2011
Securities Commissioner Benette L. Zivley today warned that promoters of fraudulent investments are using self-directed Individual Retirement Accounts to give credibility to their schemes and attract victims.
While self-directed IRAs can be a safe way to invest retirement funds, Zivley said investors should be mindful of the potential risks associated with these retirement accounts. Self-directed IRAs may allow investments in private opportunities that are not available through traditional IRA accounts, but the investments may also lack transparency, limit the ability of investors to withdraw their money, and carry a high risk of fraud.
The Texas State Securities Board has brought numerous actions against companies using self-directed IRAs. In January the State Securities Board forced the closure of the Warr Investment Group LLC, an Austin company that encouraged investors to transfer their funds to a self-directed IRA that was secretly controlled by the daughter of CEO James Elton Warr. The State alleged that Warr and his companies defrauded the public through their illegal and deceptive sales of securities in real estate investment programs. Warr promised a guaranteed 8% annual return and garnered nearly $1 million from investors.
U.S. investors hold about $94 billion of IRA retirement funds in self-directed accounts, according to industry estimates. That's a small slice of the overall $4.7 trillion held in all types of IRAs, but enough money to make holders of self-directed IRAs attractive targets for thieves.
Fraud promoters who want to engage in Ponzi schemes or other fraudulent activity may exploit self-directed IRAs because they permit investors to hold unregistered securities. Moreover, the custodians or trustees of these accounts likely have not investigated the securities or the background of the promoter. Investors should understand that the custodians and trustees of self-directed IRAs may have limited duties to investors, and that the custodians and trustees for these accounts will generally not evaluate the quality or legitimacy of an investment and its promoters.
A self-directed IRA is an IRA held by a trustee or custodian that permits investment in a broader set of assets than is permitted by most IRA custodians. Most IRA custodians are banks and broker-dealers that limit the holdings in IRA accounts to firm-approved stocks, bonds, mutual funds and CDs. Custodians and trustees for self-directed IRAs, however, may allow investors to invest retirement funds in other types of assets such as real estate, promissory notes, tax lien certificates, and private placement securities.
There are numerous ways investment promoters try to exploit self-directed IRAs to entice potential investors. Among them:
Misrepresentations regarding custodial responsibilities. Fraud promoters can misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses. Fraud promoters often state or suggest that self-directed IRA custodians investigate and validate any investment in a self-directed IRA. Self-directed IRA custodians are responsible only for holding and administering the assets in a self-directed IRA. They generally do not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters. Furthermore, most custodial agreements between a self-directed IRA custodian and an investor explicitly state that the self-directed IRA custodian has no responsibility for investment performance.
Exploitation of tax-deferred account characteristics. Self-directed IRAs are tax-deferred retirement accounts that carry a financial penalty for prematurely withdrawing money before a certain age. This financial penalty may induce self-directed IRA investors to keep funds in a fraudulent scheme longer than those investors who invest through other means. Also, the prospect of an early withdrawal penalty could encourage an investor to become passive with a lesser degree of oversight than a managed account might receive, allowing a fraud promoter to perpetrate his fraud longer.
Lack of information for alternative investments. Self-directed IRAs usually allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals, and private placement securities. Unlike publicly traded securities, financial and other information necessary to make a prudent investment decision may not be as readily available for these alternative investments. Even when financial information for these alternative investments is available, it may not be audited. Furthermore, self-directed IRA custodians usually do not investigate the accuracy of this financial information. This lack of available information for alternative investments makes them a popular tool for fraud promoters' schemes.
WAYS TO AVOID FRAUD WITH SELF-DIRECTED IRAS
Verify information in self-directed IRA account statements. Alternative investments may be illiquid and difficult to value. As a result, self-directed IRA custodians often list the value of the investment as the original purchase price, the original purchase price plus returns reported by the promoter, or a price provided by the promoter. You should be aware that none of these valuations necessarily reflects the price at which the investment could be sold, if at all.
Avoid unsolicited investment offers. Investors should be very careful when they receive an unsolicited investment offer. Whether from a total stranger or from a friend, trusted co-worker, or even family member, investors should ask themselves, "Why would anyone tell me about a really great investment opportunity?"
Ask questions. Always ask if the person offering the investment is licensed and if the investment is registered, then check out the answers with an unbiased source, such as the Texas State Securities Board or SEC.
Be mindful of "guaranteed"returns. Every investment carries some degree of risk, and the level of risk typically correlates with the return an investor can expect to receive. Low risk generally means low yields, and high yields typically involve higher risk. Fraud promoters often spend a lot of time trying to convince investors that extremely high returns are "guaranteed"or "can't miss."Remember, high yield + low risk = fat chance.
Ask a professional. For complex investment opportunities, particularly those which involve the opening or creation of a new account outside a traditional financial institution or well-recognized broker, investors should consider getting a second opinion from a licensed unbiased investment professional or an attorney.
RECENT CASES INVOLVING SELF-DIRECTED IRAS
SEC v. Durmaz
The SEC filed charges alleging that a company and its partners perpetrated a Ponzi scheme in which at least $20 million was raised from more than 120 investors. In particular, the SEC alleged that the defendants promised safe, guaranteed returns in purported investments in foreign bonds and raised money by convincing investors to invest in self-directed IRAs and steering them to custodians who offered the self-directed IRAs. Twenty million dollars of the funds invested in the fraudulent scheme came from self-directed IRAs.
State v. Smith and State v. Snelling
Indiana state securities regulators pursued an action alleging that Jerry Smith and Jasen Snelling bilked investors out of more than $4.5 million in a nearly decade-long Ponzi scheme. Smith and Snelling told investors they were talented day traders and promised up to 20% returns. Smith and Snelling, through various companies, encouraged investors to roll over their traditional IRA accounts into self-directed IRAs at a trust company. Smith and Snelling would immediately take the funds from those accounts and use them for personal living expenses, but investors continued to receive statements from the trust company, as well as bills for custodial fees, even after their money was taken out of the accounts. Smith and Snelling are charged with more than fifty counts of violations of the Indiana Uniform Securities Act.
In re: Stephen Edward Gwin, et al.
Missouri state securities regulators issued final orders against Stephen Gwin in two separate cases. Gwin, a federal felon, and others mislead senior citizens into investing in unregistered securities and diverting investment proceeds through self-directed IRAs at trust companies into accounts that Gwin controlled. Gwin and his correspondents were found liable and ordered to pay various civil penalties.