July 25, 2005
Securities Fraud, Behavioral Economics & an Investor's Duty to be Half-Way Intelligent
Posted by Christine Hurt

The SEC has recently cracked down on a number of securities fraud cases that leave you going "what?"  The scams being investigated are pump-n-dump schemes perpetrated either by fax or by telephone.  (Article here, BNA sub. required).  In the first scenario, a promoter sends a fax to thousands, or in one case to one million, fax numbers.  The fax is made to look like a missent fax originally directed from a stockbroker to his physician client.  The fax is handwritten, and tells the client to call him immediately about Company X's stock, which is gonig to double (or triple) in the next few days.  As amazing as this may sound, many recipients of these faxes believe that they have inadvertently received a hot tip, whether by luck, serendipity or divine intervention.  They buy the stock, and the thinly capitalized micro-stock goes up.  Others sell.  In one case involving AVL Global, Inc., the stock rose 25%, and the promoter, who was paid in stock, gained $300,000. 

The phone scams are similar.  You come home and there is a voicemail on your machine, but it is to another person.  The message sounds like a phone number and goes something like this, "Hey Kathy, is this you?  I couldn't read your new number very well from when I wrote it down yesterday.  Anyway, remember how mad you were at me that I gave that stock tip to my dad but not you, then it doubled within a week?  Well, I'm paying you back now.  Company Y's stock is going to triple in three days. . . ."  Apparently, these scams also work.  Both of these scams are extremely low-cost efforts, and seem to have a high return.

Both Profs. Ribstein and Bainbridge have been explicating behavioral economics this weekend and concluding that even if we can speculate on why investors do silly things, this explanation shouldn't lead us to a new way to think of securities regulation.  These scams can fit into that discussion easily.  Any investor who acts on a fax or phone message that falls into a lap can't be seen as acting rationally.  However, at some point, we should impose on an investor a duty to only rely on reasonable information.  I understand that a type of shampoo won't change my life, so I should be able to transfer that consumer savviness into the securities arena.

I suppose I could still support these schemes being criminalized, but I would hope that the policy behind criminalized certain kinds of fraud is that the fraud induces the rational, and not merely the irrational, to buy or sell stock.  The reason that these frauds succeed is because they focus on certain individuals' greed and ambition to be on the inside, to get something for nothing.  Is that something to protect?

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