Market Intelligence, Surveillance Systems and Techniques to Detect and Deter Securities Market Fraud

Ester Saverson, Jr., Assistant Director Office of International Affairs U.S. Securities and Exchange Commission*

*The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or presentation of its staff. The views expressed herein are those of the authors and do not necessarily reflect the views of the Commission, individual commissioners, or the author’s colleagues on the staff of the Commission. Three Major Types of Market Fraud  Trade Based Market Manipulation – Pre-arranged Trades • Washed Trades • MthdTMatched Tra des – Marking (pegging and capping) the Close – Short Squeeze – Controlling the Supply of a Security  AtiAction B ased dM Mark ktMet Man ipu ltilation – Misrepresentation or False Statement  IfInformat ion B ased dMk Market Man ipul ati on – Insider Trading – Front Running Why is Market Fra ud Bad?

 Fraud affects the integrity of the market – Drive pppeople out of market – Keep capital on the sidelines  MiltidittthidManipulation distorts the independ dtent trading and pricing mechanism – Raises the cost of capital – Lowers cost of securities  Securities regulation is intended to ensure tha t mar ke ts are f ai r, effi ci ent and transparent Areas of Concern

 TdiTrading at or near th hCle Close  Spikes in volume or price  Block Trading  Offerings  Redemptions  Program Trading  Short Sales  Mergers and Acquisitions  Spikes Before a material announcement Key Elements of a Market Surveillance System  AdAdiTilAutomated Audit Trail  Identification of market intermediaries and customers to eachdh trade  Surveillance tools that monitor trading for areas of concern – Real Time Surveillance System – Off Line S urve illance tool s to recreate mark et  Trade Confirmations Key Elements of a Market Surveillance System (continued) Intelligence software which integrates price, volume and time with market news is optimal  Examinations of brokers  Complaints  Investigative authority RlTiReal Time and dOff Off-line S urveill ance

 RliReal time all ows you to d etect potenti ilfdal fraud faster but not likely to prevent fraud – TkTake acti on t o mi iinimi ze f raud db by • Seeking clarification from issuer •Teepoayatgtadgmporary halting trading – Take action to prevent funds from moving off shore  Off-line Surveillance jjpust as important to recreate market – Need to be able to look at market over a period of time to capture the total fraud and make a successful case – Need to look back at market in light of new information Electronic S ur veillance

 Breakdk detect ion process b ased on th e following factors: – Price volatility – Price change – Price level – Price trend – Volume trend – Volume level – Money volume level Market Str u cture and R ules

 May affect ability to detect or deter fraud  Active dealers such as market makers know markets better then brokers and many time knows when someone has superior knowledge  Auction to set the closing price minimizes marking the close and may provide a clearer picture of when such activity is going on Trade Based Market Manipulation  Trading at prices, volumes and times desiggppned to fool people about market value  Not easy to make money on a pure trade based manipulation  Many times trade based manipulation used with other type of manipulations BTradeB. Trade-Based Manip ulation

 Trade Based Market Manipulation – Pre-arranged Trades • Washed Trades • Matched Trades - Marking (pegging and capping) the Close - Short Squeeze - Controlling the Supply of a Security Wash Sales and Matched Trades

 WhWash sal lie invol ves tradi ng wh ere th ere i s no change in beneficial ownership  MhdlMatched sale wh en two parti es agree to trad e wi ihth intent to distort the market price  Object i s to create a f al se i ndi cati on of a mark et  Trade securities above or below market price  Creating false indication of significant liquidity or high volumes  May be engaged in” – Pump and dump schemes – Money laundering – Dissemination of false news Detection of Wash and Matched Sales  UliiidlUnusual increase in price and volume over a sh ort period of time (typically 60 days to a day)  NlNo legi iitimate news to expl liiain increase trad e activity  AfdbfA pattern of trades between a few accounts e ihither within a broker or between a limited number of brokers  Look for financial and other relationships among brokers, customers, issuer and others involved in the deception Marking (Pegging and Capping) the Cl ose

 Buyi ng or S e lling at or near th e cl ose wi th i ntent to affect the closing price of the security  RfMkihClReasons for Marking the Clo – Avoid a margin call – SlififiSupport valuation of a price of security – Establish higher price before a secondary offering – Raise the price of a block trade in market that allow price of block trades to be based on last sale or closing price Detecting Marking the Close

 Away from the market trades at or near the security’s close for a day or over several days  The extent the trades influenced the closing price  Look for Pre -arranged sales  Relationships between the parties to the trade  LktLook at cust omer’ ’tds trades over a li liitdidfmited period of time at or near the close Market Domination

Short squeeze Controlling the supply of a security Price Manippgulation through Market Domination  MktdiMarket dominati on may i ncl ldude: – Reduce the supply of shares by • Reverse stock split with a merger and issuance of new shares • PhiPurchasing a s iifiignificant quanti ty of fh the securi i’flty’s float • Tying up large blocks of shares contractually, such as options or refusing to execute customers ’ sell orders • Short selling  Occurs more o ften in illi qu id mark et s Reasons for Market Domination

 MiMany times cond ddihhfffducted with other forms of fraud – False Statements or other type of action based fraud – Pump and Dump – Wash or match trading Examppqle of Short Squeeze with Action Based Manipulation

 City of New York engages Harlem Railroad (run by Cornelius Vanderbilt) to build Manhattan line  City council members then short sell stock of HlHarlem RildRailroad  City Council then votes to cancel the contract  Stock price begins to decline But plan backfires Due to Market Domiiination of fSlf Supply of Security:  Vanderbilt corners market byyp purchasing available shares  City council members lose large amount of money  Vanderbilt: “I don’t care half so much about makinggy money as I do about making gyp my point and coming out ahead.” Action Based Market Manipulation  Fraudulent Statements Look for misrepresentations and omissions in the sale of a stock – Lies and half-truths  Usually part of another fraud or manipulation – Boiler room operations – Pumppp and dump Investiggpative Steps for Fraudulent Statements a) May obtain information from volume and price change b) Look for any news stories to justify price and volume change c) Obtain all relevant broker-dealer records d) Obtain any and all records of statements made e) Interview the investor f) Take testimony from the salesman g) Examine the Issuer Information Based Market Manipulation

IidTdiInsider Trading Front Running Insider Trading

 IhIs the purc hase or sa le of a securi ibty by a person who is taking advantage of insider (non-public) information, which , if disclosed publicly , would have a material effect on the market price of the security  Insiders may include: – Officers and directors of the company or companies – Other employees with knowledge of insider information – Lawyers, accounts, investment bankers with knowledge – Persons who receive the information in a “tip” from one of the above persons with knowledge of insider information Insider Trading S ur veillance

 Earnings  Other Corporate Developments  Mergers and Acquisition Insider Trading

 Triggers  Investigation – Electronic alerts – Chronologies – Advances/declines – Blue sheet analysis – Trading halts – Account statement – complaints analysis – Interviews Front R unning

 Buy or Sell a security before execution of a large trade  Buying or selling in advance of the release of a research report  “Scalping” or a person who purchases a security prior to recommending security and then sells security at a profit on the rise in market price following the recommendation Deeectecting Fro nt ru nning  The front running will occur very close to the large b uy or sell order  Look for a pattern of buy, buy and sell or sell, sell and buy by the same broker or in accounts of other broker in which the account is controlled by an employee or good customer of broker making the block trade  Determine what constitutes a large (block) trade in the particular security  Determine the sequencing of the suspected trades from order ticket, client authorization an order time stamp  Determine profit realized from the suspected trades Front Ru nning of Reach Reports

 Report has a material impact on market price  Look for large trades in advance of the release of report (e .g . prior 3 day)  Determine broker and client behind the suspected trades  Determine whether and how broker or client had knowledge of the report Trading A wa y

 A technique to hide fraud  Occurs when an employee of a broker executes a trade through a personal or nominee account at another broker  Used to conceal trading  Used to conceal fraudulent activities  Commonly l used i n connecti on with f ront running and insider information Preventingggg and Detecting Trading Away  Requibkire broker openi ng up accounts of an employee of another broker to give notice to that other broker, the exchange or regulator – Require “know your customer” procedures – Disclosure of trades by relatives of employees  Prohibit employees of brokers from opening accounts with another firm  Periodic review of employees’ and relatives’ accounts Qu estions?