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Avoiding Fraud in US Investing: An Overview
From: Columbia University
| By:
Eric R. DinalloCharles E. SchumerArthur Levitt |
EDITOR'S INTRODUCTION |
Between newspapers, websites, television commercials, colleagues and friends, it can be hard to know where to get sound and impartial advice on investing. At a town hall sponsored by the Columbia Law School, Arthur Levitt, chairman of the US Securities and Exchange Commission (SEC), Charles Schumer, US senator from New York, and Eric Dinallo, bureau chief of the Investor Protection and Securities Bureau in the New York State Attorney General's Office, joined forces to discuss practical tips for saving and the risks and rewards of investing. |
Eric R. Dinallo<br> <font size=2>Bureau Chief, Investor Protection and Securities Bureau, <br>New York State Office of the Attorney General</font>
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| Eric R. Dinallo. | |
 he New York State Attorney General's Office has evolved over the years as a consumer advocate. The office, through Eliot Spitzer, wants desperately to see the pursuit in prosecution, both civilly and criminally, of securities fraud. |
In 1999, largely in response to consumer complaints and investor complaints, we brought an unprecedented number of actions and obtained dispositions against stock boiler rooms, pyramid schemes, foreign-currency traders and private placement scams, as well as published a report on online trading. |
But the first line of defense is a well-educated investor. I hope to share with you some of the ways that I think that you can protect yourself from securities fraud. |
Some of what I've learned I've actually obtained through debriefing securities fraudsters themselves, and some of the securities prosecutions that I've been involved in. Generally, the worst kind of securities fraud starts on the telephone. You'll be contacted by someone on the phone; there's always going to be an urgency about this call. The person will call you and make you feel like there's some opportunity that you positively, absolutely, have to get into now. I'm warning you, it may not be on the first call. It may be on the third call, but there will be a moment when there's this urgency. |
I want to say that I really believe that there's no good, prudent long-term investment that has to be made "absolutely now." The good ones take time, and there is no "moment" that you have to grasp. |
That person will also emphasize performance for you. He will note--and I say he, because it's almost always a man--that person will know very, very little about the company or the security that he is recommending. He'll just want to talk about how he's going to turn something over for you, and how he has to work for you and make you a fortune. |
If you in any way ask a question and get a rebuttal you should hang up the phone. In other words, if you say, "Well, gee, I'd like to speak to my wife or my husband or someone about this," and you get a rebuttal like, "Well, does your wife ask you when she decides who to invite over for dinner, or does your husband consult with you when he undertakes something else," you should just hang up the phone. |
That person does not have your best interests at heart, I guarantee you, in entering a fiduciary investment relationship. If you want to invest, however, let me give you some ideas of what questions to ask. |
Ask what the revenues and/or earnings of the company are. Inevitably, they'll be close to zero; that's the kind of stock fraud that we're dealing with here. Ask if the shares of the company are liquid--that has to do with whether you can easily trade the stock--and whether there's a nationwide market for this stock. |
Ask what the risks of this investment are. He or she should be able to tell you. Ask the person, "Is this a suitable investment for me?" If the person's been speaking to you for only three minutes, I guarantee you that it can't possibly be suitable, because the broker doesn't at that point know what your personal investment history and situation is. |
Ask to have the prospectus of the company and the financial statements sent to you. I guarantee you, nine times out of ten, the person will say the following words: "Oh, I could send you reams of paper, reams of documents. What would it matter? Now's the time to seize the opportunity." You should hang up. Ask them how they got your name. These are questions that securities fraudsters don't want to answer on the phone. |
Then, frankly, check out the brokerage firm, the broker and the security. Many of us put more time into researching which television or car we're going to buy than when we're putting a substantial amount of money into a stock. Maybe it's because there's an opportunity we want to seize. We feel like we're going to watch a stock go up and sit at home, when the price of a TV tends to go down over time. |
But you must do the research. Go on the Internet. Call my office. Call the Securities and Exchange Commission. Call the National Association of Securities Dealers (NASD). Call the stock exchange. Get the background on these people. It exists. |
Find out if there have been complaints or arbitrations about the firm. What's their reputation? Call a different broker at a different house, and ask about the house that's calling you. These are simply essential undertakings that you should do before you put your well-earned savings toward an investment. |
And, finally, if you are a victim of securities fraud, don't be embarrassed. I have now debriefed scores of victims. Some of them were highly sophisticated. Many of them were very successful. In fact, the fraudsters prey on successful people, because they feel a certain amount of confidence. They've been successful in their business, and they think they know how to deal with making a decision. |
So don't be embarrassed. Report it to the Attorney General's Office, report it to the NASD, report it to the SEC, or to the Manhattan DA's office. Do not hesitate. Your complaint may be the one that starts the investigation that saves hundreds of others from that bad experience. |
Charles E. Schumer<br> <font size=2>United States Senator from New York</font>
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| Charles E. Schumer. | |
The Securities and Exchange Commission is dealing with probably the most difficult issue since the initial decade when the SEC was founded, and that is, how all these new technological and global changes affect our market, and how to keep the marvelous balance that we have had between efficiency and cost-effectiveness, on one hand, and regulation, fairness and transparency in our markets, on the other, as things change, not just every week but almost every day. |
We're here today because technology and a sustained economic boom have issued in a new era of prosperity and democracy in our markets. Technology has revolutionized our markets from a bastion of the elite to the province of everyone. What could be more American than that? |
In 1999, 50 percent of all adult Americans--78.7 million--owned equities, compared with just 42.5 million 10 years earlier. That is utterly amazing. Fourteen million people in America started investing in equities in the previous three years--people who had never done it before. |
That's a good thing. But it also means that millions of investors are novices. Over the past decade, as the market has steadily increased in value, and as millions of middle-class families have made money, it's easy for people to fool themselves into believing that they know enough. |
But a little knowledge can sometimes be a dangerous thing, as all of us have learned in one phase of our lives or another. And that's why we're here today, so New Yorkers can do a better, more informed job of planning and implementing their investment strategies. |
A major theme today, one that I focused on in my first year in Washington, will be online investing. Today, almost 10 million investors trade securities through the Internet, accounting for an utterly remarkable 16 percent of retail trades. By 2003, the number of online investors is expected to total more than 20 million. It has firmly taken hold, and our markets will never be the same again. |
But with this rapid expansion of online investing, new risks to sound investing have emerged. The great democratization of the markets that online investing has helped--and which is on the whole a very laudatory thing--creates new problems as well. |
What are the risks, and how can you and the average investor protect him or herself? First, with online trading there's a risk that your trade will not be executed in a timely manner. |
The speed of the Internet and misleading advertising by some online brokers give a false illusion that your trades are executed instantaneously. The truth is that even when all systems are "go" and trading volume is light, trades can still take a while to be processed, because investors are not hooked directly into the market and you still go through that middleman. |
The order is first routed through the online broker, then to the market. The speed of this complex computer network depends on a number of factors--especially the capacity of your broker's computer system. As with all computer systems, there's also the risk of failure. Many online trading firms' systems have suffered repeated failures. These delays and failures may result in financial losses to investors as trades are delayed and executed at a different price from the one the market showed you when you first sent in your order. Or, the trade may remain entirely unexecuted. |
So, what do you do, given that situation? First, before signing up with an online broker, do some basic research. Not all online brokers are created equal. Some firms don't even offer telephone access to answer questions about service. Remember, you get what you pay for. A $7 trade that results in delayed execution could wind up costing you $500 because of price movements that may not be wise. |
Second, you should also be certain to place limit orders, which limit the price at which you'd like to buy or sell your stock. It's better that your trade go unexecuted than executed at a prevailing market price that is significantly different from the one you thought you were getting. |
In Washington, I've introduced the Online Investor Protection Act. That would require online brokers to disclose all outages that delay a broker's speed of execution, so that consumers can compare track records for reliability when opening an online account. |
You should know that maybe that $7 trade has a 5 percent risk of not happening, or not happening the way you want it, whereas a $20 trade may have only a 2 percent risk. You should make the choice between the two online firms and you should have that information. |
Another risk is cyber-fraud. With the rise of online investing, we've seen a dramatic increase in online fraud. The SEC, as Chairman Levitt can attest, receives 200 to 300 complaints daily. These scams used to take place through boiler room operations: fraudsters telemarketing their inside tips to unsuspecting consumers, swaying them into purchasing an undervalued stock, then pumping up the price and dumping their investment, while these consumers were left holding valueless paper. |
Now fraud is as easy as posting a stock tip in a popular chat room or two. And too many investors think, when they see it on that electronic screen, it's got to be true. It can be every bit as fraudulent as someone whispering to you in an elevator about something. So, just beware. The Internet is a great tool, but it doesn't change the basic honesty and dishonesty of the people who are sending the messages. |
How can you avoid all this? Well, don't get taken in by online stock tips. Smart investing, as any good investor will tell you, is the result of careful investigation and deliberation. Comb through the prospectus, study the analyst's report and, most important, invest for the long haul. |
The Online Investor Protection Act I've introduced also addressed cyber-fraud by: one, doubling penalties for Internet fraud; two, adding new money so that the SEC Office of Internet Enforcement can investigate fraud and stop it before it starts; and three, requiring online brokers and investment providers to provide a quick link to the SEC Investor Education website at www.sec.gov, which will point investors in the right direction before getting started in online investing. |
In the coming years, online brokerage will likely overtake traditional brokerage as the main method of accessing markets. Make sure you're prepared. Investors who understand the risks as well as the benefits of online trading and act to mitigate those risks by researching online firms and stocks can invest online safely and at a much lower cost than through traditional brokerage firms. |
Arthur Levitt <br> <font size=2>Chairman of the United States <br> Securities and Exchange Commission</font>
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| Arthur Levitt. | |
Why are we doing this town meeting? We're doing this because in the first place, I've had a history in America's securities market. I've been a broker, I've been a money manager, I've run a small and large brokerage firm, and I ran a stock exchange. |
And I care passionately about America's investors. Having dealt with retail clients most of my life, I know certain characteristics. One of which is that they tend to be afraid to speak up. They tend to feel that their broker, their adviser, has some mystical ability to understand issues, and they dare not ask questions that they think may not be smart questions. |
Let me say at the outset that this Securities and Exchange Commission, or, for that matter, any government agency, does not and should not have the resources to guarantee all investors against the kind of fraud that's out there. We simply cannot protect people from their own foolishness, and for that reason this commission has spent a great deal of effort in going around the country and trying to provide investors with the tools to understand what makes sound investments and how to protect yourself against the scamsters that are out there. We don't recommend or endorse any particular companies, trading strategies or financial products. But we can help you get the facts that you need to achieve financial security. |
This is a remarkable time to be an investor. But it's also an unusual time. Those of you who feel that the unusual profits of the markets in the past three years are the rule rather than the exception are mistaken. |
Taken over a period of years, markets don't go in one direction. They don't return 30 percent a year indefinitely, and you shouldn't expect that. Over the longer term, measuring over the last 70 years or so, markets have earned, on average, 10 to 12 percent. Now, I'm not making predictions. I'm just reminding you that it's important to have realistic expectations. |
Now, Senator Schumer has correctly identified the issues that we have to be careful of with respect to online trading. What happens to people? I've studied this, and I've thought about it a lot. |
We have in our society glorified the trader. Our newspapers, our magazines, our television programs and our theaters have made a big deal about the power of the trader. So when someone gets online and begins to type away on their computer, and they realize they can buy or sell hundreds and thousands of dollars' worth of securities by just punching a key, they begin to feel: I'm just as strong. I'm just as big. I'm just as powerful as a trader. |
Well, you don't have the experience. You don't have the knowledge. And, most important, you don't have the resources that a trader has. So don't be fooled by that. You've got to use, as Senator Schumer said, the same qualities of intellect and questioning that you would if you made any other investment. |
Now, I'm often asked how to pick a broker. Have you ever asked your broker how he's being paid? Brokers can be paid by the transaction. That means, every time you trade, and this is traditional, the broker gets a commission. |
Did you know that brokers can also be paid by a fee? More and more firms today are moving to fee-based compensation. Now, there's nothing wrong with paying a broker by the transaction, but it does create certain conflicts of interest. You may wonder, Would the broker have an incentive for me to buy or sell this stock if there wasn't a commission involved? You've got to be able to ask your brokers how they're being paid. You've got to be able to ask your broker, Have you had a regulatory problem? Have you ever been censured? Have you ever been kicked out of the industry? And you can get that information from the SEC, from the National Association of Securities Dealers and from your state regulator. You've got to be able to ask those questions. |
There's something else that has concerned me about brokerage practices. Some firms operate with a culture of contests. That's kind of part of the American system; contests are a pretty frequent event. But you ought to know, if a broker represents to you that you should be buying his own mutual fund, the one his firm stands behind, whether he would be part of a contest if he sells the most of those shares, or sells the most of a new issue, an IPO. There's nothing necessarily wrong with it, but you've got to know about motivations. |
Another practice that I think most people don't know about is when your broker calls you and says, "I'm moving from Firm A to Firm B. Firm B has much better research. Firm B will give you more initial public offerings. Firm B will give you better service." That may be true, but ask the broker if he's receiving any additional commissions during the period of time that he transacts business for you at Firm B. Some firms have had the practice of using accelerated payouts. For the first six to 12 months after you move to a new firm, your broker may very well get double or triple the commissions that he or she would receive when you were at the old firm. Again, you've got to ask whether your transactions are being done because of commissions rather than because of something that is important for you. |
And while I'm on the subject, I'm very concerned about the way IPOs are being bought by America's investors. It's not illegal, but there are aspects of it that I think are wrong. Firms are now coming to customers and saying to them, "If you do business with the XYZ firm, I'm going to give you more new issues." |
They'll actually open an account with a hot, new issue. And that's because new issues, over the past two or three years, have tripled, quintupled, gone to astronomical heights. But in my judgment, that is a risky game. If you take the history of new issues over the years, more of them sell down than sell up, and I don't think anybody's smart enough to know when to get out and precisely when to get in. |
Limit orders are critically important. A limit order establishes the price you are prepared to pay for a stock. If you decide that you want to get in on a new issue that a firm is offering, and you give them a market order that says you'll buy it at whatever price it is, the stock may be offered at $9 a share when it first comes out, but you may be paying $90 a share by the time you buy it. At the end of the day, it may well be selling back at $10 or $11 a share. So that's a terribly important strategy. |
Be careful about the new issue game. It's a short-term game, and investors should not be short-term runners. They should be long-distance runners. History has proven over and over again that the long-distance investor will outperform the short-term trader. |
Today, investors have access to timely information that was unthinkable just a few years ago. But when I ask investors who, when and what they consult before buying a stock, I often find surprisingly that very few people read the company's annual report or mutual fund prospectus, or do independent research. |
If you aren't familiar with it already, I encourage you to visit the SEC's website, and then click on EDGAR, the SEC's electronic database of filings on almost every public company. Type in the company's name, and you can retrieve every report they have filed with us over the past five years. |
Now, some may ask, "Why go through the trouble of reading this material? I trust my friends. I trust the Wall Street analyst on TV or in the newspaper. I trust my instincts." Well, I guess the answer can be found in something Pete Seeger once said, when explaining the difference between education and experience: "Education," that great folk singer said, "is when you read the fine print. Experience is what you get when you don't." |
As you do your research, I want you to ask specific questions about products and ask questions about those who sell them. Let's start with money market funds. Relatively speaking, they are among the safest of investments. I have a few of their prospectuses here with me now. When I look at some of their names, I see "government," "US," "cash," "trust." I don't care if a prospectus says the "Rock Solid Honesty Safety US Government Guaranteed Trust Savings Fund." It still represents a risk. |
Money market funds can include highly speculative derivative instruments. You've got to ask that question.
What's in this fund? What level of security is there? Look at the sales charge of the load that you'll pay. A front-end load, a back-end load, or no load? Look at the cost of any annual asset-based charge. That's a fee called a 12b-1 fee. On top of that, you've got to look at the management fees and other expenses that you'll pay, each year. Over time, expenses on funds make an enormous difference. |
On an investment held for 20 percent, a 1 percent annual fee reduced the ending account balance by a little more than 18 percent. The SEC's website has a mutual fund cost calculator, which will help you estimate and compare the costs of owning mutual funds. Whether you buy a fund, a stock or a bond, be sure to comparison-shop. I know people, maybe most people, who spend more time studying the cost of buying paper towels than they do their investments. |
All of you have the power and the means to be the most informed generation of investors in the history of America's capital markets. I've always believed that protecting investors begins with investors themselves. |
Don't expect the government to do all the work for you. The ease of today's technology is not an excuse to do less. It's an important opportunity, and a mandate to do more, to learn more, to be aware of more, to be informed of more and to achieve more, as individuals and as a nation. |
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