Regulators Struggle to Keep Up
With Explosion of Online Fraud

By ANDREW FRASER
THE WALL STREET JOURNAL INTERACTIVE EDITION
 

The U.S. Securities and Exchange Commission's recent sweep of Internet stock scammers belies the serious problems state and federal regulators face as they struggle to contain the breathtaking growth of online investment fraud.

<Picture: Cyber Investing>The explosive growth of the Internet and the accompanying boom in electronic trading has added to the burden of policing online stock fraud, regulators say.

Law-enforcement agencies concede that they are overwhelmed, in part, because their budget and staff levels haven't grown nearly as fast as investor complaints.

Even the SEC's highly publicized cyberfraud unit, the agency's office of Internet enforcement, consists of just three full-time staff members, including director John Stark. Its efforts are aided in part by about 100 additional investigators nationwide, but even those enforcers typically take only a few hours a week away from their regular duties to focus on Internet fraud.

And the problem of tracking and enforcing online fraud is getting worse as individuals, who flock to the Net for financial information and advice, are followed closely by crooks in search of easy targets.

"It's a huge problem," says Bill McDonald, director of enforcement for the California Department of Corporations. "And it'sgoing to be a much bigger problem a year or two from now. The Internet is the marketing vehicle for scams now and the general public is going to be increasing on the Internet."

An informal review of documents from the SEC and interviews with some state securities regulators paint a troubling picture of how authorities are coping. With staff and resources stretched, cases are piling up and some are even being purposely ignored, sacrificed for others considered more egregious.
 
 

<Picture: [Go]>SEC Charges 13 in Ongoing Sweep Against Illegal Online Stock Touting (Feb. 26)

<Picture: [Go]>After the Sweep, the Advice Is the Same: Investor Beware (Oct. 30, 1998)

<Picture: [Go]>SEC Targets Promoters for Online Stock Fraud (Oct. 29, 1998)

<Picture: [Go]>SEC Turnover Rate Leaves Agency Scrambling in Fight Against Fraud (Oct. 23, 1998)
 
 
 

Consumer advocates are concerned that con artists are feasting on online investors and getting away with it as regulators scramble to keep up -- with enforcers arriving on the scene a little too late or, in some cases, not at all. "Time is certainly on the side of the fraudsters," says Philip Rutledge, deputy chief counsel for the Pennsylvania Securities Commission.

The Internet has given stock scammers an efficient and inexpensive way to reach millions of people. They no longer have to toil away for hours in boiler-room operations making hundreds telephone calls, or spend a small fortune on sacks of junk mail just to snare one victim. On the Internet, a slick, yet inexpensiveWeb site is all it takes for scammers to reach millions of people.

And the victims themselves have made the con artist's job easier, since many individuals hoping to make a fast buck often turn to the Internet for ideas. Moreover, the anonymity of the Internet allows crooks to quickly setup a stock scam and, at the first hint of detection by enforcers, just as swiftly close up shop and start up anew somewhere else.

While securities regulators have identified Internet fraud as a top priority, most seem to have been almost blindsided by its spectacular growth. It was only a year ago that the SEC created a unit devoted to cyberfraud. And only a handful of states, including California and Pennsylvania, have active Internet surveillance programs.

In Washington, federal lawmakers are growing concerned about the effectiveness of regulators in policing the nation's securities market and protecting investors. Four leading Democrats from the House Commerce Committee, which has jurisdiction over the SEC, in February requested reports on the matter from the General Accounting Office, SEC Chairman Arthur Levitt and the North American Securities Administrators Association. The Senate's Permanent Subcommittee on Investigations is said to be planning a hearing for next month.

"We have an old saying in Dutch country: 'The hurrier I go the behinder I get.' "I think that is the position in which the SEC finds itself," says U.S. Rep. Ron Klink, a Pennsylvania Democrat and one of the four concerned Commerce Committee members. "As the pace of electronic trading increases they are getting further and further behind in handling these cases and disposing them." The other House members that joined him in requesting the report were John D. Dingell of Michigan, the committee's ranking member; Edward J. Markey of Massachusetts and Edolphus Towns of New York.

The SEC contends that it is aggressively pursuing Internet fraud cases, but internal documents and even admissions by its own staff members depict an agency that is swamped. Its backlog of pending investigations has grown steadily and the agency opens fewer cases each year, even complaints by duped investors surge.

The SEC receives about 200 to 300 complaints a day about suspected online fraud, up from a handful two years ago. The agency expects that complaints and inquiries about cyberfraud and other issues will grow to 54,000 this year, a 50% increase since 1994. Meanwhile, the portion of the agency's overall budget devoted to fighting investment fraud has remained fixed between 30% and 35%. This year that amount is about $113.7 million, up 9.3% from last year.

In the last year, the SEC has undertaken only two widespread initiatives against Internet fraud. A highly publicized nationwide crackdown last October that resulted in charges against 44 individuals and companies and another sweep in which it filed charges against 13 on Thursday. The agency has brought 65 Internet-related cases so far, most from just those two sweeps.

Despite the dramatic rise in online investing by Americans and the surge in fraud and other securities-related complaints, the overall SEC budget rose just 3% this year to $341 million.

The SEC's budget has risen slowly in recent years even though the agency is a virtual cash cow for the federal government. The agency brings in almost four times as much money as it takes out of federal coffers. Its revenues doubled to about $1.2 billion last year from $517 million in 1993. But its 1998 budget rose just 24.5% during that period to $315 million.

It's no different at the state level, where the purse strings are drawn even tighter. And as regulators confront the vast, new battleground of cyberfraud with lean budgets and staff, an army of new con artists are shifting their stings to the Internet.

The lure is the prospect of easy money presented by the tens of thousands of individuals who have become enthralled by the fast-paced world of online investing and the potential for even faster financial rewards. The number of investors trading online grew by 2.2 million to more than 5.2 million last year, according market research firm NFO Worldwide Inc. And more than 25% of all stock trades now are done over the Internet. Many of these individuals, new to online trading and starved for financial information and hot stock tips, are easy prey for savvy con artists that have put out a lot of bait.

The SEC has long been criticized for responding too slowly to securities fraud and taking much too long to bring charges in a single case -- sometimes two or three years. And while the Web sweep last October resulted in cases being prepared in less than a year, the alleged crooks were able to take in $6.3 million before the SEC moved in to unmask their operations.

SEC spokesman Duncan King says financial constraints haven't prevented the agency from effectively carrying out its mandate to protect investors from fraud. "Yes, we could do more if we had more," Mr. King says, "but we are quite comfortable with what we have allocated."

But a review of actual SEC documents tell a different tale of how the agency is coping. As fraud complaints skyrocket, SEC investigators have struggled just to keep up. The number of pending investigations has grown from 944 in 1988 to 1,839 in 1998. Moreover, fewer investigations are being opened each year. The number of new investigations opened annually have fallen steadily from 560 in 1994 to 408 in 1997, the most recent year for which those number are available. And the number of investigations being closed out is also dropping.

Meanwhile, the SEC's overall enforcement staff rose to 838 this year, from 808 in 1993. That's just a 4% increase in staff to sift through complaints and inquiries that have more than doubled, and a more than 20% increase in actual cases of potential investor fraud the agency deemed worthy enough to investigate. And the agency also has other duties that no doubt have risen with the overall growth of the industry, such as ensuring brokerages and their employees are complying with securities regulations.

And the agency's investigators are feeling the pain of an increased workload. "The caseload is definitely higher," says Tom Melton, an attorney with the SEC's regional office in Salt Lake City for more than six years. To be fair, Mr. Melton says the office is resolving cases faster, but he notes the regional enforcement staff has remained at 14 lawyers and investigators since his arrival.

Mary Keefe, director for the SEC's Midwest region, the second-biggest behind the Northeast, says her office has "more complaints than we can handle" and she could "use more people without a doubt." In the five years she has been the agency's top official for the region, Ms. Keefe says her enforcement staff has totaled 72 positions. "Their work has not diminished at all. We try to be more efficient ... but lots of matters don't get tended to because we don't have the staff."

Furthermore, Ms. Keefe says, more complex cases and a high turnover rate as lawyers and other staff members are lured away by higher-paying jobs in the private-sector have added to that burden. She said that was partially responsible for a drop in the number of cases pursued in the region last year. Ms. Keefe adds that some cases drag on because they have to be reassigned to a second and sometimes third generation of lawyers due to the department's high turnover rate. And turnover is not endemic to the Midwest -- the New York office lost half its 137-member enforcement staff to turnover in the past two years.

"You can't take a market that is growing as rapidly as the securities market has grown in last two decades and expect the agency essentially at same staffing level will be able to provide the same amount of oversight and protection for investors," says Barbara Roper, director of investor protection for the Consumer Federation of America, a non-profit consumer advocacy organization based in Washington. "If you look at the states you'll see similar patters."

She charges that neither the SEC or state regulators' resources have kept pace with the explosive growth in securities market since 1980. "If you look at the change in the number of investors, mutual funds and offerings, the growth is exponential and regulatory resources haven't begun to keep pace. And of course the advent and growth of online investing just increases those challenges," she says.

In California, the state that's viewed as being one of the most aggressive in cracking down on scams against investors, especially on the Internet, the number of investigators hasn't changed in two decades despite a surge in complaints. "We are basically redirecting the same resources," says Mr. McDonald. "We have 60 people in enforcement and we have had 60 people since 1980. We just have to work smarter."

Michael Morehead, assistant director for enforcement at the Illinois Securities Department, says investigators are being more selective in the cases they pursue. The state has 15 people reviewing 300 suspicious Web sites a month. Those same people are also handling an average of 300 fraud cases each year. But there are many that fall by the wayside.

"Simply because of the number of cases and stagnant staffing levels you could only look at so many things a day." Mr. Morehead says. "We try to look at the cases that are most troubling and hot. You have to prioritize your cases and the ones that are current and most egregious receive the highest priority."

Mr. Klink, who is the ranking member on the Commerce Committee's Subcommittee on Oversight and Investigations, said he is bothered by a growing number of news reports and complaints from constituents about problems arising from the growth of electronic trading. He says his concerns were heightened by his inability to get any satisfactory answers from the SEC about those problems.

"One of the things that we are concerned is that there are several hundred complaints going into the SEC about possible Internet fraud and only three people deal with them," Mr. Klink said. "And when we tried get information we couldn't get any. They keep no statistics (about Internet-related problems) and there is no trend line to show what's happening."

Mr. Klink says the SEC couldn't even direct congressional staff members to a day trading firm in Washington, when they wanted to make visit after hearing about a rash of problems arising from the fledging business that allows individuals to buy and sell shares quickly using powerful computers. Mr. Klink says he and the other Democrats are seeking information to find out whether the SEC needs more money or new legislation to deal with the growth of electronic investing.

Meanwhile, state regulators say individual states will never be able to deal with Internet fraud effectively without greater support from the federal government. They are trying to push for more coordination among the states through the North American Securities Administrators Association, the umbrella group of state regulators. NASSA has set up an electronic address to collect information about potential fraud from investors and forward them to state regulators. It also has formed a task force to explore ways state regulators could coordinate their efforts and improve Internet surveillance, Mr. McDonald says.

"I don't think any state can do this alone -- either from a money standpoint, resources or bodies," says Mr. Morehead, the Illinois securities official. "This really requires the cooperation of states along with federal enforcement authorities."