Prevention of Frauds and Scams in Capital Market: Role of

Investors, Market Intermediaries, and Regulators

Submitted by

Prapti Niraula

Kathmandu University School of Law

Word Count: 3000 (with Citations)

Citation style: Bluebook

 1

Table of Contents

Contents Page no.

1.Introduction 2
1.1 Overview of Frauds and Scams in Capital Markets
1.2 Importance of Prevention in Ensuring Market Integrity

2. Types of Frauds and Scams in Capital Markets 2

2.1 Insider Trading
2.2 Ponzi Schemes and Pyramid Schemes
2.3 Pump and Dump Scams
2.4 Accounting Fraud and Misrepresentation

3. Role of Investors in Preventing Frauds and Scams 3

3.1 Conducting Due Diligence
3.2 Recognizing Red Flags in Investment Opportunities
3.3 Reporting Suspicious Activities to Authorities

4. Role of Market Intermediaries in Fraud Prevention 4

4.1 Brokers and Investment Advisers: Ensuring Transparency
4.2 Role of Auditors in Detecting Financial Irregularities
4.3 Stock Exchanges: Monitoring Unusual Trading Activities

5. Role of Regulators in Preventing Frauds and Scams 5

5.1 Securities and Exchange Commission (SEC) and Other Regulatory
Bodies
5.2 Regulatory Frameworks and Policies to Combat Frauds
5.3 Enforcement Mechanisms: Investigations and Penalties

6. Case Studies of Capital Market Frauds 6

6.1 Enron Scandal: Accounting Fraud and Consequences
6.2 Bernie Madoff Ponzi Scheme: Lessons for Investors
6.3 Recent Scams and Regulatory Responses

7. Best Practices for Fraud Prevention 7

7.1 Strengthening Market Regulations and Investor Protections
7.2 Enhancing Financial Literacy Among Investors
7.3 Increasing Collaboration Between Investors, Intermediaries, and
Regulators

8. Conclusion 8
 2

1. Introduction

Fraud siphons the sanity of the capital market, as in the case of Unity Life International in Nepal,
which plundered thousands into bankruptcy. Insider trading, Ponzi schemes, and other scandals
impair investor confidence and impede financial development. Unchecked fraud turns the market
into a manipulator's playground where no investments will be encouraged or motivated.

Fraud, this essay identifies, has to be tackled by a united response from investors, intermediaries,
and regulators-an assurance for transparency and trusting through ethics and vigilance. It is
submitted here that protection of the capital market requires not mere regulation but awareness
and proactive efforts.

1.1. Overview of Frauds and Scams in Capital Markets

Fraud ranges from the insider trading, part of the Unity Life International scam in Nepal, to the
pump-and-dump schemes and Ponzi schemes of a Bernie Madoff. These frauds hoodwink market
prices and remove trust in the market. Accounting frauds, like the Enron case, lie to investors with
less than honest financial statements1 that further undermine the integrity of the market.

1.2. Importance of Prevention in Ensuring Market Integrity

Fraud prevention ensures that there is market integrity and transparency for the protection of
investor confidence, hence the opportunity for firms to raise capital. Regulators such as SEBON
have been enforcing laws so as to reduce fraud cases. Investor education also minimizes risks. The
efficient market hypothesis seems to indicate a case where, at any time, manipulation might be
tough; the prices of stocks reflect all the available information in the market. Strong regulations,
severe penalties, and better awareness among investors are the factors that can help maintain
market integrity for the development of the economy.

2. Types of Frauds and Scams in Capital Markets

Frauds in capital markets undermine investor confidence and market integrity, exploiting
vulnerabilities for financial gain. Key types include:

2.1. Insider Trading

Insider trading occurs when individuals trade securities based on non-public information,
providing an unfair advantage. For example, Raj Rajaratnam2 profited from privileged

1
Barbara Ley Toffler, Corporate Crooks: A Report on Business Fraud 21-22 (2018).
2
U.S. Securities and Exchange Commission, SEC Charges Hedge Fund Manager Raj Rajaratnam with Insider
Trading, SEC.gov (Oct. 16, 2009), https://www.sec.gov/news/press-release/2009-229.
 3

information, while similar practices in Nepal often arise during mergers, leading to rapid
speculation.

2.2. Ponzi and Pyramid Schemes

Ponzi schemes promise high returns with minimal risk, paying early investors with funds from
new ones with its “get rich schemes”.3 Bernie Madoff's notorious scheme led to massive losses,
and similar scams in Nepal have left victims feeling betrayed.

2.3. Pump and Dump Scams

In pump and dump scams, traders inflate a stock's price before selling, leaving unsuspecting
investors to suffer losses when the price crashes. During the 1990s, fraudulent brokers pushed
small or penny stocks on unsuspecting investors.4 This is particularly prevalent in Nepal’s less
regulated market. As any Nepali investor may joke, "Sometimes I feel like I'm buying shares of
invisible companies—they rise, and then they vanish!"5

2.4. Accounting Fraud and Misrepresentation

Accounting fraud involves falsifying financial statements to misrepresent a company’s health, as
seen in the Enron scandal.6 While Nepal hasn't faced similar large-scale fraud, issues like income
overstatement are concerning.
In summary, fraud in capital markets takes various forms worldwide, exploiting trust and greed,
and serving as a reminder that not everything in the market is as it appears.7

3. Role of Investors in preventing fraud and scam

Investors are considered to be the first line of defense against fraud and scams in the capital
markets. Their active vigilance protects their own assets but also significantly contributes to the
overall integrity of the financial system. As much as regulators and market intermediaries may
play important roles, it is indeed investors' hands-on engagement in scrutinizing potential
investments that can go a long way in reducing the possibility of falling prey to fraudulent schemes.

3
U.S. Securities and Exchange Commission, Ponzi Schemes, SEC.gov (Mar. 15, 2021),
https://www.sec.gov/spotlight/ponzi-schemes.
4
U.S. Securities and Exchange Commission, Pump and Dump Schemes, SEC.gov (Apr. 5, 2022),
https://www.sec.gov/oiea/investor-alerts-and-bulletins/pump-and-dump-schemes.
5
Thapa, R., Nepal's Stock Market: A Goldmine for Fraudulent Practices, Nepali Times, (May 20, 2023),
https://www.nepalitimes.com/banner/nepals-stock-market-a-goldmine-for-fraudulent-practices.
6
U.S. Securities and Exchange Commission, The Fraudulent Practices of Enron, SEC.gov (July 17, 2020),
https://www.sec.gov/news/press-release/2020-158
7
Adhikari, A., Recent Corporate Scandals in Nepal: A Study of Accounting Fraud, Nepal Journal of Business Studies,
(June 30, 2022), https://www.nepjol.info/index.php/NJBS/article/view/38229.
 4

3.1. Due Diligence

Due diligence is essential for safe investment. Investors must research a company's credibility,
finances, and market reputation before investing. As Warren Buffett said, "Risk comes from not
knowing what you're doing."8 A key example is the Bernie Madoff Ponzi scheme, where investors
failed to question his business model, leading to one of the largest financial frauds in history. In
Nepal, investors should be cautious of promises of unusually high returns, like 30% annually, and
ask critical questions. A bit of skepticism can protect against potential losses.

3.2.Identifying Red Flags in Investment Opportunities

The important thing in avoiding investment frauds is to know the red flags. These are warnings for
high returns with low risks, pressure for quick decisions, and those vague in investment detail.9
For example, if an offer on social media promises a 50% return in a month with "no risk," then it
could be a scam. Similarly, less regulated schemes or informal investment clubs, like the 2019
cryptocurrency fraud10, are often lacking in transparency. Investors who ignore such warning
signs, which include no formal registration and dubious business methodologies, have much to
lose. A mistake of that nature can easily be avoided by asking a few simple questions.

3.3 Information of Suspicious Activities to Authorities

Reporting suspicious activities is crucial for fraud prevention. In the U.S., whistleblowers under
the Dodd-Frank Act can report fraud and receive financial rewards.11 Similarly, SEBON in Nepal
encourages reporting fraud, but many investors hesitate due to fear or lack of awareness. Increasing
awareness about platforms like SEBON's investor grievance system could empower more people
to report. Timely reporting, vigilance, and due diligence can prevent fraud, reinforcing the idea
that "an ounce of prevention is worth a pound of cure."

4. Role of Market Intermediaries in Fraud Prevention

Fairness and transparency in the capital market can be assured with the help of the following:
market intermediaries; brokers, investment advisers, auditors, and stock exchanges. Primarily,
their job is to prevent every fraud that retains the integrity in the market. This section shows their
contributions using Nepalese examples with a dash of humor to keep it light.

4.1. Brokers and Investment Advisers: Ensuring Transparency

Brokers and advisors, as gatekeepers, must prioritize clients' interests to protect the financial
market. Under the Securities Act, 2063, SEBON regulates brokers in Nepal. The 2011 stock

8
Warren Buffett, Risk Comes from Not Knowing What You're Doing
9
. Know the Red Flags of Fraud, Canadian Securities Administrators https://www.securities-
administrators.ca/investor-tools/avoiding-fraud/know-the-red-flags-of-fraud/.
10
Securities Board of Nepal, Investor Protection and Grievance Redressal, 2019.

11
U.S. Securities and Exchange Commission, Whistleblower Program, available at
https://www.sec.gov/whistleblower.
 5

manipulation case highlighted the importance of transparency and honesty in preventing fraud and
maintaining market confidence. Warren Buffett's words, "It takes 20 years to build a reputation
and five minutes to ruin it," emphasize this responsibility.12

4.2 Role of Auditors in Detecting Financial Irregularities

This means auditors are like financial watchdogs that help in the unearthing of frauds before they
balloon into major ones. In Nepal, too, auditors found discrepancies in the statements of Nepal
Investment Bank and hence called for stock revaluation. The Enron case in the US showed how
auditor complacency could lead to fraud-merging of books of accounts, which Arthur Anderson
failed to detect. According to the Nepal Chartered Accountants Act, an auditor has to ensure that
the financial reporting is true and accurate and report suspicions relating to earnings. Failure to do
so, as in the hypothetical example of "Mountain Yak Expeditions" in inflating revenues, would be
fooling the investors. Auditors' role in spotting anomalies helps prevent fraud.

4.3 Stock Exchanges: Monitoring Unusual Trading Activities

The stock exchanges, like NEPSE, are usually built to avoid insider trading, price manipulation,
and irregular trading. For example, the 2020 GameStop surge, while legal, did raise some
eyebrows on issues of manipulation.13 Similarly, NEPSE would have to take action if there was
inflation in the "Himalayan Herbal Stocks." It is such actions that reinforce the integrity of the
market and increase investor confidence.

5. Role of Regulators in Preventing Frauds and Scams

Frauds in the capital market require not only keen eyes on the investors but also regulatory
supervision. The SEC, along with similar authorities, hence provides a legal platform that shields
investors from fraud and warrants market integrity. In the words of Albert Einstein, "The world is
dangerous…because of people who don't do anything about it," which brings out the relevance of
regulators in preventing such fraudulent activities.

5.1 Securities and Exchange Commission (SEC) and Other Regulatory Bodies
The SEC, established in 1934 to protect investors, promotes transparency and enforces various
regulations; the Enron case14, however, underlines the need for far-reaching oversight. Also,
SEBON, the apex body for security market regulation in Nepal, adds to investor confidence in an
emerging market.
Another underlying factor that influences fraudulent activities related to the capital market is the
availability of opportunities. Legally, full disclosure and corporate governance are obliged to
prevent fraud through key legislations established by the SEC, which are: the Securities Act of

12
Healy, P. M., & Palepu, K. G. (2003). The Fall of Enron. Journal of Economic Perspectives, 17(2), 3-26.
13
U.S. Securities and Exchange Commission (SEC). 2003. SEC Charges Martha Stewart with Securities Fraud.
Retrieved from SEC
14
Healy, P. M., & Palepu, K. G. (2003). The Fall of Enron. Journal of Economic Perspectives, 17(2), 3-26.
 6

1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002. Also, in Nepal,
the Companies Act, 2006 obliges corporate accountability.

5.2 Regulatory Frameworks and Policies to Combat Frauds

Effective regulation implies effective enforcement. Suspected fraud is investigated by the SEC
using data analytics and forensic accounting; the case of Martha Stewart was one such example.15
The recent fraud in NEPSE has pointed out that even in Nepal, the need for regulatory vigilance
is a continuous process. Severe sanctions-a really hefty fine and criminal action-emphasize an
important principle: "crime doesn't pay."

5.3 Enforcement Mechanisms: Investigations and Penalties

In a market where the potential for both profit and deception is huge, regulators protect not only
the interests of investors but also the integrity of the capital markets themselves. As the Chairman
of the SEC said, "Investors must be able to trust the information they receive. They should not be
in a position to guess whether the price of a stock is based on facts or fraud."
We must understand that fraud is a day-to-day struggle-a watchful partnership between regulators,
market participants, and well-informed investors.

6. Case Studies of Capital Market Frauds

Historically, Capital markets combine innovation and fraud, hence the need for oversight. The
Enron scandal, Bernie Madoff Ponzi scheme, and other scams of recent origin point out
weaknesses of the financial system and offer very important lessons to the investor of today.

6.1. Enron Scandal: Accounting Fraud and Consequences

The Enron scandal involved executives manipulating accounting rules to hide debt and inflate
profits. The stock price consequently collapsed from nearly $90 to less than a dollar, wiping out
$74 billion in shareholder value.16 The scandal brought down Arthur Andersen and gave rise to
the Sarbanes-Oxley Act.17 Indeed, the ironic claim by Jeff Skilling that "We are the good guys"
underlined how fast reputations could fall.
This case pins the greatest importance on transparency and scrutiny of financial statements, a
lesson which developing capital market regulations in Nepal must learn.

15
U.S. Securities and Exchange Commission (SEC). (2003). SEC Charges Martha Stewart with Securities Fraud.
Retrieved from SEC
16
David S. Hilzenrath, The Enron Collapse: A Timeline, Wash. Post (Dec. 12, 2001),
https://www.washingtonpost.com/wp-srv/business/enron/timeline.htm
17
John C. Coffee, Jr., Enron: Corporate Governance, Fraud, and the Lessons for the Future, 39 Del. J. Corp. L. 405
(2014).
 7

6.2. Bernie Madoff Ponzi Scheme: Lessons for Investors

Bernie Madoff, former head of NASDAQ, had conducted the world's largest Ponzi scheme by
swindling $65 billion from investors by paying earlier ones with money from new investors, thus
giving an impression of consistent high returns.18 His scheme exploded in 2008, sending shock
waves into the financial world. Madoff's ironic claim that "it's virtually impossible to violate rules"
stresses skepticism. His case reminds investors that healthy skepticism is warranted and trust is
only deserved from verified performance and highlighted that due diligence and verification that
investors in Nepal's emerging capital markets must be made aware of, amid internet investment
platforms.19

6.3. Recent Scams and Regulatory Responses

Large-scale frauds have struck the capital markets, bringing quicker regulatory responses. The
German Wirecard scandal, which made up $2 billion in accounts, questioned auditor effectiveness,
while the Theranos scandal led to questions about valuations applied to startups20. In Nepal,
investors are being lured by illegal online trading platforms with the promise of unrealistic returns,
eventually incurring financial losses. These show that regulations should keep pace with modern,
sophisticated frauds, drawing critical emphasis on proactive oversight for Nepal's developing
capital market.21

7. Best Practices in Capital Market Fraud Prevention.

In as much as financial markets are becoming increasingly sophisticated, fraudsters operate are
changing; hence, strong fraud prevention becomes quite indispensable. Thus some critical areas
are necessary for fraud prevention.

7.1 Improving Regulation of the Market and Protection for Investors

The regulatory system should be firm with adaptive and enforceable regulations that help avoid
fraud. This happened in the case of Bernie Madoff's fraud due to weak oversight. For example,
this day U.S. regulation is very strict promulgated by the SEC.
In Nepal, the SEBON plays a vital role, but there are ongoing challenges with trying to enforce
insider trading regulations. The most important measures for reducing fraud will be strict
regulations, increased punishments, and requirements for an external audit in public traded
companies.

18
Matthew Goldstein, The Rise and Fall of Bernie Madoff, N.Y. Times (Dec. 15, 2008),
https://www.nytimes.com/2008/12/15/business/15madoff.html;
19
Erica B. Birstler, Madoff's Fraud and the Regulation of Investment Advisers, 9 N.C. Banking Inst. 119 (2005).
20
Tessa K. Kline, Wirecard Scandal: A Case Study in Regulatory Failure, 19 N.Y.U. J. Legis. & Pub. Pol'y 407 (2016);
21
John Carreyrou, Bad Blood: Secrets and Lies in a Silicon Valley Startup, 2018
 8

7.2 Improvement of Investor Financial Literacy

Intelligent investors are harder to deceive, as financial literacy provides signals for suspicious
offers.
In Nepal, the financial literacy is low, particularly amongst the general populace. The education
programs for rural and urban investors can actually create a difference. For instance, a financially
educated Nepali farmer would show more restraint before making investments. As Warren Buffet
has rightly said, "Risk comes from not knowing what you're doing,"22 which he used to show how
education reduces fraud risks.

7.3 Strengthening Investor-Intermediary-Regulator Linkages

Better coordination among investors, intermediaries, and regulators has made markets stronger.23
The financial crisis in 2008 and the poor coordination prevalent during that time had worsened the
problems before new regulatory measures were considered. A system for fraud alerts in real-time
may be adopted by SEBON, brokers, and investors in Nepal for early detection. 24With a
strengthening of confidence, vigilance, regulations, and financial literacy, Nepal's capital market
will doubtless strengthen and weed out the possibility of fraud.

8. Conclusion
It is a serious challenge globally in the prevention of fraud in capital markets and affects investor
confidence very heavily. The most recent example in Nepal was related to the Ncell tax scandal,25
and the issue highlighted how corporate structures are opaque. Such fraud prevention in the future
requires bolstered efforts in law enforcement, blockchain, and AI for real-time fraud detection.
Crucially, there has to be enhanced whistleblower protection to protect those coming forward
bravely to report fraud. Earning trust in any financial system is not just an issue of technology and
regulations but demands transparency, education, and unity at all levels.
Fraud is a fight that is never won, but by lessons learned and new ideas and solutions being put in
place, a secure future in the capital markets can be guaranteed to all investors, new and experienced
alike. As Warren Buffett noted, “In the business world, the rearview mirror is always clearer than
the windshield,” emphasizing the importance of learning from the past to foster a trustworthy
financial environment.

22
Warren Buffet, "Risk Comes from Not Knowing What You're Doing," The Essays of Warren Buffett: Lessons for
Corporate America 12 (Lawrence A. Cunningham ed., 2013).
23
U.S. Securities and Exchange Commission, Annual Report FY 2022 (2022), available at www.sec.gov.
24
Securities Board of Nepal, Annual Report 2022/2023 (2023), available at www.sebon.gov.np.
25
Ncell Tax Scandal, The Kathmandu Post (2020), available at Kathmandu Post.
9