Market Manipulation and Insider Trading

The exam rarely asks you to define market manipulation or insider trading. It describes what a person did and asks you to name the practice.

What market manipulation is

Market manipulation is conduct that creates a false or misleading picture of a security's price, volume, or demand. It interferes with the free interaction of supply and demand.

Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 ban manipulative and deceptive devices. FINRA Rule 2020 applies the same ban to firms that belong to FINRA and their people.

Intent separates manipulation from an ordinary trade. A large buy order near the close is legal. The same order, entered to set the closing price, is manipulation.

The seven types to recognize

Market rumors. Spreading false or unverified information to move a price. A registered representative (a rep) posts on a message board that a small drug company is about to be bought, knowing there is no deal. FINRA Rule 5230 also bans paying for a publication that influences a security's price.

Pump and dump. The manipulator buys a cheap, thinly traded stock, promotes it with false claims, then sells into the buying he created. He buys 500,000 shares at $0.40, promotes it by email until the price reaches $2.20, then sells everything. The price falls back to $0.30 and the buyers hold the loss.

Front running. Trading ahead of a customer order you know is coming. A customer places an order to buy 400,000 shares. The rep buys 5,000 shares for his own account first, then sells them after the block lifts the price. FINRA Rule 5270 covers front running of block transactions, and it covers options on the security as well as the stock. FINRA Rule 5320 bars a firm from trading ahead of its own customers' orders.

Excessive trading, also called churning. Trading a customer's account far more than the customer's objectives justify, to generate commissions. Two parts must be present: the rep controls the trading, and the activity is excessive for that customer. A retired customer wants income from a $120,000 account. The rep turns the portfolio over eight times in a year and earns $14,000 in commissions.

Marking the close and marking the open. Entering orders at the end of the session to set the closing price, or at the start to set the opening price. A rep buys 300 shares in the final minute to lift the close from $9.85 to $10.10. His customer's $10 calls then expire in the money.

Backing away. A market maker publishes a firm quote, then refuses to trade at that price for the size it displayed. It shows a bid of $22.10 for 1,000 shares, then will not buy when another firm sells at that bid. FINRA Rule 5220 requires a published quote to be a real offer the firm will honor.

Freeriding. Buying a security in a cash account and selling it without paying for the purchase, so the sale proceeds cover the buy. Regulation T gives the customer two business days after settlement to pay, which is the third business day after the trade under T+1 settlement. A customer who freerides has his account frozen for 90 days. During the freeze the firm accepts a buy order only when the cash is already in the account.

Insider trading

Illegal insider trading is buying or selling a security, in breach of a duty of trust and confidence, on the basis of material nonpublic information (MNPI).

MNPI has two parts, and a violation needs both:

• Material: a reasonable investor would want it before deciding to buy or sell. A pending merger, an earnings surprise, a drug approval, or a coming bankruptcy filing all qualify.
• Nonpublic: the market has not received it yet. A press release or an SEC filing makes information public. A private call with a few analysts does not.

You do not have to work at the company to be liable. The SEC charges five groups:

• Insiders: officers, directors, and employees who trade on what they learn at work.
• Temporary insiders: lawyers, accountants, bankers, and printers who learn it while working for the company.
• Tippers: anyone who passes MNPI in breach of a duty. A tipper is liable even when he never trades.
• Tippees: the friends, family members, and business associates who receive the tip and trade on it.
• Misappropriators: people who take confidential information from an employer, a client, or a family member and trade on it. Government employees are in this group. SEC Rule 10b5-2 covers when a personal relationship creates that duty.

Penalties come in three forms:

• Civil: the SEC sues. The trader gives up the profit (disgorgement) and pays a penalty of up to three times the profit gained or the loss avoided. A firm that failed to supervise can pay a penalty as a controlling person.
• Criminal: the SEC refers the case to the Department of Justice. An individual faces up to $5 million in fines and up to 20 years in prison. A firm faces up to $25 million.
• Industry: FINRA can censure, fine, suspend a registration, bar an individual from the industry, or expel a firm from FINRA membership.

How this gets tested

Most items describe conduct and ask you to name it. A rep trading before his customer's block order is front running. A market maker refusing his own quote is backing away. Heavy trading that earns commissions and serves no customer objective is churning.

The favorite insider trading trap is the tip. A director tells his brother about a merger and never trades himself. The director is liable as the tipper and the brother as the tippee. The exam also splits enforcement: the SEC brings the civil case, and the Department of Justice brings the criminal case.