An Open Door for Online Crooks?

If a judge's flawed decision is left standing, the SEC could be stymied in cases where it believes cyber fraud is masquerading as entertainment

By Geoffrey Smith

The law is usually able to distinguish clearly between legal investments and those that constitute fraud. But the Internet is blurring lines most of us assume are easily drawn when federal prosecutors try to protect us from crooks. And that's making it increasingly difficult for authorities to keep up with a new generation of cyber thieves.

This quandary was driven home by a recent court decision from a federal judge in Boston who decided a Web site that promised sky-high returns on investments wasn't actually ripping people off -- it was merely entertaining the public. The Jan. 25 decision is disturbing because it has already triggered a tidal wave of online theft masking itself as entertainment, and it could significantly hinder the ability of a key regulatory authority to protect investors against online fraud.

"PRIVILEGED COMPANY."

  The case involves www.stockgeneration.com, a Web site based on the island of Dominica in the Caribbean. Before it was shut down by federal authorities last summer, the site marketed itself as a "virtual stock exchange" where investors could put money in fictitious companies, including one "privileged company" guaranteed to go up at least 10% a month, or 215% annually.

"Would you like to double your money each month? Then Welcome to the Virtual Stock Exchange SG," the Web site teased its unwitting victims. The site called itself a "game" but also repeatedly reassured participants that its privileged company would "only rise," according to court filings.

Last June, the Securities & Exchange Commission took the company that owned Stockgeneration.com to court, arguing it was "nothing more than a classic pyramid scheme with high-tech trappings." The SEC claimed the site amounted to securities fraud because the money needed to pay off existing investors was derived solely from investments by new or existing investors. By the time the suit was filed, thousands of investors were out a total of $5.5 million. Stockgeneration says it had 325,000 players last spring. The court ordered the money frozen in banks in the U.S., Estonia, and Cypress.

CALLING IT A GAME.

  But in a decision that could reverberate for years to come, Judge Joseph L. Tauro ruled that Stockgeneration.com is legal. The reason: It's merely a game that more closely resembles gambling than investing. Judge Tauro concluded that Stockgeneration.com had "forcefully" disclosed that it's entertainment. "While it's true that participants in the 'virtual exchange' parted with their money in the hope of doubling it through SG's promotion of the Web site and payments by other participants, all transactions were in the form of a game...and no investment vehicle was involved," Tauro wrote.

Stockgeneration's attorney, Daniel I. Small of Butters, Brazilian & Small in Boston, says the decision simply reflects a new reality of cyberspace: "That the SEC would put the full force of its resources behind this indicates a total lack of understanding of the Internet as a source of entertainment for millions of people all over the world." Others don't see it that way. "The judge seems to be saying that as long as you call something a game, then you're home free," says a federal prosecutor close to the case.

The decision has outraged Internet-fraud watchdogs, who say it has led to a flood of online scams that are now labeled games. Rana Adamchick, a Florida computer-repair technician who claims she lost $150 to Stockgeneration.com, says: "Sites now boldly proclaim they are games, whereas they were claiming for a while they were risky ventures, or investments, or even out and out Ponzis."

DUBIOUS SITES.

  Adamchick should know. After her Stockgeneration misadventure, she launched a Web site called www.victimsagainstscams.com, which attempts to expose Internet fraud. The site invites Netizens to post information on online scams and lists hundreds of suspect games and dubious sites on the Net. Adamchick claims some 20 new candidates for fraud appear each day on leading portals such as Delphi and Yahoo!, and that hundreds are operating at any one time. Many open and close within days or even hours, she says.

One example is the 711GAME, which recently appeared on Delphi and quickly disappeared. The game described itself as paying out money to participants strictly on a first-spent, first-paid basis. "For every two people spending [$7], one gets paid [$11]...the faster the spends the faster the payouts, so promote the h--- out of it. The game stalls when the spends stop coming in," the site said.

There's little doubt that online scams are a major public menace. The last time federal regulators conducted a sweep aimed at closing down Internet pyramid schemes -- in December, 1999 -- they sent warnings to some 600 sites in a single day. The SEC has appealed Judge Tauro's decision, and an appellate judge granted a restraining order that keeps Stockgeneration.com closed pending a decision in the case. Still, the case is all the more remarkable because of who may be the mastermind behind the scheme.

RUSSIAN FUGITIVE.

  Stockgeneration.com is owned by Oksana Pavluchenko, a 23-year-old Russian, the SEC says. According to a September Wired article, she's the sister-in-law of Sergei Mavrodi, a notorious Russian who ran a widely publicized, $1 billion pyramid scheme in Russia in 1994 called MMM. Afterward Mavrodi ran for national public office, saying he'd return the money if elected. He won but eventually became an international fugitive sought by Russian authorities.

Mavrodi's role in Stockgeneration.com, if any, is unclear. Small, Stockgeneration's attorney, says he isn't authorized to discuss ownership or interests in the company. He refuses to make the company's owner available for comment. No one testified for the company in pretrial discovery.

Several securities lawyers predict Judge Tauro's decision will be overturned. "Other courts considering this issue are likely to find that similar products are in fact false securities," says Mark W. Pearlstein, a securities lawyer with McDermott, Will & Emery in Boston. One critical issue in the case is Judge Tauro's finding that the Web site is only a game even though it clearly guarantees a return on the privileged stock. Such guarantees have been considered investment contracts in prior cases, securities lawyers say.

UPDATE NEEDED.

  More fodder for the appeals court is Tauro's view that Stockgeneration is like gambling and doesn't take place in "our commercial world" as defined by prior court rulings in securities-fraud cases. That precedent clearly needs updating in light of the enormous role the Internet now plays in both commerce and entertainment, and its ability to create and vaporize value out of thin air. It should be irrelevant that real estate or sales brochures didn't change hands, as in prior cases cited by the judge as examples of commercial activity involving securities fraud. The people who participated in Stockgeneration.com thought they were creating real accounts that contained real shares in fictitious companies. Many watched the value of those accounts fluctuate on a daily basis, and Stockgeneration made large payouts to some players and promoted that fact to other players to keep them hopeful they would make big money as well. On Apr. 6, 2000, Stockgeneration reduced every player's account value by amounts ranging from 90% to 99.9%, citing player panic after word spread that a bank in Estonia had frozen the company account.

Though the payouts and account values were basically determined arbitrarily by Stockgeneration.com, Judge Tauro considers that just part of the fun. He ruled that the "economic reality" is that Stockgeneration is just a game, so the site's marketing hype about a virtual stock market and investments "without any risk" is essentially irrelevant.

PROMISE OF HIGH RETURNS.

  The economic reality of Stockgeneration.com is precisely the reverse. People were fleeced under the guise of a game. Let's hope it doesn't become legal precedent for cyber crooks to call their thievery entertainment when their hook is to create fictitious investments and bait people with the promise of risk-free, impossibly high returns.

If the SEC doesn't win this case, the door will be open wide for online crooks to copy the Stockgeneration model. In addition, the SEC would lose enormous clout as a force against Internet fraud. The bulk of the heavy lifting would be shoved on to other authorities, including the Federal Trade Commission and the Justice Dept.

Numerous angry victims of Stockgeneration.com have already contacted me by e-mail. I want to hear from the other side. If you operate an online "game" or know how these programs work, let me know, using the e-mail address below, why you do what you do and what you think of Judge Tauro's ruling.

Smith covers a wide variety of topics, including personal finance issues, from BusinessWeek's Boston bureau. You can e-mail him at geoff_smith@businessweek.com