Regulators are monitoring an illegal practice called front-running
Trust is the main thrust behind nearly everything in life.
Even the simplest of transactions has an element of trust in it; for example, anyone buying fresh milk expects a certain amount of freshness or quality in the product. Trust then becomes a capital cost if it is broken or misused. In the financial markets, trust capital is very significant and is the core to many deals. However, trust is often misplaced or misused.
Zooming into a particular area of misused trust, regulators are scrutinising the illegal practice of profiting from advance information from a client or clients. A specific area which is being focused on is known in the financial industry as ‘front-running’, which is akin to insider trading.
A stockbroker or analyst is said to be front-running if he takes advantage of his prior knowledge of pending orders from his clients for a stock, and then places orders on that stock for his own account first. What the front-running stockbroker or analyst does is either to buy the stock for his own account before filling customer “buy” orders that would drive up the stock’s price, or sells for his own account before filling customer “sell” orders that drive down its price.
In either case, acting on such prior knowledge of customers’ orders clearly gives the stockbroker or analyst in question the upper hand, since he can expect to close its position at a profit at the expense of his clients.
Capitalising on information to which one has been entrusted in the course of one’s duties is not only illegal, but unethical and bad for business.
In the United States, brokers who indulge in such an errant practice have been convicted for violating the country’s securities trading laws. In 1985, for example, a writer for the Wall Street Journal tipped off US stockbrokers about what he was going to write in his column ‘Heard On The Street’. The brokers traded upon the information he had provided. The author of the article and these stockbrokers were eventually prosecuted by none other than federal lawyer Rudolph Giuliani, who went on to become the mayor of New York City. Giuliani succeeded, and their convictions were later upheld by the US Supreme Court.
In our region, there was a recent case of front-running; two analysts working in two different firms were writing recommendations on the same stock. Both of them put a “buy” note on that stock, recommended that their respective clients buy that stock, and once they got the orders from their clients, they themselves quickly purchased the stocks in their personal accounts before the clients.
These analysts knew for sure that the stock was going to move up due to the size of the buy orders they received from their clients.
The plot thickens. The analysts in the competing firms are actually husband and wife.
As the couple released their recommendations to their international clients and once the broking houses received the buy orders, the wife started to buy up the stocks concerned.
The husband then promoted the same stock to his clients, and his wife would profit unfairly by selling her positions to the unknowing clients. May I remind you that these analysts and stockbrokers are employed by reputable institutions, and this is the only reason that they are receiving trade orders.
There have been numerous landmark cases on front-running in Asia. Another glaring example also happened in South-East Asia.
In 2011, two trader analysts, again who were husband and wife, were caught front-running. The wife had tipped her husband off about certain deals, but was caught in the act of doing so. That was the first time that anyone in that country had been arrested for such front-running. The Attorney-General’s Chambers wanted to set a precedent with this case, and so appealed to the Court of Appeal for a stiffer sentence, including a jail term, for the couple. But in the end, the court upheld the lower court’s decision to slap a fine on the couple.
Of course, it is usually difficult to prove conclusively that someone is front-running.
It can happen anytime, across the board and under many varying circumstances. Also, it is very hard for regulators to keep track of individual transactions, given how swift trading is and the huge amount of money involved in the market day after day.
However, with a whistle-blowing policy in place, many firms are now encouraging staff to report front-running behaviour. For example, in the case of the husband and wife analysts, the staff overheard the wife speaking to her husband about all the front-running orders that she had placed ahead of the clients.
The staff then reported this information to the authorities, which resulted in the couple being blacklisted.
For the astute investor, one possible way to detect front-running – look at the price of a stock when your order is placed, volume transacted at each price, and how much of that stock is being moved in the market since the time of your order. Such tracking will give you an idea of how volatile the stock price is.
Broadly speaking, sharp spikes in the stock price could indicate that something might be amiss.
For all the challenges that regulators face in keeping an eye on stocks in fast-moving markets, they are beefing up their surveillance to discourage such manipulations and front-running. Indeed, it won’t be long before the Attorney-General’s Chambers achieve their preferred and much needed stiffer precedent.
© CORSTON-SMITH ASSET MANAGEMENT SDN BHD 2014