Investment Products Susceptible to Fraud
REITS
A “real estate investment trust” (“REIT”) may be a trust, corporation, or association that owns (and sometimes operates) real estate. Ownership in a REIT takes the form of transferable shares or “certificates of interest.” Owners expect to receive periodic distributions of income from the REIT. The shares in many REITs are publicly traded. REITs can also be privately held and sold through private placements. REITs provide a structure for investing in real estate similar to the structure mutual fundsprovide for investing in stocks. The value of an investment in a REIT will be heavily affected by the REIT’s underlying real estate assets and operating costs.
Traded vs. Non Traded REITS
According to the Financial Industry Regulatory Authority (“FINRA”), non-traded REITs pose additional risks not associated with traded REITs. Traded REITs are openly traded on national securities exchanges, which allow investors to buy or sell with relative ease. Non-traded REITs, on the other hand, are not listed on any national securities exchanges and pose liquidity problems. Despite a specified portion of shares being “redeemable” each year, the redemption price is usually below the current value. Non-traded REITs also typically charge investors higher fees, leaving fewer dollars for the actual investment. REIT distributions can also be suspended or stopped by the REIT’s board of directors. Early on, REITs are not likely to produce returns, and distributions are often paid out of investment capital. This means that distributions are not derived from income-producing property, but from cash reserves or new investors.
Exchange Traded Funds
An ETF is an investment fund, similar to a mutual fund, but it can be traded on stock exchanges throughout the trading day at a fluctuating market price, much like stocks. (A standard, open-end mutual fund may be resold by the investor directly to the mutual-fund company only at a price determined by the fund’s net asset value at the day’s end.) ETF’s generally hold stocks, bond or commodities and often track an index. ETFs gained in popularity in the U.S. following the introduction of Standard & Poor’s Depositary Receipts (“SPDRs” or “Spiders”) in 1993, which were intended to track the results of the S&P 500 Index. The number and types of ETFs has grown, including ETFs that are highly complex and that invest in less traditional strategies.
Promissary Notes
Promissory notes are simply contracts under which an investor loans a specific sum of principal in exchange for the promise to receive interest over the term of the note, plus return of the principal at maturity. Payment of interest and repayment of principal depend on the borrower’s creditworthiness and the security and value of the collateral underlying the note, if any. While promissory notes may sound secure, they can be quite risky.
Variable Annuities
Variable annuities are an insurance product, a contract between you and an insurance company. They combine the features of an annuity (a guaranteed single or periodic payment from an insurance company) with the possibility of market gain (or loss) depending on the performance of an underlying investment strategy (the “variable” part of the investment), similar to a mutual fund. Thus, the insurance company guarantees a minimum payment and any remaining payments can vary depending upon the performance of the underlying investments. Common drawbacks to variable annuities include substantial penalties for early withdrawal, the potential for substantial fees and expenses, and the addition of credit risk (the risk that the insurance company might default on its contractual obligations to you) to the market risk of your chosen investment strategy.
Penny Stocks/Microcap Fraud
In the U.S., shares trading for less than one dollar are known as microcap or penny stocks. Their low valuation and low trading volumes make them susceptible to price manipulation schemes. Penny stocks also lack transparency in their underlying business and operations and often do not have a verifiable financial history, making them susceptible to securities fraud schemes.
Options/Derivatives
Options are one of the most common types of derivative investments available to individual investors. Derivative investments are contracts that derive their value from another, underlying investment (e.g., a stock, bond, or commodity). A stock option, for example, may give its holder the right (but not the obligation) to buy or sell shares of stock at a specified price. An option that gives the holder the right to buy something at a specified price at or before a future date is known as a “call.” An option that gives the holder the right to sell something at a specified price at or before a future date is known as a “put.” Many options are traded on the Chicago Board Options Exchange (“CBOE”). Sometimes options are used for hedging (offsetting potential losses in another investment) or employee compensation (employee stock options). When used for speculation, options and other derivatives can present very high levels of risk.
Private Placements/Limited Partnerships/Unregistered Securities
Private placements are almost always sold under a “private placement memorandum” (“PPM”) describing the investment and its risk factors. A broker-dealer or advisor who sells non-public limited partnerships and other private placements is responsible for conducting reasonable due diligence to make sure that the PPM is complete and truthful.
Limited partnerships and limited liability companies are generally private companies (i.e., companies that are not traded on stock exchanges) in which investors can buy interests similar to shares of stock in a corporation. Oil and gas investments, real estate investments and private equity funds are often offered to investors through limited partnership interests. These investments are typically sold as “private placements” under a claimed exemption to the more stringent registration and disclosure obligations applicable to public offerings. To qualify for the most common exemptions, the offeror of limited partnership interests cannot make any general solicitation or advertisement to investors, and investors must (for the most part) be “accredited” investors meeting minimum requirements of income or net worth. The investment may be in the form of interests or units in a limited partnership or limited liability company.
Many private placements and limited partnerships are unregistered securities and/or may be sold only to accredited investors. Securities fraud may occur when a private placement is sold to an investor who does not qualify as an accredited investor. Private placements, limited partnerships and other unregistered securities carry additional risk because they are difficult to value and lack transparency in their operations and financial condition, making them susceptible to securities or investment fraudscams.
Mortgage Backed Securities
Mortgage Backed Securities (“MBS”) are debt obligations backed by pools of mortgage notes. Governmental or private entities purchase groups of mortgage notes and then combine them into pools. A “pool” typically consists of thousands of mortgage notes. The entity then offers investments in the pool by issuing “mortgage backed securities,” giving investors claims to the principal and interest payments made by the mortgagors of the notes in the pool.
The volatile nature of the underlying debt and lack of a secondary market make mortgage backed securities inherently complicated and risky. Collateralized mortgage obligations (CMOs) and mortgage derivatives are additional, more complicated forms of mortgage backed securities.
Municipal Securities
Municipal Securities can offer welcomed diversity to an investor’s portfolio. “Muni Bonds” are often perceived to be less risky than the stock market, but that perception is not always accurate. In some instances, incomplete financials and disclosure issues can hinder investment advisors from providing suitable recommendations to investors. Investment advisors are required to obtain sufficient information about the City or County issuing the bond or other security to have a reasonable basis that the security is suitable for a particular investor. Having adequate information about a municipal issuer is key to avoiding securities fraud in an investment in municipal securities.
Viaticals/Life Settlement Contracts
The sale of a life insurance policy before the death of the insured is a viatical. An investor who buys viatical purchases the right to receive all or a fractional portion of the death benefit from a life insurance policy insuring someone else’s life. These contracts are also known as “life settlement” contracts. The seller (policyholder/insured) receives a cash payment during his lifetime of less than the policy’s death benefit. The investor/buyer then receives the right to payment of the death benefit at the insured’s death.
Pitfalls inherent to viaticals/life settlement contracts include: the risk that the insured will live longer than expected (potentially increasing the amount of premiums that must be paid to keep the policy in force, and decreasing the rate of return); the risk that the death benefit will not be paid at all (because the policy has lapsed for nonpayment of premiums, the insurance company fails, or there was fraud in obtaining the policy); and the risk that the company or advisor selling the viaticals is operating a Ponzi or other fraudulent scheme.
