The Many Faces Of Investment Securities Fraud – Revealed!
- Why you must still be on the watch for securities fraud despite rules and regulations.
- How to guard your emotions against these masters of deceit.
- The extreme price you'll pay for not educating yourself about securities fraud.
Sixteen of the most common securities frauds are listed below.
Study this list and become familiar with the common characteristics of each fraud so that you recognize it when you see it and can avoid getting duped.
Educating yourself about investment securities fraud is the best defense against becoming its next victim.
Once your money is gone, you can't get it back. Protect yourself starting today.
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Securities Fraud #1 – Penny Stocks
The micro-cap stock market (ie: penny stocks) has a long history of fraud, yet it attracts new investors every day.
The dream of owning the next Microsoft, Yahoo, or eBay at the start-up stage and riding it to easy riches is enough to make even a skeptic’s greed glands salivate.
The other allure of micro-cap stocks is the false feeling of big time investing that comes from buying more shares with less money.
For example, $1,000 will only buy ten shares of a $100 stock, but it will buy 10,000 shares of a 10 cent stock, and 100,000 shares of a penny stock.
Many inexperienced investors prefer 100,000 shares of dubious value over ten shares of real value. They love the idea that a single penny change in the price can double their wealth. Exciting stuff … sort of.
Unfortunately, there are two fundamental problems with penny stocks that make them ripe for securities fraud.
- Minimal information: Many micro-cap stocks fall below minimum asset and shareholder requirements for SEC reporting. Lack of information disclosure and regulatory oversight invites fraud because the risk of discovery is lower. Additionally, there’s seldom any legitimate analyst coverage or press scrutiny for many of these stocks, which further reduces information flow and lowers the risk of discovery for scam artists. Con artists will always gravitate where the risk of getting caught is lowest – which includes penny stocks.
- Low liquidity: The second problem with penny stocks is low prices, small daily volume, and minimal stock float, making them ripe for unscrupulous promoters to control the stock and artificially manipulate prices. See the example of “Pump and Dump” below for how this manipulation works. In addition, low liquidity can also make selling a large position without negatively impacting price a difficult task when it's time to exit.
The two most common forms of securities fraud in penny stocks are “pump and dump” and “bogus offerings”.
- Pump and Dump: This fraud occurs when someone acquires control of a large amount of a company’s stock and then pumps up the price. They then provide misleading and false information in press releases, spam email, internet discussion group postings, and other unverified sources. The sudden burst in promotion temporarily increases demand for the stock, causing the price to rise, which creates additional demand from momentum buyers jumping on the bandwagon, leading to further price increases. Once price momentum is established, the scam artist sells his shares and walks away from the promotion, causing the stock to tank.
- Bogus Offerings: This fraud is sold in the form of an unverifiable breakthrough technology or forthcoming large contract announcement for some unknown company. Often, the company will have no operations, earnings, or audited financial statements, and may in fact be little more than an idea or a shell.
The general rule for penny stock investing is to avoid it unless you’re an investor with specialized expertise in the business.
“You may be deceived if you trust too much, but you’ll live in torment if you don’t trust enough.”– Frank Crane
Penny stocks have higher risk for investment fraud than conventional securities, and they require unique investment skills and experience that few investors possess in order to earn reliable profits. They’re best avoided.
Securities Fraud #2 – Prime Banks
Prime bank fraud is designed to attract conspiracy theorists who believe the Rockefeller's, Rothschild's, Saudi Royalty, and other members of the privileged class have secret access to highly lucrative investments that a mere commoner like you and I can’t normally invest in.
Triple digit returns may be promised for becoming a “privileged investor” with access to the world’s elite bank portfolios: “prime banks”.
The only problem is prime bank securities don’t exist.
Neither do other related forms of this type of fraud which include “standby letters of credit,” “revolving credit guarantees,” and other legitimate-sounding euphemisms for fictitious high yielding debt.
Avoid all forms of unconventional, high-yielding debt issued through non-verifiable sources. Be particularly cautious when the investment includes nonsense about being given access to something normally reserved for the privileged few.
Securities Fraud #3 – Institutionalized
Bull markets are often associated with a permissive social culture that can lead to brazen investment business practices resulting in institutionalized securities fraud.
Few investors take notice of lapses in integrity as long as everyone is making money and the markets continue to rise. When the punch bowl is removed, then the hangover that follows can reveal institutionalized securities fraud.
- Accounting Fraud: Enron, WorldCom, and other big name corporations defrauded millions of investors through “creative” accounting and inadequate disclosure during the late 1990’s bull market. Under normal conditions, an entire regulatory and oversight system exists to catch these problems, but during great bull markets, the scrutiny of regulators and auditors produces insufficient results.
- Unethical Mutual Fund Practices: Late-trading and front-running are two privileges that were granted by many mutual funds during the late 1990’s to insiders and large institutions. This gives them an unfair advantage while betraying their fiduciary responsibility to individual shareholders. The total cost of this fraud to Main Street investors will never be known.
- Analyst Research Conflicts: A long history of investment fraud can be found in brokerage firms co-mingling investment banking to institutions with investment sales to individuals under one roof. Individual investor recommendations by in-house analysts are often tainted by lucrative investment banking relationships.
You wouldn’t trust medical advice from your doctor if he was biased by sales commission kickbacks from drug companies, so why would you make the same mistake with your investment advice?
Related: 5 Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
Unfortunately, many investors aren’t even aware of the biases inherent in the investment advice they receive.
“Honesty: the most important thing in life. Unless you really know how to fake it, you'll never make it.”– Bernard Rosenberg
For example, Merrill Lynch settled with the New York Attorney General’s office for $100 million for this misleading practice (without admitting any wrongdoing, of course). Other big name brokerage firms ran into similar conflict of interest charges.
The fundamental problem causing institutional securities fraud is the greed and easy-money character of major bull markets that can result in a promiscuous business culture.
In the search to maximize bottom line profits, there’s always the risk that one bad apple will place expediency in front of integrity, resulting in fraud.
Just because an institution is large and reputable doesn't make securities fraud impossible.
Securities Fraud #4 – Unlicensed Sales Agents
Investment scam artists use the lure of high commissions to enroll independent insurance agents, financial advisors, investment seminar speakers, and accountants as sales representatives for securities fraud.
Independent agents are the perfect sales outlet because they’ve already earned your trust, but lack sophisticated compliance departments and due diligence procedures to uncover illegitimate investments.
The result is a trusted expert who actually knows little more than you about sorting fraud from legitimate investments.
Be wary if your agent offers high returns with little or no risk on viatical contracts, brokered CD's, equipment leases, factoring, promissory notes, or other unconventional investments.
Just because you trust your independent insurance agent or accountant for the professional services they regularly provide doesn't necessarily qualify them as an investment expert.
Securities Fraud #5 – Affinity Groups
Affinity group fraud is another example of mistaken trust. Investment fraudsters will exploit their victim’s age, religious, ethnic, sexual, or professional identity to gain your confidence knowing that it’s human nature to trust people who are like you.
Affinity fraud bypasses the natural distrust we have for schemes promoted by strangers.
The usual method of selling the fraud is to enroll a trusted, leading member of the group (who's seldom an investment expert) into selling the fraud to the remainder of the group.
The lure to invest is the supposed profits that will somehow benefit the church or professional organization that you want to support.
“We have to distrust each other. It's our only defense against betrayal.”– Tennessee Williams
For example, a respected church leader is sold an investment. The scam artist then informs this leader that if church members also purchase the investment, then profits can benefit the church or its favorite charity.
The leader unwittingly promotes the fraud to the congregation with the good intention of benefiting the church. The congregation invests based on their trust for the leader and their desire to support the church.
The con man bypasses the usual distrust he experiences by using the affinity of the group.
Senior fraud is a specialized form of affinity fraud. Seniors are natural fraud targets because they've accumulated significant assets from a lifetime of saving and investing.
Low interest rates, rising health costs, and increased life expectancy have forced many seniors to seek higher returns than conventional investments provide.
In addition, their age gives them a common set of interests and concerns for fraud promoters to exploit through affinity.
This is an unfortunate combination of circumstances that makes this group a prime target for investment fraud.
Securities Fraud #6 – Stock Brokers
Always scrutinize your brokerage statements for unexplained fees, unauthorized trades, or other financial irregularities.
In addition, your broker may have recommended investments unsuitable for your particular needs.
For the complete story on what to look out for, see the article in our investment fraud series titled “Stock Broker Fraud”.
Securities Fraud #7 – Promissory Notes
Promissory note fraud takes the form of short-term debt obligations issued by bogus companies. Typically, they're sold through independent insurance agents and offer above market returns with little or no risk – “guaranteed”.
Always beware of any investment offering above market interest rates and guarantees. It's a potentially lethal combination.
Also, beware of trusted professionals selling investment products that aren't their ordinary field of expertise (such as insurance salespeople or accountants promoting investments).
Securities Fraud #8 – Advance Fees
The objective of this fraud is to steal the advance fees you pay to participate in some larger objective.
For example, you might be asked to make a series of upfront payments for a bargain shipment of heating oil, coal, or some other commodity that ultimately never arrives.
Alternatively, you might be offered an interest-free loan from an off-shore bank if you pay an application fee in advance.
Regardless of the service or product promised, the formula is for you to pay an entrance fee now for something you’re supposed to receive later – but never arrives. The fee paid is the scam artist's profit.
Securities Fraud #9 – Inappropriate Investments
Certain legal investments cross the boundary into securities fraud when they're sold to the wrong person without adequate disclosure.
The most common investment in this category is variable annuities because of their costly surrender charges, steep commissions, and high expense structures.
For the complete story on variable annuity investment fraud see the related article “Variable Annuities Explained – What You Must Know”.
Similarly, callable CD’s are higher yielding, longer-term certificates of deposit that can be redeemed by the issuing bank. The problem with these securities is the potentially high penalty fee for early withdrawal if the investor needs liquidity.
The long-term nature and high surrender charges make them inappropriate for investors needing current access to their money.
“You may deceive all the people part of the time, and part of the people all the time, but not all the people all the time.”– Abraham Lincoln
Securities Fraud #10 – Viatical Settlements
Viatical settlements were originally created to help seriously ill people pay medical bills by selling the death benefit from their life insurance policy to an investor for immediate cash.
There’s nothing illegal about viatical settlements, but when they're misrepresented, they can become a type of securities fraud.
For example, the health condition of the seller could be falsified or even improve over time, thus impairing the return on investment.
Alternatively, the insurance could be invalid due to fraudulent applications, or there could be no actual insurance or greatly reduced benefits making the investment essentially worthless.
Viatical settlements are complicated investments requiring specialized due diligence skills. They're not for the inexperienced.
Securities Fraud #11 – Offshore Investing
Whenever your money leaves the country, the laws that protect it don’t follow. Any investment from another country requires extra due diligence because domestic regulations and oversight don’t apply.
Few investors know the laws of their own country, not to mention the laws of a foreign country. Many of the assumptions you invest on in your own country are invalid overseas. The capability to pursue grievances may be limited, increasing your risk. Beware…
Securities Fraud #12 – Bogus Business Offerings
The calling card for this fraud is an exciting, low-risk, easy money investment opportunity in an exotic sounding business. Below are certain businesses which attract more than their fair share of financial fraud:
- Oil and Gas: Beware of “working interests” in “proven” oil and gas wells. Frauds include fake drilling equipment set on worthless land or vacant wells that haven’t produced in years.
- Equipment Leasing: Pay close attention when a company sells you a piece of equipment which it agrees to lease back for a fee. Be certain the company is legitimate and the contract fee structures make business sense. Pay phones, ATM machines, internet kiosks, or any other consumer technologies are favorites among leasing fraud.
- Franchise Offerings: “Get in on the ground floor of this can’t-miss opportunity.” Yeah, right! Legitimate franchises are everywhere, causing people to abandon their usually cautious nature when confronted with a bogus franchise. Over-inflated store results and phony testimonials are used to extract upfront franchise fees for misrepresented services, supplies, and goods.
- New Technologies: Watch out for people seeking funding for a new patent or invention sure to make you rich. Similarly, beware of investment frauds designed to imitate legitimate technologies such as FCC licenses for cell phones, wireless cable, or interactive video.
Securities Fraud #13 – Precious Metals
There are several ways you can be ripped off investing in precious metals and gems. Below are the most common:
- Grading: Coins could be falsely graded at a higher quality level than is actually the case, or a precious gem could be worthless due to undisclosed flaws.
- Safekeeping: Bullion or coins may not exist at all when they are “kept safe” in the seller’s vaults. Adding insult to injury, not only do you pay for the nonexistent precious metal, but you pay fees on top of it all to store what never was.
- Mining Fraud: Beware of investment offerings claiming a new technology to mine precious minerals from previously closed mines and worthless tailings.
Any time precious metals or gems are offered at below market prices, it should serve as a red flag for thorough due diligence.
Securities Fraud #14 – Abusive Sales Practices
Never buy an investment over the phone from a cold-caller and never tolerate high pressure sales tactics from your broker.
Abusive sales people use intimidation and careful scripting to rush you into a decision without first helping you fully understand all the risks and realities of your investment.
If the caller or salesperson refuses to take “no” for an answer, then just hang up or walk away. You deserve better.
Securities Fraud #15 – Internet
The changing face of communications technology provides new tools for the investment scam artist to exploit. First was mail, then the telegraph became a popular tool for investment scammers. Next was the telephone, and now it's the internet.
“The secret of life is to appreciate the pleasure of being terribly, terribly deceived.”– Oscar Wilde
The internet has made investment fraud more efficient and effective. Con artists can purchase lists of targeted groups, use automated data-gathering tools, and post to discussion groups at almost no cost and with complete anonymity.
With a few clicks of a mouse, fraudsters can reach millions of people by building a website or entering various chat rooms. One person could use many of these web-related tools under various aliases to cheaply and easily create a virtual facade of legitimacy with little risk of detection.
Another example of internet investment fraud is online newsletter publishers who are paid cash and securities to tout certain stocks.
This isn’t illegal; however, the biased advice must be disclosed. Watch out for newsletters that bury information about who paid them, the amount, and the type of payment in fine print so you never see it.
By the way, at Financial Mentor, we never tout individual securities. Our independence and lack of bias is essential to the credibility of the educational service we provide.
You should verify all investment advice from unknown sources online by checking reputable sources offline – be skeptical. Remember, almost anyone can make himself appear to be an established and successful company for very little cost online.
Don’t be dot-conned.
Securities Fraud #16 – Ponzi Schemes
Last, but certainly not least, are Ponzi schemes. Named after Charles Ponzi, a swindler from the 1920’s, these pyramid schemes promise high returns to lure investors. It uses the money from new investors to pay previous investors.
The large payments to early investors add credibility to the fraud, which convinces skeptics to invest and further fuels the fraud’s growth.
Little or no actual investing ever takes place, and the fraud blows up when regulators step in or an insufficient number of new investors enter to pay off existing investors.
In Summary – Three Principles of Securities Fraud:
I hope you enjoyed our quick tour of the securities fraud world. It may not be a fun subject, but it's necessary to understand.
In summary, there are three principles you should take away from this discussion…
- Regulated, domestic securities and dealers have a lower risk of fraud than their unregulated and offshore counterparts. That doesn’t mean you can drop your guard against fraud with regulated securities. Quite the contrary, as evidenced by the sections on broker fraud and institutionalized investment fraud. All it means is the risk of investment fraud is lower when regulation is higher, but fraud still exists regardless of regulation.
- Investment fraud comes in many forms and changes with the times. Con men usually attempt to sell the fraud by appealing to people’s desire for easy riches and use tools of deceit to separate you from your money. See our article “The Top 26 Warning Signs of Investment Fraud” for the complete story.
- Your first line of defense against securities fraud is a healthy dose of skepticism and information that educates you to recognize fraud when you see it. Your second line of defense is a thorough due diligence process that uncovers the less obvious cases of investment fraud before you ever lose a dime. For a comprehensive checklist on investment fraud due diligence, see the article “Investment Fraud Due Diligence”.
If you invest long enough to build wealth, then the unfortunate reality is you’ll almost certainly encounter securities fraud.
Educate yourself now so that you can avoid becoming its next victim.
Forewarned is forearmed…
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How about this? Private equity firm managing partner touting educational credentials that are likely true but- via their private equity firm website, claim a registered firm, claim an office, and claim to have several billion under management; all in an attempt to lure investors and people seeking employment alike? All of which I know to be completely false.
I moved across the country to work for such a firm and found out all to be lies. I am considering suing.
Excellent content! Thank you for your help.
Uh…What about REMIC Mortgage Trusts? I know they’re only responsible for the financial collapse, but it seems worth talking about.
The fraud starts at the conception, when a future borrower thinks they’re getting a loan, but in reality, selling stock in an undisclosed sale of securities. The borrowers sign a promissory note which they believe to be nothing more than an IOU, but it’s not. And then the note is illegally converted, because convertible notes must clearly state they they are convertible.
It gets much worse, but ….
I want to know the platform where I can apply investigations against brokers? Like a y solicitor or a y companys . I lose more than £25000 with plus500 my brother father they all victims of fraud we all lose lots of money.
You neglected to expose the retirement benefits embezzlement or asset backed securities fraud perpetrated by countless employers – hedge fund – trustee banks that has been ongoing since 2002. The Government aids & abets such embezzlement by silencing the whistleblowers that expose it.
Uhhhh, you might be confusing all the wrongdoing in society with “securities fraud.” They aren’t the same thing. There are many illicit activities in the financial world that are not technically securities fraud. Hope that helps clarify.