First it was non-traded real estate investment trusts (REITs) that financially burned investors over the past year. Now another alternative investment product is causing similar concerns: Non-traded business development companies (BDCs)

BDCs invest in various debt and equity of small to mid-size businesses with debt instruments ranging from the senior-secured level to junk status. Despite their obvious risks, BDCs are quickly becoming the investment du jour. Non-traded BDCs raised almost $1.5 billion in 2011, compared with $369 million in 2010, and just $94 million in 2009, according to a Feb. 9 article by Investment News.

The growing popularity of BDCs has sparked concern among securities regulators. Reportedly, the North American Securities Administrators Association plans to intensify its scrutiny of BDCs by drafting a statement of policy on the products in the very near future. Among other things, the statement would contain a review of policies and standards governing any offering documents for a new fund.

The Financial Industry Regulatory Authority (FINRA) also is apparently interested in non-traded BDCs. According to the Investment News article, FINRA may issue an investor alert on non-traded BDCs as early as next month. As in investor alerts previously issued on non-traded REITs, FINRA’s non-traded BDC alert would likely highlight concerns regarding customer suitability and the overall lack of liquidity in non-traded investments.

As in the case of non-traded REITs, many critics of non-traded BDCs fear that some brokers may put their due diligence to clients on the backburner in favor of the high 7% sales commissions that are attached to the products.

Sometimes it takes awhile to learn a lesson. Just ask David Lerner. With his firm, David Lerner Associates, already facing a disciplinary complaint by the Financial Industry Regulatory Authority (FINRA) for misleading investors and selling shares in illiquid real estate investment trusts (REITs) to unsophisticated and elderly customers, owner David Lerner apparently continued to improperly pitch the products.

FINRA is now taking aim at Lerner personally. In an amended filing, the regulator added new allegations to the complaint it previously filed in May 2011 against Lerner’s firm. As reported on Jan. 30 by Reuters, FINRA’s latest complaint focuses on statements Lerner allegedly made to investors following the regulator’s actions against his company this past summer.

In the amended complaint, FINRA states that Lerner sent letters to more than 50,000 customers in July 2011 to “counter negative press” regarding FINRA’s action. That action concerned sales of Lerner’s Apple REITs and, specifically, the fact that Lerner’s firm reportedly mislead investors with information that failed to show distributions of the REITs exceeded income and were financed by debt.

In the letter that Lerner later issued to customers, FINRA says he also discussed a possible opportunity for Apple REIT shareholders to participate in a sale or listing on a national exchange as a way to dispose of their shares at a reasonable price.

FINRA says Lerner further made misleading, exaggerated statements to investors during a seminar that his brokerage firm hosted, including statements suggesting that closed REITs were a potential “gold mine.”

The case against Lerner and his Apple REITs has put non-traded REITs in general on shaky ground with broker/dealers throughout the country.  In October 2011, FINRA issued an investor alert about non-traded REIT investments, calling attention to the inconsistent dividends, illiquidity and inaccurate valuations associated with the products.

The financial meltdown of several high-profile companies behind tenant-in-common (TIC) offerings raises new questions about the way TIC investments are marketed and sold to investors.

One of the largest real estate companies to file Chapter 11 bankruptcy over TIC-related issues is DBSI, Inc. Some 10,000 investors were left holding the bag when DBSI filed for bankruptcy protection in November 2008.

Idaho-based DBSI was founded in 1979 and quickly became a major player in the tenant-in-common industry. A court-appointed trustee in DBSI’s bankruptcy case concluded in a 200-plus-page report that DBSI executives ran “an elaborate shell game” – one that included improper and fraudulent use of “investor money to prop up the company, to spend on pet projects and to enrich themselves.”

Not all TIC investments go the way of DBSI, of course, but they do come with certain risks that investors may be unaware of until it’s too late. TICs, which provide a fractional ownership in a commercial property, gained newfound popularity in March 2002 after a tax law change gave investors the ability to avoid capital gains taxes by investing proceeds from a property sale into a TIC.

Following the amended tax law, TIC investments began to be sold in droves by financial brokers. And therein the problems began.

In 2005, the Financial Industry Regulatory Authority (FINRA) issued the first of several notices reminding brokerage firms that it was inappropriate to recommend a TIC transaction if the recommendation was based solely upon information and representations made by the sponsoring company in the TIC’s offering document.

Instead, brokerage firms were required to conduct a “reasonable investigation” of their own in order to ensure that the offering documents did not contain false or misleading information. Moreover, members needed to have a clear understanding of the investment goals and current financial status of the investor before recommending a TIC exchange.

Unfortunately that didn’t happen in a number of instances. Many brokers never lived up to their due diligence duties when it came to making recommendations to clients about TIC investments. Instead, they took their profit in fees and commissions, while investors were left with huge – and unforeseen – losses.

All-public arbitration panels have proved to be a popular combination for investors who’ve filed securities-related complaints with the Financial Industry Regulatory Authority (FINRA).

From February 2011 to Jan. 26, 2012, more than 76% of investors have chosen the all-public option, says FINRA, the internal watchdog of Wall Street. Prior to that time, investor cases were heard by three-person arbitration panels containing two public arbitrators and one arbitrator associated with the financial industry.

FINRA has been evaluating and compiling data on the all-public pilot program following its launch on October 6, 2008.  As of Jan. 1, 2012, 12% of the cases in the pilot program were still pending. Accordingly, data-including award data-are not yet fully complete.

Based on the data available, of the 49 pilot program awards issued by all-public panels, investors were awarded damages in 26 of 40 cases, or 65% of the time.  Another 23 pilot program awards were issued by panels with one non-public arbitrator. Investors received financial relief 13 times, or a 62% win rate, in those instances.

As reported Jan. 29 by Investments News, win rates were lower in non-pilot cases. In 2009, arbitrators awarded damages to investors in 49% of cases; in 2010, the win rate was 48%.

At the time FINRA launched the all-public two-year pilot program in October 2008, the program included 14 firms that had voluntarily agreed to participate and applied only to investor cases that did not involve individual brokers. The creation behind the all-public program was in response to criticism that the presence of an industry representative on arbitration panels created bias, as well as sympathy for the defense in cases brought by investors.

In 2010, FINRA proposed making the all-public option permanent. In February 2011, the Securities and Exchange Commission (SEC) approved FINRA’s rule change for all customer cases in which a list of potential arbitrators had not yet been sent to the parties involved in the dispute.

Senior investors are an easy and vulnerable target for financial fraud. Individuals 65 or older manage a large percentage of the nation’s liquid assets and, most important to the perpetrators of financial fraud schemes, they are often more susceptible to money schemes and deception due to physical or mental limitations.

Many senior citizens who become victims of financial exploitation suffer in silence, never reporting the crimes to authorities out of fear or embarrassment. Other victims are afraid of losing their independence or that family members may move them into a nursing home.

According to the AARP, financial scammers cheat investors out of some $40 billion a year, and seniors are the most common targets. As reported by the North American Securities Administrators Association (NASAA), some of the most popular financial scams involve “investment pools” to collect money that is then used to purchase and renovate distressed real estate properties. In reality, however, these so-called flips are often Ponzi-like schemes in which the scammer takes the investor’s money to pay off previous investors. Like most Ponzi schemes, the ruse eventually falls apart when there are not enough new investors to continue the scheme.

Another popular investment scam targeting the elderly involves certain promissory notes or private placement investments. The note itself may promise high returns through a private investment, according to NASAA. But in reality, unregistered promissory notes can be a cover for Ponzi schemes or another type of financial fraud.

One prominent case that resulted in investors losing millions of dollars in fraudulent oil and natural gas private placements was that of Provident Royalties, LLC.

The Securities and Exchange Commission (SEC) filed fraud charges against Provident and three company founders in the summer of 2009 for their role in the scheme, which turned out to be an elaborate $485 million Ponzi scheme.

Investors of any age encouraged to always check with their state securities regulator to determine if an investment involving promissory notes or private placements and its sponsors are properly registered.

Brokerage firms and registered reps selling private placements, inverse and leveraged exchange traded funds (ETFs), structured notes and other complex investment products have been put on notice by the Financial Industry Regulatory Authority (FINRA). In a newly issued regulatory notice, FINRA outlined certain due-diligence and supervisory policies and procedures that firms must have in place when selling such products and that the investments themselves can be expected to face greater regulatory scrutiny in the future.

“Registered representatives should compare a structured product with embedded options to the same strategy through multiple financial instruments on the open market, even with any possible advantages of purchasing a single product,” Regulatory Notice 12-03 said in part.

As in previous notices issued by FINRA, Notice 12-03 reiterated the fact that firms should consider whether less complex products can achieve the same objectives for investors. The notice further stated that post-approval follow-up and review are particularly important for any complex investment product.

In recent years, regulators have issued a number of enforcement and disciplinary actions in cases involving complex investments. Two high-profile cases occurred in 2009, when the Securities and Exchange Commission (SEC) filed fraud charges against Medical Capital Holdings and Provident Royalties LLC over the private placements issued by both entities.

Several state regulators, including Massachusetts, also have filed regulatory actions against various broker/dealers that sold Medical Capital and Provident private placements to investors.

Clients of CapWest Securities received a vindication of sorts today when an arbitration panel of the Financial Industry Regulatory Authority (FINRA) ordered the broker/dealer to pay $9.1 million in damages and legal fees stemming from sales of failed private investments in Medical Capital Holdings and Provident Royalties LLC.

The problem is that CapWest closed last year, so the likelihood of investors receiving any substantial financial recovery from the award is slim.

Both Medical Capital and Provident Royalties were charged with fraud by the Securities and Exchange Commission (SEC) in 2009.  Investors across the country lost millions of dollars from investments in private placements from the entities.

The $9.1 million award is believed to be one of the single largest arbitration awards based on sales of failed private placements, according to a Jan. 19 article by Investment News.

The world of exchange-traded funds may look like a mass of liquidity and fast profits but lurking just beneath the surface is an array of potential risks and financial mayhem.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies and options that track market indexes. But in recent years, traditional ETFs have become increasingly complex, delving into esoteric and risky areas that involve swaps, futures contracts and other derivative instruments.

Leveraged and inverse ETFs are two of those esoteric products. Leveraged ETFs are designed to deliver “multiples” of the performance of the index or benchmark they track. Its cousin, the inverse ETF, works in the reverse by trying to deliver returns that are the opposite of the index’s returns.

The problem many investors make with leveraged and inverse ETFs is that they hold these investments for longer than one trading day. Leveraged and inverse ETFs are not designed for long-term returns. Rather, they try to achieve their stated performance objectives on a daily basis. Holding a leveraged or inverse ETF for any longer may not get you the multiple of the index return you were expecting – and instead create a financial nightmare.

As reported Jan. 13 by Businessweek, ETFs surpassed $1 trillion in assets globally in 2009. The growth has not gone unnoticed by regulators, especially as more complex and riskier versions of the ETF emerged in the market.

For example, the Securities and Exchange Commission (SEC) began examining whether ETFs that use derivatives to amplify returns may have contributed to equity-market volatility in May 2010, when the Dow Jones Industrial Average plunged some 1,000 points in one hour. At the time, the SEC stated that any new ETFs that made substantial use of derivatives would not be approved.

Congress also has taken an interest in the more complex and riskier versions of ETFs, holding several hearings in 2011 on synthetic ETFs and their transparency, leverage and use of derivatives.

So in a nutshell: Leveraged and inverse ETFs aren’t for everyone. In fact, they may not be suitable investments for most retail investors. Not only are these synthetic products complex, highly risky and lack transparency, but they require detailed knowledge and constant monitoring. And while there could be instance where certain trading and hedging strategies justify holding a leveraged or inverse ETF for longer than a single trading day, there’s an even higher probability of losing money.

Leveraged and inverse exchange-traded funds (ETFs) are getting a bad – and perhaps well deserved – reputation. Critics have coined an endless array of negative descriptors for these products, from “toxic,” to “dangerous,” to “pumped-up investment vehicles with a mountain of risks.”

The characterizations are not without some merit. The Securities and Exchange Commission (SEC), the North American Securities Administrators Association and the Financial Industry Regulatory Authority have issued separate and joint warnings to investors about leveraged and inverse exchange-traded funds. Among their concerns: the growing complexity of the products, their lack of transparency and the potential for investors to experience significant financial losses if they hold onto their funds for more than one trading day.

The first exchange traded fund was launched in 1993. As the products evolved, so did the level of risk. In 2006, ETFs became more aggressive with the introduction of leveraged and inverse exchange-traded funds to the market.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments that are created to mimic the performance of an underlying index or sector. Leveraged and inverse ETFs, however, are something altogether different. They are not your standard variety of exchange-traded funds.

Leveraged ETFs seek to deliver “multiples” of the performance of the index or benchmark they track. Inverse ETFs do the reverse. They try to deliver the opposite of the performance of the index or benchmark being tracked.

Many investors are under the mistaken belief that a leveraged ETF will give them twice the daily return of the underlying index over the long term. In reality, nothing could be further from the truth.

In recent years, there’s been an increase in arbitration claims and investor lawsuits involving leveraged and inverse exchange-traded funds. The trend is likely to continue in 2012. Moreover, the number of ETFs that have been shut down or liquidated is on the rise, up 500% in each of the past three years over 2007 levels, according to a recent investor alert by the North American Securities Administrators Association. That amounts to one ETF a week.

For investors, these liquidations often prove costly in the form of termination fees, as well as lost opportunity costs if the providers convince investors to stay in the fund through the liquidation process to save on commission costs.

The bottom line: Not all ETFs are the same. While some may be appropriate for long-term holders, others require daily monitoring. The best advice: Know your investment objectives and risk tolerance levels before making the ETF leap.

 

Information equals power, which is why securities regulators are encouraging investors to be aware about popular investment fraud scams so they don’t become a victim. One of the most popular vehicles for investment fraud includes unregistered securities such as private placements.

Also known as Regulation D offerings, private placements do not have to be registered with the Securities and Exchange Commission (SEC). This means they often lack detailed financial information, as well as a prospectus.

In 2010 and 2011, an increase in investor complaints regarding private placements caused the Financial Industry Regulatory Authority (FINRA) to launch a nationwide investigation of broker/dealers marketing and selling the products. As a result of the investigation, a number of fraud and sales practice abuses were uncovered. Two major cases involved Medical Capital Holdings and Provident Royalties.

Both entities were charged with fraud by the SEC in 2009. Since then, several broker/dealers that sold private placements in Medical Capital and Provident Royalties have faced enforcement actions, as well as fines by regulators. Meanwhile, investors are continuing to file lawsuits and arbitration claims over the failed deals.

As reported Dec. 14 by the Wall Street Journal, baby boomers are most vulnerable victims of investment scams involving private placements. Of the enforcements in 2010 for investors age 50 or older, cases involving unregistered securities outnumbered those related to ordinary stocks and bonds by a ratio of five to one, according to the North American Securities Administrators Association.

One of the victims of those crimes is Keith Grimes, 56. Grimes put $500,000 – his entire life savings – into an investment fund that promised returns of 14% to 24%. Described as having a manager with a successful track record of trading stocks and other financial products, the investment turned out to be a Ponzi scheme, in which money from new investors is used to pay returns to other investors.

The so-called manager of the fund in question was James D. Risher. On Dec. 6, Risher was sentenced to more than 19 years in federal prison. Meanwhile, Grimes, who lost almost all of his financial savings in the doomed deal, is now living in a borrowed mobile home and running an industrial-fiberglass business, according to the Wall Street Journal article.

According to the SEC, Risher raised $22 million from more than 100 investors, while placing only $2.5 million in brokerage accounts and losing about $890,000 through his trading. More than $8 million went to “management and performance fees,” with Risher spending $4.5 million on jewelry, gifts, property and personal expenses.