What was the Stratton Oakmont scandal? How did employees at Stratton Oakmont participate in stock manipulation?
While there are many ways for investment firms to make money, the practice of choice for Stratton Oakmont was stock price manipulation. Jordan Belfort’s traders artificially inflated the stock price of a company during its Initial Public Offering (IPO) while holding on to more shares of that company than was allowed by SEC rules.
Continue reading to learn more about Stratton Oakmont’s scandalous method of making money.
Stock Manipulation at Stratton Oakmont
In his book The Wolf of Wall Street, Belfort illustrates the Stratton Oakmont scandal with the specific example of Steve Madden Shoes, a company that he helped to take public.
(Shortform note: Steve Madden—not to be confused with football commentator John Madden—is a footwear designer who founded his shoe business in 1990 before Belfort took it public in 1993. When a corporation “goes public” through an initial public offering, it sells its stock for the first time on the open market. Steve Madden’s business continues to sell a wide variety of fashion accessories, though Madden himself was convicted of stock manipulation in 2002, forced to resign as CEO of his company, and served three and a half years in prison.)
Belfort explains how stock manipulation during an IPO works: He’d heavily invest in a new business, such as Steve Madden Shoes, then use his controlling interest to take the company public. Belfort’s brokers would use every strong-arm trick they knew to drive the price up when selling to investors. Once the price had gone high enough, Belfort would sell enough of his shares to recoup the cost of his initial investment—meaning that he paid nothing for the stocks he retained, which were now valued higher than ever. However, by SEC rules, an investment firm sponsoring an IPO is only allowed to own a limited stake in the company whose shares they’re selling—but Belfort and Stratton Oakmont held on to far more Madden stock than they were legally allowed.
(Shortform note: The role that an investment bank like Stratton Oakmont is supposed to play during an IPO is to guide a business through the steps of going public and promote confidence in the company’s long-term viability to prospective investors. During an IPO, people within the company who already own shares are prohibited from selling them for a period that can last from six months to a year. This “lock-up period” exists to prevent exactly the kind of stock price manipulation that Belfort and his firm were well-versed in practicing. In conjunction with new regulations by the SEC, the number of IPOs per year has dropped significantly since Belfort’s time, though it’s unclear whether increased regulation is the cause.)
Manipulation Via Proxy
Belfort hid the amount of stock he owned by making use of proxies—people who held the stock on Belfort’s behalf while owning it in name only. In the case of the Madden IPO, Belfort’s biggest proxy was Steve Madden himself. Prior to the IPO, Stratton Oakmont was required to transfer ownership of Steve Madden stock back to Madden, but this was done with the understanding (based on mutual trust) that Belfort was still the true owner of the shares. Belfort writes that this is legal so long as the shares don’t constitute more than 5% of the company, whereas Belfort’s proxy shares made up more than 50% of the business, including all the shares owned by other Belfort proxies whom Madden didn’t know anything about.
(Shortform note: Belfort’s use of proxies—commonly referred to as nominee accounts—isn’t actually illegal, though hiding them is a common way to disguise a person’s or business entity’s assets, often for illicit reasons. Any nominee who owns more than 5% of the shares in a business must register with the SEC, and nominees who own more than 25% of a business become what is known as “beneficial owners” whose status as such must be legally verified by any banks with whom the business has an account. In order to fight the rampant fraud that proxy ownership enables, the World Bank is pushing for countries to adopt regulations increasing transparency in global asset ownership.)
Belfort argues these tactics are so common that Wall Street practices are rigged to facilitate stock manipulation. For instance, before the IPO began, Madden stock was valued at $4 per share, but stock market rules let Belfort set the opening price at $5.50 per share, inflating it before trading even started. All day, Stratton traders forced the price up while selling to investors, but they also sold to other investment firms, who eagerly participated in shooting the stock price higher and higher, with the unspoken agreement that Stratton Oakmont would buy back the inflated shares before the close of trading. At the end of the day, Belfort and Stratton Oakmont still owned a controlling interest in Madden Shoes, now valued at $19 per share.
(Shortform note: For Belfort to manipulate Madden’s stock price without disclosing his controlling interest in the company is the very definition of insider trading. Insider trading often goes unpunished due to murky disclosure regulations and complex ownership structures, which Belfort took full advantage of. As for the assist Belfort got from other Wall Street investment firms, the US Justice Department has become concerned that investment banks may be colluding to drive up consumer prices, not only stock prices. The issues may actually be more wide-ranging than a handful of brokers enriching themselves at their investors’ expense.)
