CFE Exam Quiz 07

Most countries have laws that prohibit false statements and other fraudulent activity in connection with securities transactions, and although such laws vary by jurisdiction, most jurisdictions typically define securities fraud violations to include the following elements:
 The defendant made a material misstatement (false statement) or omission.
 The misstatement or omission was in connection with the purchase or sale of a security.
 The defendant acted with a specific intent to defraud.
 The victim relied on the misrepresentation or omission.
 The victim suffered economic loss caused by the misrepresentation or omission.

In basic terms, security is a fungible, negotiable financial instrument that represents an interest or a right in something else. This is a broad definition under which many types of instruments may be classified as securities. The term security, however, is not a straightforward legal concept, and there is no standard definition. Moreover, countries define the term differently; therefore, what has considered security varies from country to country. In addition, countries also vary in their use of the term itself. For example, the U.S. definition of security is substitutable with securities in India and South Africa, investments in the UK, and financial products in Australia. Accordingly, determining whether something is a security can be difficult. Nevertheless, establishing whether a financial instrument is a security is often necessary because once a financial instrument is found to be a security, it will be governed by extensive rules and regulations. (In most cases involving allegations of securities fraud, however, the exact nature of the investment does not need to be determined.) The various definitions for the term security also vary in scope. A narrow construction of the term might provide that security refers only to stocks and bonds, but there are also various
other instruments that may or may not be classified as securities.

Numerous securities fraud schemes involve futures contracts, option contracts, and over-the-counter (OTC) options (i.e., an option that does not trade on a major exchange). Futures and options are the main types of derivative instruments. Derivatives are financial instruments whose value is based on an underlying asset or economic factor. There are two main types of financial markets for derivatives: exchange-traded and over-the counter (OTC). Thus, the contracts traded on these markets derive their values from an underlying asset or economic factor. Futures and options are essentially methods of managing price risk, often called hedging. Futures and options can be used, for example, by farmers or international manufacturing companies as a form of insurance against adverse price or currency exchange rate changes. Many esoteric types of investment vehicles have been created, often using complex mathematical models, and these derivative products allow trading to take place in various indices known as strips, collateralized mortgage obligations, and leaps. Trading derivatives are risky and, consequently, internal controls must be airtight in a firm that engages in hedging or trading activities using exchange-traded or OTC derivatives.

A futures contract, or future, is an agreement between buyers and sellers to make delivery (i.e., sell) or to take delivery of (i.e., buy) a given quantity and quality of a commodity at a specified price and on a specified future date. Often, the underlying asset to a futures contract is commodities, and generally, futures contracts are bought and sold on commodities exchanges, which are similar to stock exchanges in that they function as a central marketplace and provide facilities to buy and sell commodities. A commodity is anything that can be turned to commercial advantage. Goods
commonly sold on the commodities market include such items as soybeans, wheat, corn, pork bellies, rice, gold, and silver. In the commodities market, the basic instrument of exchange is the futures contract. Futures contracts are a valuable tool that certain businesses (e.g., a rancher who is dependent on corn for feeding his cattle) rely on to reduce their exposure to price fluctuations of commodities. Prices of commodities are highly volatile, as they are affected by factors including, but not limited to, weather, industry, economy, employment, technology, and political and global events. Investors, who have no intention of taking delivery of the actual physical commodities, trade-in commodity futures contracts with the goal of profiting from price fluctuations in the underlying commodity. Futures contracts are standardized and contain terms with specifications such as the contract size, delivery months, commodity grade, location of delivery, and so on. Price and quantity are the only things negotiated by the counterparties to a trade. In the United States, agricultural, industrial, and financial futures are traded on organized exchanges known as contract markets.

One of the features of commodity futures markets that make them so liquid and cost-effective is the principle of offset. In a futures contract, the delivery or sale of the product is assumed, and the investor has an obligation to fulfill the contract; therefore, buying or selling a futures contract does not necessarily mean that the investor will accept or make delivery of the actual commodity itself. But the obligation of the buyer (to accept future delivery) and the obligation of the seller (to make future delivery) is not with each other; it is with the central clearing function of the exchange (exchanges may have a separate clearing corporation or the clearing may be a part of the exchange itself). The primary means of fulfilling one’s obligation under a future’s contract is to enter into an off-setting contract. An off-setting contract is one in which a purchase (sale) of futures contracts is liquidated through the sale (purchase) of an equal number of futures contracts with the same delivery month, thus closing out a position. This legally cancels the outstanding obligation. Each futures exchange has its own clearing organization that provides clearing services with
respect to futures contracts. The clearing is the process by which a clearing organization acts as a third-party intermediary to futures contracts and assumes the role of the buyer and seller in such contracts so that it can reconcile the orders between the transacting parties.

Futures are traded on margin, which is the initial amount of money that is invested by both buyers and sellers of futures contracts to ensure performance on the terms of the contract (the making or taking delivery of the commodity or the cancellation of the contract by a subsequent offsetting trade). A margin in futures is not a down payment, as insecurities, but rather a performance bond. A buyer puts up an initial margin at the time a futures market contact is established to act as security for a guarantee of contract fulfillment. Only a small percentage, usually about 5 percent of the contract’s notional value, is required to establish a position (long or short) in a futures market (notional value is the contract size in units
multiplied by the price per unit). Margins are set by the exchange for each commodity and are raised or lowered from time to time to reflect changing market volatility and notional contract values. Brokerage firms mayLaw Securities Fraud requires a greater margin of their customers but may not require less than what the exchange has set. Each exchange will have a margin committee made up of exchange members and support personnel that monitor and evaluates the markets and makes margin changes as appropriate. There are two types of margin: initial margin and maintenance margin. The initial margin is the amount of money per the contract that must be present in the account when the position is initiated. That is, to buy securities on margin, an investor must deposit enough assets with a broker to meet the initial margin requirement for that purchase. The maintenance (variation) margin is the minimum amount of money per the contract that must be maintained in the account while the position is open. That is, the maintenance margin is the amount investors must have in their account to maintain an open position.

1. The responsibilities of the Regulator should be clear and objectively stated.
2. The Regulator should be operationally independent and accountable in the exercise of its functions and powers.
3. The Regulator should have adequate powers, proper resources, and the capacity to perform its functions and exercise its powers.
4. The Regulator should adopt clear and consistent regulatory processes.
5. The staff of the Regulator should observe the highest professional standards, including appropriate standards of confidentiality.
6. The Regulator should have or contribute to a process to monitor, mitigate, and manage systemic risk, appropriate to its mandate.
7. The Regulator should have or contribute to a process to review the perimeter of regulation regularly.
8. The Regulator should seek to ensure that conflicts of interest and misalignment of incentives are avoided, eliminated, disclosed, or otherwise managed

Principles for the Enforcement of Securities Regulation
1. The regulator should have comprehensive inspection, investigation, and surveillance powers.
2. The regulator should have comprehensive enforcement powers.
3. The regulatory system should ensure effective and credible use of inspection, investigation, surveillance, and enforcement powers and implementation of an effective compliance program.

Principles for Cooperation in Regulation
1. The regulator should have authority to share both public and nonpublic information with domestic and foreign counterparts.
2. Regulators should establish information-sharing mechanisms that set out when and how they will share both public and nonpublic information with their domestic and foreign counterparts.
3. The regulatory system should allow for assistance to be provided to foreign regulators who need to make inquiries in the discharge of their functions and exercise of their powers.

Principles for Auditors, Credit Rating Agencies, and Other Information Service Providers
1. Auditors should be subject to adequate levels of oversight.
2. Auditors should be independent of the issuing entity that they audit.
3. Audit standards should be of a high and internationally acceptable quality.
4. Credit rating agencies should be subject to adequate levels of oversight. The regulatory system should ensure that credit rating agencies whose ratings are used for regulatory purposes are subject to registration and ongoing supervision.
5. Other entities that offer investors analytical or evaluative services should be subject to oversight and regulation appropriate to the impact their activities have on the market or the degree to which the regulatory system relies on them.

Principles for Collective Investment Schemes
1. The regulatory system should set standards for the eligibility, governance, organization, and operational conduct of those who wish to market or operate a collective investment scheme.
2. The regulatory system should provide for rules governing the legal form and structure of collective investment schemes and the segregation and protection of client assets.
3. Regulation should require disclosure, as set forth under the principles for issuers, which is necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor’s interest in the scheme.
4. Regulation should ensure that there is a proper and disclosed basis for asset valuation and the pricing and the redemption of units in a collective investment scheme.
28. Regulation should ensure that hedge funds and/or hedge funds managers/advisers are subject to appropriate oversight.

Principles for Market Intermediaries
29. Regulation should provide for minimum entry standards for market intermediaries.
30. There should be initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks that the intermediaries undertake.
31. Market intermediaries should be required to establish an internal function that delivers compliance with standards for internal organization and operational conduct, with the aim of protecting the interests of clients and their assets and ensuring proper management of risk, through which management of the intermediary accepts primary responsibility for these matters.
32. There should be procedures for dealing with the failure of a market intermediary in order to minimize damage and loss to investors and to contain systemic risk.

Principles for the Secondary Market
1. The establishment of trading systems including securities exchanges should be subject to regulatory authorization and oversight.
2. There should be ongoing regulatory supervision of exchanges and trading systems which should aim to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance between the demands of different market participants.
3. Regulation should promote transparency of trading.
4. Regulation should be designed to detect and deter manipulation and other unfair trading practices.
5. Regulation should aim to ensure the proper management of large exposures, default risk, and market disruption.
6. Securities settlement systems and central counterparties should be subject to regulatory and supervisory requirements that are designed to ensure that they are fair, effective, and efficient and that they reduce systemic risk.

ESMA’s role is to provide stability to the EU nations’ financial system by ensuring integrity, transparency, efficiency, investor protection, and orderly functioning of the securities markets. ESMA works toward the goal of a single set of regulations that apply to all EU members, so that buying and selling securities is a more stable and uniform process.
The powers of ESMA include:
 Drafting technical standards that are legally binding on EU members
 Resolving disputes between national securities authorities
 Prohibiting financial products that threaten financial stability
 Performing on-site inspections
 Monitoring systems risk of cross-border financial institutions
 Supervising credit rating agencies
 Entering into administrative agreements with supervisory authorities

As it relates to the financial service provider, professional misconduct refers to acts that go against the profession. By serving as a trusted agent and representative, the financial service provider must, at all times, place the client’s wellbeing ahead of any self-serving interests. Financial service providers are subject to certain standards of conduct, and most aspects of such standards are defined by statute and industry practice. But different jurisdictions apply different standards of conduct, and the standards might also vary depending on the type of financial services being offered by the provider. For example, brokers and investment advisors are generally subject to regulations requiring that they recommend suitable investments. Likewise, registered investment advisors are generally required to act in the best interest of their clients and are prohibited from seeking to advance personal interests to the detriment of their clients. And although not all aspects of professional standards are defined by statute and industry practice, financial service providers are held to a high standard of care.

Key elements of their duties include requirements that they must:
• Comply with industry rules and applicable regulations.
• Be well-informed consultants through continuing education.
• Use reasonable efforts to determine the needs and objectives of their customers.
• Only recommend investments consistent with customers’ objectives and risk tolerance.
• Maintain fairness in transaction costs.
• Provide full disclosure to the relevant aspects of any recommendation.
• Refrain from taking advantage of the clients or firms.
• Be a respected member of the community.

There are several reliable and long-established rules of thumb that can be used to determine if an advisor has violated his professional standard of conduct. Some examples are:
1. For most accounts, a financial advisor’s annual commissions and fees in relation to the assets should be between one and three percent.
2. Portfolio turnover (or the value of the assets bought and sold) in excess of 300 percent justify close examination.
3. Advisors should maintain due-diligence files, records related to client recommendations, and portfolio analyses.
4. Regardless of complexity, advisors should be able to articulate the primary features of any recommendation and should have evidence that they have communicated that to their clients.
5. Firm-sponsored technology, such as client-contact programs, should be regularly used.
6. Advisors should demonstrate an effort to revise client profiles to match any lifestyle changes.

Churning is the excessive trading of a customer account to generate commissions while disregarding the customer’s interests. Specifically, churning occurs when an investment professional excessively trades an account for the purpose of increasing his commissions instead of furthering the customer’s investment goals. For securities and options, commissions are charged when the trade is entered and liquidated. Futures have a round-turn commission scheme, meaning that the commission covers both the purchase and sale. Commissions on futures are not charged until the trade is closed out. To prove that a registered person or entity has engaged in a churning scheme, a complainant must prove the following three elements:
• Trading in the account is excessive in light of the investor’s objectives.
• The broker exercised control over trading in the account.
• The broker acted with intent to defraud or willful disregard for the investor’s interests

When investigating a suspected churning scheme, the fraud examiner should ask the following questions:
• Did the broker have trading authority (discretion) over the account?
• Have gross commissions increased during periods of decreasing market volatility?
• Are the gross commissions for the month in question substantially higher than the average monthly gross commissions for this account?
• Are gross commissions greater than 5 percent of the average account balance?
• Did commissions consume realized profits and/or aggravate losses?
• Were numerous trades entered into and exited over short time periods for small gains or losses?
• Was the trading unit (number of contracts per trade) too large for this account (overtrading)?
• Were the trades made for this account recommended by the research department of the brokerage and disseminated to other customers?
• Did unauthorized trading take place?

In many countries, securities laws and regulations impose a suitability requirement on broker-dealers, which are persons or firms in the business of trading securities. Broker-dealers subject to a suitability requirement is prohibited from recommending investments or investment strategies that are unsuitable for their clients. Thus, making unsuitable recommendations (e.g., recommending high-risk options to a senior citizen with limited assets) is prohibited in countries with such suitability requirements. But typically, a suitability requirement only arises when broker-dealers make recommendations or provide advice to clients to purchase a product. Suitability is a well-established regulatory concept for the financial services industry in many countries. The International Organization of Securities Commissions (IOSCO), which is an international organization comprised of securities commissioners and administrators responsible for securities regulation and the administration of securities laws in their respective countries, has addressed the issue of suitability in a report titled Suitability Requirements with Respect to the Distribution of Complex Financial Products. The report focuses on protecting consumers, and it sets out nine principles, including suitability obligations, to be used by securities regulators in addressing the risks relating to the distribution of financial products whose terms and features are unlikely to be understood by average retail customers.

Money laundering is the disguising of the existence, nature, source, control, beneficial ownership, location, and disposition of property derived from criminal activity. Put differently, money laundering is the process by which criminals attempt to disguise illicit assets as legitimate assets that they have a right to possess and spend. In this context, the term assets assume the wider definition of that which is physical, intangible, or represented in the form of rights or obligations, such as a pension or trust fund. Money laundering operations are designed to take the proceeds of illegal activity, such as profits from drug trafficking, and cause them to appear to come from a legitimate source. Once illegal money has been laundered, the perpetrator is able to spend or invest the illicit income in legitimate assets. Money laundering is a big business, although estimates of how big differ greatly. Because it is illegal and thereby falls outside the realm of official economic statistics, any estimate of global money laundering is derived from a combination of experience, extrapolation, and intuition. The International Monetary Fund (IMF) estimated that the aggregate level of money laundering is between 2 to 5 percent of the world’s gross domestic product,1 which amounts to trillions of dollars. The laundering of money occurs in the context of all forms of illegal activities. Often, criminals seek to launder money by conducting transactions in cash (currency) in such a way as to conceal their true nature. Problems can, however, occur regarding large volumes of cashtransporting it, converting small currency denominations to larger denominations, and converting cash into assets that can be invested or spent.

Placement is the first stage of the money laundering process. In this stage, the launderer introduces his illegal profits into the financial system. It is at this stage that legislation has been developed to prevent launderers from depositing or converting large amounts of cash at financial institutions or taking cash out of the country. Placement can take any number of forms. If the money launderer has a large amount of cash, he can physically move the money to a foreign location or carry it out of the country in a suitcase and deposit it in an offshore bank. Another choice is to structure transactions, where a deposit or other transfer is made using a method that is specifically designed to avoid regulatory reporting requirements or an institution’s internal controls. Many countries require financial institutions to report all currency transactions above a certain threshold (e.g., more than $10,000) to the government. As a result, the most common type of illegal structuring scheme in the money laundering context is smurfing, where the launderer breaks up the illicit money into smaller amounts and deposits it into bank accounts or purchases cashier’s checks, traveler’s checks, or money orders. A red flag of a smurfing scheme is a customer who attempts to make many deposits just under the reporting threshold. Money laundering schemes are most often detected at the placement stage. It is the most dangerous stage for the criminal because the placement process creates a direct connection between the profits and the crime; at this stage, the launderer is still associated with the crime’s physical evidence.

If the placement of the initial funds goes undetected, the launderer can design numerous financial transactions in complex patterns to prevent detection. This stage of the money laundering process is referred to as layering, and it represents the most difficult area of detection. Once the funds have been deposited into a financial institution, a launderer can move them around by using layers of financial transactions designed to confuse the audit trail. The money can even be transported out of the country. Often, launderers take advantage of jurisdictions known for their lack of cooperation with foreign courts, investigators, and law enforcement agencies. If a launderer moves funds through several such jurisdictions, tracing the final destination can be burdensome. Historically, layering primarily involved smuggling cash or running funds through traditional financial institutions, both domestic and foreign. While these practices are still very common, several types of transactions outside of traditional institutions are increasing in volumes, such as alternative remittance systems, trade-based laundering, and digital currencies.

Integration is the final stage in the laundering process. In this stage, the money is integrated back into the economy in a way that makes it appear to be part of a legitimate business transaction. This stage of the process is also difficult to detect; however, if the integration process creates a paper trail—such as deeds for real estate, invoices, loan documents, transaction reports at financial institutions, or checks—and if there is cooperation from informants or foreign entities, then the chances of detection are improved. A money-laundering scheme cannot be successful until the paper trail is eliminated or made so complex that the flow of illegal income cannot be easily traced. The number of steps used to launder funds depends on how much distance the money launderer wishes to put between the illegally earned cash and the laundered asset into which it is converted. A greater number of steps increases the complexity of tracing the funds, but it also increases the length of the paper trail and the chance that the transaction will be reported. The objective of money laundering is not only to disguise the source of illegal funds but also to convert large stores of currency into other assets. In some cases, illegal funds are spent on personal assets, such as homes, cars, jewelry, and furniture. But the typical money launderer will not dispose of all his illegal currency in this manner; he will want to have a certain amount of liquid reserves for spending. Keeping large bundles of cash is inefficient because they are difficult to hide and transport. Therefore, money launderers will often convert substantial portions of their currency into negotiable instruments such as cashier’s checks and money orders, which are routinely issued by financial institutions. Criminals prefer these negotiable instruments for two reasons. First, cashier’s checks and money orders are bearer instruments, and the holder can use them or deposit them without having to prove the source of the funds. Second, they are “liquid” assets because the holder can use them immediately.
The following is an example of how a large money-laundering scheme operated in the United States.

Open-loop items are the most versatile form of prepaid item, meaning the funds on these items can be used for any type of purchase where the seller accepts that type of payment. For instance, prepaid debit cards are generally open-loop items and can be used virtually anywhere credit cards are accepted. They are usually associated with a credit card company (e.g., MasterCard or Visa) to facilitate the transaction. And with many open-loop items, users can withdraw cash from ATM machines around the world. While in some ways they function similarly to checking accounts, open-loop items do not allow for negative balances; the user can only spend the amount on the card. Additionally, the user information that the issuer of the prepaid card collects is usually less than what a bank would collect for a person opening a checking or savings account. The prepaid issuers usually charge the user for each transaction, issue charges gradually over time, or institute some other type of fee. While not as common as prepaid debit cards, other items could be considered open loop if they allow for “paid” funds to be withdrawn. For instance, mobile phone accounts that allow for withdrawal and transfer can be open-loop.

Mobile payments, also known as mobile banking, involve using an account associated with a mobile phone—as opposed to cash, credit cards, and debit cards—to facilitate transactions. Similar to the way in which credit and debit cards significantly cut into the use of checks and cash for consumer transactions, mobile payments are likely to grow in popularity. As compared to other transaction methods, mobile payments are vulnerable to money
laundering schemes in a few key ways. For one thing, given that mobile payments are still in the process of growing and developing definitions, regulations are not as sophisticated or complete as they are for older payment systems. Also, many developing countries lack functional AML and anti-terrorism laws, making mobile payments outside of the jurisdiction even more difficult to prevent and trace. Also, a user can send mobile payments to almost anywhere in the world, making them a tool that launderers often use to move funds to foreign jurisdictions. In addition, the use of prepaid phones causes substantial money laundering issues because the owner of a prepaid phone can be virtually anonymous. Prepaid phones can be purchased
for cash, and the user typically does not need to provide personal information to open or add funds to an account associated with the phone. Anonymity is a strong attraction for launderers because it helps to obscure the paper/digital trail leading back to them.

In response to market demand, online payment services, which accept funds in a variety of ways to transfer payment either to an individual or a merchant, are emerging. In addition, the increasing demand for new payment methods has led a growing number of online markets to embrace online payment systems, which set their own clearing and settlement terms and offer no consumer protection or financial regulation. Since most transactions through these service providers are considered final and provide no recourse to individuals who believe they have been defrauded, law enforcement agencies suggest that they have become a popular payment system for individuals perpetrating online fraud. Digital currencies are a type of online payment method that has emerged as a money laundering concern. Broadly defined, digital currencies are currencies that exist and are traded in a digital format. The term typically excludes government-backed currencies, despite the fact that they can also exist and be traded digitally. Digital currencies can come in several forms and can have limited or broad uses. Among the most popular digital currencies is Bitcoin, which features a peer-to-peer network that allows users to send units of the currency to each other online without the use of a traditional financial institution. Digital currencies are often vulnerable to money laundering because many of them function as international person-to-person payment systems, which cross jurisdictional boundaries, creating difficulties for authorities pursuing enforcement or legal actions. As is typical with developing payment systems, digital currencies face less strict regulations than payments made through traditional financial institutions. Furthermore, many service providers who
exchange or otherwise deal with digital currencies do not have effective customer identification or recordkeeping practices, while others actively promote anonymously payments.

After the rise in popularity of Bitcoin, many similar alternative digital currencies also began to appear. Many have different features, so the money laundering potential varies between them. Generally, digital currencies give parties the ability to:
• Send and accept payments from any user in the world with an Internet connection for little or no transaction fee.
• Send or accept payments without the need for any identifying information (other than the users’ randomly-generated “addresses”).
• Conduct transactions in unlimited volume (assuming funds are available).
• Conduct transactions anonymously (there are investigative techniques to identify parties to digital currency transactions, but a sophisticated user
could make the process very difficult).
• Confirm transactions within minutes or less.

Virtual assets are similar to digital currencies but are generally intangible assets tied to a particular service or online community. For instance, a gambling website might offer its own mock-currency, or an online game might distribute virtual assets that users can purchase. Often, virtual assets gain value outside of their original context (i.e., they gain “real world” value) because they are scarce and can be sold to other people through online markets. The laundering process using virtual assets often resembles some variation of the following:
1. Illicit assets are used to purchase virtual currency or items from third parties. Alternatively, a criminal organization hires people to gather virtual resources themselves.
2. If the virtual assets are bought from third parties, the seller transfers the virtual items to an account controlled by the criminal.
3. The criminal could either sell the virtual assets himself for actual money or give the virtual account information to another criminal as a means of transferring the value.

Bulk-cash smuggling, which is the smuggling of cash out of the country where it was earned for deposit in foreign jurisdictions with lax financial institutions or to fund criminal enterprises, is also on the rise. The rise in bulk-cash smuggling is due to the increasingly effective antimoney laundering policies and procedures at financial institutions. In typical bulk-cash smuggling operations, smugglers hide cash in vehicles, luggage, express packages, commercial shipments, private aircraft, or private boats. For example, in 2012, an investigation into a major international bank, HSBC, revealed that criminals were using the bank to funnel large amounts of cash through its branches in Mexico. Much of this currency originated in the United States as drug proceeds before being smuggled into Mexico. An AML official of the bank estimated that at one point as much as 70 percent of the illicit currency deposited in financial institutions in Mexico was going through HSBC.