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August 24, 2012 at 04:53 AM
The North American Securities Administrators Association (NASAA) annual list of financial products and practices that threaten to trap unwary investors has been broken into two parts this year: new threats and persistent (or old) threats.
Among the new threats is inappropriate advice and practices by advisors. Matt Kitzi, Missouri Securities Commissioner and chair of NASAA’s Enforcement Section, said during a conference call announcing this year’s annual list that state enforcement actions against advisors doubled in 2011. Kitzi expects to see more advisor violations as state regulators start examining mid-sized advisors—those with assets of between $25 million and $100 million under management—that transferred from federal to state registration under the Dodd-Frank “switch” in July. Many mid-sized advisors “have not been examined in many years or ever,” Kitzi says. “We think we’ll continue to find more enforcement issues with these advisors.”
Another new threat comes from crowdfunding, which was part of the Jumpstart Our Business Startups (JOBS) Act that was signed into law in April. Since the JOBS Act took effect, Kitzi says “the number of entities pitching themselves as crowdfunding vehicles online has risen dramatically—from a couple hundred to about 1,700.” However, he notes, “none of the domain name holders can do anything until rules are written” regarding crowdfunding. That’s what the Securities and Exchange Commission (SEC) is grappling with now. NASAA expects such rules to come next year.
The Enforcement Section of the Massachusetts Securities Division on Aug. 9 brought an action against a Boston-based firm for crowdfunding-related violations.
Read on to see the NASAA Enforcement Section’s top 10 investor threats—four new and six persistent (old)—that can trap unwary investors:
NEW THREATS:
1) Crowdfunding and Internet Offers.
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.
Also, 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 when the relaxed rules and registration exemptions are effective, they will not make investments in small businesses less risky–just more prevalent. And the JOBS Act provisions do not eliminate fraud, an unfortunate common feature of Internet securities activity.
Many states and provinces report a recent increase in active investigations or recent enforcement actions involving Internet fraud, and JOBS Act-triggered activity is likely to elongate 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.
2) Inappropriate Advice or Practices From Investment Advisors.
The Bernie Madoff case opened a number of eyes and ears to the problems that could exist undetected in an investment advisory firm. Investment advisors are licensed to give specific investment advice and owe their clients a fiduciary duty, unlike brokers that may merely effect suitable securities transactions for their clients. The regulatory environment for investment advisors is shifting, and Madoff has led to increased scrutiny from both state regulators and the Securities and Exchange Commission (SEC). The 2010 Dodd-Frank Act laid the groundwork for a major regulatory shift, transferring thousands of mid-sized investment advisors to primary supervision by state regulators, rather than the SEC. The states have already begun working with these mid-sized investment advisors, assisting them in complying with state registration requirements and applying already robust examination programs.
State enforcement actions increased as well: in 2011, state actions against investment advisor firms nearly doubled over the previous year, and focused both on compliance in the firms’ general business practices and advice to clients. As the states implement regular examination schedules and analyze investment advisors that have not been audited in many years, more problems are likely to be discovered.
3) Scam Artists Using Self-Directed IRAs to Mask Fraud.
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 a self-directed IRA was used in an attempt to lend credibility to a bogus venture. Fraud promoters pushing a Ponzi scheme or other investment fraud can 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.
Fraudsters also exploit the tax-deferred characteristics of self-directed IRAs, and know that the financial penalty for early withdrawal may cause investors to be more passive or to keep funds in a fraudulent scheme longer than those who invest through other means. Self-directed IRAs also allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals, and private placement securities; financial and other information necessary to make a prudent investment decision may not be as readily available for these alternative investments.
4) EB-5 Investment-for-Visa Schemes.
The Immigrant Investor Program, also known as EB-5, is an immigration program linked to job-creation that 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 (The equivalent Canadian Immigrant Investor Program (IIP), requires a C$800,000 investment). 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.
PERSISTENT (OLD) THREATS:
1) Gold and Precious Metals.
2) Risky Oil and Gas Drilling Programs.
3) Promissory Notes.
4) Real Estate Investment Schemes.
5) Regulation D Rule 506 Private Offerings.
6) Unlicensed Salesmen Giving Liquidation Recommendations.