If the securities analyst does suspect fraud on the part of a public company he should attempt to elicit additional information in order to verify or eliminate his concerns. If he continues to suspect fraud, he should temper his analysis accordingly. If, as a result of receiving material nonpublic information about the company, he learns that fraud is occurring he should notify his employer. If the fraud is sufficiently significant he should also inform the SEC.
A major lesson that the histories recounted in this chapter have for investors involves the importance of portfolio diversification. Diversification is a process that improves the investor's perceived risk-reward ratio. One way to protect against serious losses resulting from investing a potential fraud is to severely limit the proportion of the portfolio invested in the securities of any single issuer.
It was surely not an economist who originally opined, "Crime does not pay." Change breeds opportunity and not just lawful opportunity. The securities markets represent an enormous source of opportunity for profitable fraudulent behavior. Some frauds probably never come to light as such. Some undoubtedly never come to light in any form.
The NSMC, EFCA, and ZZZZ Best cases serve to remind us that the magnitude of a single case of securities fraud involving a publicly held company can be counted in the tens of millions of dollars. Investors and security analysts cannot assume that outside audits are a failsafe device that prevents such frauds from occurring.
The investor can protect himself to a major extent by diversifying his securities portfolio. But he should still approach corporate financial statements warily. A knowledge of the "red flags" identified in this chapter may aid the process of financial analysis.