February 1997. The internet chat rooms were on fire with the speculation that the results might show richer deposits than did previous samples.  But it was not to be.

The scam ended abruptly in mid-March when the geologist, de Guzman, supposedly fell (or was pushed) out of a helicopter over the jungle. The body that was recovered days later was badly disfigured and identified through dental records.  The body quickly disappeared from the local morgue. People have claimed to have sighted de Guzman in Canada and elsewhere in the years since.

Freeport McMoran reported the results from its test a few weeks later stating that there was little or no gold on the site.  There were a few subsequent tests which concluded that the gold in the original samples had come from elsewhere which is how we now know that the early samples were salted.

The stock, of course, collapsed.  Trading was suspended in Toronto and on NASDAQ and the company filed for bankruptcy. The bankruptcy revealed that three large Canadian public pension funds had been big investors and hence, big losers.

Walsh claimed innocence of the whole affair, moved to the Bahamas and died of natural causes. Felderhof was charged with insider trading (he had apparently sold millions of dollar’s worth of stock along the way) but was eventually acquitted.  Class actions brought on behalf of shareholders returned virtually nothing to them.

Just before the end, Bre-X had blamed the meltdown of the share price on the internet.  Walsh claimed that the rumors that the company had no gold had emanated from enemies of the Indonesian government and that the people in the internet chat rooms were short sellers who wanted to see the company fail.

It is certainly correct to argue that the stock would never have run-up if the “news” about the alleged gold discovery had not circulated in the chat rooms.  It is certainly fair to assume that the stock price would have gone higher if many more people had visited these chat rooms.  As the share price went up, more and more people became convinced that the people saying it will go higher must know what they are talking about.

It is appropriate to consider just how high the price of Bre-X might have gone if there had been as many internet users then as there are now.  In the 1990s the internet was just flexing its muscles. Today it can easily move the price of any investment up or down. People who know nothing can sound like geniuses if the the stock price goes up after they say that it should.

Bre-X is actually a model for a modern pump and dump schemes.  All you need to do is acquire a lot of shares in a penny stock, set up one or more investment newsletter websites and drive traffic to those sights by sending e-mails to lists of investors.  The SEC has closed down internet investment sites that have done just that.

If there is anything that any investor should learn from the Bre-X scam it is that you should only take investment advice from people that you know and trust.  A lot of what you hear on the internet is just not real.