The SEC and state securities regulators have joined forces to fight fraudulent sales of promissory notes. While promissory notes can represent a legitimate and acceptable investment vehicle, regulators fear that they have become prone to abuse and utilized in schemes to defraud investors.
In the typical promissory note investment, an individual lends money to a company in return for periodic interest payments and the eventual repayment of the lender's principal. In fraudulent schemes, investors are deceived about the risks of the promissory notes, the potential returns and the security of their investments.
Regulators have already discovered that such fraudulent schemes are widespread, and have resulted in the loss of hundreds of millions of dollars. So far, enforcement agencies in twenty eight states have initiated proceedings against hundreds of alleged wrongdoers, while the SEC has filed thirteen actions against thirty-eight individuals and twenty-two entities.
How can investors protect themselves against such scams? Regulators note that many of the schemes involve similar fact patterns and techniques. For example, in some instances investors were offered a high rate of return and assured of a low level of risk. That, in itself is a warning sign, according to Bradley Skolnick, President of the North American Securities Administrators Association (NASAA). As Mr. Skolnick points out, "Investors must never forget the first rule of finance: the greater the reward, the greater the risk."
These thoughts were echoed by SEC Enforcement Director Richard Walker, who reminded the public that "[i]n volatile markets, investors often look for safer fixed-rate investments. This flow of investor money is not lost on those looking to defraud. As this sweep illustrates, investors must be particularly skeptical when offered unrealistically high returns."
Investigators have discovered other common elements to these fraudulent schemes. For instance, in some cases investors were falsely assured that their money was protected by an insurance policy, surety bonds or other collateral - often to be provided by a purportedly "offshore" company. In many instances regulators found that either no such protection existed, or that the investment was significantly under-insured or under-collateralized.
Regulators also discovered that many of the allegedly fraudulent sales were not made by licensed securities brokers. Instead, the salespersons were independent life insurance agents, lured by high commissions, who relied solely on information provided by the issuers of the promissory notes. As investigators came to learn, that information was often false or misleading.
Unfortunately, promissory note schemes often target the elderly - who often seek high rates of return and minimal risk. These victims can lose their entire investments when those risks turn out to be monumental and promised returns are merely illusory.
How can investors recognize a fraudulent promissory note scheme? Take note of some of the actions brought by the SEC, summarized below:
1. The Commission alleged that Pacific Air Transport, Inc. and an individual named Robert Hirsch fraudulently raised $8 million from at least 250 investors through the sale of unregistered nine-month "secured" promissory notes. Investors were promised interest rates of 12% to 13% by a sales force comprised principally of insurance agents, some of whom apparently assured customers that their investments were guaranteed by an offshore insurance company.
According to the SEC complaint, no such guarantee existed and a majority of investors, including many elderly, lost their money. The Commission also found that salespersons misrepresented the prospects for the company, the security of the investment and the potential returns.
2. The SEC filed suits in federal court in Texas charging eight insurance salesmen, Westshore Agency of Michigan, and Westshore's president James Russell Hicks (also an insurance agent), with the fraudulent sale of more than $13.5 million of worthless promissory notes to approximately 140 elderly investors. The defendants allegedly placed advertisements in local newspapers to attract elderly investors with promises of "no risk" and "guaranteed income." One salesman even placed advertisements in a local obituary section.
The Complaint charges that the salesmen, some of whom operated under the name Regal Financial Group, targeted senior citizens by promising returns of 9.25% to 15% and claiming that the investments would be guaranteed through surety bonds. In reality, according to the Commission, the sales were part of a "Ponzi" scheme and the purported surety company had no assets.
The SEC alleges that these salesmen, all of whom were licensed insurance agents, knew that many of their customers would be liquidating conservative investments (like annuities and certificates of deposit) to invest in the bogus promissory notes.
The scheme reportedly had a devastating effect on its elderly victims, many of whom lost their entire life savings - including an 86 year old World War II veteran who lost $400,000 he had saved from veterans benefits he received as a result of injuries suffered during the invasion of Sicily.
3. The SEC charged that charged two companies, both named Tamarack Funding Corporation, and their president, Garry P. Isaacs, raised approximately $4.7 million through the sale of unregistered "promissory notes." According to the Complaint, investors were told their funds would be used to finance automobile loans, and would be fully collateralized. Instead, most of the funds were used either to pay unrelated expenses or to fund the operating costs of the Tamarack companies. Some of the money was used to pay interest to existing investors - a hallmark of a "Ponzi" scheme.
4. Speaking of Ponzi schemes. The SEC filed two civil complaints on May 31st against four individuals who allegedly raised $5.2 million from the public as part of a $17.7 million Ponzi scheme conducted by Sebastian International Enterprises, Inc. The action followed an emergency action brought by the SEC in August 1999 that halted Sebastian's allegedly fraudulent offering.
According to the SEC complaint, the scheme utilized insurance agents, financial advisors and securities brokers to sell $17.7 million in promissory notes to over 400 investors across the United States. The SEC asserts that individual salespersons made material misrepresentations to investors, failed to disclose the risks of the investment, and falsely assured customers that their funds would be guaranteed by surety bonds. Three of the salesmen who were individually named in the Complaints, Linda Ballou, Ronald Wacker, and Bruce Harlan have already settled the charges
5. On May 31st, the SEC filed a Complaint in Federal District Court in New York against Tee To Green Golf Parks and several individuals in connection with a fraudulent scheme arising from the sale of about $12 million in promissory notes. The Complaint alleges that, at the direction of Tee To Green's President, Steven Blumhagen, that Company falsely represented that its promissory notes were guaranteed by insurance. Although investors were told that their funds would be used to develop golf practice facilities, at least $3.45 million was used to pay the personal expenses of Blumhagen and others, while $1.8 million went to pay undisclosed commissions to salespersons who facilitated the sale of the notes.
6. On May 31st the Commission filed a complaint in the Southern District of Florida alleging that Florida residents Larry Schwartz, Raphael ("Ray") Levy, First Capital Services, Inc. and U.S. Capital Funding, Inc., defrauded investors through the sale of promissory notes. That Complaint charges that Schwartz and Levy (who controlled First Capital and U.S. Capital Funding) used a nationwide network of insurance agents to induce over 600 investors to purchase $55 million in unregistered promissory notes.
According to the Complaint, Levy and Schwartz falsely represented that the principal and interest payments due to investors were guaranteed and that the investment was risk free. They also claimed that the funds would be used to purchase insured accounts receivable or accounts receivable of the federal, state of local governments. Apparently, none of the money raised from investors was used in the manner promised. Instead, funds were used to pay interest to the earliest investors (in a Ponzi scheme) or to make long term loans to companies affiliated with Schwartz.
7. The SEC sued Skyline Group, Inc. Robert Sheets and Mary A. West for misappropriating $1.36 million from the proceeds of a promissory note offering by Skyline. Investors were allegedly told that the promissory notes would be issued in connection with effort by a Native American tribe to recover tribal land in the Chicago Illinois area so that they could construct a casino.
The SEC says that Skyline, through Sheets and West, raised over $3 million by selling the promissory notes; then diverted $1.36 million to pay their own expenses, including the mortgage on their home.
8. The SEC charged that Jamie Piromalli, Steven Brewer, A. Michael Jaillett, Richard Mann and Seth Miller engaged in a massive Ponzi scheme through the sale of promissory notes issued by a company called World Vision Entertainment. According to the Complaint, these defendants raised at least $64 million from 1,200 investors in 33 states while misrepresenting that the notes were guaranteed and that the money would be used to develop World Vision's products. In reality, the money was used to pay personal and business expenses of World Vision directors and officers, make principal and interest payments to investors (another Ponzi scheme) and pay undisclosed commissions to the individuals selling the promissory notes.
So how can an investor tell a phony promissory note from the real thing? Start with one basic concept - the higher the potential return or promised interest rate, the greater the risk. If a salesperson downplays that risk, proceed with the utmost caution.
Don't throw that caution to the wind just because you are told the investment is guaranteed or insured. Ask for written information about the company that is supposed to be providing that insurance, including financial information. Be sure it has the financial capacity to protect your investment. Remember, a guarantee is only as sound as the party giving it.
Finally, there is a lesson to be learned here. It is one we have pointed out before. If it sounds too good to be true - it probably is.
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