Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEC wants to hurt stock spammers

The SEC in the United States resorted to an interesting subterfuge
while suspending trading in 35 stocks touted in email campaigns. Most
of the SEC’s press
appears to suggest that this is merely intended to protect
gullible investors who might fall for the spam. But the fag end of the
press release coupled with the very different tone of its actual
tell us that the true intent of the SEC is something
different – it wants to inflict heavy losses on the

If successful, this strategy of hurting the spammer rather than
just protecting investors could very effectively deter future spam
campaigns. The question is the legal and ethical justification for
what the SEC is trying to do.

The core of a spam campaign is well described by Frieder and
Zittrain in their January 2007 SSRN paper Spam
Works: Evidence from Stock Touts and Corresponding Market

The evidence accords with a hypothesis that spammers “buy low
and spam high,” purchasing penny stocks with comparatively low
liquidity, then touting them – perhaps immediately after an
independently occurring upward tick in price, or after having caused
the uptick themselves by engaging in preparatory purchasing – in
order to increase or maintain trading activity and price enough to
unload their positions at a profit. We find that prolific spamming
greatly affects the trading volume of a targeted stock, drumming up
buyers to prevent the spammer’s initial selling from depressing the
stock’s price. Subsequent selling by the spammer (or others) while
this buying pressure subsides results in negative returns following
touting. Before brokerage fees, the average investor who buys a stock
on the day it is most heavily touted and sells it 2 days after the
touting ends will lose approximately 5.5%. For the top half of most
thoroughly touted stocks, a spammer who buys at the ask price on the
day before unleashing touts and sells at the bid price on the day his
or her touting is the heaviest will, on average, earn 5.79%.

The SEC’ action has the potential to inflict heavy losses on the
touts by making his holding of the touted stock worthless. Not only
can he not sell his holding for the 10 days for which the suspension
is in force, but the SEC is making it more or less clear that it would
not like these stocks to trade any time soon. As the SEC points out:

For stocks that trade in the OTC or the over-the-counter market,
trading does not automatically resume when a suspension ends. (The OTC
market includes the Bulletin Board and the Pink Sheets.) Before
trading can resume for OTC stocks, SEC regulations require a
broker-dealer to review information about a company before publishing
a quote. If a broker-dealer does not have confidence that a company’s
financial statements are current and accurate, especially in light of
the questions raised by the SEC, then a broker-dealer may not publish
a quote for the company’s stock.

In its press release, the SEC makes its intentions very clear on
this point:

Further, broker-dealers should be alert to the fact that, pursuant to
Rule 15c2-11 under the Exchange Act, at the termination of the trading
suspensions, no quotation may be entered unless and until they have
strictly complied with all of the provisions of the rule. If any
broker-dealer enters any quotation that is in violation of the rule,
the Commission will consider the need for prompt enforcement action.

The interesting point is that unlike the press release which talks
at length of spamming, the actual
itself mentions nothing about spamming. For each company,
the order states that “Questions have arisen regarding the
adequacy and accuracy of press releases concerning the company’s
operations and performance” or something similar. This is
clearly designed to make it impossible for any broker or dealer to
have the “reasonable basis under the circumstances for
believing” that the information required under Rule 15c2-11 is
“accurate in all material respects”. The statute itself
does not require the SEC to raise questions about the accuracy of
available information to suspend trading in the stock. Section 12(k)
of the Securities Exchange Act allows the SEC to order suspension for
10 days “[i]f in its opinion the public interest and the
protection of investors so require”.

Clearly the temporary suspension permitted by law might help
protect investors, but an indefinite suspension does not do so –
it hurts those genuine investors who were holding the stock. An
indefinite suspension is needed to hurt the spammers by making their
initial investment worthless. Unfortunately, the statute does not give
the SEC the power to do this. Hence the subterfuge is needed. I find
this action disturbing because (a) it turns the regulator into a
stock price manipulator even if it is for a just cause and (b) it
compromises the honesty and integrity of the regulator.


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