State Securities Regulators Release ‘Unlucky 13’
Investor Traps

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Financial advisors should be aware of common forms of investor fraud and help investors choose legitimate investments that meet an individual’s goals. Investors should contact their state securities regulator with regard to questionable investment products or brokers.

“Investment scams can be devastating for the investor who falls victim,” said NASAA president and Wisconsin securities administrator Patricia D. Struck. “Scams come in many disguises, but they all share a common goal of separating victims from their money.”

NASAA comprises the securities administrators in all 50 United States, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, as well as the provinces and territories of Canada and Mexico. NASAA’s Fraud Center provides financial education to protect the public from investment fraud. NASAA serves as an advisor to Alliance for Investor Education (AIE), reviewed on page 71 as September’s “Website of the Month.”

NASAA 2006 Investor Traps

Affinity fraud. Members of closely knit religious, political, or ethnic groups are the frequent targets of con artists. Their pitch is essentially: “You can believe in me and in what I say.” When an investment is presented in this context, the potential investor should be extremely wary. This pitch seeks to substitute an emotional appeal for careful analysis and critical thought.

Churning. An abusive sales practice in which unethical securities professionals make unnecessary or excessive trades in order to generate commissions, churning occurs most often where a broker has discretion to trade the account. In such cases, it is not necessary that the broker receive prior approval from the client to complete a transaction.

Equity-indexed certificates of deposit. These hybrid securities products offer an interest coupon payment or return that is based on a stock market index, usually the S&P 500. Returns are not FDIC insured—they are dependent on the performance of the stock market. These are complex securities that promise a rate of return calculated over a defined period of time based upon some form of securities market index. A declining stock market means the possibility of no return on the investment. As a result, these products pose liquidity problems and therefore are not suitable for seniors who may need the money for retirement living.

Oil and gas investment fraud. High oil prices mean that oil and gas scams will continue to attract victims. Oil and gas deals are complicated investments that generally require a significant investment, often requiring a minimum deposit of thousands of dollars. Increasingly, these deals are being promoted via the Internet with claims of attractive tax advantages. Sales materials with “official-looking” surveyor maps and “geologist” opinion letters touting the likelihood that the “managers” of the drilling enterprise will hit pay dirt are sent regularly to prospective investors more than 1,000 miles from the region being “prospected.” Overall, these deals are highly risky, but the lure of high profits often proves irresistible to investors.

Personal information scams. The first step in separating a victim from his money is convincing the victim to divulge personal financial information. Con artists frequently style themselves as “senior specialists” or adopt a pretext of preparing a “living will” or a “living trust.” A pretext that is of current concern to insurance and securities regulators is the offer to help senior citizens qualify for prescription drug benefits by preparing forms. In the guise of filling out forms, the scamster may ask unnecessary questions about personal financial assets. To the con artist, this information provides a comprehensive list of what is available for the taking.

Prime bank schemes. These schemes often promise high-yield, tax-free returns that are said to result from “offshore trades of bank debentures.” Investors are told that only very wealthy people can get the benefit of these programs but the promoter is able to make it available to the victim. Sometimes the victim is required to execute a “confidentiality agreement” in order to invest and is told not to consult an attorney, accountant, or financial planner because they keep these programs for the “big boys” and will deny that they exist. There are no such programs, no such debentures, and no such high-yield trades. Once the seller has the money, it’s gone “offshore” forever.

Pump-and-dump schemes. Unethical broker-dealers frequently “pump” up the value of low-priced securities traded on the Nasdaq pink sheets and then “dump” the stock after naïve investors have purchased at inflated prices. The balloon bursts when the promoters no longer maintain the myth, and investors are left holding worthless shares. These schemes frequently appear through unsolicited e-mail messages.

Recovery rooms. Scam artists buy and sell the names and financial information of victims who have lost money to “recovery room” operators who promise, in return for a fee that the victim must pay in advance, to recover the money lost in a worthless investment. These “sucker lists” are bought by crooks who know that people who have been deceived once are vulnerable to additional scams, especially scams that give hope of recovering lost money. Fraud victims should never give out personal financial information to someone who promises to recover lost money. In the scam world this caller is known as a “reloader,” and he is setting up for a second bite at the apple.

Registered high-interest promissory notes publicly advertised. Generally, the higher the return promised, the greater the risk. A track record of paying high interest and repaying the principal is not an assurance that investors will get their money back if the company fails. These notes are not suitable for retirement funds.

Sale and leaseback contracts. In an attempt to avoid the investor protections of securities laws, some investments are structured to resemble the sale of a piece of equipment such as a payphone, ATM machine, or Internet booth located at a remote venue where the investor cannot service and maintain the equipment and must enter into a servicing agreement. To make the deal more attractive, investors are told that after a given period the equipment can be sold back to the seller at the investor’s original purchase price. The investor is also promised a specific rate of return. In a variant of this scheme, a real estate interest, such as a long-term lease in a resort community, is sold instead of physical equipment. Frequently the equipment or property does not exist and the seller lacks the financial capacity to keep the promise of repurchase.

Self-directed pension plans. Many types of securities fraud require the victim to remove funds from legitimate investments such as stock brokerage accounts, insurance policies, deferred compensation plans, and mutual funds so that they can be invested in a worthless scam. This scam may begin with advice to convert an employer-sponsored pension into a self-directed pension plan. While these plans may serve legitimate investment purposes, all too often they only serve to benefit the scam artist.

Unsuitable recommendations. Just as every investor is different, so too are investments. What may be a suitable investment for one investor may not be right for another. Securities professionals must know their customers’ financial situation and refrain from making recommendations of unsuitable securities. When securities professionals fail to live up to applicable ethical standards, great harm can be done to individual investors.

Variable annuities. Variable annuities are tax-deferred investments that typically place mutual funds inside of an insurance wrapper for tax-deferred potential investment growth. While these products are legitimate investments, regulators are concerned about their popularity in the sales community. Commissions to those who sell variable annuities are very high, which provides incentive for sellers to engage in inappropriate sales. Variable annuities are suitable for only a very small percentage of the investing public and generally are not appropriate for most seniors or short-term investors. Investors should be especially wary of any broker selling a variable annuity to hold inside
a 401(k) or IRA, which already grow tax-deferred.