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Investor Alert

Promissory Notes Can Be Less Than Promised

Update: FINRA is reissuing this alert on the heels of its disciplinary action related to the fraudulent sale of promissory notes to NFL and NBA players. In June 2014, a FINRA hearing panel expelled Washington, D.C.-based Success Trade Securities, Inc. and barred its CEO and President for the fraudulent sale of more than $19 million in promissory notes. The alert details the risks associated with promissory notes and the continued threat of promissory note schemes whose sole objective is to defraud investors.

Scams involving promissory notes rob investors of tens of millions of dollars. The promise of high guaranteed rates of interest (some as high as 26 percent) make these come-ons particularly attractive in today’s low-interest rate environment.

Investors who consider buying promissory notes need to check them out thoroughly. Unlike many investments today, promissory notes sound simple and safe, and appear to be an attractive alternative to stocks and bonds. While they can be legitimate investments, some promissory notes sold widely to individual investors are fraudulent. Recent fraudulent schemes include promissory notes purported to be secured by investments in real estate, US Treasuries, brokerage firms and a variety of businesses including one that produced personal finance-related radio programming. Investors need to understand the investment they are considering, and be aware of warning signs that may signal a scam.

What is a Promissory Note?

A promissory note is a form of debt that companies sometimes use, like loans, to raise money. The company, through the notes, promises to return the buyer's funds (principal), and to make fixed interest payments to the buyer in exchange for borrowing the money. Promissory notes have set terms, or repayment periods, ranging from a few months to several years.

Even legitimate promissory notes involve risks—the company issuing them may have problems, such as competition, bad management or severe market conditions that make it impossible for the company to carry out its promise to pay interest and principal to note buyers. Investors also need to know that bona fide notes are marketed almost exclusively to corporate and other sophisticated investors, who have the expertise and information to determine if the investment is a good one.

What's the Problem?

Problems with promissory notes fall into three main categories: fraud and deception of investors, unregistered securities and unregistered sellers.

Fraud and Investor Deception

Fraudulent promissory note programs are often characterized by deceptive statements such as: 1) investors will receive very high, double digit returns; 2) returns are guaranteed; and 3) the notes are backed by collateral to guarantee them.  Often, promissory note schemes target the elderly and their retirement savings.

Real Life Example

FINRA barred the firm Success Trade and its CEO for the fraudulent sale of more than $19 million in promissory notes to 58 investors, many of whom are current or former NFL and NBA players, while misrepresenting or omitting material facts. Most of the notes promised to pay an annual interest rate of 12.5 percent on a monthly basis over three years, with some notes promising to pay interest as high as 26 percent.

Unregistered Securities

Although those selling them may not know or admit it, these promissory notes are usually securities and must be registered with the SEC or the state they are sold in—or they must have a specific exemption from registration under the law. If the note is not registered, it will not be subject to review by regulators before it is sold, and investors have to do their own investigation to confirm that the company can pay its debt.

Unregistered Sellers

These promissory notes are usually securities, but those selling them often do not have the required securities sales license. If registered individual brokers are involved, they may be selling the notes without their firms' approval.

How to Protect Yourself

If you are thinking about investing in a promissory note, you should carefully consider the following tips:

Ask why the seller wants to sell to you.

Bona fide corporate promissory notes generally are sold to sophisticated buyers who can do their own research on the company issuing the notes to determine whether the notes are a good deal. The fact that promissory notes are being sold to individual investors is itself a danger signal.

Be wary of pushy sales tactics.

No reputable investment professional should push you to make an immediate decision about an investment, or tell you that you must “act now.” If someone pressures you to decide on a promissory note purchase, steer clear. Even if no fraud is taking place, this type of pressuring is inappropriate.

Check Check Check

Check with the SEC's EDGAR Database to see if the notes are registered. (Remember that most promissory notes are securities and have to be registered with the SEC and the state they are sold in, unless they are specifically exempt from registration under law.) Check with your state securities regulators whether the investment and the salesperson are in compliance with your state's securities laws.

Visit FINRA BrokerCheck to see if the individual investment professional is registered or has a disciplinary history. Check with the Better Business Bureau where the company issuing the notes is located to find any complaints against the company.

Broker Role

If you are buying through a broker, ask if the note is being sold through the broker's firm. If not, it is being "sold away," and you will miss important investor protections that flow from the broker's and the firm's regulatory obligations. Be alert to red flags that your broker may be operating outside the oversight of the firm. These may include the use of a personal email address instead of one associated with the brokerage firm, statements about your investment that do not bear the firm’s letterhead or appear to originate from a new entity not related to the brokerage firm or printouts that look like they came from a home computer.

Guaranteed Returns

Know that a salesperson cannot guarantee a particular return. Even if the note has a fixed interest return, the investment may not pay that amount—or return your principal—to you. Moreover, the seller may say the notes are insured, but not mention that the insurer may not be legitimate—and outside the US and beyond the reach of our laws.

High Returns

Promissory notes usually offer double-digit returns—even when current yields on fixed-income investments are much lower. But even for notes with single-digit returns, be sure to consider prevailing market conditions. And be wary of claims that an investment can provide above-market yields. Remember that the higher the potential return, the greater the risk.

Exorbitant Commissions

Ask specifically how much compensation the salesperson is getting. Normal commissions rarely exceed 5 percent; these notes offer the salesperson much more, as high as 30 percent or even 50 percent.

Issuing Company

Ask how the company issuing the notes will generate the returns to pay you your interest. Find out what part of the money that the company will be getting will be used up by marketing and promoter's costs, which may hurt the company's chances of paying you back.

If you don't get good answers to all of your inquiries, walk away from the offer.

Already Invested?

If you think you are involved in a promissory note scam, act quickly, since the law limits the time for you to take legal action.

You can complain to FINRA, the SEC, your state securities administrator, and, if an insurance agent sold the notes to you, your state insurance commissioner.

Remember: lawyers you hire and pay for can sometimes help you get your money back from a problem deal, but the best way to keep your money is to not participate in the first place.

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