Technology has long been utilized by those interested in committing frauds. However, in more recent times, the very use of technology has become a means and instrumentality for the actual fraud and other illegal activity itself. Over the last decade, the government has, essentially, “woken up” and increased its own technological capabilities to keep pace with these criminal enterprises.
Although in other areas, recent news reports implicating the National Security Agency in monitoring the email activity of private citizens1 and the Department of Homeland Security’s increased use of facial scanning software2 have demonstrated that the U.S. government and its agencies will employ sophisticated means and take action it deems necessary to combat illegal activity. At the same time—and somewhat ironically—the government is criticized for its apparent unwillingness—or inability—to combat other illegal activity such as securities fraud and other related types of economic fraud that resulted from the economic implosion beginning in 2008.3 In fact, many commentators point out the lack of prosecutions for failures in accounting control and bank fraud.4 Further, from a public perspective, the government always appears to be a step behind in prosecuting complex investment vehicles such as hedge funds and trading platforms for anything other than insider trading.5 Consequently, we are still left faced with the appalling questions regarding if the government lags behind in technology to these would-be fraudsters, and, if so, is the government even close.
This article discusses the impact of the complex technology used in the financial world, the manner it may be used to run afoul of securities and other laws, as well as the government’s development of tools to address the situation.
How Technology Is Exploited to Further Fraud
Initially, it is important to understand that technology and social media are the means and instrumentalities of a significant portion of economic crime in the United States and abroad. The use of such technology in these criminal schemes may be simple or exceedingly complex.
For example, the U.S. Attorney’s Office for the Southern District of New York recently announced the arrest of certain individuals who were allegedly involved in a penny stock fraud scheme that swindled investors in 35 countries out of more than $140 million.6 The indictment alleged that the accused promoted certain stocks in emails, social media messages and news releases—hardly the stuff of science fiction. For its part, the government was able to use traditional means such as wiretaps and video surveillance to uncover the alleged pump and dump scheme.7
That the scam was uncovered is not surprising. The Federal Bureau of Investigation (FBI) reportedly had agents on Twitter and other social media sites, such as Facebook, trolling for tips that may constitute insider trading. Despite these successes, the FBI, however, is quick to point out the difficulty in predicting the next wave of securities fraud, suggesting advances in technology and social media will be critical in its future enforcement efforts.8 In particular, an FBI agent reportedly told Reuters TV in an interview for the Reuters Investment Outlook 2013 Summit that, in terms of the future of criminal fraud, “…technology will play a huge part, social media, Twitter. Any kind of technology that is new and doesn’t exist today, if there is any way to exploit it, these individuals will exploit it.”9
Additionally, FBI Director Robert Mueller noted that the FBI had a 49 percent increase in corporate and securities fraud cases since September 2008, when Lehman Brothers Holdings Inc. filed for bankruptcy. Mueller also testified that the FBI was investigating more than 2,600 fraud cases by the end of 2011.10 The FBI has responded to this challenging environment by adding teams of accountants, financial analysts and special agents headquartered in Washington, D.C., to analyze financial data and staff complex investigations as needed. For example, the FBI used these special agents in the recent Libor investigation.11
Beyond the world of social media lies the more complex issues related to automated trading in the financial markets. In 1998, after the U.S. Securities and Exchange Commission (SEC) authorized the first electronic exchanges, computer trading programs have become commonplace.12 As a result, the vast majority of all trades in the United States occur by way of computers using complicated algorithms to buy and sell stocks in nanoseconds, making oversight extremely difficult. These computer programs are designed to trade staggering amounts of stocks, bonds and other financial instruments at extreme speeds. Further, the programs take advantage of second-to-second fractional price shifts and market trends, providing new meaning to the concept of arbitrage.13
As the technology continues to develop, oversight becomes increasingly more difficult. A recent article in Wired magazine stated that one new computer chip built specifically for high-frequency trading will create a trade in .000000074 seconds, and there is a proposed $300 million transatlantic cable being built to shave 0.006 seconds off transaction times between New York and London.14
Interviewed in CNET magazine, James Arlen, a principal and information security consultant at a company known as Push the Stack Consulting, pointed out that an unfair market advantage may be created by introducing some weaknesses into a competitor’s computer system.15 Arlen stated that, concerning the complexity of the financial markets:
It’s highly likely or statistically likely that someone is abusing a market somewhere in the world. Will they be caught at any time in the short term? Probably not. That level of complexity makes it really hard to point a finger. This is going to be hard to find in the real world.16
Government Strikes Back With New Rules
On May 6, 2010, the Dow Jones stock index fell more than 600 points in six minutes. Despite the famous stock market crashes of the last two centuries, the May 6, 2010, fall marked the deepest single-day decline in modern Wall Street’s history. Within 20 minutes of the initial crash, however, the index rebounded. The event became known as the “Flash Crash.” Although others have suggested different alternatives, it is believed that automated trading contributed significantly to the crash.17
In response to the “Flash Crash,” the SEC voted unanimously to adopt new rules for large traders such as banks and hedge funds. Initially, SEC Rule 13h-1 requires that broker-dealers record and monitor activity by large traders associated with their firms, and report the activity to the SEC via the Electronic Blue Sheet system. SEC Rule 13h-1 defines large traders as persons who exercise investment discretion and transact certain significant, aggregate volumes or values in National Market System securities. The new rules will now require “large traders” to identify themselves to the SEC, and then be assigned a unique identification number. These traders will then provide this number to their broker-dealers, who will be forced to maintain the transaction records—so the SEC may later track this activity. A “large trader” is defined as a person or company whose transactions in exchange-listed securities exceed two million shares, $20 million on any day, 20 million shares or $200 million per month.
Additionally, in July 2011, the SEC announced that “May 6 dramatically demonstrated the need to enhance the SEC’s ability to quickly and accurately analyze market events. The large trader reporting rule will significantly bolster our ability to oversee the U.S. securities markets in a time when trades can be transacted in milliseconds or faster.” Further, the SEC also announced, “[t]his new rule will enable us to promptly and efficiently identify significant market participants and collect data on their trading activity so that we can reconstruct market events, conduct investigations, and bring enforcement actions as appropriate.”
Other regulations were also enacted. Regulators adopted rules effectively prohibiting broker dealers from providing customers with unfiltered access to exchanges and other trading systems.18 Further, the exchanges and the Financial Industry Regulatory Authority (FINRA) are now required to pause trading in certain stocks listed on the S&P 500 or Russell 1000 if the price moves 10 percent or more in a five minute period. Let us also not forget the new requirements mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. This legislation dictated that the SEC was to require hedge fund managers with assets under management of more than $150 million or with more than 15 U.S.-based clients to register with the SEC.
In sum, these new regulations were adopted to both monitor and control the activities of certain market participants that the regulators perceive as, most likely, to perpetrate fraudulent acts.
RoboCop: How Government Uses Technology
Monitoring Facebook and implementing new securities regulations may be one method to combat fraud, but the government may not expect to track all possible illegal activity with its existing technology. Nonetheless, the government is quite serious about using more advanced tools to stay ahead of potential fraud issues.
Recently, the SEC announced that it has developed a software package that will stream real-time trade data from the exchanges into the Commission’s headquarters. The Commission purchased the program from a New Jersey firm called Tradeworx.19 The program is based on a model that the SEC has used to evaluate hedge fund returns and identify fraud, mostly noting if performance was inconsistent with a fund’s investment strategy. The program trawls for data from nearly 9,000 publicly traded companies, and the SEC has, according to The Washington Post, brought seven cases based upon information culled from this software since 2011.20
Moreover, pursuant to the Sarbanes-Oxley Act of 2002, the SEC must examine the financial filings from public companies every three years. Companies are now required to file those forms in a digital format with computer-readable tags easing the search for the SEC as well as the comparison of data. The new software searches for unusual accounting situations based upon various risk factors, such as frequent changes in auditors or delays in the release of earnings.21
The SEC also created an Office of Quantitative Research to develop “custom analytics intended to inform monitoring programs across the SEC.” The SEC also has another computer program that is used by this office called the Accounting Quality Model (AQM), known by some as “RoboCop.” The SEC stated that the RoboCop program is “being designed to provide a set of quantitative analytics that may be used across the SEC to assess the degree that registrants’ financial statements appear anomalous.”22
The SEC claims that this new software “extends the traditional approach by allowing discretionary accrual factors to be a part of the estimation.”23 The SEC claims that it will take filing “information across all registrants and estimate total accruals as a function of a large set of factors that are proxies for discretionary and non-discretionary components.”24 The SEC will then break the information into “two groups: factors that indicate earnings management or factors that induce earnings management. Discretionary accruals are calculated from the model estimates and then used to screen firms that appear to be managing earnings most aggressively….”25
The SEC also described some of the factors the SEC will account for as identifying outlier discretionary accruals. The SEC characterized “discretionary accruals as different types of risk indicators and risk inducers. Risk indicators are factors that are directly associated with earnings management while risk inducers are factors that are associated with strong firm incentives to manage earnings….”26 The SEC noted that “although the vast majority of ???rms use off-balance sheet ???nancing for legitimate business purposes, many of the largest accounting scandals used off-balance sheet activities to hide poor ???nancial performance.”27 The SEC also indicated that it will analyze filings data with comparable filings from peer companies, in particular, for changes in auditors or delays in the release of filings, believing “these risk indicators could be consistently estimated from filings data and compared to peers.”28
The SEC, thus, uses the fraud-detection software to seek out discrepancies between net income and actual cash outflows available to investors, and other warning signs, such as declining market share or weak profitability compared with the companies’ corporate rivals. The system also looks for companies with an unusually high number of off-balance sheet transactions. Essentially, if the companies fit the mold of Enron and other large accounting frauds where debt was hidden and artificially inflated earnings were utilized, the SEC will be there.29
Additionally, RoboCop is a fully automated system. Within 24 hours from the time a filing is posted to EDGAR, it is processed by the AQM and the results are stored in a database. The AQM produces a risk score informing the SEC staff auditors of the likelihood that a filing is fraudulent. The SEC then uses this score to prioritize its investigations and concentrate review efforts on portions of the report, most likely, to contain fraudulent information.30 The SEC has also said it plans to use the results as a means of corroborating the approximately 30,000 tips, complaints and referral submissions it estimates that will be received each year through its Electronic Data Collection Systems or completed Forms TCR.31
The FBI, in the meantime, is using advanced forensic linguistic software developed in conjunction with Ernst & Young to ferret out fraud in email traffic. Phrases such as “nobody will find out,” “cover up,” and “off the books” are, apparently, among those most likely to raise the government’s eyebrows. Such expressions as “special fees” and “friendly payments” as well as employees writing that they “want no part of this” are likely to end up in the government’s crosshairs.32 According to research by Ernst & Young, more than 3,000 such words and phrases used in email conversations among employees engaged in corporate wrongdoing have been identified through specialized anti-fraud technology. “The language, which is a mix of accounting phrases, personal motivations and attempts to conceal, are very revealing,” Ernst & Young’s director of fraud investigation and disputes services has said.33
In short, this new technology is being used by the government to detect fraudulent activity at its inception.
Back to the Future
Although technology may have, initially, outpaced government investigations into economic fraud, the government appears to have caught up in its willingness to invest in new technologies and to regulate an ever-expanding and complex economic universe. Such efforts may reap benefits and give pause to future fraudsters.
Daniel A. Schnapp and Ernest E. Badway are partners at Fox Rothschild in New York, and can be reached at firstname.lastname@example.org and email@example.com.
4. Financial Crisis Leads to Fewer Accounting Control Fraud Prosecutions, Steve Andersen, Inside Counsel: The National Underwriter Company, March 28, 2011.
8. The Globe and Mail, Matthew Goldstein and Jennifer Ablan Published Monday, Nov. 26, 2012.