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Internet Securities Fraud: Old Trick, New Medium

By Vipul Shah

Part I Online Stock Trading Part III One Trick

 

Billions of securities are traded every day in public and private markets around the world. This practice is hundreds of years old and as long as securities have been traded, someone has tried to defraud the system to make a quick buck. With the advent of the Internet, new securities fraud schemeshave appeared.

Fraud on the Internet: Recent Examples

A number of recent Internet fraud cases dramatically demonstrate the extent to which this new medium creates potential for vast losses. The US based FBI's Internet Fraud Complaint Center (IFCC), a joint project with the Department of Justice (DOJ), reports that most Internet fraud complaints stem from online auctions. The amount at issue in these claims, however, pales in comparison to the multi-million dollar hoaxes perpetrated in the financial markets. Internet fraud involving stock information is the second most common form of investment fraud, amounting to losses of over $10 billion a year

One of the most common forms of securities fraud on the Internet involves an imposter who attempts to manipulate the price of a stock by disseminating phony press releases or information, or creating phony websites. A recent example of this scheme is the hoax perpetrated against US based, PairGain Technologies. In the PairGain case, a former employee posted a fraudulent message on an Internet website designed to look like a legitimate Bloomberg news service pagem (Bloomberg is news service like Reuter or our PTI). The message falsely stated that a competitor was acquiring PairGain. In the resultant flurry of trading PairGain's stock rose 30%, and even after the message was debunked PairGain's stock remained high, eventually closing 10% up, a net gain of $46.5 million. The false site convinced even money managers at the Wall Street news and thestreet.com

Another recent example of the use of the Internet to disseminate phony information is the Emulex case. On August 25, 2000, the web-based news service Internet Wire posted a press release containing information about Emulex Corporation, a computer hardware manufacturer. The press release, posted just as the financial markets opened, stated that Emulex's CEO had resigned and that Emulex had been forced to restate 1998 and 1999 earnings as losses instead of initially reported gains. Other news services, including CBS Marketwatch, Bloomberg, and Dow Jones, picked up the release's information about half an hour later. Emulex's stock, which opened at $110.69/share, went into free-fall. By the time Nasdaq decided to step in and halt the slide until the information could be verified, the price-per-share stood at $43, a loss of over 61%. In a matter of hours, Emulex stock suffered a net loss of over $2 billion dollars.

According to the FBI, the press release was a fraud perpetrated by 23-year-old college student Mark Jakob, a former Internet Wire employee who recently lost money selling Emulex shares short. On August 17 and 18, Jakob "sold short" 3,000 Emulex shares at $80/share. Selling shares short is a form of stock speculation; in effect, an individual borrows shares from a broker and sells them under the understanding that the individual must eventually buy them back to repay the broker. The buyer hopes that in the meantime the share price of the stock will drop below the price the buyer "borrowed" them at, so that he may later repurchase the shares to repay the broker and pocket the difference. Instead, Emulex stock rose to over $113 a share and Jakob lost over $97,000 when he was forced to repurchase the stock he sold for $80/share at the new price. After submitting a press release Internet Wire drafted in a manner that suggested it had already been reviewed for veracity, Jakob again began selling shares short, this time realizing a profit of more than $54,000 as the stock plummeted. Jakob later sold another 3,500 shares short. His total profit from the hoax was morethan $241,000. On December 29, 2000, Jakob plead guilty to two counts of securities fraud and one count of wire fraud in connection with the hoax. His sentencing is scheduled for March 26, 2001; and he faces a maximum 46 months in prison, a $220 million fine, and a possible $110 million inrestitution to Emulex shareholders. In addition, attorneys recently filed a class action lawsuit against Internet Wire and Bloomberg on behalf of Emulex shareholders.

A second form of Internet fraud comprises the category of "pump and dump" schemes. While the outcome of "pump and dump" schemes is identical to imposter schemes, namely the enrichment of the perpetrator at the expense of the majority of shareholders, the means employed to effectuate that result differ. Typically, the individual gives trading advice and tips to investors on the Internet (remember www.harshad.com recommending Krishna Filament, BPL, and few other scrips?), talking up stock that the individual already owns and then selling when the demand occasioned by the advice reaches a given level. A recent representative "pump and dump" case involved the website of Yun Soo Oh Park, who billed himself out as "Tokyo Joe" and specialized in stock tips and trading advice. On January 5, 2000, the Securities and Exchange Commission (SEC) of USA, filed fraud chargesagainst Park, alleging that he used his website to maintain an ongoing "pump and dump" scam, talking up stocks he already owned to subscribers of his tips service and then surreptitiously selling them when demand increased.Between selling stocks he recommended and charging fees for subscription to his service, Park made over $ 1.1 million in a twelve-month period ending in June 1999.

In India, we see this kind of frauds happening in different way due to nature of our society. Here when you talk to broker's staff while buying or selling, he will usually advise you to buy share which he has bought and plans to dump when price goes up.

We have seen enough of PUMP and DUMP even without help of internet in cases of Harshad Mehta boom of 1992 and Ketan Parekh boom of 2000 (he even had cult following with Index of 10 shares called K-10).

Today lot of investor's depend on TV channel for recommendation about stocks to sell, or buy or hold. Channels like CNBS offer array of experts from economist to brokers to analyst. Most of these people have vasted interest in stocks they recommend and promote. In India laws are lax about Incider trading. One has to be very careful when someone on TV or in newspaper or website promotes/recommends stocks as in India rarely you will find government taking action promptly and paying back investor's who lost money.

One should ignore emails in inbox recommending any stock (especially if its stock with low market capitalization and low floating stock means little liquidity) unless you know that expert. Even if you know him, try to verify that its not bogus mail by contacting him her on phone (don't reply as email address in email).

VIPUL SHAH is Mumbai based Chartered Accountant specialising in online
security and online transactions

You might want to read more:

Part I Online Stock Tarding Part III One Trick

 


Copyright 1997-2001 Dr. Raj Mehta. All rights reserved.