Both the Uniform Securities Act (USA), Investment Advisers Act of 1940, and other securities laws make it clear that fraud will not be tolerated. For example, here’s a direct quote from the USA:
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 65 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 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 Series 7. We’ll also cover topics that are emphasized by the North American Securities Administrators Association (NASAA). These topics include:
Although this was discussed in a previous chapter, it helps to revisit what a material fact is:
If a registered person knowingly omits a material fact when discussing securities, they can be subject to 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, some disclosures (for example, the price of the security or unique market circumstances) are required when they’re pertinent to the transaction itself.
It’s possible for a registered person to omit a material fact unintentionally, although that should be uncommon. It’s part of the job to be informed about a security, especially when making a recommendation. If the lack of disclosure was a legitimate mistake, the person won’t be subject to criminal penalties. Civil liabilities could still apply.
Market manipulation comes in many forms, and it’s always prohibited. When someone engages in activity that artificially influences the price of a security, they’re manipulating the market.
We’ll cover the following forms of manipulation in this section:
Painting the tape
Painting the tape involves creating the false appearance of market activity. This is often done with thinly traded stocks, which are easier to influence because there’s less normal trading activity.
Assume a group of financial professionals picks a rarely traded common stock to invest in. The stock is traded heavily between group members, creating a noticeable increase in trading volume. That uptick can attract attention and lead other investors to make speculative purchases. As demand increases, the stock price rises. After the price increase, the group sells and collects a profit.
Painting the tape 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 placing trades right before the market opens or closes solely to influence the stock’s price. A stock’s opening and closing prices are closely watched and widely reported.
Assume a group of financial professionals places a large number of buy orders for a thinly traded stock right before the market opens, hoping to push the price upward. If the stock opens higher than expected, other investors may notice and “jump on the bandwagon.” Increased demand can push the price up further, and the financial professionals then sell for a quick 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 similar tactic is a pump and dump scheme. Assume an investor* with a large social media following “talks up” a thinly traded stock to encourage followers to buy it. The information shared is misleading and overstates the prospects of the issuer’s business. As followers buy, the market price rises. The investor who “pumped” the stock sells after the price increase, making 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, which violates 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 funded 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.
*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 providing a firm quote on a security and then failing to honor a trade request at that quote. 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 to buy at $20, the broker-dealer “backs away” if they refuse to fill the customer’s order.
Frontrunning
Frontrunning involves a financial professional placing an order for themselves before placing a customer’s order. This matters because a large customer order can “move the market.”
For example, assume an institutional investor requests to buy 100,000 shares of a rarely traded stock. Because the order is so large, the stock price could rise substantially after the trade is submitted. To personally benefit, 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, there’s “trading ahead of research.” While similar to frontrunning, this type of manipulation involves a research report release. Some research analysts are closely followed, and the market often reacts when they publish.
For example, assume Charmaine is a well-respected research analyst who plans to publish a negative report on XYZ stock. Knowing many investors will sell XYZ stock (which can drive the price down), Charmaine short sells (bets against) XYZ stock before the report is released to 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: they buy from the public at a marked-down price and resell to the public at a marked-up price. Replace used cars with stocks, and you have a market maker.
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).
However, suppose the market maker buys the stock from the selling investor at $20 and leaves the other investor’s purchase request unexecuted. In that case, the market maker has traded ahead of the investor attempting to buy at $20. The public customer should’ve had priority, but the market maker stepped in front.
It can be tricky to distinguish 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 occurring, they’re obligated to inform their supervisor (a.k.a. principal).
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