Swindling the Investor: A Look into Securities Fraud

Editor’s note: This article is an excerpt from the Association’s Fraud Examiners Manual, Third Edition, Vol. 1. It is not meant to be a substitute for the study of the entire manual. In this issue, the article covers the discussion on “Securities Fraud,” pages 1.1501 to 1.1518.  

Black’s Law Dictionary defines securities as, “Stocks, bonds, notes, convertible debenture, warrants, or other documents that represent a share in a company or a debt owed by a company.” The reference also provides a method for determining whether an investment is a security:

Test for a “security” is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others so that whenever an investor relinquishes control over his funds and submits their control to another for the purpose and hopeful expectation of deriving profits therefrom he is in fact investing his funds in a security. 

According to the Securities Act of 1933, investors have a right to information concerning securities for public sale. This act prohibits misrepresentations and omissions of material facts, which any reasonable investor would rely upon when deciding on an investment. These facts include the track record of the proposed company, management, competition, profits, and debts. Therefore, securities fraud may thus be defined as employing any device, scheme, or artifice to defraud. It can include Pyramid schemes, Ponzi schemes, advance fee loan schemes, and many others.

International securities fraud is becoming more prevalent as the changing global economy presents increasing overseas investment opportunities. And while the internet provides a new arena for fraud, the scam on the web are the same that have been foisted upon investors for centuries, but now are presented in a high-tech package.

It’s the Rule 

Under the Investment Company Act of 1940, investment companies are required to register with the Securities and Exchange Commission (SEC), which also regulates their activities. (See the end of this article). This act dictates qualifications for officers and directors, requires that certain matters are submitted for stockholder approval, and mandates SEC permission for certain transactions such as those between insiders and affiliates. It divides investment companies into three categories:

• Face-amount certificate companies: These include any companies engaged in issuing face-amount certificates of the installment type.
• Unit investment trusts: These companies are organized under a trust indenture, contract of agency, or those similar in nature, which don’t have a board of directors, and issue only redeemable securities.
• Management companies: Firms which don’t fit the criteria of the first two categories fall into this one. This includes open- and closed-end companies whether they are listed on securities exchanges or not.

Registered securities dealers are required to adhere to the Rules of Fair Practice issued by the National Association of Securities Dealers and the Investment Advisers Act of 1940. This act mandates registration and regulation of investment advisers and applies to those who regularly advise others for compensation on the investment, purchase, or sale of securities. This doesn’t apply to those who don’t receive compensation or who publish financial advice in a newspaper or magazine.

Personal Trading Violations 

Although financial advisers have been required to adhere to strict standards of fiduciary obligation for some time, SEC and government regulators have increased their vigilance on personal trading violations in large investment firms. Since the firing of Invesco Funds’ prominent portfolio manager John Kaweske in 1994 for violating company rules on personal trading, fund companies have also raised their internal regulatory efforts.

According to securities laws, financial advisers are held to a rigid code that prohibits them from engaging in trades which would create conflicts of interest with clients. The SEC demands that mutual fund companies issue and implement a written code of ethics addressing these issues.

Having full discretion over client accounts creates a temptation for some dealers to commit fraud. If clients aren’t buying or selling securities, the representatives don’t earn commissions. It isn’t difficult for a broker to manipulate a client’s account and earn a commission for doing so- all without the client ever realizing he’s been swindled.
Following are illegal and relatively simple ways in which dealers could take advantage of their clients:

• Unsuitable Recommendations: Brokers place clients into securities that are unsuitable to their financial profile, such as recommending a high-risk options contract to a senior citizen with limited assets.
• Unauthorized Trades: Brokers buy or sell securities in clients’ names without authorization.
• Churning: A broker engages in a large number of unnecessary transactions for a client to create commissions for himself and his firm.
• Mutual Fund Switching: Like churning, this involves moving a client from one fund to another purely for the sake of commission and not for the benefit of the client.
• Misrepresentations and Omissions: Investors are misled regarding all the hidden costs, risks, etc. in their investments.
• Conversion: A broker steals money from a client’s account.
• Excessive Commissions: Brokers charge commissions above the industry norm for each class of security.
• Market Manipulation: Investors are subjected to high-pressure sales pitches to buy stocks in which the broker-dealer has an undisclosed ownership.
• Front Running: In large firms, financial advisors purchase a certain stock, then push clients to buy the same, thus driving up the value of their purchases.
• Failure to Supervise: Firm managers fail to monitor their brokers and dealers to ensure their adherence to Rules of Fair Practice and state and federal laws.
• Failure to report client complaints: Investment and advisory firms don’t report client complaints to the SEC because they fear investigations.
• Parking: A security is sold by one party to another, with the understanding that the seller will repurchase it later at an agreed-upon price. This scheme allows circumvention of ownership reporting requirements and net capital rules.

Misrepresentations and Omissions 

In every securities fraud allegation the fraud examiner must examine the prospectus, sales literature, contracts, and any correspondence or possible misrepresentations or omissions of material facts.

The examiner also should investigate:

• Securities registration: Verify that all offerings to the public were registered with a state or a federal securities regulator.
• Incorporation: Ascertain whether the corporation was legally incorporated, or in the case of a partnership, whether it was legally filed.
• Financial statements: Verify the accuracy of the assets, liabilities, and income listed.
• Business history: Investigate the veracity of the company’s history- how long it’s been in business, whether it engaged in the business represented, and whether the claims of success are valid.
• Credentials: Research the Principal’s credentials for accuracy (that is, their education, experience, etc.). Make sure representatives are registered as securities dealers in the states in which they conduct business and that they are licensed brokers.
• Proceeds: Follow the money trail. Were the proceeds invested as documented or were they used for other purposes?
• Sales Commissions: Confirm the broker’s commission. Often these are higher than they appear.
• Cheap insider stock: Are the insiders retaining a majority of stock while the investors fund the company?

When brokers omit or fail to disclose material facts, it may involve:

• Legal problems: The company conceals its lawsuits, bankruptcies, criminal convictions, administrative orders, etc.
• Risk factors: The company withholds details regarding investments with high failure rates, the degree of competition in the market, or the inexperience of the company’s principals.
• Commission: The company conceals the amount of sales commission.
• Insider dealing: Company dealers receive undisclosed benefits.

A recent case shoes how the SEC handles misrepresentations and omissions. In 1997, the commission alleged that Walter Clarence Busby Jr. violated the anti-fraud provisions of the securities laws by offering and selling investment contracts in connection with three different prime bank schemes. Using misrepresentations and omissions in each of the three schemes, Busby raised money for purported trading programs in “prime bank” notes by telling clients that the investments were risk-free and would pay returns ranging from 750 percent to 10,000 percent. Busby raised nearly $ 1 million from more than 70 investors yet none of them has earned the exorbitant returns promised by Busby. Consequently, the commission sought disgorgement of all ill-gotten gains with prejudgment interest, the imposition of civil penalties, and a sworn accounting of all funds received by Busby during the schemes.

Defrauding Senior Citizens 

As with other con schemes, elderly people often are victims of securities fraud. Brokers take advantage of the trust these clients place in them and rely on the ignorance of the market to cover the scheme.

For example, in 1997, the SEC alleged that Michael J. Oberholzer, a former stockbroker, defrauded elderly clients over a six-year period by trading their accounts in “ways that were contrary to their interests so that he could obtain greater commissions,” according to the SEC’s complaint. The customers lost $320,000 as a result.

The SEC complaint also alleged that Oberholzer “traded on margin in their accounts without authorization, and purchased securities in their accounts that were unsuitable for their financial situation.” Oberholzer, the SEC alleged, made material misrepresentations and omissions to the customers, and he falsified his employer’s books and records. The customers were retired, elderly women on fixed incomes with little or no financial sophistication. Each of them had conservative financial objectives and invested a substantial part of their assets with Oberholzer’s firm, the SEC said.

International Securities Transactions 

Due to the developing global economy, foreign investments are the latest market trend. According to the North American Securities Administrator Association (NASAA), by late 1996, trading in non-U.S. securities totaled more than 10 percent each day in the average daily volume of the New York Stock Exchange. This trend has spawned a number of domestic and international securities fraud schemes. Investors are prey not only to con men operating from abroad but also to brokers seeking to circumvent domestic trade regulations by conducting phony international transactions.

Foreign securities investors face many challenges. They often are unaware that different countries’ exchanges have varying methods of regulating transactions. In some European countries, there aren’t any restrictions against insider trading. In others, there simply aren’t regulatory agencies to protect investor interests. Once an investment has been made, it may be difficult to monitor from another country. The stability of foreign economies should be researched thoroughly before any investments are made. Language barriers and unfamiliar business practices will complicate matters further.

In addition, investors should check if securities promoters from other countries are registered with state or federal securities agencies. In fraudulent securities schemes, promoters often claim they aren’t required to register their offerings because they’re based overseas.

Of course, many financial consultants and brokers attempt to circumvent SEC regulations by conducting transactions internationally. SEC Regulation “S,” for instance, provides some registration exemptions for stock sold to overseas buyers but doesn’t permit resale back to U.S. investors without registration or another exemption.

In the first criminal prosecution of a fraudster who tried to avoid registering stock under this regulation, a Florida executive masterminded a scheme to issue 1.4 million shares of his company to a 95 year-old woman and seven firms in the Bahamas, and then sell them back to U.S. investors. After the stock was issued to the woman and the companies, the executive then sold the stock back to investors in the United States for $5.5 million without registering the shares with the regulators, which was a violation of securities law.

On–line Securities Fraud  

According to the International Organization of Securities Commissions, there are more than a million brokerage accounts on-line and many investor advisory sites. Due to the ease with which transactions can be made and investment advice given on-line, many investors are turning to the Internet to conduct their financial transactions. Naturally, this means that many fraudulent securities schemes also will be circulating on the Net.

Internet fraudsters have many ways to disguise their identities. These “anonymizing” tools can obscure the source of the information or allow the sender to take on a pseudonym.

Pump and Dump 

Fraudsters post messages urging investors to either buy or sell a certain stock immediately. The message may imply that the writer has inside information or a foolproof formula for predicting stock market fluctuations. However, the person behind the message may have an undisclosed interest in the security and stand to gain from any sales while the investors take a loss.

Investment Opportunities/Pyramid Schemes 

Captivating “low-risk, high-return, once-in-a-lifetime” investment opportunities, such as ostrich farms, are touted. Often, these investments are compared to “safe” ones, such as government bonds or CDs, to raise the prospective investors’ confidence level. The opportunity may be grossly misrepresented or even a complete fabrication.

Price Manipulation 

By mass e-mailing questionable financial recommendations, the fraudster can influence the price and standing of a security. By using anonymizing tools, he can send these recommendations using different pseudonyms, lending an air of credibility to the information.

Fraudulent Offerings 

Those investing in securities offered on-line risk transacting with unregistered dealers and purchasing fraudulent offerings. Naturally, investors have no way of knowing if the investment they’re making is illegally benefiting the dealers.

The SEC offers the following guidelines to potential on-line investors to determine whether the offer is legitimate:

• Never invest without fully investigating the opportunity.
• Beware of offers that promise quick and exorbitant returns, offer inside tips, or pressure the investor to commit immediately.
• Aliases and pseudonyms, while frequently used on-line, should be regarded with suspicion when used by promoters of investments.
• International investment opportunities also should be regarded with caution. Once an investor’s money leaves the country, it becomes more difficult to track.
• Always make sure the company is registered with the SEC. The SEC’s Office of Investor Education and Assistance provides registration information: (202) 942-7040. State securities regulators also can help.

SIDEBAR 

Helpful Web Sites 

The Securities and Exchange Commission, www.sec.gov 

This site offers not only the latest information on securities legislation, but the latest in securities fraud as well. Current schemes are exposed to caution investors. Press releases are also available.

The International Organization of Securities Commissions, www.iosco.org 

IOSCO is made up of 134 member agencies, including the SEC and the U.K.’s Securities and Investment Board. Its objective is to ensure fair and uniform market regulation among its members. The website offers information on IOSCO’s structure, members, and resolutions.

North American Securities Administrator Association, www.nasaa.org 

Founded in 1919, this association is made up of securities administrators in the United States, Canada, Mexico, and Puerto Rico. The Web site provides pertinent investor advice and warnings on topics ranging from securities legislation to international investment and the licensing of brokers.

SIDEBAR 

The SEC is Securities Watchdog 

The Securities and Exchange Commission (SEC) administers the federal securities laws designed to protect investors and ensure they have full access to all material facts on publicly traded securities. The SEC regulates any company that buys and sells securities or provides investment consultation. It does this through five divisions, all headed by presidential appointees.

• Division of Corporate Finance: ensures disclosure requirements are adhered to by those publicly held companies registered with the commission;
• Division of Investment Management: guarantees observance of registration, sales, advertising, and financial responsibility requirements as they apply to investment companies;
• Division of Market Regulation: oversees securities markets, brokerage firms, and stock exchanges;
• Division of Enforcement: enforces and investigates violations of federal securities laws; and
• Office of Compliance Inspections and Examinations: inspects entities that deal in securities to ensure they comply with rules.

Legal Elements of Securities Fraud 

In most securities fraud cases, the following laws are invoked.

The Liabilities and Securities Act of 1933 

The provisions developed under this act are used to prosecute most securities law violations. They target:

• any fraud associated with the offer or sale of securities;
• offering or selling unregistered securities;
• promoting a security without disclosure that a promoter has financial interest;
• filing a false or misleading registration statement; and
• manipulating the over-the-counter market.

The Securities Exchange Act of 1934  

This Act prohibits:

• filing a false annual or periodic report;
• filing fraudulent proxy materials;
• unlawful short sales of securities;
• manipulating securities on over-the-counter and national exchanges; and
• failing to file insider ownership reports.

Rule 10b 

Securities dealers are prohibited from using manipulative or deceptive devices when purchasing or selling securities. The use or disclosure of inside information when trading securities is proscribed. It also calls for disclosure of material facts. This rule is designed to protect both the dealer and the buyer, whether the firm has securities registered according to the 1933 and 1934 acts or not. Rule 10b-5 applies to over-the-counter market, securities exchange, and private securities transactions.