Major Types of Securities Fraud

Securities fraud refers to deceptive practices in financial markets where false information is used to induce investors to buy or sell securities. It can be carried out by individuals, brokers, investment banks, or corporations, and it damages market integrity as well as investor wealth.

Major Types of Securities Fraud

Insider Trading

Insider trading is the buying or selling of a publicly traded company’s securities by a person who has non-public, price-sensitive information.

• UPSI: Unpublished Price Sensitive Information includes financial results, merger announcements, or dividend declarations.
• Insiders: Directors, employees, or associates who have access to confidential information.
• Example: The Raj Rajaratnam case in the United States involved leaked corporate information used for profitable trades.
• India: Regulated under the SEBI (Prohibition of Insider Trading) Regulations, 2015.

Ponzi Schemes

A Ponzi scheme is an investment fraud that pays returns to earlier investors using money collected from newer investors.

• Promise: High returns with minimal risk.
• Reality: No genuine underlying business or investment generates the profits.
• Collapse: The scheme fails when new investments stop or too many investors withdraw money at once.
• Name: It is named after Charles Ponzi, who ran such a scheme in the US in 1920.
• India: The Saradha Group financial scandal and the Rose Valley scam are examples.

Pump and Dump Schemes

Pump and dump schemes involve artificially inflating the price of a stock before selling the shares at a profit.

• Target: Cheap micro-cap or penny stocks with low liquidity.
• Method: False positive news or rumors are spread through social media, emails, and messaging apps.
• Effect: Retail investors buy the stock, pushing the price up rapidly.
• Outcome: Fraudsters sell at the peak, after which the price crashes.

Market Manipulation Techniques

Market manipulation means deliberate attempts to interfere with the free and fair operation of the market.

• Spoofing: Large buy or sell orders are placed without intention to execute them and later cancelled to create false demand.
• Wash Trading: The same financial instrument is bought and sold at the same time to create artificial volume.
• Cornering the Market: Acquiring a large share of an asset to control its price and pressure short sellers.

Accounting and Corporate Fraud

Corporate fraud occurs when companies manipulate financial books to mislead investors, regulators, or the public.

• Common forms: Inflating revenues, hiding debts, and fabricating assets.
• Example: The Enron scandal of 2001 used off-balance-sheet entities to hide massive losses.
• India: The Satyam Computer Services scam in 2009 involved fake customer accounts and inflated bank balances.

Front Running and Churning

These frauds are usually committed by financial intermediaries such as brokers or portfolio managers.

• Front Running: A broker trades for personal gain before executing a large client order.
• Churning: Excessive trading in a client’s account to generate commissions rather than improve returns.

Comparison of Key Fraud Types

Legal and Regulatory Framework in India

India has a multi-layered regulatory framework to detect and penalize financial market frauds.

• SEBI: The apex market regulator with powers to investigate, impose penalties, and ban entities from trading.
• SEBI Act, 1992: Provides the statutory framework for SEBI to protect investor interests and regulate the securities market.
• SEBI (PFUTP) Regulations, 2003: Prohibit fraudulent, manipulative, and unfair trade practices in the securities market.
• Companies Act, 2013: Section 447 defines fraud and prescribes imprisonment and monetary penalties for corporate wrongdoing.
• SFIO: The Serious Fraud Investigation Office under the Ministry of Corporate Affairs investigates major corporate frauds.

Historic Cases

• The Harshad Mehta Scam (1992): Used ready forward deals in the banking system to siphon funds and artificially inflate stock prices. It led to the statutory empowerment of SEBI in 1992.
• The Ketan Parekh Scam (2001): Involved circular trading and pump-and-dump operations using bank funds. It led to the banning of the Badla trading system in India.
• The Bernie Madoff Scandal (2008): The largest Ponzi scheme in global history, causing an estimated USD 64.8 billion in wealth loss.

Rare Facts for Prelims

• SEBI was established in 1988 and later given statutory powers through the SEBI Act, 1992.
• Wash trading can create a false impression of liquidity even when no real market interest exists.
• Cornering the market is especially dangerous in thinly traded assets because prices can be moved sharply with limited volume.
• UPSI is not limited to financial results; it can also include major corporate actions such as mergers, demergers, and buybacks.
• Churning is often linked to discretionary accounts, where the broker has authority to trade on behalf of the client.
• PFUTP stands for Prohibition of Fraudulent and Unfair Trade Practices, a key anti-manipulation regulation in India.