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Last Updated on: 27th November 2013, 11:47 pm
In 2011, Nicholas Cosmo of Long Island, NY was sentenced to 25 years in prison after admitting to stealing more than $195 million from thousands of investors in the course of a five-year, $400-million Ponzi scheme.
Cosmo was ordered to repay $179 million to more than 4,000 investors who thought they were investing in short-term commercial bridge loans through Cosmo's two Long Island-based companies, Agape World Inc and Agape Merchant Advance.
Cosmo and his associates bilked many investors by convincing them to invest money from their self-directed IRA’s in their program.
It wasn’t the first time he went afoul of the law. Cosmo had spent nearly two years in prison after misleading investors a decade before, and was barred from the securities industry in 2000.
But the fraudulent activity went unchecked for 5 years because the unregulated nature of many approved self-directed IRA investments made it very easy for the fraud to occur.
According to a 2013 report by the Investment Company Institute, U.S. investors held approximately $5.7 trillion in IRAs. Estimates from various sources approximate that investors’ hold 3 percent, or $171 billion, of IRA retirement funds in Self-Directed IRAs.
The large amount of money held in self-directed IRAs makes them attractive targets for fraud promoters. Fraud promoters also may target other types of retirement accounts by attempting to lure investors into transferring money from those accounts to new self-directed IRAs in order to participate in the fraud promoter’s scheme.
In particular, fraud promoters who want to engage in Ponzi schemes or other fraudulent conduct may exploit self-directed IRAs because they permit investors to hold unregistered securities and the custodians or trustees of these accounts likely have not investigated the securities or the background of the promoter.
There are a number of ways that fraud promoters may use these weaknesses and misperceptions to perpetrate a fraud on unsuspecting investors. Be on the lookout for the following:
1) Misrepresentations Regarding Custodial Responsibilities
Fraud promoters can misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses.
Fraud promoters often explicitly state or suggest that self-directed IRA custodians investigate and validate any investment in a self-directed IRA. Self-directed IRA custodians are responsible only for holding and administering the assets in a self-directed IRA. Self-directed IRA custodians generally do not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters.
Furthermore, most custodial agreements between a self-directed IRA custodian and an investor explicitly state that the self-directed IRA custodian has no responsibility for investment performance.
2) Exploitation of Tax-Deferred Account Characteristics
Self-directed IRAs are tax-deferred retirement accounts that carry a financial penalty for prematurely withdrawing money before a certain age. This financial penalty may induce self-directed IRA investors to keep funds in a fraudulent scheme longer than those investors who invest through other means.
Also, the prospect of an early withdrawal penalty could encourage an investor to become passive with a lesser degree of oversight than a managed account might receive, allowing a fraud promoter to perpetrate his fraud longer.
3) Lack of Information for Alternative Investments
Self-directed IRAs usually allow investors to hold alternative investments such as real estate, mortgages, tax liens, precious metals, and private placement securities.
Unlike publicly-traded securities, financial and other information necessary to make a prudent investment decision may not be as readily available for these alternative investments.
Even when financial information for these alternative investments is available, it may not be audited.
Furthermore, self-directed IRA custodians usually do not investigate the accuracy of this financial information. This lack of available information for alternative investments makes them a popular tool for fraud promoters’ schemes.
4) Fraudulent Valuations & Excessive Rates of Return
Alternative investments are usually illiquid and difficult to value. As a result, it’s easy for devious promoters to manufacture statements with inflated valuations.
Self-directed IRA custodians often list the value of the investment as the original purchase price, the original purchase price plus returns reported by the promoter, or a price provided by the promoter.
Investors should be aware that none of these valuations necessarily reflect the price at which the investment could be sold, if at all.
Also, be cautious if a promoter pitches a very high rate of return. When some of the smartest money managers on the planet have difficulty making 15% per year, you know that something’s up when you’re guaranteed 40%.