Lesson 11.2: Market Manipulation & Insider Trading

Market Manipulation and Insider Trading

Market Manipulation

  • No security is exempt from antifraud provisions.
  • Market manipulation and fraud are prohibited for all securities.
Types of Market Manipulation:
  • Market Rumors: Spreading misleading information to manipulate stock prices.
    • Regulators warn about fraudsters using social media (online bulletin boards, email blasts, internet chat rooms like Twitter, Facebook, and Reddit) to spread false information.
  • Pump and Dump: Inflating the price of a stock by spreading false positive rumors to sell at a higher price.
    • Shares are accumulated at lower prices.
    • Operators sell overvalued shares after the price increases due to rumors.
    • Investors lose money when the price drops after the operators dump their shares.
  • Front Running: Placing orders ahead of known large orders to profit from the anticipated price movement.
    • Example: An RR places an order for their personal account before their firm executes a large order for a mutual fund.
  • Excessive Trading (Churning): Excessive trading in a customer's account to generate commissions, not to achieve investment objectives.
    • Abuse of fiduciary responsibility.
    • Signs include excessive frequency or size of transactions inconsistent with the client's history or financial ability.
    • SROs require principal review of accounts, especially those with discretionary authority.
    • Example: A principal notices a client's trading frequency has increased significantly and initiates a discussion with the RR.
  • Marking the Open and Marking the Close: Manipulating the reported price of a stock at the beginning or end of the trading day.
    • Marking the Open: Entering orders before the opening or falsely reporting trades to influence the opening price.
    • Marking the Close: Effecting trades near the close or falsely reporting trades to influence the closing price to value a portfolio higher.
  • Freeriding: Purchasing securities and selling them before paying for the purchase.
    • Generally prohibited in cash and margin accounts.
    • Penalty: Account is frozen for 90 days; no new transactions unless cash or marginable securities are in the account before the purchase.
  • Matching Orders: Selling stock to another party with the understanding it will be repurchased later at the same price to create the illusion of high trading volume (painting the tape).
  • Other types: Supporting, capping, and pegging are other types of market manipulation.

Insider Trading

  • The Securities Exchange Act of 1934 prohibited using inside information for trading with penalties up to 5,0005,000 in fines.
  • The Insider Trading and Securities Fraud Enforcement Act of 1988 (Insider Trading Act) amended the provisions, specifying significant penalties to deter the misuse of inside information.
  • All BDs must establish written supervisory procedures prohibiting the misuse of inside information.
Firewalls
  • Firms must establish policies (firewalls or information barriers) to restrict the flow of potentially material nonpublic information between departments.
Definition of Insider
  • An insider is anyone with access to material nonpublic information about a company.
  • Material information is information that would likely influence the company’s stock price.
  • Using inside information for gain or to avoid loss constitutes insider trading.
Key Points
  • Possession of inside information is not illegal; using it to make a gain or avoid a loss is.
  • Inside information is material nonpublic information not available to the general public.
  • The Insider Trading Act prohibits insiders from trading on or communicating nonpublic information.
  • Both the tipper (relays the information) and the tippee (receives the information) are liable.
Tipper and Tippee Liability
  • Liability exists if:
    • The information is material and nonpublic.
    • The tipper owes a fiduciary duty to the company or its stockholders and has breached it.
    • The tipper meets the personal benefits test (gains something, even enhancing a friendship).
    • The tippee knows or should have known the information was inside or confidential.
Penalties for Insider Trading
  • The SEC can investigate suspected violations.
  • Civil penalties: up to three times the profits made or losses avoided.
  • Controlling person (RR or BD) fines: 1million1 million or three times the profit made/loss avoided, whichever is greater.
  • Criminal penalties: up to 5million5 million and up to 20 years in jail.
  • BD fines: Up to three times the damages or 25million25 million, whichever is greater.
Contemporaneous Traders
  • Persons trading at or near the same time on the other side of the market as someone with inside information.
  • They may sue violators; suits can be initiated up to five years after the violation.
Bounties
  • The Insider Trading Act allows for payments to informers.
  • Dodd-Frank legislation amended this, allowing awards for original information concerning any violation of securities law, including insider trading.
  • The bounty can range from 10% to 30% of amounts recovered.

Rule 5130: Restrictions on Purchase of IPOs

  • Designed to protect the integrity of the public offering process and public investors.
    • Members must make a bona fide public offering at the public offering price (POP).
    • Members cannot withhold securities for their benefit or use them to reward those who could direct future business.
    • Industry insiders cannot exploit their status for personal gain at the expense of public customers.
Rule Prohibitions
  • Member firms cannot sell a new issue to any account in which restricted persons are beneficial owners.
  • Representatives must obtain written representation from account owners that the account is eligible to purchase a new common stock issue at the POP.
Restricted Persons
  • Member firms.
  • Employees of member firms.
  • Finders and fiduciaries acting on behalf of the managing underwriter (attorneys, accountants, financial consultants).
  • Portfolio managers (those who can buy/sell securities for a bank, savings and loan, insurance company, or investment company).
  • Any person owning 10% or more of a member firm.
  • Immediate family members of the above (parents, in-laws, spouses, siblings, children, or any individual to whom the person provides material support).
De Minimis Exemption
  • If the beneficial interests of restricted persons do not exceed 10% of an account, the account may purchase a new equity issue.
Example
  • Daryl Miller, a restricted person, has a 5% interest in an investment club account; the account is not restricted.
  • Larry Miller (Daryl’s brother) buys into the account, bringing the Miller brothers' ownership to 11%; the account is now restricted.

Prohibited Activities (Beyond Market Manipulation)

  • Any manipulative, fraudulent, or deceptive activity in selling securities is prohibited.