What is Freeriding?

Also known as free riding, freeriding is a practice that involves making some type of transaction with an asset that is not considered ethical or proper. In many instances, examples of this type of financial activity have been declared illegal in many nations around the world. In terms of investing, freeriding often has to do with selling a recently acquired asset before paying for it, or withholding shares of a new security issue until it is possible to sell them at a higher price.

When related to the sell of stock options by an individual investor, freeriding involves buying a stock and then selling the stock at a profit before actually settling with the original seller. In times past, this approach was often used to purchase stocks and other investments even though the buyer did not have access to the funds to pay the agreed upon price. The idea was to gain control of the assets and quickly sell them to another buyer in hopes of recouping not only the original purchase price but also earning a little profit from the deal. If a second buyer is found quickly, this scheme could work. In situations where the investor is unable to secure a second buyer, the scheme collapses and the investor is left with the decision to either default on the purchase or find some other way of coming up with the resources to honor the deal.

Freeriding can also occur when an underwriting syndicate makes a decision to hold back a few shares of a current securities issue in hopes of selling those shares at a higher price in the future. Here, the idea is to increase profits by waiting until the value of those shares on the open market are higher than the price used for the public offering of those new securities. This practice is generally viewed to be in conflict with the concept of creating a level playing field within the investment world, since it denies investors who otherwise would be able to purchase those shares as the publicly declared price the chance to do so.

Over time, a number of nations have implemented laws and trading regulations that prohibit freeriding. In the United States, the Securities and Exchange Commission monitors suspected incidents of this type of trading strategy and imposes severe penalties if an investor or an underwriting syndicate is found to be engaging in this type of behavior. In like manner, the National Association of Securities Dealers also has strong regulations prohibiting freeriding, and takes action when this type of activity is detected. The penalties that may occur when this type of racketeering takes place range from the imposition of stiff fines to criminal charges that may result in incarceration for the offending parties.