Criminal actions
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:
- Failure to disclose material facts
- Market manipulation
- General unlawful actions
- Warning signs of fraud
- Modern forms of fraud
Failure to disclose material facts
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
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
- Matched orders
- Wash trades
- Marking the open/close
- Pump and dump schemes
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.
*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.
General unlawful actions
Three general unlawful actions will be covered in this section, including:
- Backing away
- Frontrunning
- Trading ahead
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).
Insider Trading Act of 1988
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.
Warning signs of fraud
NASAA has identified a number of “red flags” that may result in fraudulent activity occurring. In a publication to investors, the following were identified as warning signs of fraud:
- Investment with guaranteed high returns or no risk
- A shortage of investments available (get in now!)
- Offshore investments that are tax free*
- Claiming information is an “investment secret”
- Encouraging a purchase because friends or family members did the same
- “Trust me! I’m an expert!”
*While offshore investments may allow the deferral of taxes, they cannot be avoided completely.
If you see any of the same situations or language referenced above in a test question, a fraudulent scenario is most likely present. If it doesn’t pass the “smell test,” it’s likely fraud!
Modern forms of fraud
As our modern, digital world evolves, so does fraud. As newer forms of fraud begin developing in the real world, we expect them to start showing up in test questions. NASAA is currently highlighting the following as the top investor threats today:
- Social media & internet investment fraud
- Cryptocurrency-related investment fraud
- Precious metal fraud
- Foreign currency exchange fraud
- Promissory note fraud
Social media & internet investment fraud
As we become more connected to each other online through social media platforms, instances of fraudulence on the internet are on the rise. NASAA is particularly concerned with the following online-based scenarios:
- Promises of high returns with no risk
- Investments in offshore operations
- “Recruit your friends” campaigns*
- Professional websites with little information
- Offering securities with no risk disclosures
*”Recruit your friends” campaigns involve engaging networks of friends, gaining their trust, then encouraging the network to invest in a fraudulent product. When some of the network “buys in,” the fraudster then guilt trips the others into making the same investment. “Your friends did it. Why wouldn’t you?”
Cryptocurrency-related investment fraud
With the recent popularization of cryptocurrencies (Bitcoin in particular), e-currencies are becoming a legitimate part of the financial sector. While many investors have used cryptocurrencies to diversify their portfolios, there have been numerous instances of fraud. NASAA makes the following recommendation to investors:
Before you jump into the crypto craze, be mindful that cryptocurrencies and related financial products may be nothing more than public-facing fronts for Ponzi schemes and other frauds. And because these products do not fall neatly into the existing federal/state regulatory framework, it may be easier for the promoters of these products to fleece you. Investing in cryptocurrencies and related financial products accordingly should be seen for what it is: extremely risky speculation with a high risk of loss.
Precious metal fraud
Investments in precious metals like gold, platinum, and silver are becoming more popular. To ensure investors are knowledgeable about this type of commodity, NASAA makes the following proclamations:
- There are multiple ways to invest in precious metals
- Precious metal mutual funds own small amounts of the actual metals
- Mining stocks are volatile investments
- Certain products track the price of precious metals (e.g. ETFs)
- Make online purchases of precious metals through reputable dealers
- Precious metals are not necessarily safe investments
- Don’t catch “gold fever”
- Be aware of gold investment scams, like:
- Gold investments held in third party vaults that don’t exist
- Recommendations to cash out other investments for gold-colored coins (not actually gold)
- Precious metals investment in IRAs must be held by third party*
*Retirement accounts (like IRAs) do not allow the investor to gain access to the assets held in the account until retirement. Therefore, direct IRA investments in precious metals must be held with a third party. Extra caution and care should be exercised, and only reputable third parties should be utilized for this service.
Foreign currency exchange fraud
Investors can make bets on the value of currencies in the foreign exchange (known as ‘forex’) markets. A number of fraudulent forex products and services have been offered online and elsewhere, only to be a worthless investment. Even if legitimate, this is a volatile market.
Promissory note fraud
In a previous chapter, we discussed how promissory notes (a.k.a. commercial paper) could be exempt from registration if meeting certain qualifications. Interestingly enough, the exempt versions of promissory notes have been recently subject to the most fraud.
Investors should be cautious about promissory notes with durations of nine months or less, as these notes generally do not require federal or state securities registration. Such short-term notes have been the source of most (though not all) of the fraudulent activity involving promissory notes identified by state securities regulators. These short-term debt instruments may be offered by little-known (or perhaps even nonexistent) companies and extend promises of high returns – perhaps over 15 percent monthly – at little to no risk. But if an investment sounds too good to be true, it probably is.
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