Fraud: Definition, Types, and Consequences of Fraudulent Behavior

What Is Fraud?

Fraud is an intentional act of deceit designed to reward the perpetrator or to deny the rights of a victim.

Some of the most common types of fraud involve the insurance industry, the stock market, and the mortgage market, but the targets usually include individuals as well as businesses.

Understanding Fraud

Any fraud involves falsification, either by withholding important information, lying, or faking documents. Often, the perpetrator of fraud knows something that the intended victim doesn't know.

At heart, the individual or company committing fraud is taking advantage of information asymmetry. The victim cannot or does not try to verify the false information.

Despite state and federal laws that criminalize fraud, these crimes do not always result in a criminal trial. Government prosecutors have substantial discretion in determining whether a case should go to trial and may pursue a settlement for a speedier and less costly resolution.

If a fraud case goes to trial, the perpetrator may be convicted and sent to jail.

Legal Consequences of Fraud

If there is no criminal proceeding, a victim of fraud can pursue a civil case. This can result in money being recovered or rights reestablished.

Proving that fraud has taken place requires the perpetrator to have committed specific acts. The perpetrator has to provide a false statement as a material fact. The perpetrator had to have known that the statement was untrue. The perpetrator had to have intended to deceive the victim. The victim has to demonstrate that they relied on the false statement. Finally, the victim had to have suffered damages as a result of acting on the intentionally false statement.

Types of Financial Fraud

Financial fraud comes in many varieties, with the most common including mortgage fraud, insurance fraud, and securities fraud.

Common mortgage fraud schemes include identity theft and income or asset falsification by mortgage applicants. Industry insiders may dupe the system via appraisal fraud or so-called air loans , which are applications for mortgages on nonexistent properties. Common scams include property flipping, occupancy fraud, and use of straw buyers.

Insurance Fraud

A relatively small insurance claim may get a more cursory review than a large claim. In other cases, investigating a loss claim may be nearly impossible. A claims investigator can't easily prove or disprove the alleged loss of a single piece of insured jewelry.

Knowing this, some individuals file claims for losses that didn't occur. In this case, insurance fraud has been committed.

Securities Fraud

The Federal Bureau of Investigation (FBI) describes securities fraud as criminal activity that can include high-yield investment fraud, Ponzi schemes, pyramid schemes, advance-fee schemes, foreign currency fraud, broker embezzlement, pump-and-dumps, hedge-fund-related fraud, and late-day trading.

In many of these cases, the fraudster seeks to dupe investors through misrepresentation. These crimes are characterized by providing false or misleading information, withholding key information, purposefully offering bad advice, and offering or acting on inside information.

Prosecuting Financial Fraud

Fraud can have a devastating impact on investors. In 2001, a massive corporate fraud was uncovered at Enron, a U.S.-based energy company. Executives used a variety of techniques to disguise the company’s financial health, including the deliberate obfuscation of revenue and misrepresentation of earnings.

After the fraud was uncovered, shareholders saw share prices plummet from around $90 to less than $1. Company employees had their equity wiped out and lost their jobs after Enron declared bankruptcy. The company's CEO and CFO went to prison while its founder, Kenneth Lay, died of a heart attack shortly before he was to be sentenced.

The Enron scandal was a major driver behind the regulations found in the Sarbanes-Oxley Act passed in 2002.

The Bottom Line

Fraud artists commonly target businesses like insurance companies and banks, but they often need to involve innocent individuals to pull it off. Identity theft involves using other people's personal information to steal items of value. Securities fraud means conning individual investors into buying stock based on false information.

Plenty of government and corporate resources are devoted to fighting fraud, but individual consumers need to be wary to avoid being victimized.