Current and Emerging Investor Threats for 2018

CARSON CITY, NV (December 14, 2017) – The Nevada Secretary of State’s Office has released a list of top investor threats and reminds Nevadans to use caution when approached with any unsolicited investment opportunities.  “All investments involve a degree of risk.  Researching investment products and the people selling them is the best way to protect yourself from threats,” Secretary of State Barbara Cegavske said.

The top threats were determined by surveying members of the North American Securities Administrators Association (NASAA), of which the Nevada Secretary of State is a member, to ascertain the most frequently identified source of current investor complaints or investigations.

When asked to identify the top five current investment practices, products, or schemes, 74 percent of NASAA members identified promissory notes as among their leading sources of complaints or investigations.  Rounding out the top five were real estate investments and Ponzi/pyramid schemes, identified by 54 percent of state securities regulators as their second-most frequent source of complaints or investigations; oil and gas-related investments or interests, identified by 50 percent of regulators; affinity fraud, identified by 28 percent of the regulators; and variable annuity sales practices, identified by 26 percent.

Emerging Threats

Separately, NASAA has identified three emerging threats that investors should watch for in 2018: initial coin offerings (ICOs), cryptocurrency contracts for difference (CFD), and identity theft for purposes of depleting investment accounts, especially among senior investors.

“Technology, and in some instances the criminal misuse of technology, is at the heart of each of the emerging threats investors are likely to face in the coming year,” said Keith Woodwell, Utah Securities Director and NASAA Enforcement Section chair.

Woodwell noted that with mounting regulatory pressure on binary options, fraudsters are seeking other products to pitch investors.  State and provincial securities regulators believe that these fraudsters are launching a new wave of schemes involving ICOs and CFDs that use cryptocurrencies as the underlying investment.

CFDs are complex financial instruments that enable an investor to speculate on the price of an underlying asset and can be highly leveraged, which multiplies the impact of price changes on profits and losses.  Cryptocurrency CFDs allow investors to speculate on price changes in highly volatile cryptocurrency such as Bitcoin or Ethereum.  CFDs, which are prohibited from being sold to U.S. citizens or residents, are marketed through Internet platforms and regulators caution that some of these platforms can be fraudulent themselves.  “These speculative, high-risk products are prohibited in the United States for a reason; they are not suitable for investors,” Woodwell said.  “There are red flags waving everywhere.”

“All investments involve a degree of risk.  Investors can help protect themselves by taking time to research both the investment product and the person selling it.  It’s best to learn before you get burned,” Borg said.

Promissory Notes

In an environment of low interest rates, the promise of high interest promissory notes may tempt investors, especially seniors and others living on a fixed income.  A promissory note is a written promise to pay (or repay) a specified sum of money at a stated time in the future or upon demand.

Promissory notes generally pay interest, either periodically before maturity of the note or at the time of maturity.  Companies may sell promissory notes to raise capital, and usually offer them only to sophisticated or institutional investors.  But not all promissory notes are sold in this way.

Promissory notes may be offered and sold to retail investors.  Such notes must be registered with the Securities and Exchange Commission and/or the state(s) in which they are sold or qualify for an exemption from securities registration.  Most promissory notes sold to the general public also must be sold by securities salespeople who have the appropriate securities license or registration from their state securities agency.  Promissory notes from legitimate issuers can provide reasonable investment returns at an acceptable level of risk, although state securities regulators have identified an unfortunately high number of promissory note frauds.

Individuals considering investing in a promissory note should thoroughly research the investment – and the people promoting it.  Investors should be cautious about promissory notes with durations of nine months or less, as these notes generally do not require federal or state securities registration.  Such short-term notes have been the source of most (though not all) of the fraudulent activity involving promissory notes identified by state securities regulators.  These short-term debt instruments may be offered by little-known (or perhaps even nonexistent) companies and extend promises of high returns – perhaps over 15 percent monthly – at little to no risk.  But if an investment sounds too good to be true, it probably is.

FAST FACTS ABOUT PROMISSORY NOTES:

  • Promissory notes were identified by 74 percent of state securities regulators as a leading source of investor complaints or investigations.
  • State securities regulators reported 138 formal enforcement actions involving promissory notes in 2016.

CASE EXAMPLE

The Wisconsin Department of Financial Institutions’ Division of Securities found that a former registered broker-dealer agent, James Nickels, violated the Wisconsin securities laws when he engaged in a $4 million promissory note scheme through an entity he created, The Fiscal Concierge.  Nickels sold his bogus promissory notes to at least 37 investors, many of whom were seniors, based on representations that the money would be used to grow and expand Fiscal Concierge.  In the end, Nickels siphoned off over $700,000 of the funds he raised for his own personal use.

Nickels told investors and prospective investors that Fiscal Concierge was doing well financially and that it was establishing key relationships and partnerships with other agencies and organizations to expand its business.  Division of Securities staff analyzed its bank and business records, however, and found otherwise.  Fiscal Concierge was never profitable, and Nickels and Fiscal Concierge used follow-on investments to pay fictitious profits to early investors.

Nickels and his entities were charged with violating the Wisconsin Securities Act in multiple ways, including by committing securities fraud and selling unregistered securities without a valid registration exemption.  As a result, Nickels and the other respondents in the matter were subject to a cease and desist order from the state and ordered to pay restitution to investors plus civil penalties.

Details: Final Order (Wisconsin Department of Financial Institutions, Division of Securities)

Learn More About Promissory Notes

Real Estate Investments

The promise of earning quick money through investments related to real estate continues to lure investors.  Real estate investment scams are a perennial investor trap.  State securities regulators caution investors about real estate investment seminars, especially those marketed aggressively as an alternative to more traditional retirement planning strategies involving stocks, bonds and mutual funds.  Attendees at these seminars may hear testimonials from people claiming to have doubled or tripled their income through seemingly simple real estate investments.  But these claims may be nothing more than hot air.  Two of the most popular investment pitches involve so-called “hard-money lending” and “property flipping.”

Hard-money lending is a term used to refer to real estate investments financed through means other than traditional bank borrowing.  (This type of loan gets its name from the fact that it would be “hard to get” from a traditional lending source.) Some firms or wealthy individuals specialize in making hard-money loans, as these loans can command comparatively high interest rates.  But borrowers may seek to obtain such loans from retail investors as well.  Investors may be tempted by the opportunity to earn greater rates of return by participating on a hard-money loan and may (or may not) appreciate the potential risks, including as to the borrower’s credit, the expected stability of income from the investment, or time constraints.

There are three players in a hard-money transaction: the investor, the lender and the borrower.  Private lenders raise money from investors to lend to borrowers.  If funds from different investors are combined, the investment vehicle used to purchase the property is a “pooled investment,” which is a security and, as such, is subject to the protections and disclosure requirements of securities laws and regulations.  While traditional loans are based on the ability of the borrower to repay using indicators such as credit scores and income, hard-money loans are based primarily on the value of the property with which they are secured, which the borrower already owns or is acquiring with the loan.  If the borrower defaults, the lender may be able to seize the asset and try to sell it; however, it may be harder for the investor to recoup the loan depending on how it is structured.

Property flipping is the practice of purchasing distressed real estate, refurbishing it, and then immediately re-selling it in hopes of earning a profit.  A property flipper can use its own money to finance the flip or can seek financing from others.  Property flipping financed through borrowed funds or outside investments can be done entirely lawfully, but it can also be a source for fraud.  A scammer may, for example, defraud potential investors in the flip by misrepresenting the value of the underlying property or the expected profit potential on the flip.  Scammers may also misappropriate borrowed or invested funds or seek to use unwitting investors as “straw buyers” with outside banks or mortgage lenders, leveraging investors’ names and credit scores to facilitate their scams.

FAST FACTS ABOUT REAL ESTATE INVESTMENTS:

  • Real estate-related investors were identified by 54 percent of state securities regulators as a leading source of investor complaints or investigations.
  • State securities regulators reported 100 formal enforcement actions in 2016 involving real estate investments.

CASE EXAMPLE

In 2017, a Montana man was sentenced to 60 years in prison (20 years of which was suspended) for his role in a property-flipping investment scheme.  Richard Brandt of Miles City was convicted on six counts of elder exploitation, operating a Ponzi scheme, theft by embezzlement, and securities fraud.  The Office of the Montana State Auditor, Commissioner of Securities and Insurance, prosecuted Brandt in a joint effort with the Custer County Attorney.  Brandt had deceived elderly Montanans into investing in his house flipping company.  Eighteen people invested more than $1.9 million with Brandt; most lost their entire life savings.

According to court records, Brandt told investors they were investing in his business, Home Investors LLC (also known as Faith Investors LLC), and promised a 15 percent rate of return on investments to remodel and flip homes in Nebraska and Missouri.  The money was used instead to fund Brandt’s lifestyle and keep Brandt’s scheme going.  Brandt was found guilty on six felony charges: exploitation of elderly persons, theft by embezzlement, failure to register with the state as a salesman of securities, failure to register those securities, fraudulent practices and operating a pyramid promotional scheme (also known as a Ponzi scheme).  The case began with Adult Protective Services in Miles City filing a securities inquiry with the Commissioner of Securities and Insurance after Brandt had stolen about $90,000 from a 100-year-old woman’s bank account.

Details: Motion and Affidavit (Office of the Montana State Auditor, Commissioner of Securities and Insurance)

Learn More About Real Estate Investment Fraud

Ponzi/Pyramid Schemes

A Ponzi scheme (named after 1920’s swindler Charles Ponzi) is a ploy wherein earlier investors are repaid through the funds deposited by subsequent investors.  Charles Ponzi took investors for $10 million by promising 40 percent returns from arbitrage profits on International Postal Reply Coupons.

In a Ponzi scheme, the underlying investment claims are usually entirely fictional; very few, if any, actual physical assets or investments generally exist.  As the number of total investors grows and the supply of potential new investors dwindles, there is not enough money to pay off promised returns and cover investors who try to cash out.  A Ponzi bubble will burst when the con artist simply cannot keep up with the payments investors are expecting to receive.

When the scheme collapses (as it always does), investors may lose their entire investment in the fraud.  In many cases, the perpetrator will have spent investment money on personal expenses, depleting funds and accelerating the bursting of the bubble.

Similarly, a pyramid scheme is a fraudulent multi-level marketing strategy whereby investors earn potential returns by recruiting more and more other investors.  Multi-level marketing strategies are not intrinsically fraudulent, and there are many legitimate multi-level marketing companies offering various consumer products and services.  What makes a multi-level marketing strategy into a fraudulent pyramid scheme is the lack of a genuine underlying investment enterprise or product upon which the strategy can hope to be sustained.

Signs of a pyramid scheme may include:

  • An invitation from a friend, neighbor, or coworker to attend an “opportunity meeting” to learn how to earn lots of money;
  • At the meeting, a well-rehearsed presentation that downplays the traditional methods of acquiring money and will offer instead an exciting shortcut to wealth and adventure;
  • Vague generalities about the underlying investment or product supporting the venture and/or an unwillingness to share financial information about the venture; and
  • Payment of large fees for products, courses, etc., and/or the right to recruit others and profit from their participation.

The scammers’ emphasis is to get others to invest; victims’ money gets filtered through the pyramid, and ultimately lost.  Sooner or later, all pyramid schemes (like all Ponzi schemes) will collapse of their own weight, taking many investors down with them.

FAST FACTS ABOUT PYRAMID/PONZI SCHEMES:

  • Ponzi or pyramid schemes were identified by 54 percent of state securities regulators as a leading source of investor complaints or investigations.
  • State securities regulators reported 80 formal enforcement actions involving Ponzi or pyramid schemes in 2016.

CASE EXAMPLE

In 2017, the West Virginia Securities Commission, a division of the West Virginia State Auditor’s Office, in conjunction with the Ohio Securities Commission, helped secure a conviction in the largest Ponzi scheme ever perpetrated in West Virginia.  Donna S. Brown of Clarington, Ohio, was sentenced to 10 years and one month in prison following her guilty plea to wire fraud, mail fraud and money laundering.  She further was ordered to pay restitution in the amount of $20.7 million.

Brown was the owner of Budget Finance, both a licensed consumer loan company and an unlicensed investment company.  She was accused of defrauding investors by promising annual returns of between 8 and 12 percent for investing funds with her firm.  Brown mailed checks to investors located in West Virginia and Ohio who requested periodic payments and sent them fraudulent quarterly investment statements reflecting their account balances and interest paid.  She also mailed investors IRS 1099 forms, but never sent those forms to the IRS.  Although there were well over 800 investment accounts with investments exceeding $31 million, there were no substantial loans or other sources of legitimate business revenues to generate investment returns.  Instead, the money from new investors was used to pay previous investors in Ponzi-like fashion.  Budget Finance closed suddenly in November 2015.

Details: News Release  (West Virginia Securities Commission, a division of the West Virginia State
Auditor’s Office) | News Release (U.S. Department of Justice)

Learn More About Ponzi and Pyramid Schemes

Oil and Gas Investments

Many oil and gas investment opportunities, while involving varying degrees of risks to the investor, are legitimate in their marketing and responsible in their operations.  However, as in many other investment opportunities, it is not unusual for unscrupulous promoters to attempt to take advantage of investors by engaging in fraudulent practices.  Fraudulent oil and gas deals may be structured with a legal entity (such as a limited partnership) registered in one state but with operations and physical presence in a second state.  Prospective investors in the venture may be solicited from still more states (with the obvious benefit to the perpetrators being a reduced chance an investor will ever seek to visit a well site or the organization’s headquarters).

Typically, in these types of scams, promoters invent false or misleading information about oil and gas properties to lure investors and keep them on the hook in bogus investments.  The diffuse structure of such scams make it difficult for authorities and victims to identify them as frauds before it is too late.

Investors are usually offered fractional interests in oil or gas leases that have been obtained by a drilling company.  Investors hope the drilling company will drill the well properly, that the well will be productive, and that they will share in the eventual profitability of the endeavor.  These investments may be marketed as safe and secure, high-yield investments and therefore attract investors, such as seniors, who are interested in safety of principal with some income-producing potential.  Oil and gas ventures are typically highly speculative, though, and may not be suitable for many investors.

As pooled investment enterprises, these ventures generally will be treated as securities under state laws, though they may be exempt from state securities registration if certain conditions are met.  Because these ventures are so speculative, the potential for fraud is rife.  Scammers may misrepresent the likelihood that an oil or gas well will be successful – or may not even ultimately drill a well at all.  Fraudulent oil and gas schemes frequently take the form of Ponzi schemes, with investors’ funds being “recycled” to keep the scheme going.

FAST FACTS ABOUT OIL & GAS INVESTMENTS:

  • Oil and gas-related investments or interests were identified by 50 percent of state securities regulators as a leading source of investor complaints or investigations.
  • State securities regulators reported 134 formal enforcement actions involving oil and gas-related investments or interests in 2016.

CASE EXAMPLE

A Texas man was sentenced to eight years in prison earlier this year for fraudulently selling investments in an oil and gas drilling program following an investigation by the Texas State Securities Board.  The investigation revealed that Arthur P. Wilson, of Addison, Texas, and the principal of Alerli Resource Group, LLC, was fraudulently selling investments in an oil and gas drilling program with wells located in Sabine Parish, Louisiana.  The evidence showed that he also falsely told potential investors he was a “registered member with the Texas State Securities Board,” a ruse often used by exploitative promoters to create the illusion legitimacy.  (Potential investors conducting due diligence on the scheme could have learned from the Board that this claim was phony and that Wilson had never been registered in any capacity to sell any type of security in Texas.)

The Texas State Securities Board initially brought an emergency action against Wilson and Alerli Resource Group to stop the fraudulent securities offering tied to wells purportedly located in Sabine Parish, Louisiana.  After the entry of the emergency action, however, Wilson began fraudulently selling investments in different oil and gas drilling programs.  The Board’s investigators quickly obtained evidence that proved Wilson raised approximately $400,000 in the new offerings and that he used these funds to pay for expenses wholly unrelated to the actual drilling of wells.  They also learned that Wilson concealed the entry of the emergency action from new investors, a tactic promoters often use to hide “red flags” associated with their schemes.

The Board’s attorneys, acting as appointed special prosecutors, worked closely with a local district attorney’s office to secure criminal indictments against Wilson.  The indictments charged him with felony securities fraud, theft, money laundering and engaging in organized criminal activity.  The prosecution was successfully resolved when Wilson pleaded guilty to felony securities fraud in connection with the recent sale of investments in new oil and gas drilling programs.

Details: News Release | Indictment (Texas State Securities Board)

Learn More About Oil and Gas Investments

Affinity Fraud

In an affinity fraud, a con artist uses some sort of connection with the victim as the basis for the fraud.  Affinity frauds may involve people who attend the same church, belong to the same club or association, or share a common hobby.  The con artist knows it is often easier for victims to trust someone who seems to be like them.  And once trust is gained, it is easier to exploit that trust to perpetrate a scam.

Everyone, in some way or another, is connected to a group or association.  Our interests, backgrounds, and other factors will naturally lead us to those organizations or affiliations that serve our needs.  Ethnicity, culture, and religious beliefs also play a role in identifying us as members of unique groups that we often come to trust.  In a world of increasing complexity, many people feel the need for a short-hand way of knowing whom to trust.  This is especially true when it comes to investing money.  Unfamiliar with how our financial markets work, too many people don’t know how to thoroughly research an investment or a salesperson.

“You can trust me,” says the scamster, “because I’m like you.  We share the same background and interests.  And I can help you make money.”

Another equally effective pitch, if the con artist is not a member of the group, is to lull members into a misplaced trust by selling first to a few prominent members, then pitching the scam to the rest of a group.  The effect is the same: Once the connection to the group is understood, the natural skepticism of the individual member is overcome, and one more group name is added to the sales column.

Once a victim realizes that he or she has been scammed, too often the response is not to notify the authorities but instead to try (usually unsuccessfully) to solve problems within the group.  Swindlers who prey on groups joined by commonality play the loyalty angle for all its worth.  Affinity fraud can not only be financially devastating to the victims, but often has the perverse effect of causing victims to lose trust in the group or affiliation that was previously a source of comfort or support.  The psychological damage can be just as harmful as the financial damage.

FAST FACTS ABOUT AFFINITY FRAUD:

  • Affinity fraud was identified by 28 percent of state securities regulators as a leading source of investor complaints or investigations.
  • State securities regulators reported 59 formal enforcement actions involving affinity fraud in 2016.

CASE EXAMPLE

An investigation by the Utah Division of Securities and the Federal Bureau of Investigation led to the criminal conviction of Dwight Shane Baldwin, who through his Salt Lake City company SilverLeaf Financial, raised approximately $17 million from investors between 2010 and 2014 for various purported real estate investments.  In reality, SilverLeaf Financial was in effect a Ponzi scheme.  Baldwin had previously served as a Mormon missionary and used his affiliation with the Mormon church to solicit investors.  Some investors cited this shared religious affiliation as a major factor influencing their decision to trust Baldwin and invest in his enterprise.

Baldwin told investors that SilverLeaf acquired distressed or defaulted commercial properties through FDIC auctions or other means and then rehabilitated the properties in order to sell them for large profits.  He offered high rates of return on the investments and promised that the investments would be fully collateralized by liens against the real estate.  In soliciting investments, though, Baldwin made numerous misrepresentations regarding the value and condition of the properties, the rental income being generated by the properties, and the extent to which there were other liens on the properties.  He also failed to disclose that the Utah Division of Securities had taken action against him in 2008 for securities fraud, resulting in a $250,000 fine and a cease and desist order.fter pleading guilty to multiple felony counts of securities fraud in Utah state court, Baldwin was sentenced in May 2016 to between four and 30 years in prison.

Details: Criminal Information | News Release (Utah Division of Securities and Utah Office of the Attorney General)

Learn More About Affinity Fraud

Variable Annuity Sales Practices

Variable annuities are hybrid investments containing both securities and insurance features.  The securities features of variable annuities provide the investor with an opportunity to participate in potential capital appreciation and income through investments in the securities markets, but also subjects the investor to market risks.  The insurance features permit an investor to receive a series of periodic payments from the investment over time and provide a death benefit to the beneficiary should the investor die during the accumulation phase (that is, if the account value is less than the “basis” — principle plus gains — at the time of death).

Variable annuities are considered to be securities under federal law and the laws of some states.  Certain states consider variable annuities to be strictly insurance products, while other states consider them to be both insurance and securities.  In states where variable annuities are regulated by both the state’s insurance and securities regulator, variable annuities must be registered with both state regulators.  Individuals selling variable annuities also must be registered with their appropriate state regulator.  And because variable annuities are securities under federal law, individuals selling them must be registered with the Financial Industry Regulatory Authority (FINRA).  (To find out how your jurisdiction treats variable annuities, you should contact both the securities and insurance regulators for your jurisdiction.)

Variable annuities are tax-deferred.  Accordingly, issuers typically place mutual funds inside of an insurance wrapper for tax deferred investment growth.  While these products are entirely legitimate, they are not suitable for all investors and state securities regulators are concerned about the risks of sales practice abuses.  Senior investors, in particular, should beware of the high surrender fees and steep sales commissions agents often earn when they move investors into variable annuities.

Commissions to those who sell variable annuities are very high, which provides incentive for sellers to engage in inappropriate sales.  Variable annuities also generally should not form more than a portion of an investor’s portfolio, and many not be suitable for seniors because of the steep penalties for early withdrawals.  Investors should be especially wary of any broker who wants to sell a variable annuity to hold inside a qualified retirement plan, such as a 401(k) plan or Individual Retirement Account (IRA), as these types of retirement account will already benefit from tax deferment.  Putting a variable annuity into a 401(k) or IRA adds a layer of expense and investment restriction without any additional tax benefit.

FAST FACTS ABOUT VARIABLE ANNUITY SALES PRACTICES:

  • Variable annuities were identified by 26 percent of state securities regulators as a leading source of investor complaints or investigations. 
  • State securities regulators reported 21 formal enforcement actions involving variable annuities in 2016.

CASE EXAMPLE

In Massachusetts, Secretary of the Commonwealth William F. Galvin ordered LPL Financial LLC to offer approximately $2.5 million in restitution to retirees and other older investors in the healthcare field in connection with the sale of unsuitable variable annuities.  The order also fined LPL $975,000 and required disgorgement of $208,000 in commissions on these sales.  Specifically, the Massachusetts Securities Division charged LPL with failing to supervise one of its investment advisers (Roger Zullo) who sold unsuitable variable annuity products to his clients.  In particular, Zullo misrepresented the clients’ ages and net worths to make the the variable annuity investments appear more suitable for them.  For its part, LPL failed to detect various red flags and discrepancies in Zullo’s activities.

In addition to the client restitution and fine payments, LPL was subject to a cease and desist and a censure, and the firm was required to conduct a comprehensive internal investigation of Zullo’s activities and the firm’s related policies and procedures.  Zullo was censured, subject to a cease and desist order, and barred from securities registration in Massachusetts or from associating with any registered entity as a control person or partner.

Details: Consent Order (Massachusetts Secretary of the Commonwealth, Securities Division)

Learn More About Variable Annuities

Secretary of State Barbara Cegavske encourages Nevadans to check before investing: the Securities Division of the Office of the Secretary of State offers a wealth of free investor education materials and can help investors research the background of those selling or advising the purchase of an investment.  For additional information, please contact the Securities Division at (702) 486-2440.