As with anything involving money, investing in stocks can be subject to fraud and abuse. The most important things to guard against are churning, unsuitable investments and boiler-room operations.
Churning occurs when a broker makes excessive trades in an account to generate commissions. This can occur when an investor opens a discretionary account that allows your broker to make investment decisions for you. It can also occur when your broker pressures you to approve an excessive number of transactions.
Sometimes investors are often pressured to buy unsuitable investments. An example would be an 80-year-old widow on a tight budget who is coerced into selling her Treasury bonds to build a portfolio of highly volatile stocks and stock options.
But educated investors can get stuck with unsuitable investments, too. One example is mutual funds that make risky derivative investments that haven’t been adequately disclosed. Another is collateralized mortgage obligations, which are highly volatile and risky mortgage-backed bonds, i.e. the recent financial crisis.
Then there are the boiler-room brokers. If you get a cold call from a high-pressure salesperson hawking low-priced stocks, watch out. A boiler room will heavily promote a volatile over-the-counter stock of dubious value. But once the price of the stock is sufficiently inflated and the boiler room has sold off its supply of share, the promoting stops. At that point, the price of the stock drops and investors are left with virtually worthless shares they can’t get rid of. The strategy is called “pump and dump.” Many boiler-room operators have also sold unregistered investments in commodity futures and the like. Back in the 1990s a growing problem was boiler-room scams involving telecommunications lotteries and auctions held by the Federal Communications Commission.
Some investments are only suited for what is known as an accredited investor. These investments should never be presented to a non-accredited investor. According to the Securities & Exchange Commission, “The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
1. A bank, insurance company, registered investment company, business development company, or small business investment company;
2. An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
3. A charitable organization, corporation, or partnership with assets exceeding $5 million;
4. A director, executive officer, or general partner of the company selling the securities;
5. A business in which all the equity owners are accredited investors;
6. A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
7. A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.”
If you are not one of the above then you not do not qualify as an accredited investor.
While there are many different types of scams the ones above are the most common. The best way of protecting yourself is to do business with firms and individuals of good reputation. Seek out recommendations and ask those who you intend to work with if several of their clients will call and talk with you. Finally, use common sense. If its sounds too good, it usually is. Beware and be careful.
Quote of the Week:”Do not let what you cannot do interfere with what you can do”—John Wooden
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.