DFI: Identifies top investor threats for 2012

Contact: George Althoff, Communications Director, 608-261-4504

MADISON – The Wisconsin Department of Financial Institutions (DFI) today released its annual list of the top 10 financial products and practices that threaten to trap unwary investors. While this year’s list includes many long-standing or persistent threats, it also features practices that attempt to exploit new and existing federal laws designed to promote job creation and stimulate economic recovery.

Patricia Struck, Administrator of the Division of Securities, said DFI is particularly concerned about two provisions of the recently passed JOBS Act that could unwittingly open the door to fraud. These include provisions to expand crowdfunding to allow businesses to raise money from investors and to allow the general solicitation and advertising of private placement offers. According to Struck, the top 10 investor threats are:

* Crowdfunding and Internet offers (new)

* Use of self-directed IRAs to mask fraud (new)

* EB-5 investment-for-visa schemes (new)

* Oil and gas drilling programs

* Promissory notes

* Ponzi schemes

* Real estate investment schemes

* Reg D/Rule 506 private offerings

* Affinity fraud

* Gold and precious metals

Struck reminded investors to independently verify any investment opportunity as well as the background of the person and company offering the investment. State securities regulators provide detailed background information about those who sell securities or give investment advice, and about the products being offered. The Internet is also a good research tool.

“Investors should insist on working only with registered brokers and investment advisers in dealing with both traditional and alternative securities investments, and should quickly report any suspicion of investment fraud to their state securities regulator,” Struck said.

Investors who believe they have been subjected to questionable practices may contact DFI at 608-266-1064. More information about each of the Top Investor Threats is available on DFI’s website at http://www.wdfi.org.

2012 Top Investor Threats

Crowdfunding and Internet offers (new)

The 2012 JOBS Act makes significant changes to the methods startup businesses and entrepreneurs may employ to bring their ventures to the investing market, and investors must be wary of the attendant risks. It is important to keep in mind that many more rules and mechanisms must be put into place for those changes to actually take effect. For example, the relaxed rules governing registration of relatively small securities deals, public solicitation for private funds, and disclosure of information to investors over the Internet are not yet written. So the JOBS Act provisions related to crowdfunding, a much-publicized method for startups seeking capital, are not yet available – and will not be until sometime in 2013 – to legitimate businesses. Even once the relaxed rules and registration exemptions are effective, they will not make investments in small businesses less risky – just easier to access. And the JOBS Act provisions do not protect against fraud, an unfortunate common consequence of Internet securities activity. Many states have reported a recent increase in active investigations or recent enforcement actions involving Internet fraud, and JOBS Act-triggered activity is likely to increase this trend. Investors must remember that small startups are among the riskiest of investment categories under the best of situations. The crowdfunding and Internet investing marketplaces in North America will develop and undergo major changes in the next year, and investors should monitor this emerging capital formation community with a wary eye, and only invest what they can bear to lose.

Use of self-directed IRAs to mask fraud (new)

Scam artists, forever on the lookout for new ways to entice investors, are using self-directed IRAs to increase the appeal of their fraudulent schemes. State securities regulators have investigated numerous cases where the services of self-directed IRA custodians (often called “trust” companies) were used in an attempt to lend credibility to a bogus venture. 

Fraud promoters pushing a Ponzi scheme or other investment fraud often misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses. While a scam artist may suggest that self-directed IRA custodians analyze and validate investments, those custodians only “hold” the assets in a self-directed IRA and generally do not evaluate the quality or legitimacy of any investment, or confirm its market value. In some frauds, the custodial statements gave the investors the false impression that their account had a cash value, when often the numbers reported had been arbitrarily chosen by the fraudster and provided to the custodian for reporting to customers.

Self-directed IRAs also allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals and private placement securities; however, financial and other information necessary to make a prudent investment decision may not be as readily available for these alternative investments. While self-directed IRAs can be a legitimate way to hold retirement assets, investors should be mindful of potential fraudulent schemes when considering investments for their self-directed IRA.

EB-5 investment-for-visa schemes (new)

An immigration program linked to job-creation is growing in popularity, but investors must beware of promoters who falsely claim that an investment in their venture is safer or guaranteed due to an influx of foreign cash. The EB-5 immigration category is a 20-year-old program that grants a U.S. visa to foreign nationals who invest a minimum of $500,000 into a new commercial enterprise. This job-creation effort has attracted investors from around the world, and as with any investment approach, increased interest has been accompanied with new challenges.

All investments with an EB-5 component are subject to traditional securities laws, and investors need to be alert to the foreign-funding feature. Unscrupulous promoters may seek to prop up the plausibility of their scheme by highlighting a connection with a federal jobs program. Similarly, investors may be intrigued by the prospect of big funding from investors in China or other foreign countries with traditional or growing economic power. Investors considering any enterprise with an EB-5 or Immigrant Investor Program feature should make sure to obtain full information on every component of the venture, including all funding sources and the background of all promoters.

Oil and gas drilling programs

Investors considering alternatives to traditional securities may be attracted to the lucrative returns often associated with investments in oil and gas drilling programs. These investments may also appeal to those who are frustrated with the volatility of the stock market or skeptical of the culture of Wall Street. Unfortunately, energy investments often prove to be a poor substitute for traditional retirement planning. Investments in oil and gas drilling programs typically involve a high degree of risk and are suitable only for investors who can bear the loss of the entirety of their principal. Moreover, some promoters will conceal these risks, using high pressure sales tactics and deceptive marketing practices to peddle worthless investments in oil wells to the investing public. Often promoters of these deals use unlicensed salespeople to market them, even if the security is registered. Some promoters have a disciplinary history with state regulators from prior deals.

In a recent survey of the states, oil and gas fraud was ranked as the fourth most common product or practice leading to investigations and enforcement actions. There are active investigations into suspect oil and gas investment programs in over two dozen states and in every region of the U.S. and Canada. Investors should therefore conduct thorough due diligence and appraise their own tolerance for considerable risk when considering the purchase of interests in oil and gas programs.

Promissory notes

Promissory notes are often promoted as a safe and secure way for investors to earn returns in excess of those prevailing on conventional investments. Promoters flaunt high returns from private loan agreements, interim short term financing or startup capital opportunities. Investors must be wary of promises of security and liquidity in these promissory notes, which are very often false or overstated. Investments of this nature are highly speculative and the risk of total loss of the funds invested is high. But issuers often use notes and prior relationships with investors to downplay the true nature and risk of these investments.

Sales of promissory notes are frequently the favored investment vehicle for Ponzi schemes. In a recent survey, 20 states identified promissory notes as one of the top five most common products or features in fraudulent schemes. Promissory notes are securities and subject to state regulation. As with all investment opportunities, investors are encouraged to do their due diligence, ask questions and check with state regulators.

Ponzi schemes

Ponzi schemes are scams where money received from new investors is used to pay returns to those who invested previously to give the appearance of a successful investment. In reality, no investments are made and the perpetrator is typically using the funds for his or her own benefit. The best known recent example of a Ponzi scheme is Bernie Madoff. A red flag may be that the investment sounds too good to be true. The Madoff investors believed that they were receiving consistent returns even in down markets when in fact no investments were made, and the scheme failed when Madoff could no longer solicit enough new investors. Unfortunately, the money is often long gone by the time a Ponzi scheme is revealed, so it is important to check out any investment opportunity before turning over your hard-earned funds.

Real estate investment schemes

As news of a possible bottom being reached in the U.S. housing market has spread, the popularity of investment offerings involving distressed real estate has continued to increase. While legitimate real estate investments can be an important component of a diversified portfolio, investors should be aware that schemes related to buying, renovating, flipping or pooling distressed properties are also popular with con artists. Some are run like Ponzi schemes, giving the appearance of a successful venture by the use of investor money to pay earlier investors. Even with legitimate real estate investments, there are substantial risks with properties that are bank-owned, pending short-sale, or in foreclosure. And the field is littered with scam artists intent on fleecing middle-class investors. As with all investments, careful vetting and due diligence is a must with real estate investments.

Regulation D/Rule 506 private offerings

In a recent survey of state securities regulators, fraudulent private placement offerings were ranked as the most common product or scheme leading to investigations and enforcement actions. These offerings also are commonly referred to as Regulation D/Rule 506 offerings (the exemption in federal securities laws that allows private placements to be sold to investors without registration). By definition, these are limited investment offerings that are highly illiquid, generally lack transparency and have little regulatory oversight.

While Regulation D/Rule 506 offerings are used by many legitimate companies to raise capital, these investment offerings are often risky and may not be suitable for many individual investors. The 2012 JOBS Act significantly relaxed the restrictions on the manner in which Regulation D/Rule 506 offerings can be marketed to the general public, eliminating the previous ban on general solicitations and advertising. Once the rules implementing this change are finalized by the SEC, investors will begin to see a variety of advertisements related to private placement offerings, even though only a very small percentage of the population will be eligible to invest.

Affinity fraud

A scam that targets members of religious, ethnic, retired, and/or professional groups is called an “affinity fraud.” The perpetrator encourages potential investors to trust him or her because they have something in common such as church membership. The tight-knit structure of many groups is the perfect environment for crooks because group members will often make referrals of an investment opportunity to other members.

Gold and precious metals

The hype surrounding gold, silver and other precious metals continues despite both the fact that these investments are just as vulnerable to risk as others, and signs that some precious metal markets are declining or increasingly turbulent. The promise of continuing increases in value pitched by high-profile celebrities on television, radio or the Internet too often lure unsuspecting investors into any number of scams.

Often, scams begin with an unsolicited communication such as an e-mail or telephone call offering to sell investors gold coins, bullion, bars or other forms of the precious metal that the promoter will hold in safekeeping for the investor. Far too often, the gold simply does not exist. Even when the company actually delivers the product, its value may not grow as represented by the seller. Increases in the value of precious metals during the recession have led unwary consumers to believe that the value will perpetually increase. Like any risky investment, there are no guarantees.

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