MARKET MAKERS" METHODS OF STOCK MANIPULATION
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by
Message: MARKET MAKERS" METHODS OF STOCK MANIPULATION
Market Makers’
Methods of Stock
Manipulation
HOW TRADING MANIPULATIONS CAN ADVERSELY AFFECT A FIRM’S EQUITIES AND WHAT
FINANCE MANAGERS CAN DO ABOUT IT.
B Y A . J . C A TA L D O , P H . D . , C M A , C PA , A N D L A R R Y N .
K I L L O U G H , P H . D . , C PA
Methods of Stock
Manipulation
HOW TRADING MANIPULATIONS CAN ADVERSELY AFFECT A FIRM’S EQUITIES AND WHAT
FINANCE MANAGERS CAN DO ABOUT IT.
B Y A . J . C A TA L D O , P H . D . , C M A , C PA , A N D L A R R Y N .
K I L L O U G H , P H . D . , C PA
If you are involved in the decision to finance assets
with debt or equity and your company’s shares are
publicly traded or may be, you should watch for
and guard against exposure to broker-dealer or
market maker manipulation (MMM). In this article,
we offer you a primer on MMM, “naked shorting,”
and Internet-based sources of additional information.1
By increasing your awareness of market maker manipulation,
you may be able to (1) better recognize and
defeat the adverse effects of MMM on your firm’s equity
securities, (2) dramatically reduce the risks associated
with your firm’s failure to maintain market-based debt
covenant ratios with lenders, and (3) avoid the need to
recapitalize with additional equity issues at a manipulated
or artificially low price per share.
THE MARKET MAKER
A market maker, who handles small-sized and microcap
stocks; an exchange floor specialist, who is involved
with mid-sized or large-capitalized stocks; or a brokerdealer,
who handles all stocks, performs two separate
and, apparently, incompatible functions.
First, all maintain an inventory of the stocks their
firms have underwritten, continue to trade, or make a
market in. They buy and sell these inventories for profit.
In theory, they will buy low, which reduces the
decline in price per share (PPS), and sell high, which
reduces the rise in PPS. Therefore, these profit-making
behaviors are presumed to provide a stabilizing effect
on changes in the PPS of the stocks they make a
market in.
Second, they post the bid and ask prices at which
others are willing to buy or sell and match incoming
buy and sell orders. In return for performing these functions,
market makers or specialists generate revenue for
their firm through various order-flow or transaction-fee
schemes.
But like the conflicts apparent in the dual role of an
analyst-broker or auditor-consultant, the broker-dealer is
faced with an opportunity to sell his or her firm’s inventory
before others in a declining market or buy for his or
her firm’s inventory before others in a rising market.
This practice is one form of market maker manipulation.
It is illegal, difficult to detect, but alleged in many
instances—both correctly and, often, incorrectly—on
Internet stock-chat message boards. One relatively
Market Makers’
Methods of Stock
Manipulation
highly publicized example of MMM is referred to as
front running.
FRONT RUNNING
In front running, specialist market makers use their
knowledge of private, incoming order-flow information
revealed by limit orders to generate monopolistic trading
profits. Though front running per se may not be
particularly damaging to your firm, it illustrates the
abuse of the conflicting roles of the broker-dealer as
both a facilitator of an orderly market (matching incoming
orders from other investors to buy and sell) and as
someone with the desire to generate profits from the
inventories traded for their firm’s account.2
On June 4, 2002, The Wall Street Journal reported that
Knight Trading Group, which handled more than 11%
of all the buy and sell orders for Nasdaq-listed stocks in
2000, was under investigation by the Securities &
Exchange Commission (SEC) and the National Association
of Securities Dealers (NASD) for alleged front running.
Knight’s former head of institutional trading
accused Knight traders of front running. He alleged that
the traders placed their own orders for stock before
placing the same orders for Knight’s customers, profiting
in advance from customer orders they knew would
push the stock of a company up or down, costing
investors millions of dollars. The day the Journal story
was published, Knight’s chief executive issued a statement
denying the allegations. In November 2002,
Knight announced that the SEC began formally investigating
the front-running charges. The investigation has
not yet been concluded.
Another type of market manipulation is the naked
short sale. Firms with a declining PPS are targeted for
naked short selling. This practice is very damaging to the
publicly traded firm and may be popular among the offshore
brokerage firms where U.S. securities laws are less
easily enforced or do not apply. It is similar to the counterfeiting
of currencies. In a naked short sale of stock,
short positions
with debt or equity and your company’s shares are
publicly traded or may be, you should watch for
and guard against exposure to broker-dealer or
market maker manipulation (MMM). In this article,
we offer you a primer on MMM, “naked shorting,”
and Internet-based sources of additional information.1
By increasing your awareness of market maker manipulation,
you may be able to (1) better recognize and
defeat the adverse effects of MMM on your firm’s equity
securities, (2) dramatically reduce the risks associated
with your firm’s failure to maintain market-based debt
covenant ratios with lenders, and (3) avoid the need to
recapitalize with additional equity issues at a manipulated
or artificially low price per share.
THE MARKET MAKER
A market maker, who handles small-sized and microcap
stocks; an exchange floor specialist, who is involved
with mid-sized or large-capitalized stocks; or a brokerdealer,
who handles all stocks, performs two separate
and, apparently, incompatible functions.
First, all maintain an inventory of the stocks their
firms have underwritten, continue to trade, or make a
market in. They buy and sell these inventories for profit.
In theory, they will buy low, which reduces the
decline in price per share (PPS), and sell high, which
reduces the rise in PPS. Therefore, these profit-making
behaviors are presumed to provide a stabilizing effect
on changes in the PPS of the stocks they make a
market in.
Second, they post the bid and ask prices at which
others are willing to buy or sell and match incoming
buy and sell orders. In return for performing these functions,
market makers or specialists generate revenue for
their firm through various order-flow or transaction-fee
schemes.
But like the conflicts apparent in the dual role of an
analyst-broker or auditor-consultant, the broker-dealer is
faced with an opportunity to sell his or her firm’s inventory
before others in a declining market or buy for his or
her firm’s inventory before others in a rising market.
This practice is one form of market maker manipulation.
It is illegal, difficult to detect, but alleged in many
instances—both correctly and, often, incorrectly—on
Internet stock-chat message boards. One relatively
Market Makers’
Methods of Stock
Manipulation
highly publicized example of MMM is referred to as
front running.
FRONT RUNNING
In front running, specialist market makers use their
knowledge of private, incoming order-flow information
revealed by limit orders to generate monopolistic trading
profits. Though front running per se may not be
particularly damaging to your firm, it illustrates the
abuse of the conflicting roles of the broker-dealer as
both a facilitator of an orderly market (matching incoming
orders from other investors to buy and sell) and as
someone with the desire to generate profits from the
inventories traded for their firm’s account.2
On June 4, 2002, The Wall Street Journal reported that
Knight Trading Group, which handled more than 11%
of all the buy and sell orders for Nasdaq-listed stocks in
2000, was under investigation by the Securities &
Exchange Commission (SEC) and the National Association
of Securities Dealers (NASD) for alleged front running.
Knight’s former head of institutional trading
accused Knight traders of front running. He alleged that
the traders placed their own orders for stock before
placing the same orders for Knight’s customers, profiting
in advance from customer orders they knew would
push the stock of a company up or down, costing
investors millions of dollars. The day the Journal story
was published, Knight’s chief executive issued a statement
denying the allegations. In November 2002,
Knight announced that the SEC began formally investigating
the front-running charges. The investigation has
not yet been concluded.
Another type of market manipulation is the naked
short sale. Firms with a declining PPS are targeted for
naked short selling. This practice is very damaging to the
publicly traded firm and may be popular among the offshore
brokerage firms where U.S. securities laws are less
easily enforced or do not apply. It is similar to the counterfeiting
of currencies. In a naked short sale of stock,
short positions
are not declared or disclosed, shares are
not borrowed to cover the short sale, and the stock is
never delivered to the purchaser. The result is dilutive in
that it results in an artificial, unauthorized, and illegal
increase in the number of shares issued and outstanding
and in a manipulated decline in the PPS of the firm’s
stock. The broker-dealer merely floods the market with
cheap, nonexistent shares of your firm’s stock. The seller
of these nonexistent shares keeps the proceeds.3
For example, on August 13, 2002, GeneMax Corp.
announced concerns over naked shorting and took measures
to ensure that trading in their shares occurred in a
“fair and appropriate manner.”4 Records indicated that
as of August 2, 2002, shareholders of record held
400,820 shares, where only 265,654 were available, freetrading
shares, leaving the Depository Trust Corporation
and Canadian Depository for Securities Limited
with a net deficiency of more than 168,000 shares.
On August 16, 2002, a two-year federal sting led to
the indictment of 58 stock brokers and corporate executives.
The unsealed indictment alleged stock manipulation
of JagNotes.com, Softsquad Software Ltd., and C
Me Run Corp. On January 23, 2003, Jag Media Holdings,
Inc., the parent company of JagNotes.com,
announced that it would allow “custody only” trading
of its stock to protect stockholders against naked short
selling. Under custody-only trading, a company’s stock
is issued only in the name of beneficial owners in physical
certificate form.
Even the once large-capitalization, business-to-business
firm PurchasePro.com, in an open letter from the
CEO, suggested that shareholders move their holdings
to cash accounts or request delivery of their share certificates
to prevent the shares from being legitimately
shorted.
STOCK-CHAT MESSAGE BOARDS
We recommend that publicly traded firms, particularly
small-caps and micro-caps, monitor the Yahoo! Finance
and Raging Bull stock-chat message boards. This additional
task doesn’t need to be onerous but requires
some understanding or review of the history and sophistication
of the person who is posting the message. For
example, an unsophisticated investor attempting to purchase
5,000 shares of your firm’s stock may receive what
is referred to as an automatic execution or a partial fill
of a larger limit-price day order for 100 or 200 shares.5
Here, for example, is one message:
OT: I can’t believe that someone bought $2 worth of
stock (100 shares) and paid a minimum $8 dollar commission.
not borrowed to cover the short sale, and the stock is
never delivered to the purchaser. The result is dilutive in
that it results in an artificial, unauthorized, and illegal
increase in the number of shares issued and outstanding
and in a manipulated decline in the PPS of the firm’s
stock. The broker-dealer merely floods the market with
cheap, nonexistent shares of your firm’s stock. The seller
of these nonexistent shares keeps the proceeds.3
For example, on August 13, 2002, GeneMax Corp.
announced concerns over naked shorting and took measures
to ensure that trading in their shares occurred in a
“fair and appropriate manner.”4 Records indicated that
as of August 2, 2002, shareholders of record held
400,820 shares, where only 265,654 were available, freetrading
shares, leaving the Depository Trust Corporation
and Canadian Depository for Securities Limited
with a net deficiency of more than 168,000 shares.
On August 16, 2002, a two-year federal sting led to
the indictment of 58 stock brokers and corporate executives.
The unsealed indictment alleged stock manipulation
of JagNotes.com, Softsquad Software Ltd., and C
Me Run Corp. On January 23, 2003, Jag Media Holdings,
Inc., the parent company of JagNotes.com,
announced that it would allow “custody only” trading
of its stock to protect stockholders against naked short
selling. Under custody-only trading, a company’s stock
is issued only in the name of beneficial owners in physical
certificate form.
Even the once large-capitalization, business-to-business
firm PurchasePro.com, in an open letter from the
CEO, suggested that shareholders move their holdings
to cash accounts or request delivery of their share certificates
to prevent the shares from being legitimately
shorted.
STOCK-CHAT MESSAGE BOARDS
We recommend that publicly traded firms, particularly
small-caps and micro-caps, monitor the Yahoo! Finance
and Raging Bull stock-chat message boards. This additional
task doesn’t need to be onerous but requires
some understanding or review of the history and sophistication
of the person who is posting the message. For
example, an unsophisticated investor attempting to purchase
5,000 shares of your firm’s stock may receive what
is referred to as an automatic execution or a partial fill
of a larger limit-price day order for 100 or 200 shares.5
Here, for example, is one message:
OT: I can’t believe that someone bought $2 worth of
stock (100 shares) and paid a minimum $8 dollar commission.
This unsophisticated investor failed to understand
that an automatic execution caused the transaction for
100 shares of a stock selling at two cents per share. This
was a partial fill from a larger order but was misinterpreted
as a completed trade. These transactions are
often blamed on MMM but result only from a buyer’s
failure to place an all-or-none order.
Another message is about a large spread between the
best bid and lower bids:
Some unfortunate traders were thought (sic) a sorry
lesson today using stops. Use stops on IWAV and you
will be taken out.
This sophisticated investor is referring to stop loss
market orders for the stock of Interwave Communications
International, suggesting that the market maker
was able to sell a few shares (even to himself or herself)
to reach or activate the stop loss orders, buy a large
quantity of cheap shares, and allow the PPS to rise
quickly, rebounding to the appropriate market value per
share. These trades are very profitable for the market
maker but could also have been made by sophisticated
individual investors who use the Nasdaq Level II quote
system (L2).7 L2 provides additional information to
those buying or selling a security, including the depth
of bid-ask spreads, by broker-dealer.
Repeated complaints of these types of trades on the
stock-chat message boards may suggest that the issuer
do a preliminary investigation into the day’s trading log
and MMM.8 One form of market maker manipulation
may be a predictor of future, more damaging cases of
MMM. In any case, high frequencies of trading complaints
may lead new or potential investors to avoid
investments in your firm’s stock.
We recommend you develop a checklist summary
that you periodically review. Table 1 provides a simple
example of the format you may want to use to monitor
people on stock-chat message boards. You can modify
this format as your experiences require.
DETECTION METHODOLOGY
The simplest way to detect MMM in your company’s
stock is to have one or more of your administrative personnel
monitor the stock-chat message boards for comments
or complaints about trading of it. Only unusual
commentary or atypical stock price or volume activity
would be cause to investigate further.
We recommend monitoring trading in your company’s
stock on L2 when posting activity increases, stock
price or volume behavior is atypical, or a large number
of complaints are detected on the stock-chat message
boards. The level of sophistication can often be determined
by reviewing the aliases’ posting history, a feature
available on both Raging Bull and Yahoo! Finance
stock-chat message boards.
Finally, you should not respond directly to stock-chat
message-board complaints because, as a company insider,
you may violate the SEC’s Regulation FD (Fair
Disclosure). ■
that an automatic execution caused the transaction for
100 shares of a stock selling at two cents per share. This
was a partial fill from a larger order but was misinterpreted
as a completed trade. These transactions are
often blamed on MMM but result only from a buyer’s
failure to place an all-or-none order.
Another message is about a large spread between the
best bid and lower bids:
Some unfortunate traders were thought (sic) a sorry
lesson today using stops. Use stops on IWAV and you
will be taken out.
This sophisticated investor is referring to stop loss
market orders for the stock of Interwave Communications
International, suggesting that the market maker
was able to sell a few shares (even to himself or herself)
to reach or activate the stop loss orders, buy a large
quantity of cheap shares, and allow the PPS to rise
quickly, rebounding to the appropriate market value per
share. These trades are very profitable for the market
maker but could also have been made by sophisticated
individual investors who use the Nasdaq Level II quote
system (L2).7 L2 provides additional information to
those buying or selling a security, including the depth
of bid-ask spreads, by broker-dealer.
Repeated complaints of these types of trades on the
stock-chat message boards may suggest that the issuer
do a preliminary investigation into the day’s trading log
and MMM.8 One form of market maker manipulation
may be a predictor of future, more damaging cases of
MMM. In any case, high frequencies of trading complaints
may lead new or potential investors to avoid
investments in your firm’s stock.
We recommend you develop a checklist summary
that you periodically review. Table 1 provides a simple
example of the format you may want to use to monitor
people on stock-chat message boards. You can modify
this format as your experiences require.
DETECTION METHODOLOGY
The simplest way to detect MMM in your company’s
stock is to have one or more of your administrative personnel
monitor the stock-chat message boards for comments
or complaints about trading of it. Only unusual
commentary or atypical stock price or volume activity
would be cause to investigate further.
We recommend monitoring trading in your company’s
stock on L2 when posting activity increases, stock
price or volume behavior is atypical, or a large number
of complaints are detected on the stock-chat message
boards. The level of sophistication can often be determined
by reviewing the aliases’ posting history, a feature
available on both Raging Bull and Yahoo! Finance
stock-chat message boards.
Finally, you should not respond directly to stock-chat
message-board complaints because, as a company insider,
you may violate the SEC’s Regulation FD (Fair
Disclosure). ■
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