THE FREE RIDE: BUYING SECURITIES WITH NO MONEY DOWN

The following is an excerpt from the SEC website: “Washington, D.C., Oct. 26, 2011 – The Securities and Exchange Commission today charged a pair of purported money managers with orchestrating an illegal “free-riding” scheme of selling stocks before they paid for them and netting $600,000 in illicit profits. The SEC alleges that Florida residents Scott Kupersmith and Frederick Chelly portrayed themselves to broker-dealers as money managers for hedge funds or private investors, and they opened brokerage accounts in the names of purported investment funds they created. Kupersmith and Chelly then engaged in illegal free-riding by interchangeably buying and selling the same quantity of the same stock in different accounts – frequently on the same day – with the intention of profiting on swings up or down in the stock price. Unbeknownst to broker-dealers, Kupersmith and Chelly did not have sufficient securities or cash on hand to cover the trades, and they instead used proceeds from stock sales in one brokerage account to pay for the purchase of the same stock in another brokerage account. The SEC alleges that when trades were profitable, Kupersmith and Chelly took the profits. But when the trades threatened to result in substantial losses, Kupersmith and Chelly failed to cover their sales and left broker-dealers to settle the trades at a significant loss. In total, their brokers suffered more than $2 million in losing trades. “Kupersmith and Chelly engaged in a classic ‘heads I win, tails you lose’ scheme to trade risk-free at the expense of broker-dealers,” said George S. Canellos, Director of the SEC’s New York Regional Office. “The SEC is firmly committed to pursuing individuals who fraudulently game the system thinking that they will never be caught.” According to the SEC’s complaint filed in U.S. District Court in New Jersey, Kupersmith and Chelly traded through a special type of cash account that broker-dealers offer to customers with the understanding that the customer has sufficient securities and cash held with a third-party custodial bank to cover the trades that the customer makes in the account. Kupersmith and Chelly never disclosed to broker-dealers that they were instead using proceeds from sales of shares in one brokerage account to pay for their purchase in another brokerage account. Kupersmith and Chelly also used offshore accounts to facilitate their trading activity. According to the SEC’s complaint, the free-riding scheme occurred in 2009 and 2010, and unraveled when Kupersmith and Chelly failed to deliver shares to settle long sales in various brokerage accounts. The SEC’s complaint charges Kupersmith and Chelly with violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act, and Rules 10b-5 and 10b-21 thereunder. The complaint seeks a final judgment permanently enjoining the defendants from future violations of these provisions of the federal securities laws and ordering them to disgorge their ill-gotten gains plus prejudgment interest and pay financial penalties. In parallel actions, the U.S. Attorney’s Office for the District of New Jersey and the Manhattan District Attorney’s Office today announced the unsealing of criminal charges against Kupersmith. The SEC’s investigation was conducted by Stephanie D. Shuler, Vincenzo A. DeLeo, and Peter Lamore of the SEC’s New York Regional Office. The SEC acknowledges the assistance of the U.S. Attorney’s Office for the District of New Jersey, Federal Bureau of Investigation, and Manhattan District Attorney’s Office. The SEC’s investigation is continuing.” The above free-riding activity looks like it might be fraud however, it is easy to make a mistake and get a free-ride notice from your broker or the Federal Reserve. When you are suffering significant losses on a stock that is headed into oblivion it makes it hard not to hit the sell button without doing the proper calculations to make sure the stock has been paid for. Of course opening up a margin account or using only settled funds are two easy ways to avoid being accused of violating free ride restrictions."