What is Securities & Commodities Fraud? A Conversation with a Professor

Securities and commodities fraud is, in its most simple definition, misrepresenting information in order to make a profit in the financial market. When it comes to major investment schemes and corporate misconduct, even a little white lie isn’t necessarily so little, as it can result in billions of dollars misappropriated illegally.

In 1920s America, leading up to the Great Depression, approximately half of the $50 billion worth of new securities issued became worthless through abuse, manipulation, and outright willful ignorance by financial agents. This was securities fraud before the term had been invented, and, as a result, public confidence in financial markets plummeted.

It took President Franklin D. Roosevelt’s passage of the Securities Act of 1933 and the Securities Exchange Act of 1934 to restore that trust. These laws established two critical but commonsense notions as enforceable truths: publicly traded companies must tell investors the truth about their dealings and their securities offerings, and people who trade securities must treat investors fairly and put investors’ interests first.

According to the FBI, securities and commodities fraud can involve providing false information, withholding key information, or acting upon inside information. But securities and commodities fraud encompasses a wide range of subcategories. Pyramid and Ponzi schemes can masquerade as legitimate businesses while in truth simply shuffling around investors’ wealth. Accountant fraud may misrepresent a company’s financial statements to the tune of billions of dollars. Insider trading can involve the buying or selling of stocks on the basis of non-public information, while boiler rooms can pressure investors into buying worthless stocks in an effort to momentarily drive up their price. But a common element among these and other subcategories of securities and commodities fraud often involves the perpetrator misrepresenting and manipulating financial markets for personal gain, and often at the expense of unwitting investors.

Elon Musk’s $20 Million Tweet

Sometimes that misrepresentation can even seem innocent. In August 2018, Elon Musk tweeted to his 22 million followers that he could take one of his companies, Tesla, private, at an inflated price of $420 per share, saying he had secured funding for such a transaction. As a result, Tesla’s share price jumped 7 percent and led to market disruption. The Securities and Exchange Commission, a regulatory entity, performed an investigation that found no such funding had been secured, despite Mr. Musk’s claims to the contrary. While it’s hard to believe that Mr. Musk believed he was committing securities fraud, the SEC, through the course of its investigation, became convinced that he had indeed committed it by providing false and misleading information to the public. And in a rare case of swift justice, by September 2018 Mr. Musk had agreed to pay $20 million in fines and step down as chairman of his company.

Enron Defrauds Investors & California

Securities and commodities fraud is rarely so upfront and straightforward. In the late 90s, Enron, an energy-trading and utilities company, was hailed as the most innovative corporation in America. With its leaders, Ken Lay and Jeff Skilling, acting as evangelical proponents of deregulation, Enron helped rewrite—and in some cases, erase—the rules of the game for its own benefit. Of its many creative ventures was a financial practice known as “mark-to-market accounting,” which allowed Enron to book future profits on the day a deal was signed, rather than the day those profits were realized. And, crucially, it was up to Enron to decide what those future profits could be.

The problems arose when the hypothetical future didn’t match the rapidly encroaching reality. And instead of acting in a transparent and responsible manner, the leaders of Enron doubled down on their ideas, and built a militant corporate culture where all was in service of boosting the stock price, and therefore public confidence. The reality, however, was that after a few majorly failed deals—transactions which appeared as huge profits on the balance sheets—Enron was drowning in debt and dedicating a lot of time and energy into inventing ways to hide rather than fix that fact.

It began to unravel when Enron went to war with California. Seizing upon recent deregulation ventures in the world’s sixth largest economy, Enron engaged in gross price manipulation that cost California some $30 billion. The deregulation that Enron’s executives had campaigned for didn’t result in a fairer marketplace in any regard, and its traders simply focused themselves on finding loopholes and making profit at the expense of investors and citizens. Still, in an incredulous display of hubris, Jeff Skilling and Ken Lay claimed that the losses were the fault of too much regulation still remaining in California.

How Could This Happen at Enron?

Many red flags had been there all along, but it was at this point that people began to pay attention to them. Firstly, Enron was a black box, meaning it was not transparent with its balance sheets and cash flow, and, furthermore, it was hostile to criticism of this. Secondly, the company’s profits, up until then, had been by most estimates simply too good to be true. Thirdly, Jeff Skilling abruptly resigned from his position as CEO, leaving the position to Ken Lay, but first cashing out $33 million worth of stock. Many other executives followed suit, cashing out a total of almost $2 billion while maintaining, in public, that the company was performing the best it ever had.

Four months later, that stock would be trading at mere pennies, a calamitous fall from its peak of near $100 a share. Over 20,000 Enron employees would lose their jobs in the resulting bankruptcy, and their pension and retirement funds would lose billions of dollars of value, leaving many to read Enron’s old slogan with an ironic new inflection: Ask Why?

Bringing Enron to Justice

Many men’s greed can be exposed with a few small acts of integrity, and that’s what happened in the case of Enron. A journalist’s dogged pursuit of red flags began with a Forbes article titled “Is Enron Overpriced?” She continued despite threats and pressure to back off. A whistleblower in Enron’s financial department wrote detailed memos about the worrying accounting practices she’d uncovered. She, too, continued her crusade, despite internal pressure to desist. And while Enron’s accounting firm, Arthur Andersen, should have been performing critical oversight, instead it was shredding relevant documents—as much as a ton a day—as the SEC and their investigations department was racing to build a case.

In the end, Lay and Skilling were charged with securities fraud and a host of other white-collar crimes. But Enron’s other employees were still left with nothing. And after a slew of other securities fraud cases (e.g., Adelphia, WorldCom, Tyco International), public confidence in securities markets had bottomed out yet again. As was the case in the 1920s, the only cure was new regulations.

“The regulatory system helps to protect investors from unscrupulous characters that would use unfair or deceptive methods to gain an undue advantage for personal benefit,” says Mary-Jo Kranacher, a certified fraud examiner and professor of accounting at York College, CUNY. “Most investors are aware that investing in the stock market has certain risks; one of those risks should not include being taken advantage of by those who engage in fraudulent financial reporting.”

In 2002, the Sarbanes-Oxley Act passed and directly addressed the failures of Enron. It outlined new laws regarding corporate responsibility, accounting regulations, increased punishments for financial crime offenders, and increased protections for investors. Market confidence was restored but tenuous. And while regulations act as preventative measures, forensic financial investigators are required to catch the perpetrators who persist.

Prevention and Detection of Securities & Commodities Fraud

Fraud is often seen as more of a legal issue than an accounting issue, and as a result many accountants have chosen to treat fraud as something outside their principle jurisdiction. But forensic accountants and forensic financial investigators explore precisely the intersection between fraud and accounting. And that requires its own unique skill set.

“Successful forensic accountants and fraud examiners are detail-oriented and aren’t afraid to ask lots of questions,” Professor Kranacher says. “They have a good foundation in the basics of accounting, and are persistent in finding the answers to their questions. They also have good written and oral communication skills to write persuasive reports on their investigative findings and to testify about their findings in a court of law.”

This is a different job than that of an auditor, who generally works in deterrence and is supposed to provide reasonable assurance that material misstatements do not exist; if they do exist, they are detected. Forensic investigators, however, have a narrow scope of practice, charged with collecting factual and documented evidence of fraud, assessing the damage from that fraud, and making recommendations on how to deter such fraud in the future.

This requires a knowledge of the investigated company’s industry, a knowledge of the financial industry at large, a thorough understanding of the regulatory landscape, and an objectively independent mindset. The SPADE framework for forensic investigators recommends Skepticism, Probing communication, Analytics, Documentation, and Evaluation as key areas of focus.

While auditors often enjoy a passive relationship with their clients, forensic investigators usually have a more adversarial relationship with the entity they are investigating, which can lead to a lack of cooperation and extra work for the forensic investigations team, who are often looking for a needle in a haystack. Investigators may need to work clandestinely at first, as public knowledge of an investigation could lead to resignations of culpable parties, destruction of evidence, and further interference.

This is a job that’s not getting easier. New forms of securities (e.g., cryptocurrencies) are taking advantage of a deregulated landscape, a crop of unassuming new investors, and extravagantly complex technologies to make illicit gains.

A new political tide in America is calling for deregulation and even considering rolling back the Sarbanes-Oxley Act. If that happens, the securities and commodities frauds that lay in waiting have the potential to obliterate pension funds and destabilize the global financial marketplace. The need for forensic accountants and financial investigators who have keen minds with integrity to match is dire.

Featured Experts in Fighting Securities and Commodities Fraud

Mary-Jo Kranacher, MBA – York College, CUNY

Mary-Jo Kranacher is a professor in York College’s Department of Accounting and Finance, where she teaches courses in fraud examination and accounting. She received her MBA with a focus in accounting from St. John’s University, and has since added credentials as a certified public accountant (CPA), a certified fraud examiner (CFE), and is certified in financial forensics (CFF).

Professor Kranacher worked on a Department of Justice project that culminated in developing a model curriculum for fraud and forensic accounting education. A veteran of numerous forensic financial investigations, she writes and speaks extensively on the subjects of forensic accounting and fraud detection and deterrence. Professor Kranacher served as president of the Institute of Fraud Prevention from 2009 to 2011, and was the winner of the ACFE’s Educator of the Year and Hubbard Awards.

Angel Otero, PhD , Florida Institute of Technology

Dr. Angel Otero is an assistant professor and academic chair of Florida Tech’s online accounting and finance program, where he teaches classes in advanced auditing theory, accounting information systems, and information systems auditing and control.

After earning a BS in accounting, Dr. Otero went on to attain an MS in software engineering from Florida Tech and a PhD in information systems from Nova Southeastern University, giving him a uniquely technical focus. Before joining the ranks of academia, Dr. Otero spent over ten years at Deloitte & Touche, where he acted as a senior manager of enterprise risk services, overseeing offices in Florida and Puerto Rico. In addition to his contributions to a number of professional journals and conferences, Dr. Otero is the most recent author of the updated Information Technology Control and Audit—a university textbook which explores the intersection and application of IT with auditing, regulation, and governance.