Until Bernie Madoff reminded us what a Ponzi scheme was, the term had fallen out of regular use. Fifty-billion dollars and many hurt investors later, the scheme and even the creator, Charles Ponzi, have made a return to the popular consciousness. We'll look at five forgotten frauds and whether or not they can ever expect to make a Ponzi-like comeback.
IN PICTURES: Biggest Stock Scams
- Watering Stock
With the exception of insider trading, watering stock is one of the oldest tricks in the book. Before it was used in finance, it was a livestock term for when a seller allowed his animals all the water they could handle to add weight before stepping on the scales.
Daniel Drew is credited with bringing this term into Wall Street during his many battles over rail lines. When Drew and his friends found themselves cornered with an opposing shareholder owning a majority of one of their companies, they cranked up the printing press and started making more shares, diluting everyone's position. (These fraudsters were the first to commit fraud, participate in insider trading and manipulate stock. Check out The Pioneers Of Financial Fraud.)
Today, watering stock goes by a different name and is legal. A secondary stock issue naturally dilutes the value of existing shares in the same was as printing illegal shares does. Another legal method of watering stocks is done through mergers and acquisitions, where a company keeps overpaying for acquisitions to both increase its perceived value and gain more shares to sell. Tyco is just one example in recent memory. So, watering stock hasn't gone away, it's just camouflaged a little better.
The last big kiting scandal was E.F. Hutton. The company saved millions by depositing and withdrawing funds they didn't have between multiple accounts daily to avoid final clearing, using what was essentially $4 billion in interest-free funds.
Kiting, or chasing checks, is getting more and more difficult. With even the smallest banks clearing electronically, irregularities are caught quicker. While you can buy some time using an ATM over the weekend, there is no longer a seven-day window where you can juggle checks from bank to bank. (Wall Street continues to attract fresh hordes of ghoulish people committing the same old crimes. Learn more in Tales From Wall Street's Crypt.)
A corner in a stock involves buying up enough of the stock to force people that are shorting the stock to pay a premium to cover their bets. Now there are disclosure laws that prevent any investor from secretly building up a majority stake to flay the bear raiders. This disclosure comes at a low enough percentage (5%) that it provides an early warning on any large moves. Cartels of buyers could still control smaller stocks, but even this approach has it risks if the SEC finds out.
The commodities market remains one of the only major markets still prone to the occasional corner. As Silver Thursday and Mr. Copper have shown, corners can still be established, but they often turn on their creators.
- Front Running
Imagine you are a broker and one of your clients - a multi-millionaire who made a killing last year - wants to buy a significant stake in a mid-cap company. Not only will the buy immediately move the stock price up, but this guy's picks are as good as gold. What's to stop you from buying a bit for your own portfolio before executing his order? Other than ethics and the SEC, nothing.
Front running is still pretty fresh, with cases cropping up throughout the '80s and '90s. With the SEC cracking down on front running, brokers are hesitant to take the risk. Banks, however, may have found a better way. Many investment banks are running black box trading algorithms that allow them to capitalize on price change at a speed no trader can match. The law of averages suggests that big enough banks are making black box profits off of trades they are executing for their clients. Whether this is the new face of front running or something entirely different has yet to be decided.
There are still countries where you are almost guaranteed to come back with several useless bills as a souvenir of your trip. While counterfeiting is still a problem, even in the United States, the security measures built into currency make it much more difficult than it was even 30 years ago. Instead of going to the trouble to get the special paper mix and recreate the inks, fraudsters in the digital era are more likely to copy your plastic than your cash. As with currency, the issuers are working on ways to up the security. (For more schemes, don't miss Flash Trading: Wall Street's Latest Scam?)
The Bottom Line
Some of these frauds are gone, but not forgotten; others are forgotten but not gone. Even without the Bernie Madoffs of the world reminding us of old-time fraud, current frauds like cooking the books, tunneling and insider trading mean that fraud is never far from the public mind. The best an investor can do is watch out for warning signs and chose investments only after careful study. Even then, it can still be risky.
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