Manipulation and the Individual Investor

Here's a nasty and dirty fact about Wall Street -- manipulation is real. Stock manipulation is real and alive today, just as it was 10 years ago, 50 years ago, and 100 years ago and likely will be 100 years from now. The bad news is that the forces arrayed against the individual investor are generally sophisticated, smart, and merciless.

The good news is that cautious, patient, and diligent investors can generally avoid most of the problem areas of the market. That's not to say that there won't be nasty surprises from time to time, but history shows that stock manipulation is only a blip on the radar screen of the market over time.

Naked shorting
Naked shorting is currently the manipulation du jour that investors scream about most. At the risk of oversimplification, naked shorting is the shorting of shares without making any attempt to actually locate the shares to be shorted. In other words, it's roughly akin to counterfeiting stock.

Although market makers can in some instances legally engage in naked shorting transactions (primarily when it's deemed necessary to maintaining a liquid market), by and large it's illegal. While I won't repeat all of Karl Thiel's previous piece on the topic here, I will give just a bit more explanation of what this phenomenon is.

In regular shorting, the seller (or the seller's broker, rather) must locate the shares to be shorted, borrow them, and sell them. Can't find any shares to borrow and short? Well, you can't short the stock. Unless you want to try a naked short, that is.

In a naked short, you just short the stock -- you don't make any attempt at actually locating the shares or borrowing them. Now, in theory there is a 13-day window in which those shares must be delivered. But brokerage houses have been known to hand off transactions to other houses and keep them moving around in such a way that they never settle.

If the bird actually does come home to roost after 13 days and no shares have been delivered, the broker has to buy those shares back. But if the manipulators succeeded in their attempt to push the stock down, that buyback can still be at a price that gives the wrongdoer a profit. Neat little scam, huh?

Naked shorting seems most rampant with those stocks where there are highly publicized issues (real or imagined) with accounting, liquidity, or the overall quality of the business. While some of the companies targeted by naked shorting like Calpine (NYSE: CPN  ) are legitimately troubled, others such as NovaStar (NYSE: NFI  ) are awash in rumors and fears and still others suchas Motley Fool Rule Breakers selection Overstock (Nasdaq: OSTK  ) seem to be targeted with a presumption that the stock will collapse if pushed hard enough.

Though I don't believe that naked shorting really hurts the company in question (unless it really needs to raise money via equity financing), it can hurt investors in the short run. I utterly reject the notion that legitimate and legal shorting can keep a good stock down for too long, but naked shorting can potentially absorb huge amounts of buying momentum. That translates into a stock price that is lower than it would be otherwise.

What can investors do? For starters, whining and ranting about the problem -- whether on message boards or conference calls -- isn't going to solve it. What's more, the SEC is clearly aware that the problem exists. So what is left, then, is a need for greater enforcement. Instead of writing pointless rants on Yahoo! Finance, investors should be writing their congressional representatives and pushing them to force the SEC to take a harder line with those found to be engaging in illegal naked shorting.

Given how Congress generally acts, that could be considered the long-term solution. For the short term, there's not much that investors can do. If you really think that a stock you own is being illegally shorted, you have two options -- put up with it and hope that the qualities of the business win out over time, or sell it and stop playing what you believe to be a rigged game.

Fraud
Simple fraud has to be one of the oldest and most consistent means of manipulating a stock. Sometimes the fraud is just at the accounting level. In other extreme cases, the entire company in question is built upon fraud and lies. Whether it's a WorldCom or a Bre-X, a ZZZZ Best or a Lernout & Hauspie, fraud has always been a means of separating investors from their hard-earned money and bequeathing a cushy lifestyle on the executives who orchestrate the scam -- at least until they're caught.

Entire books could be, and have been, written on this topic, so I'm not going to belabor the point. The best ways to avoid fraud in the stock market are the same as in real life -- be aware that there are no free lunches, treat everything with skepticism, and remember that if something is too good to be believed, it probably shouldn't be believed.

In other words, if a previously unheard-of or otherwise unspectacular company suddenly finds a new way to seemingly mint money, or seems to be redefining an entire industry, investors would do well to give it a healthy dose of skepticism before buying in for themselves.

Take the case of Lernout & Hauspie -- a stock that Fool writers wrote about extensively a few years back. The idea was hot -- voice recognition software is still something of a Holy Grail today, and the market potential could be enormous -- but management had some credibility issues going into it, given that a key member of Lernout's management team had run a prior company, Quarterdeck, into the ground.

What followed was classical fraud -- the company made up customers, made up revenue, and generally just cooked the books like some sort of Belgian burgoo. Investors who took a sharp eye to the financials saw some warning flags, and even those who didn't got a wake-up call when the likes of Herb Greenberg began questioning the books. Top that off with suddenly appearing (and disappearing) revenue and publicly announced customers who denied being customers, and you had more than a couple of "Get Out Now!" red flags.

This is where we'll leave off the discussion today, but don't go away! Tomorrow we have a whole new piece on some of the other ways that Wall Street's evildoers will try to separate you from your money.

Stephen Simpsondoes not own any stocks mentioned in this article. The Motley Fool has a disclosure policy.


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