The Uniform Securities Act (USA) makes it clear that fraud won’t be tolerated. In its 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. A criminal action occurs when a law or rule is broken willfully (knowingly). Fraud is generally treated as willful conduct, so it’s typically handled as a criminal matter.
Many of the criminal actions discussed in this chapter also appear on other licensing exams, including the SIE, Series 6, and Series 7. You’ll also see topics that are emphasized by the North American Securities Administrators Association (NASAA), including:
Although this was discussed in a previous chapter, it helps to keep the definition of a material fact front and center:
If a registered person knowingly omits a material fact when discussing securities, they can face criminal penalties. This issue comes up most often when recommendations are made.
Because of the nature of their business and their 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 aren’t under the same obligation to disclose all material facts about the security. However, certain disclosures (for example, the price of the security or unusual market circumstances) are still required when they’re pertinent to the transaction itself.
A registered person could omit a material fact unintentionally, although that should be rare. It’s their job to understand the security, especially when making a recommendation. If the omission is a legitimate mistake (not willful), the person won’t be subject to criminal penalties. Civil liabilities may still apply.
Market manipulation takes many forms, and it’s always prohibited. Any activity that artificially influences the price of a security is market manipulation.
We’ll cover the following forms of manipulation in this section:
Painting the tape
Painting the tape creates a false appearance of market activity. It’s often done with thinly traded stocks, which are easier to influence because there’s less natural trading volume.
Assume a group of financial professionals selects a rarely traded common stock. The group trades the stock heavily among its members, creating the appearance of strong market interest. That activity attracts attention and may lead other investors to buy speculatively. As demand increases, the price rises. The group then sells at the higher price and profits.
When this is done by a group, it’s commonly called matched orders. When it’s done by one person using multiple accounts they control, it’s called wash trades.
Marking the open or close
Marking the open or close means placing trades right before the market opens or closes for the purpose of influencing the stock’s price. Opening and closing prices are widely reported and closely watched.
Assume a group of financial professionals places many buy orders for a thinly traded stock right before the market opens, hoping to push the opening price higher. If the stock opens above expectations, other investors may notice and buy as well. That added demand can push the price up further, allowing the group to sell quickly for a profit.
The same approach can be used near the market close. Either way, marking the open or close is prohibited.
Pump and dump schemes
A related tactic is a pump and dump scheme. Assume an investor* with a large social media following promotes a thinly traded stock to encourage followers to buy. The investor’s statements are misleading and overstate the prospects of the issuer’s business. As followers buy, the market price rises. The investor then sells after the price increase, locking in a quick profit. This 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 paying with settled funds, violating Regulation T. If the investor sells before paying, they’re effectively 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 that period, all purchases must be fully paid for in advance. While free riding is a violation in cash accounts, it’s possible to avoid free riding violations in a margin account by using borrowed funds to cover purchases while waiting for sales to settle.
Spoofing
Spoofing creates a false impression of market demand or supply. It involves placing large orders with no intention of executing them, then canceling the orders after the market reacts.
Assume a trader places several large buy orders for a thinly traded stock, making it look like strong demand exists. Other investors notice the apparent interest and begin buying, pushing the price up. Once the price moves, the trader cancels the original buy orders and sells at the higher price. Spoofing is illegal market manipulation under federal and state anti-fraud laws.
Ghosting
Ghosting is a deceptive trading practice that is essentially the same as spoofing. It involves entering non-bona fide orders to mislead other market participants, then canceling them before execution.
Assume a trader places multiple sell orders above the current market price to create the illusion of heavy selling pressure. Other investors expect the price to fall and rush to sell. After the price declines, the trader cancels the fake orders and buys at the lower price. Ghosting is treated as fraud and is prohibited.
Capping
Capping occurs when a trader tries to prevent a security’s price from rising by selling or offering large quantities of the stock. This interferes with natural supply and demand.
Assume a trader repeatedly places large sell orders whenever a stock starts to rise. The ongoing selling pressure discourages buyers and keeps the price from increasing. Capping is an illegal form of price manipulation designed to keep a stock’s price down.
Pegging
Pegging refers to trading activity intended to fix, maintain, or stabilize a security’s price at a specific level. This is typically done by placing buy and sell orders to keep the price from moving.
Assume a trader enters buy orders below and sell orders above a stock’s current price to keep it trading within a narrow range. By controlling price movement, the trader interferes with normal market forces. Pegging is generally prohibited unless the activity qualifies as a permitted pegged order under exchange rules.
*While many of the prohibited actions we’ve discussed involve registered persons (broker-dealers, agents, investment advisers, and IARs), anyone can manipulate the market. It doesn’t matter whether 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 and then failing to honor it when a trade is requested. A firm quote is a legitimate security quote provided by a financial firm.
Assume a broker-dealer quotes a stock from its inventory at $20 per share. If an investor requests to buy at $20, the broker-dealer is backing away if it then refuses to fill the order.
Frontrunning
Frontrunning occurs when a financial professional places an order for themselves before placing a customer’s order. The concern is that a large customer order can “move the market.”
For example, assume an institutional investor wants to buy 100,000 shares of a rarely traded stock. Because the order is so large, the stock price could rise substantially once the trade hits the market. To profit from that expected price increase, the agent handling the order buys shares for themselves first, then submits the institution’s order. After the price rises, the agent sells their shares for a quick profit.
Trading ahead
There are two versions of trading ahead.
First, there’s trading ahead of research. This is similar to frontrunning, but the expected market move comes from a research report. Some analysts are closely followed, and their reports can move prices.
For example, assume Charmaine is a well-respected research analyst who plans to publish a negative report on XYZ stock. Knowing that many investors may sell (which could drive the price down), Charmaine short sells (bets against) XYZ stock before the report is released to profit from the expected decline.
Second, trading ahead can refer to a market maker prioritizing its own trades over a public customer’s. Market makers are similar to used car dealerships: they buy from the public at a lower price and sell to the public at a higher price. Replace used cars with stocks, and you have the basic idea.
Market makers must prioritize public customer orders over their own.
Assume an investor places an order 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 at $20 (if it’s the best price). If the market maker instead buys the stock from the selling investor at $20 and leaves the other investor’s buy order unfilled, the market maker has traded ahead of the public customer.
It can be tricky to separate frontrunning from trading ahead:
All of these actions are prohibited and can result in criminal penalties. If an agent and/or IAR notices any of these actions, they’re obligated to inform their supervisor (a.k.a. principal).
The Insider Trading Act of 1988 regulates the use of inside information. It primarily makes it illegal to use this information when executing securities transactions.
By definition, insider trading involves trading on material, non-public information:
Insiders of publicly traded companies often have access to large amounts of material non-public information. For example, executives at a biotechnology company may know about a new medical product before it’s announced publicly. If the product is groundbreaking, those executives could buy stock before the announcement. Once the product is publicly released, demand for the stock could rise, increasing the price and creating a profit for the insiders.
This becomes a serious problem if the SEC discovers it. Insiders may possess and discuss inside information, but they can’t trade on it. Once a trade occurs, both the person providing the information (the tipper) and the person receiving and trading on it (the tippee) can face serious consequences. If a customer tells you they have inside information and asks you to place a trade, you can’t do it. You can be held liable and may be sued by the SEC.
Regardless of the size of the profit made or the loss avoided, the SEC treats insider trading as a serious violation. In civil court, perpetrators can be sued for up to three times the profit achieved or loss avoided. These are called 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 imposed for insider trading. An individual can be fined up to $5 million and sentenced to up to 20 years in prison. If the misconduct 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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