The Uniform Securities Act (USA) makes it clear fraudulence will not be tolerated in any way. In their own words:
It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly:
To employ any device, scheme, or artifice to defraud, or
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person
Series 63 exam questions will test your ability to recognize fraudulent activities, which are subject to criminal penalties. As a reminder, a criminal action occurs when a law or rule is willfully (knowingly) broken. It can be safely assumed fraud is always the result of a willful action, and therefore considered a criminal action.
Many of the criminal actions discussed in this chapter are also covered on other licensing exams, including the SIE, Series 6, and 7 exams. We will additionally cover some new topics unique to the North American Securities Administrators Association (NASAA). These topics include:
Although it was discussed in a previous chapter, let’s refresh ourselves with the definition of a material fact:
If a registered person knowingly omits a material fact when discussing securities, they can be subject to criminal penalties. This especially comes into play when recommendations are made. Due to the nature of their business and its fiduciary duty, the obligation to disclose all material facts is most applicable to investment advisers and investment adviser representatives (IARs). If a broker-dealer and/or an agent receives an unsolicited order, they are not under the same obligations to disclose all material facts related to the security. However, some disclosures (e.g. price of the security, unique market circumstances) are required if pertinent to the transaction itself.
It’s possible a registered person unknowingly omits a material fact, although unlikely. After all, it’s their job to be informed about a security, especially if making a recommendation. However, the person will not be subject to criminal penalties if the lack of disclosure was a legitimate mistake. Civil liabilities would still be applicable, though.
Market manipulation comes in many shapes and forms, and is always prohibited. When a person engages in an activity that artificially influences the price of a security, they are manipulating the market. We’ll cover the following forms of manipulation in this section:
Painting the tape
Painting the tape sounds nice, but it involves creating a false appearance of market activity. This is normally done with thinly traded stocks, which are easier to manipulate due to their lack of trading.
Assume a group of financial professionals picks a rarely traded common stock to invest in. The stock is traded heavily between group members, which creates a significant amount of trading activity. The uptick in the stock’s trading activity grabs the market’s attention, driving some investors to make a speculative purchase. With more demand, the stock price rises. After the increase in price, the group sells and collects a profit. Painting the tape together in a group is commonly referred to as matched orders. If it’s done by one person through several of their own accounts, it’s called wash trades.
Marking the open or close
Marking the open or close is the act of placing trades prior to the market open or close solely to influence the price of the stock. A stock’s opening or closing price is very closely followed in the market. Think about it - how many times have you seen the news report on closing prices at the end of the trading day?
Assume a group of financial professionals place a bunch of orders to buy a thinly traded stock together right before the market opens in hopes of manipulating the price upward. If the stock were to open at a higher price than expected, other investors may notice and “jump on the bandwagon.” The increase in demand results in the price going up further, and the financial professionals sell the stock for a quick profit. The same could be done towards the close of the market. Either way it’s done, marking the open or close is prohibited!
Pump and dump schemes
A similar tactic is known as a pump and dump scheme. Assume an investor* with a large following on social media “talks up” a thinly-traded stock in hopes their followers purchase the stock as well. The information shared with followers is misleading and overstates the prospects of the issuer’s business. Regardless, a number of followers purchase the stock, driving the market price upwards. The investor that “pumped up” the stock sells it after the price increase, resulting in a quick profit. This action is prohibited and subject to criminal penalties.
Free riding
Free riding is a prohibited trading practice that occurs when an investor buys a security and sells it before making payment with settled funds, which violates Regulation T. If an investor fails to pay before selling the security, they are essentially using the broker’s funds to complete the trade without putting up their own capital. As a penalty, the brokerage firm must freeze the investor’s account for 90 days, during which all purchases must be fully funded in advance. While free riding is a violation in cash accounts, it is possible to avoid free riding violations in a margin account by using borrowed funds to cover purchases while waiting for sales to settle
*While many of the prohibited actions we’ve discussed relate to registered persons (broker-dealers, agents, investment advisers, and IARs), anyone can manipulate the market. It doesn’t matter if it’s a financial professional or a retail investor. Criminal penalties can apply to all types of persons.
Three general unlawful actions will be covered in this section, including:
Backing away
Backing away is the act of providing a firm quote on a security, but then failing to fulfill a trade request. A firm quote is a legitimate security quote provided by a financial firm. Assume a broker-dealer provides a quote for a stock in their inventory at $20 per share. If an investor requests a purchase at $20, the broker-dealer “backs away” if they subsequently refuse to fill the customer’s order.
Frontrunning
Frontrunning involves a financial professional placing an order for themselves prior to a customer’s order. When a large order is placed, it has the potential to “move the market.” For example, assume an institutional investor requests a purchase of 100,000 shares of a rarely traded stock. Due to the size of the order and the demand it introduces to the market, the stock price could rise substantially after the trade is submitted. To personally benefit from the transaction, the agent handling the order places a smaller buy order for themselves first, then places the institution’s order. After the stock price rises, the agent sells their shares for a quick profit.
Trading ahead
There are two versions of ‘trading ahead.’ First, we’ll cover ‘trading ahead of research.’ While similar to frontrunning, this type of market manipulation involves a research report release. There are many security analysts in the industry, some of which are very popular and closely followed. When a prominent research analyst releases a report, the market tends to react. For example, assume Charmaine is a well-respected research analyst that plans on publishing a negative report on XYZ stock. Knowing many investors will sell their investment in XYZ stock (which will drive down the price of the stock), Charmaine short sells (bets against) XYZ stock prior to the report being released to make a profit.
‘Trading ahead’ may also refer to a market maker prioritizing its own trades over a public customer’s. Market makers are similar to used car dealerships, which buy used cars from the public at a marked-down price, and resell those cars to the public at a marked-up price. Replace the used cars with stocks trading in the market, and you have a market maker.
Market makers are under the obligation to prioritize public customer orders over their own. Assume an investor places a trade to buy stock from the market maker at $20. At the same time, another customer submits an order to sell the same stock at the market price. The market maker should “cross” the market order to sell against the other order to buy stock at $20 (if it’s the best price). However, let’s say the market maker buys the stock from the selling investor at $20 and leaves the other investor’s purchase request unexecuted. In this scenario, the market maker took part in trading ahead of the investor attempting to buy the stock at $20. They should’ve had the priority, but the market maker stepped in front.
It’s sometimes difficult to determine the difference between frontrunning and trading ahead. Frontrunning occurs when a financial professional places a personal trade prior to placing their customer’s trade in order to take advantage of a temporary price increase. On the other hand, trading ahead occurs when a market maker “jumps the line” and doesn’t prioritize public orders.
All of these actions are prohibited and can result in criminal penalties. If an agent and/or IAR notices any of these actions occurring, they’re obligated to inform their supervisor (a.k.a. principal).
The Insider Trading Act of 1988 regulates the usage of inside information, primarily making it illegal for investors to utilize this type of information when performing securities transactions. By definition, insider trading involves trading on material, non-public information. Material information is any information that can drive someone to make an investment decision. Non-public information is not widely available or disseminated.
Insiders of publicly traded companies have access to significant amounts of material non-public information. For example, the executives at a large biotechnology company will know about a new medical product prior to releasing it publicly. If the product was groundbreaking, the executives could buy a bunch of stock prior to its release. Once the product is announced publicly, the demand and price of the stock would increase, creating a significant profit for the insiders.
This would be a big problem if the SEC found out. Insiders can discuss and obtain insider information, but cannot trade on it. As soon as a trade occurs, the person providing the insider information (the tipper) and the person receiving and trading on the insider information (the tippee) are subject to serious consequences. If a customer tells you they have insider information and they want you to place a trade, you cannot do it. You will be held liable and may be sued by the SEC.
Regardless of the size of the profit made or the loss avoided, the SEC takes insider trading very seriously. In civil court, perpetrators can be sued for up to three times the profit achieved or loss avoided. Known as “treble damages,” any investor in the security at the time of the trade (known as contemporaneous traders) can sue those responsible for insider trading for up to this amount.
Criminal charges and fines can also be levied against those found guilty of insider trading. If a person is caught, they could be fined up to $5 million and sent to jail for up to 20 years. When the problem is widespread across a financial firm, the firm can be fined up to $25 million. Collected fines are typically distributed to the SEC’s Fair Fund, which holds and distributes money to victims of financial fraud.
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