Securities Fraud Laws

In the current economic climate, everyone has an interest in maintaining fair, orderly and efficient markets that can help individuals secure a stable future, pay for their homes, and send their children to college.

Securities fraud, also known as stock or investment fraud, consists of deceptive practices related to the offer or sales of securities. Fraud can result if a stockbroker or financial analyst purposely gives misleading advice, omits vital information, or fails to fully explain the risks associated with an investment decision. Violations of U.S. laws can also occur when publicly traded companies misrepresent their assets or liabilities or when individuals use special "insider" knowledge not available to the general public for their own benefit. The Association of Certified Fraud Examiners estimates that U.S. companies lost an estimated $652 million to fraud in 2006.

Basic Securities Laws

The functioning of securities markets in the United States is governed primarily by the Securities Act of 1934, often referred to as "the truth in securities law." This law seeks to ensure that investors receive full and accurate financial and other significant information about investment opportunities offered to the public and to prohibit deceit, misrepresentations, and other fraud in the sale of securities.

An agency of the U.S. government, the Securities and Exchange Commission (SEC) is charged with monitoring the securities market and regulating securities fraud. Individual states also regulate securities markets through state securities commissioners.

Protecting against securities fraud primarily relates to the activities of stock brokers, financial advisors and analysts as well as corporations and large investors. However, security fraud can affect anybody. The most common types of securities fraud fall all into three categories: misrepresentation, insider trading, and stock options fraud.

Members of the general public are most susceptible to violations involving misrepresentation. Misrepresentation falls under Section 10b and Rule 10b-5 of the 1934 Securities Exchange Act. These provisions clearly prohibit stock brokers, financial advisors and others from making false statements or omitting important information in connection with the sale or purchase of securities. For example, a wave of scandals took place in the United States in 2002, when leading public accounting firms, including Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers—admitted that they had failed to prevent the publication of some corporate financial reports that had the effect of misleading private investors.

According to the 1934 Securities Act, a "false statement" is any statement that misleads or creates a false impression. However, to be considered a crime, the false statement or omission must be sufficiently important to sway the decisions of a reasonable investor. In addition, the statement or omission must have been made with the willful intent to deceive, manipulate or defraud. Thus, reasonable mistakes not intended to mislead or defraud are not considered actionable.

SOX Act

Misrepresentation can also occur when a company's executives or accountants illegally conceal or falsify records concerning the debts, earnings, acquisitions, mergers, or other financially relevant transactions. Shareholders buy stock in companies on the belief that the companies are going to make profits, from which they will benefit. Therefore, misrepresentation, or accounting fraud, occurs when corporations purposely mislead investors into thinking that they are more financially sound than is truly the case. For example, during the Enron scandal of 2001, several of its top executives were accused of manipulating financial reports. As a result of this and other accounting scandals, the U.S. government introduced the Sarbanes-Oxley Act of 2002 to tighten controls concerning financial disclosures and to further discourage corporate fraud.

Insider Trading

Insider trading occurs when a person, such as a corporate officer or major shareholder, with "inside knowledge", or information not generally available to the public, about a company uses that information to trade stocks in a way that generates an unfair advantage. Corporate "insiders," such as offers and members of the board, have a fiduciary responsibility to shareholders. They violate that trust if they share "insider" knowledge with others. For example, if an employee of a company shared confidential information about its profits or losses with a friend, and the friend bought or sold stocks in a way that gained unfair profits based on this information, both the employee and the friend would be guilty of insider trading. People who might have access to such insider information include stock brokers, financial analysts, investment bankers, and company employees. It is illegal for anyone with inside information to buy or sell stocks based on their unique perspective or special knowledge. Another kind of insider trading, called misappropriation, can occur when the "insider" knowledge concerned involves the abuse of confidential information. For example, a lawyer working for a corporation may help structure deals with other corporations. If the layer uses privileged information related to the companies' transactions as a basis for buying or selling securities, or shares his knowledge with others for the same purpose, he or she would be guilty of "insider trading."

Options Fraud

Stock options fraud entails backdating the stock options given to corporate executives and employees in a way that guarantees profits. Stock options are routinely offered to employees of publicly traded companies as an incentive for them to make their careers with the company and to gain their loyalty. Allowing employees within companies to buy stock options also helps to align their personal interest with that of the companies' shareholders. Under these programs employees are given options to buy stocks in the company at a certain date in the future. However, the price they will pay for the stock in the future is fixed based on the valuation of the stock on the date the stock option is granted. Thus, if the face value of the stock rises over time, the employee stands to make a significant profit. Stock options fraud occurs when companies backdate the stock option grant to a time when the stock was trading at a lower price than it was when the granting actually occurred. This ensures that the stock option was already profitable at the time it was granted. In June 2006, an internal investigation at Apple revealed irregularities related to the backdating of stock option grants between 1997 and 2001. There has been an increase in the number of cases involving stock options fraud in recent years.