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California Leads Securities Regulators Crackdown on Promissory Note Fraud

Since the sweep began in July of 1999, California regulators have also taken enforcement action against 185 individuals and 45 entities for unlicensed broker-dealer activity and filed two major civil actions against five entities and nine individuals. The department recently announced the illegal sale of promissory notes to be number one on its list of "Top-Ten Investment Scams" for this year.

Promissory notes pay a fixed rate of return and are typically secured by property or assets of the issuing company, but regulators say they are only as good as the property that secures them. In many of the cases investigated by the department, shell companies issued the notes with no assets, overvalued assets, or by new companies looking for start-up capital.

The notes, often sold by insurance agents, were marketed as safe and conservative investments when in fact, they are very risky and often fraudulent. Many victims were elderly or retired and were attracted by high "guaranteed" returns of 10 percent to 15 percent or more. The department noted that low interest rates are great for the economy but hard on investors that rely on safe and predictable income from bank accounts, money market funds and dividends. This has provided an opportunity for fraudulent schemes that promise high return with low risk.

Responding to complaints about promissory notes, securities regulators in 28 states formed a task force under the auspices of the North American Securities Administrators Association (NASAA) in May 1999, and coordinated their investigative activity with the U.S. Securities and Exchange Commission. The task force received technical support from the National White Collar Crime Center. Nationally, these actions involved more than 3,000 investors. In addition, the U.S. Securities and Exchange Commission has filed charges in 13 enforcement actions against 38 individuals and 22 entities involved in fraudulent sale of promissory notes. In all, the defendants named in these actions are alleged to have fraudulently obtained hundreds of millions of dollars from investors.

In California, the Department of Corporations investigations showed that these promissory notes are often sold by independent life insurance agents--lured by high commissions -- that may know nothing about the promoters of the investments beyond what they are told. The agents may not realize that they must be licensed as securities brokers with state securities regulators to sell promissory notes. However, some notes are issued on behalf of companies that don’t even exist. Investors often get official-looking promissory note certificates complete with legal-sounding language and gold embossed seals. Many of these notes were purportedly "bonded" or "guaranteed" by non-licensed insurance companies located offshore.

A promissory note scam could work like this. A life insurance agent who previously had sold a client an annuity calls with an intriguing investment opportunity. A supposedly "well-established" company is looking to expand its business and needs capital. Instead of borrowing money from a traditional lender it is offering investors an opportunity to purchase "promissory notes," typically with a maturity of nine months and an annual interest rate between 12% - 18%, far more than an investor could get elsewhere. The agent fails to disclose that he or she is getting a fat commission for the sale and may urge clients to "cash in" their life insurance policies and "roll" them into these notes.

What’s the attraction of promissory notes? Some investors don’t want exposure to the risk of the general securities market and aren’t interested in traditional insurance products. They’re attracted to this type of investment that seems to offer safety with a higher-than-market rate of return. Unlike traditional boiler-room cold callers, who solicit clients by telephone and usually have no prior relationship with them, insurance agents (some of whom are unlicensed) know their customers well. Besides life insurance agents, out-of-state financial planners and investment advisers also sell promissory notes, and some are promoted over the Internet.

Here are some tips California investors can use to protect their money:

Before investing in any promissory note, always check with the local office of the Department of Corporations to confirm that the notes are properly registered or legally exempt from registration. If the notes are not registered or exempt from registration, hold onto your money. Do research to ascertain the legitimacy of the company whose notes are being offered.
Agents selling these "notes" usually require a license as a securities broker by both the state and the National Association of Securities Dealers. To find out if the agents are registered or have a disciplinary history, contact the Department of Corporations or call the NASD Public Disclosure Hotline at 800-289-9999.
Be suspicious if the notes have an above-market interest rate with a maturity of less than a year. With a one-year FDIC-insured bank certificate of deposit yielding a little over 6%, investors should be very skeptical when a nine-month "note" from an obscure firm is offered promising 12% and "guaranteed" by an offshore insurance company.
Additional information can be obtained from the Department of Corporations’ Website at www.corp.ca.gov and NASAA’s Website at www.nasaa.org.

The Department of Corporations is California's Investment and Financing Authority, reporting to the Business, Transportation and Housing Agency and the Governor. The Department is responsible for the regulation, enforcement and licensing of securities, franchises, off-exchange commodities, investment and financial services, independent escrows, consumer and commercial finance lending and residential mortgage lending. For further information or to obtain a complaint form, see the Department's Web site at www.corp.ca.gov.

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