BE ON THE LOOKOUT:

A fraud may succeed because people hear and believe the promises of the promoter and do not investigate the investment (or the person promoting it). To help educate investors, securities regulators of NASAA’s Enforcement Section have identified the following financial products and practices as potential traps for the unwary.

INVESTOR THREATS

PROMISSORY NOTES

In an environment of low interest rates, the promise of high interest promissory notes may tempt investors, especially seniors and others living on a fixed income.

A promissory note is a written promise to pay (or repay) a specified sum of money at a stated time in the future or upon demand. Promissory notes generally pay interest, either periodically before maturity of the note or at the time of maturity. Companies may sell promissory notes to raise capital, and usually offer them only to sophisticated or institutional investors. But not all promissory notes are sold in this way.

Promissory notes may be offered and sold to retail investors. Such notes must be registered with the Securities and Exchange Commission and/or the state(s) in which they are sold or qualify for an exemption from securities registration. Most promissory notes sold to the general public also must be sold by securities salespeople who have the appropriate securities license or registration from their state securities agency.

Promissory notes from legitimate issuers can provide reasonable investment returns at an acceptable level of risk, although state securities regulators have identified an unfortunately high number of promissory note frauds. Individuals considering investing in a promissory note should thoroughly research the investment – and the people promoting it. Investors should be cautious about promissory notes with durations of nine months or less, as these notes generally do not require federal or state securities registration.

Such short-term notes have been the source of most (though not all) of the fraudulent activity involving promissory notes identified by state securities regulators. These short-term debt instruments may be offered by little-known (or perhaps even nonexistent) companies and extend promises of high returns – perhaps over 15 percent monthly – at little to no risk. But if an investment sounds too good to be true, it probably is.

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REAL ESTATE INVESTMENTS

The promise of earning quick money through investments related to real estate continues to lure investors. Real estate investment scams are a perennial investor trap.

State securities regulators caution investors about real estate investment seminars, especially those marketed aggressively as an alternative to more traditional retirement planning strategies involving stocks, bonds and mutual funds. Attendees at these seminars may hear testimonials from people claiming to have doubled or tripled their income through seemingly simple real estate investments. But these claims may be nothing more than hot air.

Two of the most popular investment pitches involve so-called “hard-money lending” and “property flipping.” Hard-money lending is a term used to refer to real estate investments financed through means other than traditional bank borrowing. (This type of loan gets its name from the fact that it would be “hard to get” from a traditional lending source.)

Some firms or wealthy individuals specialize in making hard-money loans, as these loans can command comparatively high interest rates. But borrowers may seek to obtain such loans from retail investors as well. Investors may be tempted by the opportunity to earn greater rates of return by participating on a hard-money loan and may (or may not) appreciate the potential risks, including as to the borrower’s credit, the expected stability of income from the investment, or time constraints.

There are three players in a hard-money transaction: the investor, the lender and the borrower.

Private lenders raise money from investors to lend to borrowers. If funds from different investors are combined, the investment vehicle used to purchase the property is a “pooled investment,” which is a security and, as such, is subject to the protections and disclosure requirements of securities laws and regulations.

While traditional loans are based on the ability of the borrower to repay using indicators such as credit scores and income, hard-money loans are based primarily on the value of the property with which they are secured, which the borrower already owns or is acquiring with the loan.

If the borrower defaults, the lender may be able to seize the asset and try to sell it; however, it may be harder for the investor to recoup the loan depending on how it is structured.

Property flipping is the practice of purchasing distressed real estate, refurbishing it, and then immediately re-selling it in hopes of earning a profit. A property flipper can use its own money to finance the flip or can seek financing from others. Property flipping financed through borrowed funds or outside investments can be done entirely lawfully, but it can also be a source for fraud.

A scammer may, for example, defraud potential investors in the flip by misrepresenting the value of the underlying property or the expected profit potential on the flip. Scammers may also misappropriate borrowed or invested funds or seek to use unwitting investors as “straw buyers” with outside banks or mortgage lenders, leveraging investors’ names and credit scores to facilitate their scams.

PONZI/PYRAMID SCHEMES

A Ponzi scheme (named after 1920’s swindler Charles Ponzi) is a ploy wherein earlier investors are repaid through the funds deposited by subsequent investors.

Charles Ponzi took investors for $10 million by promising 40 percent returns from arbitrage profits on International Postal Reply Coupons.

In a Ponzi scheme, the underlying investment claims are usually entirely fictional; very few, if any, actual physical assets or investments generally exist. As the number of total investors grows and the supply of potential new investors dwindles, there is not enough money to pay off promised returns and cover investors who try to cash out.

A Ponzi bubble will burst when the con artist simply cannot keep up with the payments investors are expecting to receive.

When the scheme collapses (as it always does), investors may lose their entire investment in the fraud. In many cases, the perpetrator will have spent investment money on personal expenses, depleting funds and accelerating the bursting of the bubble.

Similarly, a pyramid scheme is a fraudulent multi-level marketing strategy whereby investors earn potential returns by recruiting more and more other investors. Multi-level marketing strategies are not intrinsically fraudulent, and there are many legitimate multi-level marketing companies offering various consumer products and services.

What makes a multi-level marketing strategy into a fraudulent pyramid scheme is the lack of a genuine underlying investment enterprise or product upon which the strategy can hope to be sustained. 

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OIL & GAS INVESTMENTS

Many oil and gas investment opportunities, while involving varying degrees of risks to the investor, are legitimate in their marketing and responsible in their operations.

However, as in many other investment opportunities, it is not unusual for unscrupulous promoters to attempt to take advantage of investors by engaging in fraudulent practices.

Fraudulent oil and gas deals may be structured with a legal entity (such as a limited partnership) registered in one state but with operations and physical presence in a second state. Prospective investors in the venture may be solicited from still more states (with the obvious benefit to the perpetrators being a reduced chance an investor will ever seek to visit a well site or the organization’s headquarters).

Typically, in these types of scams, promoters invent false or misleading information about oil and gas properties to lure investors and keep them on the hook in bogus investments. The diffuse structure of such scams make it difficult for authorities and victims to identify them as frauds before it is too late.

Investors are usually offered fractional interests in oil or gas leases that have been obtained by a drilling company. Investors hope the drilling company will drill the well properly, that the well will be productive, and that they will share in the eventual profitability of the endeavor.

These investments may be marketed as safe and secure, high-yield investments and therefore attract investors, such as seniors, who are interested in safety of principal with some income-producing potential.

Oil and gas ventures are typically highly speculative, though, and may not be suitable for many investors. As pooled investment enterprises, these ventures generally will be treated as securities under state laws, though they may be exempt from state securities registration if certain conditions are met.

Because these ventures are so speculative, the potential for fraud is rife. Scammers may misrepresent the likelihood that an oil or gas well will be successful – or may not even ultimately drill a well at all. Fraudulent oil and gas schemes frequently take the form of Ponzi schemes, with investors’ funds being “recycled” to keep the scheme going.

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AFFINITY FRAUD

In an affinity fraud, a con artist uses some sort of connection with the victim as the basis for the fraud.

Affinity frauds may involve people who attend the same church, belong to the same club or association, or share a common hobby.

The con artist knows it is often easier for victims to trust someone who seems to be like them. And once trust is gained, it is easier to exploit that trust to perpetrate a scam.

Everyone, in some way or another, is connected to a group or association. Our interests, backgrounds, and other factors will naturally lead us to those organizations or affiliations that serve our needs. Ethnicity, culture, and religious beliefs also play a role in identifying us as members of unique groups that we often come to trust.

In a world of increasing complexity, many people feel the need for a short-hand way of knowing whom to trust. This is especially true when it comes to investing money.

Unfamiliar with how our financial markets work, too many people don’t know how to thoroughly research an investment or a salesperson. “You can trust me,” says the scamster, “because I’m like you. We share the same background and interests. And I can help you make money.”

Another equally effective pitch, if the con artist is not a member of the group, is to lull members into a misplaced trust by selling first to a few prominent members, then pitching the scam to the rest of a group.

The effect is the same: Once the connection to the group is understood, the natural skepticism of the individual member is overcome, and one more group name is added to the sales column.

Once a victim realizes that he or she has been scammed, too often the response is not to notify the authorities but instead to try (usually unsuccessfully) to solve problems within the group. Swindlers who prey on groups joined by commonality play the loyalty angle for all its worth.

Affinity fraud can not only be financially devastating to the victims, but often has the perverse effect of causing victims to lose trust in the group or affiliation that was previously a source of comfort or support. The psychological damage can be just as harmful as the financial damage.

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VARIABLE ANNUITIES SALES PRACTICES

Variable annuities are hybrid investments containing both securities and insurance features.

The securities features of variable annuities provide the investor with an opportunity to participate in potential capital appreciation and income through investments in the securities markets, but also subjects the investor to market risks.

The insurance features permit an investor to receive a series of periodic payments from the investment over time and provide a death benefit to the beneficiary should the investor die during the accumulation phase (that is, if the account value is less than the “basis” — principle plus gains — at the time of death).

Variable annuities are considered to be securities under federal law and the laws of some states. Certain states consider variable annuities to be strictly insurance products, while other states consider them to be both insurance and securities. In states where variable annuities are regulated by both the state’s insurance and securities regulator, variable annuities must be registered with both state regulators.

Individuals selling variable annuities also must be registered with their appropriate state regulator. And because variable annuities are securities under federal law, individuals selling them must be registered with the Financial Industry Regulatory Authority (FINRA). (To find out how your jurisdiction treats variable annuities, you should contact both the securities and insurance regulators for your jurisdiction.)

Variable annuities are tax-deferred. Accordingly, issuers typically place mutual funds inside of an insurance wrapper for tax deferred investment growth.

While these products are entirely legitimate, they are not suitable for all investors and state securities regulators are concerned about the risks of sales practice abuses.

Senior investors, in particular, should beware of the high surrender fees and steep sales commissions agents often earn when they move investors into variable annuities. Commissions to those who sell variable annuities are very high, which provides incentive for sellers to engage in inappropriate sales.

Variable annuities also generally should not form more than a portion of an investor’s portfolio, and many not be suitable for seniors because of the steep penalties for early withdrawals.

Investors should be especially wary of any broker who wants to sell a variable annuity to hold inside a qualified retirement plan, such as a 401(k) plan or Individual Retirement Account (IRA), as these types of retirement account will already benefit from tax deferment. Putting a variable annuity into a 401(k) or IRA adds a layer of expense and investment restriction without any additional tax benefit.

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