How to Protect Yourself Against Securities Fraud

Stories of big wins, the big score that happens quickly, makes us all wonder if we would want to try our hand in the stock market. However, the truth of the market is that although there are a handful of people who get rich quickly, there are far more who lose money or make a much smaller percentage only because they held their investments for many years. It takes good research, patience, confidence, and competence to do well in the stock market. And for most people, that means having a good broker.

Stockbrokers are the ones who stand between the regimented, complex world of Wall Street and the average person wanting to create an investment portfolio to retire on, to send his children to college, or just to create a secure nest egg for his family. It is the broker who has the knowledge and the contacts to help the layperson invest money in appropriate places. Because of the huge fiduciary responsibility of this position, stockbrokers are held to very high standards. Sometimes, however, stockbrokers abuse that power, perpetrating fraud on their clients.

Congress set up an agency to regulate the securities trade. After the Stock Market crash in 1929, Congress set up hearings to discover what had happened. They were appalled at testimony about insider trading, withholding of information, stock price manipulation, and other abuses that ended in brokerage firms separating clients from their hard-earned savings. Because of these abuses, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934 and created the Securities Exchange Commission to oversee the securities trade. The SEC still makes sure that companies comply with federal standards and punishes those who do not comply.

There are many ways brokers can perpetrate securities fraud. Using insider information (for example, knowledge that a company is about to announce of a launch a bold new product when only a handful of people inside the company know of this) to encourage clients to buy the stock is a federal offense. Any time a broker guarantees that a stock will make money is a sure sign that the buyer should beware. There is no guarantee in the stock market; good research can help offset the risk, but there are never "sure things."

Brokers can also be charged with fraud for making trades on a client's account without permission and for trading excessively, if this is done without the permission of the client and/or without the client's knowledge. This excessive trading, also called "churning," is done purely to increase the fees and commissions for the broker and his company. Securities fraud is also a broker's misrepresentation of facts, omission of facts, or mismatching an investment opportunity with a client's money, desire of risk, and sophistication.

The difference between broker incompetence and fraud is the motives of the broker-fraud implies an intention to deceive. This knowledge of the fraud-of the misinformation that is being given to a client-is called scienter; and to win a case of securities fraud, this is what must be proven for the court or arbiter. When this intention to deceive is proven, brokers can be held liable for monies lost in bad investments, the interest that could have been accrued on that money, and charged with punitive damages as well. Stockbrokers can help protect themselves from such charges by exercising due diligence on the companies they promote. Due diligence is the research needed to ensure that the company in question is doing everything they should be doing to comply with the laws that they are accountable for and that the business is as profitable as is declared in its financial statements.

Securities fraud has changed in the last ten or so years. The proliferation of corporate fraud-scandals such as the ones with Enron, Arthur Anderson, and WorldCom-and the liberties taken by traders such as the 1980's superstars Michael Milken and Ivan Boesky have created new statutes that raised the bar for today's stockbrokers. The Sarbanes-Oxley Act of 2002, among other things, substantially raised the fines and prison terms for those convicted of securities fraud, set a longer statute of limitations for those wanting to bring chargers against a broker or a company, changed the classification of debts from judgments as nondischargeable in a corporate bankruptcy, and stated that those convicted of attempted fraud or conspiracy can be punished as harshly as those convicted of actual fraud.

In addition, those charged with securities fraud today are also often charged with conspiracy, increasing potential liability and punishment. And it is not just he stockbrokers that are coming under fire right now. Stock analysts are also facing more stringent standards for accountability. The corporate scandals of the last ten years made the SEC take a closer look at the work they were doing, and it was discovered that many analysts were acting as cheerleader, setting strong "buy" ratings for stocks that had invested heavily with the companies where the analysts worked. Because of this, when an analyst for Merrill Lynch set a strong rating on a stock, the company sold more stock, made money for Merrill, and Merrill was then rewarded by the company with more business, which made more money for Merrill Lynch; and for all this, the analyst was awarded a bonus. When this practice was discovered, the outrage resulted in new rules being set for analysts, including that they are no longer allowed to accept bonuses from the investment banking departments of the companies they work for. Many top firms have been sanctioned for this practice.

While is it possible that anyone can be taken in by a slick huckster, there are things you can do to protect yourself from stockbrokers and analysts that see your investment only as a way to line their own pockets. The first thing is to do research on your stockbroker. The SEC keeps a database on its website (www.sec.gov) where investors can check for complaints. Investors can also check with the state securities regulator or National Association of Securities Dealers (NASD) for information on brokers. Knowledgeable investors will learn about their broker's background, education, investment record, and complaints before actually investing any money.

Any time a broker offers a guaranteed winner, tells you there is no risk, or pressure you to make a decision right away, it is prudent to take a step back and do some extra research. No legitimate trades are guaranteed, without risk, or are intensely time-sensitive. Consider these warning signs that something is wrong with your relationship with your broker. Skepticism, research, patience, and attention to detail are your best friends in investing.