Stock Manipulation Creates Havoc for Investors
Look before you leap is sage advice for arbitrageurs and stock investors poised to snap up shares of a hot stock. But an inexplicable boost in the price and volume of a company's stock in the absence of good news actually may be the work of a stock manipulator who drives up the price and then profits by selling the artificially inflated shares.
If many manipulators are engaged in deceptive practices, average traders seeking valid information about a firm’s prospects and the true value of its stock may be driven out of the market, thereby reducing its efficiency. Although it’s too late to help those who lost money on Enron, Worldcom or Tyco, there are lessons to be learned, says Guojun Wu, assistant professor of finance at the University of Michigan Business School.
Wu and colleague Rajesh K. Aggarwal of Dartmouth College’s Tuck School of Business studied 51 of 142 stocks involved in litigation with the Securities and Exchange Commission over stock-market manipulation from 1990 to 2001. In their analysis and modeling, they observed most manipulation cases occur in small, illiquid markets, such as the OTC Bulletin Board and the Pink Sheets, which have much lower disclosure requirements for listed firms and less stringent securities regulations.
Their study, “Stock Market Manipulation---Theory and Evidence,” found that corporate insiders, brokers, underwriters, large shareholders and market makers are more likely to be stock manipulators. The reason, they say, is that these individuals are close to the information loop, so it is easier for them to pose as informed parties who have knowledge about the future value of stocks.
The most common type of manipulation, say Wu and Aggarwal, is inflating the stock price through wash trades and the use of nominee accounts (owned by essentially the same individual or group). The increased trading volume and price often attract the attention of investors or information-seekers.
Some manipulators also gain unfair advantage by spreading false information through stock promoters, news releases, SEC filings and Internet chat rooms and bulletin boards to encourage other information-seeking investors to purchase shares. The more information-seekers who can be drawn in, and the greater the market’s uncertainty about the true value of the stock, the higher the manipulator’s returns are likely to be, the researchers say. Manipulation also increases stock volatility, with stock prices rising throughout the manipulation period and then falling afterward.
Wu and Aggarwal argue that government regulators must play a strong role in discouraging manipulation while encouraging greater competition for information.
“These results are consistent with our model and suggest stock-market manipulation may have important impacts on market efficiency,” Wu said.
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