Nebraska Law Review Volume 80 | Issue 4 Article 7 2001 Securities Fraud in Cyberspace: Reaching the Outer Limits of the Federal Securities Laws Constance Z. Wagner Saint Louis University School of Law, [email protected] Follow this and additional works at: https://digitalcommons.unl.edu/nlr Recommended Citation Constance Z. Wagner, Securities Fraud in Cyberspace: Reaching the Outer Limits of the Federal Securities Laws, 80 Neb. L. Rev. (2001) Available at: https://digitalcommons.unl.edu/nlr/vol80/iss4/7 This Article is brought to you for free and open access by the Law, College of at DigitalCommons@University of Nebraska - Lincoln. It has been accepted for inclusion in Nebraska Law Review by an authorized administrator of DigitalCommons@University of Nebraska - Lincoln. Constance Z. Wagner* Securities Fraud in Cyberspace: Reaching the Outer Limits of the Federal Securities Laws TABLE OF CONTENTS I. Introduction .......................................... 920 II. The Rise of Securities Fraud on the Internet and the Regulatory Response .................................. 923 A. The Impact of the Internet on the U.S. Securities M arkets ........................................... 923 B. The SEC Enforcement Program for Internet Fraud. 926 III. The Case of Tokyo Joe: Why the Existing Regulatory Framework Does Not Work ........................... 929 A. Sections 206(1) and (2) of the Advisers Act ......... 932 B. Section 10(b) and Rule 10b-5 of the 1934 Act ....... 939 IV. An Alternative Approach to the Regulatory Issue ...... 943 I. INTRODUCTION Securities regulation is an area of the law in which existing rules are being rendered obsolete by technological developments. More and more securities activities in both the primary and the secondary mar- kets are moving on-line these days. However, the rules for regulation of such activities were drafted before the dawning of the computer age and do not adequately cover the novel issues raised by securities issu- ance and trading in an electronic world. While the Securities and Ex- change Commission ("SEC") and state securities regulators have begun to address the consequences of use of the new medium by issu- ers, intermediaries, and investors, many basic questions remain unasked and unanswered by such regulators.' © Copyright held by the NEBRASKA LAw REVIEW. * Constance Wagner, Associate Professor, Saint Louis University School of Law. This Article reflects developments through October 2001. I gratefully acknowl- edge research funding provided by SLU Law School and the research assistance of Erin Rathjen and Maria Thiagarajan, Class of 2002. 1. See John C. Coffee, Jr., Brave New World? The Impact(s) of the Internet on Mod- ern Securities Regulation, 52 Bus. LAw. 1195 (1997) (outlining the major issues raised by use of the Internet). 20011 SECURITIES FRAUD IN CYBERSPACE While use of the Internet for securities transactions has been praised for the convenience and lowered costs it affords, the Internet has also served as a breeding ground for fraudulent activity. Internet- related stock fraud is now one of the most common types of investment fraud.2 Realizing the ease with which such fraud can occur, the SEC identified combating such fraud as a priority and set up the Office of Internet Enforcement ("OIE") in 1998, which has brought over 200 en- forcement actions. 3 Despite its recognition of the scope of the fraud problem and its willingness to take steps to put special enforcement mechanisms into place, the SEC has not publicly proposed any changes to the antifraud provisions of the federal securities laws or SEC regulations tailored to this new form of fraud. To the contrary, the highest ranking SEC offi- cials have taken the position that Internet fraud does not require the enactment of new statutes or the promulgation of new regulations. Former Director of the SEC Division of Enforcement Richard Walker stated that such fraud, although perpetrated through new means of electronic communication, is essentially of the same type as tradi- tional securities fraud and can be prosecuted under existing laws and regulations. 4 Former SEC Chairman Arthur Levitt compared the pro- visions of the federal securities laws to those of the U.S. Constitution in their ability to remain relevant in spite of societal change, conclud- ing that it is unnecessary for the SEC "to pronounce a totally new and radical scheme of regulation specifically tailored to on-line investing."5 2. Hearing on Sec. Fraud on the Internet Before the Sen. Permanent Subcomm. on Investigations, Senate Governmental Affairs Comm., 106th Cong. (1999) (testi- mony of Peter C. Hildreth, President, North American Securities Administrators Association, Inc.) (stating that Internet securities fraud is the second most com- mon type of investment fraud), at http'J/www.nasaa.org (last visited May 31, 2002). 3. See SEC Internet Enforcement Program, About the Office of Internet Enforce- ment, at http'J/www.sec.gov/divisions/enforce/internetenforce.htm (last visited May 31, 2002) [hereinafter SEC Internet Enforcement Program]. 4. Richard Walker, A Bull Market in Securities Fraud?, Speech at the National Press Club, (Apr. 5, 1999), at http:J/wvw.sec.gov/news/speech/speecharchive/ 1999/spch265.txt (last visited May 31, 2002); see also Judith R. Starr & David Herman, The Same Old Wine in a Brand New Bottle: Applying TraditionalMar- ket Manipulation Principlesto Internet Stock Scams, 29 SEC. REG. L.J. 236, 239 (arguing that Internet scams involving stock manipulations can be prosecuted under existing law in view of the SEC Division of Enforcement); Richard H. Walker & David M. Levine, "You've Got Jail: CurrentTrends in Civil and Crimi- nal Enforcement of Internet Securities Fraud, 38 Ai. Cani. L. REv. 405, 429 (2001) (concluding that existing prohibitions sufficiently cover the misconduct of today). 5. SEC Chairman Arthur Levitt, Plain Talk About On-Line Investing, Speech at the National Press Club, (May 4, 1999), at http'//www.sec.gov/news/speech/ speecharchivel1999/spch274 (last visited May 31, 2002). NEBRASKA LAW REVIEW [Vol. 80:920 This view cannot be maintained in the long-term because it fails to take into account the unique characteristics of the new communica- tions medium that is the Internet. A complete overhaul may be un- necessary, but some revisions are critical. While the SEC's position on this matter may serve the agency's interests, its strategy makes for bad law, stretching existing provisions to reach these new cases by using flawed reasoning. 6 A new approach that takes into account the differences between traditional securities transactions and those that take place in cyberspace needs to be devised and implemented. 7 Recent SEC enforcement actions involving Internet fraud involve a variety of fact patterns, but share certain common characteristics and can be categorized. One category involves so-called "cyberhype," in- cluding "pump and dump" schemes, in which the stock of small compa- nies, often microcap stocks, are promoted for profit over the Internet through the use of unsolicited e-mail "spain," chat rooms, bulletin boards, investment websites, or investment newsletters. Such activity may involve fraud if the promoter makes material misrepresentations, fails to disclose its intention to dispose of its stock at a profit into the rising trading market that develops after such promoter's recommen- dation, or fails to disclose that it promoted the stock for compensation. This Article will focus on a recent case involving a subcategory of such scams, namely the use of investment websites and on-line investment newsletters to generate interest in a stock, as an example of the fail- ure of pre-cyberspace law to adequately address the new world of on- line securities fraud. In the first and most widely-publicized action of this type, the SEC sued Yun Soo Oh Park, a/k/a Tokyo Joe ("Park" or "Tokyo Joe"), who operates a popular investment website called Tokyo Joe's Societe Anonyme ("S.A.") frequented by day traders.8 This case, 6. Richard Walker has advocated using the enforcement process to combat Internet securities fraud on a case-by-case basis rather than adopting new regulations. His stated reasons include the ability to respond quickly to new types of fraud without the need for engaging in a lengthy rule-making, the dangers of promul- gating rules that are both over-and under-inclusive, and the unwillingness to re- open issues resolved by the courts. Richard Walker, Regulation vs. Enforcement in an On-Line World, Speech to Bond Market Association (Oct. 25, 2000), at http./ /www.sec.gov/news/speechlspch4l3.htm (last visited May 31, 2002). It is also possible that the SEC prefers an ad hoc enforcement approach rather than promulgating rules, or seeking amendments to the statute, to avoid conflicts with industry groups opposed to new regulation. 7. SEC Chairman Harvey Pitt announced, prior to his confirmation, that he will undertake a broad review of federal securities laws to simplify and modernize them. He did not refer specifically to antifraud provisions relating to the In- ternet. See Shannon Murray, SEC Nominee Vows to Update Securities Law, at http:J/www.law.com (last visited May 31, 2002). 8. See SEC v. Yun Soo Oh Park a/k/a Tokyo Joe and Tokyo Joe's Societe Anonyme Corp., No. 00C 0049 (N.D. Ill. Jan. 2000), SEC Litigation Release No. 16,399, at http://www.sec.gov/litigation/litreleases/Ir16399.htm. The SEC subsequently brought other similar actions, including SEC v. DynamicDaytrader.ComL.L.C. 20011 SECURITIES FRAUD IN CYBERSPACE which was settled after pre-trial litigation, offers interesting insights into the legal theories used to support the SEC's enforcement proceed- ings in this area. This Article will argue that such theory, based upon the existing antifraud provisions of the securities laws, is inadequate to deal with this new type of securities fraud in a coherent manner. Revised measures that take into account the nature of cyberspace transactions are needed to ensure that the securities regulatory scheme provides greater certainty and adequate notice to market participants.