fraud

The Second Life Exchange Commission met last night, and came out with this official statement

The Second Life Exchange Commission (SLEC) has been closely investigating the recent issues that surround the recent theft at the World Stock Exchange. It is our policy that we will not make public statements based on speculation, we will only deal in facts.

At this point, we have confirmed that the theft has occurred and we believe that this issue clearly shows that independent regulation is a necessity in order to protect the investing public.

At this time, there are several questions that have not yet been answered to our satisfaction. We are confident that the issue will be resolved. The SLEC will only support the exchanges & companies that are willing to work with us toward our mission of full disclosure.

We caution investors not to panic since this is an issue that faces Hope Capital Limited and should not directly impact the balance sheets of other listed companies. We believe that investor confidence has been decreased however, and we expect it to remain so until the WSE takes actions to conform to the standards required by the investing public and set forth by the SLEC.

We will continue to monitor the situation and update our position accordingly. Please see our website for current information: http://www.freewebs.com/theslec/

The statement was work of TraderJohn Susa, SLEC Chairman, and at least some of his appointees, Patrickj Ah (CEO of CGI, listed on WSE), Marc Attenborough (CEO of NDX, listed on the WSE), Maelstrum Baphomet (COO of AVIX), and Rodders Holgado (founder and CEO of 8 Dragons Bank, listed on ISE).

The meeting included one big surprise: LukeConnell Vandeverre , CEO of WSE, showed up. Much to the disappointment of the many members of the SL press in attendance, however, he showed up merely as an observer of the meeting, and declined to answer questions. His statements did not extend beyond expressing a willingness to “keep an open mind with the potential to work together [with the SLEC] in the future,” and directing us to official statements already issued by the WSE, such as this one at http://www.wselive.com/research/announcement_detail/1951:

Just prior to closing down the WSE for updates, that include WSE 3.0, I noticed a large withdrawal by an avatar with no history. I then closed the WSE immediately and began to investigate. It appears that a past employee of Hope Capital, who assisted in fixing previous bugs in our ATM, had decided to try and use their inside knowledge of our ATM communication channel to their advantage. We can confirm that there is more than one avatar under investigation which are possibly controlled by the same person in real life. A detailed announcement will be released soon.

Linden dollars were withdrawn from the WSE by the avatar in question; however, there are a number of interested parties investigating the situation. We are hoping that most of the linden dollars will be returned.

WSE 3.0 is progressing well and should be released soon. The security of WSE has now been setup so that only the real life developers working for Hope Capital will know key site details. As part of the new WSE 3.0 update we were intending to increase security of the WSE ATM, along with installing Risk API supplied by Linden Lab. This could explain why the avatar in question tried to take advantage of their knowledge before we started the update. The WSE is financially stable and there is no foreseen security related risk to the WSE in future.

We are almost ready to release the latest updates which include an improved database structure, application improvements, and the full integration of the World Internet Currency.

The World Internet Currency (WIC) will provide the majority of Internet users with the ability to trade on the WSE.

The World Internet Currency will act as one fictional currency in both the real and virtual worlds. This will encourage growth in the virtual economy and provide everyday Internet users with the ability to invest in its future.

Connie McMahon of SL-Newspaper provides a comprehensive summary of the meeting at http://sl-newspaper-bnc.blogspot.com/2007/07/exchange-commission-chief-m..., emphasizing TraderJohn Suza’s personal belief (not an official SLEC statement) that there will not be a severe run on the WSE.

My own contribution to the meeting was to propose that the SLEC construct a list of specific disclosures they would like Luke to provide, and a deadline for providing it. For example, SLEC could ask Luke to report the current cash balances of WSE Huet (the account from which withdrawals are taken), when the ATMs will reopen, the cause for the repeated delays on reopening, etc. The SLEC would not “require” the disclosures, but would be able to state publicly their concern if the information is not provided. Investors can decide how reasonable the SLEC’s requests were, and draw their own conclusions from WSE’s response.

Analysis
The SLEC primarily emphasizes the need for regulations that are developed in concert with the exchanges, a desire for more (but unspecified) information, and that the immediate financial damage is limited to Hope Capital Limited (HCL), the banking arm of the WSE.

The last point of emphasis is an interesting one, because it points out a key difference between real-world exchanges and SL exchanges like WSE: the WSE (like AVIX and ISE) serve not only as exchanges for raising capital and trading securities, but also serve as banks for investors, who deposit cash into WSE, and then use that cash to purchase shares. The L$3.2 Million withdrawal is really just a run-of-the-mill banking embezzlement.

The SLEC is correct to note that the theft “should not directly impact the balance sheets of other listed companies.” However, all WSE investors may worry that they can’t withdraw their funds. If investors lose confidence in the banking arm of WSE, they will have to liquidate their shares in order to withdraw cash from WSE control, which will affect the prices of all shares. This may well lead to the shares being undervalued (relative to the firms’ true assets and dividend potential), with the undervaluation reflecting a discount for the risk of leaving funds in WSE control.

I expect many readers will find the SLEC’s response rather timid, and may well point to the current board/appointee composition, with heavy representation from the exchanges and companies listed on them. A repeated joke at the meeting was to question whether TraderJohn is simply an alt for LukeConnell. (I can put this one to rest…I have spoken with both through Skype, and unless Luke is a master of Chicago dialects, they are different people.) But like most jokes, this one points at an important truth: the SLEC is struggling to determine their relationship with the exchanges. Naturally, the people who are interested in regulation will have close ties to the exchanges and listing firms. Also, SLEC doesn’t have any power to impose standards upon the exchanges against their will, even if they wanted to. The exchanges could simply ignore the SLEC, leaving the markets no better off than they are now. Thus, ‘conspiracy theory’ isn’t the only reason for the SLEC to want to cooperate with the exchanges.

A second thread of the discussion centered on the role and motivations of Mystik Boucher, who first reported the scam on her blog, and then provided interviews to various reporters, including me. (I believe I was the first to report her accusation of a coverup.) TraderJohn even suggested that “she does indeed appear to be working hard to kill the WSE.” I think the whistleblowing/coverup dimension of the story highlights the difficult position of regulators (in RL or SL) who are worried about investor/depositor panic. Demanding public reporting of risks reduces the risk of runs in the long-term, by forcing firms to maintain good policies, but can cause a run in the short term by inducing panic.

The SLEC is also struggling to determine the forms of regulation that they can and should impose. Regulations could include security requirements (e.g., limited numbers of people who can modify key software), requirements for minimum cash reserves (to ensure resilience against bank runs), and/or disclosure requirements for both the exchanges and listed firms. Disclosure requirements are likely to be the easiest to construct, and they need not be enforced by anything more than a statement of whether an exchange has met them. As I argued in the SLEC meeting, investors can draw their own conclusions, by assessing the reasonableness of the SLEC’s requests and the firms’ responses.

As it is, WSE has so far provided only the most limited disclosures, and the ATMs are still unavailable for cash withdrawals, and apparently will not open until noon SLT on Friday the 27th. When that happens, we will see what conclusions investors have drawn.

In the second installment of our coverage of the WSE situation, I clarify the nature of the alleged theft, and discuss its impact on WSE and Mystik Design (whose CFO allegedly engineered the theft. I also tread ground familiar to anyone involved in allegations like this: what really shakes confidence, whether among voters or investors, is not the [alleged] crime, it's the [alleged] coverup.

What Happened
Here are some more details on the alleged theft. Thurston Hallard was, until this weekend, Chairman of Mystik Design (MDS). According to Mystik Boucher, LukeConnell Vendeverre, CEO of WSE, gave Thurston some rights to modify the scripts used for the ATMs that WSE clients use to make deposits and withdrawals. Thurston apparently used these rights to make bogus deposits, and then withdrew L$3.2 Million from WSE Huet, the avatar used to store the money used to provide the bank with liquidity for cash transactions. (Think of Huet as the cash in the teller’s drawer at your neighborhood bank.)

As soon as the alleged theft was discovered, both Thurston Hallard and Mystik Boucher’s Second Life accounts were suspended by Linden Lab. Mystik, who was CEO of MDS, was under suspicion because she had quite naturally had a number of cash transactions with Thurston. Mystik Boucher’s account has been reinstated, while Thurston Hallard’s has not. Linden apparently has been reassured that Mystik was uninvolved.

Alleged Coverup
In my interview yesterday with Mystik Boucher, CEO of Mystik Design (MDS), Mystik stated that LukeConnell Vandeverre, the WSE CEO, intended to cover up the hack and theft. According to Mystik, Luke hoped to "keep a very tight lid on it, like it never happened." Mystik’s blog entry makes that impossible now. Mystik reports that Luke has frozen her accounts with WSE. Because she had access to the accounts after Luke was aware of Thurston Hallard’s alleged involvement, and did not freeze her accounts until she went public, it seems plausible to infer that this was in retaliation for her decision to report the theft to the SL community. Moreover, WSE has deleted a number of recent announcements by MDS previously posted on www.WSELive.com, including an announcement that MDS is voluntarily delisting from WSE due to a lack of confidence in management.

Luke has provided no public statement on the theft, which is highly unusual for a financial institution that relies heavily on investor confidence.

Mystik also makes a more troubling assertion: she claims that "LukeConnell and the CFO of Linden Labs plan[ned] on a full cover-up of this, LukeConnell told me personally." Mystik notes (and I wish to emphasize) that she has only Luke’s word on the willingness of Linden Lab CFO, John (Zee Linden) Zdanowsky, to aid and abet a coverup. Mystik only has Luke’s statement about John’s involvement. I contacted John personally, and his comments suggest that his involvement is highly unlikely. Perhaps unsurprisingly, John was unwilling to go on the record without approval from LL’s marketing czar. According to Catherine Smith, Director of Marketing for Linden Lab, Linden plans to issue a public statement soon.

Impact on WSE
While L$3.2 Million is small relative to the total capitalizations of the stocks traded on WSE, it may be large relative to WSE’s cash reserves. (WSE has raised hundreds of millions of Lindens for listed companies, but most of that is tied up in investments.) However, it is not clear whether cash constraints are responsible for the delays in reopening WSE’s ATMs, which provide the means for cash deposits and withdrawals. Reopening has been delayed several times, and is now scheduled for today (3pm, SLT).

More serious than the cash squeeze would be a loss of investor confidence. Any bank lives on the willingness of investors to maintain their accounts, which they will only do if they are sure they will be able to withdraw their money sometime in the future. I don’t see too much evidence of a bank run on the horizon, although about 20 people were waiting at the World Stock Exchange on the Hope Capital Sim at 3pm SLT yesterday, when the ATMs were to reopen.

Investors and listing firms are likely to want to know more about WSE’s policies regarding modification rights to key scripts, as well as the current cash position of WSE. Also, Investor Allen, CEO of the competing exchange AVIX, has expressed surprise that Luke allowed so much money to accumulate in the publicly-known WSE Huet. (Again, think of the bank example: Investor Allen compares it to having too much money in the teller’s drawers, rather than stored more securely in a vault.)

The allegation of cover-up is perhaps going to be even more damaging to WSE’s credibility, as investors may wonder how quickly they will be informed of other unpleasant surprises.

Impact on Mystik Designs (MDS)
It is always difficult to project how allegations against an officer will affect a company. Both Mystik and Investor Allen confirm that they are preparing to talk about listing MDS on AVIX, which might happen as soon as today or tomorrow. However, MDS will still face the challenge of regaining public confidence. Personally, I expect to see some public statements soon, from both MDS and AVIX, announcing an agreement.

This story continues to develop. I will keep you posted. If you have information or comments, please contact me either through Second Life (IM Beyers Sellers) or email me at rjb9@cornell.edu.