Does Your Firm Monitor For Market Maker Manipulation?
"The OTCBB has been decimated by naked short selling over the last 2 years or so." (Tom Allinder, President of HotStockChat.com, Inc., as quoted in a CBS MarketWatch article dated August 19, 2002).
Introduction
The events leading to the creation of the stock market 'bubble' and the subsequent 'crash' of April 2000 have resulted in pressures not encountered in recent history. Though this contemporary pattern is reminiscent of the great crash of 1929 and the subsequent legislation leading to the creation of the Securities and Exchange Commission (SEC) in the Securities Exchange Acts of 1933 and 1934, the international nature of the Internet and off-shore brokerages, the growth in on-line brokers and broker-dealers, individuals trading their own accounts, and day-trading has resulted in some contemporary variations designed to profit from the damages caused to firms and their investors. One technological innovation is the access that the average individual has to low- or no-cost level two (L2), providing the investor with the ability to monitor the behaviors of broker-dealers in filling orders. This powerful tool has resulted in many stock-chat message board discussions alleging and relating to market maker manipulation.
The case of Enron, Merrill, and Andersen increased public awareness of the inherent and structural conflicts between the non-owner-manager executive with target price-based stock options, the broker-analyst, and the auditor-consultant. The WorldCom exposé followed, but was more representative of the traditional case of accounting fraud (e.g., capitalization of expenses to increase earnings per share measures).
This article focuses on additional issues relating to the broker-dealer or market maker (MM), and some specific instances to guard against, where your firm may be exposed to damages arising from market maker manipulation (MMM). We provide this primer and Internet-based sources of additional information on MMM. As the chief financial officer or management accountant in your firm, you are involved in the decision to finance assets with debt or equity. By increasing your awareness of MMM, you may be better able to recognize and defeat the adverse effects of MMM on your firm's equity securities, dramatically reduce the risks associated with your firm's failure to maintain market-based debt covenant ratios with lenders, and avoid the need to recapitalize, with additional equity issues, at a manipulated or artificially low price per share.
The Market Maker
Like the broker-analysts and auditor-consultant, the market maker, specialist, or broker-dealer performs two separate and, apparently, incompatible functions:
First, they 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 (reducing the decline in price per share) and sell high (reducing the rise in price per share). Therefore, these profit-making behaviors are presumed to provide a stabilizing effect on changes in the price per share of the stocks they make a market in.
Second, they post the bid and ask prices that others are willing to buy or sell at, and match these orders. They generate revenues for their firm, under a variety of order flow or transaction fees schemes, for the performance of this function.
Therefore, like the conflicts apparent in cases of the analyst-broker (Merrill) or the auditor-consultant (Andersen), the broker-dealer is faced with the opportunity to sell his/her firm’s inventory before others in a declining market, or buy for his/her firm’s inventory account, in a rising market before others. This practice is difficult to detect, but alleged in many cases - both correctly and, often, incorrectly - on stock-chat message boards. MMM is illegal. One relatively highly publicized example of MMM is that referred to as front-running.
Front-Running - An Illustration of MMM
Specialist market makers may make use of their knowledge of the order-arrival process as revealed by limit orders to generate monopolistic trading profits. After all, they possess private (incoming order flow) information and may choose to use this information to trade their own inventory before processing or matching incoming orders to buy or sell the stocks they make a market in.
In early June 2002, allegations of front-running flooded the business press and media, and SEC- and National Association of Securities Dealers'-based investigations were underway to examine trading practices at the Knight Trading Group, Incorporated (NASDAQ NM: NITE). Front-running is operationally defined as using order flow (or insider) information to generate profits by trading the firm's inventory, while delaying the matching of incoming orders from other investors. Knight Trading Group handled more than eleven percent of all NASDAQ trading in 2000.
Though front-running, per se, may not be particularly damaging to your firm, it provides a contemporary illustration of the conflict between the broker-dealer as both a facilitator of an orderly market (e.g., matching incoming orders from other investors to buy and sell) and their desire to generate profits from the inventories traded for their firms account.
Another illustration is the naked short sale. This practice is very damaging to the publicly traded firm and appears to be popular among the off-shore brokerage firms where U.S. Securities laws are less easily enforced or do not apply.
Naked Short Selling - The Behavior Most Damaging to the Public Firm
Assume that your firm has one million shares of common stock issued and outstanding at a current market price of $10 per share. If you were to release news of the need to recapitalize by issuing additional shares of stock, this would be perceived as dilutive to your firm's earnings per share and may result in a decline in the price per share (PPS) of your firm's common stock.
Now, consider the short sale. An investor, believing that the PPS for your firm's stock will decrease in the future may short the stock. They do this by borrowing stock held by an investor holding a long position and of the opinion that your firm's stock PPS will rise in the future. If the long shares are not available, the short sale is not permitted. This fact pattern represents a legitimate short sale/position, presumed to lead to increased liquidity and efficiency for the capital markets.
Alternatively, consider the naked short sale. In this case, 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 a manipulated decline in the PPS of the firm's stock. The broker-dealer merely floods the market with cheap, non-existent shares of your firm's stock. A few contemporary examples follow:
An August 16, 2002, a two-year federal sting led to the indictment of 58 stockbrokers and corporate executives. The unsealed indictment alleged the death spiral financing convertible debenture-related common stock manipulation of JagNotes.Com (OTC: JNOT), Softsquad Software Ltd. and C Me Run Corp. (OTC: CMER).
On August 13, 2002, GeneMax (OTC BB: GMXX) announced concerns over naked shorting. Records indicated August 2, 2002, shareholders of record of 400,820 shares, where only 265,654 free trading shares were available.
On July 8, 2002, MarketCentral.net Corp. (OTC BB: MKCT(E)) filed suit against a European short seller.
Even the once big cap business-to-business firm, PurchasePro.com (NASDAQ SC: PPRO(E)), 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.
Monitoring the Stock-Chat Message Boards - Investor Sophistication
We recommend that publicly traded (and, in particular, small- and micro-cap) firms monitor the stock-chat message boards. This additional task need not be onerous, but requires some understanding or review of the poster's message board posting history and level of sophistication.
Investors possess varying levels of sophistication. For example, an unsophisticated investor attempting to purchase 5,000 shares of your firms 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:
EXAMPLE 1:
OT: I can't believe that someone bought $2 worth of stock (100 shares) and paid a minimum $8 dollar (sic) commission.12
In the above case, this unsophisticated investor failed to understand that an automatic execution caused the transaction for 100 shares of a stock selling at 2 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 are nothing more than the result of a buyer's failure to place an all or none (AON) order.
Another example is that where a large spread evolves between the best bid and lower bids:
EXAMPLE 2:
Some unfortunate traders were taught a sorry lesson today using stops (emphasized). Use stops on IWAV and you will be taken out.
In the above example, this sophisticated investor is referring to stop loss market orders, suggesting that the MM was able to sell a few shares (even to himself) to reach or activate the stop loss orders, buy a large quantity of cheap shares, and allow the price per share to quickly rise, rebounding to the appropriate market value per share. These trades are very profitable, but could also have been made by sophisticated individual investors with access to L2. None-the-less, repeated complaints of these behaviors may suggest the need for the firm's management to make some form of preliminary investigation into the day's trading log and MMM. One form of MMM may be a predictor of future, more damaging cases of MMM and, in any case, high frequencies of trading complaints may lead new or potential investors to avoid investments in your firm's stock.
We recommend that a checklist summary be developed and maintained for periodic review. EXHIBIT 1 provides a simple example of the format you may wish to use for personnel monitoring the stock-chat message boards, using EXAMPLES 1 and 2, above, where RB represents the Raging Bull and YF represents the Yahoo! Finance stock-chat message boards, respectively. You may wish to modify this format as your experiences require.
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EXHIBIT 1
Stock-Chat Message Board Summary Worksheet
Msg
Msg
Author
Issue or Bd
No.
Date
Time
or Alias
Content
Comments
RB
94231
4/12/2002
11:17a.m.
Aim4theFence
Small trade
EX 1: Auto execution unsophisticated
YF
19751
8/1/2002
6:23p.m.
wall street guy
Stop losses
EX 2: MM take out stops - sophisticated
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Suggested Detection Methodology
The simplest solution for the publicly traded firm is to have one or more of their administrative personnel monitor the stock-chat message boards for comments or complaints regarding their trading experiences. This task need not be performed by a member of management or an executive, but a relatively low-salaried staff person may be used at this initial or preliminary screening level. Only unusual commentary or atypical stock price or volume activity (e.g., exceptions) should lead to further investigation at a more senior level.
Access to L2 is recommended as a useful tool to monitor during periods 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 RB and YF stock-chat message boards.
Finally, stock-chat message board complaints should not be responded to directly, but may be reviewed for validity. Direct or clarifying responses by those identifying themselves as insiders (e.g., management) may constitute a violation of SEC Regulation FD (Fair Disclosure).
by A.J. Cataldo1
Assistant Professor of Accounting
Department of Accounting and Finance - EH 412
Oakland University
Rochester, Michigan 49309
and
Larry N. Killough
KPMG Professor of Accounting
Department of Accounting and Information Systems
Pamplin College of Business Administration
3082 Pamplin Hall
Virginia Polytechnic Institute and State University
Blacksburg, VA 24061-0101
