Online Securities Fraud
| Pages | 54-70 |
| Published date | 01 March 2001 |
| DOI | https://doi.org/10.1108/eb026007 |
| Date | 01 March 2001 |
| Author | Russell G. Smith,Peter N. Grabosky |
| Subject Matter | Accounting & finance |
Journal of Financial Crime — Vol. 9 No. 1
Online Securities Fraud
Russell G. Smith and Peter N. Grabosky
Journal of Financial Crime
Vol.
9. No. 1, 2001. pp. 54-70
Henry Stewart Publications
ISSN 1359-0790
INTRODUCTION
Finance is the lifeblood of an economy. Businesses
require capital in order to start up, and usually require
additional resources to maintain or expand their
activities. In some cases, they may simply reinvest
their profits. But expansion on a significant scale
may require more than this. Thus, businesses may
also seek to borrow funds or to solicit investments
in return for the investor's share of future profit.
One of the basic means by which this latter strategy
is pursued in industrial societies is for businesses to
solicit investments from the public through the initial
public offering of shares, and for subsequent buying
and selling of shares by investors who expect the
value of the shares in question to rise or fall. Securities
markets are thus integral to a nation's economic
system.
One of the fundamental strategies of governance
in modern democratic systems is to allow capital
markets to flourish and thereby drive economic
growth. But the simple theory that crime follows
opportunity is no less applicable to securities markets
than it is to other areas of social life. Since the inven-
tion of the joint stock company in the 17th century,
securities markets have provided golden opportu-
nities for the unscrupulous, and numerous traps for
the unwitting.
Governments, therefore, seek to create a climate
favourable to legitimate entrepreneurs and investors,
but one which discourages criminality. The funda-
mental goal is a market which is (and is seen to be)
fair and efficient. This requires something of
a
balan-
cing act. On the one hand, the rules of the game
should be perceived as just and fairly enforced. On
the other, the offer of and subsequent trading in
securities should occur in a timely manner without
buyers, sellers and intermediaries having to bear
excessive regulatory burdens.
This paper will discuss how the advent of digital
technology has facilitated crime arising from trade
in securities. Following a brief historical overview,
it will discuss traditional forms of illegality to
which securities markets may be vulnerable, and
the regulatory apparatus which exists to ensure fair-
ness and efficiency in markets. It will then discuss
the impact of digital technology on securities markets
and the new potential for criminal exploitation which
accompanies these technologies. Discussion will then
turn to available countermeasures against securities-
related crime using high technology. It will first
explore the adequacy of existing legislation and reg-
ulatory arrangements, then discuss the potential for
selfregulation by the various institutions involved
in securities transactions. It concludes by speculating
on what the landscape of the securities industry, and
its vulnerability to criminal exploitation, might
look like in the years ahead.
There are markets, and there are markets. Descrip-
tions of the early days of Change Alley in the City of
London, or of the New York Stock Exchange,
describe how brokers would meet in a coffee house,
and how the president called each security one by
one,
with members wishing to sell indicating the avail-
ability of a security, and those wishing to buy, bidding
for them. The secretary would transcribe the prices at
which sales were concluded and these were published
in newspapers. In 1820, 28 stocks were listed on the
New York Stock Exchange, and the average daily
trading volume was 156 shares. By contrast, on 7th
April, 1999 (to pick a more or less typical day) the
NYSE consolidated volume was 997,525,530 with a
total of 3,566 consolidated issues traded.
In Australia, the rather unique nature of its estab-
lishment and early history as a penal colony delayed
the formation of a financial system. It was not until
1828 that one Matthew Gregson was given permis-
sion to deal in Bank of New South Wales shares.
By 1837, the first Australian stock market was estab-
lished, and the Sydney Morning Herald commenced
daily publication of price quotations. The Melbourne
Stock Exchange was established at the end of the
1850s as a result of the economic activity inspired
by the gold rush. Each Australian capital city had
its own exchange until the formation of a national
exchange, the Australian Stock Exchange (ASX), in
1991.
TRADITIONAL FORMS OF SHARE
MARKET ILLEGALITY
Although there are many permutations and combina-
tions of illegality relating to securities markets, they
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Online Securities Fraud
take three basic forms: misrepresenting the underly-
ing value of a security at the time of the initial
public offering; market manipulation during second-
ary trading of a security; and insider trading. There
are,
in addition, various other possible offences that
relate to irregularities involved in mergers and acqui-
sitions and to breaches of fiduciary duties by profes-
sional advisers. Examples of these include
embezzlement of client funds, as well as a broker's
gratuitous trading on a client's account in order to
generate commissions — known in some jurisdic-
tions as 'churning'.
Misrepresentation
Perhaps the classic offence relating to securities
involves the offering of securities for sale which are
either essentially worthless, or whose underlying
value is significantly overstated. A variety of indivi-
duals may benefit from misrepresenting a company's
investment potential. Misrepresentations can be made
by principals of the company whose shares are being
offered or traded, by intermediaries such as under-
writers and brokers, and by investment advisers. At
the grossest level, they promise guaranteed returns.
Unfortunately, the returns flow to the deceiver, not
the deceived.
Misrepresentation is an elastic concept. At one
extreme, it may involve deliberate falsification with
unabashed fraudulent intent. At the other end of
the continuum, it may involve naive ebullience and
unrestrained optimism. The threshold of criminality
may not always be clear.
The potential for misrepresentation of all kinds
increases when speculative activity increases, and an
atmosphere of general optimism prevails. An histori-
cal example of wild speculation in Australia's rela-
tively recent history is the Poseidon Nickel boom of
1969,
when the price of shares in one mining company
rose from 75 cents to AS280 in four months, and any
company purporting to have anything to do with
nickel attracted investor attention. In such an environ-
ment, it is not difficult to imagine how ordinary
citizens, lured by the prospect of instant wealth, may
be seduced by offers too good to be true.
Myths and conjectures can be disseminated or
amplified by irresponsible news media coverage.
Simply riding a speculative bandwagon in an atmos-
phere of infectious optimism is bad enough. But
reporting on financial matters has always provided
opportunities for conflicts of interest. In Australia
during the freewheeling days of the 1980s it was
not uncommon for financial journalists to be offered
shares or options in newly formed companies. The
conscious temptation, or subconscious inclination,
to accord the company favourable treatment in
subsequent media coverage was
inevitable.2
Misrepresentation can also occur once trading in a
security begins, such as when a broker or investment
adviser recommends the purchase of a stock knowing
it to be overvalued, or suggesting a sale of a stock
with good growth prospects.
Market manipulation
The second basic form of illegality involving securi-
ties markets is market manipulation.3 Once trading in
a stock commences, an offender will seek to influence
the price of a security in a manner enabling him or
her to benefit from the price change. This may be
accomplished by words, as well as by deeds. The
practice is as old as the share market
itself.
Robb4
relates how a 17th-century director of the Bank of
England manipulated the price of government
securities issued by the Bank for his own advantage.
The annals of business are littered with examples of
'announcements' or rumours of impending discov-
eries which turned out to have been without founda-
tion. Merely to encourage speculation that a
company is close to developing an AIDS vaccine or
discovering an ore body may trigger speculative
investment.
Of course, what goes up sometimes comes down.
Not all misrepresentation is positive, and there are
those individuals who may seek to profit from
fabrication of a negative nature. The use of rumour,
hyperbole or other forms of misinformation to
boost the price of a stock prior to the manipulator's
quick and profitable exit is termed 'pump and
dump'. The converse, where a manipulator talks
down a stock so that he or she may buy in at a bargain
price, is called 'slur and slurp'.5
In contrast to manipulation by word, one may
manipulate the price of a stock by engineering a
pattern of transactions to attract the attention of the
unwitting investor. For example, a person who
holds a number of shares in a company may arrange
to make an inflated offer for an additional small parcel
in order to drive up the price of a stock. When the
price rises, the person will then sell her shares. A
related practice involves the engineering of trans-
actions which achieve a quick movement in the
share price immediately prior to the close of trading.
The artificially high bid may be withdrawn at the
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