SEC, States Collaborate in Sweep of ‘Promissory Note’ Investment Scams

Federal and state securities regulators announced Thursday a joint effort to combat the sale of fraudulent short-term bonds, or “promissory notes,” to investors.

As part of the effort, state securities regulators in 28 states, including California, have charged hundreds of individuals and companies with improper sale of the notes.

The Securities and Exchange Commission, meanwhile, filed charges against 38 individuals and 22 companies it accuses of fraudulently obtaining hundreds of millions of dollars from investors buying the notes.

The sweep, which started quietly nearly a year ago, is ongoing, regulators said.

“This is more pernicious than most of the scams we see,” said Brad Skolnik, Indiana’s securities commissioner and president of the North American Securities Administrators Assn.

“This doesn’t involve the cold calling or aggressive sales tactics that we normally warn people about. By and large, the victims are approached by their own insurance agents, who have already built up a level of trust,” Skolnik said.

“This is one of the hottest investment products in the state of California right now. People feel safe about buying this, and they shouldn’t,” said Bill McDonald, director of enforcement at the California Department of Corporations.

“Some of the most vulnerable people are being put into this, and they’re doing this because they trust their financial advisor who is selling it,” McDonald said. Often, the victims are senior citizens, he said.

While the scams can vary in their details, they primarily involve the sale of nine-month promissory notes--basically, IOUs--to investors. By and large, the notes promise to pay relatively high, “guaranteed” yields, Skolnik said.

The “guarantees,” which quickly prove worthless, are issued by offshore insurance companies or are supposedly backed by surety bonds or other collateral. In most cases, the offshore insurance companies are nothing but mail drops and the surety bonds and other collateral are either nonexistent or disastrously insufficient.

But unlike most such scams, neither the interest rates nor the sales tactics are off-kilter enough to raise investor defenses, regulators say.

The promised interest rates on these bogus notes generally range from 10% to 20%, which strike many investors as reasonable in part because of the huge returns on many stock investments over the last year, Skolnik said.

Moreover, the investments generally are being sold by licensed insurance agents, many of whom are mining their existing customers. Some of these agents are not aware that they are selling bogus investments--they simply haven’t done the appropriate due diligence before marketing them to clients, Skolnik added.

“The agents [who were charged in the scam] are going to tell you that they were duped, and they didn’t know what they were selling,” McDonald said. “But, in reality, they didn’t ask the right questions. They didn’t do their due diligence because all they wanted to know was ‘what is my commission.’ ”

Investors who have purchased a promissory note can determine whether the sale was legal by calling their state securities regulator to check whether the security is registered or is legally exempt from registration.

In most cases, promoters of the bogus notes maintain that these notes are exempt from registration requirements because they fall into a loophole that allows established companies to freely issue short-term debt.

However, that loophole is very narrow, McDonald said. It allows established firms to issue notes for short-term financing needs (nine months or less in duration) in denominations of $25,000 or more.

That exemption was to allow major companies to issue so-called commercial paper to meet their cash flow needs, he added. That type of investment is fairly safe, he said.

The bogus notes usually are issued in the names of start-up firms or nonexistent companies. They are issued in smaller denominations, and the nine-month period is just for show, McDonald said. Generally, when the nine-month maturity date hits, the salesman convinces investors to roll over their money, often arguing that they’re doing “so well earning 12% to 15%,” McDonald says.

If investors want their money returned instead, they’re highly unlikely to get it, added Skolnik.