Fraud Files: What the SEC Should Really Be Investigating About SpongeTech

Last week, the Securities and Exchange Commission charged SpongeTech Delivery Systems (SPNG), which makes a soap-filled SpongeBob sponge, with masterminding a pump-and-dump scheme. The SEC also named five individuals -- including executives Michael Metter and Steven Moskowitz -- in the civil complaint, which was accompanied by a criminal charge from the U.S. Attorney's Office for the Eastern District of New York.

The SEC claims the company made up customers and faked sales numbers, using fraudulent press releases and SEC filings to market the company's alleged success. These activities caused SpongeTech's stock price to rise, and the SEC says SpongeTech and its executives also flooded the market with unregistered shares of stock. When the investigation started, SpongeTech executives supposedly used phony documentation to try to substantiate its sales figures.

Reporters and bloggers grabbed their keyboards and started writing, calling the case a sign of a new, "tough" SEC. Hooray for the government finally paying attention to fraud and doing something about it, they said, suggesting SpongeTech might signal more enforcement cases to come. Market watchers also have been cheering about what they view as the SEC getting tough with Goldman Sachs (although I remain much more skeptical).

A Tiny Victory

The truth is that the SpongeTech case puts hardly a dent in the mountain of fraud that dishonest executives are committing every day. It's an interesting story and a case on which the SEC needed to act, based on the information it had. But it's way too small to be an indicator that the SEC is getting serious about corporate fraud.

To me, the real SpongeTech story is not the fact that the SEC is pursuing the company, but all the issuer retaliation that bubbled up when the company's problems were brought to light. Issuer retaliation is the special kind of revenge that public companies and their supporters exact on those who would dare to speak publicly about the wrongs they see, and this story is rife with it.

The victim is Kaja Whitehouse of the New York Post, who has been writing about SpongeTech since September 2009, when she reported the SEC's inquiry into SpongeTech's financials. She followed up with an article about attorney Joel Pensley, who said SpongeTech was fraudulently using his name on letters he hadn't written. Whitehouse then exposed the fact that five of the six largest customers SpongeTech cited in an SEC filing didn't appear to exist. The stories continued with SpongeTech's mounting legal woes, including lawsuits from Madison Square Garden, the New York Giants and CBS Radio.

SpongeTech Fires Back

And for her diligence, Whitehouse and her family were slammed with insults and accusations. Emails and message board postings have threatened "stock bashers" and their families with attacks. Whitehouse's personal information and photos have been posted on the Internet for the world to see.

While these attacks have never been linked directly to SpongeTech, the company has engaged in a bit of gameplay itself. In September, the company issued a press release, SpongeTech Delivery Systems, Inc. Sets The Record Straight, stating that press reports were inaccurate and based on forgeries. The company went even further in April, going after a critic at a competing company who questioned the company's sales figures and suing the New York Post, Whitehouse and several others.

Of course, I am well aware that this is only one of many examples of what the supporters of companies can do when someone attempts to ask serious questions about a business or expose red flags of fraud. One of the more colorful companies, when it comes to the smearing of critics, is Overstock.com (OSTK). The company's CEO Patrick Byrne has regularly retaliated against critics, not only with outrageous insults, but also with methods like cyberstalking and interfering in a divorce.

Felon-turned-corporate-watchdog Barry Minkow has been on the receiving end of attacks and lawsuits by companies he has criticized, as well. My colleagues and I (including Minkow) have been targeted in malicious anonymous attacks, and more recently, have been defending ourselves against a $270 million lawsuit from Medifast (MED).

Skeptics Wanted

I am not against the right of companies to defend themselves against false information and baseless attacks by critics, but I am against malicious personal attacks and lawsuits aimed at shutting down free speech. People have a right to ask questions about the financials and the dealings of public companies. If companies and executives don't want the public to scrutinize their activities, then they ought not be public companies.

If they are public, critics and supporters alike have a right to look at disclosures and public records and ask questions about them. Whitehouse was in the right: She was asking questions about things that didn't add up at SpongeTech. And apparently the SEC agrees with her.

In fact, the market needs critics to help examine public companies. Even if the SEC had the resources to conduct thorough investigations on a wide scale, its lack of competence means it would always be only marginally effective at reducing corporate fraud. Corporate executives have an inherent self-interest in inflating financials and engaging in positive public-relations campaigns. Public-company critics (including short sellers, fraud investigators, reporters and bloggers) help level the playing field and provide the skepticism and accountability necessary to keep those executives honest.

The SEC needs to take a serious look at issuer retaliation against those who ask questions and criticize public companies. The critics are providing a valuable public service and the SEC needs to take action to protect them from undeserved attacks by the public companies they're criticizing.