Catching the Bad Guys: Inside FINRA’s Fraud Surveillance and Insider Trading Groups

In the second installment in a three-part series, The Alert Investor takes you behind the scenes at FINRA's Office of Fraud Detection and Market Intelligence to explore the inner workings of a tenacious group of Wall Street regulators.

To catch fraud and insider trading, the Financial Industry Regulatory Authority's Office of Fraud Detection and Market Intelligence (OFDMI) combines a mixture of high-tech market surveillance with old-fashioned detective work.

Each of the four groups that comprise the OFDMI approaches its job a little differently. Paul Lane and Sam Draddy head the Fraud Surveillance and Insider Trading Surveillance groups, respectively. Both men are career prosecutors who also spent time working at the Securities and Exchange Commission (SEC) before landing at FINRA.

Here's a glimpse into how they monitor the financial markets for wrongdoing.

Fraud Surveillance

Lane views the news of the day a little differently than most people. When marijuana was legalized in a number of states and when a major oil spill hit the Gulf Coast, for example, he and the Fraud Surveillance Group started thinking about how fraudsters might gather inspiration from the headlines to dupe people.

One common way fraudsters use headlines is in so-called pump-and-dump schemes — often in stocks that trade over the counter.

Since shares of companies that trade over the counter are often relatively inexpensive and illiquid, market manipulators can acquire large stakes in a company, spread misleading information to pump up its share price, and then sell when the price spikes. Generally speaking, sudden price movements in little-traded stocks can be a red flag to regulators.

Pump-and-dump schemes are one of the most common frauds Lane investigates. Perpetrators have been known to spend enormous sums on email campaigns, direct mail and press releases. And they sometimes pay people to buy stock in small increments to create the illusion of widespread investor interest, he said.

"These can be multi-million dollar schemes," Lane said. "Some of these operations are very sophisticated, and they've drawn the interest of not only the SEC, but of criminal prosecutors around the country."

FINRA is interested in pump-and-dumps because trading stocks requires a broker-dealer, which the organization regulates. If brokers are either actively involved in a scheme or don't take proper precautions in executing trades, FINRA can take action against them.

To ferret out pump-and-dumps, FINRA uses market surveillance software called SONAR to search through press releases and news stories for companies making suspicious claims. The software also looks for stocks that experience unusual price moves.

Seeing unusual activity across a number of similar stocks can prompt an investor alert, such as the one FINRA and the SEC issued about companies claiming to have Bitcoin platforms following the suspension of trading in a company called Imogo Mobile Technologies Corp., which announced in early January that it had developed a secure mobile platform for trading Bitcoin. This, despite previous statements that the company, which developed software to synchronize email, calendars, files, and other documents, didn't plan to enter any new businesses.

Tips to the Fraud Surveillance Department also come in the old-fashioned way — through FINRA's hotlines for senior citizens and whistleblowers, for example. In all, Lane's office sent nearly 300 reports about investigations to the SEC over the past year, he said.

Insider Trading

Insider trading occurs when someone buys or sells stock in a company based on facts that the company has not disclosed to the general public. Said facts may have either positive implications for the share price — a company being acquired or a pharmaceutical company getting a new drug approved — or negative ones, as in the case of a bankruptcy filing.

Here, too, SONAR is a key source of information. When a major announcement comes out, the OFDMI team can go back and see if the software picked up any unusual movements in the stock prices of the companies involved.

FINRA then typically sends out a notice to the companies involved, asking for the names of people who would have known about the announcement and when they would have known. Combined with SONAR data about unusual trading patterns, the list gives FINRA the basic ingredients necessary for finding insider trading, if any occurred.

People who engage in insider trading often come up with all kinds of ways to try to cover their tracks. In one notorious case, a law firm clerk allegedly passed information about mergers on which his firm was working to an intermediary. That middleman would then allegedly meet with the broker, write the ticker on a sticky note, show it to the broker, and eat it.

Nevertheless, regulators such as FINRA and the SEC — in this case, with some help from the Federal Bureau of Investigation — can root through all that trickery to catch insider traders.

OFDMI sent 303 insider trading investigations to the SEC in 2014. Draddy says that prosecutors have in recent years brought more criminal cases against those who use their privileged access to material, non-public information to profit in ways that ordinary investors cannot. And yet, insider trading cases keep popping up.

"No matter how times you prosecute insider trading and people are sanctioned through fines or going to prison, many people think they won't get caught," Draddy said. "The inherent nature of some people is that they are greedy, and when they come into possession of material nonpublic information, they sometimes can't help themselves."

As long as that's true, FINRA and other agencies will be watching the markets to make sure every investor is playing on a level field.

This is the second part of a three-part series. Don't miss part one, Inside FINRA’s Office of Fraud Detection and Market Intelligence, and part three, FINRA's Detective Work.