Securities Fraud
From FraudWiki
The key principle of securities fraud is that the investor's interests are secondary to the financial gain the broker can make.
Securities fraud usually takes place when brokers try to manipulate their customers into trading stocks without regard for the customers' own real interests. Stock fraud can be at a company level, or can be committed by a single stockbroker. Stock fraud can also vary in size from multi-million deals to penny stocks, but it consistently involves the intentional disregard for the financial situation of the customers and with personal profits. Corporate insiders, brokers, underwriters, large shareholders and market makers are likely to be manipulators.
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Types of fraud
The following lists the broad categories of securities fraud:
- Churning or excessive trading: Excessive trading in a customer's account to give profit to the broker/dealer in disregard of the customer's best interests. Prosecutable under the 1934 Securities Exchange Act.
- Unsuitable investments: Investments that ask the client to assume a greater financial risk than he or she can reasonably sustain; investments that are inconsistent with the clients financial needs; or investments in which the client is not adequately made aware of the risks involved.
- Insider trading: Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
- Misrepresentation and false statements: Disguises risk factors associated with that particular stock; the broker intentionally misleads the customer about material facts regarding the stock.
- Unauthorized trades: Unless the client of a brokerage firm has signed a contract that allows his or her broker to engage in discretionary trading, each transaction performed by the broker must be done with the client's permission.
- Breach of fiduciary duty: A breach of fiduciary duty includes, among other things, abdication of duty, abuse of trust and approval of unlawful transactions, and may be based on nonfeasance as well as misfeasance.
- Overconcentration: Diversification is one of the most important rules of investing. Brokers should never concentrate all of a client's investments in one area. The broker who does so is potentially liable if that investment declines in value.
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Types of Market Manipulation and Insider Trading
Most forms of market manipulation involve gaining control of the market by purchasing significant volumes at artificially set prices. Also called "cornering". This can be followed by increasing or decreasing prices to desired levels. The more illiquid the stock, the easier to gain control and therefore the easier to manipulate.
There are two type of Market Manipulation:
- Demand side manipulation - any manipulative technique used to increase the price of the securities. The rising price often leads other buyers into the market. The resultant market price bears no relation to the merits of the investment.
- Supply side manipulation - any manipulative technique used to decrease the price of securities. The falling price induces others to sell, including short sellers. The resultant market price bears no relation to the merits of the investment.
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Manipulative Techniques
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Equities by Price
- Bait and switch - Stock-of-the-month recommendations are issued, usually without appropriate foundation, and sold to a group of customers. They then re-sell the stock for a small profit, thereby creating interest and encouraging other investors to buy at higher levels. This process can be repeated several times, pushing the price higher. Highest bidder or transactions at progressively higher prices - consistently appearing as the highest bidder, a device which could be used to support or raise the price of securities; following the market too closely on a rise with either purchases or bids, may also constitute apparent activity. Each time new buyers enter the market, even as a result of an independent purchase or bid, it exhausts the supply of securities at lower levels, and forces others to raise their bid. (See also pump and dump). The inverse is used to lower the price of the security.
- Hype and dump - talking up the price of stock by using false or exaggerated reports, rumours, brokers recommendations etc. Once price has risen, stock is dumped. The antithesis can be known as slur and slurp and occurs when the price of a stock is talked down, allowing manipulator to buy shares at lower prices.
- Pump and dump - transactions at successively higher prices, giving the appearance of real activity by investors, then dumping or selling at highs. Can occur as a supply side manipulation as well, by making undisclosed offers for only small parcels of shares, thereby inducing others to sell and allowing the manipulator to buy a large parcel of shares later at a cheaper price.
- Ramping - marking (up) the close either by placing bid or purchasing parcel at or near the close which changes the closing price (bid often dropped next morning). Also called painting the tape or window dressing. Can also be used to push share price lower.
- Window dressing - ramping by institutional investors to allow valuation at desired prices.
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Equities by Volume
- Chain letter rally - occurs as speculators enter market thereby unwittingly assisting manipulator by increasing volume and price movement.
- Churning - the manipulator acquires a holding of shares and then places both buy and sell orders either through one broker or several in order to create an impression of large turnover. These orders are usually placed at progressively higher prices. Also called pass the parcel.
- Pools - a group of manipulators who trade shares back and forth between themselves, usually through one broker, thereby raising volumes and creating other investor interest. Similar to churning and pass the parcel.
- Short squeeze - purchasing significant amount of stock i.e. cornering the market in order to force short sellers to purchase shares to cover their short positions at successively higher prices, thereby increasing the price.
- Matched orders - pre-arranged trades by associated parties who enter purchase or sale order knowing associate has entered corresponding order.
- Wash sales - purchase and sale orders placed at same time where beneficial ownership does not change.
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Options
- Capping and pegging - when the holder of a large short put and/or call option position sells or buys the underlying security in order to affect the price of the security so that the option position expires valueless and the holder avoids assignment.
- Mini-manipulation - a relatively short-term stock manipulation in which the price of an underlying stock is manipulated upwards or downwards in order to benefit the liquidation of an open option position.
- Short squeeze intermarket - a short squeeze between the share market and a related security, such as the options market.
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General
- Warehousing or parking - selling parcels of shares to the warehouser in order to disguise the path from original seller to the ultimate buyer. Often used to disguise ownership in a takeover situation, or where control over the shares is needed to ensure a company resolution is passed without disclosing the association between the warehouser and the beneficial owner.
- Failure to disclose - any failure to disclose control or association of the purchase or sale of securities prescribed by statute. The lack of disclosure can allow a manipulator to incorrectly convey to the market that demand or supply for securities is genuine when, in fact, it is related to his own position.
- Churning and burning - the excessive trading of an account by a broker (churning) for the purpose of generating commission without regard to the needs and objectives of the client (who is burnt).
- Guarantees or payments - guaranteeing purchasers against loss or making payments to induce others to purchase or sell the security.
- Use of nominee accounts - the use of nominee/fictitious accounts to stage widespread buying and selling activity at designated price levels, thereby concealing the actual control exercised by the manipulators and the purpose of such activity.
- Spinning - Securities firms involved in initial public offerings may allocate shares to preferred investors on the understanding of obtaining future business, creating a transfer of wealth to those individuals at the expense of other investors. In India, SEBI, in the recent past, has taken measures for avoidance of such situations. Merrill Lynch, J.P.Morgan, Citi have been indicted for spinning during the dotcom induced stock market boom in the US in early 2000.
- Investor loans - In order to ensure that an underwriting goes well, a bank may make below market loans to third-party investors on condition that the proceeds are used to purchase securities underwritten by its securities unit.
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Types of Insider Trading
- Front-running - when a broker/dealer, knowing a client has a large or market-sensitive order, puts through a transaction on his/her or another client's behalf, thus benefitting from the pre-warning. Can occur in either the securities or related instruments market. Financial firms may exploit institutional, corporate or other wholesale clients by executing proprietary trades in advance of client trades that may move the market.
- Scalping - trading prior to the release of a research report.
- Piggy-backing - when a broker, after observing a series of transactions of a client who has a high degree of success, repeats their investments for him/herself or clients. Is similar to front-running but occurs after the transaction of the client has been completed.
- Inside market information - when a broker/dealer disseminates information that certain trading activity is occurring or about to occur which will cause a price change. Similar to front running.
- Classic insider trading - when a director or associate of a company buys or sells shares before the release of a price-sensitive announcement.
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Signatures
Manipulators are mostly involved in selling rather than buying. So identification of the seller brokers with abnormal sell quantity is the most vital need for stock fraud detection.
- Identify seller IDs whose sell quantity rise up suddenly.
- Identify seller IDs whose sell quantity fall suddenly.
- Identify buyer IDs whose buy quantity rise up suddenly.
- Identify seller/buyer IDs who suddenly starts a large volume of trade.
- Identify stock IDs if trade volume or trade quantity increases suspiciously.
- Identify stock IDs with sudden raise or fall in price or having same buyer and seller.
Sequence Matching is employed when a particular order of events (over a window of time) contains some important clue that points to a hidden relationship or relationships. For example, front-running: a stock trader who receives a large customer order may try to trade ahead of that order because they believe it will move the market and giver them an instant profit.
