How Internet Fraud Works
There are a variety of ways that a fraud can be perpetrated via the Internet. The Securities and Exchange Commission lists several types of Internet fraud on their website;1 we will briefly discuss each of those and others, but it is not possible for us to cover every variation of each fraud scheme that has been used on the Internet. Such an undertaking would not only fill an entire book, but also possibly several volumes. What we can do is to cover the more common scams, and try to extrapolate some general principles that you can apply to any potential fraud. If you use these specific cases to extrapolate some general principles, then you should be prepared to avoid most fraud schemes.
Investment offers are nothing new. Even some legitimate stockbrokers make their living by cold calling, the process of simply calling people (perhaps from the phone book), and trying to get them to invest in a specific stock. This practice is employed by some legitimate firms, but it is also a favorite con game for perpetrators of fraud. The Internet has allowed investment offers—both genuine and fraudulent—to be more easily disseminated to the general public. Most readers are probably familiar with investment offers flooding their inbox on a daily basis. Some of these email notifications entice you to become directly involved with a particular investment plan; other emails offer seemingly unbiased information from investors, free of charge. (Unfortunately, much of this advice is not as unbiased as it might appear to be.) While legitimate online newsletters can help investors gather valuable information, keep in mind that some online newsletters are fraudulent.
One of the more common schemes involves sending out an email that suggests that you can make an outrageous sum of money with a very minimal investment. Perhaps the most famous of these schemes has been the Nigerian fraud. In this scenario, an email is sent to a number of random email addresses. Each one contains a message purporting to be from a relative of some deceased Nigerian doctor or government official. The deceased person will be someone you would associate with significant social standing, thus increasing the likelihood that you would view the offer more favorably. The offer goes like this: A person has a sum of money he wishes to transfer out of his country, and for security reasons, he cannot use normal channels. He wishes to use your bank account to “park” the funds temporarily. If you will allow him access to your account, you will receive a hefty fee. If you do agree to this arrangement, you will receive, via normal mail, a variety of very official-looking documents, enough to convince most casual observers that the arrangement is legitimate. You will then be asked to advance some money to cover items such as taxes and wire fees. Should you actually send any money, you will have lost the money you advanced and you will never hear from these individuals again. The U.S. Secret Service has a bulletin issued detailing this particular fraud scheme.2
Now consider this investment scam, and variations of it, from a logical point of view. If you had large sums of money you needed to transfer, would you send it to a person in a foreign country, someone you had never met? Wouldn’t you be worried that the recipient would cash out her account and take the next plane to Rio? If a person needs to transfer money internationally, why doesn’t he just transfer the money to an account in the Bahamas? Or cash out the account and send it via Federal Express or United Parcel Service to a storage facility in the United States? The point is that there are many ways a person could get money out of a country without trusting some stranger he has never seen before. That fact alone should indicate to you that this offer is simply not legitimate. This concept is the first general principle you should derive concerning fraud. In any offer, consider the point of view of the person offering it. Does it sound as if he is taking an inordinately large risk? Does the deal seem oddly biased in your favor? Put yourself in his position. Would you engage in the deal if you where in his position? If not, then this factor is a sign that the deal might not be what it seems.
Such blatant fraud schemes are not the only investment pitfall on the Internet. Some companies pay the people who write online newsletters to recommend their stocks. While this activity isn’t actually illegal, U.S. federal securities laws do require the newsletters to disclose that they where paid to proffer this advice. Such laws are in place because when the writers are recommending any product, their opinion might be swayed by the fact that compensation is being provided to them for that opinion. Many online investment newsletters do not disclose that they are actually being paid to recommend certain stocks. This situation means that the “unbiased” stock advice you are getting could actually be quite biased. Rather than getting the advice of an unbiased expert, you may be getting a paid advertisement. This pitfall is one of the most common traps of online investment advice, more common than the blatant frauds.
Sometimes these online stock bulletins can be part of a wider scheme, often called a pump and dump. A classic pump and dump is rather simple. The con artist takes a stock that is virtually worthless and purchases large amounts of the stock. The con artist then artificially inflates the value,3 in several ways. One common method is to begin circulating rumors on various Internet bulletin boards and chat rooms that the stock is about to go up significantly. Often it is suggested by the trickster that the company has some new innovative product due to come out in the next few weeks. Another method is to simply push the stock on as many people as possible. The more people vying to buy a stock, the higher its price will rise. If both methods are combined, it is possible to take a worthless stock and temporarily double or triple its value. The perpetrator of the fraud has already purchased volumes of the stock, at a very low price, before executing this scheme. When the stock goes as high as she thinks it can, she then dumps her stock and takes the money. In a short time, and certainly by the time the company’s next quarterly earnings report is released, the stock returns to its real value. This sort of scheme has been very popular in the past several decades; thus, you should always be wary of such “insider” information. If a person is aware that Company X is about to release an innovative new product that will drive her stock value up, why would she share that information with total strangers?
The U.S. Securities and Exchange Commission lists several tips for avoiding such scams:4
- Consider the source. Especially if you are not well versed in the market, make sure you accept advice only from well-known and reputable stock analysts.
- Independently verify claims. Do not simply accept someone else’s word about anything.
- Research. Read up on the company, the claims about the company, its stock history, and so forth.
- Beware of high-pressure tactics. Legitimate stock traders do not pressure customers into buying. They help customers pick stocks that customers want. If you are being pressured, that is an indication of potential problems.
- Be skeptical. A healthy dose of skepticism can save you a lot of money. Or, as the saying goes, “If it’s too good to be true, it probably isn’t.”
- Make sure you thoroughly research any investment opportunity.
The truth is that these types of fraud depend on the greed of the victim. It is not my intent to blame victims of fraud, but it is important to realize that if you allow avarice to do your thinking for you, you are a prime candidate to be a victim of fraud. Your 401K or IRA may not earn you exorbitant wealth overnight, but they are steady and relatively safe. (No investment is completely safe.) If you are seeking ways to make large sums of money with minimal time and effort, then you are an ideal target for perpetrators of fraud.
Online auctions, such as eBay, can be a wonderful way to find merchandise at very good prices. I routinely use such auctions to purchase goods. However, any auction site can be fraught with peril. Will you actually get the merchandise you ordered? Will it be “as advertised”? Most online auctions are legitimate, and most auction websites take precautions to limit fraud on their website. But problems still occur. In fact, the U.S. Federal Trade Commission5 (FTC) lists the following four categories of online auction fraud:
- Failure to send the merchandise
- Sending something of lesser value than advertised
- Failure to deliver in a timely manner
- Failure to disclose all relevant information about a product or terms of the sale
The first category, failure to deliver the merchandise, is the most clear-cut case of fraud and is fairly simple. Once you have paid for an item, no item arrives. The seller simply keeps your money. In organized fraud, the seller will simultaneously advertise several items for sale, collect money on all the auctions, and then disappear. If he or she has planned this well, the entire process was done with a fake identification, using a rented mailbox and anonymous email service. The person then walks away with the proceeds of the scam.
The second category of fraud, delivering an item of lesser value than the one advertised, can become a gray area. In some cases, it is outright fraud. The seller advertises something about the product that simply is not true. For example, the seller might advertise a signed copy of the first printing of a famous author’s book, but then instead ship you a fourth printing with either no autograph, or one that is unverified. However, in other cases of this type of problem, it can simply be that the seller is overzealous, or frankly mistaken. The seller might claim his baseball was signed by a famous athlete, but not be aware himself that the autograph is a fraud.
This problem is closely related to the fourth item on the FTC list, failure to disclose all relevant facts about the item. For example, a book might be an authentic first printing and autographed, but be in such poor physical condition as to render it worthless. This fact may or may not be mentioned in advance by the seller. Failure to be forthcoming with all the relevant facts about a particular item might be the result of outright fraud or simply of the seller’s ignorance. The FTC also lists failure to deliver the product on time as a form of fraud. It is unclear whether or not that is fraud in many cases, or merely woefully inadequate customer service.
The Federal Trade Commission and Auction Fraud
The FTC also lists three other areas of bidding fraud that are growing in popularity on the Internet. From the FTC website:5
- Shill bidding, when fraudulent sellers (or their “shills”) bid on the seller’s items to drive up the price.
- Bid shielding, when fraudulent buyers submit very high bids to discourage other bidders from competing for the same item. The fake buyers then retract their bids so that people they know can get the item at a lower price.
- Bid siphoning, when con artists lure bidders off legitimate auction sites by offering to sell the “same” item at a lower price. Their intent is to trick consumers into sending money without proffering the item. By going off-site, buyers lose any protections the original site may provide, such as insurance, feedback forms, or guarantees.
Shill bidding has been probably the most common of these three auction frauds. It is not very complex. If the perpetrator is selling an item at an auction site, she will also create several fake identities. She will use these fake identities to bid on the item and thus drive the price up. It is very difficult to detect if such a scheme is in operation. However, a simple rule of thumb on auctions is to decide, before you start bidding, what your maximum price is. And then, under no circumstances, do you exceed that price, by even one penny.
While shill bidding may be difficult to combat, bid shielding can be addressed fairly easily by the proprietors of the auction site. Many of the major auction sites, such as eBay, have taken steps to prevent bid shielding. The most obvious is to revoke bidding privileges for bidders who back out after they have won an auction. So if a person puts in a very high bid to keep others away, then at the last moment retracts his bid, he might lose his ability to be on that auction site.
Bid siphoning is a less-common practice. In this scheme, the perpetrator places a legitimate item up for bid on an auction site. But then, in the ad for that item, she provides links to sites that are not part of the auction site. The unwary buyer who follows those links might find himself on an alternative site that is a “setup” to perpetrate some sort of fraud.
All of these tactics have a common aim: to subvert the normal auction process. The normal auction process is an ideal blend of capitalism and democracy. Everyone has an equal chance to obtain the product in question, if he or she is willing to outbid the other shoppers. The buyers themselves set the price of the product, based on the value they perceive the product to have. In my opinion, auctions are an excellent vehicle for commerce. However, unscrupulous individuals will always attempt to subvert any process for their own goals.