Securities Fraud

Updated on April 4, 2024
Article byKhalid Ahmed
Edited byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Securities Fraud?

Securities fraud involves deceiving investors by engaging in insider trading, misrepresentations, and accounting fraud with the primary goal of enticing them to invest in inappropriate assets while the perpetrators earn significant profits from brokers, companies, or individuals. This type of fraud is often carried out through various means, such as providing false information, misleading investors, and providing insider information.

Securities Fraud

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The U.S. government considers securities fraud a serious crime within the investment world, encompassing a range of illegal and antisocial activities, including duping investors and manipulating financial markets through pyramid schemes, high-yield investments, and Ponzi schemes. Spreading false information and engaging in insider trading are also classified under securities fraud.

Key Takeaways

  • Securities fraud involves misleading investors through misrepresentation, omission, or false data to gain profits and deceive them.
  • The main objective of securities fraud is to defraud investors using pyramid schemes, Ponzi schemes, and High-Yield Investment fraud.
  • Investors who have been defrauded have a two-year or five-year statute of limitation to prove the elements of fraud, such as material misrepresentation and resulting losses.
  • Securities fraud is governed by 18 U.S. Code § 1349, while wire frauds fall under Title 18 U. S. Code.

Securities Fraud Explained

Securities fraud as defined by the Federal Bureau of Investigation is a collection of illegal activities aimed at defrauding investors, manipulating or exaggerating financial markets, or misrepresenting a company’s financial health to lure customers into buying or selling shares, resulting in financial losses. These illegal activities include Ponzi Schemes, Pyramid Schemes, High Yield Investment Fraud, foreign currency fraud, hedge-fund-related fraud, advanced fee schemes, and broker embezzlement.

In accordance with 18 U.S.C. § 1349, the penalty for securities fraud can lead to imprisonment for up to twenty-five years and a fine. After the fraud has been committed, the investor plaintiff has a window of two to five years to prove the fraud and establish certain elements, as discussed in the next section. The Federal Bureau of Investigation (FBI) also considers securities fraud a criminal activity, whether conducted individually or in collaboration. This crime typically involves misinformation, misrepresentation, or omitting critical financial data related to a company or individual.

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Elements

In order to establish securities fraud under Section 10(b) of the Securities Exchange Act of 1934, the following elements must be present:

  • Material Misrepresentation or Omission: The fraudster makes a significant misrepresentation or omits crucial information concerning a company’s financial health, stock, or securities.
  • Scienter: The fraudster possesses knowledge of the false information and intentionally conceals it to deceive investors and gain an unfair advantage or profits.
  • The connection between misrepresentation and trading activity: There must be a direct link between the fraudulent misrepresentation and the investor’s decision to buy or sell securities based on that false information.
  • Reliance on False Information: The investor makes their trading decision based on the fraudulent misrepresentation, relying on the accuracy of the provided information.
  • Actual Loss: The investor suffers a financial loss due to the fraudulent misrepresentation or omission.
  • Causation: The investor’s monetary loss must be directly caused by the fraudster’s misleading information or actions.

Types

The common types are the following:

  • Ponzi schemes: Investors are promised high returns, but payouts to existing investors are funded by new investments, making it a fraudulent scheme.
  • Short selling abuses: False information causes stock prices to decrease, as seen during the JP Morgan Chase and Bear Stearns acquisition in 2008.
  • Mutual Fund Fraud: Brokerage houses engage in short-term trading at the expense of other investors, leading to losses.
  • Boiler rooms: Large brokerage houses pressure clients into deceptive microcap fraud strategies via telesales, harming investors.
  • Accountant fraud: Negligence by accounting firms in identifying falsified financial data causes investors to suffer significant losses.
  • Microcap fraud: Small companies’ stocks are fraudulently promoted and sold to unsuspecting investors, resulting in cheating and losses.
  • Insider trading: Trading company stocks using non-public information disadvantages retail traders.
  • Internet fraud: Traders use the internet to spread false information and manipulate stock prices for personal gain.
  • Dummy corporations: Fraudulent individuals create fake companies and sell shares with the promise of high returns before disappearing.
  • Corporate misconduct: Deliberate misrepresenting expenditures can lead to false profits, hiding financial fragility and risking investor losses.

Examples

Let us go through some examples to understand the topic clearly.

Example #1

Arguably the most infamous case of securities fraud in history is the Enron scandal. In this instance, corporate officers of Enron purposefully omitted to report substantial expenses from the company’s financial statements. As a result, Enron’s reported profits appeared inflated and grew to levels far beyond the actual value. Eventually, the truth came to light, exposing the fraudulent accounting practices. Consequently, Enron collapsed, filing for bankruptcy and causing massive losses to investors. The scandal led to the complete shutdown of the company’s operations.

Example #2

Imagine Mr. S, a corporate accountant working for Company X, discovers that the company has been experiencing significant and rapid financial losses, placing it on the brink of bankruptcy. Despite being privy to this critical information, Mr. S decides to sell his shares in Company X without disclosing the dire financial situation to the company’s board or the public. By engaging in such conduct, Mr. S commits insider trading, a form of securities fraud. Insider trading involves using non-public information to gain an unfair advantage in buying or selling securities, which is illegal due to its detrimental impact on market fairness and the interests of other investors who lack such confidential insights.

Statute Of Limitations

For the securities fraud statute of limitations, there have been two separate timelines:

#1 – A Two-Year Statute Of Limitations

It has a time limit of two years, during which any legal action can be taken against a person or entity involved in securities fraud. It becomes effective from the date an investor learns about truths comprising the violation of stock law.

#2 – The Five-Year Statute Of Repose

It starts from the date the fraudster got caught doing the fraudulent act. Moreover, it becomes effective even if a defrauded investor knows about the fraud’s last act of forgery or not.

Securities Fraud vs Wire Fraud

Let us use the table below to understand the difference between the two:

Securities FraudWire Fraud
  It involves using misinformation or omitting correct data to deceive investors. It involves using any form of communication medium to carry out the fraud.
  Investors are the primary targets of securities fraud.Wire fraud can target individuals or entities through various communication channels, such as telephone, internet, fax, and email.
Securities fraud may have a statute of limitations.Wire fraud is considered a federal crime and may not have a statute of limitations.

  Phishing is not specifically classified under securities fraud.
 Phishing may fall under wire fraud if it involves using electronic communications to deceive victims.
Securities fraud typically involves more than three elements to be proven.Wire fraud generally requires the establishment of three main elements to be categorized as a crime.

Frequently Asked Questions (FAQs)

1. How can investors protect themselves from securities fraud?

Investors can protect themselves by conducting thorough due diligence before investing, diversifying their portfolio, staying informed about the companies they invest in, and being cautious of unsolicited investment offers or “get-rich-quick” schemes.

2. Is securities fraud a global issue?

Yes, securities fraud is a global issue that affects investors and financial markets worldwide. Fraudulent schemes can transcend borders, making international cooperation and coordination among regulatory agencies essential.

3. How do regulatory agencies combat securities fraud?

Regulatory agencies combat securities fraud through enforcement actions, investigations, audits, and public awareness campaigns. They also implement regulations and reporting requirements to enhance market transparency.

4. What role do whistleblowers play in uncovering securities fraud?

Whistleblowers play a crucial role in uncovering securities fraud by providing insider information and exposing fraudulent activities to regulatory authorities. Many regulatory agencies offer financial incentives and protection to encourage individuals to come forward with valuable information.

This article has been a guide to what is Securities Fraud. Here, we explain its elements, statutes of limitations, comparison with wire fraud, examples, and types. You may also find some useful articles here –

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