Stock Market Manipulation: How Can Investors Protect Their Investments?
Stock market manipulation occurs when fraudulent entities work to artificially inflate or de-value stock prices. This type of manipulation undermines the Securities and Exchange Commission’s goal to provide “fair, orderly, and efficient markets.” Studies suggest that securities manipulation is extremely widespread and has cost ordinary investors billions of dollars. The SEC is always on the lookout for unfair trading practices, but skilled stock market manipulators employ subtle techniques and may avoid detection for years.
Stock Market Manipulation Examples
Several types of stock market manipulation involve trading a stock expressly to generate hype and artificially increase its price.
Matched trades: Stockbrokers might artificially inflate a share’s prices by executing matching buy and sell trades between their investors. These trades do not offer any benefit to their client and serve only to inflate the share’s price.
Painting the tape: Traders who own significant shares of a particular stock may buy and sell the shares to each other, once again making it seem like there is more interest in a particular stock than there actually is. The fraudulent traders sell their stocks once outside interest increases the price of their shares.
Pump and dump schemes: In pump and dump, stock pumpers express excitement over a stock and make unfounded statements about an investment’s potential. Often, the fraudulent promoter is a celebrity or a social media influencer. The promoter sells their shares once money pouring in from new investors inflates stock prices.
Insider trading: Insider trading describes the illegal use of nonpublic information to direct trading strategies. Instances of insider trading often occur before mergers and acquisitions. For instance, in 2020, the SEC charged an employee of a biopharmaceutical company with insider trading based on allegations he purchased company stock options shortly after learning that Pfizer would acquire his company. This information was not yet available to the public, and the acquisition would presumably add considerable value to his company’s shares.
Front running is a type of insider trading. Stockbrokers cannot execute securities transactions based on advanced knowledge of their customer’s trades. If a broker hears that a client is about to buy a huge number of shares of a certain stock, they might purchase shares of that stock based on their knowledge that the price is about to go up. The SEC alleged that a quantitative analyst fraudulently earned approximately $8.5 million using information he gleaned from his clients, two large asset management firms.
Financial misreporting offers ample opportunity for market manipulation. In 2021, A healthcare group paid $6 million to settle SEC charges that they overstated their earnings per share (EPS). Companies calculate their EPS by dividing their profit by the value of their outstanding shares. This number helps boost the price of shares, as more profitable companies will draw more interest from investors. Investigators uncovered this manipulation when they discovered that the accounting statements had suspiciously low instances of the number four, suggesting that the accountants had been rounding up numbers.
Financial restatements happen when an outside auditor discovers an error in a company’s financial statements. Companies are supposed to issue a correction and a notice that investors should not rely on the previous statement. All too often, the company keeps the restatement quiet, and the new figures only appear in later quarterly reports, disguised as immaterial errors.
Marking the close: This practice occurs when investors buy and sell securities near the end of a trading day. Trading at the end of the day has a greater impact on the share’s price. “Price drift” around the last trading day of fiscal quarters has led experts to conclude that this type of market manipulation is alarmingly widespread.
Window dressing: Similar to marking the close, window dressing is a type of market manipulation that involves buying shares on the last trading day of the month.
What Are the Most Manipulated Stocks?
Over-the-counter stocks, i.e., penny stocks, are particularly prone to fraud because these types of stocks do not face as much SEC scrutiny. They also can come with sizable commissions for brokers, making them especially worthwhile to recommend. Penny stock manipulations include pump and dump schemes.
How to Tell if a Stock is Being Manipulated
It is often impossible for the ordinary investor to determine if unseen forces have manipulated a stock. The SEC does highlight some warning signs — for instance, be wary of celebrities or social media personalities expressing enthusiasm for a stock or financial instrument when they have never previously mentioned an interest in finance or investing.
Financial instruments that consistently beat the odds are likely the subject of manipulation. According to Market Watch, the majority of mutual funds beating the market is a mathematical impossibility. And yet, it happens all the time.
Did Reddit Manipulate the Stock Market?
When hedge funds lost a significant amount of money following the concerted effort of ordinary investors to drive up the price of GameStop and AMC, certain hedge fund managers claimed market manipulation. The hedge funds had a trading strategy in place that would make money if the price of GameStop shares fell. Traders inspired by the subreddit r/WallStreetBets bought shares of GameStop en masse, and the sudden swell of enthusiasm for the stock drove its price higher, causing the hedge funds to lose money.
As far as regulators are aware, what Redditors did was not illegal. For the SEC to determine illegal market manipulation transpired, they would have to see evidence that Redditors knowingly spread false information to drive interest in the stock. As far as the SEC is aware, the enthusiasm around GameStop stemmed from the addition of a new director and excitement fueled by the notion that ordinary investors could cause massively wealthy hedge fund investors to lose money.
Who is Responsible for Catching Market Manipulation?
Regulator surveillance and whistleblowers have made major strides toward managing market manipulation. The Market Abuse Unit’s Analysis and Detection Center uses sophisticated algorithms to detect trading patterns that indicate market manipulation. Brokerage firms are also required to use their supervisory capabilities to catch the signs of stock manipulations.
LPL recently had to pay the Financial Industry Regulatory Authority (FINRA) a $1.5 million fine following allegations that they had not sufficiently supervised their stockbrokers to prevent market manipulation. FINRA found that LPL stockbrokers had engaged in marking the close and matching trades and that LPL had not provided its supervisors with adequate training or surveillance tools.
Market Manipulation: The LIBOR Scandal
The Libor scandal offers evidence that market manipulation is rampant. Recently, banks have had to move away from using London Interbank Offered Rate (LIBOR) to establish interest rates after major banks were caught manipulating their reports to move interest rates in their favor. LIBOR was supposed to represent the average cost of a bank borrowing from another bank. Banks merely had to provide an estimate, and they did not have to show how they reached their estimate.
According to The Wall Street Journal, many banks offer derivative products that allow investors to bet on future interest rates, so LIBOR significantly affected those products. Adjusting a tiny decimal point in their LIBOR report could mean millions of dollars in profit. Regulators have agreed to phase out LIBOR by the end of 2021 and transition to the Secured Overnight Financing Rate.
What Can Investors Do If They Are Victims of Stock Market Manipulation?
If you have reason to believe your stockbroker engaged in any type of market manipulation, reach out to the securities attorneys of Kurta Law for a free case evaluation. Our attorneys are experts on financial products and can help you figure out the next steps to build your FINRA arbitration case.