Investment fraud is a very broad category of fraudulent schemes that involve soliciting money from investors, often with the promise of enormous returns. The U.S. Securities and Exchange Commission (SEC) and the Federal Bureau of Investigation (FBI), along with state financial agencies, investigate alleged investment fraud and prosecute it under various state and federal criminal statutes. The SEC offers some tips for investors to help identify fraudulent investment schemes, such as:
A large number of investment schemes involve microcap or “penny” stocks. These are stocks in small companies that are not traded on the large exchanges like the New York Stock Exchange or NASDAQ, and therefore are not subject to many of the disclosure and reporting rules. A sting set up by the FBI , one of the largest in history, uncovered a scheme that involved paying 50% kickbacks to a front company for a hedge fund manager, actually an undercover FBI agent, in exchange for investments by the hedge fund in microcap companies.
A common type of microcap or penny stock fraud is known as a “pump and dump.” Fraudsters purchase large amounts of cheap stock and then convince investors to pay a much higher price for the stock by misrepresenting the size or condition of the company, essentially “pumping” up the stock’s price. They then “dump” the stock on the investors, who might lose huge amounts of money. The internet enables fraudsters to reach far more people than they could through boiler rooms, mailers, and other low-tech means.
Online newsletters, online bulletin boards, and spam email offer ways to broadcast fraudulent investment information to a vast audience of inexperienced and unwary investors. While many legitimate newsletters offer helpful tips or guidance for investors, it can be difficult to tell the legitimate from the fraudulent. The federal wire fraud statute gives the government a relatively straightforward way to prosecute cases such as these.
The term “pyramid scheme” is often used to describe some legitimate business models, such as multi-level marketing (MLM) companies, as well as fraudulent ones. Some illicit pyramid scheme disguise themselves as MLMs. A pyramid scheme is a fundamentally unstable system that promises payments to participants for enrolling new participants. A participant pays a fee to join the organization and receives a commission based on new people whom he or she enrolls.
The structure of the organization resembles a pyramid, with the original members at the top, the people they enroll in a larger layer below or “downstream” from them, and so on in ever-larger layers. A new participant’s enrollment fee is split among everyone “upstream” from that participant. Eventually, the pyramid gets too big, and the original members cannot raise enough money from new members to maintain payments to existing members.
A Ponzi scheme is similar to a pyramid scheme, in that they both use funds obtained from new members to pay earlier members until they grow too large and collapse. This type of scheme is named after Charles Ponzi, who got thousands of people to invest in fraudulent schemes in Boston in the 1920s.
An organizer solicits investments, often with promises or guarantees of exorbitant returns at little to no risk. Ponzi himself promised returns that were 10 times greater than normal interest rates in the space of only a few months. Rather than investing the money, the organizer uses it to pay earlier investors, which makes it look like the organization is paying returns. Eventually, the scheme collapses when the organizers cannot solicit enough new investors to satisfy the promised returns for previous investors.
One of the largest Ponzi schemes in history was run by Bernie Madoff, who may have obtained more than $65 billion from investors. When his investors requested $7 billion after the payments slowed in 2008, he had less than $300 million on hand. He was convicted of fraud and sentenced to 150 years in prison.
