Spotting Stock Fraud

Trading securities used to be the exclusive privilege of professionals, the wealthy and ultra-wealthy. It used to involve physical brokers acting as agents for their clients and acting out their orders. These days, other than the rave for crypto currencies and the promises of quick wealth growth that it presents, the next big sensation for wealth creation is ‘day trading of stocks.

ONLINE STOCK TRADING

The range of participants in day trading includes everyone with a smart phone and enough money to spare. With the proliferation of technology, people (anyone in fact) can access the stock market and trade stocks in real time. Stocks represent ownership in companies and since companies tend to grow in value, people seek to purchase fractions of ownership in them while they’re lower only to sell when they appreciate. Now it involves risk. Just as the value of companies can rise, they can also fall for a plethora of reasons. These two cycles are referred to as the Bull and the Bear in financial parlance.

To get involved, one only needs to sign up to any of the several applications including but not limited to; Robinhood, Sogo Trade, Chaka, Ally Invest, Webull, Trove, and Bamboo. These platforms require some personal information to confirm the identity of users. Upon registration, a common feature among these platforms is a dashboard which contains the wallets, stock indexes, charts, and several other tools to enable an average user to reach decisions regarding buying stocks they’re interested in. A few of these platforms equally have demo accounts with real stock information but fake monies. This is to aid inexperienced users play around and understand the risk involved in day-to-day stock trading. Now, can anything go wrong while using these platforms? Is there anything to worry about? You’ll find out that there are in fact many things to be careful about.

WHAT IS STOCK FRAUD?

Stock fraud may be otherwise known as securities fraud or investment fraud. It is a type of white-collar job that primarily involves misrepresenting all information investors use to make decisions.^[1] Perpetrators of this wrongful act induce and manipulate investors in making purchase or sale decisions on a premise of inaccurate information which results to great losses on the side of the investors, and violation of securities laws. The perpetrators of this heinous financial crime can be a stockbroker, brokerage firm, corporation, investment bank, or an independent individual.

The Federal Bureau of Investigation (FBI) describes stock fraud as a criminal activity which involves the deception and manipulation of financial markets that can include high-yield investment fraud, Ponzi schemes, pyramid schemes, advanced fee schemes, foreign currency fraud, broker embezzlement, hedge-fund-related fraud, and late-day trading.^[2]

TYPES OF STOCK FRAUD

• Pump and Dump Schemes:

Pump and dump is a form of stock fraud that attempts to boost the price of a stock or security based on false, misleading or exaggerated recommendation.^[3] The goal of the perpetrators of this scheme is to lure in buyers through fake analysts or fake research reports on a stock with an attempt to sell many shares as possible.^[4] First, having bought the stock, they boost the price with misleading statements about the company. When the stock price rises because of the rush to buy due to false information they sell their holding of the stock by dumping shares into the stock market for profits. Small companies (microcaps) are mostly vulnerable to pump and dump schemes. This is because of limited information about microcaps available to the public.

The increase of internet penetration has created an easier path to access investors all over the globe as Pump and dump schemes now often take place online. We see messages online daily from promoters who claim to have firsthand information about the company’s stock, and as well as new developments of the company. The promoters of these misleading messages use convincing words to prompt investors to buy the stock quickly. Once these fraudsters sell their overvalued shares, they cease to promote the shares which leads to a fall in the price of the shares and results in great losses for vulnerable investors.

According to the United States Securities and Exchange Commission, the false or misleading information of a company’s stock price may be spread through social media, investment research websites, investment newsletters, online advertisements, email, internet chat rooms, direct mail, newspapers, magazines, and radio.^[5]

Cryptocurrency being a digital currency in an unregulated market is prone to pump and dump schemes. The operators organize pump and dump schemes through social media platforms like Telegram and Discord.^[6] In 2017, the Securities and Exchange Commission, Nigeria published an article warning citizens and investors of the radio advertisements and other modes of solicitations of the public to invest in cryptocurrencies such as Swisscoin, OneCoin, Bitcoin and such other virtual or digital currencies. The Commission pointed out that none of the persons, companies or entities promoting cryptocurrencies has been recognized or authorized by it or by other regulatory agencies in Nigeria to receive deposits from the public or to provide any investment or other financial services in or from Nigeria. The Commission further advised that the public should also be aware that any investment opportunities promoted by these persons, companies or entities are likely to be of a risky nature with a high risk of loss of money, whilst others may be outright fraudulent pyramid schemes.^[7]

• Short and Distort:

Short and distort is an illegal practice that involves investors who speculate the decline in a stock and then spread rumors in an attempt to drive down its price and make personal gains.^[8] This type of stock fraud is made common through the use of social media platforms to spread negative information quickly and anonymously. In the illegal act of short and distort, the investor borrows the shares of a company, and goes ahead to spread false rumors about the company with the intent that some holders of the company will sell their shares, which will result in a drop in stock price. Once the price drops, the investor buys back the shares and makes a profit. An instance of this would be someone who borrows 50 shares when the price is at =N= 100 per share and sells it. Then through social media and other sources, spreads false information that the Security and Exchange Commission is investigating the Executives of the company for fraud. This false information causes panic and investors begin to sell their shares causing the share price to drop to =N= 50 per share. He promptly buys backs the 50 share at this reduce rate and returns it back making a profit.

The act of short selling must not be misconstrued as short and distort as there is an underlying distinction between “short selling” and “short and distort”. Short selling is a legal and legitimate investment strategy that speculates on the decline of a stock and may be used by traders or investors as a hedge against downside risk.^[9] The speculations of short sellers would only amount to short and distort where they traffic in falsehood.^[10

• Corporate Fraud:

Corporate fraud consists of illegal actions committed by a company or by an individual acting in their capacity as an employee of the company.^[11] This act includes, among others, the falsification of accounting details, misrepresentation of services and information, breach of confidentiality and so on. The perpetrators of corporate fraud usually hide behind the company’s veil of incorporation, in disguise of legitimacy, and same continues until the company is placed in a state of bankruptcy. For instance, falsified accounting might be done to make the company more attractive to potential buyers or investors, or ultimately protect a public company’s stock or valuation from dropping.^[12]

A worthy instance of corporate fraud and its grave effect is the “Enron Scandal”. Enron Corporation, an energy company was a corporate giant. The company’s profits on its trade were ranked in billions dominating the natural-gas market. However, Enron Corporation began to struggle with debts and declining revenues. The company resorted to an unethical practice of off-the-books accounting, misled regulators, and went further to incorporate fake holdings which led to the company’s collapse.

Also, the “Wirecard Scandal”. Wirecard, a German financial services company, in 2020 was discovered to have had a huge a discrepancy between what was contained in the company’ book and the actual money the company had. The accounting auditors discovered that the company was involved in a corporate fraud scheme which resulted to the insolvency of Wirecard.

In order to tackle corporate fraud and identify the perpetrators, the corporate veil must be lifted as the courts will disregard the corporate personality to discover the criminal.

Corporate fraud causes series of destructive economic consequences for companies, including damage to their reputation, decreased investor confidence, increased financing costs, and company value reduction.^[13]

HOW TO AVOID STOCK FRAUD

In the light of everything we have considered so far, a proper question would be, is there any remedy? How can stock frauds be avoided? The following steps can be taken to avoid stock fraud.

1.  Sign up on well-known platforms: The first way to avoid being a victim of stock fraud is to sign-up on already established trading platforms. The risk of newer platforms that are not well known is apparent. There may be promises of free stocks as incentives. Although this is not all together rare, the emphasis is on joining platforms whose authenticity can be easily verified.
2. Look out for Affinity Fraud: In stock trading, if movement with regards to the value of the stock is not rooted in proper analysis, logical information but on affinities such as religion, personalities and life style, then it could be dangerous waters.
3. Look out for Obvious Red Flags: When it feels off, it’s probably off. If you find yourself feeling a hunch as to the veracity of the platform, don’t suppress it. To this end, you must be observant and ask as much questions as possible before committing funds.
4. Conduct your own due diligence: This cannot be said enough when it involves stock trading. At the end of the day, you’re the ultimate risk bearer. You shouldn’t take people’s words for it. You must conduct your own risk analysis and due diligence.
5. Beware of random offers: Don’t jump at random offers. Don’t jump at random calls. Verify before you dive in.
6. Always deal with verified systems Support: If you’re encountering problems on the platform, don’t engage a third party. Contact the platform support and follow their directions.

CONCLUSION

One thing to note about stocks is that investing in them is very risky. Financial experts have still not reached a consensus on how best to analyze stocks. There is a school of thought that believes in a method called Technical Analysis which employs the investigation of trends (using stock price movement over time to predict their future prices). This method has been known to succeed as much as it has been known to fail, hence it is not considered final. Another school of thought has been known to promote Fundamental analysis, a method that involves the investigation of all the economic and financial factors that influence business growth. The method of analysis has its short comings too, hence the emergence of the random walk analysis, which can be simply described as speculation, a method which has its basis in game theory.

At the risk of becoming too technical, the essence of pointing all these out is to show that stock trading involves consistent learning and deep work. Always consider the risk elements and do not take on more risk than you can handle. It is our hope that after going through this article, you won’t lose your wallet while chasing the bag.

Contributors

• Perpetua Ogwuche
• Chibuike Gabriel Offor

REFERENCES

1. Investopedia – “Securities Fraud” Accessed April 14, 2022.
2. FBI. “Securities Fraud Awareness & Prevention Tips.” Accessed April 15, 2022.
3. Investopedia – “Pump and Dump” Accessed April 15, 2022.
4. Seeking Alpha. “Beware of ‘Analysts’ Assisting Pump and Dump Schemes” Accessed April 14, 2022.
5. U.S Securities and Exchange Commission. “Pump and Dump Schemes” Accessed April 14, 2022.
6. Wikipedia – “Pump and Dump” Accessed April 14, 2022.
7. SEC. “Public Notice on Investments in Cryptocurrencies and other Virtual or Digital Currencies” Accessed April 15, 2022.
8. Investopedia. “Short and Distort” Accessed April 15, 2022.
9. Investopedia. “Short and Distort” Accessed April 15, 2022.
10. Harvard Law School Forum on Corporate Governance. “Short Activism: The Rise in Anonymous Online Short Attacks” Accessed April 15, 2022.
11. Corporate Finance Institute. “Corporate Fraud” Accessed 15 April, 2022.
12. Investopedia. “Corporate Fraud” Accessed April 15, 2022.
13. Yu, F., & Yu, X. (2011). Corporate Lobbying and Fraud Detection. Journal of Financial and Qunatitative Analysics, 46(6), 1865-1891.