NYT: Investor Fraud Expanding Due to Complex Products

Tuesday, 12 Feb 2013 07:53 AM

By Michael Kling

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Investor fraud is increasing, as yield-hungry investors embrace exotic financial products and speculative bets.

“Since the crisis, we’ve seen more and more people reaching out into different types of exotic investments that are a big concern to us,” said William Galvin, the Massachusetts secretary of the commonwealth, according to The New York Times.

For instance, Massachusetts ordered LPL Financial, a large brokerage firm, to pay $2.5 million for improperly selling non-traded real estate investment trusts (REITs).

Editor's Note:
An $87,500 Tax Loophole Discovered by Cherry Hill Accountant

Funds put into alternative investments spiked from $312 billion in 2008 to $712 billion in 2012, The Times reports, citing McKinsey & Co. Brokers often push complex, alternative investments because the get larger commissions.

Private placements — investments in new private companies — is one growing problem, according The Times. They’re typically open only to wealthy, sophisticated investors. However, loopholes, including relaxed procedures for verifying wealth, can allow unsophisticated investors to obtain them.

Complex products have become more attractive as investors chase yield in today’s low-rate environment, said Susan Axelrod, executive vice president of the Financial Industry Regulatory Authority (FINRA), at a financial services conference last fall.

“Complex products — often discussed in compliance forums with great concern — serve a very legitimate purpose,” she said. “But they also pose very legitimate risks that can harm retail investors.”

Non-traded REITs and reverse convertibles are two top concerns, she said.

Instead of being listed on stock exchanges, nontraded REITs are traded only in private transactions. That’s supposed to protect them against stock market volatility, but it makes them more difficult to value and less liquid. Investors hoping to sell them have few options.

“REIT offerings normally last several years, and during the offering period, broker-dealers selling them reflect an estimated per-share price on customer statements — typically the public offering price,” Axelrod said.

“This is sometimes the case for years after the customer’s initial purchase. Unfortunately, we have recently seen several high-profile instances of REITs re-pricing their per-share estimated values at substantially less than the offering price — with little or no advance notice to investors.”

Another unconventional tool is a reverse convertible note, which pays a high initial fixed coupon with return of principal tied to the performance of a basket of stocks or sometimes a specific security.

“Investors and brokers may misunderstand this complex product — and its downside,” she said.

“FINRA examiners have noted that some investor portfolios are over-concentrated in these products, generally due to unsuitable recommendations.”

Editor's Note: An $87,500 Tax Loophole Discovered by Cherry Hill Accountant

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