Testimony of Peter C. Hildreth
Director of Securities Regulation, New Hampshire & NASAA President
Permanent Subcommittee on Investigations of the Governmental Affairs Committee,
United States Senate
March 22, 1999
Chairwoman Collins and Members of the Subcommittee:
I am Peter Hildreth, Director of Securities Regulation for the State of New Hampshire and President of the North American Securities Administrators Association, (“NASAA”)*. I am pleased to have the opportunity to present the states’ perspective as you examine issues related to securities fraud on the Internet and on-line trading issues. State securities regulators are often referred to as the “local cop on the beat” because they are closest to the investing public and are frequently the first to identify problems and trends in new investment fraud schemes.
Over the past decade, technology has revolutionized the securities markets. Today, any home equipped with a computer and modem is just a few keystrokes away from a wealth of instantly accessible research data and financial news. The Internet holds great promise for investors by disseminating information previously available to a relative privileged few on Wall Street and by dramatically lowering trading costs. Many investors have opted to make their own investment decisions, bypassing traditional methods of conducting business. Technology is changing the relationship between broker-dealer and customer.
The legitimate business opportunities for financial services on the Internet are unlimited. It is already used for direct offerings of securities through company Web sites, electronic voting of proxies and online brokerage services.
At the same time, however, the risks for fraud are great. With the click of a mouse, fraudsters can reach tens of thousands of people via e-mail literally for pennies. E-mail and web sites are more efficient and much cheaper than contacting unsuspecting investors the old fashioned way, through telephone boiler rooms. The Internet is a global borderless environment that offers instant access to tens of millions of people. Con artists can hide their identities through the use of fictitious names, multiple aliases, remailers and by using public venues with Internet access such as Internet coffee shops and libraries. Because the Internet is so cheap and easy to use and reaches so many people, any con artist not on the Net should be sued for malpractice.
NASAA members are concerned about unwary investors being taken for an Internet ride. States are seeing violations of state securities law on the Internet such as the offer and sale of unqualified securities; unlicensed broker-dealer and investment adviser activity; fraudulent offers and sales of securities; market manipulation; and insider trading.
Given the size and growth of the Internet, regulators can’t police it alone – it is like expecting one precinct house to patrol all of New York City. It simply can’t be done. State and local governments have limited resources and defined jurisdictional boundaries. That is why we have asked investors to become partners with us in the fight against securities fraud on the Internet. When I assumed the NASAA Presidency last October, I announced NASAA would create a new e-mail address for investors to report suspected Internet securities fraud. The address is
firstname.lastname@example.org. [Edit- Address no longer in use]
NASAA encourages investors to forward suspicious securities-related e-mail they receive and to include the state in which they live so the “spam” can be sent on to the appropriate state regulator. To date, over 4,700 unsolicited email messages have been forwarded by investors to the NASAA site. So far NASAA has forwarded e-mail to regulators in 33 states, from Arizona to Wisconsin. Late last year, the messages were analyzed to detect trends. Approximately 40 percent of the e-mails were securities related, a similar percentage involved business opportunities; the rest included credit and loan pitches, gambling/casino web sites, herbal and other health treatments and “cures” and sex-related topics.
Two messages sent to NASAA during the last few weeks are typical examples of “spams” sent to thousands of other unsuspecting investors. There are uncanny similarities contained in the messages.
BIO TECH BREAKTHROUGH!!
Company: Endovasc Ltd., Inc.
Symbol: E N D V
Price: ½ ($.50/share)
The April issue of the British Biotechnology Letter, Oxford, England, states “scientists at Glaxo Wellcome have proven the efficacy of Endovasc’s PGE-1 and have submitted to management a multi-million dollar joint venture proposal.”
ENDV is recommended as an immediate and “STRONG BUY.”
Go t Http://quote.yahoo.com/q?s=endv&d=t
URGENT BUY ALERT
Company: PDC Innovative Industries
Symbol: P D C I D
Price: 5 ($5.00/share)
PDCID has announced priority production of their proprietary Hypo-Sterile 2000 which render medical contaminants harmless. Analysts indicate there is “almost limitless demand in the market place for this revolutionary stand-alone medical device.”
PDCID is rated an immediate and “STRONG BUY”
Go to http://quote.yahoo.com/q?s=pdcid&d=vl
An informed Internet user would be very skeptical about such hyberbole. Both messages contain claims that are not supported with data. Who is recommending the stocks? Who is rating the stocks? There is no disclosure of such information. But, these messages are on the Internet and use Yahoo’s link which lends them an air of credibility. It is becoming increasingly difficult for some investors to tell the difference between fact and fiction.
State securities regulators have been policing Internet based investment scams for years. One great advantage of state securities regulators is their authority to use an undercover operation to detect fraud on the Internet. A state agency can establish e-mail addresses to go “shopping” for fraudulent Internet solicitations to obtain information to pursue enforcement cases. At the beginning of 1998, NASAA’s Internet Committee conducted a survey of all member jurisdictions and reported securities being offered in the following types of securities offerings as involving the most suspected investment frauds: ATM machines, prime bank schemes, internet gambling, advance fee schemes, oil and gas interests and entertainment ventures.
In 1994, The Missouri Securities Division and the New Jersey Bureau of Securities announced the first regulatory actions taken in the U.S. against on-line investment schemes. In Missouri, a stockbroker unlicensed to do business in the state used the Internet to tout his own services and make dubious claims for stocks not registered for sale in the state. The case in New Jersey amounted to a high-tech variation on the old pyramid scheme, which is barred under federal and state laws.
The Ohio Division of Securities has been on the leading edge of securities activity on the Internet. In September, 1996, the Division became one of the first state securities agencies to establish a formal program to monitor the Internet for compliance with the Ohio securities laws. On-line securities offerings not in compliance with Ohio law are identified and listed on the Division’s Internet homepage under the link “On-Line Securities Offerings that Ohio Residents Should Avoid.” Exhibit A.
Texas issued its first Internet related order in March of 1996 against a woman using the Internet to raise funds for an illegal securities offering. The violations included selling unregistered securities without a securities sales license. Earlier this year Texas made its first criminal referral to a prosecutor of an alleged securities fraud over the Internet.
In March of 1998, the New York Attorney General announced legal actions designed to raise consumer awareness of the law regarding illegal Internet pyramid schemes. Exhibit B. The AG’s Internet and Computer Unit worked with the Investor Protection and Securities Bureau and reached settlement agreements in 12 cases involving illegal pyramid schemes circulated on the Internet. Pyramid schemes are illegal under both New York’s civil and criminal law so participants risk being prosecuted for a misdemeanor or felony offense, which could result in fines and possible imprisonment.
Last June, the California Commissioner of Corporations issued nine actions against Internet investment opportunities ranging from a floating condominium to a time machine. Exhibit C. The actions ordered ten companies and 15 individuals offering investment opportunities on the Internet to comply with state securities requirements or stop offering their investment products in California.
California has one of the more active Internet Surveillance programs in the United States. The Department of Corporations has set up a dedicated Internet Compliance and Enforcement Unit consisting of two attorneys, one investigator and one examiner. In all, the California Department of Corporations has issued 39 Desist and Refrain Orders to a total of 158 subjects, has filed one civil injunctive action and obtained a preliminary injunction against 26 defendants, and has referred two cases for criminal
Through a joint investigation conducted by the Illinois Securities Department and the US Postal Inspection Service, in August of 1998, W. Charles Grace, United States Attorney for the Southern District of Illinois announced Ronnie Joe Graham plead guilty to one count Information filed in Federal District Court in East St. Louis, Illinois. Appendix D. Graham was charged with Mail Fraud by use of the Internet. Graham devised a scheme to defraud and obtain money from investors, through the offer, sale and issuance of the unregistered securities, in an amount in excess of $750,000 by means of materially false and fraudulent pretenses, representations and promises.
Ronnie Joe Graham was sentenced to three years probation of which the first six months was home confinement. He paid restitution in the amount of $55,000.
In August of last year, NASAA joined federal regulators in a crackdown on entertainment-related securities fraud. Not surprising, the Internet figured prominently in several securities offerings state regulators acted against. Regulators in New York obtained a temporary restraining order and froze the assets of World Interactive Gaming Corp. of Bohemia, NY which used the Net to sell and promote stakes in an illegal Internet gambling company. South Dakota and Wisconsin took related actions. Regulators in Iowa ordered Denis M. Benson of Tustin, CA to stop selling unregistered securities in an online sports casino. Washington State ordered White Witch Doctor, Inc. of Florida to stop promoting sales of stock, via the Internet, to finance “Diamante” a movie based on company owner Dennis Alexander’s “real life experience as a missionary and diamond smuggler.”
NASAA and 30 state and provincial jurisdictions participated in the Internet Investment Opportunities Surf Day in November, 1998 looking for suspicious or fraudulent investment opportunities. Exhibit E. Also taking part in the surf day were regulators from the FTC, the CFTC, and the NASD. Over 400 web sites were surfed. They found that investors were being sought for both traditional and exotic investment opportunities such as viatical settlements, foreign currency, films and restaurants, Internet-related and “offshore” investments.
The vast majority of the securities-related e-mails NASAA analyzed during the “surf” promoted eight over-the-counter stocks. The e-mails invariably contained bullish, if not far-fetched predictions such as a restaurant chain whose revenues were projected to grow 300 percent for the 97-98 fiscal year. In another case, a web site promoting low-priced over the counter stocks claimed that “with 1.2 million visitors per day starting with the next few days, there’s NO CHANCE the stocks can’t rise!!!
Just last week NASAA joined other federal, state and local law enforcers to announce 33 law enforcement actions against 67 defendants promoting Internet pyramid schemes. Exhibit F. The sweep also included a two-day Internet “surf” to seek out sites that may be hosting illegal pyramid schemes. The FTC and state law enforcement offices have pledged to continue this sweep and will announce additional actions targeting Internet Pyramid schemes in upcoming months. My advice to the investing public is “Ask yourself – if it’s such a great money-making idea, why is someone telling 100,000 of their closest friends about it on the Internet?” Never make a decision to buy or sell an investment product based solely on information you read on the Internet.
In addition, last week Maryland Attorney General J. Joseph Curran, Jr. announced that his Division of Securities has issued a Stop Order against Efox.net, Inc., an Internet “adult entertainment” company that had planned on becoming one of the first “adult” Internet businesses to sell shares to the public. Exhibit G. The Stop Order was issued after allegations surfaced that Efox was promoting the sale of its securities before making required filings with regulators, a practice known as “gun-jumping.” Gun-jumping is illegal because of its potential to mislead investors.
In recent months state securities regulators across the country have brought actions against suspected Internet frauds, including on-line casinos, pyramid schemes and supposed investments in “soon-to-be produced” motion pictures. Websites, news groups, chat rooms and e-mail messages are increasingly being used to tout risky “microcap” stocks, which are a major concern of state regulators.
There will never be enough regulators to keep the on-line world free from fraud and abuse. Even if the state securities regulators, the Securities and Exchange Commission (“SEC”), and the National Association of Securities Dealers – Regulation (“NASDR”) all put aside their other tasks in a massive bid to shut down on-line investment scams, it is doubtful that fraud on the Internet could be stamped out altogether.
Investor education is the key to successful on-line investing. Individuals who venture on-line need to do so with caution. The good news is there are self-defense steps that small investors can take to fend off cyberfraud. We have included these tips in a simple brochure as well as on the poster before you today.
- Don’t expect to get rich quick
- Don’t assume that your online computer service polices its investment bulletin boards
- Don’t buy thinly-traded, little known stocks strictly on the basis of online hype
- Don’t act on the advice of a person who hides his or her identity
- Don’t get suckered by claims about “inside information” including pending news releases, contract announcements and products
- Don’t assume that just because someone says that they have checked something out that they have actually done so
- Call your state or provincial securities agency
The NASAA Board of Directors has also formed several Project Groups to deal with the issues you are addressing today. In November 1998, an Internet Enforcement Project Group was established to review Internet enforcement by state regulators; develop a comprehensive plan on how the states can better police the Internet; and work with other NASAA project groups to coordinate efforts and determine the best way to utilize available technology.
The Project Group consists of Charles Neal (TX) Chair, Marc Crandall (CA), Martin Eady (BC), Laurie Goodman (NJ), Kyle Martin (OR) and Joel Michael Schwartz (NY). They represent states that are some of the most experienced in Internet surveillance.
A Neighborhood Watch Project Group has been charged with developing a comprehensive plan to review and refer the e-mails alleging fraud that are sent to NASAA via e-mail or other means. Its members are Jerel Hopkins (PA) Chair, T. Webster Brennner (MD), Martin Cordell (WA) and Joseph Punturo (NY).
Online Trading Issues
NASAA has been active in educating investors about on-line trading. Technology has revolutionized the way securities in this country are bought and sold and the way the securities industry operates. Reports show that there are approximately 7.5 million online brokerage accounts today. This figure is expected to grow to 18 million by the year 2002.
Too often the media uses the terms on-line investing and day trading interchangeably. Although the two areas may sometimes blur together, a distinction should be made between electronic on-line trading and day trading.
On-line trading is the term used for more traditional brokerage arrangements between customer and firm. Investors access brokerage firm web sites and submit orders to the firm electronically. Those orders are then processed through the firm’s order routing system for execution. The transaction is completed without the assistance from a registered representative. The elimination of the registered representative has led to the tremendous reduction in commission fees over the past several years. On-line trading is normally done through one’s own personal computer and not at a central location.
Day trading is usually done at day trading firm locations using computer equipment supplied by the firms. Day trading is conducted with rapid-fire speed, buying and selling the same security within several minutes with the goal of making a small gain in the transaction. An important aspect of day trading is that the traders have direct access to the markets where they place their trades. Direct access is often in the form of both market information and execution. Day traders customarily have access to in-depth market information which enables the traders to identify securities where the bid and offer price differential for a security presents the potential for doing a quick trade and receiving a small gain. Direct access to the markets in the sense of execution gives the day trader the ability to execute trades immediately at known prices. Immediate execution in day trading is of paramount importance for a day trader to lock in their small gains, often just pennies per share.
Another aspect of day trading is that the firms often provide training program to teach customers how to day trade.
NASAA has been active in trying to educate the public on the risks of day trading. In November, 1998, NASAA issued a press release cautioning investors about the day trading “craze” and pointed out that day trading is extremely risky and a strategy only for people using money they can afford to lose. Exhibit H. The release attracted extensive coverage and resulted in stories in dozens of print and broadcast outlets including: Dow Jones, The Wall Street Journal, CBS News, National Public Radio, BusinessWeek, Fortune, NBC News and the BBC.
In late 1998, NASAA formed a project Group to look into day trading firms. The project group is chaired by David Shellengerger (MA), with Jay Cassidy (CO), Jerel Hopkins (PA), and Joel Sauer (TX) serving as members. The NASAA Board of Directors charged the project group to:
- Work with the NASD, SEC and exchanges on coordination of examinations and enforcement actions where appropriate.
- Detail abusive practices and advise states on state securities law implications.
- Assist states with expertise in enforcement analysis.
- Gather statistics on how widespread problems are in this segment of the industry and coordinate efforts.
To accomplish these tasks, the project group has outlined a plan to issue an internal report identifying day trading firms; analyzing issues presented by the day trading industry; analyzing profitability of customer accounts; and including a bibliography of books and articles. In addition to the report, the project group plans to create a guide for state regulators to assist in licensing day trading firms, conducting examinations and investigating and prosecuting cases. As this material becomes available, NASAA will be happy to forward to you all non-confidential materials.
Colorado, Indiana, Maryland, Massachusetts, Tennessee, Texas and Wisconsin have taken action against day trading firms for alleged violations of state securities laws. Please contact the NASAA office if you want additional information on these actions. As this letter is transmitted, several other states are beginning investigations in addition to some ongoing.
With the widespread use of the Internet, investing and trading with Internet has increased exponentially and many expect this trend to continue for quite some time. The availability of information has leveled the playing field between securities professionals and individual investors.
On-line investing, however, is not a panacea. Many individual investors falsely believe they are empowered by the wealth of information available on the Internet. More and ore people are moving to self-directed brokerage. With the Dow hovering near 10,000, everyone assumes that there is easy money to be made. How will all of these investors react during a market correction? Many would be wise to rely on the advice of a securities professional.
State regulators have generally not reported widespread increase in complaints by on-line investors. With the stock markets still experiencing gains, NASAA believes that the on-line brokerage community needs to address several issues before the market trends downward. To that end the NASAA Board of Directors recently authorized the formation of a multistate project group to explore the issues facing on-line brokerage firms. The members of the project group have yet to be identified so NASAA is not in a position to supply individual names.
It is expected that the project group and individual states will be addressing the following issues with respect to on-line investing:
Do on-line broker-dealers have the infrastructure to allow for continued growth? Is this new form of commerce stressing existing regulatory structures?
Due to the low commission structure, or because of it, the key to a successful Internet brokerage firm appears to be market share. To get market share, on-line brokers advertise aggressively. Are they creating false impressions in these advertisements regarding availability of the trading platform?
- System Outages
What happens to customers when the Internet or the brokerage firm’s web site is unavailable? What obligations, if any, does the firm have to its customers at these times? Does it matter if the outages are due to technology glitches or market activity?
Do on-line brokers have any suitability obligations to their customers? Generally, suitability is not an issue for unsolicited transactions. However, on line brokerage firms are offering ever-increasing amounts of research on their Internet sites. When does information rise to the level of being analogous to a recommendation?
A frequent complaint from on-line investors is execution of orders, particularly of initial public offerings. Customers have placed market orders to buy shares of an IPO and their trades are not executed until the price is much higher than the IPO price. This problem can most likely be addressed through increased disclosures to put the customer on notice and education about use of limit orders and other strategies to reduce risk.
- Contingency Plans
In the case of system outages or market events, are the on-line firms ready to handle the volume? Is there a contingency plan if the system collapses. Can a broker-dealer be reached by telephone? Are there registered representatives available to take orders?
The New York Bureau of Investor Protection and Securities, under the New York Attorney General, on February 4, 1999, announced an inquiry of online brokerage firms based on a “recent surge of customer complaints.” Exhibit J. The Attorney General sent a letter to eight of the major on-line firms based upon customer complaints about frequent system crashes, server unavailability, and long delays in executing trades. The Attorney General has also established an on-line questionnaire for investors to complete to relate their experiences and complaints with on-line brokerage firms. (http://www.oag.state.ny/surveys/brokerage.html)
State securities regulators are committed to protecting investors and preserving the integrity of the U.S. capital markets. Investigations and inquiries into securities fraud on the Internet, on-line trading, and day trading issues are works in progress. NASAA is pleased to share with you our experiences to date and will maintain a dialogue with you to keep you informed with new developments.
Thank you for the opportunity to testify before you today. NASAA appreciates the interest you have demonstrated in exploring all of these issues and we are committed to working with you as your fact-finding continues.
*The oldest international organization devoted to investor protection, the North American Securities Administrators Association, Inc., was organized in 1919. It is a voluntary association with a membership consisting of the 65 state, provincial and territorial securities administrators in the 50 states, the District of Columbia, Canada, Mexico and Puerto Rico. In the United States, NASAA is the voice of the 50 state securities agencies responsible for grass-roots investor protection and efficient capital formation.
March 22, 1999