Chapter 17: Exercises — Financial Misinformation and Market Manipulation

Part A: Conceptual and Analytical Exercises

Exercise 1: Spectrum Classification

For each of the following statements made by corporate executives or promoters, classify them on the financial misinformation spectrum (legitimate spin / puffery / misleading but true / material omission / outright fraud) and briefly justify your classification:

a) "We are well-positioned for strong growth in the coming year." (Said by a CEO whose company is quietly drawing down a credit line to meet payroll.)

b) "Our average customer returns 15% annually." (True on a simple average basis, but the median customer return is -3%, and several months of data were excluded from the calculation.)

c) "This investment has never had a losing year." (The fund was created two years ago during a bull market; the promoter does not mention the fund's age.)

d) "Our revenues grew 40% last quarter." (Accurate; but 35 percentage points of that growth came from a one-time asset sale that is not identified as such in the press release.)

e) "We have strong demand from institutional partners." (False; no institutional partners exist. The speaker knows this.)

Exercise 2: South Sea Bubble Information Analysis

Research the South Sea Company's 1720 collapse (primary sources are available through historical archives; the Bank of England's economic history resources provide accessible summaries).

a) Identify three specific types of information manipulation used by South Sea Company directors to maintain investor confidence as the scheme progressed.

b) The Bubble Act of 1720 was enacted in the immediate aftermath. Evaluate its design: did it address the actual mechanisms of the fraud, or did it target something else?

c) Draw parallels between the South Sea Company's information strategy and a modern financial fraud of your choosing.

Exercise 3: Ponzi Scheme Identification

The following five "investments" are described in summary form. For each, identify which characteristics of Ponzi schemes are present and calculate what you would need to verify to confirm or rule out fraud:

a) A fund claiming 12% annual returns, consistent and unvarying for 15 years, across all market conditions including 2008 and 2020.

b) A cryptocurrency lending platform offering 18% annual yield on stablecoin deposits, described as being generated by "algorithmic arbitrage strategies."

c) A real estate investment trust (REIT) that has paid consistent dividends for 20 years, with independently audited financials showing rental income sufficient to cover distributions.

d) A private fund that accepts only referral-based investors, maintains offshore accounts, and has never provided audited financials to investors, citing "proprietary strategy protection."

e) An investment club that has generated 8% annual returns over 10 years through documented stock purchases, with transaction records available for member review.

Exercise 4: Pump-and-Dump Pattern Recognition

The following is a price and volume dataset for a fictional company, "NovaTech Inc." (ticker: NVTC). Analyze the data and answer the questions below.

a) Identify the specific weeks that correspond to each phase of the pump-and-dump scheme (accumulation, pump, dump, collapse).

b) What additional data would you want to obtain to establish whether this was actually a pump-and-dump rather than a legitimate run-up and correction?

c) The press release in Week 7 announces a "major partnership." What steps would you take to verify whether this partnership is real?

d) If you were an SEC investigator, what records would you subpoena and in what order?

Exercise 5: Enron's Off-Balance-Sheet Structures

Enron used Special Purpose Entities (SPEs) to remove liabilities from its balance sheet. This exercise requires you to understand the basic mechanics.

a) Explain, in plain language, how an entity can technically be "independent" from a parent company for accounting purposes while still being economically controlled by that parent.

b) Enron's SPEs had names like "Raptor I," "Chewco," and "LJM." Research the basic structure of the Chewco SPE. What accounting rules was it designed to exploit, and what was the actual economic relationship to Enron?

c) Sarbanes-Oxley (2002) required disclosure of off-balance-sheet arrangements. Evaluate whether this requirement adequately addresses the informational problems Enron exploited.

Exercise 6: GameStop Short Interest Analysis

At its peak, GameStop's short interest exceeded 140% of its float. This exercise explores the mechanics.

a) Explain how short interest can exceed 100% of a company's float. What sequence of borrowing and lending transactions makes this possible?

b) If a stock has 10 million shares in its float and 14 million shares sold short, and the price increases from $20 to $100, what is the total mark-to-market loss for all short sellers? (Assume all shorts were established at $20.)

c) Keith Gill (Roaring Kitty) made his investment thesis public on Reddit before buying and disclosed his position throughout. Does this transparency matter legally? Does it matter ethically? Are these the same question?

d) The SEC's staff report concluded that the GameStop price increase was driven more by retail buying than by a "gamma squeeze." Explain what a gamma squeeze is and why the distinction matters for regulatory analysis.

Exercise 7: Cryptocurrency Red Flag Assessment

For each of the following cryptocurrency projects (based on composite real-world characteristics), identify the specific red flags present and rate overall fraud risk (Low / Medium / High / Very High):

a) A token launched by anonymous developers, with a white paper describing a "revolutionary consensus mechanism" that uses vague technical terminology. The project has a celebrity Twitter endorsement. The smart contract code is not publicly audited. Early investors receive 60% of the token supply.

b) A DeFi protocol with published, audited smart contracts, a doxxed (publicly identified) development team, clear documentation of the yield mechanism (transaction fees from a real exchange), and a bug bounty program. Annual yield is approximately 6%.

c) A "stablecoin" that maintains its dollar peg through an algorithmic mechanism involving a governance token. The protocol offers 20% annual yield on stablecoin deposits. The white paper does not explain what happens to the peg mechanism if governance token value declines.

d) A cryptocurrency fund that accepts only wire transfers, is registered in the Cayman Islands, and claims returns of 3x annual market performance through "proprietary AI trading." The fund manager has no verifiable professional background.

Exercise 8: Finfluencer Disclosure Analysis

Examine the following three hypothetical social media posts and evaluate each for compliance with SEC and FTC disclosure requirements:

a) A TikTok video in which a creator says "I've been doing a lot of research on $ABC stock and I think it's going to explode. I'm buying more tomorrow. Not financial advice!" The creator does not disclose that they were paid $15,000 to promote the stock. They currently hold 50,000 shares.

b) An Instagram post showing stock charts with the caption "Thinking about adding to my $XYZ position. What do you think? [Disclosure: I own shares of XYZ. Not investment advice.]"

c) A YouTube video in which a creator explains how to read a 10-K filing using a specific company as an example, without recommending the stock or disclosing any position. The creator does not own shares of the company.

For each: (1) Is the content likely regulated as investment advice? (2) Are disclosure requirements satisfied? (3) What additional information would you need to make a definitive determination?

Part B: Research and Applied Exercises

Exercise 9: EDGAR Research

Using the SEC's EDGAR database (sec.gov/edgar), locate the filings for a company of your choice that has faced SEC enforcement action for financial fraud in the past 15 years.

a) Find the company's 10-K filing from the year prior to the enforcement action. Identify three disclosures or risk factors that, with hindsight, signaled the underlying problems.

b) Find the SEC's complaint or enforcement order against the company. What specific provisions of securities law were alleged to have been violated?

c) Compare the language used in the company's public communications (press releases, investor presentations) with the actual financial results disclosed in its filings during the fraud period.

Exercise 10: Regulatory Registration Verification

For each of the following investment vehicles, describe the process you would use to verify regulatory registration and legitimate status:

a) A hedge fund claiming to be registered with the SEC as an investment adviser.

b) A cryptocurrency exchange claiming to be registered with FinCEN as a money services business.

c) A financial adviser claiming to be a Certified Financial Planner (CFP) in good standing.

d) A company offering an investment opportunity claiming to be exempt from SEC registration under Regulation D.

Exercise 11: The "Guaranteed Returns" Red Flag

The SEC and virtually all securities regulators prohibit guaranteeing returns on investments. Research the following:

a) Why is guaranteeing investment returns illegal under U.S. securities law? Cite the specific legal authority.

b) What is the economic argument against guaranteed returns being legitimate? (Think about what would have to be true about the underlying assets for guaranteed returns to be possible.)

c) Find three real enforcement actions where the SEC pursued cases involving "guaranteed returns" language in the past five years. What were the penalties?

Exercise 12: Short Selling and Information

Short sellers have been accused of spreading negative misinformation about companies to profit from price declines ("short and distort"). They have also been credited with uncovering corporate fraud.

a) Research the role of short sellers in uncovering Enron's fraud. How early were major short sellers like Jim Chanos warning about Enron, and what information did they use?

b) Research a documented case of short-seller misinformation (a "short and distort" scheme). What was the mechanism? Was the short seller prosecuted?

c) Evaluate the net social value of short selling. Does the fraud-uncovering function outweigh the manipulation potential?

Part C: Creative and Simulation Exercises

Exercise 13: Design a Pump-and-Dump Detection Protocol

You are a compliance officer at a retail brokerage. Design a systematic protocol for detecting potential pump-and-dump activity in your customers' trading.

a) What data would you monitor? (Consider price, volume, order flow, account characteristics, external data sources.)

b) What thresholds would trigger escalation to human review?

c) What steps would you take upon identification of suspicious activity?

d) What are the limitations of your protocol? What types of manipulation would it miss?

Exercise 14: Write a Regulatory Disclosure

You have been hired to advise a financial influencer who produces stock pick content on YouTube with 500,000 subscribers. Write a disclosure policy for the channel that:

a) Satisfies SEC Rule 17(b) requirements for paid promotions.

b) Satisfies FTC guidelines on endorsements.

c) Goes beyond minimum requirements to provide genuine transparency to viewers.

d) Is written in plain language accessible to a general audience.

Exercise 15: The Madoff Whistleblower

Harry Markopolos submitted detailed complaints to the SEC about Bernard Madoff's fund starting in 2000, eight years before the fraud collapsed. His analysis demonstrated that Madoff's reported returns were mathematically impossible.

a) Read Markopolos's 2005 submission to the SEC (publicly available). Identify his three strongest analytical arguments that Madoff was committing fraud.

b) Why did the SEC fail to act on these complaints? What organizational and structural factors explain the failure?

c) What changes to SEC operations (some implemented after Madoff) were designed to address these failures?

d) Do you think the regulatory environment today would better detect a Madoff-style fraud? Why or why not?

Exercise 16: Comparative Regulatory Analysis

Different countries regulate financial misinformation differently. Research and compare the following:

a) The EU's Market Abuse Regulation (MAR) vs. U.S. securities law: How do their approaches to market manipulation and insider trading compare?

b) How do cryptocurrency markets in the EU (under MiCA — Markets in Crypto-Assets Regulation) compare in regulatory protection to the U.S. regulatory approach?

c) Australia's ASIC has pursued cases against finfluencers. How does their enforcement approach compare to the SEC's?

Exercise 17: TerraLuna Post-Mortem

The TerraLuna collapse of May 2022 destroyed approximately $60 billion in value.

a) Describe the technical mechanism of the TerraUST "algorithmic stablecoin" peg. Why was the mechanism designed the way it was?

b) The Anchor Protocol offered 20% annual yield on TerraUST deposits. Where was this yield coming from? Was this a sustainable mechanism?

c) Several venture capital firms had invested in Terraform Labs and promoted TerraLuna to their networks. Evaluate their conduct: were they victims, complicit parties, or something else?

d) Do Kwon (Terraform Labs CEO) faced criminal charges in multiple jurisdictions. Research the specific charges and evaluate whether existing securities laws were adequate to address this type of collapse.

Exercise 18: Market Manipulation through Social Media — Legal Analysis

The SEC's October 2022 action against eight social media influencers for securities fraud alleged a specific scheme: coordinated promotion of stocks on Discord/Twitter while simultaneously selling.

a) Look up the specific SEC complaint (SEC v. McCall et al., or search EDGAR enforcement actions for October 2022). What specific conduct was alleged to violate Rule 10b-5?

b) The defendants claimed they were simply sharing investment opinions, protected by the First Amendment. Evaluate this defense. Where is the legal line between protected speech and actionable market manipulation?

c) Design a social media monitoring system that could have detected this scheme before the SEC brought its action.

Exercise 19: Due Diligence Simulation

You have received an unsolicited email from someone claiming to be a financial adviser, offering you a chance to invest in a "private equity fund" with a 10-year track record of 25% annual returns. The email says the minimum investment is $50,000 and the offer closes in 48 hours.

Write a due diligence checklist of at least 20 specific steps you would take before making any investment decision. For each step, identify what information it would reveal and how it relates to fraud indicators discussed in this chapter.

Exercise 20: Comparative Fraud Case Analysis

Compare the following two frauds across five dimensions: (1) information mechanism, (2) victim selection, (3) longevity, (4) detection pathway, (5) regulatory response.

• Charles Ponzi (1919-1920)
• Bernie Madoff (approximately 1990-2008)

What does the comparison reveal about whether financial fraud detection has improved over the century separating these cases?

Exercise 21: Financial PR and Earnings Management

"Adjusted EBITDA" is a non-GAAP (Generally Accepted Accounting Principles) financial measure frequently used in corporate communications.

a) Define adjusted EBITDA and explain how it differs from GAAP net income.

b) Research three companies that have faced SEC comment letters (available on EDGAR) about their use of non-GAAP metrics. What were the SEC's concerns?

c) Evaluate the legitimate uses of non-GAAP metrics versus their potential for misleading investors.

d) The SEC has issued guidance on non-GAAP metrics. Summarize the current requirements for presenting non-GAAP measures in public communications.

Exercise 22: Celebrity Endorsement and Financial Harm

Kim Kardashian was fined $1.26 million by the SEC for promoting EthereumMax without disclosing her $250,000 payment.

a) The fine represents five times her payment. Is this penalty structure an effective deterrent? Calculate how large the deterrent effect would need to be given her net worth.

b) Research what happened to EthereumMax's price after Kardashian's promotion and after the SEC action. Who bought during the promotion? What happened to their investment?

c) Should celebrities who endorse fraudulent financial products face liability beyond disclosure violations? Design a legal framework for celebrity financial endorsement liability.

Exercise 23: Algorithmic Trading and Manipulation

High-frequency trading algorithms can execute thousands of trades per second. Several tactics — "spoofing" (placing and then canceling orders to move prices), "layering," and "quote stuffing" — are illegal market manipulation.

a) Explain how spoofing creates false price signals. Use a numerical example.

b) The CFTC and DOJ prosecuted Navinder Sarao for spoofing related to the 2010 "Flash Crash." Research this case: what was Sarao's technique, and how did his actions contribute to the crash?

c) How can algorithmic trading also be a tool for detecting market manipulation? What signals would an anti-manipulation algorithm look for?

Exercise 24: Investment Fraud Victim Psychology

Financial fraud researchers have studied why intelligent, educated people fall for investment schemes.

a) Research the concept of "affinity fraud" — fraud targeting tight-knit communities through social trust networks. Find two documented examples and analyze the information dynamics.

b) The concept of "proportionality neglect" suggests that people evaluate the probability of fraud based on the scale of the operation rather than its actual characteristics. How does this bias benefit fraudsters?

c) Design a brief (one-page) fraud prevention guide targeted at a specific community (e.g., retirees, young cryptocurrency investors, immigrant communities) that addresses the specific psychological vulnerabilities that make that community a target.

Exercise 25: Regulatory Gaps and Reform

Identify three specific regulatory gaps that the GameStop, FTX, and finfluencer ecosystem cases revealed, and propose a specific regulatory reform for each.

For each proposed reform: - Describe the specific problem it addresses. - Identify who would need to implement it (SEC, CFTC, Congress, state legislatures, self-regulatory organizations). - Anticipate the strongest objection to the reform and respond to it. - Estimate whether the reform would be politically feasible given current regulatory dynamics.

Exercise 26: Whistleblower Economics

The Dodd-Frank whistleblower program awards 10-30% of sanctions exceeding $1 million to individuals providing original information that leads to successful SEC enforcement.

a) Research three large whistleblower awards made by the SEC under Dodd-Frank. What was the nature of the original information, and how much was the award?

b) Before Dodd-Frank, Harry Markopolos received nothing for reporting Madoff to the SEC. How might financial incentives have changed the outcome if the Dodd-Frank program had existed?

c) Are there ethical concerns with financially incentivizing whistleblowing? What might be the unintended consequences of large financial awards?

Exercise 27: Cross-Market Contagion

The FTX collapse in November 2022 affected not just FTX customers but other cryptocurrency markets, lending protocols, and even some traditional financial institutions.

a) Trace the contagion pathway from FTX's collapse to at least three other entities that suffered significant losses or failures. What informational linkages enabled this contagion?

b) Compare this contagion pathway to that of Lehman Brothers' collapse in September 2008. What structural similarities and differences do you observe?

c) What disclosure requirements, if any, might have given market participants earlier warning of FTX's vulnerability?

Exercise 28: Cross-Cultural Perspectives on Financial Fraud

Ponzi schemes and pump-and-dump operations are documented globally, but cultural and regulatory contexts shape their specific forms.

a) Research the Chinese P2P lending scandal (approximately 2015-2019), in which hundreds of peer-to-peer lending platforms collapsed. What were the specific information mechanisms that enabled this fraud at scale?

b) Compare the regulatory response to P2P lending fraud in China versus the regulatory response to similar schemes in the United States.

c) How does a culture's relationship to regulatory authority and financial institutions affect vulnerability to financial fraud?

Exercise 29: Media Complicity

Major financial media — including CNBC, Bloomberg, and the financial press — gave extensive positive coverage to Enron, Theranos, FTX, and other subsequently revealed frauds.

a) Research the coverage of Enron by major financial media from 1999-2001. Find specific examples of positive coverage. What information was available to journalists that should have raised doubts?

b) What structural incentives in financial journalism push toward positive coverage of corporate stories?

c) Evaluate the role of financial journalists Bethany McLean (Enron) and John Carreyrou (Theranos) as examples of investigative journalism that challenged the prevailing corporate narrative. What methods did they use?

Exercise 30: Financial Literacy and Vulnerability

Research suggests that financial literacy — the ability to understand and use financial concepts — is correlated with resistance to investment fraud.

a) Find a validated financial literacy assessment tool (e.g., the FINRA Foundation's Financial Capability Study). Take the assessment if available online. What dimensions of financial knowledge does it measure?

b) Research the evidence on whether financial literacy education reduces investment fraud victimization. What does the literature say?

c) Design a 30-minute financial fraud awareness module for high school students. Identify three key concepts, two interactive activities, and two assessment questions.