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Investment Fraud


Investment advisors and stockbrokers are responsible for providing information that is accurate and complete to investors. Investment fraud (also known as brokerage fraud) occurs when an advisor, stockbroker, or brokerage firm offers inaccurate, incomplete, or biased information in an effort to control the market or draw business. The SEC (Securities Exchange Commission) has established guidelines for stockbrokers and advisors to follow to ensure that investment advice is being given fairly and consistently.

Types of Investment Fraud

  • Biased investment advice - An advisor may have a preference toward or against a specific company for various reasons and advise his or her clients according to that bias instead of research results.
  • Unfounded advice - An advisor may persuade or discourage an investor toward, or against a company, without the support of appropriate research.
  • Contradictory investment advice - An advisor may give contradicting advice to different clients.
  • Continuing a risk - An advisor may advise his or her client to 'stay in' when the risk is apparent and the potential gain is unlikely.
  • Conflict of interest - An advisor or firm that has outside ties to a business may sell that business's stock, even if the investment opportunity is not the most lucrative for the client.

SEC guidelines for Stockbrokers

Because the investor-advisor relationship balances the trust of the investor with the knowledge of the advisor, guidelines are necessary to protect both parties. The investor must receive accurate information, but also must understand the risks involved in investment. In October of 1998, the SEC set standards for how stockbrokers, dealers, and advisors would distribute information (section IV of the "Compliance Guide to the Registration and Regulation of Brokers and Dealers"). The intent of the compliance guide was to create an investment environment where the investor knew his advisor was seeking to find him or her the best possible gains, and the advisor could perform his or her duties reasonably within a risk market with normal fluctuations. These rules are the standard by which fraudulent companies are now being judged:

Fair Dealing

By establishing oneself as a stockbroker, an individual becomes accountable to the standard rules and laws of the profession. Among these standards are requirements to: "execute orders promptly, disclose material [relevant] information...charge prices reasonably related to the prevailing market, and fully disclose any conflict of interest."

Best Execution

The stockbroker must find the best deal for the client. As an advisor, he or she is responsible to the client for the money being invested. An advisor must assess what the appropriate risk level for the investor is, and which market will provide that investor with the greatest gains. The stockbroker is responsible to buy and sell within this market.

Customer Confirmation Rule

The stockbroker must receive the investor's permission before purchasing stocks, bonds, or mutual funds. The investor must be informed as to:

  • The date and time the investment will be made
  • Which companies will be invested in
  • How many shares will be purchased
  • What the purchase price of each share is
  • How much stockbroker commission will be charged, and how it will be charged (order flow, or mark up/mark down)
  • If the stockbroker or dealer is an SIPC (Securities Investor Protection Corporation) member
  • Expected yield

Disclosure of Credit Terms

If the client desires to purchase securities on credit, the dealer must explain the credit terms upfront. In addition, the status of the client's account must be provided when he or she initially purchases shares, and again on each of the client's quarterly account statements.

Short Sales

In a short sale a stockbroker sells securities that are 'on loan.' If an investor realizes that the value of his or her shares is going down, he or she may lend them to a stockbroker, who will sell them at the market price. When prices go down, the stockbroker will repurchase the shares at their low point, and make a profit between the difference of what they were sold at (high market price), and what they were bought back at (new, low market price). Regardless of whether share prices go up or down, the stockbroker must return the original number of shares to the lender. He or she is, in a sense, borrowing them against a drop in the market. These sales are highly restricted.

Trading During an Offering

A public offering occurs when new securities are made available to the public. When a company first 'goes public,' it will hold an initial public offering (IPO). Individuals participating in an offering may not manipulate the price of the security. For example, a brokerage firm that is underwriting an IPO may not purposefully undervalue its IPO client's shares to make profits when the shares hit a more accurate market price.

Inside Trading

Stockbrokers, dealers, and advisors often have access to private material. Dealers may not make trades based on this information. Preventative measures must be taken to maintain an equal distribution of information among investors (that is to say, certain investor should not be privileged with inside information). Some ways through which information leaks can be prevented are:

  • Employee training
  • Trading restrictions for employees of brokerage houses
  • Information control between departments of brokerage firms

Recent Brokerage Fraud Accusations

Merrill Lynch

Stock analysts at Merrill Lynch were accused of committing brokerage fraud on April 8, 2002. New York's Attorney General, Eliot Spitzer, brought securities fraud charges against the analysts, claiming they'd given investors biased advice, favorable to companies who used Merrill Lynch as their investment banker. Merrill Lynch's head Internet investment analyst, Henry Blodget, rated InfoSpace stock, for instance, as 'buy' through 2000, though in his own correspondence he called it a "piece of junk." InfoSpace did not do its investment banking through Merrill Lynch, but Go2Net, which InfoSpace was in the process of purchasing at the time (summer 2000), used the firm as its financial advisor.

Spitzer cited the poor advice given in this instance and others as evidence of a conflict of interest. Brokerage firms bring in immense revenues when companies choose them as their investment bankers, and when they act as underwriters during public offerings. Although Blodget and the analysts under him played no official role in the investment banking side of Merrill Lynch's business, their favorable coverage encouraged businesses to choose and continue to use Merrill Lynch as their investment brokerage. Merrill Lynch settled with the state of New York for $100 million on May 21, 2002, but did not admit to wrongdoing. $100 million was added to the fine on April 28, 2003, after the SEC and other regulators completed an investigation into the acts of Merrill Lynch and nine other brokerage firms.

Salomon Smith Barney

Citigroup's investment banking unit, Salomon Smith Barney, came under investigation in 2002 by New York's Attorney General, Eliot Spitzer. According to the findings of the investigation, Smith Barney, as an IPO underwriter, offered shares of new stocks with high gain potential to executives and board members of current and prospective corporate banking clients. In one such deal, Bernie Ebbers, WorldCom's former CEO, purchased IPO shares that rose 200% in value their first day on the market. Smith Barney was suspected of having acted and advised in a biased manner to obtain and maintain key investment banking relationships. In addition to offering IPO perks, Smith Barney gave its corporate customers high public ratings through heavy declines in the value of their stock.

Stock ratings by Smith Barney's former telecom analyst, Jack Grubman, were investigated during the inquiry. Grubman, who resigned from Smith Barney August 15, 2002, was suspected of having presented failing telecom stocks as valuable out of a conflict of interest. Grubman was involved with WorldCom, a Smith Barney customer, as a proxy solicitor in 1997, and he sat in on three of the corporation's board meetings in the years before they declared bankruptcy. Although these actions were disclosed and fully legal, they raised two questions: How close was Grubman, an analyst, to WorldCom, a Smith Barney investing client? And Did Grubman's interactions with WorldCom influence his stock analysis?

During a recent (April 2003) settlement with the SEC, Smith Barney agreed to pay $400 million to end investigations into its banking practices. Grubman was fined $15 million and barred from the securities industry.

Morgan Stanley

Morgan Stanley has faced opposition on two fronts. Moet Hennessy Louis Vuitton (LVMH) is attempting to sue Morgan Stanley for what it claims were biased ratings in favor of its competitor, Morgan Stanley's investment banking client, Gucci. Morgan Stanley has issued a counter suit against LVMH for what it claims are "vexatious" allegations, "without merit." If LVMH succeeds in presenting its case, and is awarded a settlement, the gates may be opened for other companies to reclaim money lost because of inaccurate stock analysis. The suit will begin to be heard on March 3, 2003 in France.

In addition, Morgan Stanley's correspondence records were recently scrutinized by Eliot Spitzer's office for evidence of a conflict of interest. Mary Meeker, one of Morgan Stanley's top Internet analysts, published ratings that are now suspected of having been biased toward companies she assisted in bringing public. Meeker was highly involved in Morgan Stanley's investment banking business. Her approval or disapproval was a deciding factor for Morgan Stanley as it chose whether or not to underwrite Internet clients that wanted to go public. Because she had set a precedent early on that she would only give her approval to companies that had strong fundamentals, her signature meant, 'buy.' This exclusiveness, however, was compromised as the telecom boom grew. Meeker became less stringent with her 'buy' ratings and continued to support failing companies (usually Morgan Stanley clients) into their proverbial graves. Spitzer's investigation aimed to discover if Morgan Stanley indeed offered investors inaccurate ratings out of conflicts of interest. Morgan Stanley agreed to pay a $125 million fine in April of 2003 to end investigations into the practices of its research division.

Further Investigations

The following brokerage firms were also investigated by the New York Attorney General, Securities Exchange Commission (SEC), NASD, New York Stock Exchange (NYSE), and North American Securities Administrators Association (NASAA):

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