P.T. Barnum on the Web

There’s a sucker born every minute, and sometimes it appears as if the Internet’s most important function is to prove the truth of that cliché over and over again. While stock scams and other grifts are hardly exclusive to the Internet, the Net has made it easier for scam artists to work their magic on a wider scale and lent stock tipsters a patina of credibility the telephone can’t impart. For some unknown reason, people who would scoff at a cold call tipping a penny stock will leap at the chance to buy that same stock if they read about it on a Website message board or in an e-mail.

Not surprisingly, then, today the Securities Exchange Commission announced its most important action to date against Internet stock fraud, the filing of 23 different complaints against 44 different entities and individuals. The SEC accuses the defendants of violating Section 17b of the 1933 Securities Act, which requires people touting a stock to disclose the compensation they’ve received in exchange for the promotion. In addition, the SEC also accused certain of the defendants of “pumping-and-dumping,” which simply means spreading false rumors about a company to pump up its stock price, and then dumping it as soon as the price rises. A total of 235 different micro-cap stocks were the object of touting, and the defendants received $6.2 million in cash and another $2 million in cheap stock options for their promotional work, all of which went unmentioned to the hapless marks. Thirteen of the 23 cases have already been settled, with the other 10 waiting to be tried in civil court.

In a world where all investors were economically rational, scams of this sort would not exist because they would not work. Almost without exception, after all, the micro-cap companies being touted had no underlying business prospects that would justify sharp run-ups in their stocks, and in many cases had no underlying business prospects at all. (For instance, one of the SEC’s targets, “The Future Superstock” e-mail newsletter, spent months earlier this year pushing an essentially worthless company called Electro-Optical Systems.) The reasoning provided by these Websites and these spam e-mails generally consists of little more than: “This stock is going to the moon!” and even a modicum of due diligence on the part of investors would bring these pyramid schemes to a halt almost immediately.

But investors are not rational, of course, and the Internet stock scams work in part for the same reason that state lotteries work: People are willing to toss away their money on the incredibly slim chance that they’ll strike gold. The great irony of the bull market in stocks of the last five years, in fact, is that it has not been accompanied by a fundamental change in the attitude most Americans have toward investing. In the most banal sense, most people still don’t believe in the power of compound interest, preferring the essentially nonexistent possibility of becoming rich as Croesus tomorrow to the concrete reality of becoming financially secure 20 years from now. Couple that with the fact that Americans’ savings rate is still scandalously low, and you have fertile ground for tipsters.

It still strikes me as preposterous that anyone would buy a stock based on an e-mail tip–if the company’s stock is going to explode, why would the tipster want everyone else to get in on the ground floor?–but investors’ credulity is deeper than that. The SEC’s first action against Internet stock fraud shut down a scheme where people were buying unregistered securities over the Net. In other words, people were actually sending money to someone they had never met to buy worthless pieces of paper in a company whose products they had never seen. P.T. Barnum must have felt honored.

A Case in Point?

Weirdly enough, just yesterday my intrepid editor forwarded me a current example of this kind of Internet stock hype, an e-mail touting a company called 21st Century Frontier Group, which allegedly has come up with a solution to the Y2K problem that is in the process of being patented and solves the Y2K problem “100% of the time.” Not only that, but this small company is “now negotiating with the ‘Big Boys’!” (Wow, the “Big Boys!” That bodes well.)

A more hackneyed pitch could hardly be imagined. But a look at the trading in this particular stock–which trades only over-the-counter, which means it can be hard to get in and out of it–shows that since Oct. 20 its price has risen 400 percent, from 12 cents a share to 60 cents, and that yesterday–when we got the e-mail–one million shares of the stock traded, up from 69,000 a week before. Looking at the numbers, you can almost see the scam in front of your eyes, with insiders buying more and more shares last week and then yesterday watching the stock’s price double in a single day. It’ll be surprising if within a few weeks the stock’s not back below 30 cents. Now, maybe 21st Century really has a magic bullet for the Y2K problem, in which case I congratulate all those clever enough to get in on the ground floor. But at the moment the whole thing seems more like an excellent reminder of just how much work the SEC has ahead of it.