The Pioneers of Financial Fraud

Financial fraud dates back to the year 300 B.C. when a Greek merchant named Hegestratos took out a large insurance policy known as bottomry. The merchant borrowed money and agreed to pay it back with interest when the cargo—in this case, corn—was delivered. If the merchant refused to pay back the loan, the lender could claim the cargo and the boat used for its transportation. Hegestratos planned to sink his empty boat, keep the loan, and sell the corn. The plan failed, and he drowned trying to escape his crew and passengers when they caught him in the act.

This is the first recorded incident of financial fraud, and there have been many since. This article will focus on the growth of stock market fraud in the U.S., as tracked by a quartet of scandals—all of them devious schemes based on greed and a desire for power.

The First Insider Trading Scandal

In 1792, only a few years after the U.S. officially became independent, the nation experienced its first fraud. At this time, American bonds were similar to developing-world issues or junk bonds today—they fluctuated in value with every bit of news about the fortunes of the colonies that issued them. The trick of investing in such a volatile market was to be a step ahead of the news that would push a bond's value up or down.

Alexander Hamilton, Secretary of the Treasury, began to restructure American finance by replacing outstanding bonds from various colonies with bonds from the new central government. Consequently, big bond investors sought out people who had access to the Treasury to find out which bond issues Hamilton was going to replace.

William Duer, a member of President George Washington's inner circle and assistant secretary of the Treasury, was ideally placed to profit from insider information. Duer was privy to all the Treasury's actions and would tip off his friends and trade in his own portfolio before leaking select information to the public that he knew would drive up prices. Then Duer would simply sell for an easy profit. After years of this type of manipulation, even raiding Treasury funds to make larger bets, Duer left his post but kept his inside contacts. He continued to invest his own money as well as that of other investors in both debt issues and the stocks of banks popping up nationwide.

With all the European and domestic money chasing bonds, however, there was a speculative glut as issuers rushed to cash in. Rather than stepping back from the overheating market, Duer was counting on his information edge to keep ahead. He piled his ill-gotten gains and that of his investors into the market. Duer also borrowed heavily to further leverage his bond bets.

It all came out—and came crashing down—eventually; Duer and a lot of other New Yorkers were left hanging onto worthless investments and huge debts. Hamilton had to rescue the market by buying up bonds and acting as a lender of last resort

The Aftermath

William Duer ended up in debtor's prison, where he died in 1799. The Financial Panic of 1792 was, interestingly enough, the catalyst for the Buttonwood Agreement, which marked the beginnings of the Wall Street investment community and the New York Stock Exchange.

Fraud Wipes out a President

Ulysses S. Grant, a renowned Civil War hero and U.S. president, only wanted to help his son succeed in business, but he ended up creating a financial panic.

Grant's son, Buck, had already failed at several businesses but was determined to succeed on Wall Street. Buck formed a partnership with Ferdinand Ward, an unscrupulous man who was only interested in the legitimacy gained from the Grant name. The two opened up a firm called Grant & Ward. Ward immediately sought capital from investors, falsely claiming that the former president had agreed to help them land lucrative government contracts. Ward then used this cash to speculate on the market. Sadly, Ward was not as gifted at speculating as he was at talking, and he lost heavily.

Of the funds Ward squandered, $600,000 was tied to the Marine National Bank, and soon both the bank and Grant & Ward were on the verge of collapse. Ward convinced Buck to ask his father for more money. Grant Sr., already heavily invested in the firm, was unable to come up with enough funds and was forced to ask for a $150,000 personal loan from William Vanderbilt.

Ward essentially took the money and ran, leaving the Grants, Marine National Bank, and the investors holding the bag. Marine National Bank collapsed after a bank run, and its fall helped touch off the panic of 1884.

The Aftermath

Grant Sr. paid off his debt to Vanderbilt with all his personal effects including his uniforms, swords, medals, and other memorabilia from the war. Ward was eventually caught and imprisoned for six years.

The Pioneering Daniel Drew

The second half of the 19th century saw men such as Jay Gould, James Fisk, Russell Sage, Edward Henry Harriman, and J.P. Morgan turn the fledgling stock market into their personal playground, and their maneuvers weren't always the most honorable. However, Daniel Drew was a true pioneer of fraud and stock market manipulation.

Drew started out in cattle, bringing the term "watered stock" to our vocabulary—watered stock are shares issued at a much greater value than its underlying assets, usually as part of a scheme to defraud investors. Drew later became a financier when the portfolio of loans he provided to fellow cattlemen gave him the capital to start buying large positions in transportation stocks.

Drew lived in a time before disclosure when only the most basic regulations existed. His technique was known as a corner. He would buy up all of a company's stocks, then spread false news about the company to drive the price down. This would encourage traders to sell the stock short. Unlike today, it was possible to sell short many times the actual stock outstanding.

When the time came to cover their short positions, traders would find out that the only person holding stock was Daniel Drew and he expected a high premium. Drew's success with corners led to new operations. Drew often traded wholly owned stocks between himself and other manipulators at higher and higher prices. When this action caught the attention of other traders, the group would dump the stock back on the market.

The danger of Drew's combined poop and scoop and pump and dump schemes lay in taking a short position. In 1864, Drew was trapped in a corner of his own by Vanderbilt. Drew was trying to short a company that Vanderbilt was simultaneously trying to acquire. Drew shorted heavily, but Vanderbilt had purchased all the shares. Consequently, Drew had to cover his position at a premium paid directly to Vanderbilt.

Drew and Vanderbilt battled again in 1866 over a railroad, but this time Drew was much wiser, or at least much more corrupt. As Vanderbilt tried to buy up one of Drew's railroads, Drew printed more and more illegal shares. Vanderbilt followed his previous strategy and used his war chest to buy up the additional shares. This left Drew running from the law for watering stock and left Vanderbilt cash poor.

The Aftermath

The two combatants came to an uneasy truce: Drew's fellow manipulators, Fisk and Gould, were angered by the truce and conspired to ruin Drew. He died broke in 1879.

The Stock Pools

Until the 1920s, most market frauds affected only the few Americans who were investing. When it was confined largely to battles between wealthy manipulators, the government felt no need to step in.

After World War I, however, average Americans discovered the stock market. To take advantage of the influx of eager new money, manipulators teamed up to create stock pools. Basically, stock pools carried out Daniel Drew-style manipulation on a larger scale. With more investors involved, the profits from manipulating stocks were enough to convince the management of the companies being targeted to participate. The stock pools became very powerful, manipulating even large-cap stocks such as Chrysler, RCA, and Standard Oil.

Prices continued to spiral upward. Eventually, though, a sense that the market was overvalued began to spread—and investors began to sell. The inflated share prices collapsed, and as the panic spread, the entire stock market crashed in 1929.

The Aftermath

Both the general public and the government were staggered by the level of corruption that had contributed to the financial catastrophe. It's possible that the news released in October 1929 that the public utility holding companies would be regulated was the actual trigger of the crash. Stock pools took the lion's share of the blame, leading to the creation of the Securities and Exchange Commission.

The Bottom Line

With the creation of the SEC, market rules were formalized and stock fraud was defined. Common manipulation practices were outlawed as was the large trade in insider information. Wall Street would no longer be the Wild West where gunslingers like Drew and Vanderbilt met for showdowns. That isn't to say that the pump and dump or insider trading has disappeared. In the SEC era, investors still get taken in by fraud, but legal protection do now exist giving investors some recourse.