Market Manipulation

IN THE FALL of 2002, two international firms made headlines in the United States for their involvement in market manipulation. Specifically, Enron Corporation and Tyco International were charged with artificially inflating the value of their firms' respective stock. For example, the Federal Energy Regulatory Commission found that Enron had manipulated the price of its stock and hid the related transactions. There were several other large firms also charged in this time period, culminating in several task forces, commissions, reports, media coverage and ultimately resulting in structural reforms.

Manipulation has been formally defined by Blacks' Law Dictionary: “A series of transactions involving the buying or selling of a security for the purpose of creating a false or misleading appearance of active trading or to raise or depress the price to induce the purchase or sale by others.”

Brokers who have a stake in a particular stock might be inclined to make misleading or false assertions to prospective clients. Often, this is done in order to create the impression that the price of a stock is soon to rise, and thereby such actions create an artificial demand for it (artificial inflation). There are many ways broker-dealers manipulate markets (upward or downward). Most frequently, market manipulation involves a brokerage firm purchasing large volumes of stock in a small (or sham) company that is frequently owned by the brokerage firm itself. The brokerage firm, which owns the overwhelming majority of shares, drives up the worthless stock by “cold-calling” scores of unsuspecting investors (often senior citizens). At some predetermined point (that is, price), the brokerage firms' insiders dump their shares, leaving the public with worthless stocks and the brokers with millions in ill-gotten gains. Though market manipulation can take place in virtually any securities exchange, it takes place most commonly in the penny-stock industry.

In general, penny stocks are considered those securities not listed on a recognized exchange, hence they are traded over-the-counter (OTC), and information about them is only available on the “pink sheets.” Pink sheets refer to a weekly list of firms trading in over-the-counter stocks along with their price quotes on securities. The National Quotation Bureau, a private firm publishes the list, which is [Page 513]printed on pink paper. With respect to market manipulation, there is a key reason offenders target the pink sheets and the OTC market—lack of serious regulations.

For example, to get onto the National Association of Securities Dealers Automated Quotation System (NASDAQ), a company is required to have a minimum of several millions of dollars in assets and just slightly less in shareholders' equity. Perhaps more importantly, for a stock to be listed on NASDAQ it must have at least two market makers (a market maker is a broker-dealer that regularly buys and sells a particular security).

The reason for this should be obvious: a single market maker can, with ease and virtual impunity, illegally manipulate a security's price. Pink-sheet firms and the stocks they trade are only required to be registered with the Securities and Exchange Commission (SEC). NASDAQ securities average nine market makers per security, thus promoting competitiveness, while the pink sheet stocks typically have only one.

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