What Is Financial Fraud?

Financial fraud dates back to the year 300 B.C. when a Greek merchant name Hegestratos took out a large insurance policy known as bottomry. In layman's terms, the merchant borrowed money and agreed to pay it back with interest when the cargo, in this case, corn, was delivered. If the merchant refused to pay back the loan, the lender could claim the cargo and the boat used for its transportation.

Hegestratos planned to sink his empty boat, keep the loan, and sell the corn. The plan failed, and he drowned trying to escape his crew and passengers when they caught him in the act. This is the first recorded incident of fraud, but it's safe to assume that the practice has been around since the dawn of commerce. Instead of starting at the very beginning, we will focus on the growth of stock market fraud in the U.S.

Key Takeaways

  • William Duer committed an insider trading scandal in the late1700s when he relied on his information edge to keep ahead of the market.
  • Ulysses S. Grant, the Civil War leader, created a financial panic in 1884 when he could not raise funds to save his son's failing business.
  • In the late 1800s, Daniel Drew used techniques known as a corner, poop and scoop, and pump and dump to defraud stock market investors.
  • After the second world war, stock pools composed of the wealthy manipulated large stocks such as Chrysler, RCA, and Standard Oil until the bubble burst in 1929.

How Fraud Perpetrators Work

There have been many instances of fraud and stock pool scams in the history of the United States, and all of them expose devious schemes based on greed and a desire for power.

The first documented fraud occurred in 300 B.C., and it is unlikely that it will ever by stamped out completely because it is driven by greed and the desire for power.

The First Insider Trading Scandal

In 1792, only a few years after America officially became independent, the nation experienced its first fraud. At this time, American bonds were similar to developing-world issues or junk bonds today—they fluctuated in value with every bit of news about the fortunes of the colonies that issued them. The trick of investing in such a volatile market was to be a step ahead of the news that would push a bond's value up or down.

Alexander Hamilton, secretary of the Treasury, began to restructure American finance by replacing outstanding bonds from various colonies with bonds from the new central government. Consequently, big bond investors sought out people who had access to the Treasury to find out which bond issues Hamilton was going to replace.

William Duer, a member of President George Washington's inner circle and assistant secretary of the Treasury, was ideally placed to profit from insider information. Duer was privy to all the Treasury's actions and would tip off his friends and trade in his own portfolio before leaking select information to the public that he knew would drive up prices. Then Duer would simply sell for an easy profit. After years of this type of manipulation, even raiding Treasury funds to make larger bets, Duer left his post but kept his inside contacts. He continued to invest his own money as well as that of other investors in both debt issues and the stocks of banks popping up nationwide.

With all the European and domestic money chasing bonds, however, there was a speculative glut as issuers rushed to cash in. Rather than stepping back from the overheating market, Duer was counting on his information edge to keep ahead. He piled his ill-gotten gains and that of his investors into the market. Duer also borrowed heavily to further leverage his bond bets.

The correction was unpredictable and sharp, leaving Duer hanging onto worthless investments and huge debts. Hamilton had to rescue the market by buying up bonds and acting as a lender of last resort. William Duer ended up in debtor's prison, where he died in 1799. The speculative bond bubble in 1792 and the large amount of bond trading was, interestingly enough, the catalyst for the Buttonwood Agreement, which was the beginnings of the Wall Street investment community.

Fraud Wipes Out a President

Ulysses S. Grant, a renowned Civil War hero and former president, only wanted to help his son succeed in business, but he ended up creating a financial panic. Grant's son, Buck, had already failed at several businesses but was determined to succeed on Wall Street. Buck formed a partnership with Ferdinand Ward, an unscrupulous man who was only interested in the legitimacy gained from the Grant name. The two opened up a firm called Grant & Ward. Ward immediately sought capital from investors, falsely claiming that the former president had agreed to help them land lucrative government contracts. Ward then used this cash to speculate on the market. Sadly, Ward was not as gifted at speculating as he was at talking, and he lost heavily.

Of the capital Ward squandered, $600,000 was tied to the Marine National Bank, and both the bank and Grant & Ward were on the verge of collapse. Ward convinced Buck to ask his father for more money. Grant Sr., already heavily invested in the firm, was unable to come up with enough funds and was forced to ask for a $150,000 personal loan from William Vanderbilt. Ward essentially took the money and ran, leaving the Grants, Marine National Bank, and the investors holding the bag. Marine National Bank collapsed after a bank run, and its fall helped touch off the panic of 1884.

Grant Sr. paid off his debt to Vanderbilt with all his personal effects including his uniforms, swords, medals, and other memorabilia from the war. Ward was eventually caught and imprisoned for six years.

The Pioneering Daniel Drew

The late 1800s saw men such as Jay Gould, James Fisk, Russell Sage, Edward Henry Harriman, and J.P. Morgan turn the fledgling stock market into their personal playground. However, Daniel Drew was a true pioneer of fraud and stock market manipulation. Drew started out in cattle, bringing the term "watered stock" to our vocabulary—watered stock are shares issued at a much greater value than its underlying assets, usually as part of a scheme to defraud investors. Drew later became a financier when the portfolio of loans he provided to fellow cattlemen gave him the capital to start buying large positions in transportation stocks.

Drew lived in a time before disclosure, when only the most basic regulations existed. His technique was known as a corner. He would buy up all of a company's stocks, then spread false news about the company to drive the price down. This would encourage traders to sell the stock short. Unlike today, it was possible to sell short many times the actual stock outstanding.

When the time came to cover their short positions, traders would find out that the only person holding stock was Daniel Drew and he expected a high premium. Drew's success with corners led to new operations. Drew often traded wholly owned stocks between himself and other manipulators at higher and higher prices. When this action caught the attention of other traders, the group would dump the stock back on the market.

The danger of Drew's combined poop and scoop and pump and dump schemes lay in taking the short position. In 1864, Drew was trapped in a corner of his own by Vanderbilt. Drew was trying to short a company that Vanderbilt was simultaneously trying to acquire. Drew shorted heavily, but Vanderbilt had purchased all the shares. Consequently, Drew had to cover his position at a premium paid directly to Vanderbilt.

Drew and Vanderbilt battled again in 1866 over a railroad, but this time Drew was much wiser, or at least much more corrupt. As Vanderbilt tried to buy up one of Drew's railroads, Drew printed more and more illegal shares. Vanderbilt followed his previous strategy and used his war chest to buy up the additional shares. This left Drew running from the law for watering stock and left Vanderbilt cash poor. The two combatants came to an uneasy truce: Drew's fellow manipulators, Fisk and Gould, were angered by the truce and conspired to ruin Drew. He died broke in 1879.

The Stock Pools

Until the 1920s, most market fraud affected only the few Americans who were investing. When it was confined largely to battles between wealthy manipulators, the government felt no need to step in. After World War I, however, average Americans discovered the stock market. To take advantage of the influx of eager new money, manipulators teamed up to create stock pools. Basically, stock pools carried out Daniel Drew-style manipulation on a larger scale. With more investors involved, the profits from manipulating stocks were enough to convince the management of the companies being targeted to participate. The stock pools became very powerful, manipulating even large cap stocks such as Chrysler, RCA, and Standard Oil.

When the bubble burst in 1929, both the general public and the government were staggered by the level of corruption that had contributed to the financial catastrophe. Stock pools took the lion's share of the blame, leading to the creation of the Securities and Exchange Commission. Ironically, the first head of the SEC was a speculator and former pool insider, Joseph Kennedy Sr.

Fast Fact

The first head of the SEC was a speculator and former pool insider, Joseph Kennedy Sr. The stock pools were held largely to blame for the bubble that burst in 1929.

The SEC Era

With the creation of the SEC, market rules were formalized and stock fraud was defined. Common manipulation practices were outlawed as was the large trade in insider information. Wall Street would no longer be the Wild West where gunslingers like Drew and Vanderbilt met for showdowns. That isn't to say that the pump and dump or insider trading has disappeared. In the SEC era, investors still get taken in by fraud, but legal protection do now exist giving investors some recourse.