What Is Securities Fraud? Meaning, Elements And Punishments

A security is an investment that you buy with the goal of profiting from outside events or someone else’s efforts or actions.

For example, stocks are securities. You purchase shares of stock in a company with hopes that the company will perform well and your shares will become more valuable, allowing you to make a profit.

Examples of securities include bonds, debentures, investment contracts, notes, oil and gas interests and stocks.

Engaging in dishonest securities-related behaviors is illegal on both the federal and state level. These behaviors may fall within the category of securities fraud crimes.

Legal Definition

Many types of behaviors are considered securities fraud. 18 U.S. Code § 1348 is one of the key federal statutes defining and prohibiting the crime.

Under 18 U.S. Code § 1348, it is illegal to knowingly execute, or attempt to execute, a “scheme or artifice” that is designed to do any of the following the following:

• defraud anyone in connection with a security registered under or required to file reports under the Securities and Exchange Act of 1934.
• defraud anyone in connection with any commodity that will be delivered in the future or any option to buy a commodity for future delivery.
• to use false or fraudulent pretenses, representations or promises to obtain money or property in connection with the purchase or sale of a commodity for future delivery, options to buy a commodity for future delivery or stocks registered under or required to file reports under the Securities and Exchange Act of 1934.

Meaning of Securities Fraud

While securities fraud is a complicated crime with many state and federal rules prohibiting specific types of behavior, the basic meaning is simple.

If an individual or an entity, such as a company or investment professional, is dishonest in connection with stocks, bonds or other investments to trick others, they have likely violated laws prohibiting various types of securities fraud.

Securities fraud is both a criminal offense and a civil wrong, which means that those who were defrauded can file a lawsuit in civil court to recover compensation for their losses.

Under the 10b-5 rule—promulgated by the Securities and Exchange Commission under the Securities and Exchange Act of 1934—the Securities and Exchange Commission could bring a criminal enforcement action, and an individual could file a private lawsuit against a defendant who, in connection with the purchase or sale of any security:

• employs devices, schemes or attempts to defraud.
• makes untrue statements of material facts or material omissions.
• engages in acts, practices or business that operates as a fraud or deceit.

In a civil action, the plaintiff would also have to show they were harmed due to the defendant’s misconduct.

Many different kinds of behaviors are considered securities fraud. Here are some common examples.

Misrepresentation

Misrepresentation occurs when individuals or businesses make false or misleading statements or knowingly omit key facts that impact the value of securities. For example, a company might lie about its earnings to inflate its stock price, or a broker might market a risky investment as safe because he makes a large commission for selling it.

Insider Trading

Insider trading involves buying or selling a security or tipping off others to buy or sell a security because of non-public information.

For example, if you work for a drug company and you find out through your work that the company is announcing a breakthrough weight loss drug in the coming days, it would be insider trading to buy stock (or tell your friend to) to profit from the likely increase in share prices due to the public announcement.

Ponzi and Pyramid Schemes

Ponzi and pyramid schemes are a type of investor fraud.  They usually involve promising a high rate of return to investors to entice them to give you money.  Funds collected from new victims (those on the bottom of the pyramid) are used to pay high returns to those who put money in earlier.

Churning occurs when brokers or investment advisors convince clients to engage in frequent trades, which come at a high cost, to generate more commissions for the broker or advisor.

The specific elements of a securities fraud offense vary depending on the type of fraud. For example, while insider trading involves taking advantage of non-public information to guide investing choices, misrepresentation involves lying or omitting information to entice others to act.

Here are some common elements of most security fraud offenses.

Misrepresentation or Omissions

Most securities fraud involves being dishonest about facts or omitting key facts. The information must be material—important—and you must intend for others to rely upon it.

Intent

Securities fraud isn’t an accidental crime. You must intend to engage in dishonest or fraudulent behavior, often for self-enrichment.

There are exceptions to the intent rule. Under Rule 10b-5, issuers of securities can be civilly liable for material misrepresentation in registration statements regardless of intent. When registration statements include material misrepresentations, strict liability applies, so issuers are always liable for losses caused by their misrepresentations.

Securities fraud involves dishonest or fraudulent behavior in connection with financial securities.

Wire fraud is a broader offense that involves any fraudulent or dishonest behavior using electronic communications such as the phone or the Internet.

A person who uses the Internet to knowingly share false information about stocks could be guilty of wire and securities fraud.

The best defense against securities fraud depends on the specific offense. Some common examples of defenses include the following.

Good Faith Belief

If you are accused of securities fraud based on false statements or material misrepresentation, you can argue that you had a good faith belief in the truth of the statements or promises you made. Your belief must have been reasonable, as you cannot willfully turn a blind eye to your statements being untrue.

Lack of Evidence

The prosecutor has the burden of proving every element of a securities fraud offense beyond a reasonable doubt. If there is insufficient evidence that you committed securities fraud or acted with intent, you should be able to avoid conviction.

Punishments for securities fraud are very serious. While the specific penalties depend on what laws you violated, you can expect fines and a lengthy prison sentence.

For example, the penalty for violating 18 U.S. Code § 1348, a broad federal regulation prohibiting fraud or misrepresentation related to securities or commodities, is a fine and up to 25 years imprisonment.

Violating any of the following federal statutes could result in a conviction for securities fraud:

• Securities Act of 1933
• Securities Exchange Act of 1934
• Trust Indenture Act of 1939
• Investment Company Act of 1940
• Investment Advisers Act of 1940

State laws also prohibit various types of securities fraud.