The Watchdog Report

By Comptroller General Richard Eckstrom
 

In the last few years we have witnessed an alarming increase in promissory note fraud in South Carolina.  Unwary investors, lured by high yields, have invested millions of dollars in unsecured promissory notes.  Sadly many of these well-intentioned investors have been defrauded and stand little chance of recovering their money.

 

A promissory note (often simply called a note) is basically a loan.  When people lend money, they are often given a promissory note that yields interest on the amount loaned  and promises repayment of the amount loaned at the end of the loan term.  Promissory notes typically run anywhere from 30 days to several years.

 

In some cases promissory notes are secured by collateral. However, in many cases high rates of return are offered instead of collateral, thereby making the note unsecured.  These unsecured notes carry an extremely high degree of risk for investors in that it’s nearly impossible to collect on an unsecured note if the borrower goes out of business or declares bankruptcy.

 

Promissory note fraud is on the increase. Scam artists that use promissory note schemes are very shrewd.  Typically they establish a flimsy marketing firm to “assist” small companies in need of emergency cash.  The marketing firm raises the cash it needs by issuing promissory notes on behalf of the cash-strapped small business. 

 

These notes are often marketed to the investing public through a network of unwary insurance agents.  Under the scheme, each note comes with a “guarantee” from an imaginary foreign insurance company.  The marketing firm gives a portion of the proceeds raised from the note “sale” to the cash-strapped borrower, keeps a hefty share for themselves, and pays a generous commission to the agents that sold the notes.

 

Unwary insurance agents and investment advisors eagerly recommend the promissory notes because of high commissions paid by the marketing firm.  Investors, on the other hand, are attracted to the high rates of return.  Such unsecured notes often carry  “guaranteed” interest rates as high as 12%-20%. 

 

It is important to understand that these hollow promissory notes are often issued to prop up troubled companies in need of quick cash.   While the businesses may be legitimate, they sometimes fold when saddled with the financial burden of paying high interest rates and hefty commissions to the marketing company.  When the cash strapped business ultimately folds, investors are left holding worthless paper.

 

Nationwide promissory note fraud has cost Americans hundreds of millions of hard-earned money.  This figure will undoubtedly rise as con artists become more creative with their schemes.  Because of this likelihood it is important to be alert to warning signs of possible promissory note fraud.

 

Be particularly cautious of notes that mature in nine months or less.   According to the National Association of Securities Deaers, short-term notes have been the source of most of the known fraudulent activity because they are sometimes exempt from state securities registration.  This lack of registration means that investors might not be entitled to normal remedies offered by securities laws.

 

As with all investments, be suspicious of above-market interest rates offered on any investment opportunity.  There is usually a greater risk of loss associated with investments that have to be sweetened with inflated rates of return.  Although the company behind the promissory note may appear to be legitimate, the unsecured nature of the investment and the high rates of return are clear red flags.  

 

A “prime note” offered by a relatively new company is another warning sign.  In the securities industry a company must have a long and proven track record to offer prime quality investments.  Investors should steer clear if the company offering the “prime note” is a start-up or new company.

 

Promissory note fraud is particularly painful, as it graphically represents not only a loss of an investment but also a broken promise.   Victims suffer the theft of money and the embarrassment of being taken advantage of by a schemer.  The advice offered in this and previous columns is intended to help you avoid such scams by acting as a watchdog for your hard earned money.