Commission-Free Trades and Other Scams

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Posted 2/20/2003

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The Speculator
Commission-free trades and other scams
Cons are a part of investing and of life. Some are so audacious that they border on art. But most simply appeal to our free-lunch gene.
By Victor Niederhoffer and Laurel Kenner

A con man approaches the mark with the old story that he needs an honest man to finance a dishonest project.
-- David W. Maurer, "The American Confidence Man"

Cons, scams and related shenanigans are as common in the stock market as losses. Most come-ons aren’t as exotic as the Nigerian scam letters that pour over the e-mail transom these days, but grifters have plenty to teach us about markets. Consider:

Check out your options.
Record low rates
could save you a bundle.

“No commission to you” offers from brokers
Mutual fund “B” shares laden with hidden fees and exit penalties
Small up opens in the market that seem to say “buy now”
Unexpected bounces in shares of newly bankrupt companies
Penny-stock companies that hint at big pending government contracts for fighting bioterrorism or cancer.

Cons are so prevalent, so various, so all-encompassing that the normal weapons that the Specs use to shed light on a subject -- the pencil and envelope -- provide only a partial vista.

Nevertheless, we start from the bottom up with a few counts, insights and stories; and then turn the subject over to our readers, whose knowledge is much superior to our own.

The artistry of short and big cons
Confidence games can conveniently be divided in markets and life into short and big. A typical modern short con is the pump-and-dump: Someone goes on the Net, seeds the rumor that some penny biotech company has a cure for cancer, waits for the stock to go up a few hundred percent and then sells before the Securities and Exchange Commission halts trading.

A related shenanigan is the chief executive officer who goes on television to talk about his company’s stock. J. Felix Meschke, a doctoral candidate at Arizona State University, finds in his paper “CEO Interviews on CNBC” -- based on the 3,641 CEO interviews between 1999 and 2001 -- that the average performance of a companies’ shares on the day of an interview was up 1.65%. In the 10 days after the interview, the average performance was down 2.78%. (To read the paper, click on “Read CEOs on CNBC” under related sites at left.)

A big con is a theatrical production of operatic sweep, luxurious props and supporting actors in which the mark is taken not for the money he has on him (the short con) but for everything he has. One of the most famous big cons was pulled off in the 1920s by Victor Lustig. Posing as a government bureaucrat, he sold the Eiffel Tower twice to scrap metal dealers. Adding to the realism, he pocketed a bribe from one of the winning bidders. (Lustig was a renowned con artist both in Europe and America and so good an escape artist that he was ultimately locked up in Alcatraz, where he died in 1947.)

Today’s big bankruptcies, with their income-statement revisions and secret off-the-books partnerships, might be likened to big cons. Such scams are so frequent now that some people have ceased investing in stocks altogether. But stock cons are nothing new. In the 1920s, phony brokerage and gambling houses served as stage sets for victims lured by supposed insider tips. The 1950s grifter Lowell McAfee Birrell, a practitioner of a game that’s still going strong today, would acquire a respected company, increase its shares astronomically and switch its assets to another company on the verge of collapse. He would then promote the shares of the watered-down company and quickly sell when the price ran up, ruining other shareholders.

We sympathize with the investors and authorities who find it so hard to appropriately punish the perpetrators of the big cons. One of the reasons is detailed in a highly recommended book by Victor Santoro, "Frauds, Ripoffs and Con Games," which notes that a code of silence exists between lower-level executives and those higher up in big cons involving stocks. When the scam collapses, the lower executives are expected to assume responsibility for the fraud, while the CEO disclaims all knowledge. “In reality,” Santoro observes, “the CEO knows very well what’s going on; he did it himself when he was a subordinate.”

The mark in today’s market is, of course, the public.

A mark’s qualifications: money -- and larceny in his heart
Central to the big con is the “convincer” -- that’s the stock that rises, convincing the mark there is vast money in the operation. But the crucial ingredient is the bait, the opportunity for easy money that lures the victim with larceny in his veins into throwing the whole kit and caboodle, often including his house and bank accounts, into the scheme.

“You can’t cheat an honest man,” the saying goes. Today’s marks, however, do not so much lack integrity as they lack the willingness to do hard work, to count, to visit the premises and employees of the big con.

We will concentrate on the easy-money aspect of the big cons. In reality, goods are scarce and desires are unlimited. You cannot have one good without the cost of giving up the opportunity of spending your money or time on another. You cannot produce one kind of good without giving up the opportunity to use your resources to produce another. The concept is so important that first-year economics classes in almost all universities start out by memorializing the principle with the acronym TNSTAAFL: “There’s no such thing as a free lunch.”

When you see a proposition that guarantees you a high return with no risk, take the elevator to the ground floor immediately and start walking.

Vic wishes he had taken this advice himself. In 1996, investments in the Asian Tiger countries Thailand, Malaysia and Singapore were touted as opportunities for a free lunch. Not only would investors profit in the fast-growing economies, the story went, they would also enjoy the benefits of diversification. Enhanced return and reduced risk -- what could be better? What’s more, these countries paid high interest rates, and since stocks would no doubt return the standard 3% to 5% above the rate of interest, investors would lock in a 20% return by investing in their stock markets.

The denouement was terrible. One tiger after another couldn’t maintain a stable currency while paying those high interest rates. The money these countries attracted was invested in real-estate scams and crony capitalist venture. The average decline in these markets in 1997 was some 50%. Many individual stocks -- such as the leading bank in Thailand, Krung Thai Bank, in which Vic had invested -- went down 99%. So much for the free lunch in emerging markets.

There is one excuse Vic can make for his proneness to be victimized by scams: It runs in the family. His great-grandfather, who delivered fruit by horse and carriage to wealthy customers on the Upper East Side of Manhattan in the early 20th century, once fell for a Manhattan version of the Eiffel Tower con. Two businessmen from the “Grand Central Development Authority” approached him with a top-secret proposition. The management of Grand Central Terminal, they said, had decided to close the building's central information booth. Why take up all that valuable floor space when the ticket agents could answer questions? If the Niederhoffers would deposit $25,000 in cash with them, the space was theirs. The family managed to come up with the finder’s fee, but before things went any further, the crooks found a pair of brothers who agreed to an even higher price for the chance to peddle fruit at Grand Central.

The day after handing over $100,000 in cash, the brothers showed up at the booth to start building shelves. The flabbergasted clerks told them there was no such thing as the Grand Central Development Authority -- and the cops showed them the door.

‘Net to You, Doctor’
As always happens when the Specs come up with an idea, our readers have the best elaborations, based on their specific knowledge of time and place. A trader friend of ours, Scott Barrie, notes:

The best clue that a stock is ripe for shorting is when your broker calls you with a hot stock tip, informing you that you can purchase this wonderful company sans commissions! Usually this is a tip-off that the brokerage has a large inventory of it that they wish to part with.

A broker in the Midwest expresses with inimitable style the skepticism that all investors should have toward such offers:

The guys in the office used to call those "Net to you, Doctor" deals. Doctors and lawyers were the worst investors, always thinking primarily about the fee. Doctors paid little attention to whatever the investment was, and lawyers always thought they were being screwed in some way -- and the "Net to you, Doctor" (or “Counselor”) secondary or new offerings or the hideous bond funds, etc., made them extremely happy. “You don't pay me -- the issuer pays me” was music to their moronic ears, and they bought, figuring they were so smart. They had sidestepped the nasty commission, and bought -- largely -- junk.

“No commission to you,” says our veteran broker friend, Tim Melvin of Baltimore, is one of the oldest and most effective lines in the brokerage business. “Retail investors are suckers for commission-free deals,” Melvin said. “This technique shows up in the peddling of Nasdaq stocks and secondary preferred stocks, one of the more frequent showings in today’s markets. All too often, these preferred stocks are bought at the offer and then marked up as a principal trade -- perfectly legal, but less than open. The investor is paying the bid/ask spread plus a bump that doesn’t show on the confirmation. He feels he got a cost-free deal; in reality he paid a vig (or fee) of 5% to 6%.”

Bankrupt companies, ruined traders
Another apparent free lunch in the market is the company that admits its assets are not enough to pay off its liabilities, yet still carries a stock price above zero. When a company files for Chapter 11 bankruptcy protection, trading in the stock is often immediately halted and only reopens when the market makers figure out best how to take advantage of the millions of sell orders that flood the gates. The fact that a bankrupt stock is reopened at all gives the market makers and specialists one last chance to buy low and sell high, confirming the notion that even shorting a company worth nothing is the quickest way to ruin.

James Altucher, of Subway Capital, a reformed addict of shorting bankrupt companies, pointed out the following recent, large-scale bankruptcies that lined the pockets of the professionals and took one more chunk out of the free-lunchers.

Recent Chapter 11 filings

Stock	Date of Chapter 11 filing	Date halt lifted	Low after halt lifted	High after halt lifted	Return
F.A.O. Schwartz (FAOOQ, news, msgs)	1/13/02	1/14/02	$0.25	$0.63	152%
UAL Corp. (UAL, news, msgs)	12/9/02	12/13/02	0.64	2.09	226%
Kmart (KMRTQ, news, msgs)	1/22/02	1/30/02	0.70	1.63	133%
Enron (ENRNQ, news, msgs)	12/3/01	12/5/02	0.26	1.26	385%
WorldCom (WCOEQ, news, msgs)	7/21/02	7/29/02	0.08	0.17	113%

Final note
Ever wonder how a real broker sees things from his side of the phone line? Michael Lewis’ “Liar’s Poker” and the movie “Boiler Room” didn’t have the half of it. This week, a broker spills the beans on our Web site. Read what your “market consultant” really thinks.

Kindly write to us with your own stories of cons in life and markets. We'll send the good ones a cane. Those who e-mail us with comments, augmentations and critiques will receive our workout of how the up open is a con.

If you’re looking for more information on scams
There’s no end of sites on or about investment and consumer fraud scams. MSN Search lists some 39,000 sites on stock scams alone. We found a number of interesting sites on the topic. The links to these sites are under Related Web sites at left. Here’s a sampling.

Stock Scams 101
This site lists 10 top investor scams, including the pump-and-dump and short-and-distort, and tells how to spot investment con games. It also explains techniques promoters use, gives the lowdown on off-exchange foreign currency speculations, prime bank investments and affinity frauds, offers tips for online investing and explains how to tell if investment newsletters are biased. There’s also a section on penny stocks vs. saving pennies.

Nigerian fraud e-mail gallery
No less than 421 versions of Nigerian con letters are reproduced here.

U.S. Secret Service Nigerian Advance Fee Fraud page
The U.S. Secret Service says Americans lose hundreds of millions of dollars each year to Nigerian advance fee scams.

Internet Fraud Complaint Center
The Internet Fraud Complaint Center (IFCC) is a partnership between the Federal Bureau of Investigation (FBI) and the National White Collar Crime Center (NW3C). You can report fraud complaints and check news. It also has a useful tips section. It also has a separate page on Nigerian mail scans.

MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.