Insights & Reports > Kroll Global Fraud Report

The tumble in global stock prices has changed the fraud environment, with fraudsters now pursuing scams intended to exploit the new realities. Although short selling is not in itself illegal, one of the risks companies face is that the pessimism and panic in the markets can be exploited by short sellers to deliberately manipulate share prices. The danger is present in developed and emerging economies alike: India and Hong Kong’s leading indices dropped by over 50 percent between January and November 2008, a faster decline than New York’s. Investors in less well-policed markets obviously face an even higher risk.

A growing number of brokers and traders are creating loosely organized cartels which start negative rumors about companies whose shares they are short-selling. The strategy, known as “short and distort,” can yield substantial profits quickly.

First, traders enter into short-selling contracts for a given company’s shares. They select the target based on fundamentals and its media profile. Well-known or controversial businesses tend to have volatile stock prices even under normal conditions. Shareholders will thus be inclined to believe negative rumors and sell in a panic, which will drive down the share price.

Next, traders borrow shares from a custodian – a company which has physical possession of shares for investors who hold stock certificates. When they lend shares, custodians need to maintain a record of custody but, when involved in this kind of illegal cartel, they sometimes fail to do so.

Before the settlement of short-selling contracts, the borrowed stock is sold in the cash market resulting in a high liquidity for the stock. Then, invented bad news is spread about the company to bring down the price. Cell phone text messages and Internet-based instant messaging, rather than blogs and emails, are used. This helps to hide the origin of such rumors, since it is more difficult to identify who sent the former types of communication.

Once the price has declined, the broker, using the proceeds of the initial sale, purchases a larger number of the company’s shares than sold originally. Since the broker is still liable to return the borrowed stock to the custodian, some of the newly purchased shares are used to fulfill the short-selling contract. The remainder is again put up for sale which further drives down the company’s share price.

In a recent case, Kroll learned that some fraudsters had created a large volume of shares to be sold in the cash markets through intraday trading. Intraday transactions cannot be traced back to their origin since the data for them is not publicly available. As gathering evidence of a broker borrowing shares from a custodian is also difficult, a fraud using this technique can be identified only through intelligence from well-placed sources, as well as anecdotal and circumstantial evidence.

A typical sign of such manipulation is unusually high delivery volumes of a company’s shares in the cash markets coupled with a fall in its share price, because such volumes normally mean that many buyers want the stock, driving prices up. If suspicions are aroused, finding those responsible for initiating rumors is not simply a matter of following a technological trail. It requires subtle and sophisticated intelligence-gathering techniques and interviews with a wide range of individuals. Evidence gathered may then be forwarded to the relevant authorities to take further action.

The financial environment has changed in emerging as well as developed markets, and so too have the targets and techniques of fraud. Companies need to adjust their defenses as well.

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Niren Shah, an analyst at Kroll’s Mumbai office, has been studying the global financial markets over the past four years. At Kroll, his experience includes cases involving financial and reputational due diligence, tackling financial fraud and reputational management in the ongoing financial crisis. Prior to joining Kroll, he wrote features analyzing Indian capital markets in Business Standard, one of India’s leading business dailies.

Richard Dailly is a managing director for Kroll’s office in Mumbai. He has many years of experience working in international politics and political risk for the British government and Kroll. Richard has a deep understanding of investigative and intelligence techniques and analysis, in support of corporate investigations, due diligence, political risk and litigation support.

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