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PERSPECTIVE By Geoff Smith May 24, 1999


Extend the Safety Net for Cyber Investors
Two areas on the Web -- day trading and microcaps -- need more stringent regulation, not just tougher enforcement

The Securities & Exchange Commission has launched 66 cases of Internet investment fraud since the beginning of 1998 and recently pledged to sharply step up enforcement. The cases represent some of the most egregious examples of online fraud, but none address other problems that are emerging along with the explosive growth of online investing.

Why not? The online investment fraud cases brought by the SEC are based on securities laws dating back nearly 70 years. And online investing is a far different beast than the one covered by the Securities Act of 1930. At least two areas of Internet investing are inadequately covered by today's regulatory safety net. One is day trading, an industry in which some companies are luring investors online without requiring adequate training for customers or making sufficient disclosure of the risks. A second is the microcap stock arena, where novice online investors are getting burned trading stocks they hear about in chat rooms, message boards, and investment newsletters.

SUITABILITY RULES. One of the great things about the Internet is that it has brought powerful investing tools to the public. And the government should tread cautiously when interfering with the investment revolution now unfolding. But day trading and microcap investing are two areas of the online world that cry out for more stringent regulatory oversight because unwitting investors are losing money they might not lose if adequate regulatory controls were in place.

What should be done? Day trading firms should be required to make sure their customers fully understand the implications of rapid-fire trading. The SEC has suitability requirements in place for brokers when they recommend investments to customers (the "know-your-customer" rule), and for anyone who wants to invest in initial public offerings. Suitability rules should be created for anyone who wants to be a day trader because they are taking risks that long-term investors do not take and are going up against an entirely different set of market issues than most investors.

The problem is how to define day trader. When the National Association of Securities Dealers attempted to establish new suitability rules for day traders in the early 1990s, it defined a day trader as anyone trading five times a day or more. A Federal Court rejected the rule outright, saying it was arbitrary, and no new suitability rules have been implemented since.

 

There ought to be new registration requirements for anyone using a NASDAQ Level II screen
 

But regulators gave up their goal too quickly. One place to start anew: design new registration requirements for anyone using a NASDAQ Level II screen. This tool shows the actual buy and sell orders of market makers and is increasingly being marketed by online brokers. E*Trade offers Level II screens to its most active traders. Charles Schwab & Co. and Fidelity don't offer Level II screens because they don't want to encourage their customers to day trade.

Microcap fraud is another area ripe for stricter regulations. Fortunately, one way to address the problem is relatively painless: require online brokers to display special pop-up screens whenever a microcap stock, including those listed on the OTC bulletin board, is requested by a customer. The screen would say something like: "You are about to buy a stock listed on the OTC Bulletin Board. You should be aware of the following risks." Some of the risks might be that the stock is thinly traded and that the company may or may not have filed audited financial statements with the SEC.

MESSAGE BOARD BARRAGE. Why is this a good thing to do? Millions of online investors are being barraged with information on message boards, through E-mail, and through online newsletters that contain information about microcap stocks. Some of this information is simply bogus, as the SEC's recent enforcement actions demonstrate. And this is not likely to get better considering the explosion of online trading: It now accounts for 25% of all trades by individual investors, and the percentage will sharply increase over the next few years.

Consider the case of the online newsletter called "futuresuperstock.com." According to Richard H. Walker, the SEC's enforcement director, the Web site's author, Jeffrey C. Bruss of West Chicago, Ill., began recommending to 100,000 subscribers the purchase of 25 microcap stocks, predicting they would double or triple in the next three to 12 months. Indeed, Walker says, Bruss was paid by many of the companies to make the recommendations and failed to disclose that information to subscribers. Bruss declined to comment, but has since posted a detailed statement on his Web site identifying compensation he received from various companies. Bruss's attorney, Arthur M. Schwartzstein, also declined to comment. But he claims in a recent court filing that the SEC's charges are too vague to prove fraud.

Kevin Lichtman, editor of stockdetective.com, a Web site that tracks online investment newsletters, says the SEC has only scratched the surface of the problem. "They're on the right track, but they're intervening in only a small percentage of the cases," he says.

To be sure, the SEC already has powerful tools available to go after online investment fraud. Most notably, the agency can subpoena online firms to determine the name of anyone posting anything online and to gain access to a company's financial records. And the agency has started to use this power well.

 

Now that there's a new financial arena -- the Net -- a wider window on the information it brings is needed
 

The 66 cases, which cover three broad areas of fraud, demonstrate that. One area focuses on Ponzi schemes or fake securities. A second is market manipulation, such as "pump-and-dump" investment scams, in which newsletters, for example, promote stocks publicly on the Net while the writer secretly sells the shares after investors push up the stock price. The third involves the ubiquitous problem of stock "touting," in which someone promotes a stock without disclosing they're getting paid to do it. This type of stock promotion, unlike market manipulation, does not necessarily involve trading in a company's shares.

At the root of all these cases is the issue of disclosure. Someone didn't disclose information when they were supposed to. The problem for investors is that now that the Internet has brought the tools of professional investors to the public marketplace, the public is suddenly expected to know as much as professionals about investing. The U.S financial markets are built on the principle that more disclosure is better than less. Now that there's a new financial arena -- the Internet -- a wider window on the information it brings is needed.

If you want to comment on these ideas, or have firsthand experience with Internet fraud that you think should be more closely regulated, contact me though my E-mail address.

Geoffrey Smith covers a wide variety of topics, including personal finance issues, from Business Week's Boston bureau
Have a question or a comment? Let him know at geoff_smith@ebiz.businessweek.com.


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Geoffrey Smith
covers personal finance and other topics, from Business Week's Boston bureau




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