Too big to fail vs too small to matter

Previously published as "The long tail of stock fraud" UNDERGOING RE-WRITE

The long tail theory can be applied to fraud in the public stock markets. Instead of charting popularity to inventory on the x/y graph, as Chris Anderson does in his book,The Long Tail, the re-rederivation from the reference to the tail of a demand curve, is the relationship between losses (or the less quantifiable "attention") and the frequency of frauds.

There are about 3,000 stocks quoted on the OTCBB. These stocks are regulated by FINRA and the SEC and are required to file their reports. There are roughly 5,000 more quoted on the Pink Sheets These stocks DO NOT HAVE TO FILE with the SEC. Even the 3000 isues on the OTCBB that DO HAVE TO FILE financials with the SEC, can raise money under REGULATION D without having dto disclose the lender.

Pump and dumps on the pink sheets are unsophisticated and ... the shares are just issued to close groups pumped up and sold directly on the open market.

Pumps on the OTCBB are a bit more sophisticated Hedge funds invest via pipes and lend companies money, if the money is not paid back they are given stock or convertible stock istead and thne need a market to convert these shares back into their origial loan


The high amplitude segment of the chart is composed of well-known and highly publicized frauds: Enron, WorldComm, Michael Milken, Martha Stewart, and Ivan Boesky. (add MADOFF TO THE LIST- this article was written beforehand orignally) These cases are fodder for big law firms, the SEC, and the mainstream media. The "long tail" of this chart comprises the thousands of frauds, cons and general chicanery relating to small-public-companies, whose stock usually trades on less-regulated exchanges. In this tail, the total volume and frequency (and overall deleterious impact) is much higher, but the individual cases are relatively small. Novice investors1 are attracted to the potential for huge returns in these penny stocks; predators use schemes and mechanisms like fax spams, e-mail spams, chat room manipulation, misleading advertising and PR, pump and dump schemes, and 504 offerings2 to adulterate the markets and steal money. Fraudsters prey upon investors' psychology, flaws/loopholes in the law, and a system where those laws go unenforced. With relative ease they are able to create scams that go unchallenged, unpunished, and generally unnoticed. These affronts get little public attention, perhaps because they're just so prevalent in these markets. (Or perhaps are they so prevalent because they are unnoticed and unchallenged.) There is almost a baseline expectation of fraud in these markets. However, just because something is accepted does not necessarily mean that it is acceptable. This collective long tail of fraud is detrimental to a sense of fairness in society and to the integrity of the market on the whole. Confidence in the integrity of public markets is vital at any level and these frauds should not go unchecked because they are "too small". It is the small nature of the individual fraud, that makes it so effective, consequently creating the higher frequency and the long tail. The cycle then perpetuates itself leading to more frauds making each individual one all the more insignificant. It makes more sense for the bulk of investors burned in penny stocks to move on because, on an individual level, the stakes are too small to put up a BIG fight. But these are the very reasons why the creation of these schemes are so desirable for the criminals -- and that's also what feeds the tail.

The cases on the high amplitude side of the chart are the high profile shows. The Journalists and reporters want to write about them and cover them, the politicians want to regulate them, and the lawyers want to sue them. The media wants to cover the titillating tales of theft and scandal. Politicians want to legislate high profile cases. It makes economic sense for big law firms to start class action suits against the big frauds. Publicity can be garnered and fees generated. The small stories just don't make the cut: there are not enough pages in the paper, air-time is limited, resources are limited, and money is scarce. Most legislators could not be bothered with something so small and the SEC is overwhelmed and understaffed.3 It usually doesn't make sense for a lawyer or firm to make a case against these frauds and it makes even less sense for an individual to try and do so. The fallout of the long tail of the chart remains relatively quiet and is (unfortunately) greeted with a general complacency by almost everyone. These "islands" of crime and deception are kept intentionally small, to make a legal ordeal (or any crusade to "fight back") against the fraudulent companies uneconomical or undesirable. They fly under the radar because very few have the means to fight back, and the targets of the prospective lawsuits are often shell companies with few assets by the time the fraud is known. (The company has gone bankrupt, funds have been hidden offshore, etc.). It is not worth it for the law firm to spend $200k and 3 years to recover $20k in judgments or potentially collect nothing. People may not fight back on their own because they don't want to spend "good money after bad." Less understandably, they convince themselves that the lies and fraud are expected and just part of the market and that they could use the loss as tax write-off against gains. There are also intangible, psychological reasons why the people do not do anything about these scams. They do not want to admit to themselves, much less make a big deal to others that they fell for something so stupid. Not only are lawsuits costly and time consuming but there is a negative connotation about being litigious and looking to blame someone else for your losses. It makes more sense for the bulk of investors burned in penny stocks to move on because its just not "big" enough to fight. But these are the very reasons why the creation of these schemes are so desirable for the criminals -- and that's also what feeds the tail. It is the small nature of the fraud that causes/produces/leads the frequency to increase, thus producing the incredibly large tail. (we just need to create an index and show what the same value of stocks is worth year over year-- ) i can get data that shows the pipes invested and how these stocks go to zero repeatedly http://www.spamstocktracker.com/ http://www.nytimes.com/2006/03/15/business/15place.html?_r=2

For the most part, these small stock frauds were islands before the Internet. They were intentionally set up to be too small to matter (or too small to fight). They were impossibly small for each individual "mark". They were the "obscure books" that Anderson notes in The Long Tail. In the exact same way, the Internet provided "virtual shelf space" and cheaper search costs that has provided a way for users to "unite around a common symbol."

Unlike the retail long tail which is desirable, a long tail of fraud is not. The Internet can be a mechanism to shorten this tail or one used to perpetuate it. The Internet provides a cheaper and easier medium to create and disseminate each of these islands. It is also a place where the public can "meet at the symbol" in order to create economies of scale in defending and pro-actively protecting each other. The Internet can continue to serve as a medium to assist fraudsters in perpetrating their schemes, or it can be the antidote. One may make an argument that the antidote is just banning all of these small pennystocks and unregulated exchanges. But there is legitimate value for smaller companies to be able to access the capital markets. So it is not desirable to eliminate this facet of commerce altogether, nor is it realistic. The answer to allow it to continue but with a stronger focus on Internet transparency and vigilante regulation. Message boards, blogs, web-sites like Sharesleuth.com and search engine transparency can be used to create economies of scale, to make it easier, more realistic, and more productive for people to fight back after they have been scammed. More comforting still, those same tools can be used to educate and shine a light on things in a common arena to prevent fraud and to obviate the need to fight back in the first place.