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SECuRItIES fRAuD

SECURITIES FRAUD

Securities Fraud iii

TABLE OF CONTENTS Course Overview ..................................................................................................................................................... ix

Organization......................................................................................................................................................... ix

I. INTRODUCTION Overview .................................................................................................................................................................... 1

The Price of Fraud in the Markets ..................................................................................................................... 1

The Language of Fraud: Definitions and Perspectives ....................................................................................... 3

Securities and Investments .................................................................................................................................. 3

Fraud ...................................................................................................................................................................... 4

Securities Fraud .................................................................................................................................................... 5

The Personality of Fraud ......................................................................................................................................... 7

Heroes and Villains .............................................................................................................................................. 7

Single-Minded Focus ........................................................................................................................................... 8

Preventing and Detecting Securities Fraud ........................................................................................................... 9 Enforcement and Oversight .................................................................................................................................... 9

Securities Rules and Regulations ........................................................................................................................ 9

Overview of Securities Fraud Investigation and Enforcement in the United States ............................... 10

International Securities Regulatory Institutions ............................................................................................. 16

Conclusion ............................................................................................................................................................... 19 Review Questions ................................................................................................................................................... 20

II. FINANCIAL MARKETS AND INVESTMENT SECURITIES Origins of the Financial Markets .......................................................................................................................... 21

Introduction ........................................................................................................................................................ 21

The Origins of Trading ..................................................................................................................................... 21

Access to Credit and Capital ............................................................................................................................. 22

The First Securities ................................................................................................................................................. 22

Publicly Financed Enterprise ............................................................................................................................ 22

Securitization: The French Connection .......................................................................................................... 23

Jay Cooke’s “Five-Twenty” Civil War Bonds ................................................................................................ 23

Shared Interests .................................................................................................................................................. 25

Organized Exchange Trading ............................................................................................................................... 25

Securities .............................................................................................................................................................. 25

Securities Markets ............................................................................................................................................... 27

The Potential for Profit and Fraud....................................................................................................................... 31

Fraud Involving the Bid/Offer Spread ........................................................................................................... 31

The Vig ................................................................................................................................................................ 34

Prevention and Detection ................................................................................................................................. 35

Review Questions ................................................................................................................................................... 36

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III. THE DEVELOPMENT OF SECURITIES REGULATION Pre-SEC America .................................................................................................................................................... 39

An Agricultural Nation in Need of Regulation .............................................................................................. 39

Self-Regulatory Organizations .......................................................................................................................... 39

Key Regulatory Topics for Securities .............................................................................................................. 41

Federal Securities Statutes...................................................................................................................................... 41

The Securities Act of 1933 ................................................................................................................................ 42

The Securities Exchange Act of 1934 ............................................................................................................. 46

Federal Regulation of Futures .......................................................................................................................... 58

The Investment Advisors Act of 1940 ............................................................................................................ 61

The Investment Company Act of 1940 .......................................................................................................... 62

The Bank Secrecy Act of 1970 ......................................................................................................................... 64

Sarbanes-Oxley Act of 2002 ............................................................................................................................. 67

The USA PATRIOT Act of 2001 .................................................................................................................... 74

Fraud Enforcement and Recovery Act ........................................................................................................... 76

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ................................................. 76

State Securities Laws ............................................................................................................................................... 79 Securities Rules and Regulations........................................................................................................................... 81

FINRA Rules ...................................................................................................................................................... 81

SEC Rules ............................................................................................................................................................ 83

Alternative Dispute Resolution ............................................................................................................................. 85

Securities Arbitration ......................................................................................................................................... 85

Common Arbitration Claims ............................................................................................................................ 87

Venues to Hear Allegations of Securities Fraud ............................................................................................ 90

Conclusion ............................................................................................................................................................... 91 Review Questions ................................................................................................................................................... 92

IV. ORGANIZATIONAL FRAUD Overview .................................................................................................................................................................. 95 The First Jersey Securities Case Study ................................................................................................................. 95

“Come Grow with Us” ...................................................................................................................................... 95

Command and Control at First Jersey Securities ........................................................................................... 97

Underwriting and Trading of Sovereign Chemical ........................................................................................ 98

Structure and Coordination .............................................................................................................................. 98

The National Century Financial Enterprises Case Study ............................................................................... 100

The NCFE Fraud ............................................................................................................................................ 100

Lance Poulsen .................................................................................................................................................. 101

NCFE’s Timeline ............................................................................................................................................ 101

Command and Control at NCFE ................................................................................................................. 102

Shared Interests ............................................................................................................................................... 102

Special-Purpose Subsidiaries .......................................................................................................................... 103

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IV. ORGANIZATIONAL FRAUD (CONT.)

As Simple as Data Entry ................................................................................................................................ 104

False Investor Reports .................................................................................................................................... 104

Investor Harm ................................................................................................................................................. 105

Red Flags of Organizational Fraud (Top-Down Fraud) ................................................................................ 105 Review Questions ................................................................................................................................................ 106

V. THE ORGANIZATION AS A VICTIM Organizational Perspective ................................................................................................................................. 107

Democratic Nature of Fraud ......................................................................................................................... 107

Respondeat Superior ....................................................................................................................................... 107

Frank Gruttadauria Case Study ..................................................................................................................... 108

The Trading Area ................................................................................................................................................. 109

Market Quotes Versus Marks ........................................................................................................................ 109

The Bank of Montreal Case ........................................................................................................................... 110

Prime Internal Target Areas ............................................................................................................................... 111

The Enemy Within .......................................................................................................................................... 111

Vanguard Development and Management Case Study .................................................................................. 111

Selling Away ..................................................................................................................................................... 111

Vanguard Development and Management .................................................................................................. 112

Safety Nets for Some, But Not for All ............................................................................................................. 115

SIPC and FDIC Protection ........................................................................................................................... 115

Customers and Depositors ............................................................................................................................ 116

The Barings Bank Case Study ............................................................................................................................ 117

Nick Leeson ..................................................................................................................................................... 117

Error Accounts ................................................................................................................................................ 118

The Aftermath ................................................................................................................................................. 119

Review Questions ................................................................................................................................................ 121

VI. INVESTOR FRAUD Suttonism .............................................................................................................................................................. 123 Investor Fraud Schemes ..................................................................................................................................... 123

Counterfeit, Stolen, and Forged Securities .................................................................................................. 123

Other Investor Fraud Schemes ..................................................................................................................... 125

Robert Lee Vesco Case Study ............................................................................................................................ 133

Vesco: The Early Years .................................................................................................................................. 133

Robert Vesco Meets Wall Street ................................................................................................................... 134

Bernard Cornfeld and Investors Overseas Services ................................................................................... 136

National Politics and the Looting of IOS .................................................................................................... 137

Tom Adams ..................................................................................................................................................... 138

Review Questions ................................................................................................................................................ 140

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VII. ADVISOR FRAUD—REGISTERED SECURITIES Introduction .......................................................................................................................................................... 141

Employment..................................................................................................................................................... 141

Methodology .................................................................................................................................................... 141

Advisor Fraud Schemes ...................................................................................................................................... 142

Material Misstatements or Omissions .......................................................................................................... 142

Selling Away ..................................................................................................................................................... 146

Professional Misconduct ................................................................................................................................ 148

Pay to Play ........................................................................................................................................................ 149

Churning ........................................................................................................................................................... 150

Unauthorized Trading .................................................................................................................................... 151

Registered Securities ............................................................................................................................................ 152

Commingling Prohibitions ............................................................................................................................. 153

Equity or Common Stock .............................................................................................................................. 153

Preferred Stock ................................................................................................................................................ 154

Fixed-Income Bonds ...................................................................................................................................... 155

Warrants: Rights of Future Equity Ownership ........................................................................................... 155

Options and Futures ....................................................................................................................................... 156

Variable Annuity Insurance Contracts ......................................................................................................... 160

Using Technology to Detect Advisor Misconduct and Fraud ...................................................................... 162 Review Questions ................................................................................................................................................ 163

VIII. ADVISOR FRAUD—UNREGISTERED SECURITIES Unregistered Securities Fraud ............................................................................................................................ 165

Advance-Fee Fraud ......................................................................................................................................... 166

West African/Nigerian Scams/419 Schemes .............................................................................................. 169

Affinity Fraud .................................................................................................................................................. 170

Computer-Enabled Securities Fraud ............................................................................................................ 173

Partnerships ...................................................................................................................................................... 176

Hedge Funds .................................................................................................................................................... 179

Ponzi Schemes ................................................................................................................................................. 184

Bernard Madoff ............................................................................................................................................... 185

Introduction ..................................................................................................................................................... 185

Background ...................................................................................................................................................... 185

Madoff’s Investment Scheme ........................................................................................................................ 185

How Madoff Made It Happen ...................................................................................................................... 186

Red Flags .......................................................................................................................................................... 188

Conclusion ........................................................................................................................................................ 190

R. Allen Stanford ............................................................................................................................................. 190

The Allegations and Conviction .................................................................................................................... 190

The Red Flags .................................................................................................................................................. 191

Conclusion ........................................................................................................................................................ 192

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VIII. ADVISOR FRAUD—UNREGISTERED SECURITIES (CONT.) Microcap Companies ........................................................................................................................................... 193

Prime Bank Investments ................................................................................................................................ 195

Promissory Note Fraud .................................................................................................................................. 195

Viatical Settlements and Investments ........................................................................................................... 197

Conclusion ............................................................................................................................................................ 199 Review Questions ................................................................................................................................................ 200

IX. INVESTIGATING AND REPORTING INSTANCES OF SECURITIES FRAUD Introduction .......................................................................................................................................................... 203

Preliminary Investigation ............................................................................................................................... 203

Fraud Examination Methodology ................................................................................................................. 205

Act on Predication .......................................................................................................................................... 205

Steps in a Securities Fraud Examination .......................................................................................................... 206

Prepare for the Investigation ......................................................................................................................... 206

Establish Ground Rules ................................................................................................................................. 209

Collect Documents and Conduct Further Analysis ................................................................................... 210

Conduct Interviews ......................................................................................................................................... 216

Prepare the Final Report ................................................................................................................................ 218

Review Questions ................................................................................................................................................ 224

X. CONCLUSION ........................................................................................................................................... 225

XI. SOLUTIONS TO REVIEW QUESTIONS I. Introduction ................................................................................................................................................. 227 II. Financial Markets and Investment Securities .......................................................................................... 229 III. The Development of Securities Regulation ............................................................................................. 232 IV. Organizational Fraud ................................................................................................................................... 236 V. The Organization as a Victim ..................................................................................................................... 238 VI. Investor Fraud .............................................................................................................................................. 241 VII. Advisor Fraud—Registered Securities...................................................................................................... 243 VIII.Advisor Fraud—Unregistered Securities ................................................................................................. 248 IX. Investigating and Reporting Instances of Securities Fraud .................................................................. 253

XII. APPENDIX A: FREQUENTLY USED ABBREVIATIONS.................................................... 255

XIII. APPENDIX B: PRESS RELEASES ................................................................................................ 257

XIV. APPENDIX C: EXAMPLES OF 419 SCAM LETTERS ............................................................ 269

XV. APPENDIX D: REDACTED BROKER STATEMENT ............................................................ 273

XVI. APPENDIX E: LETTER TO INVESTORS ................................................................................. 275

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XVII. APPENDIX F: RISK FACTORS FOR OFAC COMPLIANCE ............................................ 279

XVIII. APPENDIX G: FOR FURTHER CONSIDERATION ......................................................... 285

XIX. SECURITIES FRAUD FINAL EXAMINATION ...................................................................... E-1

XX. INDEX .......................................................................................................................................................... I-1