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SEC cracks down on kickback schemes

The U.S. Securities and Exchange Commission (SEC) is stepping up efforts to foil kickback schemes that use hedge funds to illegally manipulate stock values. As an indication, the SEC announced in December that its Miami Regional Office had joined forces with the Federal Bureau of Investigation in a sting operation that netted 10 defendants who have been charged with violating antifraud provisions of federal securities laws.

"[Kickback schemes] are a growing problem, and they're part of a larger problem with thinly traded, penny stocks," said Teresa Verges, assistant director of the SEC's Miami Regional Office. "It's like the Wild West out there for over-the-counter stocks. We see a lot of fraud and we're doing everything we can to protect investors."

The Miami sting operation provides a window into how kickback scams of this type work. In response to information about suspicious activity gathered by the two federal agencies, the FBI used one of its agents to impersonate a hedge fund manager and, according to Verges, "spread the word" that this manager might be open to making illicit deals.

The agent posing as a hedge fund manager was subsequently approached to participate in five different schemes in which he was offered a percentage of the sale price if his fund bought a substantial number of low-priced shares in publicly traded companies that were either owned or being promoted by the defendants. The undercover agent told the defendants

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that in order to keep the kickbacks secret from his purported employer, he would create a phony consulting firm through which the defendants could disguise their payments as consulting fees, an arrangement to which the defendants agreed.

In each case that the hedge fund actually bought the stocks the defendants promoted, there was a significant effect on the stock-trading volume of the companies involved, according to the SEC.

Stock manipulation schemes are particularly common in the trading of penny stocks, cheap shares of little-known companies, said Verges. Because hedge funds are aggressive, large-volume traders, they present a tempting target for those who are intent on manipulating stock prices and trading volumes.

While kickbacks offered to fund managers can be substantial -- as much as 30% of the sale price in the Miami sting -- the schemes promise high returns for scammers who make money on the sale and can then sell more of the stock at the pumped-up price.

"This is beyond telephone boiler rooms and spam email touting -- it's the next evolution of a scam," said Brad Balter, president of Balter Capital Management, a hedge fund in Boston. "I guess it's a labor-saving variation on a pump-and-dump scheme, but I've never heard of anyone getting an offer, and most hedge fund managers would just hang up the phone and call the SEC."

Besides the ethical considerations, Balter said taking a kickback as either an individual manager or with a hedge fund would be too risky in terms of criminal liability and reputation.

"In the end they all get caught, and it will ruin at least a career and maybe a business," he said.

Rogue employees of either a legitimate investing company or a hedge fund that were involved in kickback scams could be difficult to detect, said Bruce Eissner, CEO of Polar Cove, an information security consultancy in Providence, R.I..

"There are certainly ways to do this that would leave no electronic fingerprints," said Eissner. "And if the malfeasance came from the top of the firm selling or the hedge fund, there would be no one looking for the fingerprints."

To protect investors and the integrity of markets, the SEC uses sophisticated software to continuously monitor trading and detect suspicious patterns or anomalies, but Eissner said that information would likely come too late for an honest company to stop a rogue employee before a crime has been committed.

Although not foolproof, there are security measures imposed on communications transactional systems that could lessen the possibility that a kickback scheme would go undetected, said Eissner. He said a good starting point is email-filtering software that identifies confidential or suspicious information on an organization's network and blocks it from leaving.

About the author:
Tommy Peterson is a freelance writer and editor in Newton, Mass., who specializes in technology, business and science topics.


This was first published in March 2008

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