Testimony of Thomas M. Gardner
Before the Permanent Subcommittee on Investigations of the United States Senate Committee on Government Affairs

March 22, 1999

My name is Thomas Gardner and I am a founder of The Motley Fool, Inc. of Alexandria, Virginia. It is a great honor for me to address the Senate Permanent Subcommittee on Investigations. Fools do not often get the chance to speak in the U.S. Senate.

I am particularly gratified to have the opportunity to address securities fraud on the Internet. I believe that the main factor that permits Internet securities fraud, indeed all securities fraud, is ignorance, and this sort of ignorance is exactly what we founded The Motley Fool to combat.

We founded The Motley Fool in 1994 to "educate, amuse, and enrich" the individual investor. Today, we have 1.2 million members of our Internet service, we have an internationally syndicated newspaper column in over 150 newspapers, four best-selling books, a nationally syndicated radio program, and all of it is borne out of our belief that individuals can and should direct the management of their money. At The Motley Fool, we recognize that technology, especially the Internet, now allows people around the world to do just that by obtaining information that once was the exclusive property of the financial-services industry. The general inaccessibility of critical information coupled with the lack of financial education in America has delivered an ignorance that is the very reason we're meeting here today.

I. Bad Pennies

As this Subcommittee has previously learned, much of the securities fraud that takes place on the Internet apparently involves microcap, or "penny" stocks. Penny stocks are the stocks of small companies that don't qualify for listing on any of our major exchanges but trade "over the counter." These stocks generally trade at less than five dollars per share. Statisticians note that 75% of all the companies whose stocks trade for less than $5 per share go bankrupt over any ten-year period. These are the obscure diamond miners in Zaire, the meat-packing business that just launched an Internet service, the fingerprint-technology company that claims it will provide the foundation for all transactions in the century ahead.

Now, because these companies do not trade on the major exchanges, they often do not need to make comprehensive electronic or hardcopy filings with the SEC. Further, because of their relative obscurity, many of these public corporations lack liquidity. In many situations, the majority of the shares in a penny stock company may be held by company insiders and/or promoters. Obviously, not all, or even most, microcap companies are fraudulent, and I'm not criticizing companies for failing to be Wal-Mart or General Electric, but the cheapness and obscurity of penny stocks makes them tremendous targets of fraud and manipulation.

Why, when they present such little opportunity to long-term investors, do penny stocks still attract attention?

First, inexperienced investors may be attracted by the fact that they can buy many shares for little money. To take an extreme example, $3,000 could buy only one share of Warren Buffett's Berkshire Hathaway Class B stock, but it could buy six thousand shares of, say, "Marginal Technology Systems, Inc." at fifty cents a share. The combination of the opportunity to hold large share positions and that appearance of unlimited upside draws scads of new investors into this most highly speculative form of equities ownership. After all, if the microcap stock goes up just fifty cents, the stockholder would double his or her money. Never mind that the odds are very remote that this penny stock will rise and then sustain its gains. Many new investors will buy it up, not having been taught that bankruptcy and micro-cap shares travel arm in arm. Penny stocks are the public market's own brand of lottery ticket - the engine of financial dissolution among those who have not been educated about their money.

Secondly, penny stocks are popular because, with little liquidity and a limited float (few shares available for public trading), they do not demand much popular interest to run higher, momentarily. The relative volatility of microcap stocks re-creates the thrill of a gambling casino, where fortunes can be won in an instant - yet where fortunes are clearly lost over the long haul. What many penny-stock investors don't entirely grasp is that manipulators and touts can pump up share prices with a promotional campaign only to opportunistically dump their stock as the trading volume levels out. Brokerage firms, newsletters, tip sheets, and company insiders have driven this familiar scheme for years.

For all of these and other reasons, The Motley Fool abhors the dreaded penny stocks. In our work, we've sought to teach people that penny stocks are extremely risky and subject to manipulation. We do not report on penny stocks, except to share horror stories. We will not open message folders for our community members to discuss penny stocks. Instead, we celebrate the unfortunate confessions of burnt penny-stock investors, which litter our Dumbest Investments message folder at The Fool. Our chat hosts will not discuss penny stocks. And when members of our community try to discuss such stocks on our message boards or in chat rooms, our staff tries to warn other readers of how little enduring reward chases this substantial level of risk.

In excluding these stocks, we are certainly foregoing a line of business that would have a substantial readership and drive considerable short-term revenues for our company. But, in a free-market system, we believe that the corporations that commit themselves to the greatest good of their customers will flourish. Penny-stock ownership is not beneficial to newcomers to our public markets, is absurdly comic to experienced investors, and thus is not reported on by The Motley Fool.

Penny stocks have given us great fun, though. I can't talk about them without mentioning Zeigletics, the penny stock that never was. In 1994, while my brother and I were cranking out our monthly newsletter, we were also taking part in online discussions about stocks and investing. On Prodigy and America Online we would join message board discussion groups in the hopes of educating others and being educated ourselves. Our comments, though, were quickly drowned out by the overwhelming noise of penny stock hypesters screaming about Canadian mining companies at twelve cents a share and how we had to "GET IN NOW!!!!" Thus, on April 1st, we decided to play a practical joke by inventing a fictional company with a fictional product, listed on a fictional stock exchange and bearing a fictional ticker symbol. All we needed was a hypester.

Joey Roman was the name we gave to our penny stock superman. He launched a massive propaganda blitz, just like all the other hypesters. But Roman was better than all his competitors, even if he didn't have a real company to hype. Joey Roman always bought all of the competitors' stocks for a dime less, always pushed them up a few nickels higher, and he claimed to enjoy the gushing admiration of the entire penny stock world. He was, in short, a disgusting extreme.

We posted some fifty-odd messages on Prodigy over a one-week period that were read by thousands of investors. Roman hyped our fictional company, Zeigletics, Canadian manufacturer of linked sewage-disposal systems for the Central African nation of Chad, and he hyped them on our fictional Halifax Exchange.

In the first message we posted, Roman boasted of how Zeigletics was "a HUGE bargain!" because it was trading at just 37 cents a share. The company, Roman explained, had just introduced portable toilets (Zeig-Lo-Pots) along with bathroom accessories to Chad. Roman further hyped that "in Africa the name Zeigletics is virtually synonymous with toilets. The company recently sponsored the Sudanese equivalent of the Boston Marathon, where hundreds of fans were waving plungers at the finish line!!!" In further messages we had Roman boasting of his success with lines like, "This baby just tripled, in ONE DAY!!!�Our stocks never go down. If you haven't bought Zeigletics yet (Halifax Canadian Exchange, symbol ZEIG.H), you're no player at all."

As you might imagine, we got a great many responses from investors all over the world. Some of them frantically posted questions and stated they'd contacted their brokers to try to buy shares, but those brokers had never heard of Zeigletics or the Halifax Exchange. The best message posted serves as the best possible closing to this little episode. It comes from a Mr. Hughes, whom we've never met, but he thinks as we do:

The point Joey Roman is making is pretty clear: It is so easy for a fast-talking hypester to establish a position in a low-volume stock, rattle off a bunch of crap that sounds plausible enough to convince a novice, let the price pop due to uninformed amateurs flying in, and sell into the rise, laughing all the way to the bank.

Dear people, learn to evaluate and think for yourselves. There are some legitimate stock pickers on this board, and good ones at that, but please check their records and do your own research before buying�

Ziegletics taught us several lessons, too. First, it demonstrated that there was an audience for humorous material about personal finance. Second, it showed that some people will believe just about anything they read, unless they are educated on the subject, first. Third, it showed that many people have not learned how to make informed decisions about their money for themselves but will trade on tips, even ridiculous ones.

Education is critical to our nation's financial future.

II. The Problem of Securities Fraud On (and Off) the Internet

I'm often asked whether securities fraud on the Internet is a significant problem. My answer is that securities fraud is a significant problem, and it takes place on the Internet, over the telephone, in restaurants, on the trading floors of the exchanges, and in boardrooms. As far as securities fraud is concerned, the Internet is just another medium through which people communicate with each other. Opportunists have used all advances in communications, from the printing press, telegraph, telephone, and radio to television, so it would be surprising if securities fraud was not taking place online.

But the Internet does present some unique problems. Securities scams on the Internet try to take advantage of how the medium makes it easy for people to communicate across the world, instantly and inexpensively. The best known activity, against which the SEC has conducted some high-profile enforcement actions, occurs when a seemingly independent, reporter, newsletter, newspaper, magazine, website or e-mail publication publishes favorable stories about a penny stock company that it has been expressly paid to promote, without disclosing this relationship. Sometimes the company or its promoters even pay the touts with stock. After the stock has been sufficiently "pumped," its promoters usually "dump" their shares, leaving their victims with stock that is virtually worthless.

Other examples of securities fraud using the Internet have included: Individuals soliciting for investors in companies that don't really exist, or that exist on paper but are really scams. These con artists may use websites elaborately designed to look like real businesses. In one example, a "start-up" called Interactive Products & Services used a sophisticated Web site to describe its "revolutionary" Internet technology (which didn't work), based on a Microsoft partnership (which didn't exist), key employees (who later denied any affiliation with the company), and SEC filings (which the SEC had never seen). Before the scam was revealed, 150 people sent the company $190,000, which - according to the SEC - the owner of the company spent on groceries, clothing, and stereo equipment. Individuals or groups, including brokers, may try to spread rumors or hype or smear companies through posts in Internet message boards or live chat rooms. I don't know of any prosecutions or enforcement actions based solely on this sort of manipulation, but several companies have filed lawsuits alleging "cyber-smears."

Some hypesters use mass emailings of unsolicited commercial email, or "spam," to spread the word about the stocks they promote.

One of the most interesting characteristics of these investment scams is that they are so uninteresting. They are the same scams that criminals have been trying to perpetrate for decades, such as pumping and dumping, Ponzi schemes, stock touting and hyping, and rumor mongering. Ill-intentioned operators have always tried to sell nonexistent companies, or worthless swampland, or the Brooklyn Bridge to unknowing individuals. Only the mechanism of transmission is new, and more powerful. While the telephone let schemers and low-grade salesmen contact individuals in their homes, the Internet allows for instantaneous mass distribution into tens of millions of homes around the world. Furthermore, people may be more likely to be taken in by Internet scams than by scams via telephone or personal contact because the Internet is essentially a text medium, and people may believe what they read.

Thankfully, though, as the SEC's John Stark and we have noted, the Internet can also make it harder for malefactors to get way unseen. Unlike telephone or personal contacts, Internet scams leave themselves open for rebuttal by others in communities online. It can be hard to hype a stock in a chat room, for example, when hundreds of others of others can easily challenge the promotion, demanding evidence and the source of that evidence in their search for a hidden agenda. This is the role that our community monitors play when, in online postings, promotion seems to have supplanted education and curiosity. If every investor had access to this public dialogue, made possible only by the Internet, I can assure you that the misdeeds of criminal brokers, insurance salesmen, and realtors would be fodder for the mockery of the people.

Perhaps most importantly, though, Internet messages leave "footprints" - they can provide all the clues to a crime, clues that schemers can never be sure that law enforcement will not obtain. Even the apparent anonymity of cyberspace can work against the would-be con. A few years ago The New Yorker magazine ran a cartoon declaring that on the Internet "nobody knows you're a dog." Well, nobody online knows that you are a securities regulator, either.

III. The Nightmare of Day Trading

The phenomenon of day trading, whereby individuals spend their days trading securities, often holding them for only hours or even minutes, is also not new. There have always been individuals who would spend their days at brokerages or call their brokers dozens of times each day. There have always been those who would risk their savings on short-term phenomena, even when the odds and the costs associated with doing so pointed to subpar returns. Nevertheless, the rise deep discount brokerages online and even day trading "parlors" have contributed to a meaningful increase in the number of people who, from their homes, offices, or rented desks and terminals, may spend their days buying and selling ticker symbols. I have no doubt this craze is only momentary. The poor economics of active day trading cannot support its sustained, widespread use.

I do not have any data to support me on this, but the logical inference is that the rise of day trading will increase the incidence of market manipulation. The more that the public markets are used for short-term speculation, the more frequently will its players attempt to fix prices in the short term. Because rumors - stirred on every medium - can drive small, quick moves throughout the market, a select group of daytraders can be expected to use gossip across every communications and broadcasting network to wiggle a stock that way or waggle it this.

It is important not to forget that the Internet didn't invent either day trading or attempts at manipulation. But the sensitivity of short-term stock movements to rumors, half-truths, and undigested data and the awesome power of the Internet would seem to give day traders incentive to spread misinformation online. That is one of the hundreds of reasons why The Motley Fool advocates a less sexy strategy for buying and holding companies listed on our major exchanges. In our attempts to coach individuals into sound, inexpensive money management, we know that we cannot convince everyone of the merits of that model. We believe, though, that we're making a significant contribution to the reduction of financial fraud throughout the world.

IV. Addressing Securities Fraud

a. Enforcement
Over the past year, the SEC has been particularly active in pursuing securities fraud on the Internet. In October 1998 and again in February 1999, they announced a series of high-profile enforcement actions against over fifty alleged fraudsters, most of whom were accused of promoting penny stocks over the Internet in return for undisclosed payments by those companies and their promoters.

These enforcement actions were reassuring because they showed that the police were on the beat, ready to treat criminal activity online just as they do that offline. That the NASD and the North American Association of Securities Administrators are also active in addressing fraud on the Internet is also good news.

In addition to its enforcement actions, the SEC last month announced some regulatory amendments designed to increase the amount of information available to microcap investors and address some loopholes that penny stock issuers have used. I am hopeful that these reforms will help investors make informed decisions about their investments. Certainly, though, their adoption will not eliminate the misconduct I've discussed today.

Enforcement and monitoring of the Internet (and the securities markets, including the microcap market) must continue, but will never stop all misguided behavior, just as the regulators cannot catch every broker who churns senior citizens' accounts nor every cold caller who sells a na�ve investor an unsuitable investment vehicle. Similarly, while the SEC's efforts to make more information available about individual microcap companies will shed light upon a shadowy corner of the securities markets, it won't solve everything.

If government regulation and enforcement are medicine to cure the disease of securities fraud, then the public needs pre-emptive immunization, too. That immunization is education.

b. Education
If people knew enough not to make investment decisions based upon tips, rumors, and touts, but to do their homework, they wouldn't fall for most stock frauds. The SEC has played an active role in trying to educate investors. In truth, though, they have a gigantic task. They face massive financial illiteracy in this country (though not nearly so substantial as that across the world), because a great number of Americans are never taught basic principles of personal finance in school or at home. For instance, many people graduate from high school without understanding the effects of compounding credit card debt (or investment returns), let alone how to plan for retirement. What flows from that lack of training are savings and investment plans that are either too risky (i.e., lotteries, casinos, sports betting, options, futures, and commodities trading, or daytrading), or that are too careful (i.e., 33% of all 401k plan money is sitting in money market funds).

In addition, let me outline a few other facts that I think underline the lack of fundamental financial knowledge in this country:
Money continues to pour into managed mutual funds, including energetically managed funds with high fees that may turn over their portfolios like day traders. This while more than 90% of all managed stock funds have underperformed the stock market's average return in the 1990s. In short, people are richly rewarding money managers for reducing their returns.

The average American family has $5800 of credit card debt at 19% interest, even while increasing numbers of them are investing in stocks. With that interest rate on their debt, individuals would have to make historically unprecedented stock market returns over a long period of time just to stay above water. The best investment these investors could make would be to pay off their credit cards first.

If we, as a country, are concerned about citizens' ability to control their own financial futures, to avoid fraudulent offerings, to sidestep poor investment vehicles, and to rely less on government in the decades to come, then this ignorance is our greatest obstacle.

At The Motley Fool we coach a few commonsense principles to help individuals make sense of the money world. We advise that they do their own homework, understand what they own, not act on tips, and not instinctually believe the conventional wisdom that professionals in the financial-services industry know what they're doing and have their clients' best interests at heart.

If something sounds too good to be true, it probably is. If someone implies that you must act now to win big, skip it. Finally, the only surefire way to get rich is to be patient, to learn more about investments, to understand the role of money in the world, and to know thyself. Though unoriginal, these are principles that have served us and our community well.

c. The Future of Online Trading
Finally, I'm often asked what I make of the growth in online trading.

First, I'm certain that online trading represents the future of the securities industry. Digital transactions are more efficient, more transparent, and less expensive than their analog counterparts. More than half of all discount-brokerage trades occur online today; over the next ten years, it's clear that well more than half of all stock-market transactions will originate on the Internet.

Because these transactions will occur on a medium that allows for greater communication than any before it, I'm supremely optimistic about the long-term effects of online trading. I believe that twenty years from now, tens of millions of Americans will be in control of their money, and thus, in control of their future opportunities.

But as happy as I am about the stock market's land rush online, I'm pleased that this committee is paying attention to what will happen to investors once they arrive in digital domains. If investors are not warned about the potential pitfalls, many will suffer losses both trivial and tragic. Yet, also, if online areas are not allowed to flourish without burdensome regulation, we can expect nothing more than the same ignorance that has offered subpar standards of living for tens of millions of people in what is certainly the most prosperous nation on the planet. Thank you for giving me the opportunity to address this Subcommittee. I would be happy to answer any of the Subcommittee's questions.