SECURITIES FRAUD

Question 2

Stock

Answer 2

an equity that represents a right of ownership in a corporation

Question 3

Bond

Answer 3

a debt instrument, for example treasury bills, corporate bonds, municipal bonds, and “junk bonds

Question 4

junk bonds

Answer 4

high-risk, below investment grade, commercial bonds

Question 5

Certificates of Deposit

Answer 5

acknowledgement by a bank of the receipt of money with a promise to repay it with interest

Question 6

Future

Answer 6

contract agreeing to buy or sell a specified quantity of something (such as foreign currency or commodities) at some future time at a price agreed upon now

Question 7

Options

Answer 7

to buy (known as a “call”) or sell (known as a “put”) an asset (such as stocks, bonds, commodities, or real estate) on or before a future date at a price agreed upon now.

Question 8

strike price

Answer 8

price at which the option may be exercised

Question 9

option premium

Answer 9

The price paid for the option

Question 10

plain-vanilla options

Answer 10

Standardised exchange-traded options contracts

Question 11

call option

Answer 11

right but not the obligation to purchase the underlying security at the strike (exercise) price by the option’s expiration date

Question 12

put option

Answer 12

right but not the obligation to sell the underlying security at the strike (exercise) price by the option’s expiration date

Question 13

A call option is in the money

Answer 13

when the price of the underlying exceeds its strike price

Question 14

a put option is in the money

Answer 14

when the price of the underlying is less than its strike price

Question 15

Over-the-Counter (OTC) options

Answer 15

agreements made between private parties

Question 16

Churning

Answer 16

excessive trading of a customer account for the purpose of generating commissions

Question 17

Parking

Answer 17

practice of selling a security to one party with the understanding that the seller will repurchase the security later at an agreed-upon price.

Question 18

Front running—Dual Trading

Answer 18

use for profit of the privileged knowledge of a customer’s order to buy or sell a large amount of a commodity, options, or security that, because of its size, is likely to move the market

Question 19

Bucket shops

Answer 19

fraudulent enterprises that masquerade as licensed brokerage operations

Question 20

Following are types of investments that frequently qualify as “investment contracts” and are,
therefore, considered securities

Answer 20

PONZI SCHEMES
PYRAMID SCHEMES
WORM, RABBIT, AND OSTRICH FARMS
PRIME BANK FRAUD
PRECIOUS METAL SCHEMES
VIATICALS
PARTNERSHIPS
JOINT VENTURES
OIL, GAS, AND MINERAL INTERESTS 
PROMISSORY NOTES

Question 21

A note is presumed to be a security unless it

Answer 21

bears a strong resemblance to a category of instruments that are not
securities.

Question 22

With notes and other potential securities it is often helpful to apply the family resemblance test and look at three things:

Answer 22

MOTIVE AND EXPECTATION
What is the issuer’s primary motive? If it is to raise money for the general use of a business
enterprise then a security may be held to exist. What is the buyer’s primary motive? Is it
really a loan or an investment-type transaction? What is a reasonable investor thinking, what
are his expectations?

PLAN OF DISTRIBUTION
Is there some form of common trading? If so, a security probably exists.

REGULATION
Is there some other regulatory system that significantly reduces the risk of the transaction
thereby rendering the application of the securities laws unnecessary? If the transaction is
deemed appropriately regulated in ways other than through the application of the securities
laws, then it is less likely that securities laws will be brought to bear.

Question 23

initial margin

Answer 23

the amount of money per contract that must

be present in the account when the position is initiated

Question 24

maintenance (variation) margin

Answer 24

the minimum amount of money per contract that must be maintained in the account while
the position is open.

Question 25

Unsuitable Recommendations

Answer 25

Securities representatives are required to “know their customer.” They must take into account the financial profile and level of sophistication of the individual investor. Placing clients into unsuitable securities, for example recommending high-risk options to a senior citizen with limited assets, is prohibited.

Question 26

Failure to Supervise

Answer 26

Broker-dealer firms are responsible for oversight of their representatives to ensure adherence to Rules of Fair Practice and the laws.

Question 27

Excessive Markups

Answer 27

Excessive markups involve selling at a marked-up price or buying at a marked-down price not reasonably related to the prevailing market price

Question 28

Misuse or Misappropriation of Customer’s Securities

Answer 28

This scheme may involve outright theft or using the securities in improper ways, for example, as collateral for loans or to conduct other securities transactions (e.g., margin trading)

Question 29

Unauthorised Trading

Answer 29

Unless otherwise agreed to in writing, only the customer named on the trading account can authorise trades. Any losses accruing to the customer account because of an unauthorised trade, whether made by mistake or intentionally, are the responsibility of the brokerage firm and must be reimbursed to the customer. Gains from unauthorised trades also belong to the customer. This prevents brokers from executing unauthorised trades, claiming error, and taking any profits that may occur. The only entries to the brokerage company error account should be losses; profits in an error account should be investigated. Customers must report unauthorised trades to the management of the brokerage firm as soon as detected. Silence would imply ratification of the transaction.

Question 30

Systematically Trading Accounts Against Each Other

Answer 30

The scheme involves someone with trading authority simultaneously establishing opposite market positions in two separate investment pools that he controls.

Question 31

Market Manipulation

Answer 31

Market manipulation consists of a series of transactions designed to artificially raise/lower price or to give appearance of trading activity for the purpose of inducing others to buy or sell

Question 32

Penny stocks

Answer 32

low- priced (usually less than $5), speculative securities that are registered but do not meet the listing requirements of an exchange

Question 33

Micro-cap

Answer 33

stocks of companies with very | small market capitalisation

Question 34

Insider Trading

Answer 34

Under the legal theory of misappropriation, the use of non-public information to profit from purchase or sale of securities may violate the insiders’ fiduciary duty to their company or shareholders

Question 35

Disclosures (Misrepresentations and Omissions)

Answer 35

Securities laws require that the investor receive full and fair disclosure of all material information. Giving the investor or prospective investor false or misleading information is clearly a misrepresentation. An omission occurs when the issuer, in connection with the offer or sale of securities, omits to state a material fact necessary in order to make the statements made not misleading. Making misrepresentations to the investor or failing to inform the investor of certain facts (omissions) is a violation of law only if the misrepresentation or omission is material.

Question 36

Backdating Stock Options

Answer 36

a company alters the date of the grant to a time when the stock was trading at a lower price in the interest of making the option instantly valuable and further increasing the employee’s gain if the stock price continues to rise

Question 37

The IOSCO’s main objective is to assist its members to:

Answer 37

• Cooperate to promote high standards of regulation in order to maintain just, efficient, and sound markets. • Exchange information on their respective experiences in order to promote the development of domestic markets. • Unite their efforts to establish standards and an effective surveillance of international securities transactions. • Provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offences.

Question 38

The IOSCO Principles are based on the following three objectives:

Answer 38

* The protection of investors * Ensuring that markets are fair, efficient, and transparent * The reduction of systemic risk

Question 39

_____is the most important means | for ensuring investor protection.

Answer 39

Full disclosure of information material to investors’ decisions

Question 40

___ helps to ensure fair markets.

Answer 40

The regulator’s approval of exchange and trading system operators and of trading rules

Question 41

In an efficient market, ____

Answer 41

the dissemination of relevant information is timely and widespread and is reflected in the price formation process

Question 42

Transparency may be defined as

Answer 42

he degree to which information about trading (both for | pre-trade and post-trade information) is made publicly available on a real-time basis

Question 43

A. Principles Relating to the Regulator

Answer 43

1. The responsibilities of the regulator should be clear and objectively stated. 2. The regulator should be operationally independent and accountable in the exercise of it functions and powers. 3. The regulator should have adequate powers, proper resources, and the capacity to perform its functions and exercise its powers. 4. The regulator should adopt clear and consistent regulatory processes. 5. The staff of the regulator should observe the highest professional standards including appropriate standards of confidentiality.

Question 44

B. Principles for Self-Regulation

Answer 44

6. The regulatory regime should make appropriate use of Self-Regulatory Organisations (SROs) that exercise some direct oversight responsibility for their respective areas of competence, to the extent appropriate to the size and complexity of the markets. 7. SROs should be subject to the oversight of the regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities.

Question 45

C. Principles for the Enforcement of Securities Regulation

Answer 45

8. The regulator should have comprehensive inspection, investigation, and surveillance powers. 9. The regulator should have comprehensive enforcement powers. 10. The regulatory system should ensure an effective and credible use of inspection, investigation, surveillance, and enforcement powers and implementation of an effective compliance program.

Question 46

D. Principles for Cooperation in Regulation

Answer 46

11. The regulator should have authority to share both public and non-public information with domestic and foreign counterparts. 12. Regulators should establish information sharing mechanisms that set out when and how they will share both public and non-public information with their domestic and foreign counterparts. 13. The regulatory system should allow for assistance to be provided to foreign regulators who need to make inquiries in the discharge of their functions and exercise of their powers.

Question 47

E. Principles for Issuers

Answer 47

14. There should be full, timely, and accurate disclosure of financial results and other information that is material to investors’ decisions. 15. Holders of securities in a company should be treated in a fair and equitable manner. 16. Accounting and auditing standards should be of a high and internationally acceptable quality.

Question 48

F. Principles for Collective Investment Schemes

Answer 48

17. The regulatory system should set standards for the eligibility and the regulation of those who wish to market or operate a collective investment scheme. 18. The regulatory system should provide for rules governing the legal form and structure of collective investment schemes and the segregation and protection of client assets. 19. Regulation should require disclosure, as set forth under the principles for issuers, which is necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor’s interest in the scheme. 20. Regulation should ensure that there is a proper and disclosed basis for asset valuation and the pricing and the redemption of units in a collective investment scheme.

Question 49

G. Principles for Market Intermediaries

Answer 49

21. Regulation should provide for minimum entry standards for market intermediaries. 22. There should be initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks that the intermediaries undertake. 23. Market intermediaries should be required to comply with standards for internal organisation and operational conduct that aim to protect the interests of clients, ensure proper management of risk, and under which management of the intermediary accepts primary responsibility for these matters. 24. There should be procedures for dealing with the failure of a market intermediary in order to minimise damage and loss to investors and to contain systemic risk.

Question 50

H. Principles for the Secondary Market

Answer 50

25. The establishment of trading systems including securities exchanges should be subject to regulatory authorisation and oversight. 26. There should be ongoing regulatory supervision of exchanges and trading systems which should aim to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance between the demands of different market participants. 27. Regulation should promote transparency of trading. 28. Regulation should be designed to detect and deter manipulation and other unfair trading practices. 29. Regulation should aim to ensure the proper management of large exposures, default risk, and market disruption. 30. Systems for clearing and settlement of securities transactions should be subject to regulatory oversight, and designed to ensure that they are fair, effective and efficient and that they reduce systemic risk.

Question 51

report Strengthening Capital Markets Against Financial Fraud (the Fraud Report) in February 2005. This report identifies seven separate areas that have figured prominently in many high-profile financial scandals:

Answer 51

1. Corporate governance, including the role of independent directors on an issuer’s corporate board, the protection of minority shareholders, the importance of independent auditor oversight committees, and mechanisms to protect against conflicts of interest presented by related-party transactions 2. Auditors and audit standards, including auditor independence, the effectiveness of audit standards and auditor oversight, and issues related to mandatory auditor rotation 3. Issuer disclosure requirements, including management’s discussion and analysis of material events and factors likely to have an impact on the issuer 4. Bond market regulation and transparency, including the types of financial disclosures required of bond issuers and the transparency of bond market price-setting mechanisms 5. The role and obligations of market intermediaries, whether they contributed to recent financial scandals, and how these entities can mitigate reputational, legal, and operational risk through adequate controls and procedures, and ensure that material non-public information they acquire about an issuer is not misused 6. The use of complex corporate structures and special purpose entities, and the circumstances where they may pose particular regulatory issues 7. The role of private-sector information analysts, and the ways in which such individuals and entities can protect their analytical integrity and independence