Wall Street Fraud

What is Wall Street Fraud?

Wall Street Fraud refers to all kinds of fraudulent and deceptive corporate practices executed by professionals within the financial industry, specifically in the realm of investments, banking, and trading securities.

Wall Street frauds are any kind of fraudulent activity or scam affecting Wall Street investors, including banks. They can include inducing the investors to acquire or execute the sales of assets or securities based on false information.

Wall Street investors are always hunting for an edge in the market. Over the years, many have either fallen victim to greed or taken advantage of it through some unsavory methods.

These fraudulent activities can take the form of various activities, some examples of Wall Street Frauds are:

• Insider Trading
• Ponzi Schemes
• Market Manipulation
• Accounting Frauds
• Misrepresentation Of Financial Statements

From Ponzi schemes to insider trading to pump-and-dump schemes, fraudsters have scammed investors and banks out of billions of dollars. 

A number of the most famous cases throughout history will be reviewed to fully understand how these frauds begin and continue to fool intelligent investors. 

Having at least a surface-level knowledge of how these types of frauds have been perpetrated in the past could end up saving you a lot of money in the future. 

The ability to recognize a possible scam or when something is just too good to be true is extremely important in the fast-moving world of Wall Street. 

Through this historical look at Wall Street fraud, we can see when and why investors were not able to identify scams.

Wall Street Fraud Cases Throughout History

Through this list, we will analyze some of the greatest Wall Street frauds in history. While this list does not cover every fraud in Wall Street history, it will provide the most famous examples of common frauds on the Street, such as:

• First, pump-and-dump schemes will be covered by looking at how Jordan Belfort made millions. 
• Next, with Enron as our example, we’ll look at fraudulent accounting practices. 
• To see how Ponzi schemes begin and proliferate, we can analyze Bernie Madoff and his defunct organization. 
• Insider trading will be reviewed through one of the most infamous cases of this kind of fraud in history, Raj Rajaratnam. 
• Lastly, and debatably the most complex, we’ll examine Bill Hwang and how, by hiding his positions, he managed to borrow and ultimately lose billions for banks.

Looking at these examples gives a greater understanding of how greed, reputation, etc., lead to billions being defrauded.  

Jordan Belfort, a.k.a The Wolf of Wall Street

You might be familiar with Jordan Belfort and his swindling through the film The Wolf of Wall Street. Yet, in the film, Jordan Belfort’s exploits fail to fully underline how fraudulent Stratton Oakmont’s dealings were.

Belfort would acquire a large percentage of a “penny stock,” a company with a low market capitalization. These stocks have fewer regulations and are very easy to manipulate due to their low trading volumes.

Jordan’s company, Stratton Oakmont, would then call clients and sell these highly speculative penny stocks. While this is not inherently illegal, hiding Belfort’s large positions in said companies to clients was. 

After Stratton Oakmont's huge push in sales, while the stock's value was artificially high, Belfort sold off his shares. This created huge profits while tanking the company's value. This is known as a “pump-and-dump” scheme. 

As Stratton Oakmont grew from him and his right-hand-man Danny Porush to an organization of over 1,000 employees, so did the scale of their fraud. 

A prime example of Jordan’s fraud was shown briefly in the film: the Steve Madden initial public offering (IPO). Stratton Oakmont served as the underwriter (financial aid that, among other things, picks the offering price of each security and purchases and sells securities from the company).

Belfort, as the underwriter, was legally unable to own more than 5% of the issuing company. However, through the use of “ratholes,” Jordan managed to own 50% of Steve Madden after the IPO. These “ratholes” were friends and family who owned securities on paper that were, in reality, owned by Belfort. 

After the company went public, Stratton Oakmont performed this “pump-and-dump” method. This scheme made millions of dollars in minutes. 

After everything was said and done, “The Wolf of Wall Street” managed to defraud investors out of over $200 million. Jordan Belfort was arrested on September 2, 1998, served two years in prison, and was ordered to pay $110 million in fines. He still owes an estimated $97 million. 

Enron

Enron was an energy company that demonstrated explosive revenue growth with strong debt ratios in the late 1990s and early 2000s. With strong growth prospects, it quickly gained huge buzz on Wall Street. 

However, all of this turned out to be a fraud, done by “cooking the books,” a term for falsifying financial statements. 

It all began when Enron began utilizing an accounting method called “mark-to-market.” The method allowed them to appraise the value of their contracts constantly, predicting the profits they would bring in. This meant that Enron could use projected income and count it as current income. 

Using this accounting method, they were able to manipulate future forecasts to falsely inflate revenue exceedingly high. 

The false revenues generated, however, also led to confusingly low tax payments for public investors not privy to Enron’s fraud. 

This was shrugged off by management as good accountants decreased their taxes through a variety of methods.  

To hide their debts, Enron used entities not accounted for on the balance sheet. After purchasing countless acquisitions, they began forming special purpose entities (SPEs). 

Using various legal entities, they managed to hide immense portions of their debt and secretly pay large amounts to executives. 

Lastly, they hedged their previously mentioned acquisitions with Enron stock through stock options. The way they hedged this risk assumed it would stay at the new high price, largely driven by their fraudulent balance sheet. 

After allegations of fraudulent accounting began to surface, investors became wary. Stock prices fell, and the hedging based on a high Enron stock price caused a domino effect that ultimately led to the company's collapse.

Accounting malpractice and the countless entities hiding Enron’s debt were uncovered, leading to the incarceration of many of Enron’s executives. Jeffrey Skilling, the former Enron CEO, was sentenced to 24 years in prison.

This clearly demonstrates how basic accounting know-how is essential in finance. 

Bernie Madoff

Bernie Madoff, unlike the other cases, had an extremely lucrative legal business outside of his fraudulent dealings. Whatever led him to do it, he executed the largest Ponzi scheme in history. 

Bernard L. Madoff Investment Securities LLC began in 1960, trading penny stocks with less than $50,000. Madoff was a small fish in a big pond on Wall Street. 

Real money started coming to Madoff once he and his brother started dealing in electronic trading focused on market making. The tech developed was the backbone of the creation of the Nasdaq exchange. 

Madoff even chaired the Nasdaq exchange in the 1990s. Overall, the firm earned around $100 million per year before Madoff claimed the Ponzi scheme began. 

This credible and completely legal venture lent to the credibility Madoff had on Wall Street. So, when his fund offered 10-20% annual returns, investors didn't bat an eye. 

Madoff claimed to be using a method of investment known as a split-strike conversion. 

This is done by owning an underlying asset, purchasing an out-of-the-money put, and decreasing the possible downside while selling an out-of-the-money call to fund the purchase of the put, limiting potential profits should the asset price rise. 

Through executing this strategy on equity indexes, Madoff claimed that he managed to get a return of 10-20% per year. Behind the scenes, however, it was all a lie. 

Madoff's scheme and Ponzi schemes, in general, are very simple. The fund began, and Madoff recruited a few early investors, putting all the money into a bank account. 

The supposed "returns" given to investors were just earlier investments and money from new investors, baited by the steady returns.

This scheme can theoretically go on forever, as long as new investors continue to join and current investors rarely withdraw their money. 

These two conditions held strong, as current investors were content with the strong returns, and new investors were constantly funneled in. According to Madoff, this system worked for 17 years until the stock market crash of 2008, the Great Recession.

When the stock market crash occurred, Madoff's clients wanted to liquidate their positions in the fund, and Madoff couldn't keep up. Bernie confessed to his sons, who promptly turned him in the next day.  

Around half of Bernie's investors managed to turn a profit but were forced to give back a portion of their returns to a fund aimed at paying back Madoff's victims. 

There was an estimated $17.5 billion invested into the fund. Including the false profits invented by Madoff, more than $65 billion was scammed from investors. Bernie was sentenced to 150 years in 2009.

Bernard Madoff passed away due to natural causes at age 82, on April 14, 2021, in Federal Medical Center, Butner.

Raj Rajaratnam

As a hedge fund manager and founder at the Galleon Group, Raj Rajaratnam managed to average a return of 23.25% from the Galleon Diversified Fund.

With over $7 billion under management by Galleon, Raj was doing exceedingly well controlling one of the largest hedge funds in the world. 

Rajaratnam amazed the public, predicting, among others

• The merger of AMD and ATI Technologies 
• Berkshire Hathaway's investment in Goldman Sachs

Galleon stated that their investment edge was merely due to the deep research they performed on all their positions. This, however, was all lies.

The Federal Bureau of Investigation (FBI) began investigating Rajaratnam for insider trading. Raj, however, was prepared. Anticipating an investigation, Raj had insisted his informants speak exclusively over the phone. 

After Galleon turned over 10,000 documents to the FBI, they found some odd instant messages between Raj and "Roomy81," who turned out to be Roomy Kahn, a previous violator of insider trading laws.

After pressure from the FBI, Khan agreed to act as an informant. Khan baited Raj into making incriminating statements over the phone while the FBI listened. The FBI was permitted to wiretap Raj using these conversations.

Ultimately, Raj and over 50 others connected to Galleon's insider trading were caught and arrested. 

The FBI uncovered a vast network, convicting employees from AMD, Intel, IBM, McKinsey, Google, Hilton, Goldman Sachs, and more. These insiders would inform Raj of investment opportunities in exchange for a kickback. 

The fund was closed, and all its directors were sentenced to 2 to 10 years in prison. Overall, Galleon directors were estimated to have generated $72 million from their insider trading. 

Rajaratnam was ultimately sentenced to 11 years in prison, a $10 million fine, and forfeiture of over $53 million in profits. 

Bill Hwang

Bill Hwang is a former employee of Tiger Management, once one of the world's most significant hedge funds. 

After Tiger Management shut down, Hwang started Tiger Asia Management and did very well for himself. Then, he began Archegos Capital Management, a family office.

Family offices manage the assets of a single wealthy family. They are significantly less regulated than a hedge fund, a fact exploited by Hwang in his fraudulent dealings.

Bill Hwang increased his fortune from $1.5 billion to over $35 billion through Archegos Capital Management. 

Hwang's problems began once he started using leverage from banks like Credit Suisse, Goldman Sachs, etc. Using derivative securities, Hwang could hide the true extent of his positions, exploiting the lack of public disclosure required to manipulate some of the world's largest investment banks. 

Hwang was leveraged 5:1 at the collapse of the fund. This means that for every dollar Bill had invested in the fund, 5 dollars were loaned to him from banks on margin, leading to over $100 billion in borrowed funds. 

Through a lack of diversification and heavy leverage, Archegos was open to extreme risk from movement in a small handful of stocks. 

This movement occurred, and Hwang was caught in margin calls, forcing him to close his position. This led to massive drops in the securities Archegos dealt in, causing further closures of their positions due to more margin calls. This domino effect ultimately forced the closure of the firm. 

Bill caused enormous losses for many of the largest banks. For example, the collapse of Archegos cost Credit Suisse $5.5 billion through the leverage they provided and subsequently lost. 

Bill is believed to still have billions in assets. He faces a maximum of 380 years in prison and is currently awaiting sentencing.

Conclusion

These examples have demonstrated that extraordinary returns aren't always the result of exceptional investing expertise. 

Regulatory bodies and watchdog agencies continue to evolve, but so does fraud. 

Something as simple as a Ponzi scheme defrauded present-day investors of billions of dollars. This fact proves that investing is not a perfectly transparent space controlled by omnipotent regulators. 

Cryptocurrency is a prime example of regulation evolving with fraud. 

Cases of "r"g pull" "re increasing. A rug pull occurs when an insider sells off mass quantities of a cryptocurrency, flooding the supply and obliterating value. 

Some predict that cryptocurrencies will be regulated sooncting the cycle of fraud regulation. Fraud is committed, regulators act, and fraud evolves. 

Ultimately, falsely inflated returns will continue to lure in naive investors, and regulators will continue to lag behind the cutting edge of financial crime. 

To avoid losing your money to Wall Street fraud, remember that what appears "too good to be true" might be just that. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Corporate Fraud

• Cost of Debt

• Debt Financing

• Debt Refinancing

• White-Collar Crime