More On Legal & Compliancefrom The Advisor's Professional Library
- Risk-Based Oversight of Investment Advisors Even if the SEC had a larger budget and more resources, it is doubtful that the Commission would have the resources to regularly examine all RIAs. Therefore, the SEC is likely to continue relying on risk-based oversight to fulfill its mission of protecting investors.
- Proxy Voting RIAs are not required to vote proxies on behalf of their clients. However, when an RIA does assume responsibility for voting proxies, the firm’s policies and procedures should help to ensure that votes are cast in the best interest of clients.
The SEC’s Office of Investor Education and Advocacy and the North American Securities Administrators Association (NASAA) issued an Investor Alert on Friday warning investors of the potential risks associated with investing through self-directed individual retirement accounts.
The alert also includes recent Securities and Exchange Commission and state enforcement cases that involve funds from self-directed IRAs invested in fraudulent schemes.
NASAA says it has noted a recent increase in reports or complaints of fraudulent investment schemes that utilized a self-directed IRA as a key feature. State securities regulators have investigated numerous cases where a self-directed IRA was used in an attempt to lend credibility to a fraudulent scheme. Similarly, the SEC has brought numerous cases in which promoters of fraudulent schemes steered investors to self-directed IRAs.
While self-directed IRAs can be a safe way to invest retirement funds, the alert tells investors to be mindful of potential fraud when considering a self-directed IRA.
“Investors should understand that the custodians and trustees of self-directed IRAs may have limited duties to investors, and that the custodians and trustees for these accounts will generally not evaluate the quality or legitimacy of an investment and its promoters,” the alert states.
The alert goes on to say that as with every investment, investors should undertake their own evaluation of the merits of a proposal, and should check with regulators about the background and history of an investment and its promoters before making a decision.
Investing through Self-Directed IRAs
As the alert explains, an IRA is a form of retirement account that provides investors with certain tax benefits for retirement savings. Some common examples of IRAs include the traditional IRA, Roth IRA, Simplified Employee Pension (SEP) IRA, and Savings Incentive Match Plan for Employees (SIMPLE) IRA. All IRA accounts are held for investors by custodians or trustees. These may include banks, trust companies, or any other entity approved by the Internal Revenue Service to act as a trustee or custodian.
A self-directed IRA is an IRA held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians.
Most IRA custodians are banks and broker-dealers that limit the holdings in IRA accounts to firm-approved stocks, bonds, mutual funds and CDs. But other types of assets such as real estate, promissory notes, tax lien certificates, and private placement securities can also be available as investments in these kinds of assets may have unique risks that investors should consider. Those risks can include a lack of disclosure and liquidity, as well as the risk of fraud.
In particular, the alert says that “fraud promoters who want to engage in Ponzi schemes or other fraudulent conduct may exploit self-directed IRAs because they permit investors to hold unregistered securities and the custodians or trustees of these accounts likely have not investigated the securities or the background of the promoter.”
The alert notes a number of ways that promoters may use these weaknesses and misperceptions to perpetrate a fraud on unsuspecting investors. For example:
- Misrepresentations Regarding Custodial Responsibilities: Fraud promoters can misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses.
- Exploitation of Tax-Deferred Account Characteristics: Self-directed IRAs are tax-deferred retirement accounts that carry a financial penalty for prematurely withdrawing money before a certain age. This financial penalty may induce self-directed IRA investors to keep funds in a fraudulent scheme longer than those investors who invest through other means.
- Lack of Information for Alternative Investments: Self-directed IRAs usually allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals, and private placement securities. Unlike publicly traded securities, financial and other information necessary to makeprudent investment decision may not be as readily available for these alternative investments. Even when financial information is available, it may not be audited.
The alert offered the following ways for investors to avoid fraud with self-directed IRAs.
- Verify Information in Self-Directed IRA Account Statements: Alternative investments may be illiquid and difficult to value. As a result, self-directed IRA custodians often list the value of the investment as the original purchase price, the original purchase price plus returns reported by the promoter, or a price provided by the promoter. You should be aware that none of these valuations necessarily reflects the price at which the investment could be sold, if at all.
- Avoid Unsolicited Investment Offers: Investors should be very careful when they receive an unsolicited investment offer. Whether from a total stranger or from a friend, trusted co-worker, or even family member, investors should ask themselves, “Why would anyone tell me about a really great investment opportunity?” Investors also should be especially wary of an unsolicited investment offer that promotes the use of a self-directed IRA. As noted above, fraud promoters may attempt to lure investors into transferring money from