So Easy, Even a Baby Can Do It (Or How to Insider Trade Using Junior’s E-Trade Account)


Today I’m proud to introduce you to the work of Dr. Paul Koch, an esteemed finance professor at my current school, the University of Kansas (Go Jayhawks!).

For those unfamiliar with Professor Koch’s work, he’s been a pioneer in the area of data-based examination of insider trading in various financial markets. Fascinating stuff, and I highly recommend taking the time to read and absorb his work:

Most recently, Prof. Koch is receiving attention for an article in the Journal of Finance that he co-authored with researchers from the University of Auckland and the University of Sydney. Harvard Law School and numerous other academic outlets are recognizing the article both for it’s clarity and it’s significant findings.

Essentially, Prof. Koch and his collaborators reviewed a very large, 15-year dataset of underage account holders in a large stock market clearinghouse entity. With typical academic understatement, the authors titled their paper “Informed Trading Through the Accounts of Children.”

In a nutshell, the data revealed a significant outperformance of the market as a whole by the accounts held in the names of children, particularly prior to market-moving events related to the stocks held in those accounts – as much as nine basis points in some instances. As the article notes:

We find that underaged accountholders exhibit superior stock-picking skills on both the buy side and the sell side over the days immediately following trades. They significantly outperform older investors by an average of 9 basis points (bp) based on all trades made one day earlier, by 7 bp based on trades two days earlier, by another 5 bp for trades three days earlier, and by an average of 2 bp per day for previous trades made over days -4 through –10.

Since this outperformance is especially evident for short horizons, it likely stems from superior private information that is about to become public. (boldface emphasis added by me). We explore this possibility, and find that underaged accountholders perform extremely well when they trade just before major information events. For example, on the day before major earnings announcements, young accountholders trade in the correct direction 57% of the time and outperform older investors by an average cumulative abnormal return on days 0 and +1 (CAR(0,+1)) of 1.1%. Likewise, one day ahead of large price changes, young accounts trade in the correct direction 58% of the time and outperform older investors by an average CAR(0,+1) of 2.1%. Finally, on the day before takeover announcements, their proportion of correct trades is 72% and their mean outperformance is a CAR(0,+1) of more than 12%.”

Quite simply, savvy insiders use their children’s accounts to insider trade and (illegally) reap the monetary rewards associated with the information disequilibrium they posses. It is common knowledge in the financial universe that most regulatory agencies can barely analyze the data on registered insiders, let alone their relatives, friends, and other associated individuals. Prof. Koch clearly proves that insider trading is easy and relatively risk-free, as long as you don’t trade under your own name.

Once again, the weasels win, and everyone else loses, and unless governments get serious about increasing scrutiny and oversight of these enormously complex financial markets, the general public can expect inferior financial returns and higher costs. As easy as taking candy from a baby indeed…

The One Where I Find Myself in a Vegas Casino With Andy Fastow…

As I noted in my previous post, me and my lovely and talented better half  traveled to Las Vegas for the 2013 annual convention of the Association of Certified Fraud Examiners. The ACFE is an excellent organization with a plethora of colorful characters as members, including Mr. Harry Markopolous, the dogged investigator who repeatedly and stridently warned the federal Securities and Exchange Commission about a little Ponzi scheme he uncovered. There are many other distinguished members of the ACFE, and if you live in the audit or accounting universe, I highly recommend membership.

Among the usual academic and professional highlights (new investigative techniques & technologies, legislative changes, etc.) were a couple of emerging themes:

1) Cloud computing is not only here to stay, it is RAPIDLY supplanting in-house storage and processing for a majority of entities across the public-private institutional spectrum. Investigators, auditors, and legal staff take note – you’re going to be asking for subpoenas for Amazon/Rackspace servers and personal cell phones and computers a LOT more frequently in the coming years.

2) The nascent recovery from the Great Recession has done little to reduce the overall incidence of fraud. White-collar crime is just too easy to commit for international criminal syndicates, and continuing economic weakness in the US and the EU creates perfect conditions for fraud losses.

One of the most fascinating aspects of the ACFE convention is their annual tradition of inviting a convicted “fraudster” to speak to the general assembly, which numbered over 2,600 this year.¹ Usually the speaker is a mid-level management employee who, while providing valuable psychological insights into the fraud mindset, is relatively anonymous to the general public. Not so this year, however. Our closing keynote speaker was none other than Andrew Fastow, the former CFO of Enron.

In case you aren’t aware, Fastow, along with other Enron Principals such as Kenneth Lay and Jeffrey Skilling, conspired to commit among the most extensive (and expensive) corporate frauds in history. The breathtaking scope and complexity of their various fraudulent activities was directly responsible for the passage of the federal anti-fraud legislation known as Sarbanes-Oxley, and was an unfortunate harbinger of even greater corporate frauds in the decade following the spectacular implosion of Enron in 2001-2002. Fastow was charged with conspiracy, wire fraud, securities fraud, false statements, insider trading, and money laundering. He served six years in federal prison, followed by two years of probation.²

I was keenly interested in not only what Fastow had to say, but how he would be received by such an obviously adversarial audience. 2,600 fraud investigators is a pretty tough room if you’re a convicted con man. I expected to see the smooth-talking, self-assured corporate executive that dominated the Greek tragedy that unfolded across the global media a decade ago. The man who took the podium was anything but a swaggering master-of-the-universe, though. Fastow is 51 now but looks older, and among his first statements after being greeted by polite applause was how very nervous he was being in front of us. He was clearly jittery and appeared unsure of how he would be received.

Of course, he then did the only intelligent thing one could do in front of such an audience – admitted full guilt. He didn’t prevaricate or attempt to divert culpability. He said simply, “I was guilty of the crimes for which I was charged, and I’m immeasurably sorry for my actions. I am very aware of the lives I destroyed and the chaos I caused, and I understand why people hate me.”

As he delivered his prepared remarks, he repeatedly made a point of stating that his actions at Enron were illegal and inexcusable, but he continues to be greatly troubled by what he perceives as a continuing culture of criminality within corporate America. For example, he said that he knew his use of off-balance sheet entities was wrong, even though it was approved by Enron’s attorneys, accountants, auditors, and corporate board. Despite the Enron example, the use of off-balance sheet accounting remains pervasive. Fastow noted that United Airlines, for example, keeps over half of it’s aircraft inventory in off-balance sheet entities in order to make its financial position appear far more solvent than it is. He says that corporate boards are asleep or willfully ignorant of the risks being taken, particularly in the financial sector. He cited the Bear Stearns, Lehman Brothers, Washington Mutual-era of the financial crisis as potent examples of what happens when an organization tries to conceal it’s true financial position from stakeholders.  He also said that what he knows of the Dodd-Frank regulation process is not encouraging, and that industry lobbyists continue to successfully weaken the legislation’s mechanisms for fraud detection, deterrence, and prosecution.

Finally, and most surprisingly to me, Fastow took questions submitted from the audience. Perhaps the most news-worthy moment was when he answered the first submitted question about his thoughts on the recent reduction of former Enron CEO Jeffrey Skilling’s prison sentence from 22 years to about 14 years. He talked about how prison time is brutal, that there is no “Club Fed,” and that he hoped that Skilling would be able to function in society after his release. He then went on an extended dialogue about how difficult it was for him to have to have his kids visit him in prison, how frightened he was in prison, and how he has a morning ritual each day that includes looking at his prison ID card as a reminder of everything he’s done and the lives he’s damaged and destroyed. It was sobering and worrisome, and an excellent way to end the conference. CNBC covered the conference and published an  article focusing on Fastow’s speech:

¹ The ACFE does not compensate convicted fraudsters, which one thinks is probably a good thing.

² For the (in my opinion) definitive account of the Enron debacle, I recommend The Smartest Guys in the Room, by Bethany McLean & Peter Elkind,

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