Unit 11

 

Investment Fraud

 

 

Review Questions

 

 

1.         What is the best advice an investor can follow to avoid investment fraud? (See page 11-1)

 

Ask questions – about the investment as well as the firm or company selling the investment.  Start with the source, but also contact the state securities regulator or the U.S. Securities and Exchange Commission (SEC).

 

 

2.         What is the difference between legitimate cold calling and a search for “quick hits”? (See pages 11-1 and 11-2)

 

Calls are considered “cold” when the caller attempts to sell an investment (or other product) to an individual with whom they have had no previous business, or personal, relationship.  For many years, security industry professionals have used cold calling as a legitimate business practice for reaching new clients.  But it is also a common approach employed by fraudsters.

 

Legitimate users of this approach ask relevant questions about your financial situation and investment goals, whereas dishonest scammers may simply try to persuade you to purchase a “sure thing” investment with a high potential return.  High-pressure sales techniques are used to encourage “quick hits” to buy the investment.  “Boiler rooms” of phone banks are used to reach as many potential customers as quickly as possible.  

 

 

3.         What rules must legitimate cold callers follow? (See page 11-2)

 

The cold calling rules require cold callers to:

·        Call only between 8 a.m. and 9 p.m. unless you have given them permission to call other times or you are a customer of the firm.  These restrictions do not apply to calls at work.

·        Identify the caller, firm represented, and the purpose of the call—to sell investments.

·        Put you on the “do-not-call” list, if you ask.  Should a future call occur, record the caller’s name, telephone number, date and time of the call so you can complain to the firm’s compliance officer, the state securities regulator, and the SEC.

·        Communicate with you only in a respectful manner and not call repeatedly.

·        Send you written information about the investment and get your permission in writing to debit your checking or savings account.  Do not give this information over the telephone.

·        Tell you the truth about the investment product.

 

4.         How has the Internet been used for investment fraud?  Why does it occur so easily?  (See page 11-3)

 

Like cold calling, the Internet is a legitimate tool for investment research and trading.  However, like cold calling its availability for reaching large numbers of people inexpensively has resulted in abuse by fraudsters.  Web sites, online message boards, “chat” rooms, and mass e-mails have been used to make fraudulent schemes appear to be legitimate investment information sources.  One of the most important tips to remember:  Know the source is credible before ever following the advice offered.  This is true whether the “hot tip” comes from your neighbor, a cold call, or the Internet. The most commonly used methods of Internet investment scams include:

·        Online investment newsletters:  Many are sources of solid, unbiased information but others are simply paid sources used to endorse investment purchases or sales that will ultimately benefit the promoters.  While promotions are not illegal, the securities laws require the disclosure of the payment to the newsletter providers.  Fraudsters either fail to disclose this information, or provide false information regarding their independence, research, or track record in picking solid investment choices.

·        Online message boards: False information or multiple postings by the same individual or company using multiple aliases, may make information appear to be legitimate.  Instead, it may be bogus or timed to encourage others to follow advice to buy or sell a security for the benefit of the fraud or scam artist.

·        E-mail spams:  A junk e-mail message to literally thousands or millions of recipients is used to promote phony investment schemes or spread information about an “unbeatable” opportunity to purchase, or later sell, stock X.

 

 

5.         How do fraudsters use the Internet to increase sales of small stocks with low trading volume?  (See pages 11-3, 11-4, and 11-7)

 

By using aliases to post information about the potential for significant returns from a particular company, or simply sending “spam” to large numbers of recipients, some readers are likely to follow the advice.  Even a few of the thousands targeted who follow through with purchases can dramatically push up the price of a small, little known company with few shares traded.  The increasing price may only fuel subsequent purchases, as the initial purchasers see the projections come true.  At some point the individual or group behind the run up, sell all their shares, take their profits and move on to another operation.  The other shareholders watch share prices drop back to the lower levels as the false, and highly touted promotions to purchase, cease to encourage future buyers. 

 

Because little legitimate information may be available about the company, particularly with very small, or microcap, companies, it may be difficult to confirm the information claims made.  Furthermore, the smaller the company the easier it is for a scam to significantly affect the price.

 

 

 

 

6.                  List and briefly explain the five most common investment schemes and the “red flags” that might alert you to these dangerous frauds.  (See pages 11-4, 11-5, and

11-6)

 

With early identification of fraudulent schemes, you can protect yourself and others. Important rules to always remember—ask questions and seek full disclosure of all information. Five common investment schemes are promoted using the phone, mail, and Internet.

1.      The “Pump and Dump” Scam:  Promoters or insiders encourage stock purchases that push the price up.  Once the price is sufficiently “pumped” up, the fraudsters “dump,” or sell their shares at a significant profit.  Stock prices return to lower levels and the investors lose, with little or no opportunity to ever regain their losses.  The “red flag” to watch for—claims of insider information, a “no-fail” stock pick, the need to act NOW, and a small company for which little information is available.

2.      The Pyramid Scheme: Classic fraud based on recruiting new “investors” whose funds are used to pay off the former investors.  Over time, sheer size causes the scheme to fail as enough new recruits cannot be involved to pay off the former ones.  The “red flag” to watch for—claims of very high returns for doing nothing or for doing nothing more than recruiting others to do the same.

3.      Ponzi Schemes: Based on the pyramid scheme, Ponzi schemes are typically based on a legitimate sounding investment opportunity that fails to make a profit.  The profit, or return, is generated from sales to future investors.  The “red flag” to watch for—claims of very high, quick returns with little or no risk.

4.      Affinity Fraud: Investment scams promoted to members of a specific group, such as religious communities, ethnic groups, or professionals.  The “red flag” to watch for—claims from a respected, and trusted, member of the community or affinity group.

5.      Foreign or “Offshore” Frauds: Microcap, or very small, companies sell unregistered stock to fraudsters posing as foreign investors.  Purchased at a very low price, the fraudsters subsequently sell the stock to U.S. investors at a large profit, which is shared with the microcap company.  Following simple rules of supply and demand, with the flood of stock into the U.S., the prices drop and the unsuspecting investors are left with large losses.  The “red flag” to watch for—an investment opportunity in unregistered U.S. stock that comes from a foreign company.

 

 

7.         To avoid investment fraud, what three questions should an investor always ask?  What sources can help you locate the answer?  (See pages 11-6 and 11-7)

 

To help you determine if an investment is sound or fraudulent, remember to ask questions and invest only the money you can afford to lose. Start with these three questions, and the sources noted:

1.      Is the investment registered?  Check with the SEC and your state securities regulator. Since smaller companies are not required to register with the SEC, always check with the state securities regulator.

2.      Is the person licensed to sell securities and law-abiding?  Two sources are available to answer this question, but the state securities regulator may provide more information than the National Association of Securities Dealers Regulation, Inc. (NASDR), available by phone or on the Internet.  Both sources retrieve information from the Central Registration Depository (CRD), a database of brokers, investment advisors, and their firms.

3.      Does the investment sound too good to be true?  Remember the risk and rate of return rule discussed in Unit 2.  Be alert to investment promises.  Read the investment prospectus, and review the company’s financial statements being sure to look for the name of the accountant or accounting firm that audited or certified the records. 

 

 

8.         What four investment descriptors might alert you to a potentially fraudulent offering?  (See page 11-7)

 

Investors should be alert to the following descriptors as “red flags” for a potentially fraudulent offering:

·        promises of “guaranteed” or “risk-free” returns;

·        extremely high yields in a short period of time;

·        “offshore” or foreign investments; and

·        exotic or unusual sounding investments.

 

 

9.         List six sources of company information that an investor should always consult prior to making an investment.  (See pages 11-7 and 11-8)

 

Brokers and other financial professionals typically provide investors with a variety of information to review when making investment choices.  In addition, there are a variety of sources available to the individual investor as noted below.  However, if you cannot locate information from these sources, then you should immediately contact both your state securities regulator and the SEC. 

 

Six sources to consult prior to making an investment include the following:

1.      The company:  Ask if it is registered with the SEC and request copies of the reports filed.  If you are told the company does not have to file with SEC because of its size, call the state securities regulator to get information about the company.

2.      The SEC:  Check the EDGAR database, and, if the company is not listed, check with the Public Reference Room of the SEC, which will take your request by phone, fax, or e-mail.

3.      The state securities regulator:  Every company must be cleared to sell securities in your state, even if the company is not listed with the SEC. 

4.      Other government regulators:  Banks do not have to file with SEC, but must file with other government agencies.  Before investing, check the National Information Center of Banking Information of the Federal Reserve System, the Office of the Comptroller of the Currency, or the Federal Deposit Insurance Corporation.  (See Unit 11for the URL to reach the Internet site for each.)

5.      Reference books and commercial databases: Available at larger public or university libraries, these sources compile data and evaluate companies on the basis of their history, management, products and services, revenues, and credit rating.  Ask the reference librarian for assistance, or remember names like Dun & Bradstreet, Standard and Poor’s, or Value Line as good places to start to your search.  (Other references are also cited in Unit 11.)

6.      The Secretary of State where the company is incorporated:  As a corporation in good standing, annual reports must be filed with the Secretary of State where the company is incorporated.  This office can tell the status of the company, and may be able to provide copies of relevant documents.

 

 

10.            Outline the steps you should take to solve an investment problem.   (See page 11-9)

 

Remember, investors must act promptly to resolve a dispute, as you have only a limited time to take legal action.  Follow the following complaint chain:

·        Broker

·        Branch manager of the broker’s firm

·        Compliance Department of the firm’s main office

·        State securities regulator or the Office of Investor Education and Assistance at the SEC

 

Once you go beyond the branch manager, put your complaint in writing noting the actions and response from the other parties.  Making it a habit to use the SEC provided Form for Taking Notes might help you document your initial interactions with a broker or investment advisor.  Although just a precaution, it’s also a good way to document the information provided.

 

 

 

Notes