Tuesday, November 30, 2010

Illegal Stock Market Activities



The Stock Market is a very sensitive and fragile entity whose value may rise and fall without apparent reason. As you may already know, the price of a stock may go up or down based on the demand and supply theory. So, coming to the topic, an illegal stock market activity is one where the actions of an individual is considered unethical and may cause losses to one or more investors (others) or may result in unusual profit for the person involved in the activity.

For ex: Scams perpetrated by Telgi or Harshad Mehta which resulted in losses to numerous Indian Investors can be considered illegal stock market activities.

Please Note: All of the activities mentioned in this article are illegal and all countries have laws forbidding citizens from indulging in such practices and they can be fined and/or imprisoned for the same when caught. Please do not try to do them and also do not help people who are trying to do it because it is a crime.

Now that we know what an illegal stock market activity is, let’s take a look at the types of these activities. The two main illegal stock market activities (and the most commonly occurring ones) are
1. Insider Trading and
2. Front Running

Insider Trading:

Insider Trading is one where an individual with upfront information about a company or organization and its business buys the stock of that company before the news goes public thereby gaining an undue advantage over the rest of the investors.

For Ex: Let us say you are the managing director of ABC Bank Ltd which is a stock market listed company. After weeks of negotiation you know that ICICI bank the country’s leading bank has accepted to buy your company and issues shares of its own company to investors who hold shares of your company. As any intelligent investor would know, shares of an ICICI Bank are much more valuable than shares of an ABC Bank. Once this news of ICICI acquiring ABC Bank goes public people will start accumulating shares of ABC Bank so that they can benefit out of the acquisition. This will send the price of ABC Bank skyrocketing. So, knowing this information, if you buy shares of ABC Bank for your personal share trading account before this news goes public, you can sell them off once the acquisition is complete and the share price has exploded. This way you gain an undue advantage and make a profit at the expense of the company.

This is insider trading.

So, to avoid this almost all company’s have rules related to trading of its own shares by its employees especially ones that are higher up in the food chain. Employees of a company cannot buy/sell shares of their company during predetermined windows every year for ex: during quarterly financial result announcing period. This is to avoid those employees who may possess vital statistics reg. the company performance from taking advantage of this to make quick bucks in the stock market.

By now you are mumbling, what else constitutes insider trading. Let us say your brother in law or uncle is working for a large organization which is going to post impressive annual results. He tips you of the same and you buy shares of that company. Though there is no rule stopping you from buying the share because you are not its employee, it is illegal because you got the inside information from your relative who is working for them. Hence this too constitutes Insider Trading.

Or, let us say you work for a brokerage firm for example ICICI Direct and you are a relationship manager who gets detailed reports about stock recommendations to the valued customers of the brokerage house. You are only supposed to share this information with your clients and not anyone else. You cannot buy shares from your wife’s account based on the recommendations or tip of your friend or relative to do the same because this is proprietary insider information which is meant strictly for the customers of the brokerage house and not everyone else. Hence this too constitutes Insider Trading.

Coming to a hypothetical situation – Lets say you are in a restaurant and a bunch of businessmen in your neighboring table are talking aloud about their company’s results and expecting jump in their share prices, you go ahead and buy the share prices. Though you heard from an insider about the company and bought the share, you do not have any concrete evidence that the company is indeed doing great and the share price may go up. In all probabilities the shares may go down and you may lose your money. Since your decision to buy the share would be considered an impulsive buy based on a rumor you heard, this will not constitute Insider Trading. But do remember the fact that, you are risking your hard earned money based on some small talk you heard in a restaurant is dangerous and it could all be a bluff and you may end up losing money.

Front Running:

Now that we have elaborated on what is and is not insider trading, let us take a look at the next big illegal activity in the stock market. “Front Running” is an activity wherein a stock broker/dealer who executes trades uses his position to execute trades for himself before executing the orders for his customers to gain from the difference in time gap between the orders executions. Let me explain with an hypothetical example.

Let us say that Mr. X is working for a trading house and is in charge of placing orders for its high value customer. The brokerage house attached to them has sent a recommendation to its customers to accumulate ICICI Bank shares with immediate effect. Because of which, many of its customers have placed huge orders to buy ICICI shares.

The trading day opens with ICICI shares @ Rs. 1000/- per share. The Trading house has received orders from numerous customers to buy around 1 lakh shares at market price. Mr. X knowing the fact that because of all these orders, the price of ICICI shares would go up, places an order of 1000 shares for himself at the day open price and then proceeds to place the remaining orders. By the time all the other orders are executed, because of the heavy demand for the shares, the price of ICICI has become Rs. 1050/- per share by midday. Taking advantage of this, Mr. X sells off his 1000 shares pocketing a lump profit of Rs. 50,000/-

This is “Front Running” and is illegal. A person who is executing trades for a brokerage/trading firm is not supposed to place his interest ahead of his customers and hence is not supposed to do this.

You are now thinking, what if Mr. X places orders for himself after executing the orders of his customers. Is this illegal? Of course No. This actually is termed as tailing and is not illegal. Because the person is placing orders for himself after his customers it will not affect their interest and hence is not illegal.

Apart from these 2 types, there are many other illegal activities that are prohibited in the stock market.

Painting the tape – Engaging in a series of transactions in securities that are reported publicly to give the impression of activity or price movement in a security;

Marking the close – Buying and selling securities at the close of the market in an effort to alter the closing price of the security;

Improper matched orders – Engaging in transactions where both the buy and sell orders are entered at the same time with the same price and quantity by different but colluding parties;

Engaging in buying activity at increasingly higher prices and then selling securities in the market at the higher prices (hype and dump) or vice versa (i.e. selling activity at lower prices and then buying at such lower prices);

Wash Sales – Engaging in transactions in which there is no genuine change in actual ownership of a security taking into consideration internal control systems adopted by the firms to prevent manipulative practices;

Squeezing the float – Taking advantage of a shortage of securities in the market by controlling the demand side and exploiting market congestion during such shortages in a way as to create artificial prices;

Disseminating false or misleading market information through media, including the internet, or any other means to move the price of a security in a direction that is favorable to a position held or a transaction; and

A Word to Wrap up:
Institutions like SEBI or SEC (USA) were created to safeguard the interests of the investors and to prevent anyone taking use of the stock market for their personal gains thereby causing losses to others. Their sole purpose is to protect the investor public and punish the wrong doers who indulge in the aforementioned illegal activities.

So, as responsible investors we should abide by all the laws and should not indulge in such dubious activities.

Please Note: I have made references to ICICI Bank and ICICI Direct just for explanation purposes. Since it is one of the largest and most famous banks in the country I thought people reading my article would be able to relate to the contents better and hence their usage. This does not mean that I endorse the brand or suggesting such incidents may happen in it. It is used strictly for the sake of example/illustration and nothing else.

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