How to spot a wolf

With the recent Australian release of The Wolf of Wall Street, starring Leonardo Di Caprio, many people have been left pondering exactly how he ripped people off and what he did that was illegal?

The movie - based on the book of the same name - by one-time star trader Jordan Belfort, shows just how rapacious brokers and traders can become in a bull market. While the tale is historic – and expressly specific to Wall Street – it does provide an insight into the worst excesses the global stockmarket can unleash.

What is clear in the movie is that Belfort and his circle made a lot of money via commissions, yet this was not necessarily illegal in its own right. 

The art of stockbroking

In order to grasp this concept, it is important to realise that a stockbroker’s role is typically nothing more than a middle-man for individuals (and other entities) to find/buy “cheap” stocks then sell them for a profit. The typical way American stockbrokers get paid is via a commission, which these days range between 0.5% and 1% for every transaction to buy or sell; usually with a minimum fee of around $50. This fee structure leaves some stockbrokers prone to hawking on uneducated individuals, because they can convince them to buy and sell regularly.

Financial advisors on the other hand tend to charge approximately 1% per year of an individual’s assets. The general idea behind this is that an “expert” will be able to gain at least 1% more than an individual could, and in theory this aligns both peoples interests because the greater the assets grow the more the advisor earns.

How ‘the Wolf’ did it

Belfort was a born salesman. He started out preying on uneducated individuals and allegedly collected up to 50% commission on “pink sheets*” which are companies that are listed for the first time on the U.S. stock exchange (an Initial Public Offering or IPO). This wasn’t exactly standard practice, but it wasn’t uncommon in the 1990s.

Where the Wolf went wrong is that his company Stratton Oakmont did it via market manipulation. We thought that Ronald L. Rubin explained this best, as he was an investigator for the SEC at the time and was involved in the conviction of Belfort’s associate Steve Madden.

Here’s Rubin’s version of The Wolf’s 5 steps to ‘success’

1. Create IPO stock: The first thing Stratton Oakmont needed was a business to sell, and the definition of "business" was very flexible. A judo school, a bagel maker, a newfangled water purifier, or a recovering alcoholic selling shoes out of the trunk of his car would do. What was needed was not so much an actual business as a business entity with a story that could be converted into publicly traded shares of stock through a Stratton initial public offering. An important element of the scheme was that the Stratton IPO stock was not really sold to the public—it was sold to Stratton.

Securities laws forbid underwriters like Stratton from buying more than a small percentage of the IPO stock they issue. To avoid this roadblock, Stratton sold all of its IPO stock to friends (nicknamed "flippers") like Madden, who immediately sold the stock back to Stratton for a small profit. The IPO stock was usually issued to the flippers at $4 per share, and then sold back to Stratton for $4.25 per share. This was a pretty nice deal for the flippers, who could pocket $50,000 or so from an IPO without breaking a sweat or risking a loss.

2. Line up the victims: Suckers aren't born, they're trained. Stratton Oakmont's salesmen would first gain the confidence of investors by letting them make a small profit on one or two Stratton IPOs. Once trust had been established, the Stratton salesmen would inform these customers that a really hot IPO was coming soon with a $4 issue price.

Like all Stratton IPOs, the stock's price was expected to take off when it began trading in the aftermarket. An excited customer with $100,000 of savings might authorize the Stratton salesman to buy 25,000 shares of the IPO stock, and then transfer the $100,000 to his Stratton account. By totalling up all such commitments, Jordan Belfort knew exactly how much buying power Stratton's customers had.

3. Bait and switch: Shortly before an IPO, the Stratton salesmen would call these customers and inform them that the IPO was so hot that the salesmen could offer only a (very) few shares at the $4 IPO price. However, the salesmen could create purchase orders to be executed as soon as the stock began trading on the open market. Many customers assumed that such orders would result in stock purchases near the $4 issue price, so they simply agreed. Some balked at giving the salesmen permission to invest their money without knowing the purchase price, or simply refused to buy stock in the aftermarket.

This was when the boiler-room hard sell depicted on screen began. The pressure on customers could be overwhelming, especially since they had already agreed to buy the same stock at the issue price: "What do you mean you don't have the money to invest in this stock? You already gave me $100,000 to buy it at $4 per share!" "I made money for you before, and now you don't trust me?" "I'm never going to let you in on another IPO if you back out on me now!"

The Stratton brokers could have just placed orders in these customers' accounts without their permission, but they rarely did. Unauthorized orders were more likely to trigger complaints to regulators, and the move would have violated some unofficial boiler-room code of honor. These guys took pride in their ability to talk suckers into parting with their life savings.

4. Market manipulation: Stratton Oakmont could have made millions of dollars just by selling its customers stock in nearly worthless companies for $4 per share, but after a couple of such IPOs, investors and regulators would have caught on. Instead, Jordan Belfort used the stock market to camouflage his theft.

Let's say that one million shares of the IPO stock had been issued, and Stratton's customers had committed to buying $12 million of the stock in the aftermarket. Belfort would therefore want the stock price to rise from $4 to $12 per share before selling it to them. Having bought all of the IPO stock back from the flippers, Belfort and Porush could make the stock trade in the aftermarket at any price. The simplest way to do so was to buy and sell shares between Stratton accounts at increasing prices, but that would have been too obvious. The same result could be accomplished by having friends buy small amounts of stock using "market orders," which buy shares at the lowest price offered from any seller. The only seller was Stratton Oakmont.

As soon as aftermarket trading commenced on IPO day, the friends of Belfort and another associate Danny Porush started placing these small market orders. Stratton would simultaneously sell its stock using "limit orders," which offer stock for sale only above a specified minimum price. After each sale, Stratton would place another (sell) limit order with a slightly increased minimum price, and the friends' market orders would execute at each higher price.

What the market recorded was a steady progression of trades at $4.25, $4.50, $4.75, all the way up to the $12 target price. The run-up from $4 to $12 could be accomplished in minutes. This was a common first-day trading pattern for legitimate hot IPO stocks during the 1990s, so the manipulation wasn't obvious.

5. Sell high and shut the door: When the IPO stock price hit the $12 target, Stratton executed its customers' buy orders. This was the payoff moment when Stratton got the victims' money and the movie's over-the-top partying began.

Had customers holding the inflated stock tried to resell it quickly on the market, they would have found almost no real buyers, and the stock price would have plummeted about as quickly as it had risen. Such an early price crash was rare for legitimate IPO stocks and would have attracted regulatory scrutiny and scared away future Stratton victims. So Stratton made a practice of supporting the high price for a while—usually about a month—by buying any of its IPO stock offered for sale on the market.

But letting customers sell their stock for $12 while Stratton Oakmont was the main buyer would defeat the entire purpose of the scheme.

The victims had to be discouraged from selling too soon. Stratton brokers could usually do so by heaping more hyperbole onto investors who called to place sell orders. (Stratton operated before Internet self-service brokers like E-Trade enabled most investors to place their own orders).

When customers couldn't be talked into holding on to their stock, their sell orders would usually just be lost and their phone calls ignored. When the sell orders were finally executed, there would be few buyers, the stock would crash, and the customers would be wiped out. By that time Belfort had the next IPO ready and was lining up new lambs for the slaughter.

* The extract above is a direct and extensive quote from Ronald L. Rubin, who is a partner at Hunton and Williams LLP. The full article was first published in the Wall Street Journal.

Cheats rarely win

Jordan Belfort spent 22 months in prison, which was seemingly short given the extent of his crimes. He got away with such a small sentence because he and his partner Danny Porush cut deals with the Government to unveil the other criminals; their “flippers” and friends involved. In fact, Steve Madden (as a flipper) eventually spent more time in prison than Jordan Belfort, with a 30 month sentence and lost his position as the CEO of his own company.

What to look out for

These days, the Regulators have a much better idea on spotting illegal activity; although they are much better at preventing old schemes than identifying new ones. In Australia, the primary regulators (ASIC) seem to be doing an excellent job and have employed “shadow shoppers” over recent years to help identify crooks. These shadow shoppers tend to get financial advice from unguarded industry practitioners and secretly report everything back to the regulators. This allows ASIC to get behind the scenes and find out if any manipulation tactics are at play. In Australia, we are also in the late stages of banning many commissions via “FOFA regulations” (the future of financial advice), although the practicalities are controversial.

It is never a straight forward conclusion, but the industry is cleaning up its name one year at a time. In the meantime, the Wolf continues to give motivational speeches around the globe whilst teaching his sales tactics.

This article was first published in the investment newspaper, Mr-Market. Scott Dixon is the founder and chief editor.

* An earlier version of this article referred to the use of pink slips. The correct term is pink sheets.