A (Very Brief) Encyclopedia of Securities Fraud

Submitted by Alan J. Berkeley
By M. Owen Donley III

June 2007
 
Donley is a senior counsel in the Office of the General Counsel of the United States Securities and Exchange Commission in Washington, D.C. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues on the staff of the Commission.
 
During the cacophony of a Friday evening happy hour at a crowded bar in downtown Washington, D.C. not too long ago, I could not help but overhear a loud conversation between a man and woman standing next to me. Being in the nation's capital, it was easy to peg the two as lawyers--nice suits, well-coifed hair, leather cases stuffed full with brown Redweld file folders. I couldn't hear everything they said, but the discordant bits of conversation I made out got me thinking. Here's a sample:
 
"They were spring-loading, channel stuffing, and using cookie jar reserves! And all this after the round-tripping!"
 
"That's nothing. I've seen naked shorting, marking the close, and painting the tape--all by one guy using the same dummy account. And the broker that spotted it had just been tagged with churning and cherry-picking, not to mention selling away."
 
"I tell you, when you think about the late trading, backdating, and market timing on top of it all, it seems the whole world is just one big Ponzi scheme...."
All right, I didn't actually hear all that in one conversation. But I bet I've heard most of it in the last year or so at bar events, conferences, restaurants, parties--and all over the news. Even though I'm a securities lawyer and have an affected predilection toward securities-related vernacular, there always seems some strange new term I can't make heads or tails of floating around the legal landscape and lately, seeping into popular culture. Tired of having to do an Internet search every other time I read the business newspapers, I decided to put together a list of some of the more colorful words and phrases often used in discussing securities fraud. The list may not contain enough terms for an entire Securities Fraud for Dummies volume, but I think it might help the average lawyer understand a little bit more about the scams and schemes of which clients (and their counsel) need always be on guard.
A few important caveats: This brief list includes many practices that are not per se unlawful, but seem to arise repeatedly when discussing securities fraud--or were too colorful to exclude (see, e.g., "naked option"). Also, I have not provided a proper cite for each of the definitions, which I compiled from various dictionaries and securities-related websites, as well as from caselaw, periodicals, and conversations with other securities lawyers. Many of the definitions come from the Securities and Exchange Commission's website, www.sec.gov, which is an excellent resource for questions regarding all types of securities issues. Finally, most of these terms are described in shorthand--for more precise guidance, please consult a securities lawyer!
- Affinity fraud: Fraud specifically targeted at a certain group, such as a particular religious affiliation, a minority group, or the elderly.
- Backdating: Usually discussed in the current news in terms of stock options, backdating refers to the act of listing the grant date of an option at an earlier date than the date the option was actually granted. Typically, the stock price on the backdated grant date will be lower than the price on the actual grant date; the earlier date is selected in order to increase the value of the option when it was later exercised.
- Big bath: When a company undergoes a restructuring, typically with the purpose of increasing efficiency or productivity, the company often incurs costs. The company estimates these costs, called "charges," in their financial reporting. An unscrupulous company may overstate these charges as a way of artificially cleaning up the books--when the actual costs of the restructuring are determined and end up being less than the costs charged, the difference looks like income. This method of making the company's financials appear better than they actually are (i.e., cleaning the books) is sometimes referred to as a "big bath."
- Boiler rooms: High-pressure sales operations from which sales people make unsolicited sales calls to promote and sell securities that are usually unsuitable for the buyer and/or completely fraudulent. The name "boiler room" refers to the downstairs basement area of a building which serves as a base of operations for numerous sales agents to place calls.
- Candy deals: A variation of channel stuffing, where products are sold to distributors or middlemen who have no specific orders from customer for the goods. The company selling the goods agrees to buy the goods back, and pay the distributor a fee for its trouble.
- Channel stuffing: Where a seller sends a retailer more goods than the retailer is able to sell, with the purpose of increasing the seller's sales figures. In some industries channel stuffing may take the form of a supplier announcing a future hike in price in hopes that customers will buy unneeded stocks of product at the current price. While not necessarily unlawful if accurately disclosed, when done at the end of a reporting period this practice may raise questions of the accuracy of a company's financial statements.
- Cherry picking: The practice of a broker-dealer or investment advisor usurping client opportunities by taking all the best trades for itself, rather than offering those trades to customers.
- Churning: The excessive buying and selling of securities in a customer's account by a broker for the purpose of generating commissions.
- Club deals: Where groups of private equity firms coordinate bidding in deals to buy out companies. There have been allegations that these types of arrangements, under some circumstances, may implicate bid rigging and antitrust issues.
- Cold call: When a broker or other securities salesperson calls a potential customer (who does not know the broker) and tries to sell the person a security.
- Cookie jar reserves: Creating a reserve (money a company earmarks to pay for future potential liabilities) that is larger than necessary, to be taken down at a future time to boost the company's numbers as needed. When the liability actually becomes due and is less than the company had reserved, the company puts excess amount into earnings--making it look like the company's losses were less (or gains were more) than they actually were during the later period.
- Cooking the books: Improperly adjusting or falsifying financial statements.
- Directed brokerage: This is the practice of a fund adviser sending trades to a specific broker-dealer for execution ("directing" the trade), often in exchange for some benefit to the advisor, such as additional shelf space for its products. The broker-dealer gains because it receives the commissions from placing the trades (the "brokerage"). This practice can create a conflict of interest between the investment advisor and the investor because the advisor may be tempted to direct trades to the broker-dealer that sells the most of the advisor's fund's shares, rather than the broker-dealer that provides the best execution or best price for trading.
- Dirt pile scheme: In this scam, the fraudster sells to the unsuspecting customer an interest in a piece of land that purportedly has gold in it, and guarantees the buyer a certain rate of return based on the amount of gold in the land. Of course, the land usually has almost no gold.
- Dummy account: An (often anonymous or untraceable) account from which to trade securities, often used as part of a stock manipulation scheme.
- Earnings management: When a company intentionally manipulates their reported earnings to meet a specific monetary goal, often an amount consistent with analyst expectations. One of the motivations behind earnings management is to "smooth" earnings, or to make a company's profits look less volatile and more consistent.
- Flipping: The practice of purchasing shares in an offering from the underwriter of the offering and then quickly selling them to individual investors at higher prices. The term is often been used to describe institutional investors' activity, but it can also apply to an individual investor who receives shares from an offering such as an IPO.
- Fraudster: Someone who commits securities fraud.
- Free-riding: A purchaser directing his or her broker to buy a security typically must pay for the security before selling that security to another person. If a purchaser buys the stock and then sells the stock before paying for the original purchase (in essence borrowing money from the broker), the trader is free riding. This practice may violate the credit extension provisions of the Federal Reserve Board rules, as well as the federal securities laws.
- Friends and family: The phrase friends and family arises in the context of private placements or public offerings when some investors (usually friends and family of company insiders) get preference in buying shares when a company goes public. This is intended to allow the purchasers to buy at an initial low price, with the expectation that shares traded afterward will increase in value.
- Front running: When a broker-dealer trades on the basis of material nonpublic information about an impending trade. For example, if a broker knows a client is selling a large amount of stock in a particular company, pany, enough such that that the price of the stock will likely fall, the broker will sell or short that stock before executing the client's sale.
- Grease payments: Also known as "facilitation payments," grease payments are payments to a foreign official made to secure or expedite routine government action by a foreign government. Under certain circumstances, these payments are exempt from the Foreign Corrupt Practices Act's prohibition on bribing a foreign government official. When not exempt they may be bribes, and may be illegal under foreign law anyway.
- Haircut: When calculating net capital (essentially, a broker-dealer firm's net worth) for purpose's of the Commission's rules, firms must put a specific value on the securities they own. Haircuts are amounts that reduce the value of a security.
- Insider trading: Generally speaking, insider trading is a when corporate insider trades in the securities of his or her corporation on the basis of material nonpublic information. The "classical" theory of insider trading targets a corporate insider's breach of duty to shareholders with whom the insider transacts. The "misappropriation" theory prohibits trading on the basis of nonpublic information by a corporate outsider in breach of a duty owed not to a trading party (i.e., the shareholders of the company), but rather to the source from which the trader learned the information. As with most violations of the antifraud provisions of the federal securities laws, e.g., Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, scienter is a required element for liability.
- Laddering: Not officially defined in the federal securities laws, laddering has several different meanings depending on the context in which the term appears. With respect to portfolio management, laddering refers to the practice of purchasing roughly equal amounts of bonds with staggered maturity dates, as a way of spreading the risk of potential interest rate fluctuations over time. In initial public offerings, laddering refers to the practice whereby a brokerage firm requires IPO investors to buy shares at higher prices in the aftermarket as a condition for receiving lower-priced shares in earlier allotments.
- Late trading: Late trading is the practice of placing orders in mutual fund shares after the time the mutual fund has calculated its net asset value (which is typically 4:00 p.m. Eastern Time), but receiving the price of the mutual fund share based on the net asset value already calculated as of the day of the trade. This practice can allow the trader to capitalize on information by making trades at prices calculated before the information was publicly released.
- Lulling: The act of convincing an investor not to redeem his or her investment--usually by making false representations or paying unearned dividends.
- Market timing: Market timing is the practice of buying and selling mutual fund shares within a short time frame with the purpose of profiting from inefficiencies of the pricing of those shares (for example, the price of a fund traded on the NYSE may not reflect events occurring in international markets after the close of the NYSE). This practice may cause harm to a fund's other investors because of the costs of trading to the fund as well as the dilution of profits. Market timing is not necessarily illegal; however, it may be fraudulent when not adequately disclosed to other investors.
- Marking the close: This is the practice of buying a security at the very end of the trading day at a significantly higher price than the current price of the security. The purpose is to raise the closing price of the security, making it appear to be higher-valued than it actually is.
- Matched orders: Matched orders are orders to buy or sell a security while entering (or knowing another person is entering) an opposite order for the same security at the same time and price. The purpose of this scam is often to give the impression of greater volume in a security.
- Naked option: The purchase or sale of an option when the purchaser or seller does not actually own or possess the security underlying the option.
- Naked short selling: Where a trader sells short a security (i.e., borrows a security and then immediately sells it, hoping to buy it back at a lower price in the future for a profit) without owning, or having arranged to borrow, the security.
- Off balance sheet: Corporate transactions structured so that the transactions do not show up on a company's balance sheet, even though they may materially affect the company's available credit, cash position, etc. Such transactions may be designed to hide the negative aspects of a company's finances by keeping unwanted items off the financial statements.
- Painting the tape: This term describes reporting fictitious trades to an exchange, for the purpose of manipulating the information in the market about a security, e.g., to make it appear there is a greater trading volume in a security than is actually the case.
- Phishing: The use of e-mail and phony Web sites to trick recipients and visitors into revealing private information, such as PINS, social security numbers, and credit card account numbers.
- Ponzi scheme: A Ponzi scheme is a type of securities fraud where the promoter makes some sort of false or misleading statement about an investment (often including a guaranteed high rate of return) and pays off older investors with newer investor's monies. Eventually, when the promoter can't find any new investors, the scheme collapses. Ponzi schemes are named for Charles Ponzi who, in the early part of last century, took investors for millions by guaranteeing big returns from arbitrage profits from purported investment called an "International Postal Reply Coupon."
- Puffing: Subjective, usually extraordinary, claims as to the merits of something, including a security.
- Pump and dump: This is a fraud where a promoter makes false positive statements about a stock he or she owns, often using several different lines of communication; e.g., press releases, chat rooms, bulletin boards, etc. After this "pump," the promoter then sells his or her own shares for a profit--the "dump."
- Pyramid scheme: Purported investment opportunities that promise profits based on the investor's ability to recruit other individuals to join the program--as opposed to profits based on actual sales or investment results.
- Round-tripping: Where a company will sell an asset to another company with an agreement to re-purchase the asset sometime in the future. The purpose of such transactions may be to increase the company's revenue and sales numbers.
- Scalping: Scalping is when a broker, analyst, or other securities professional recommends that an investor buy a security--and then sells that security at a profit immediately after the recommendation has been disseminated and investors have driven the price of the security up with their purchases.
- Scienter: The mental state evidencing the intent to deceive, manipulate or defraud. Many violations of the federal securities laws require proof that a defendant acted with scienter. In some cases, severe recklessness is sufficient to sustain a fraud charge.
- Selling away: When a registered representative of a broker-dealer sells financial products not authorized by the broker-dealer.
- Short against the box: When an investor takes a short position in a security (i.e., borrows a security and then immediately sells it, hoping to buy it back at a lower price in the future for a profit), even though he or she owns the security.
- Short squeeze: A "short squeeze" occurs when the price of a security begins to rise rapidly and short sellers of that stock attempt to buy shares to cover their positions. As more short sellers buy, the demand on the stock increases and drives up the price--making it more expensive for short sellers to cover their positions.
- Soft dollar arrangements: Arrangements where investment advisers are given certain benefits (such as research) from a broker-dealer in exchange for the adviser directing trades to that broker-dealer for the broker-dealer to execute for a fee. These arrangements may implicate a conflict of interest in some cases between the adviser's clients' interest in cheap and efficient brokerage services and the adviser's desire to use a broker that provides the most benefits to the adviser.
- Spinning: Where investment advisors and broker-dealers allow preferred customers to purchase shares in "hot" initial public offerings of stock (IPOs).
- Spring loading: Often discussed in terms of options pricing, spring loading is when a company issues stock options right before the company announces positive news that will likely increase the value of the issuer's stock.
- Sticky assets: This term arises in the context of the market timing and late trading scandals where an investor would promise to give a mutual fund adviser additional money to manage (the so-called "sticky assets") in exchange for the adviser allowing undisclosed practices that favored the investor. The adviser's management of the sticky assets provided the adviser additional fees and commissions.
- Tipping: Providing material non-public information to another individual in breach of a fiduciary duty or other similar duty of trust, for the purpose of allowing the "tippee" to profit from the tip.
- Touting: Where a person advertises, promotes, or otherwise describes a security for sale without disclosing that the person is being paid to do so.
- Trading ahead: A broker or specialist trading in their own accounts before placing trades in their customers' accounts, thereby essentially taking the profit from the customer.
- Viatical settlements: Originated as a way to help the gravely ill pay their bills, viatical settlements are interests in the death benefits of terminally ill patients. The insured terminally ill patient gets a percentage of the death benefit in cash, and the investors get a share of the death benefit when the insured dies. For many reasons, including because of uncertainties predicting when someone will die, these investments can be extremely speculative.
- Wash trades or sales: Wash trades are trades involving no change in beneficial ownership; i.e. buying and selling the same number of shares at the same time at the same price--often to artificially increase the reported volume of trading in that security.
I hope this small collection of terms is useful and helps lawyers unfamiliar with some of these practices understand a little more about the area. At very least, perhaps it will be a bit clearer the next time someone mentions a big bath, says they are short against the box, or asks about sticky assets. Finally, and while some may say I'm a cynic, I fully expect this list will soon be outdated by a whole host of new schemes to talk about--and with those schemes, the attendant colorful language of securities fraud.