Securities Fraud: How

Securities Fraud: How It Happens and How to Avoid It

Securities fraud is when someone purposefully lies or omits important information to get investors to buy or sell stocks or other investments. It’s illegal and can lead to huge fines or even jail time if caught. But it still happens more often than you’d think. Let’s break down exactly what securities fraud is, some high-profile examples, how regulators try to catch it, and most importantly – how regular investors can avoid falling victim to schemes and scams.

What Exactly is Securities Fraud?

There’s a few main types of securities fraud:

• Insider trading – when corporate insiders use non-public information to profit on trades
• Accounting fraud – where companies cook the books or leave important info out of financial statements and earnings reports
• Pump-and-dump schemes – when scammers promote (“pump up”) a stock through false or misleading info, then sell their shares when the price gets high enough
• Boiler room operations – call centers that use high-pressure sales tactics to get people to buy worthless or fake stocks

Some other common examples include:

• Lying on a prospectus about the risks of an investment
• Spreading false rumors to drive a stock price up or down for profit
• Manipulating share prices through techniques like wash trading or spoofing
• Bribing stock brokers to sell specific bad investments for a commission

As you can see, it covers everything from flat-out lying about a company to more complex and hard-to-catch stuff like insider trading and share price manipulation. But in all cases, its lying or cheating to take advantage of investors.

Famous Cases of Securities Fraud

Some of the biggest securities fraud cases over the last 20 years include:

• Enron – The energy company falsely inflated earnings to boost its stock price. It ended up wiping out $78 billion in stock value when the massive accounting fraud came to light in 2001.
• Worldcom – The telecom giant inflated assets by as much as $11 billion through fraudulent accounting. Its 2002 bankruptcy, caused by the fraud, was the largest in U.S. history at the time.
• Bernie Madoff – His Ponzi scheme defrauded thousands of investors out of $65 billion over 30+ years. He was sentenced to 150 years in prison.

Some more recent big cases include German software maker Wirecard which disclosed $2.1 billion of cash was missing in 2020. The CEO was arrested and the company filed for insolvency. Also the 2021 collapse of investment fund Archegos Capital which cost banks like Credit Suisse and Nomura nearly $10 billion in losses from margin calls on Archegos’ heavily leveraged portfolio.

How Securities Fraudsters Try to Avoid Getting Caught

The SEC and other regulators have gotten stricter over the years when it comes to fraud. But as the Wirecard and Madoff cases show, big schemes can still slip through the cracks for years. Fraudsters use every trick imaginable to avoid getting caught, like:

• Hacking or bribing auditors and regulators to hide problems
• Setting up shell companies to hide losses or shift liabilities
• Getting friends to vouch for their claims to add credibility
• Blaming mistakes on technical glitches or bad processes
• Suing critics and whistleblowers with gag orders to silence them
• Complex accounting tricks like deferred expenses or inflated valuations on hard-to-value assets like patents or brands

No investor is completely safe from fraud. Even pros like hedge fund managers and research analysts get tricked sometimes. But the average investor is a lot more vulnerable if they don’t know what red flags to watch out for.

Red Flags Regular Investors Should Watch For

The SEC and sites like Investor.gov list pages of red flags. But there’s too many for the average person to track. Here’s a short list of the most important signals for everyday investors:

• Missed earnings targets multiple quarters in a row
• CEO/CFO quits suddenly without explanation
• Company keeps changing auditors every 1-2 years
• Superfast revenue growth compared to competitors
• Strange spikes in trading volume without news
• Analyst price targets always seem “too good to be true”

Learning how to read earnings reports and financial statements yourself is so valuable. It lets you rely less on what the company or analysts say. Look for weird jumps in things like debt, executive compensation, or off-balance sheet items. Anything that seems smoothed out or manipulated is worth digging into more.

Lastly, always check for stock price manipulation. Volume spikes, trading halts, or volatile single-day moves should all prompt more research.

How to Report Suspected Securities Fraud

If you come across something suspicious in a stock you own or are researching, here’s a few things you can do:

1. Report it to the SEC’s Office of the Whistleblower at (202) 551-4790
2. Contact FINRA’s whistleblower hotline at (866) 963-4672
3. File a complaint form with the SEC’s Tips, Complaints and Referrals program
4. Hire an SEC whistleblower lawyer to anonymously report on your behalf for a potential reward

The SEC and FINRA rely heavily on investor tips to know where to start fraud investigations. So even if you just suspect something fishy, it’s worth reporting. You could end up helping them stop the next Bernie Madoff!

How Investors Can Protect Their Money

Here’s a few quick tips to help investors avoid losing their savings in investment frauds:

• Stick with large, reputable brokers like Fidelity and Vanguard
• Set up 2-factor authentication on your investment accounts
• Don’t take stock tips from cold callers – hang up!
• Check brokercheck.finra.org before working with any advisor
• If guaranteed returns sound too good to be true, they always are
• Pay attention to news and SEC filings instead of hype and rumors

Diversifying your portfolio across asset classes, companies, industries, and geographic regions helps minimize damage too. If one stock craters from fraud, it won’t sink your whole nest egg.

Lastly, don’t underestimate the power of common sense. Step back from the excitement of a hot stock tip and objectively ask – does this really make sense? If you avoid greed and FOMO, you’ll stay safer.

The bottom line is fraudsters rely almost entirely on the greed and gullibility of investors. The more calm and critical thinking you can maintain, the less likely you’ll end up the victim. If something seems questionable, don’t hesitate to dig deeper or just walk away.