Picking losing stocks or losing on your investments is not a form of securities fraud, even though it may feel like it. However, another risk lurks besides your lackluster stock picks, called securities fraud. And when scams happen, unsuspecting investors are often caught off guard.
Over 40 million Americans are defrauded billions of dollars yearly through investment fraud. Similarly, according to the Canadian government, between January 2014 and December 2016, fraudsters swindled approximately $290 million from Canadians.
Securities fraud, or stock or investment fraud, involves manipulating information investors use to make decisions. It’s a white-collar crime committed in various ways but commonly involves the manipulation of financial markets through illegal methods.
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Common Forms of Securities Fraud
Unfortunately, the instances of securities fraud happen at an alarming rate. The most common forms of securities fraud are listed below:
- Breach of fiduciary duty
- Failure to supervise employees
- Misrepresentations or omissions
- Ponzi schemes
- Unauthorized or excessive trading
- Embezzlement
- Insider trading
- Boiler rooms
We’ll discuss each of these in further detail below.
1. Breach of Fiduciary Duty
As we covered in previous blogs, brokers and registered financial advisors are legally obligated to meet and uphold fiduciary standards.
This means they must act in the best interest of their clients, disclosing all possible conflicts of interest. A failure to do so amounts to a breach of their fiduciary duty.
2. Failure to Supervise Employees
Investment firms are responsible for supervising their employees. Included in this are the regular reviews of client portfolios to ensure the investments meet the objectives and risk tolerance of the investor.
An investment firm failing to implement an adequate supervisory system can be liable for investor losses.
3. Misrepresentations or Omissions
Of all the types of securities fraud, Misrepresentation is one of the most common. It can be a false statement about an investment in a company. This company supposedly has a cutting-edge product, massive earnings, or a multi-million dollar contract when none is true.
Misleading statements by omission include scenarios where the financial advisor fails to tell you the earnings surprise was a one-time past event. Or perhaps the so-called cutting-edge product can’t be patented. And the multi-million dollar contract is with another company about to file bankruptcy.
Those missing facts undoubtedly influenced whether or not you sunk your money into the investment. Sadly, however, the fraudster doesn’t care. All they care about is making money off the commissions.
4. Ponzi-Like Schemes
With the promise of little low risk for investors and a high return, Ponzi schemes are a staple form of securities fraud. Scammers have been taking advantage of people since the early 1900s; the scheme has resulted in the loss of billions of dollars.
What’s unique about Ponzi schemes is the timing and source of money to investors. Instead of issuing returns to investors from the profits, new investors’ funds are paid to early investors. Thus, regardless of market conditions, victims of Ponzi schemes are promised guarantees of returns.
However, Ponzi schemes unravel quickly when companies fail to attract new victims. This is why most Ponzi scheme companies focus on advertising to new investors to keep their schemes afloat.
Unauthorized trading occurs when a broker trades in a customer’s account without authorization. Excessive trading happens when a financial advisor makes multiple transactions in a customer’s investment account to increase commissions. Excessive trading costs investors significantly in the long run and is a common form of securities fraud.
6. Embezzlement
Embezzlement refers to the theft, misappropriation, or conversion of money placed in one’s trust or that belongs to an employer. Essentially, you’re taking money without permission. In some cases, the perpetrator may take small amounts over a large sum at once using various methods to cover up the crime.
This sometimes includes moving funds from one account to another or producing fake receipts to ensure the missing money goes unnoticed. Sometimes, embezzlement can occur over several years before the owner or financial department realizes what has happened.
7. Insider Trading
An inside trade involves using “non-public, material information” to buy or sell stocks. This person or “insider” has information about the company no one else is privy to.
An insider typically includes any of the following:
- A director or officer of an issuer.
- A director or officer of a person who is an insider or subsidiary of an issuer.
- A person with beneficial ownership of or control or direction over (directly or indirectly) securities of an issuer with over 10% of the voting rights attached to the issuer’s outstanding voting securities (a significant shareholder).
8. Boiler Rooms
A boiler room is a scheme in which salespeople apply high-pressure sales tactics to persuade investors to purchase. Investors are told that they can buy into a company about to go public, where they can expect the price to skyrocket when the event occurs. But when the dust settles, no such company exists.
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The Largest Ponzi Scheme in History
American hedge fund investor Bernie Madoff was best known for operating history’s largest Ponzi scheme. Evidence showed that Madoff falsified trading reports to indicate clients were earning profits on investments that did not exist. Madoff received a 150-year sentence in federal prison after pleading guilty.
Victims of Securities Fraud
You can claim securities fraud under federal and state statutes and ordinary common law fraud. Notably, though, securities fraud statutes usually have statutory remedies. One, for example, includes the provision of prejudgment interest on the full purchase price of the securities and your attorney fees.
Problem With Securities Fraud Statutes
The only problem with securities fraud statutes is that they generally come with short statutes of limitation. You must act and file suit quickly to take advantage of them.
State and Federal securities laws mandate complete disclosure of all material information about a security. That includes any conflict of interest that exists. Failure to provide clients with the full disclosure of information amounts to a breach of fiduciary duty and is a form of investment fraud.
How Not to Become a Victim of Securities Fraud
Identifying crafty schemes or shady, fraudulent investments – can be tricky. Below are four questions to ask yourself to help you identify if an investment is legitimate or not:
- Does it sound too good to be true?
- Did you get a ‘hot tip’ or insider information?
- Did the person selling it to you use phrases like “high-return,” “no-risk,” or “once-in-a-lifetime opportunity?”
- Is the person selling it registered to sell investments?
If the answers to the questions are yes, you may want to seriously reconsider the investment and consult with a registered financial advisor. Overall, it’s important that you:
- Ask to see the prospectus or other disclosure documents for the investment.
- Only deal with registered advisors.
- Make cheques payable to registered firms, not individuals or other unrelated companies.
Red Flags to Watch Out For
To prevent becoming a victim yourself, watch out for any or all of the following “red flags”:
- Any mention of guaranteed returns
- A promise of zero to no risk
- Pressure to act quickly
- Any mentions of limited-time offers
- Name-dropping or talk of how many people, especially well-known investors, have purchased.
- Free lunch or dinner is provided if you sit through the pitch.
- Any offer that wants to use untraceable wire transfers for the exchange of money
Final Thoughts: What Is Securities Fraud?
First and foremost, follow your gut. If something feels off, it likely is. You have a responsibility to ask tough questions. After all, it’s your hard-earned dollars on the line.
