For Investors, the Internet Has Promise, Perils

There is a new force at work in the nation’s stock markets, one that is powerful, amorphous and often beyond regulators’ control.

It is the Internet, and last month it helped propel the stock market value of a little-known company called Comparator Systems Corp. from about $36 million to more than $1 billion in just three days.

During a trading frenzy that set volume records on the Nasdaq stock market, computer chat rooms, bulletin boards and discussion groups were littered with hundreds of electronic postings on Comparator, a money-losing Newport Beach-based maker of electronic fingerprint-identification systems.

“Everyone who hasn’t gotten in on this stock get in now,” said one newsgroup posting early on May 3, the first day of record trading. “Volume is approx. 25 million . . . share price jumped from 6 cents to 12 cents today!!! Don’t miss the boat!!!”

Few did, as more than 449 million shares changed hands over the next three days, until nervous regulators halted trading and launched investigations that culminated last week in a sweeping lawsuit filed against the company by the Securities and Exchange Commission.

But the Comparator postings represent just a fraction of the thousands of messages about various stocks that appear every day on online services and on the Internet, a worldwide network of computers that many believe will someday be a stock market.

The power of the Internet to reach millions of people--and give each of them an equal voice--is both promising and problematic to securities regulators.

The Net gives investors new access to information that can help them make wiser decisions, and it affords small companies and entrepreneurs an opportunity to raise capital from investors who couldn’t easily be solicited in any other way.

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But it also gives the unscrupulous a new medium for spreading misinformation and a vast new supply of targets for their fraudulent schemes.

That dichotomy puts stock market officials in the precarious position of having to both nurture the new technology and figure out a way to keep from being overrun by it.

“This is technology getting ahead of regulators,” said David Weisman, director of money and technology at Forrester Research Inc. in Cambridge, Mass. “There are only a few times in history when something with this kind of impact comes along.”

Even top stock market officials acknowledge that technology is reshaping their role in fundamental ways. “We need to think about the whole regulatory structure,” said Steven Wallman, an SEC commissioner.

For now, regulators have their hands full just sorting through the avalanche of online postings, looking for cases of fraud and illegal touting. While most online messages are probably just the musings of individual investors, experts believe that some postings are attempts by executives or brokers to manipulate markets.

“There are probably insiders touting stocks on the Internet either anonymously or under assumed names,” said Mary Schapiro, president of the regulatory arm of the National Assn. of Securities Dealers, which oversees the Nasdaq market. “There is a tremendous amount of hype.”

Whether that hype violates securities laws or NASD regulations largely depends on who’s doing the touting and what that person’s motivations are. Investors can post their opinions about a stock, but executives or brokers who spread false information and conceal their identities could be breaking the law.

The question for Schapiro and other regulators is not merely how to catch these electronic violators but whether it’s even possible.

“The Internet is going to be an enormous challenge,” she said. “I haven’t given up on the idea that we can do more in the policing area, but we need to do a better job of impressing the public that you can be defrauded more easily through the Internet than through pieces of paper in the mail.”

Soaring Popularity

The growing influence of the Internet and online services is largely a function of their soaring popularity. The Internet was still the obscure domain of scientists and government officials a decade ago, but now studies show that as many as 20 million people use the Net for everything from sending electronic mail to shopping for cheap plane tickets.

The number of subscribers to America Online, where many of the Comparator messages were posted, has soared to 5.5 million, up from just 2 million a year ago.

That has brought dramatic changes to the investment landscape. Investors who once exchanged stock tips at cocktail parties or subscribed to stock newsletters are now inundated with information from electronic sources whose reliability is far more difficult to measure.

In the midst of the Comparator trading, for instance, the rumors swirled wildly.

“From what I hear, MasterCard is going to announce an agreement with [Comparator],” said one message to the misc.invest.stocks newsgroup. “There’s a rumor that this company is getting involved in the Internet,” said another.

Neither rumor was true, but they were part of the cacophony of misinformation that pushed tiny Comparator’s shares as high as $1.88 before they plunged to 56 cents as regulators stepped in and halted trading May 9.

In fact, Schapiro said the Internet chatter on Comparator intensified several days before the trading surge. NASD has recently observed similar activity surrounding a few other stocks, she said.

Executives at Comparator, who for years have taken huge volumes of stock in lieu of salaries, said they had nothing to do with the Internet hype about their company. Instead, they speculate that the stock surge may have been related to the release of the company’s new fingerprint-identification system, which received mixed reviews at an Atlanta trade show in May.

Those claims were called into question Friday, when an SEC lawsuit accused Comparator of, among other things, lying about its finances, cheating investors and stealing its key product from an engineering professor at Edinburgh University in Scotland. Comparator executives have said the company is legitimate and that the federal accusations rely on the testimony of people out to damage the firm.

Smart investors know to approach online information with skepticism, experts say. But even skeptical investors can find it hard to sit on the sidelines during an event like the Comparator frenzy.

“People want to make money so badly,” said Clark Hooper, senior vice president in NASD’s office of investor protection. “They forget that they ought to put the same amount of time into buying a stock as buying a refrigerator or a car.”

Critical Postings

Postings can also punish stocks. Experts say short-sellers--investors who bet that certain stocks will fall in price--use the Net to heap scorn on those issues so their short bets pay off.

The tactic sometimes appears to work. Several years ago, a small New Jersey company called Medphone Corp. claimed in a lawsuit that critical postings by one individual caused the company’s stock price to tumble almost 50%.

People who manage chat rooms, bulletin boards and other electronic sites concede that their services are vulnerable to manipulators, but they say most subscribers take that into account.

“What you’re really talking about is nothing more than a bar where people get together to talk about stocks,” said Erik Rydholm, a partner in the Motley Fool, a popular investment bulletin board on America Online. “Someone might say this is the greatest stock since sliced bread. But anyone listening should have the intelligence not to take that person at their word.”

Regulatory Challenge

Regulators’ role on the Internet is likely to become even more complicated as the Net and stock markets increasingly overlap.

Earlier this year, a small New York brewing company conducted its initial public stock offering entirely over the Internet. Spring Street Brewing Co. allowed investors to place stock orders on the company’s World Wide Web site in an offering that raised $1.6 million.

Spring Street then essentially created its own miniature stock exchange by letting investors fill out buy and sell contracts on its Web site. Buyers and sellers sent their checks and stock certificates to the company, which acted as a clearinghouse.

The SEC frowned on that arrangement and asked Spring Street to have a bank or an escrow agent handle the transactions. But that was a minor complaint, given that many observers were amazed that the SEC even allowed the Internet stock offering in the first place.

More recently, Spring Street has started a new firm to help other companies hold stock offerings on the Net. And in recent years, several services have popped up that handle stock trades on the Net. Others, including discount broker powerhouse Charles Schwab, allow trading through private dial-up accounts.

There were 412,000 online accounts in 1994, and the number is expected to surpass 1.3 million by 1998, according to Forrester Research.

Some analysts believe that the potential for small companies in particular to market and trade their shares directly over the Net is huge, and represents a long-term threat to established stock markets such as the Nasdaq market and the Nasdaq-run OTC Bulletin Board, now home to most smaller stocks.

“That’s got to be the future,” said Paul H. Schultz, associate professor of business at Ohio State University and an expert on capital-raising issues. “A lot of people want to gamble, and it’s easy to gamble over the computer.”

Tools for Investors

Regulators are quick to point out that the Internet gives investors a number of tools to help them invest more wisely. Chief among them is the SEC’s own huge database of financial reports and other documents filed by public companies.

The SEC has pursued a handful of Internet-related cases, but so far it has targeted only allegedly bogus investment schemes. Last year, for instance, the SEC filed a complaint in federal court in Massachusetts against a man accused of trying to sell phony bank investments through a classified advertisement on an online computer service.

The NASD said it already has a few investigators who routinely surf the Internet, and it plans to hire several more. Similarly, the SEC recently assigned a few analysts to patrol the Net. But even investigators acknowledge that their jobs are a bit like trying to catch rain in a thimble.

“People shouldn’t rely on the SEC to protect them,” said Gary Sundick, associate director of the SEC’s enforcement division. “It’s an educational problem. People should be buying stock based on the company’s financial statements and business prospects, not because somebody they don’t know talked about it on the Internet.”

Otherwise, online investors may find themselves in the unhappy position of one America Online subscriber who bought Comparator shares before their value tumbled.

“This is too scary,” the subscriber wrote several days after Comparator trading was halted. “If Comparator doesn’t have anything good to offer, why would people buy the stock? Just my thoughts . . . trying to remain optimistic . . . bought at $1.50.”