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Securities fraud

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Title: Securities fraud  
Author: World Heritage Encyclopedia
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Subject: Bernard Madoff, Christopher Cox, Fraud Enforcement and Recovery Act of 2009, David G. Friehling, Microcap stock fraud
Collection: Corruption, Finance Fraud, Securities (Finance)
Publisher: World Heritage Encyclopedia

Securities fraud

Securities fraud, also known as stock fraud and investment fraud, is a deceptive practice in the stock or commodities markets that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of securities laws.[1] Offers of risky investment opportunities to unsophisticated investors who are unable to evaluate risk adequately and cannot afford loss of capital is a central problem.[2][3]

Securities fraud can also include outright theft from investors (embezzlement by stockbrokers), stock manipulation, misstatements on a public company's financial reports, and lying to corporate auditors. The term encompasses a wide range of other actions, including insider trading, front running and other illegal acts on the trading floor of a stock or commodity exchange.[4][5][6]


  • Types of securities fraud 1
    • Corporate fraud 1.1
      • Corporate misconduct 1.1.1
      • Dummy corporations 1.1.2
    • Internet fraud 1.2
    • Insider trading 1.3
    • Microcap fraud 1.4
    • Accountant fraud 1.5
    • Boiler rooms 1.6
    • Mutual Fund fraud 1.7
    • Short selling abuses 1.8
    • Ponzi schemes 1.9
  • Pervasiveness of securities fraud 2
  • Characteristics of victims and perpetrators 3
  • Other effects of securities fraud 4
  • Penny Stock Regulation 5
  • Related subjects 6
  • References 7
  • External links 8

Types of securities fraud

Corporate fraud

Corporate misconduct

Fraud by high level corporate officials became a subject of wide national attention during the early 2000s, as exemplified by corporate officer misconduct at Enron. It became a problem of such scope that the Bush Administration announced what it described as an "aggressive agenda" against corporate fraud.[7] Less widely publicized manifestations continue, such as the securities fraud conviction of Charles E. Johnson Jr., founder of PurchasePro in May 2008.[8] FBI Director Robert Mueller predicted in April 2008 that corporate fraud cases will increase because of the subprime mortgage crisis.[9]

Dummy corporations

Dummy corporations may be created by fraudsters to create the illusion of being an existing corporation with a similar name. Fraudsters then sell securities in the dummy corporation by misleading the investor into thinking that they are buying shares in the real corporation.

Internet fraud

According to enforcement officials of the Securities and Exchange Commission, criminals engage in pump-and-dump schemes, in which false and/or fraudulent information is disseminated in chat rooms, forums, internet boards and via email (spamming), with the purpose of causing a dramatic price increase in thinly traded stocks or stocks of shell companies (the "pump").

When the price reaches a certain level, criminals immediately sell off their holdings of those stocks (the "dump"), realizing substantial profits before the stock price falls back to its usual low level. Any buyers of the stock who are unaware of the fraud become victims once the price falls.[10]

The SEC says that Internet fraud resides in several forms:

  • Online investment newsletters that offer seemingly unbiased information free of charge about featured companies or recommending "stock picks of the month." These newsletter writers then sell shares, previously acquired at lower prices, when hype-generated buying drives the stock price up. This practice is known as scalping. Conflict of interest disclosures incorporated into a newsletter article may not be sufficient. Accused of scalping, Thom Calandra, formerly of MarketWatch, was the subject of an SEC enforcement action in 2004.[11][12]
  • Bulletin boards that often contain fraudulent messages by hucksters.[13]
  • E-Mail spams from perpetrators of fraud.[14]
  • Phishing

Insider trading

There are two types of "insider trading". The first is the trading of a corporation's stock or other security by corporate insiders such as officers, key employees, directors, or holders of more than ten percent of the firm's shares. This is generally legal, but there are certain reporting requirements.[15]

The other type of insider trading is the purchase or sale of a security based on material non-public information. This type of trading is illegal in most instances. In illegal insider trading, an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise misappropriated.[16]

Microcap fraud

In microcap fraud, stocks of small companies of under $250 million market capitalization are deceptively promoted, then sold to an unwary public. This type of fraud has been estimated to cost investors $1–3 billion annually.[17] Microcap fraud includes pump and dump schemes involving boiler rooms and scams on the Internet. Many, but not all, microcap stocks involved in frauds are penny stocks, which trade for less than $5 a share.

Many penny stocks, particularly those that sell for fractions of a cent, are thinly traded. They can become the target of [19] The expanding use of the Internet and personal communication devices has made penny stock scams easier to perpetrate.[20] But it has also drawn high profile public personalities into the sphere of regulatory oversight. Though not a scam per se, one notable example is rapper 50 Cent's use of Twitter to cause the price of a penny stock (HNHI) to increase dramatically. 50 Cent had previously invested in 30 million shares of the company, and as a result made $8.7 million in profit.[21][22] Another example of an activity that skirts the borderline between legitimate promotion and hype is the case of LEXG. Described (but perhaps overstated) as "the biggest stock promotion of all time", Lithium Exploration Group's market capitalization soared to over $350 million, after an extensive direct mail campaign. The promotion drew upon the legitimate growth in production and use of lithium, while touting Lithium Exploration Groups position within that sector. According to the company's December 31, 2010, form 10-Q (filed within months of the direct mail promotion), LEXG was a lithium company without assets. Its revenues and assets at that time were zero.[23][24] Subsequently, the company did acquire lithium production/exploration properties, and addressed concerns raised in the press.[25][26]

Penny stock companies often have low liquidity. Investors may encounter difficulty selling their positions after the buying pressure has abated, and the manipulators have fled.

Accountant fraud

In 2002, a wave of separate but often related accounting scandals became known to the public in the U.S. All of the leading public accounting firms—Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG, PricewaterhouseCoopers— and others have admitted to or have been charged with negligence to identify and prevent the publication of falsified financial reports by their corporate clients which had the effect of giving a misleading impression of their client companies' financial status. In several cases, the monetary amounts of the fraud involved are in the billions of USD.[27]

Boiler rooms

Boiler rooms or boiler houses are stock brokerages that put undue pressure on clients to trade using telesales, usually in pursuit of microcap fraud schemes. Some boiler rooms offer clients transactions fraudulently, such as those with an undisclosed profitable relationship to the brokerage. Some 'boiler rooms' are not licensed but may be 'tied agents' of a brokerage house which itself is licensed or not. Securities sold in boiler rooms include commodities and private placements as well as microcap stocks, non-existent, or distressed stock and stock supplied by an intermediary at an undisclosed markup.

Mutual Fund fraud

A number of major brokerages and mutual fund firms were accused of various deceptive acts that disadvantaged customers. Among them were late trading and market timing. Various SEC rules were enacted to curtail this practice.[28] Bank of America Capital Management was accused by the SEC of having undisclosed arrangements with customers to allow short term trading.[29]

Short selling abuses

Abusive [31]

Ponzi schemes

A Ponzi scheme is an investment fund where withdrawals are financed by subsequent investors, rather than profit obtained through investment activities. The largest instance of securities fraud committed by an individual ever is a Ponzi scheme operated by former NASDAQ chairman Bernard Madoff, which caused up to an estimated $64.8 billion in losses depending on which method is used to calculate the losses is used prior to its collapse.[32][33]

Pervasiveness of securities fraud

The Securities Investor Protection Corporation (SIPC) reports that the Federal Trade Commission, FBI, and state securities regulators estimate that investment fraud in the United States ranges from $10–$40 billion annually. Of that number, SIPC estimates that $1–3 Billion is directly attributable to microcap stock fraud.[17] Fraudulent schemes perpetrated in the securities and commodities markets can ultimately have a devastating impact on the viability and operation of these markets.[34]

Class action securities fraud lawsuits rose 43 percent between 2006 and 2007, according to the Stanford Law School Securities Class Action Clearinghouse. During 2006 and 2007, securities fraud class actions were driven by market wide events, such as the 2006 backdating scandal and the 2007 subprime crisis. Securities fraud lawsuits remained below historical averages.[35]

Some manifestations of this white collar crime have become more frequent as the Internet gives criminals greater access to prey. The trading volume in the United States securities and commodities markets, having grown dramatically in the 1990s, has led to an increase in fraud and misconduct by investors, executives, shareholders, and other market participants.

Securities fraud is becoming more complex as the industry develops more complicated investment vehicles. In addition, white collar criminals are expanding the scope of their fraud and are looking outside the United States for new markets, new investors, and banking secrecy havens to hide unjust enrichment.

A study conducted by the New York Stock Exchange in the mid-1990s reveals approximately 51.4 million individuals owned some type of traded stock, while 200 million individuals owned securities indirectly. These same financial markets provide the opportunity for wealth to be obtained and the opportunity for white collar criminals to take advantage of unwary investors.

Recovery of assets from the proceeds of securities fraud is a resource intensive and expensive undertaking because of the cleverness of fraudsters in concealment of assets and money laundering, as well as the tendency of many criminals to be profligate spenders. A victim of securities fraud is usually fortunate to recover any money from the defrauder.

Sometimes the losses caused by securities fraud are difficult to quantify. For example, insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth.[36]

Characteristics of victims and perpetrators

Any investor can become a victim, but persons aged fifty years or older are most often victimized, whether as direct purchasers in securities or indirect purchasers through pension funds. Not only do investors lose but so can creditors, taxing authorities, and employees.

Potential perpetrators of securities fraud within a publicly traded firm include any dishonest official within the company who has access to the payroll or financial reports that can be manipulated to:

  1. overstate assets
  2. overstate revenues
  3. understate costs
  4. understate liabilities

Enron Corporation[27] exemplifies all four tendencies, and its failure demonstrates the extreme dangers of a culture of corruption within a publicly traded corporation. The rarity of such spectacular failures of a corporation from securities fraud attests to the general reliability of most executives and boards of large corporations. Most spectacular failures of publicly traded companies result from such innocent causes as marketing blunders (Schlitz),[37] an obsolete model of business (Penn Central, Woolworth's),[38] inadequate market share (Studebaker),[39] non-criminal incompetence (Braniff).[40]

Other effects of securities fraud

Even if the effect of securities fraud is not enough to cause bankruptcy, a lesser level can wipe out holders of common stock because of the leverage of value of shares upon the difference between assets and liabilities. Such fraud has been known as watered stock, analogous to the practice of force-feeding livestock great amounts of water to inflate their weight before sale to dealers.

Penny Stock Regulation

The regulation and prosecution of securities fraud violations is undertaken on a broad front, involving numerous government agencies and U.S. District Court,[45] and the statute became the template for laws enacted in other states. Shortly thereafter, both FINRA and the SEC enacted comprehensive revisions of their penny stock regulations. These regulations proved effective in either closing or greatly restricting broker/dealers, such as Blinder, Robinson & Company, which specialized in the penny stocks sector. Meyer Blinder was jailed for securities fraud in 1992, after the collapse of his firm.[46] However, sanctions under these specific regulations lack an effective means to address pump and dump schemes perpetrated by unregistered groups and individuals.

Related subjects


  1. ^ "Securities Fraud Awareness & Prevention Tips faq by FBI, accessed February 11, 2013
  2. ^ Nathaniel Popper (February 10, 2013). "Complex Investments Prove Risky as Savers Chase Bigger Payoff". The New York Times. Retrieved February 11, 2013. 
  3. ^ "2012 NASAA Top Investor Threats". North American Securities Administrators Association (NASAA). Retrieved February 11, 2013. A con artist will use every trick in the book to take advantage of unsuspecting investors, including exploiting well-intended laws, in order to fatten their wallets 
  4. ^ Testimony Concerning Insider Trading, Linda Chatman Thomsen, Director, Division of Enforcement, U.S. Securities and Exchange Commission
  5. ^ Norris, Floyd (April 14, 2005). "Trading Scandal May Strengthen Stock Exchange". New York Times. Retrieved 5/3/08. 
  6. ^ San Francisco FBI web link, supra
  7. ^ "The President's Leadership in Combating Corporate Fraud". Retrieved 2012-02-18. 
  8. ^ Kang, Cecilia (2008-05-16). "Ex-PurchasePro Chief Found Guilty of Fraud, Obstruction". Retrieved 2012-02-18. 
  9. ^, Retrieved May 18, 2008
  10. ^ "Internet Fraud: How to Avoid Internet Investment Scams". Retrieved 2012-02-18. 
  11. ^
  12. ^ Vardi, Nathan. "Calandra Quits Amid Probe, Forbes, January 23, 2004, article". Retrieved 2013-11-21. 
  13. ^ "Internet Fraud". Retrieved 2013-11-21. 
  14. ^ "N.Y. broker charged in e-mail spam stock scam". Usatoday.Com. 2011-02-02. Retrieved 2013-11-21. 
  15. ^ Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 584
  16. ^ Laws that Govern the Securities Industry U.S. Securities and Exchange Commission, accessed March 30, 2007
  17. ^ a b "Securities Investor Protection Corporation > Who > Not FDIC". SIPC. Retrieved 2013-11-21. 
  18. ^ SEC (2005-01-11). "Pump&Dump.con". U.S. Securities and Exchange Commission. Retrieved 2006-11-21. 
  19. ^ FINRA (2012). "Spams and Scams". Financial Industry Regulatory Authority. Retrieved 2012-07-29. 
  20. ^ Harry Domash (2000-06-12). "Internet Makes Scams Easy". San Francisco Chronicle. Retrieved 2006-06-15. 
  21. ^ Zakarin, Jordan (11 January 2011). "Importing By Encouraging Fans To Invest". Huffington Post. Retrieved 30 March 2012. 
  22. ^ Penny Stocks. "Penny_Stocks". Twitter. 
  23. ^ "Lithium Exploration Group: Beware of Mailmen Bearing Gifts". Seeking Alpha. 10 May 2011. Retrieved 30 March 2012. 
  24. ^ Gary Weiss (1997-12-15). "Investors Beware". Business Week. Retrieved 2006-06-15. 
  25. ^ Lithium Exploration Group (2012-07-17). "LEXG Answers Dean Beeby of The Canadian Press on Lithium Mining". the chairmans blog. Retrieved 2013-11-21. 
  26. ^ "Lithium Exploration Group Inc. News - Company Information - The New York Times". Retrieved 2013-11-21. 
  27. ^ a b Time. 2002-06-18,8599,263006,00.html. 
  28. ^ "The Mutual Fund Trading Scandals" . Journal of Accountancy. December 2004. Retrieved 5/3/08. 
  29. ^ SEC Admin. Proc. File No. 3-11818, February 9, 2005
  30. ^ "Key Points About Regulation SHO". Securities and Exchange Commission. Retrieved May 4, 2008. 
  31. ^ Anderson, Jenny (April 30, 2008). "A New Wave of Vilifying Short Sellers". New York Times. Retrieved May 15, 2008. 
  32. ^ "Bernard Madoff Gets 150 Years in Jail for Epic Fraud". Bloomberg. 2009-06-29. Retrieved 2009-08-05. 
  33. ^ "Madoff mysteries remain as he nears guilty plea". Reuters. 2009-03-11. Retrieved 2009-08-05. 
  34. ^ "Iowa Insurance Division" (PDF). Retrieved May 9, 2008. 
  35. ^ "Stanford Securities Class Action Clearinghouse" (PDF). Retrieved May 26, 2008. 
  36. ^ "The World Price of Insider Trading" by Utpal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002)
  37. ^ "How Milwaukee's Famous Beer Became Infamous". The Beer Connoisseur. Retrieved 2013-11-21. 
  38. ^ Hall, James (2009-11-14). "Woolworths: the failed struggle to save a retail giant". London: Telegraph. Retrieved 2013-11-21. 
  39. ^
  40. ^ Lengnick-Hall, Cynthia A. (1985). "Splash of Colors: The Self-Destruction of Braniff International by John J. Nance". The Academy of Management Review 10 (3): 617–620.  
  41. ^
  42. ^ "SEC Charges Eight Participants in Penny Stock Manipulation Ring". U.S. Securities and Exchange Commission. May 21, 2009. 
  43. ^ Stan Darden (March 20, 1990). "Georgia to OK Tough Law for Penny Stocks". Los Angeles Times.  
  44. ^
  45. ^ "GEORGIA LAW WON'T HURT BROKERS, JUDGE RULES". Deseret News. July 11, 1990. 
  46. ^ Diana B. Henriques (February 16, 2003). "Penny-Stock Fraud, From Both Sides Now". New York Times. 

External links

  • New York Attorney General Report on Microcap Stock Fraud
  • President's Corporate Crime Task Force
  • Significant Criminal Cases, Department of Justice website
  • Stanford Securities Class Action Clearinghouse
  • Public Investor Arbitration Bar Association "PIABA"
  • Billion Dollar Investment Fraud, FBI
  • U.S. Securities and Exchange Commission Investor Alert: 10 Red Flags That an Unregistered Offering May Be a Scam
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