Securities Fraud
An Ounce of Prevention
By Jay Perlman (TMF Jay)
February 23, 2000
Are you now completely petrified? Do you think everyone is out to steal your money and that every investment opportunity is a scam? Hopefully, the answer to this question is no. However, a healthy dose of skepticism is absolutely necessary to avoid being scammed. This article will give you some principles to follow when making an investment decision and provide some questions you should ask. These principles and questions will give you that healthy dose of skepticism and help you make informed investment decisions.
Here are some principles you should follow when making an investment decision:
- Always do your homework. Never invest based solely on a tip someone gives you or that you overhear. Never base an investment decision solely on what you read on a bulletin board or hear in a chat room.
- Don't succumb to high-pressure sales tactics. It's your money -- take time to fully vet each investment decision. If you feel pressured, simply walk away. If you get fed up with cold callers using high-pressure sales tactics, tell them to knock it off. If the calls keep coming, complain to the SEC, the National Association of Securities Dealers (NASD), the Better Business Bureau, and anyone else you can think of. If you're being spammed, complain to the sender's service provider. Don't give in just to get people off your back; that's what a cold caller hopes for.
- Watch out for certain catchphrases like "risk-free" and "guaranteed return." Also watch out for promoters who tell you this is a "once-in-a-lifetime opportunity," and "this is an opportunity to get in on the ground floor of the next [insert name of today's hot company]."
- Additionally, anytime you're urged to liquidate a safe investment (like a certificate of deposit or T-bill) to invest in something else, you should probably decline.
- Always get information about the investment in writing before you invest. Any legitimate investment opportunity should have an offering circular with information about the company and the investment. Additionally, if the promoter tells you that the information is too difficult to understand because it contains too much "legalese" or that by the time you receive the information, the opportunity will be gone, pick another investment opportunity.
- Don't invest in something you don't understand.
- If something sounds too good to be true, it probably is. So watch out for promises that sound like the pot of gold at the end of the rainbow.
These are pretty sound principles to follow when making any investment decision, but they're only half of what you need to fully consider an investment decision. You also need to ask questions about the company, the promoters, and the investment itself. The questions below are not an exhaustive list, but they are a good place to start.
About the company
- In which state is the company incorporated? Once you have an answer, call the appropriate secretary of state and get the company's most-recent annual report (here is a link to the National Association of Secretaries of State: http://www.nass.org). The annual report will give you information about the company's financial condition, its officers, its business plan, and the like.
- Contact the Better Business Bureau and the state's attorney general and ask whether there have been any complaints about the company.
About the promoters
- Ask your state's securities regulator, the NASDR (the regulatory arm of the NASD), and the SEC whether the people and the company pitching the investment are registered.
- Ask your state's securities regulator and the NASDR whether there have been any complaints about the people and the company pitching the investment.
- Ask your state's securities regulator, attorney general, the NASDR, and the SEC whether there have been any actions taken against the people and the company pitching the investment.
- Ask the promoters how they are compensated. Specifically, ask whether it's salary or commission and find out what the commission rates are. Commission structures (depending on the rate) are incentives for brokers to consistently get you in and out of investments because every transaction makes them money.
- Ask the promoter for references. People do this for contractors and painters, why not brokers?
- Ask the promoter whether they have ever been disciplined, sued, or charged with any offenses.
- If the investment is being promoted in an ostensibly independent newsletter, ask whether that promoter has been paid, and if so, how much.
About the investment itself
- Is the investment consistent with your objectives?
- Ask whether the investment is registered with the SEC or any state and get a copy of the offering documents. Some investment opportunities are exempt from registration with the SEC, but in virtually all of those cases, the investment must be registered with the state.
- What are the risks associated with the investment? Are there certain economic factors that will impact the investment, such as changing interest rates. How will competition affect your investment? Is there a possibility that the company's product will not gain necessary regulatory approval? Is it possible that the company's product won't catch on like the promoters say? Finally, is it possible that you will lose your entire investment?
- Find out specifically how the investment will generate the returns that you've been promised. In other words, will your returns be a result of dividends, interest, or capital gains? How much product has to be sold for the company to generate enough money to pay you?
- Find out specifically how investor funds are to be used.
- What percentage of investor funds are going to be used for commissions and other administrative expenses? If the amount is more than 25%, it's probably not a good investment.
- How liquid is the investment? Will you be able to sell the investment quickly if you need money right away?
- Make sure you regularly receive account statements.
OK, now that you have to find out all this information, you're thinking, "There's no way I can do it by myself." Relax. The Internet, your phone book, and your local library are all excellent sources of information. The Internet has revolutionized investing, giving folks on Main Street many of the resources used by the folks on Wall Street. With a computer and a modem, you can access all the information you need to make financial decisions -- information that a few years ago might have cost you thousands of dollars per year, but is now mostly free.
On the Internet, visit the SEC's website at www.sec.gov. You'll find educational information, investor alerts about online trading, and information about Internet fraud and microcap stocks. You'll also find information about SEC cases. The NASDR's website provides information about brokers, specifically whether they've ever been disciplined. The North American Securities Administrators Association, www.nasaa.org, also provides educational information as well as links to the various state securities regulators.
Of course, we'd be remiss if we didn't mention www.fool.com as a starting point. Not only does the Fool provide stock prices updated throughout the day, company news and commentary, historical financial information, and current earnings estimates, but our message boards and investor education materials are excellent resources.
Here is a list of some of the resources you can use to educate yourself about various investment opportunities:
- The Motley Fool
- SEC
- NASD Regulation
- North American Securities Administrators Association
- Better Business Bureau
- Investor Protection Trust
- Investor Online Resource Center
Every investment decision is a choice -- and it's your choice. Before you make that choice, think about it, analyze it, and get comfortable with it. The key to making an informed investment decision is education, and if you do your research and ask the right questions, you will be an educated investor.
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