Avon Hoax Embarrassing but Not Easy for SEC to Prevent

NEW YORK (TheStreet) -- One of the biggest strengths of the Securities and Exchange Commission's electronic filing system is how quickly it can share documents containing potentially lucrative information on American businesses with investors looking for the next big trade.

That's also one of its biggest weaknesses, as illustrated Thursday when a phony takeover bid submitted to the agency electronically prompted a brief spike in the stock of Avon (AVP), a cosmetics merchant whose neighborhood sales force made it a cultural icon. The filing outlined an offer of $18.75 a share, or about $8.2 billion, roughly three times Avon's current market value.

For investors who considered SEC filings a reliable source of market-moving information, the incident was a wake-up call. The agency has no system in place to vet the accuracy of each of the 4,000 filings it receives every day. Adding one would not only be costly but would work against e-filing's goal of sharing information rapidly with investors of all kinds -- a goal designed to make stock markets more fair for investors both large and small.

The SEC "operates a disclosure regime based upon the assumption that they want filers to be accurate, but they can't check the accuracy," said James Fanto, a professor of business law and regulation at Brooklyn Law School. "Maybe the system is too accessible."

The system, known as EDGAR, an acronym for Electronic Data Gathering, Analysis and Retrieval, was set up in 1993, and all public companies were required to start using it by May 1996, almost 20 years ago. Today, it consists of a network of computers that allow 300,000 individuals and 28,000 companies and mutual funds to file documents via the Internet.

To gain access, users -- either individuals or companies -- must submit an electronic application with contact and identification information that's been signed and notarized. Once it's accepted, they are given a login, known as a Central Identification Key, that allows them to access the EDGAR platform and generate three more passcodes required to upload filings.

Afterward, the information filers submit is subject to review at the agency's discretion. That doesn't happen with all, or even with most, of the documents.

"EDGAR is an open system by design," said Tom Sporkin, a former SEC enforcement official now at Buckley Sandler LLP in Washington. "EDGAR balances the interests of third parties by allowing them quick access to file ownership positions. Employing a gatekeeper may be a lot of effort to take for a minimal increase in security."

The SEC maintains that filers are responsible for the truthfulness of information they submit to Edgar and notes that information found to be fraudulent or misleading may lead to enforcement actions. 

That could be too late for people who lost money in the brief run-up of Avon stock. 

The private-equity firm, PTG Capital, making the bid turned out not to exist. Ditto for the Texas attorney who supposedly advised it. In the interval before that became clear, the supposed bid provided a bright spot to investors who had seen their shares drop 70% over five years while the broad S&P 500 (SPY) more than doubled.

Some 69 million of company's shares traded hands following Thursday's false filing, about five times the average daily volume so far this year, according to data compiled by Bloomberg.

One easy step the SEC might take to protect investors is posting a warning that not all of the information provided has been vetted by the SEC, Sporkin said.

While phony takeover bids have been used to push up a company's stock many times, the sting for investors is particularly acute when the source of misinformation is the agency in charge of protecting them from market manipulation and malfeasance.

"You have people gaming the system and benefiting," Fanto notes. "You can't let your system be a tool for online manipulation."

Particularly ironic is that the SEC has been urging firms to take measures to increase their cybersecurity yet its own system has been proven to be vulnerable to manipulation.

"One would think that, in addition to threatening these fraudsters with enforcement, the SEC should be taking efforts to impose more security protections on EDGAR," Fanto said.

While federal law makes defrauding investors a crime, punishment requires apprehending the person responsible. Electronic filing -- which makes information easily and rapidly accessible -- also means that filings can be submitted anywhere and makes catching people committing fraud infinitely more difficult.

Just last year, the SEC filed a complaint in federal court in New York accusing Luis Chang and his Everbright Development Overseas of fabricating a $750 million takeover bid for Allied Nevada Gold (ANVGQ) to push up the value of their shares, then selling them at a gain of about $7 million. The agency admitted in the filing that Chang was in China, outside of its jurisdiction.

In Avon's case, "hackers did this in the belief they could not be identified," said John Coffee, a professor from Columbia Law School. "The SEC could require more formality but that raises the costs for all. If they can find them, there is no doubt" that the law provides a remedy.

There are two ways the SEC might go about finding the person behind the Avon hoax, said Sporkin, the former enforcement official.

The first would be tracking the upload data, which ideally would give the agency a link to the perpetrator's computer address. The second is reviewing the recent trading history of Avon stock for unusual patterns, which is a more difficult path.

The SEC would have to act quickly to freeze suspicious accounts before the trades settle -- typically three days later -- and profits become available for use, Sporkin said. There's a high risk that investigators might be diverted by trading activity that appears suspicious but is actually legal and run out of time to apprehend the culprit before he or she gets away with the proceeds.

 

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