More On Legal & Compliancefrom The Advisor's Professional Library
- Trading Practices and Errors When SEC-registered investment advisors conduct annual audits of firm policies and procedures, they should pay close attention to trading practices. Though usually not required to, state-registered advisors should look at their trading practices and revise policies that do not fully protect clients.
- Regulatory Oversight of Investment Advisors Although the regulatory environment is in a state of flux, it is imperative that RIAs adhere to their compliance obligations. To ensure compliance, RIAs and IARs must fully understand what those obligations are.
The North American Securities Administrators Association’s annual list of top threats that can trap unsuspecting investors includes two new threats facing small-business owners under the JOBS Act.
The top 10 list also includes two new threats for investors.
In releasing the annual list, NASAA’s new president, Ohio Securities Commissioner Andrea Seidt, said that with the rollout of rules required by the JOBS Act, “investors and small-business owners alike must be on heightened alert for questionable investment offers and services.”
Seidt said NASAA members were concerned that the recent lifting of an 80-year-old ban on the advertising of private offerings, mandated by the JOBS Act, would lead to greater abuse by unscrupulous promoters.
The implementation of the JOBS Act also has created opportunities for unregulated third parties to provide ancillary services. “Whether a crowdfunding portal or an accredited investor aggregator, it is important to do your due diligence and to understand that use of an unregulated third party to provide such services does not change your obligations under federal and state securities laws,” Seidt said. “Investors are not alone in their potential to be scammed. Using a fraudulent portal means both the business and the investor stand to lose.”
The following is NASAA’s list of the top 10 financial products and practices — in three categories — that threaten to trap unwary investors and small-business owners:
Persistent Investor Threats
Private Offerings: Fraudulent private placement offerings continue to rank as the most common product or scheme leading to investigations and enforcement actions by state securities regulators. These offerings commonly are referred to as Reg D/Rule 506 offerings, named for 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 Reg D/Rule 506 offerings are used by many legitimate companies to raise capital, they carry high risk and may not be suitable for many individual investors. With the passage of the JOBS Act and recent adoption of rules implementing certain aspects of the Act, restrictions on how Reg D/Rule 506 offerings can be marketed to the general public have been relaxed, including the lifting of an 80-year ban on general solicitations (advertising).
Real Estate Investment Schemes: The popularity of investments involving distressed real estate continues throughout the boom and bust cycle in the U.S. housing market. Even as housing prices continue to recover in many U.S. markets, investors should be aware that schemes related to new real estate development projects or buying, renovating, flipping or pooling distressed properties are popular with con artists. In the latest NASAA enforcement survey, real estate investments were the second-most common product leading to securities fraud investigations by state securities regulators.
High-Yield Investment and Ponzi Schemes: Retail investors chasing yield often fall prey to high-yield investment and Ponzi schemes promising unbelievably high rates of returns. That trend does not appear to be going away any time soon. As with other alternative investments, high yield means higher risk, and these types of alternative investments are favorites of scam artists. Whether a typical Ponzi scheme or a high-yield investment program, many of the characteristics are the same — promise of incredibly high return coupled with low risk; a reasonably plausible explanation of why the investment is so good; a scam artist with credibility often based on claims of holding false credentials or being part of a particular group or organization. Initial investors are paid a return and help spread the word by promoting the investment to others. Ultimately the scam will collapse, leaving later investors with nothing to show for their trust in the scheme.
Scam Artists Using Self-Directed IRAs to Mask Fraud: Scam artists are using self-directed individual retirement accounts (IRAs) to increase the appeal of their fraudulent schemes. State securities regulators have investigated numerous cases where a self-directed IRA was used in an attempt to lend credibility to a bogus venture. While self-directed IRAs can be a safe way to invest retirement funds, investors should be mindful of potential fraudulent schemes when considering a self-directed IRA. Custodians and trustees of self-directed IRAs may have limited duties to investors, and generally will not evaluate the quality, value or legitimacy of an investment or its promoters. Fraud promoters pushing a Ponzi scheme or other investment fraud can misrepresent the responsibilities of self-directed IRA custodians in order to deceive investors into believing that their investments are legitimate or protected against losses.
Risky Oil and Gas Drilling Programs: Investors exploring alternatives to traditional securities may be attracted to the lucrative returns often associated with investments in oil and gas drilling programs. Retail investors increasingly are turning to alternative investments including oil and gas drilling investments as opposed to traditional stocks, bonds and mutual funds. These investments appeal to those frustrated with stock market volatility or skeptical of Wall Street. Unfortunately, energy investments generally 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.
New Threats to Investors
Proxy Trading Accounts: Investors should be wary of individuals who claim to have trading expertise and offer to set up or manage a trading account on an investor’s behalf. Allowing an unlicensed individual to have access to the username and password for your brokerage account — or worse, allowing an unlicensed individual to set up a brokerage account in your name — is a recipe for disaster. Allowing someone without the legally required safeguards of proper registration and bonding requirements to control your account often leads not only to substantial trading losses, but the loss of investment funds through improper withdrawals from the account including theft. Investors should check with their state securities regulator to confirm that anyone offering to manage your accounts is properly registered and has a clean background.
Digital Currency: Virtual reality may exist only in science fiction, but consumers now are able to purchase goods and services with virtual money such as Bitcoin, PP Coin and other digital currencies. Unlike traditional coinage, these alternatives typically are not backed by tangible assets, are not issued by a governmental authority and are subject to little or no regulation. The value of Bitcoin and other digital currencies is highly volatile, and the concept behind the currency is difficult to understand — even for sophisticated financial experts — given the complicated mathematical algorithms that determine when new blocks of coins will be released. This environment has provided fertile ground for scam artists to capitalize on the increasing popularity and acceptance of digital currencies.
New Threats to Small Businesses
Capital-Raising Pitfalls: Recent law changes and newly available capital from investors including “angels” — affluent individuals who provide capital for a business startup — have changed the business funding landscape. The new and enhanced opportunities to raise capital through crowdfunding, public advertising for investors under JOBS Act regulations and angel funding “solutions” also carry risks for unwary entrepreneurs. Securities offerings either must be exempt from registration requirements or properly registered, even under the new laws. Exempt securities remain subject to federal or state anti-fraud provisions, meaning entrepreneurs must provide full and accurate disclosures as part of any offering.
Unregulated Third-Party Service Providers: The implementation of the JOBS Act has created opportunities for unregulated third parties to provide ancillary services. Whether a crowdfunding portal or an accredited investor aggregator, it is important to do your due diligence and to understand that use of an unregulated third party to provide such services does not change your obligations under federal and state securities laws. Not only should a small business or other entrepreneur make sure they are dealing with a legitimate service provider, they should also make sure that the service being offered is in full compliance with all federal and state requirements. Since the passage of the JOBS Act, new firms have joined existing firms that offer to sell lists of accredited investors for use in private placement offerings. However, new rules recently adopted by the SEC include more stringent requirements replacing the old failsafe of reliance on an investor-completed questionnaire claiming accredited investor status.
Check out Top 10 Investor Threats for 2012: Some New, Some Old on ThinkAdvisor.