Nova Southeastern University
Huizenga Graduate School of Business and Entrepreneurship
Law and Ethics Courses
Case Study Ė Stock Manipulation on the Internet
(Prepared by Professor F. Cavico 11/00)
(Sources: WSJ, BW, Herald, CBSí "60 Minutes")

Determining the difference between what is legal and illegal in the area of stock transactions has always been difficult, but drawing this crucial line today in the Internet age is a much more complicated, and legally hazardous, endeavor, especially when opinion, predictions, facts, "hype," and "puffing" are combined in a readily accessible, "virtual" format.

When the Securities and Exchange Commission (SEC) proceeds against stock manipulators, the agency generally brings charges pursuant to a broad anti-fraud statute enacted by Congress in 1934. This law makes illegal, civilly and criminally, fraudulent or misleading misrepresentations pertaining to the purchase or sale of securities. The law also makes it illegal to use or employ any deceptive or manipulative device or practice in the purchase or sale of a security. Thus, when someone knowingly provides false or misleading statements with a clear intent to affect a stockís price, and then defrauds others by trading the shares, an illegal act is committed..

According to the law, a key legal issue is the alleged falsity of the factual statements. A major problem, however, arises when an "opinion" is offered, for example, the prediction that a certain stock will rise to a specific price. Courts have ruled that such statements in the form of opinions or predictions must be based on a "genuine belief" that they are true, and that belief must be evidenced by behavior. Thus, if one states that a $2 stock will rise to $20, but one has an order in to sell when the stock reaches $5, it would be difficult to sustain an assertion that one genuinely believed in the statement. Another major problem deals with the legal necessity of finding intent. Specifically, the government (or a private party plaintiff seeking damages) bears the burden of demonstrating there was an intent to deceive, or to manipulate the price of stock. That is, was the commentatorís intent to artificially "pump up" the price of stock, and then to "dump it"? Of course, it is by no means an easy task to produce evidence showing that someone who "hypes" a stock was aware that his or her action would deceive investors. Consequently, if one makes opinionated statements, but with no reference to any fundamental rationales, one can be said to be acting on a completely artificial basis, and with an intent, and a "bad" intent, to influence the purchase and sale of securities.

To complicate matters, there may be activity that looks deceptive or manipulative, but is not technically illegal. For example, Web postings on the Internet that praise a stock as the "best buy," or "THE stock to buy now," are not contrary to the law if these statements truly reflect the commentatorís belief. Defining "deceptive" and "manipulative" can be quite difficult. An important factor is whether any allegedly false postings contain enough factual information so that a reasonable person would rely on the statements. Otherwise, the statements may be regarded as mere, and permissible, "puffing" or exaggeration.

To really complicate matters, however, one must be aware that it is not only the actions and comments of individuals on Web bulletin boards and in chat rooms that bear scrutiny. Analysts at Wall Street firms also issue buy or sell recommendations on stocks; and, moreover, these stock recommendations occur at the same time the firm is selling or buying the same stock. Many Wall Street firms, however, contend that their investment research and investment activities act independently of one another, and that they adhere to strict firm-wide and business-specific guidelines and prohibitions concerning market transactions. Thus, Wall Street firms are supposed to maintain "Chinese Walls" to prevent traders from acting on an analystís call before it is made public. Moreover, proving that an analyst and a firm acted in concert is a very difficult undertaking. To date, the SEC has not brought any cases in which firms fraudulently traded based on advance knowledge of analystís reports.

All legal experts agree that it is extremely difficult in all these cases to prove the requisite intent in such situations, but the lack of legally required intent does not mean there are not ethical conflict of interest problems.

A particularly interesting and recent stock manipulation case involved a teenager, Jonathan G. Lebed, 16 years of age, of Cedar Grove, New Jersey. The SEC announced in October of 2000 that it had reached a settlement with the teenager, who the SEC accused of using Internet message boards to manipulate stocks. In the settlement, the teenager neither admitted nor denied any guilt, but was compelled to return profits made on certain trading. The SEC initially announced that it forced the teenager to disgorge $285,000, including interest, but then it was discovered that the teenager actually made $800,000, meaning that Jonathan has kept more than $500,000 in profits! Why was the teenager, who started trading on-line from his bedroom at age 13 with several thousand dollars in a custodial account opened by his parents, not charged with more illegal trades. The SEC declared that it charged violations in those cases which the agency considered to be clear instances of fraud. Specifically, the SEC said the teenagerís illegal activities were part of a "pump and dump" manipulative scheme which rose to the level of a very serious Internet fraud case.

Yet, most interestingly, the teenagerís modus operandi in the 16 trades that the SEC did not charge followed essentially the same pattern of the 11 trades for which the Commission extracted the settlement. The teenager identified companies with low price and trading activity, the SEC explained, because it is easier to move the price of a smaller company than a big one. The SEC said that the teenager would buy the shares of the small companies he had targeted, and then plaster Internet bulletin and message boards and Web-sites with postings, sometimes hundreds of them, "hyping" the stock. He touted one company, for example, as the "next stock to gain 1000%," and as the "most undervalued stock ever," and in another example, "this stock will explode." Often, Jonathan would use numerous aliases, thus allowing him to create the impression that other investors were interested in a single stock. When other investors snapped up shares, and the stock price rose accordingly, the teenager would unload his shares, the SEC contended.

Lebed, moreover, is being investigated by the U.S. Attorneyís office in Newark, New Jersey, in connection with possible criminal charges.

Yet, many people wonder why the SEC went after the teenager, and why the government may go after him criminally, since there are allegedly so many people seeking to manipulate the prices of stock on the Internet. The teenagerís case thus raises the significant question as to why so many wildly "bullish" price predictions, made each day, and often by expert commentators, are routinely ignored by the SEC.

The SEC maintains that there is a big difference between normal stock-touting messages, on the Internet and on other media, and what the teenager did. The huge volume of the teenagerís Internet postings evidenced his intent to move the market and manipulate the prices of stocks. The SEC particularly underscored the fact that Lebed would put out 500 messages under different names. The SEC inferred that the deluge of multiple messages was for the purpose of creating an illusion that a particular security was a good security, and that it was not just one person praising the security. For example, the SEC points out that the teenager predicted, without any substantive basis, the agency contends, that a stock would rise to $20 from $2, and that a stock would rise by 1000%.The prediction that a stock price will rise dramatically, without a reasonable basis, is illegal, declares the government. Some legal experts, moreover, assert there are very good reasons why the SEC targeted the teenager. In addition to stopping the teenagerís troublesome conduct, the SECís action generated valuable publicity. The SECís message, with the teenager as the messenger, is that stock manipulation is a very serious manner and not a childish prank.

Lebed, however, is quite a "child." Now a junior in Cedar Grove High School, Lebed showed a talent for trading in eighth grade, when he and two friends were among the finalists in a stock-picking contest sponsored by CNBC. As a matter of fact, he has been on the SECís radar screen for several years. Commencing in early 1998, at age 13, he was regularly writing on Silicon Investor, a financial Web-site, and had formed a stock-picking Web-site called StockDogs.com.

The teenagerís lawyer did not deny that Lebed made exaggerated statements in postings about the potential of stock prices for individual companies, but the lawyer contended that the statements were not illegal, only mere opinions and "puffing." The lawyer added that the teenager almost always offered a disclaimer that investors should do their own research. He also claimed that Lebed did a great deal of his own research, including talking to several company executives and visiting some of the companies he promoted.

Mr. Lebed presently is not doing any trading, but his settlement with the SEC does not prohibit him from investing in stocks, and he stated firmly in his "60 Minutes" interview that he intends to begin trading in the very near future.

Questions: What are the legal and ethical problems that arise from the Lebed Internet stock trading case; and how should they be resolved? Discuss.