CFE Exam Quiz 05

After the commencement of an insolvency proceeding, transactions by the debtor that are not consistent with the debtor’s ordinary course of business or engaged in as part of an approved administration should be avoided (canceled), with narrow exceptions protecting parties who lacked notice. Certain transactions prior to the application for or the date of commencement of the insolvency proceeding should be avoidable (cancellable), including fraudulent and preferential transfers made when the enterprise was insolvent or that rendered the enterprise insolvent. The suspect period, during which payments are presumed to be preferential and may be set aside, should be reasonably short in respect to general creditors to avoid disrupting normal commercial and credit relations, but maybe longer in the case of gifts or where the person receiving the transfer is closely related to the debtor or its owners.

The system should ensure that:
1. Criteria as to who may be an insolvency representative should be objective, clearly established, and publicly available.
2. Insolvency representatives are competent to undertake the work to which they are appointed and to exercise the powers given to them.
3. Insolvency representatives act with integrity, impartiality, and independence.
4. Insolvency representatives, were acting as managers, be held to director and officer standards of accountability and be subject to removal for incompetence, negligence, fraud, or other wrongful conduct.

Strong institutions and regulations are crucial to an effective insolvency system. The institutional framework has three main elements:
1. The institutions responsible for insolvency proceedings
2. The operational system through which cases and decisions are processed
3. The requirements needed to preserve the integrity of those institutions

Transparency and good corporate governances are the cornerstones of a strong lending system and the corporate sector. Transparency exists when information is assembled and made readily available to other parties and when combined with the good behavior of “corporate citizens,” creates an informed and communicative environment conducive to greater cooperation among all parties. Transparency and corporate governance are especially important in emerging markets, which are more sensitive to volatility from external factors. Without transparency, there is a greater likelihood that loan pricing will not reflect underlying risks, leading to higher interest rates and other charges.

A predictable, reliable legal framework and judicial process are needed to implement reforms, ensure fair treatment of all parties, and deter unacceptable practices. Corporate laws and regulations should guide the conduct of the borrower’s shareholders. A corporation’s board of directors should be responsible, accountable, and independent of management, subject to best practices on corporate governance. The law should be imposed impartially and consistently. Creditor rights and insolvency systems interact with and are affected by these additional systems, and are most effective when good practices are adopted in other relevant parts of the legal system, especially the commercial law. Investment in emerging markets is discouraged by the lack of well-defined and predictable risk allocation rules and by the inconsistent application of written laws. Moreover, during systemic crises, investors often demand uncertainty risk premiums too onerous to permit markets to clear. Some investors may avoid emerging markets entirely despite expected returns that far outweigh known risks. Rational lenders will demand risk premiums to compensate for systemic uncertainty in making, managing and collecting investments in emerging markets.

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:
1. The defendant made a material misstatement (false statement) or omission.
2. The misstatement or omission was in connection with the purchase or sale of a security.
3. The defendant acted with a specific intent to defraud.
4. The victim relied on the misrepresentation or omission.
5. The victim suffered economic loss caused by the misrepresentation or omission.

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.

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. That is, the clearing organization matches futures transactions and becomes a counterparty to both sides of the trade, eliminating counterparty credit risk by guarantying both sides of the transaction. As a result, traders can liquidate their positions (obligations) by merely executing an equal and opposite offsetting transaction (selling out a long position or buying back a short one). Clearing also transfers funds between transacting parties when futures trades are marked to market at the end of each day.

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 may require 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. For example, a December corn contract had a closing price of $2.84 1/4 per bushel. The notional value of this contract is $14,212 (5,000 bushels x $2.84 1/4). The initial margin requirement is $810 per contract, which is 5.69 percent of the notional contract value, while the maintenance margin is set at $625 per contract, which is 4.39 percent of the notional contract value. Positions can be liquidated without customer authorization in accounts that violate margin requirements.

Options (or options contracts) are like futures contracts, but unlike futures, options do not impose obligations on the buyer and seller to make or take physical delivery of the commodity. An option contract confers a right—not an obligation—to the option buyer to take delivery of (i.e., buy) the underlying asset and imposes obligations on the option seller. Options can be traded on exchanges, over-the-counter (OTC), between individual business entities, or between individuals. Options contracts have widespread appeal and application, and they are used and abused. Businesses and individuals commonly use options in real estate, personal property, and interest rate transactions. The main difference between options contracts and futures contracts is that options confer rights and impose obligations, whereas futures impose obligations. More specifically, an option contract confers a right—not an obligation—to the option buyer to take delivery of (i.e., buy) the underlying asset and imposes obligations on the option seller. Futures impose obligations on both the buyer and the seller to either make or take physical delivery of the commodity or to agree to cash settlement at contract expiration. If an option is not exercised, it expires unexercised (most exchange-traded options expire worthlessly). In contrast, if a commodity contract is held to expiration, the investor who has a long position takes delivery of the commodity, and the investor in the short position makes delivery.

In options transactions, the seller of a call option is the call writer, while the seller of the put option is the put writer. Option buyers pay a premium to option writers for the options they buy. Option writers (sellers) collect this premium for the options they write and are obligated
to deliver the underlying security if the option is exercised. Options come in various styles such as:
1. Plain vanilla option: This is the most standard version of an option. Plain vanilla options have simple expiration dates and strike prices and no additional features.
2. Exotic option: This option has more complex features than plain vanilla.
3. American option: This option may be exercised on any trading day on or before expiration.
4. European option: This option may only be exercised on expiration.

Again, options can be traded over-the-counter. A security that does not trade on a major exchange is said to trade over-the-counter (OTC). Unlike the floor trading in physical exchanges, OTC trading is conducted electronically, through direct contact with a market maker, or through communication among professional buyers and sellers. Banks, large brokerage firms, insurance companies, and many other businesses are active in the OTC options markets. OTC options are not centrally cleared or standardized. These options are usually customized by the option writer to fit the needs of the option buyer. Because OTC options are not centrally cleared, counterparty credit risk can be a major concern and risk factor. The option is worthless if the option writer cannot perform. OTC options can be plain vanilla or exotic. When traded OTC, exotic forms can be problematic for market participants, accountants, and auditors, but such problems are beyond the scope of this writing.

In many countries, such as in the United States, the term security includes investment contracts. The leading global definition of investment contract parallels the Howey test established by the U.S. Supreme Court, and it provides that a contract, transaction, or scheme is an investment contract if all of the following four elements are met:
• There is an investment of money or other assets.
• The investment is in a common enterprise. In very general terms, the common enterprise requirement means the success of the investor is dependent on the efforts and success of those seeking the investment of third parties (typically the promoter). The third-party, who provides the entrepreneurial skill, shares in the profits (or losses) with the investor.
• The investment was made with expectations of making a profit. Profit is generally defined as either money received for the use of capital or capital appreciation.
• The profits are to come solely from the efforts of people other than the investor. To qualify as a security under this definition of an investment contract, the essential managerial efforts, which affect the success or failure of the enterprise, must come from someone other than the investor. As a general rule, the more actively involved an investor is in the enterprise, the less likely it is that an investment contract will be found to exist. Thus, if the investor’s efforts are significant to the enterprise’s success, an investment contract will not be found to exist.

Ponzi schemes refer to illegal operations that use financial instruments of some sort to extract money from victims, and these schemes constitute securities fraud. In countries like the United States, in which the term security includes investment contracts, Ponzi schemes fall under securities laws and regulations because they qualify as investment contracts. A Ponzi scheme is generally defined as an illegal business practice in which new investors’money is used to make payments to earlier investors. In a Ponzi scheme, there are few or no actual investments being made, just funds passing up a ladder. The term Ponzi scheme is named after Charles Ponzi who, in the early 1920s, persuaded tens of thousands of Bostonians to invest over $10 million. He created an entity, aptly named the Securities and Exchange Company, and issued investors a promissory note guaranteeing a 50 percent return in 90 days on every $1,000 invested.

An illegal pyramid is a scheme in which a buyer or participant is promised payment for each additional buyer or participant he recruits. Typically, these schemes involve a strategy whereby the fees or dues a member pays to join the organization are paid to another member, and in many cases, these schemes contain a provision for increasing membership through a process of new members bringing in other new members. In these schemes, the members make money not by earning a commission on the bonafide retail sale of a legitimate product, but by recruiting new people. Illegal pyramids pay participants commissions for recruiting new members and the schemes generate revenue by recruiting new members. Illegal pyramids have unsustainable organizational structures that, like Ponzi schemes, rely on bringing in new people. Although illegal pyramid schemes are fraudulent, not all pyramid schemes are investment contracts.

Prime-bank note schemes involve the issuance and purported trading of so-called prime banknotes or other high-yield investment opportunities. In these schemes, investors are often told that they can obtain returns exceeding several hundred percents per year when their funds are placed in an offshore trading program. These programs are generally characterized by a number of factors. They are often excessively complex and secret. Investors are usually told that the investment opportunity is only available to a select few and the signing of nondisclosure agreements is mandatory. Typically, the explanation of how the program actually works is full of obscure terminology, and it makes reference to legitimate banks or organizations, such as the International Monetary Fund (IMF), to lend credibility. Often, to promote these schemes, investors are told that there is little or no risk of losing their principal. While prime-bank note schemes were once an effective type of fraud, these schemes have died out for three key reasons. First, consumers are better informed. Second, investigative agencies have effectively prosecuted these schemes. Third, fraudsters have moved on to faster and more productive opportunities to commit fraud.

Insurance companies have historically offered policies with an accelerated death benefit option. This option allows the insured to receive up to 80 percent of the death benefit or face value of the policy within the last year of the insured’s projected life. The remaining 20 percent is paid upon death to the insured’s estate. In a viatical settlement, a terminally-ill policyholder sells the death benefit under his insurance policy at a discount to a third party. In this type of settlement, the owner of the insurance policy receives cash, and the buyer becomes the new owner, or beneficiary, of the life insurance policy. The new owner pays all future premiums on the policy and receives the entire death benefit upon the insured’s death. If the new owner does not pay the insurance premiums, the insurance policy will be voided, and the end payment will not be paid out. Moreover, in a viatical settlement, the third party who purchases the policy can resell the policy—along with the insured’s medical and personal history.

A partnership is a business structure that is used to separate a business from its owners. According to Barron’s Dictionary of Finance and Investment Terms, a partnership is a “contract between two or more people in a joint business who agree to pool their funds and talent and share in the profits and losses of the enterprise.” Put differently, a partnership is an association of two or more persons acting as co-owners in a business for profit. There are various partnership forms, including general partnerships and limited partnerships. General partnerships are associations of two or more persons acting as co-owners in a business for profit. In a general partnership, each general partner can incur obligations on behalf of the partnership, and each partner assumes unlimited liability for the partnership’s debts. Thus, a general partner has unlimited personal liability. Also, in a general partnership, the partners take an active role in the operation of the business (i.e., they have management responsibilities). Typically, however, general partnerships are not considered securities because the profits derived from such structures are generated from the efforts of the investors, not from the efforts of others. Thus, because the partners take an active role in the operations of general partnerships, these arrangements do not qualify as securities.

The following types of misrepresentations and omissions are often encountered in these investments:
• Inflated drilling and completion costs: Costs are often inflated to bilk the investor.
• Invalid lease: Promoters frequently do not have a valid mineral rights lease—a lease conveying property rights to exploit an area for the minerals it holds.
• Misinformation on discovery and production potential: The investor might be misled regarding the likelihood of striking oil, gas, or mineral deposit and the amount produced. This information is usually contained in the geologist’s report.
• Exaggeration about the wells: The promoter might exaggerate the number and depth of wells, thus inflating the operating costs paid by investors.
• Self-dealing: Often, promoters of such interests engage in self-dealing. The promoter might, for example, declare a good well dry to reap the benefits of a productive well later when the investors have given up.
• Dry holes: Often, the promoter completes dry holes—wells drilled for oil or gas but yielding none—solely to improve his completion record and collect completion funds from investors.
• Disproportionate royalties: Insiders might be assigned the majority of royalties while investors receive only a small portion.
• An unreasonable number of partners: Promoters are likely to oversell the well (e.g., 99/64ths).

In general, hedge funds refer to private pooled investment vehicles managed by advisors who generally have a very large financial interest in the funds based on a management fee that includes a percentage of the fund’s performance. Put differently, hedge funds pool investors’ money and invest it in financial instruments with the goal of earning a positive return. Hedge funds employ various speculative and aggressive strategies. For example, they often combine traditional investments with short sales, leveraging, and arbitrage strategies to maximize returns. In addition, hedge funds are often complex and lack transparency, and they are not as heavily regulated as other types of funds. Certain factors make hedge funds vulnerable to fraud. For one thing, hedge funds have become an increasingly popular form of investment, causing some managers to become more aggressive and less meticulous in their transactions. For another thing, hedge fund managers typically charge a performance fee of 20 percent of a hedge fund’s profits, on top of an asset management fee of 1 to 2 percent of assets managed. Such lofty fees can motivate hedge fund managers to take greater risks with the hope of generating greater returns.

Typical hedge fund frauds committed by hedge fund managers include:
 Theft of investor assets
 Late trading
 Insider trading
 Overvaluation of portfolios
 Entering into inappropriate timing arrangements
 The exploitation of mutual fund investors for private gain
 Entering into inappropriate arrangements with mutual fund advisors in which the mutual fund advisors waive restrictions on market timing in exchange for placement of other assets by the hedge fund advisor in funds managed by a mutual fund advisor
 Conspiring with intermediaries to identify hedge funds from mutual fund personnel.

Some red flags of improper hedge fund activities include:
 The fund’s manager is resistant to due diligence or is resistant to provide the information necessary to conduct due diligence.
 The fund’s manager is not willing to provide information upfront, including verification of employee date of births, Social Security numbers, employment history, education, professional licensing, professional credentials, corporate affiliations, and so on.
 The fund’s manager is not willing to provide a signed release to allow the investigator to perform thorough checks.
 The fund’s structure is not appropriate.
 The fund does not have verifiable and reputable independent service providers (e.g., independent accountants, attorneys, fund administrators, and prime brokers).
 The fund or its key employees have criminal records and civil litigation issues.
 There are misrepresentations (e.g., misrepresentations of education, employment history, or professional credentials).
 The fund has omitted significant background information (e.g., prior employment, employment terminations, or prior fund closures).
 The fund has experienced relevant or repeated regulatory issues.
 The fund lacks independent or experienced service providers.

A promissory note is a contract in which one party (the maker or issuer) makes an unconditional promise in writing to pay a sum of money to the other party (the payee), under specific terms, at a stated time or on-demand of the payee. Promissory notes are a securities Fraud Law 2.422 2017 Fraud Examiners Manual (International) form of debt similar to loans or IOUs, and they are investments that typically involve investors loaning money to a company in exchange for a fixed return over a stated period. Private companies issue promissory notes to raise money and finance some aspect of their
business, from launching new products to repaying expensive debt. In return for the loan, companies agree to pay investors a fixed return over a stated period. A promissory note may be security but determining whether a promissory note actually is a security can be difficult. Under certain circumstances, promissory notes are not held to be securities. A note is presumed to be secure unless it bears a strong resemblance to a category of instruments that are not securities. Generally, longer-term commercial paper is similar in many respects to a bond and may be held to be secure unless it relates to such transactions as consumer finance or residential mortgages. For example, in the case of a residential mortgage, the note signed is simply a promise to repay, not a method to raise capital for some business venture. To determine if a note is a security, it is often helpful to apply the resemblance test and look at three things: motive and expectation, plan of distribution, and regulation.

Securities regulation refers to laws, rules, and procedures enacted by a legislative body and administered by dedicated agencies that govern the way in which companies, consumers, and financial professionals behave when trading securities. Securities regulation serves several purposes, the primary one being to balance the legitimate needs of businesses to raise capital against the need to protect investors. Other purposes served by securities regulation include:
1. Fostering an active and competitive market
2. Maintaining market confidence
3. Reducing financial crime
4. Protecting investors
5 Discouraging behavior that might harm the market

A securities exchange (or stock exchange) is a market in which stocks, bonds, and other securities are traded. Securities exchanges host markets where securities are traded. That is, a securities exchange is a market that provides services for brokers and traders to buy and sell stocks, bonds, and other securities. Securities exchanges do not buy or sell securities; they simply provide the location and services for brokers who buy and sell securities. Securities exchanges provide many essential functions. They provide a mechanism for private enterprises to raise investment funds, supply investors with a forum to liquidate their holdings, help in the valuation of securities, and serve as indicators of economic trends. Securities exchanges are largely self-regulatory, which means that they regulate themselves. That is, self-regulatory exchanges exercise some degree of authority to create and enforce industry regulations and standards in the markets they organize. Although exchanges have regulatory authority, they are also regulated entities to the extent that they are subject to national control and supervision. To trade a security on a certain exchange, the security must be listed in the exchange, and securities must meet an exchange’s requirements to be listed and traded there.

Although securities are regulated on a national level, there are also numerous international bodies involved in the regulation or governance of international securities trading. The most important of these is the Basel Committee on Banking Supervision (Basel Committee), the International Organization of Securities Commissions (IOSCO), and the International Accounting Standards Board (IASB). Other international securities regulatory organizations include:
• The International Securities Association for Institutional Trade Communication (ISITC)
• The International Capital Market Association (ICMA)
• The World Federation of Exchanges (WFE)
• The International Councils of Securities Associations (ICSA)
• International Swaps and Derivatives Association (ISDA)
• The European Securities and Markets Authority

The Basel Committee on Banking Supervision (Basel Committee) provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Basel Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements—statutory or otherwise—that are best suited to their own national systems. In this way, the committee encourages convergence toward common approaches and common standards without attempting detailed harmonization of member countries’ supervisory techniques. For more information on the Basel Committee, see the “Financial Institution Fraud” chapter in the Financial Transactions and Fraud Schemes section of the Fraud Examiners Manual.

IOSCO’s main objective is to assist its members to:
 Cooperate to promote high standards of regulation in order to maintain just, efficient, and sound markets.
 Exchange information on their respective experiences in order to promote the development of domestic markets.
 Unite their efforts to establish standards and effective surveillance of international securities transactions.
 Provide mutual assistance to promote the integrity of the markets through a rigorous application of the standards and effective enforcement against offenses.

Investors should be protected from misleading, manipulative, or fraudulent practices, including insider trading, front running or trading ahead of customers, and the misuse of client assets. Full disclosure of information material to investors’ decisions is the most important means for ensuring investor protection. Investors are, therefore, better able to assess the potential risks and rewards of their investments and, as a result, to protect their own interests. As key components of disclosure requirements, accounting and auditing standards should be in place and they should be of a high and internationally acceptable quality. Only duly licensed or authorized persons should be permitted to hold themselves out to the public as providing investment services, for example, as market intermediaries or the operators of exchanges. Initial and ongoing capital requirements imposed upon those license holders and authorized persons should be designed to achieve an environment in which a securities firm can meet the current demands of its counterparties and, if necessary, wind down its business without loss to its customers.

Although regulators cannot be expected to prevent the financial failure of market intermediaries, regulation should aim to reduce the risk of failure (including through capital and internal control requirements). Where financial failure nonetheless does occur, regulation should seek to reduce the impact of that failure, and, in particular, attempt to isolate the risk to the failing institution. Market intermediaries should, therefore, be subject to adequate and ongoing capital and other prudential requirements. If necessary, an intermediary should be able to wind down its business without loss to its customers and counterparties or systemic damage. Risk-taking is essential to an active market, and regulation should not unnecessarily stifle legitimate risk-taking. Instead, regulators should promote and allow for the effective management of risk and ensure that capital and other prudential requirements are sufficient to address appropriate risk-taking, allow the absorption of some losses, and check excessive risk taking. An efficient and accurate clearing and settlement process that is properly supervised and uses effective risk management tools is essential. There must be effective and legally secure arrangements for default handling. This is a matter that extends beyond securities law to the insolvency provisions of a jurisdiction. Instability may result from events in another jurisdiction or occur across several jurisdictions, so regulators’ responses to market disruptions should seek to facilitate stability domestically and globally through cooperation and information sharing.