| Nothing is securities fraud? |
The simplest form of fraud is that you lie to someone and they give you money. Perhaps you give them something in exchange for their money, but you lie about its attributes. (They pay you for magic beans, but the beans are not magic.) Or perhaps you lie about giving them something and give them nothing. (They pay you for the Brooklyn Bridge, but you do not give them the Brooklyn Bridge.) Fraud is oftenillegal, though exactly how it is illegal will depend on how you do the fraud, and to whom, and what you are lying about.
For instance, doing fraud about securities is illegal under US federal law; this is called securities fraud. Securities fraud often takes the simple form: You lie to someone (about securities) and they give you money (for the securities). You tell people that you have started a company that has discovered cold fusion, you offer them a 1% stake in the company (stock, a security) for $1 million, they pay you, you deliver the stock, but you were lying about the cold fusion.[1] This is fairly standard; Elizabeth Holmes and Sam Bankman-Fried are recent high-profile cases of people convicted of fraud for lying about their companies to sell stock to investors.[2]
But securities fraud often does not work that way. In modern public stock markets, it is possible to lie to people in a way that costs them money, and gets you money, without them giving you the money. Schematically:
- You have some stock.
- You lie about it.
- The people who believe your lies buy the stock, anonymously, on the stock exchange, so it goes up.
- You sell the stock at a profit, anonymously, on the stock exchange.
- Eventually your lies are discovered and the stock goes back down again.
You made money (Step 4), and your victims lost money (Step 5), and your lies caused their losses and your gains. But you didn’t necessarily sell the stock to the victims: You sold the stock on the stock exchange, they bought it on the stock exchange, and you have no idea who was on the other side of any of those trades. Quite likely the victims bought the stock from some sophisticated electronic market maker, and you sold the stock to some sophisticated electronic market maker, and the market makers didn’t believe or even see your lies.
This is quite a common form of securities fraud. Companies, for instance, are regularly accused of doing securities fraud for lying about their business in a way that keeps their stock price up, even if they are not selling the stock themselves and lying directly to the purchasers. (“Everything is securities fraud,” I often say.)
But this sort of securities fraud doesn’t have to be done by the company. We have talked a few times about fake takeovers, where someone buys stock, puts out a fake press release saying that the company will be bought, and then sells the stock at a profit. More broadly, a “pump and dump” is a classic form of securities fraud in which someone — perhaps a promoter affiliated with the company, perhaps just a guy online — buys a stock (often a small, illiquid penny stock) and then tells lies about it. “This company discovered cold fusion,” he says, to his email newsletter subscriber list, or on X or Reddit or whatever. People believe him, they buy the stock, the stock goes up (the pump), and he sells his shares (the dump) before the price crashes again. He doesn’t necessarily sell the shares to his email subscribers or X followers, but their buying is what makes his sales profitable.
This is, if you think too hard about it, actually a bit of a puzzle. If you are charged with fraud, you might say: “Oh sure I lied about this stock, and it went up, and then I sold the stock. But nobody can prove that I sold the stock to the people I lied to. So how can I have committed fraud? As far as you know, the people I lied to never gave me money, and in fact I never even wanted them to. I just wanted them to buy the stock, so it would go up, so somebody else — some anonymous person on the stock exchange who never even heard my lies — would give me money.”
I think most people think this is too cute. It sure looks like fraud: You lied, someone believed you, they paid money, a fairly mechanical process (the workings of the stock market) occurred, the money came to you. Surely that’s fraud. In US securities law, this is called the “fraud on the market theory.” In 1988, the Supreme Court endorsed the theory[3]:
The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. The causal connection between the defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. …
The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5’s reliance requirement must encompass these differences.
In face-to-face transactions, the inquiry into an investor’s reliance upon information is into the subjective pricing of that information by that investor. With the presence of a market, the market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price. Thus, the market is performing a substantial part of the valuation process performed by the investor in a face-to-face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price.
If you lie to the market, and the market believes you and gives you money, then that is fraud, even if the particular people who believe you are different from the people who give you money.
Or, I mean, that’s what I thought yesterday.
In 2022, federal prosecutors and the US Securities and Exchange Commission brought securities fraud charges against a group of people who allegedly did pump and dumps using Twitter, Discord and a podcast. We talked about the case at the time. It was typically silly: The defendants went by online nicknames like “MrZackMorris” and “Mystic Mac” and “The Stock Sniper,” the podcast was titled “Pennies: Going in Raw,” the SEC complaint had pictures of a Lamborghini, and the defendants were publicly saying things like “I’ll never get sick of pumping … money into my followers bank accounts. LETS ALL GET RICH!” while they were privately saying things like “We’re robbing f*cking idiots of their money.”
So I couldn’t not write about it. But it was kind of boring, really, just the most garden-variety pump and dump imaginable. “Pretty straightforward fraud,” I called it. “I don’t know why people keep falling for it,” I wrote. There was nothing particularly novel or interesting about this case except I guess the names.
But yesterday a federal judge in Texas dismissed the criminal charges against MrZackMorris and friends in an absolutely wild opinion ruling that, in fact, a pump and dump is not securities fraud, because the people who bought the stock didn’t buy it from the pumpers[4]:
Unlike a traditional fraud case, in which the victim directly surrenders their property to the defendant (or an entity in the defendant’s control), the investors here surrendered their property to the stock market at market prices, and in return, received the benefit of the bargain in the form of securities. Thus, the scheme did not deprive investors of their money or property through any misrepresentation; the misrepresentations deprived them only of accurate information necessary to make discretionary economic decisions.
And:
There are allegations that the Defendants intended to “maximize” their own trading profits and that Defendants in fact profited from their activities. These allegations adequately allege that obtaining financial gain was an object of the Defendants’ scheme to defraud; obtaining financial gain, however, is only half of the equation. It is the other half of the equation — harming a victim’s traditional property right — that is lacking.
The Indictment states that “the defendants used their credibility to maximize their own trading profits through their tweets and posts in Atlas Trading Discord, often at the expense of their Twitter followers and members of Atlas Trading Discord.” That allegation, however, underscores the issue with the Government’s allegations when accepted as true — the defendants may have “used their social media influence to pump and dump securities for their own financial gain,” but the language of the Indictment indicates that losses to victims happened incidentally (i.e., “at the expense of”) rather than as the “object of” the alleged scheme. Rather than plead a scheme aimed at harming someone’s traditional property right, the scheme as pleaded is totally indifferent to its effect on the alleged victims. Many of the alleged victims may have actually made money. This was confirmed at the oral arguments. Moreover, even accepting as true that the alleged victims ultimately lost money on the stock market because the value of their shares went down, the Defendants did not obtain something of value from the entity to be deceived. The investors’ trading losses are one step too far removed from the Defendants’ alleged fraudulent misrepresentations.
What a weird opinion. Part of the theory here seems to be that it’s only fraud if you want your victims to lose money, which … I mean, then nothing is fraud, is it? Surely everyone who does a fraud is “indifferent to its effect” on the victims: The goal is to get money for yourself, not to cost the victims money, though of course that is the usual outcome.[5] If you sell people fake magic beans, you will get money, which is what you want, and they will probably lose money, which you don’t care about one way or the other. But if they turn around and resell the beans at a profit to some other sucker, you don’t care, and you still did the fraud!
But the main part of the judge’s theory is just that, since the victims bought stock on the stock market instead of directly from the pump-and-dumpers, the pump-and-dumpers could not have been doing fraud on them. Fraud requires a direct connection, a victim who “directly surrenders their property to the defendant.” And in the public stock market, where everyone is buying and selling anonymously and probably through market makers, you can never really prove that the victim traded with the defendant.
Seems wrong to me, but what do I know![6] If it’s right, though, it means that pump and dumps are completely legal, as are fake takeover offers[7]: It’s not fraud to lie about stocks and make money trading them, as long as you are only trading on the stock market and not directly with the people you’re lying to. (Not legal advice! This is one weird opinion in Texas, don’t try it at home.) If that’s right, the stock market, and social media, are going to get pretty weird.[8]