Securities Fraud 101

Con artists practicing securities fraud can strike investors through a variety of scams and schemes. Here are a list of the most common frauds—and more importantly, some strategies to help you protect yourself.

Affinity Fraud

If you're familiar with the old adage "birds of a feather flock together," you understand the basis of affinity fraud. Our interests and backgrounds, including race, culture and religious beliefs, help identify us as members of unique groups that we often come to trust.

Affinity fraud preys on commonalties and feelings of trust. Affinity fraud occurs when a member of a group, organization or community abuses trust to take advantage of other members. Members of a group are more likely to trust an upstanding member of their community; unfortunately, it is this very trust that leaves consumers vulnerable to affinity fraud.

Con artists first sell to a few prominent members of the community and then pitch the scam to the rest of a group by using the names of those previously sold. This scam often goes unreported as groups typically opt to work it out amongst their members.

Victims of affinity fraud are not of just one demographic group or background. However, groups often targeted for this type of crime include:

  • Recent immigrants
  • Minority groups
  • Religious groups
  • Elderly people

How You Can Protect Yourself:

  • Ask for written information.
  • Do not rely on the testimony of others, regardless of how well you know them.
  • Call the Indiana Securities Division at 1-800-223-8791 to check on the investment and the person selling it
  • Report any fraudulent activity to the Securities Division

Read more about affinity fraud.

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Hedge Funds

Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.

Unlike mutual funds, however, hedge funds are not required to register with the SEC. Hedge funds typically issue securities in “private offerings” that are not registered with the SEC under the Securities Act of 1933. In addition, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. But hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.

What are "funds of hedge funds?"

A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds of hedge funds must provide investors with a prospectus and must file certain reports quarterly with the SEC.

Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.

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Oil and Gas Ventures

Some of the riskiest investments capitalize on current events and consumer fear. A prime example of this fraud concerns oil and gas ventures. In oil and gas ventures, con artists use the rising price of fuel and what investors learn of the news about wars and terrorism to make them believe there are easy gains to be made.

Consumers should understand that even when an oil and gas opportunity is legitimate, it is still a risky venture and should be approached with caution. But unfortunately, the reality of oil and gas opportunities is that they can often be fraudulent. Investors often find out too late that their "great opportunity" is actually linked to fraudulent activities and dry or nonexistent wells. The investor who lands in one of these bad investments is commonly dealing with unregistered agents, unregistered securities offerings, misinformation, unsuitable investments, phony profits, or even outright theft.

Oil and gas venture offers are also often touted by high-pressure telemarketing sales—often known as boiler room tactics—or through solicitations. The fraudulent activities are usually set up with the firm's office in one state, the operations and physical location in another state, and the offering in yet a third state. Spreading things out like this allows the con artists to delude the investors for a longer period of time, because when offices and sites are not within an accessible distance, the investors are less likely to try to stop by the office or site.

How You Can Protect Yourself:
Always check with the Securities and Exchange Commission and the Indiana Securities Division to see if an opportunity is required to be registered at either the federal or state level. Also check on the individual selling the investment as well. A phone call to the Indiana Securities Division at 1-800-223-8791 allows you to check out the opportunity and the securities agent.

It's essential to ask key questions before investing money in a risky investment:

Are the seller and investment registered in the state?
Call the Indiana Securities Division at 1-800-223-8791 to find out. If they are not registered, they may be operating illegally.

Has the seller given you written information that fully explains the investment?
Make sure before you buy that you get proper written information, such as a prospectus or offering circular. The documentation should contain enough clear and accurate information to allow you or your financial adviser to evaluate and verify the particulars of the investment. Watch for jargon that sounds sophisticated, but makes no sense.

Are claims made for the investment realistic?
Some things really are too good to be true. Use common sense and get a professional, third-party opinion when presented with investment opportunities that seem to offer unusually high returns in comparison to other investment options. Pie-in-the-sky promises often signal investment fraud.

Does the investment meet your personal investment goals?
Whether you are investing for long-term growth, investment income or other reasons, an investment should match your own investment goals.

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Ponzi Schemes

Ponzi schemes operate under the notion of "robbing Peter to pay Paul." Although the original scam-orchestrated by get-rich-quick entrepreneur Carlo "Charles" Ponzi—dates back to the 1920s, its tactics are still widely used today. While high returns are promised to investors, the only people who consistently make money are the promoters who set the schemes in motion.

A Ponzi scheme uses new investors' monies to repay previous investors. Sometimes referred to as a type of pyramid scheme, the promoter relies on the next layer of victims to invest their monies to support the previous layers of investors who are expecting certain promised returns on their investments. When the con works, it appears that the "investment" is legitimate and performing as represented by the promoter. But inevitably, the pool of new victims cannot support the previous investors, the pyramid crashes, and many victims lose their assets. Other times, the operator flees with all the proceeds.

How You Can Protect Yourself:
To protect yourself from Ponzi schemes, remember the following five points:

  • Do not expect to get rich quickly. If an investment sounds too good to be true, it probably is.
  • Most bad deals offer high yields and meaningless talk of "guarantees" to "zero risk." The promise of high returns almost always implies high levels of risk.
  • Be suspicious of any investment opportunity that seems inordinately complicated. This often is intentional, for it encourages consumers to make the investment on faith without really understanding what is involved.
  • Ask an investment adviser or accountant to review the prospectus or offering memorandum with you. Promoters who balk at this kind of review should be treated with suspicion. They want you to trust them, without seeking professional counsel.
  • Ponzi schemes often straddle regulated and non-regulated markets—but reputations are constant. Check out the promoters with government regulators or industry trade groups.

Read more about Ponzi schemes.

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Unregistered Securities

Many consumers invest their money in securities. Securities—investments with a potential for loss, but with the expectation of return—can include different investments with varying degrees of risk.

Securities may include, but are not limited to:

  • Stocks
  • Bonds
  • Oil and gas ventures
  • Promissory notes
  • Viaticals
  • Mutual funds
  • Investment Contracts

When unregistered securities are sold, con artists often promise high returns on opportunities that they can't guarantee. These frauds prey on victims by using high-pressure tactics, not giving the victims enough time to check out the investment first.

These unlicensed brokers bypass state registration requirements to pitch viatical settlements, pay telephone contracts, ATM leasing contracts, and other "limited or no-risk" investments. Con artists also prey on consumers who may not know that they can call securities regulators for assistance.

Remember, all investment opportunities must either be registered or qualify for an exemption from registration.

How to Protect Yourself:
Call the Indiana Securities Division at 1-800-223-8791 if you have questions about a potentially unregistered security. Investigators can help consumers make sure the opportunity and the person selling it are properly registered.

Registration of both the security and the broker are safeguards to help protect the public from fraud and lessen the chances of fraudulent activity. Even if investments are registered, however, it does not mean that they can't be used to defraud investors. Remember, if it sounds too good to be true, it probably is.

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Viatical Investments

Viatical investments involve betting on someone's life – literally.

Consumers who invest in a viatical have chosen to purchase an interest in the life insurance policy of a terminally ill person (viator). A viator may need the money for medical expenses or simply would like to spend the money during what may be the last few months or years of his or her life.

In a viatical investment, the investor buys the life insurance policy benefits for less than face value, and then when the viator dies, the investor receives the policy amount. In this situation, it appears that everyone wins — but this is not always the case. There is no guarantee when a person's death will occur, and, with the constant updates in modern medicine, a terminally ill person could live twice as long as originally anticipated. The longer the viator lives, the less the policy is worth to the investor. The investor may even be required to start paying the premium or lose their entire investment. While the opportunity seems like an extremely sound investment, choosing to invest in viaticals can be a very risky decision, even when done legitimately.

It is extremely important to thoroughly research a viatical investment. The following are red flag phrases to look out for with viatical investments:

  • Using the terms "guarantee" and "high profits" when referring to returns.
  • Using the term "death is inevitable" when talking about the viator.
  • Promising high rates of return.

In reality, a guarantee is nothing more than an illusion created by the promoter of a fraudulent investment pitch. Since the rate of return on a viatical is completely dependent upon the amount of time between the date of the viatical investment and the date of the viator's death, fantastic rates of return are usually not an accurate promise.

When con artists promote fraudulent viaticals, they often use false medical information that may not match what the insurance company has on record. Con artists may lie about the life expectancy of the viator, encourage the viator to falsely indicate a positive condition of health (known as cleansheeting), or sell the policy immediately after it has been written (known as a wet-ink policy), before the investor or companies involved know what has happened. In some fraudulent investments, the investors may not even be notified of the viator's death and may continue to be billed for premiums.

Even when a viatical is not fraudulent, it is still considered a risky investment. The viator's obligations to pay premiums ends when they enter into a viatical settlement. If there are still periodic premiums to be paid, this obligation is passed on to the investors. If the viator lives longer than expected, the investors may find themselves paying more in premiums than the actual value of the investment.

How to Protect Yourself:
There is no easy way to know whether the underlying insurance policy of a viatical investment was obtained without fraud, or if the viatical company and the trustee will be around for the duration of the insurance policy.

Be sure that the viatical seller gives you a prospectus and that the offering is registered with the Indiana Secretary of State Securities Division.

In addition, here are some important questions to ask:

  • Have these securities been registered with the Secretary of State's office for sale in Indiana? NOTE: Do not believe any seller who tells you that viaticals are not subject to securities law.
  • Is the salesperson a registered broker/dealer? If not, is the salesperson exempt from registration?
  • Who are these sellers and how long have they been in business?
  • Where is the business located?
  • Who are the principals in the business?
  • Have there ever been any complaints filed against the company or the principals with either state or federal securities regulators, or lawsuits filed by other investors?
  • Is a prospectus about the investment available from the company before you invest? If not, why not?

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Related Information:

- Read glossary of investment terms

- Contact the Securities Division to report fraud

Or visit our Library of Resources section