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Securities fraud, also known as stock fraud and investment fraud, is a practice in which investors make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of the securities laws.

Generally speaking, securities fraud consists of deceptive practices in the stock and commodity markets, and occurs when investors are enticed to part with their money based on untrue statements.

Securities fraud includes outright theft from investors and misstatements on a public company's financial reports. The term also encompasses a wide range of other actions, including insider trading and front running and other illegal acts on the trading floor of a stock or commodity exchange.

According to the FBImarker, securities fraud includes false information on a company's financial statement and Securities and Exchange Commission (SEC) filings; lying to corporate auditors; insider trading; stock manipulation schemes, and embezzlement by stockbrokers.

Types of securities fraud

Corporate fraud

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. Less widely publicized manifestations continue, such as the securities fraud conviction of Charles E. Johnson Jr., founder of PurchasePro in May 2008. FBI Director Robert Mueller predicted in April 2008 that corporate fraud cases will increase because of the subprime mortgage crisis.

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.

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." They are sometimes used for fraud.

  • Bulletin boards that often contain fraudulent messages by hucksters.

  • E-Mail spams from perpetrators of fraud.

Insider trading

Insider trading 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.

Some insider trading is illegal. 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.

Microcap fraud

In microcap fraud, stocks of small companies of under $250 million market capitalization are sold fraudulently to the public. Its prevalence has been estimated to run into the billions of dollars a year.

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.

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.

Boiler rooms

Boiler rooms 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. Securities sold in boiler rooms include commodities and private placements as well as microcap stocks.

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. Bank of America Capital Management was accused by the SEC of having undisclosed arrangements with customers to allow short term trading.

Short Selling Abuses

Abusive short selling, including certain types of naked short selling, are also considered securities fraud because they can drive down stock prices. In abusive naked short selling, stock is sold without being borrowed and without any intent to borrow. The practice of spreading false information about stocks, to drive down their prices, is called "short and distort." During the takeover of The Bear Stearns Companies by J.P. Morgan Chase in March 2008, reports swirled that shorts were spreading rumors to drive down Bear Stearns' share price. Sen. Christopher Dodd, D-Conn., said this was more than rumors and said, "This is about collusion."

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 was worth an estimated $64.8 billion prior to its collapse.

Pervasiveness of securities fraud

Securities regulators and other prominent groups estimate civil securities fraud totals approximately $40 billion per year. Fraudulent schemes perpetrated in the securities and commodities markets can ultimately have a devastating impact on the viability and operation of these markets.

Class action securities fraud lawsuits rose 43 percent between 2006 and 2007, according to the Stanford Law School Securities Class Acton 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.

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 Statesmarker securities and commodities market, 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 Exchangemarker 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.

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 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), an obsolete model of business (Penn Central, Woolworth's), inadequate market share (Studebaker), or non-criminal incompetence (Braniff).

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.

Related subjects

External links

  • New York Attorney General Report on Microcap Stock Fraud [192198]
  • President's Corporate Crime Task Force [192199]
  • Securities Lawyer's Deskbook, University of Cincinnati College of Law [192200]
  • Significant Criminal Cases, Department of Justice website [192201]
  • Stanford Securities Class Action Clearinghouse [192202]
  • Securities Arbitration Overview [192203]


  1. San Francisco Securities Fraud
  2. Testimony Concerning Insider Trading, Linda Chatman Thomsen, Director, Division of Enforcement, U.S. Securities and Exchange Commission
  3. "Trading Scandal May Strengthen Stock Exchange" New York Times, April 14, 2005, accessed 5/3/08
  4. San Francisco FBI web link, supra
  5. The President's Leadership in Combating Corporate Fraud
  6. Ex-PurchasePro Chief Found Guilty of Fraud, Obstruction -
  7. ABC News, Retrieved May 18, 2008
  8. Internet Fraud: How to Avoid Internet Investment Scams
  9. ibid
  10. ibid
  11. ibid
  12. Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 29 "Insider Trading" p. 584
  13. Laws that Govern the Securities Industry U.S. Securities and Exchange Commission, accessed March 30, 2007
  14. "Micro-cap Fraud," North American Securities Administrators Assn.
  15. "The Mutual Fund Trading Scandals," Journal of Accountancy, December 2004,, access 5/3/08
  16. SEC Admin. Proc. File No. 3-11818, Feb. 9, 2005
  17. "Key Points About Regulation SHO," Securities and Exchange Commission, accessed May 4, 2008
  18. "A New Wave of Vilifying Short Sellers," New York Times, April 30, 2008, accessed May 15, 2008
  19. Iowa Insurance Division,, accessed May 9, 2008
  20. Stanford Securities Class Action Clearinghouse,, retrieved May 26, 2008
  21. "The World Price of Insider Trading" by Utpal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002)

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