What Is Securities Fraud? Definition, Types & Examples

The trading of securities like stocks, commodities, derivatives, and bonds is overseen by the Securities and Exchange Commission (SEC), a government agency responsible for protecting investors and regulating the securities industry. Ideally, all securities trading would be conducted truthfully and transparently, but in practice, this is not always the case.

What Is Securities Fraud in Simple Terms?

Securities fraud occurs when one party illegally acts on or misrepresents information in order to make money in the securities market at the expense of other parties. According to the Federal Bureau of Investigation, securities fraud is a broad term that includes many different types of crimes, all of which involve the “deception of investors or the manipulation of financial markets.”

The perpetrator of securities fraud can be a person (like a fund manager or a stockbroker), a group of people, or a company. In general, securities fraud is considered a “white-collar crime,” a colloquial term for a nonviolent offense associated with finance and/or business.

3 Common Types of Securities Fraud

There are many different types of securities fraud, many share similar characteristics. The following are some of the most common types to watch out for.

Ponzi Schemes

A Ponzi scheme involves a group or individual acting as a fund manager, promising uniquely high returns with little risk. In a Ponzi scheme, the “fund manager” doesn’t usually invest customers’ money at all. Instead, a fraction of the money received from new customers is passed on to older customers as dividends or interest along with documents fraudulently claiming high returns, convincing most existing customers to leave their principal investment in the “fund” and possibly invest more.

If a customer withdraws their principal, they are paid with money invested by other customers. As long as the perpetrator(s) are able to continue finding new “investors” (often via word of mouth from existing customers about their stellar returns), there is plenty of new money available to pay interest and dividends to existing investors and cash out the few investors who withdraw their principal.

Eventually, if the influx of new investors wanes, and enough investors attempt to withdraw from the fund in a relatively short period, a Ponzi scheme usually collapses, as not enough money exists to cover existing customers' withdrawals.

Pump-and-Dump Schemes

In a pump-and-dump scheme, one or more fraudsters urge any investors who will listen (often via internet message boards) to buy shares of stock. Usually, it is a relatively cheap, obscure stock with low trading volume and low liquidity like a penny stock. The fraudster claims to have inside information or knowledge about an upcoming development that should send the stock’s price skyward. Usually, there is very little public information available about low-price, low-volume stocks, so it is difficult for investors to diligently research the fraudster’s claims.

In reality, the fraudster already owns many shares of this stock but has no genuine reason to recommend it to others. If their message is convincing enough, and enough investors buy enough shares of this stock, it does go up significantly in price simply due to the influx of new buyers (a stock’s price is dictated by its supply and demand). This is the “pump” portion of the scheme.

Once the fraudster is satisfied with the stock’s price, they quietly sell all of their shares at once, pocketing their gains (this is the “dump” portion of the scam). This massive selloff causes the stock’s price to plummet, resulting in all of the duped investors who bought in at the advice of the fraudster to lose a large percentage of the value of their investment.

Advance-Fee Fraud

Advance-fee fraud describes any scheme in which a party asks a potential investor or customer to pay a tax, commission, insurance fee, security deposit, or other expense before some sort of deal can go through. In many cases, this fee is described as a sort of refundable deposit that the investor will get back later in the process.

These sorts of schemes are often targeted at individuals who have already lost money on an investment. For instance, if an investor had purchased shares of an obscure, low-liquidity penny stock with low trading volume and then lost money on them, a fraudster might claim to be able to sell all of their shares at once but require some sort of advance fee to do so.

Once the investor pays the fee, the fraudster pockets it and does not facilitate the sale, purchase, or deal as agreed upon. In many cases, advance-fee schemers tell their victims to transfer the fee to some sort of independent agent or escrow account in order to seem more secure and legitimate.

Frequently Asked Questions (FAQ)

Below are answers to some of the most common questions investors have about securities fraud.

Is Securities Fraud a Criminal or Civil Offense? Is It a Felony or Misdemeanor?

Securities fraud is a criminal offense and may be prosecuted as such, but civil penalties may also be disbursed if the perpetrator is sued for damages by victims in civil court.

Criminally, securities fraud is a federal crime and Class C felony that carries a maximum sentence of 25 years in prison in addition to any applicable fines.

Who Investigates Allegations of Securities Fraud?

The SEC has an enforcement division responsible for the detection, investigation, and prosecution of securities fraud. Other government agencies involved in the investigation of securities violations include the Federal Bureau of Investigation (FBI) and the Federal Trade Commission (FTC), whose goal is to protect consumers against “anticompetitive and fraudulent business practices.”

What Are the 4 Legal Elements Required to Claim Civil Damages for Securities Fraud?

In order to prove securities fraud “by a preponderance of the evidence” (the burden of proof in civil cases), the plaintiff must establish the following four elements.

1. The perpetrator misrepresented material information.
2. The perpetrator did so knowingly.
3. The plaintiff acted on this misinformation.
4. Acting on this misinformation resulted in the plaintiff losing money.