Chapter 17: Quiz — Financial Misinformation and Market Manipulation
Instructions: Answer each question to the best of your ability. For multiple-choice questions, select the single best answer. Answers are hidden below each question; reveal them only after completing your response.
Question 1
Which of the following best defines "material information" in U.S. securities law?
A) Any information that the SEC deems relevant to a company's operations B) Information that a reasonable investor would consider significant in making an investment decision C) Information disclosed in a company's annual report (10-K) D) Financial data that affects a company's credit rating
Answer
**B) Information that a reasonable investor would consider significant in making an investment decision.** This is the standard established by the Supreme Court in *Basic Inc. v. Levinson* (1988) and consistently applied in securities law. The test is objective — what a "reasonable investor" would find important — not what the company or regulator deems relevant. It applies to both affirmative statements and omissions.Question 2
The "puffery" doctrine in securities law:
A) Prohibits all optimistic statements about a company's future prospects B) Shields genuinely forward-looking statements from liability under the Private Securities Litigation Reform Act C) Provides that overly general, boosterish statements cannot form the basis of fraud claims because reasonable investors would not rely on them as factual D) Is only applicable to statements made to institutional investors
Answer
**C) Provides that overly general, boosterish statements cannot form the basis of fraud claims because reasonable investors would not rely on them as factual.** Puffery encompasses statements like "our products are the best" or "we are well-positioned for growth" that are so vague and promotional that they cannot be proven false and would not be relied upon by a reasonable investor as a factual representation. This is distinct from the Safe Harbor for forward-looking statements in option B, which applies to specific predictions accompanied by meaningful cautionary language.Question 3
In the classic pump-and-dump scheme, which phase occurs FIRST?
A) Public promotion through newsletters or social media B) Secret accumulation of a large position in a low-liquidity security C) Selling into the rising price D) Filing false SEC documents to create legitimacy
Answer
**B) Secret accumulation of a large position in a low-liquidity security.** The operator must establish their position before promotion begins; if they promoted before accumulating, they would be buying into their own artificially inflated price. The sequence — accumulate, then pump, then dump — is definitional to the scheme. SEC investigations often focus on establishing the timing of position accumulation relative to promotional activity.Question 4
Which of the following accurately describes the mechanism of a short squeeze?
A) Short sellers spread negative misinformation to drive a stock's price down B) A rapid price increase forces short sellers to buy shares to cover positions, further driving up the price C) Regulators require short sellers to close positions when a stock's price rises above a threshold D) A company buys back its own shares from short sellers at above-market prices
Answer
**B) A rapid price increase forces short sellers to buy shares to cover positions, further driving up the price.** Short sellers borrow and sell shares, hoping to buy them back at a lower price. When prices rise against them, they face unlimited losses (since prices can rise indefinitely). This motivates covering — buying shares to close positions — which increases buying pressure and further drives up prices, creating a self-reinforcing cycle.Question 5
Enron's primary accounting fraud involved:
A) Fabricating revenue from fictitious customers B) Misstating the company's geographic revenues to avoid taxation C) Using off-balance-sheet Special Purpose Entities to hide billions in debt and losses D) Bribing auditors to certify financial statements that were never actually prepared
Answer
**C) Using off-balance-sheet Special Purpose Entities to hide billions in debt and losses.** Enron's core fraud involved creating SPEs (with names like Raptor, Chewco, and LJM) that were structured to appear independent of Enron for accounting purposes but were actually controlled by Enron or its officers. By transferring liabilities to these entities, Enron kept them off its consolidated balance sheet. Enron also abused mark-to-market accounting, but the SPE structure was the mechanism for hiding the consequences of its trading losses.Question 6
The Sarbanes-Oxley Act of 2002 was primarily a response to:
A) The dot-com bubble and the subsequent stock market crash of 2000-2002 B) The Enron and WorldCom accounting scandals C) The collapse of Long-Term Capital Management in 1998 D) The SEC's concerns about pump-and-dump schemes in penny stocks
Answer
**B) The Enron and WorldCom accounting scandals.** Sarbanes-Oxley was signed into law in July 2002, immediately following the WorldCom fraud revelation (June 2002) and the post-Enron congressional investigations. Its key provisions — CEO/CFO certification of financial statements, auditor independence requirements, internal control reporting, and criminal penalties for false certifications — directly addressed the failures revealed in those cases.Question 7
In January 2021, short interest in GameStop (GME) exceeded what percentage of its float?
A) 40% B) 70% C) 100% D) Approximately 140%
Answer
**D) Approximately 140%.** Short interest in GME reached approximately 140% of its float at its peak. This was possible because the same shares could be lent, sold short, lent again, and sold short again in a chain of borrowing transactions. This extraordinarily high short interest created the conditions for the January 2021 short squeeze, as covering would require purchasing more shares than were readily available in the float.Question 8
Which of the following best describes a cryptocurrency "rug pull"?
A) A sudden regulatory crackdown that forces a cryptocurrency exchange to close B) A fraud in which developers create a token and liquidity pool, attract investors, then withdraw all liquidity C) A coordinated short-selling attack on a cryptocurrency token D) A technical vulnerability in a DeFi protocol exploited by hackers
Answer
**B) A fraud in which developers create a token and liquidity pool, attract investors, then withdraw all liquidity.** In a rug pull, the developers create a token on a decentralized exchange, provide initial liquidity, and promote the token to attract buyers. Once sufficient value has accumulated in the liquidity pool, the developers withdraw all the liquidity they control, collapsing the token's price and leaving investors with worthless assets. This is distinct from a hack (option D) because it is an intentional act by the project's own developers.Question 9
SEC Rule 10b-5 prohibits:
A) Insider trading only B) Material misstatements and omissions in connection with the purchase or sale of any security C) Short selling during market downturns D) Securities promotions without prior SEC registration
Answer
**B) Material misstatements and omissions in connection with the purchase or sale of any security.** Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934, is the primary anti-fraud provision of U.S. securities law. It prohibits any person from employing any device, scheme, or artifice to defraud, making any materially untrue statement or omitting to state a material fact, or engaging in any act or practice that operates as a fraud in connection with the purchase or sale of securities. It covers much more than insider trading.Question 10
Charles Ponzi's original scheme claimed to profit from:
A) Speculative purchases of real estate in Florida B) Currency exchange rate differences between European and American markets C) International postal reply coupon arbitrage D) Investments in government bonds of recovering European nations
Answer
**C) International postal reply coupon arbitrage.** Ponzi claimed to exploit price differences in international postal reply coupons (IRCs) — coupons that could be purchased in one country and redeemed for postage in another. The arbitrage opportunity was theoretically real, but the volumes required to generate Ponzi's claimed returns (and support his promised investor payouts) would have required hundreds of millions of coupons that simply did not exist. In reality, no IRC trades were ever made at significant scale.Question 11
According to historian Anne Goldgar's research, the popular historical account of Dutch tulip mania is:
A) Largely accurate, though the number of bankruptcies has been somewhat overstated B) Substantially false, with the scale and economic devastation greatly exaggerated by later writers C) An accurate account of a genuine bubble driven by irrational investor psychology D) Mostly accurate but missing the important role of government corruption
Answer
**B) Substantially false, with the scale and economic devastation greatly exaggerated by later writers.** Goldgar's archival research found that only a few thousand people participated in the tulip futures market, that the "ruins thousands" of popular history do not appear in bankruptcy records or court documents, and that many of the extreme prices cited come from post-collapse satirical pamphlets rather than contemporaneous market records. The popular account was largely shaped by Charles Mackay's 1841 book, which relied heavily on these satirical sources.Question 12
The SEC's Investment Adviser Public Disclosure (IAPD) database allows the public to:
A) View real-time trading data for registered investment advisers B) Verify whether an investment adviser is registered and view their disciplinary history C) File complaints against financial institutions D) Access audited financial statements for hedge funds
Answer
**B) Verify whether an investment adviser is registered and view their disciplinary history.** The IAPD database (adviserinfo.sec.gov) allows verification of whether an investment adviser is registered with the SEC or with state regulators, and displays their Form ADV (the registration document), which includes information about the adviser's background, services, fees, and any regulatory actions or disciplinary events. This is a key tool for conducting due diligence on investment advisers.Question 13
"Payment for order flow" (PFOF), which became controversial during the GameStop episode, refers to:
A) The SEC's practice of paying informants for tips about market manipulation B) Payments made by market makers to retail brokers for routing customer orders to them C) The practice of paying retail investors for their trading activity data D) Commission structures used by financial advisers to sell investment products
Answer
**B) Payments made by market makers to retail brokers for routing customer orders to them.** In PFOF, retail brokers like Robinhood receive payments from market makers (like Citadel Securities) in exchange for routing customer orders to those market makers for execution. The market makers profit from the bid-ask spread on the trades. This created controversy during GameStop because Robinhood's primary revenue source was Citadel, which had invested in Melvin Capital (a firm with a large short position in GME) — creating the appearance of a conflict of interest when Robinhood halted GME trading.Question 14
The Dodd-Frank Act's whistleblower program awards:
A) A fixed payment of $500,000 for information leading to successful SEC enforcement B) 10-30% of sanctions exceeding $1 million for original information leading to successful enforcement C) Reimbursement of legal fees for whistleblowers who bring qui tam actions D) 5% of all fines collected in any given year, distributed to qualifying whistleblowers
Answer
**B) 10-30% of sanctions exceeding $1 million for original information leading to successful enforcement.** Section 922 of the Dodd-Frank Act created the SEC's whistleblower program, which provides financial awards of 10-30% of sanctions exceeding $1 million to individuals who voluntarily provide original information that leads to successful SEC enforcement. The program has resulted in numerous large awards — the largest single award exceeding $279 million — and has been credited with significantly increasing the flow of information about securities fraud to the SEC.Question 15
Jordan Belfort's brokerage firm Stratton Oakmont operated primarily as a:
A) Legitimate brokerage that also engaged in occasional market manipulation B) Pump-and-dump operation that used high-pressure sales tactics to promote shares of companies it controlled C) Ponzi scheme that fabricated trading records for client accounts D) Insider trading network that exploited information from public company insiders
Answer
**B) Pump-and-dump operation that used high-pressure sales tactics to promote shares of companies it controlled.** Stratton Oakmont was a "boiler room" operation — it used hundreds of brokers to cold-call customers and sell shares in companies that Stratton controlled, at prices inflated by promotional activity. The firm would then sell its own holdings into the artificially inflated market. Belfort pleaded guilty to securities fraud and money laundering in 1999.Question 16
The SEC's EDGAR database provides access to which of the following for publicly traded companies?
A) Real-time stock prices and trading volumes B) Quarterly and annual financial filings, proxy statements, and registration documents C) Private communications between corporate executives D) Credit ratings and analyst recommendations
Answer
**B) Quarterly and annual financial filings, proxy statements, and registration documents.** EDGAR (Electronic Data Gathering, Analysis, and Retrieval) is the SEC's electronic filing system, which makes public all required disclosures from registered companies and investment funds. This includes 10-K (annual), 10-Q (quarterly), 8-K (current events), proxy statements (DEF 14A), and registration statements. It does not provide real-time trading data (available elsewhere), private communications, or third-party analyst products.Question 17
The SEC's 2022 enforcement action against Kim Kardashian involved:
A) Insider trading on pharmaceutical stock based on tips from a friend B) Failure to disclose $250,000 in compensation for promoting the EthereumMax token C) Operating an unregistered securities exchange for cryptocurrency trading D) Fraudulent misrepresentation in a real estate investment fund
Answer
**B) Failure to disclose $250,000 in compensation for promoting the EthereumMax token.** The SEC charged Kardashian with violating the anti-touting provisions of Section 17(b) of the Securities Act, which requires disclosure of compensation for promoting securities. She had received $250,000 to promote EthereumMax on Instagram without disclosing that payment. She settled with the SEC for $1.26 million (return of the $250,000 payment plus approximately $1 million in interest and penalties) and agreed not to promote crypto securities for three years.Question 18
WorldCom's primary accounting fraud involved:
A) Marking illiquid trading positions to inflated fair values B) Classifying ordinary operating expenses as capital expenditures C) Creating fake revenue through round-trip transactions with related parties D) Overstating inventory values to inflate reported assets
Answer
**B) Classifying ordinary operating expenses as capital expenditures.** WorldCom's fraud, directed by CEO Bernie Ebbers and CFO Scott Sullivan, involved improperly capitalizing approximately $3.8 billion in line costs (network access fees paid to other telecom carriers) as capital expenditures rather than operating expenses. This spread the costs over many years rather than recognizing them immediately, dramatically overstating reported profits. The fraud was discovered by WorldCom's own internal auditor, Cynthia Cooper.Question 19
The concept of "mark-to-market" accounting, as abused by Enron, refers to:
A) Marking up asset values to their replacement cost B) Recording the present value of anticipated future profits at contract signing C) Adjusting balance sheet values quarterly to reflect current market prices D) The requirement to write down asset values when market prices decline below cost
Answer
**B) Recording the present value of anticipated future profits at contract signing.** Mark-to-market accounting records the current fair value of financial instruments rather than historical cost. Enron received SEC approval in 1992 to apply this to its energy trading contracts, allowing it to record the present value of anticipated profits from long-term energy contracts immediately. This became abusive as Enron applied it to increasingly speculative and illiquid contracts, recording profits from deals that might never materialize and that could not be independently valued.Question 20
An ICO (Initial Coin Offering) is most similar to which traditional financial activity?
A) A bank loan B) An initial public offering (IPO) of stock C) A real estate mortgage D) A government bond auction
Answer
**B) An initial public offering (IPO) of stock.** An ICO raises capital by selling newly created cryptocurrency tokens to investors, analogously to how an IPO sells shares in a company to investors. The SEC has applied this analogy using the Howey test: if an ICO token represents an investment of money in a common enterprise with the expectation of profits from the efforts of others, it is a security and is subject to securities laws. The primary difference is that ICOs have historically lacked the registration requirements, disclosure obligations, and auditor oversight that apply to IPOs.Question 21
"Regulation FD" (Fair Disclosure), enacted by the SEC in 2000, requires:
A) All corporate communications to be filed with the SEC before public release B) That when companies disclose material nonpublic information to select individuals, they must make simultaneous or prompt public disclosure C) Financial advisers to disclose all fees to clients in a standardized format D) Companies to disclose risk factors associated with their business in annual reports
Answer
**B) That when companies disclose material nonpublic information to select individuals, they must make simultaneous or prompt public disclosure.** Regulation FD was designed to eliminate selective disclosure — the practice of sharing important information with favored analysts or large investors before the general public. Before Reg FD, companies routinely "pre-released" earnings to selected analysts, creating information advantages for sophisticated investors at the expense of retail investors. Reg FD requires that whenever a company intentionally discloses material nonpublic information to a covered person, it must simultaneously disclose that information publicly.Question 22
The term "finfluencer" refers to:
A) A financial institution with significant market influence B) An SEC-registered investment adviser who uses social media for marketing C) A social media content creator who produces and distributes financial commentary and investment ideas D) A high-frequency trading algorithm that influences market prices
Answer
**C) A social media content creator who produces and distributes financial commentary and investment ideas.** A finfluencer is a financial influencer — a social media personality who creates content about personal finance, investing, and related topics. The term is non-legal and encompasses a wide range of people from legitimate financial educators to unregistered investment advisers to outright fraudsters. The key regulatory issue is whether their content crosses the line from education into investment advice, and whether they are disclosing compensation and conflicts of interest as required by the SEC and FTC.Question 23
Which of the following is NOT a characteristic commonly associated with investment fraud?
A) Guaranteed or unusually high returns B) Independently audited financial statements available for investor review C) Urgency and pressure tactics ("limited time offer") D) Difficulty or conditions attached to withdrawing invested funds
Answer
**B) Independently audited financial statements available for investor review.** Independently audited financials are a positive indicator of legitimacy — they provide third-party verification of the fund's financial position and investment activity. The other options (guaranteed returns, urgency/pressure, withdrawal difficulties) are classic red flags associated with investment fraud. Madoff's fraud might have been detected earlier if investors had demanded audited statements from a credible firm rather than accepting the confirmation statements produced by Madoff's own operations.Question 24
The "Liar's Dividend" concept, discussed in the context of synthetic media but relevant to financial contexts as well, refers to:
A) The illegal profits generated by market manipulators who lie about securities B) The ability to dismiss true, damaging information as fabricated (applied broadly, not just to synthetic media) C) The tax benefit derived from writing off fraudulent investment losses D) Profits generated by short sellers who spread false negative information
Answer
**B) The ability to dismiss true, damaging information as fabricated.** The "Liar's Dividend" (coined by Chesney and Citron in the context of deepfakes) describes how the existence of sophisticated fabrication technology creates plausible deniability for those who wish to dismiss authentic evidence as fake. In financial contexts, this dynamic appears when executives deny authentic whistleblower reports as "fabricated," or when companies dismiss accurate negative reporting as "misinformation" — the existence of actual misinformation makes it easier to discredit true information.Question 25
Harry Markopolos first submitted a complaint about Bernie Madoff to the SEC in approximately what year, and how many years before the fraud collapsed?
A) 2000, approximately eight years before the 2008 collapse B) 2004, approximately four years before the 2008 collapse C) 2006, approximately two years before the 2008 collapse D) 2007, approximately one year before the 2008 collapse