In April 2009, the Securities and Exchange Commission issued a notice to investors entitled, Broken Promises: Promissory Note Fraud (U.S. Securities & Exchange Commission 2009).The notice defines a promissory note as a form of debt—similar to a loan or an IOU—that a company may issue to raise money. Typically an investor agrees to loan money to the company for a set period of time. In exchange, the company promises to pay the investor a fixed return on his or her investment—customarily, principal plus annual interest. While promissory notes can be legitimate investments, those that are marketed broadly to individual investors often turn out to be scams.
Fraudsters across the nation continue to use promissory notes as vehicles to defraud investors out of hundreds of millions of dollars. Most promissory note scams follow predictable, fraudulent fact patterns.
1. The fraudsters—who may or may not be affiliated with the borrower—persuade sales personnel to sell promissory notes, luring them with lucrative commissions of up to 20 or even 30 percent. These agents often do not have a license to sell securities. In selling the notes, they frequently rely solely on the information provided by the company, which is intentionally misleading to the investor.
2. Investors purchase the promissory notes, enticed by the promise of a high, fixed-rate return—upwards of 15 or 20 percent—and a very low level of risk. The promissory notes may appear all the more attractive because the seller falsely claims that they’re guaranteed or insured. Few investors ask tough questions about these investments because they know and trust the sellers with whom they’ve done business in the past.
3. The fraudster uses a portion of the money they collect from investors to pay the sellers their commissions and abscond with the rest.
4. They may also use some of the proceeds to support an elaborate Ponzi scheme in which money from the sale of new notes pays the interest to investors on older notes. Some fraudsters make prepayments of interest and also try to avoid repaying investors’ principal by convincing investors to “roll-over” their promissory notes upon maturity. These investors may, for at least a time, continue to receive interest payments. However, they rarely get their principal back.
Promissory note scams often target the elderly, bilking them of their retirement savings and their home equity at a time when they can least afford to lose it. No one is immune to scams. Fraudsters rarely discriminate when it comes to separating investors from their money. Most investors don’t even realize their investment dollars are at risk until it’s far too late.
Investors were lured by a trusted friend and sales person to invest in First and Second Lien notes that were backed by developed real estate with high loan to value ratios paying 12% interest, due in 12 months. The funds were to be used for the acquisition of the property and renovating apartment units. The borrower did not disclose that he had to add a new roof and remediate asbestos and black mold. He also did not disclose he would use the loan proceeds for the repayment of investors in another project with the funds of the new investors. Furthermore, he failed to tell his new investors he would spend the money on personal expenditures. Ultimately, the borrower took in more and more funds from investors to where the loan to value ratio was very low.
As a result of not segregating loaned funds for improvements and paying old investors with new investor funds, the borrower fell behind and fled the country, leaving the lenders to take over the completion of the renovation. Ultimately, the decision was to raze the entire structure and the investors lost their investment.
Future investors in these types of investments should learn to be skeptical, ask hard questions, research on the web for similar investments, look into the background of the borrower beyond just the statements of the salesmen. Investors should determine if the investment is registered with the state and if the sales person is registered to sell securities. Investors should remember, “If it is too good to be true, it probably is.” If a lawsuit materializes, consider hiring a skilled and knowledgeable private investigator that is a forensic accountant and a qualified Ponzi scheme expert.
To learn more about protecting your client’s assets contact Retired IRS Special Agent Edmond J. Martin, Chief Investigator at Sage Investigations, LLC, e-mail: firstname.lastname@example.org website: www.sageinvestigations.com or call 512-659-3179 and let our 26 plus years of IRS experience work for you.