Approaches to Detect Securities Fraud in Capital Markets

Introduction

The current market prices play a crucial role in explaining price fluctuations, market anomalies and market performance. In an efficient market, it is expected that the prices reflect all available public and private information about the asset. In the 1970s, it was widely concluded that financial markets are remarkably efficient and capable of reflecting all relevant information into the current prices; therefore no one can accurately predict future prices or inconsistent changes in market activities. However, there are risks and misconducts that are based on various reasons such as judicial, managerial, cultural, behavioral and psychological.

It is widely acknowledged that financial frauds have received the attention of accounting and finance literature (Reurink, 2018). As a part of the financial markets, securities market offers more profits than other markets, and it leads investors to deposit their savings on financial instruments (e.g. stocks, bonds, options, swaps) and to supply them as funds. For every financial instrument, there is a minimum of single agreement between at least two parties (issuer and investor); therefore, this reveals the necessity of a regulated trading environment where market participants can exchange financial instruments for future economic benefits under the rules with transparency and confidence. In a regulated market, efficient price discovery liquidity maintenance that motivate an investor to modify or trade his instrument, reduced transaction costs and investor protection can improve the efficiency of resource allocation, increase returns from investments, thereby boost economic growth.

Global economic cost of fraud is estimated to reach around $5.12 trillion in 2019 and the losses owing to economic crimes have risen by almost 60% since 2009 (Gee & Button, 2019). According to Association of Certified Fraud Examiners (ACFE) report of 2020, 21% of fraud cases cause losses over $1 million and companies lose 5% of their revenues to fraud each year (ACFE, 2020a). Roughly half of reported cases that experienced a fraud resulting in losses more than $50 million are committed in financial markets and nearly 35% of those are deceptive practices, which encompass a wide range of illegal acts in stock or commodities markets (PwC, 2020). In addition to the direct economic losses that arise naturally from the breach of securities laws, indirect costs such as loss of productivity and profits, brand damage, employee and stock market demotivation, breach of fiduciary duty can lead to volatile stock prices; therefore, resulting an increase in economic losses.

The term fraud refers to a broad terminology that involves illegitimate or unlawful actions characterized by act of deceit. While the definitions of fraud vary among jurisdictions and seems problematic, the legal concept of the definition is shaped by guile and deception (Kapardis, 2016). It denotes the entire spectrum of illegal conducts in the financial markets by individuals from inside or outside, for the benefit of the organization or personal gain. The concept of fraud is not limited to a single activity or statutory offence in the law and practice. For example, in UK, Serious Fraud Office (SFO) provides the definition of fraud as “gaining dishonest advantage, which is often financial, over another person by misuse of position with material falsehoods” (Palmer, 2017). According to the ACFE, intentional or deliberate acts perpetrated by individuals or a group of persons that relate to the deprivation of property, money, service or other legal rights constitute fraud (ACFE, 2020b). As a civil wrong, fraud has been identified as a tort, which resulting in someone’s suffer or loss and it can include injuries, emotional distress, privacy breaches and so on. In common law, fraud is a criminal offence and a fraudulent act must meet the following requisites: (1) false statement or nondisclosure, (2) violation of trust or intent to deceive, (3) material, factual fact that makes a reasonable change in investment decisions, (4) being in a state of justifiable reliance in which a plaintiff must rely to his/her detriment, (5) the deception must result in loss of one party (Krauss, 2019). Section 1001-1040 of Title 18 of the U.S.C. states that the definition of fraud can include falsifying, concealing or covering up the material fact by any device or schema and it is not only a false statement statute but also failure to disclose of material information, knowingly and willfully (18 U.S.C. § 1001).