SECURITIES FRAUD

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TABLE OF CONTENTS

I. INTRODUCTION Course Overview ...... 1 Organization...... 1 Learning Objectives ...... 1 Introduction to Securities Fraud ...... 2 The Price of Fraud in the Markets ...... 2 The Language of Fraud: Definitions and Perspectives ...... 4 Securities and Investments ...... 4 Fraud ...... 6 Securities Fraud ...... 6 The Personality of Fraud ...... 9 Heroes and Villains ...... 9 Single-Minded Focus ...... 10 Preventing and Detecting Securities Fraud ...... 10 Enforcement and Oversight ...... 11 Securities Rules and Regulations ...... 11 Overview of Securities Fraud Investigation and Enforcement in the United States ...... 11 International Securities Regulatory Institutions ...... 18 Conclusion ...... 20 Review Questions ...... 21

II. FINANCIAL MARKETS AND INVESTMENT SECURITIES Origins of the Financial Markets ...... 23 Introduction ...... 23 The Origins of Trading ...... 23 Access to Credit and Capital ...... 24 The First Securities ...... 24 Publicly Financed Enterprise ...... 24 Securitization: The French Connection ...... 25 Jay Cooke’s “Five-Twenty” Civil War Bonds ...... 25 Shared Interests ...... 27 Organized Exchange Trading ...... 27 Securities ...... 27 Securities Markets ...... 29 The Potential for Profit and Fraud...... 33 Fraud Involving the Bid/Offer Spread ...... 33 The Vig ...... 36 Prevention and Detection ...... 37 Review Questions ...... 38

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III. THE DEVELOPMENT OF SECURITIES REGULATION Pre-SEC America ...... 41 An Agricultural Nation in Need of Regulation ...... 41 Self-Regulatory Organizations ...... 41 Key Regulatory Topics for Securities ...... 43 Federal Securities Statutes...... 43 The Securities Act of 1933 ...... 44 The Securities Exchange Act of 1934 ...... 48 Federal Regulation of Futures ...... 60 The Investment Advisors Act of 1940 ...... 63 The Investment Company Act of 1940 ...... 63 The Bank Secrecy Act of 1970 ...... 66 Sarbanes-Oxley Act of 2002 ...... 69 The USA PATRIOT Act of 2001 ...... 75 Fraud Enforcement and Recovery Act ...... 77 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ...... 78 State Securities Laws ...... 81 Securities Rules and Regulations...... 82 FINRA Rules ...... 82 SEC Rules ...... 85 Alternative Dispute Resolution ...... 86 Securities Arbitration ...... 87 Common Arbitration Claims ...... 88 Venues to Hear Allegations of Securities Fraud ...... 92 Conclusion ...... 92 Review Questions ...... 93

IV. ORGANIZATIONAL FRAUD Overview ...... 95 The First Jersey Securities Case Study ...... 95 “Come Grow with Us” ...... 95 Command and Control at First Jersey Securities ...... 97 Underwriting and Trading of Sovereign Chemical ...... 98 Structure and Coordination ...... 98 The National Century Financial Enterprises Case Study ...... 100 The NCFE Fraud ...... 100 Lance Poulsen ...... 101 NCFE’s Timeline ...... 101 Command and Control at NCFE ...... 102 Shared Interests ...... 102 Special-Purpose Subsidiaries ...... 103 As Simple as Data Entry ...... 104 False Investor Reports ...... 104 Investor Harm ...... 105

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IV. ORGANIZATIONAL FRAUD (CONT.) Red Flags of Organizational Fraud (Top-Down Fraud) ...... 105 Review Questions ...... 106

V. THE ORGANIZATION AS VICTIM Organizational Perspective ...... 107 Democratic Nature of Fraud ...... 107 Respondeat Superior ...... 107 Frank Gruttadauria Case Study ...... 108 The Trading Area ...... 109 Market Quotes Versus Marks ...... 109 The Bank of Montreal Case ...... 109 Prime Internal Target Areas ...... 111 The Enemy Within ...... 111 Vanguard Development and Management Case Study ...... 111 Selling Away ...... 111 Vanguard Development and Management ...... 112 Safety Nets for Some, But Not for All ...... 115 SIPC and FDIC Protection ...... 115 Customers and Depositors ...... 116 The Barings Bank Case Study ...... 117 Nick Leeson ...... 117 Error Accounts ...... 118 The Aftermath ...... 119 Review Questions ...... 121

VI. INVESTOR FRAUD Suttonism ...... 123 Investor Fraud Schemes ...... 123 Counterfeit, Stolen, and Forged Securities ...... 123 Other Investor Fraud Schemes ...... 125 Robert Lee Vesco Case Study ...... 133 Vesco: The Early Years ...... 133 Robert Vesco Meets Wall Street ...... 134 Bernard Cornfeld and Investors Overseas Services ...... 136 National Politics and the Looting of IOS ...... 136 Tom Adams ...... 138 Review Questions ...... 139

VII. ADVISOR FRAUD—REGISTERED SECURITIES Introduction ...... 141 Employment...... 141 Methodology ...... 141

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VII. ADVISOR FRAUD—REGISTERED SECURITIES (CONT.) Advisor Fraud Schemes ...... 142 Material Misstatements or Omissions ...... 142 Selling Away ...... 146 Professional Misconduct ...... 148 Pay to Play ...... 149 Churning ...... 150 Unauthorized Trading ...... 151 Registered Securities ...... 152 Commingling Prohibitions ...... 153 Equity or Common Stock ...... 153 Preferred Stock ...... 154 Fixed-Income Bonds ...... 155 Warrants: Rights of Future Equity Ownership ...... 155 Options and Futures ...... 156 Variable Annuity Insurance Contracts ...... 160 Using Technology to Detect Advisor Misconduct and Fraud ...... 162 Review Questions ...... 163

VIII. ADVISOR FRAUD—UNREGISTERED SECURITIES Unregistered Securities Fraud ...... 165 Advance-Fee Fraud ...... 166 West African/Nigerian Scams/419 Schemes ...... 169 Affinity Fraud ...... 170 Computer-Enabled Securities Fraud ...... 173 Partnerships ...... 176 Hedge Funds ...... 179 Ponzi Schemes ...... 184 Bernard Madoff ...... 185 Introduction ...... 185 Background ...... 185 Madoff’s Investment Scheme ...... 186 How Madoff Made It Happen ...... 186 Red Flags ...... 188 Conclusion ...... 190 R. Allen Stanford...... 190 The Allegations and Conviction ...... 191 The Red Flags ...... 191 Conclusion ...... 193 Microcap Companies ...... 194 Prime Bank Investments ...... 195 Promissory Note Fraud ...... 196 Viatical Settlements and Investments ...... 198 Conclusion ...... 200 Review Questions ...... 201

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IX. INVESTIGATING AND REPORTING INSTANCES OF SECURITIES FRAUD Introduction ...... 203 Preliminary Investigation ...... 203 Fraud Examination Methodology ...... 205 Act on Predication ...... 205 Steps in a Securities Fraud Examination ...... 206 Prepare for the Investigation ...... 206 Establish Ground Rules ...... 209 Collect Documents and Conduct Further Analysis ...... 210 Conduct Interviews ...... 216 Prepare the Final Report ...... 218 Review Questions ...... 224

X. CONCLUSION ...... 225

XI. SOLUTIONS TO REVIEW QUESTIONS I. Introduction ...... 227 II. Financial Markets and Investment Securities ...... 229 III. The Development of Securities Regulation ...... 232 IV. Organizational Fraud ...... 236 V. The Organization as a Victim ...... 238 VI. Investor Fraud ...... 241 VII. Advisor Fraud—Registered Securities...... 243 VIII. Advisor Fraud—Unregistered Securities ...... 248 IX. Investigating and Reporting Instances of Securities Fraud ...... 253

XII. APPENDIX A: FREQUENTLY USED ABBREVIATIONS...... 255

XIII. APPENDIX B: PRESS RELEASES ...... 257

XIV. APPENDIX C: EXAMPLES OF 419 SCAM LETTERS ...... 269

XV. APPENDIX D: REDACTED BROKER STATEMENT ...... 273

XVI. APPENDIX E: LETTER TO INVESTORS ...... 275

XVII. APPENDIX F: RISK FACTORS FOR OFAC COMPLIANCE ...... 281

XVIII. APPENDIX G: FOR FURTHER CONSIDERATION ...... 285

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XIX. FINAL EXAMINATION ...... E-1

XX. INDEX ...... I-1

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