Table of Contents:
2. Index of abbreviations
4. Basic knowledge concerning the topic
4.1 Stock exchange and stock pricing
4.2 The legal situation of stock market manipulation
4.3 Pump and Dump strategy
6. Case Study
7. Ethical issues
8. Conclusion and Outlook
10. Declaration in Lieu of Oath
2. Index of abbreviations
ECB European Central Bank
IPO Initial Public Offering
GDP Gross Domestic Product
WPHG Wertpapierhandelsgesetz / Securities Trading Act
WpDVerOV Wertpapierdienstleistungs-Verhaltens- und Organisationsverordnung
This essay aims to answer the question how fraudulent trading activities at the stock markets, such as stock price manipulation due to pump and dump schemes, could be prevented. This is especially considered under an ethical point of view.
The paper includes a case study about stock price manipulation at the well-known investment banking firm Stratton Oakmont. The case study is used to relate the consequences and involved ethical issues using a real-life example.
The analysis is mainly based on screening external newspapers, internet articles and books which concern related topics, such as business ethics and stock market manipulation.
The word stock exchange is related with contrasting adjectives: Euphoria, anxiety, greed, anger, speculative but also exciting. For some people it is the perfect implementation of the market principle. Others maybe have had bad experiences, lost a lot of their savings and since then relate the word only with misdirected capitalism.
Only 14% of Germans have got an equity investment.1 It seems like the image of the stock exchange could be better. Basically there are given two reasons for the aversion against an investment in stocks: The vocabulary is too complicated and the correlations about how stock prices come about are not comprehensible.2 Indeed private investors don´t have the opportunity to influence the big adjusting screws. They have to take most of the circumstances as granted, which implies the need of a certain extend of trust. Thus completing the circle, this trust hasn´t always been threatened as it should be. There have been several cases of fraudulent activities in the past, which did not positively contribute to a better image of the stock exchange.
Fraudulent activities such as customer fraud, false statements about a companies current situation or the manipulation of stock prices are detrimental to both, investors and companies, that are in need of equity. Investors loose trust, which leads to less investments in stocks. This again leads to negative consequences, that are demonstrated more precise further down in this essay.
Since the negative consequences are intense, there is a need for the question how to stop fraudulent activities at the stock market. Therefore in this essay there will first be a brief summary of how the stock exchange works and how stock prices come about. This knowledge will be important for the next part of the essay, which points out how stock prices can be manipulated due to a technique called pump and dump. As a next part, to consider the mentioned question, we will have a look on a case study about a company called Stratton Oakmont, an Investment Banking Firm, that used fraudulent trading activities including the pump and dump scheme to fraud their customers. The reason for using a case study is, that “[…], the case study method allow to investigators to retain the holistic and meaningful characteristics of real-life events – such as individual life cycles, small group behaviour, organizational and managerial processes, neighbourhood change, school performance, international relations, and the maturation of industries.“3 Furthermore it will enable a closer look on the problem, which will be considered in an ethical context in the next chapter. Finally, after the general ethical point of view, the essay describes the ethical comprehension at the stock market and the related problems involving the question, if there is a contradiction between behaving in an ethical manner and maximising profits at the stock market.
To sum it up there are some related research questions in this essay: First it is considered how stock manipulation works, what it causes to the stock market and especially how it could be prevented. As a consequence it is necessary to have a look on the ethical point of view. It will be discussed, whether ethical theories could prevent fraudulent activities at the stock market and finally there will be an answer to the question, if there is the mentioned contradiction.
4. Basic knowledge concerning the topic
To understand how it is possible to manipulate stock prices, it is necessary to have some basic knowledge about how the stock market works and how stock prices come about.
4.1 Stock exchange and Stock pricing
The stock market is nothing else than a marketplace for determined goods, which price is set due to supply and demand. Every stock market sets the framework for a regular financial market, where supply and demand are brought together. The price has the task to create a balance between those two parties.4 The trade at the stock market is strictly controlled by each stock market itself and furthermore by the government. As the reader will notice on the following pages, supervision at stock markets actually is very important. The controlled trade leads to a maximum amount of transparency, because the market player can retrace how the price-determination process came about. This transparency again leads to the necessary trust which is the foundation-stone for a functioning stock market.5
But how does a stock price exactly come about? The basic principle nowadays is the same as in the early days of all trading places. A higher supply, other things being equal, leads to a lower price and the other way round, a shortage leads to a price increase.6 There are many factors that can have an effect on the buying or selling behaviour of shareholders, which is the reason why stocks vary in price. In fixed intervals statistic institutes publish macroeconomic data about various facts like the unemployment rate, the GDP, export and import rates and many more. Furthermore the central banks like the ECB in Europe or the Federal Reserve in the US have a huge impact on the share prices. Their actions on the fiscal policy and base rate decisions, which is the key fiscal tool, give important impulses for the stock market. Besides microeconomic data like ad-hoc information, annual statistics on the investor relations pages of each company, profit expectations and others, there are the mass media, which constantly report about many facts and thereby influence the shareholders by giving information.7
Searching for indicators, that can explain the ups and downs at the stock market and using them to predict a stock price is more difficult than it seems and it is not exactly possible until today.8 But why is that? If you have a look on the differences between natural sciences and the economic sciences there is one crucial difference: Whereas in natural sciences there is a reliable relation between cause and effect, there is no such thing in economic sciences. They are only grounded on different probability of occurrences.9 Even Isaac Newton learned it the hard way: Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he could calculate the motions of the heavenly bodies, but not the madness of the people.10 Newton dumped his South Sea shares, pocketing a 100% profit totaling£7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost£20,000, which would be worth more than three million Dollar in 2005. For the rest of his life, he forbade anyone to speak the words 'South Sea' in his presence.11
Whereas it is not sure how many buyers there are at the stock market which are influencing the price, it is sure how the stock price eventually is fixed. The task to finally set the stock price has to be done by a stockbroker. He chooses the price with the most bid and offer on sale, because this price leads to the maximum turnover.12 Due to the fact that there never is the exact same amount of people who want to buy a stock and people, who want to sell it, the stock price, which can be figured as a line chart, will almost never look like a straight line, it will always have its ups and downs.13
With this basic knowledge about how the stock market works combined with the fact that you can never be sure about a future stock price we can now move on to the chapter of market manipulation. Therefore we will first have a look on the legal situation before there will be an explanation of the most important stock price manipulation technique.
4.2 The legal situation of stock manipulation
Within the fourth financial market support act there was a new paragraph added to the German Securities trading act (WPHG) §20a. It prohibits manipulation of prices and markets. Apart from securities this paragraph also refers to money market instruments, derivates, contracts of rights, foreign currencies and goods.14 Since a modification in 2017 you can find this legal text in §37b – 37c.
More exactly it is illegal to:
1. “supply untrue or misleading information concerning circumstances that are of crucial importance for the valuation of financial instruments or to withhold such information in contravention of statutory provisions, if the provision or withholding of the information has the potential to influence the domestic stock exchange or market price of a financial instrument or the price of a financial instrument on an organised market in another member state of the European Union or another signatory to the Agreement on the European Economic Area.”
2. “initiate transactions or issue purchase or sell orders that have the potential to generate untrue or misleading signals affecting supply, demand or the stock exchange or market price of financial instruments or to create an artificial price level”
3. “execute any other deceptive act that has the potential to influence the domestic stock exchange or market price of a financial instrument or the price of a financial instrument on an organised market in another member state of the European Union or another signatory to the Agreement on the European Economic Area.”
There has not to be an intention in the purpose of wittingly. It is sufficient if the perpetrator is familiar with the fact, that the act of deception is basically suitable for an exposure of the market price.15
4.3 Pump and Dump Strategy
“Market manipulation has existed for as long as the markets. Compared to the primitive manipulation schemes in the early ages of the markets, their modern successors have evolved greatly to cope with ever stricter regulation and surveillance.”16 “[…];the perpetual game between manipulators and regulatory bodies is likely to continue in the foreseeable future.”17 According to Aggarwal and Wu (2006) there have been detected 142 cases of stock manipulation at a well-regulated US stock market in the 1990s. “This modest number is widely believed to be merely a tip of the iceberg, since hundreds, even thousands, of abnormalities of price movements, for no proper reasons regarding fundamentals, could be observed during that period. Essentially, a stock manipulation exercise, aimed at obtaining an undue profit, typically involves deliberately taking advantages in funds, information and other resources to create false impressions about the true value of a stock, inducing uninformed investors to make wrong or irrational trading decisions.”18 There is only limited empirical research on market manipulation. This is partly due to the fact that manipulation is illegal and only a small fraction of manipulation is detected and prosecuted by market regulators. Thel (1994, p. 287) points out “[w]e do not know how often prices are manipulated, how much harm manipulation does or how existing manipulation rules influence behavior.” The incentives, means, and opportunities to carry out new manipulation schemes are continually evolving.”19
On the other hand it is sure that market manipulation is detrimental to stock markets and their participants. Manipulation harms investor confidence and discourages investor participation in markets. This harms liquidity, increases trading costs, and can increase the cost of capital for listed companies. Manipulation distorts prices, thereby reducing market efficiency and causes deadweight economic losses from distorted resource allocation. Market operators and regulators around the world expend significant resources to ensure that they have adequate systems and processes to detect, investigate, and prosecute market manipulation.20
There are several methods how it is illegally possible to influence a security price. However, in this paper there is only described a strategy which is called “pump and dump” because it´s essential for the following case study.
Pump-and-dump schemes involve the touting of a company’s stock through false and misleading statements to the marketplace. Typically therefore are used so called “microcaps” or “penny stocks”, which are shares of small companies with only a small amount of stocks because it is easier to influence the price within these stocks. The false claims can be spread on social media like Facebook and Twitter, as well as on e-mails or in early years also by using the telephone. Pump-and-dump schemes often occur on the Internet where it is common to see messages posted that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have “inside” information about an impending development. In reality, they may be paid promoters or even fake accounts who are just waiting to profit by selling their shares after the stock price is “pumped” up by the buying frenzy they create. Once these fraudsters “dump” their shares and stop hyping the stock, the price typically falls, and investors lose their money.21
1 Cf. http://www.handelsblatt.com/finanzen/maerkte/boerse-inside/aktionaerszahlen-deutsche-bleiben-aktienmuffel/19389000.html, Access 18.11.2017.
2 Cf. Heese, Viktor, Riedel, Christian, Fundamental versus Chartanalyse, 2016, p. 4.
3 Yin, Robert K., Case Study Research Design and Methods, 2013, p. 4.
4 See Scherbaum, C. A., So funktioniert die Börse, 2013, p. 6.
5 Cf. Scherbaum, C. A., So funktioniert die Börse, 2013, p. 8.
6 Cf. Scherbaum, C. A., So funktioniert die Börse, 2013, p. 10.
7 Cf. Scherbaum, C. A., So funktioniert die Börse, 2013, p. 63.
8 Cf. Heese, Viktor, Riedel, Christian, Fundamental versus Chartanalyse, 2016, p. 7.
9 Cf. Heese, Viktor, Riedel, Christian, Fundamental versus Chartanalyse, 2016, p. 11.
10 Cf. http://www.businessinsider.de/isaac-newton-lost-a-fortune-on-englands-hottest-stock-2016-1?r=US&IR=T, Access 05.11.2017.
11 Cf. Graham, Benjamin, Intelligent Investieren, 2014, p. 292.
12 Cf. Scherbaum, C. A., So funktioniert die Börse, 2013, p. 69.
13 Cf. Scherbaum, C. A., So funktioniert die Börse, 2013, p. 67.
14 Cf. http://www.antizyklischer-boersenbrief.de/kursmanipulation.php, Access 10.11.2017.
15 Cf. http://www.antizyklischer-boersenbrief.de/kursmanipulation.php, Access 10.11.2017.
16 Liu, Ke, Kin, Keun, Lai, Yen, Jerome, Zhu, Qing, A model of Stock Manipulation Ramping Tricks, 2013, p. 1.
17 Liu, Ke, Kin, Keun, Lai, Yen, Jerome, Zhu, Qing, A model of Stock Manipulation Ramping Tricks, 2013, p. 1.
18 Liu, Ke, Kin, Keun, Lai, Yen, Jerome, Zhu, Qing, A model of Stock Manipulation Ramping Tricks, 2013, p. 1.
19 Comerton-Forde, Carole, Putnins, Talis J., Stock Price Manipulation: Prevalence and Determinants, 2013, p. 2.
20 Cf. Comerton-Forde, Carole, Putnins, Talis J., Stock Price Manipulation: Prevalence and Determinants, 2013, p. 1.
21 Cf. https://www.sec.gov/fast-answers/answerspumpdumphtm.html, Access 12.11.2017.
- Quote paper
- David Baur (Author), 2017, Stock price Manipulation and involved ethical Issues, Munich, GRIN Verlag, https://www.grin.com/document/988695