Anyone who has experienced an email account intrusion or “hacking” knows how frustrating it can be to deal with the aftermath—from telling friends in milder cases that you didn’t send the flurry of bogus emails they received to regaining access to a blocked account. In the most serious cases, a compromised email account can lead not only to identity theft, but also to theft of your money. That’s why one of the most important first steps you should take if your email account has been hacked is to notify your brokerage firm and other financial institutions.

FINRA has received an increasing number of reports involving investor funds being stolen by fraudsters who first gain access to the investor’s email account and then email instructions to the firm to transfer money out of the brokerage account. In addition to issuing a Regulatory Notice to firms, we are issuing this Alert to warn investors about the potential financial consequences of a compromised email account and to provide tips for safeguarding your assets.

How Cons Use Compromised Email Accounts to Wire Money Out of Accounts

The Federal Bureau of Investigation (FBI), Financial Services Information Sharing and Analysis Center (FS-ISAC) and Internet Crime Complaint Center (I3C) recently issued a joint fraud alert describing a similar trend in which hacked email accounts are being used to facilitate wire transfers. These frauds tend to follow a typical pattern. For example, in some of the instances FINRA has seen, the perpetrators appear to have obtained the investor’s brokerage information by accessing the investor’s email account and searching contact lists or emails in the “sent” folder. The fraudster then typically sends an email to the investor’s broker or brokerage firm (using the investor’s personal email account) with instructions to wire funds to a third-party account, often overseas. The instructions may be accompanied or followed by a fraudulent letter of authorization, which also is emailed from the compromised email account.

In some instances, firms have released funds after unsuccessfully attempting to verify emailed instructions by phone. In at least one case, the fraudulent email stressed the urgency of the requested transfer, pressuring the brokerage firm to release the funds before verifying the authenticity of the emailed instructions. As the FBI/FS-ISAC/I3C alert notes, these fraudsters can be quite creative and persuasive with their excuses, fabricating tales of woe involving a death in the family or some grave illness that keeps the investor from contacting the firm via phone or whatever channels the investor ordinarily uses, while seeking the expedited transfer of assets.

How to Spot a Hack Job

Tell-tale signs that you’ve been the victim of an email account intrusion include reports of spam from people in your “contacts” folder or a slew of “bounced” email messages from people you don’t know. You might find that your password or other account settings have been changed—or that your email provider has blocked you from accessing your account. For information on staying safe online, visit the Federal Trade Commission’s Identity Theft and Data Security website as well as I3C at ic3.gov.

What to Do if Your Email Account Gets Hacked

If your email account gets hacked—or if for any reason you think that your personal financial information has been stolen—immediately contact your brokerage firm and other financial institutions, including credit card issuers, to notify them of the problem. You should also notify the credit bureaus to put a fraud alert on your file.

Check your brokerage account for unauthorized transactions—especially withdrawals or wire transfers to an account that is not yours—and ask the firm to investigate if you find any. It will take time to determine what happened, and the firm will likely need your help in identifying anyone who might have access to your account.

In the meantime, be sure to change your username, password and PIN for your financial accounts—and also change your password to your email account. For additional tips on staying safe online, read our alert, Keeping Your Account Secure: Tips for Protecting Your Financial Information. One of the best defenses against hacking is having a subscription to antivirus software that is installed, active and kept up to date.

Tough economic times have taken a toll on many Americans over the last couple of years. But making sound financial decisions and saving for the future can help you weather financial storms. The start of a new year is a great time to take stock of your finances, so the FINRA Investor Education Foundation has put together these 12 practical tips that can help keep your finances on course in 2012.

1. Start a Rainy Day Fund. Set aside at least one month of your current salary (and work your way up to three months) in a federally insured savings account. This will give you a cushion to handle medical bills, a short job loss, a surprise car repair or other financial emergency—and help keep your finances under control. 
2. Handle Credit Cards With Care. Keep your credit card spending in check and try to pay your credit cards in full. If you have accumulated holiday debt, pay it off as quickly as possible. If you cannot pay your whole monthly bill, at least pay more than the minimum due. Every dollar you pay above the minimum payment can reduce the amount of interest you will pay. Getting a handle on monthly bills and expenses can help keep you from overusing credit cards. Resources at SaveandInvest.org can help you track your spending. 
3. Check Your Credit Report and Score. Good credit and financial fitness go hand in hand. Start the new year by requesting a copy of your free credit report. Call (877) 322-8228 or visit www.AnnualCreditReport.com. Check to be sure your credit history is accurate and correct any discrepancies immediately. You can also request your score from the site. There will likely be a fee to obtain your score—but it’s an important number to know, since it’s what lenders use to help them decide not only whether you get a mortgage, a credit card or some other line of credit but also the interest rate you are charged for this credit. To learn more, read How Your Credit Score Impacts Your Financial Future. 
4. Shop Around For Financial Products. Comparison shopping for financial products—including credit cards, loans and investments—is as crucial as shopping around for a television or phone plan. FINRA has resources to help you evaluate and compare credit cards, bank fees and loan rates. Saving even a percentage point or two on a loan can make a big difference to your bottom line. And when it comes to investments, be sure to visit FINRA Market Data Center, and use FINRA’s Fund Analyzer to compare fees on mutual funds and exchange traded funds. 
5. Don’t Leave Money on the Table: Contribute to Your 401(k). Too many workers leave free money on the table by not contributing enough to their 401(k) to receive their full employer match. According to a recent study, nearly 3 in 10 workers (29.4 percent)—and 43 percent of workers age 20 – 29—fail to contribute to the full extent of their employer’s match. Here’s another way of looking at it—taking full advantage of the match literally doubles your savings, even assuming no increase in the value of your investments. For more information, read FINRA’s Investor Alert, Why Leave Money on the Table—Make the Most of Your Employer’s 401(k) Match. 
6. Avoid Payday Loans and Other Money Drains. During difficult economic conditions, some Americans might be more tempted to use alternative forms of borrowing, including auto title or payday loans, advances on tax refunds, pawn shops or rent-to-own plans. Steer clear, since these borrowing methods are likely to levy higher interest rates than those charged by banks, credit unions or credit card companies and can drain away your money. 
7. Don’t Overdraw Your Checking Account or Debit Card. Making ends meet during an economic downturn can put a strain on family budgets. While overdraft protection may seem like a helpful feature on a checking account or debit card, overdraft fees can add up. To avoid that expense, balance your checkbook regularly and consider opting out of programs that automatically approve ATM and debit card transactions. 
8. Do a Background Check on Your Financial Professional. Far too few investors have reported checking the background of their investment professional with a state or federal regulator. Investing a few minutes of your time to take this free and easy step could save you time, money and other trouble down the road. FINRA BrokerCheck^® is a free tool that allows investors to check the professional background of brokerage firms and individual brokers. 
9. Keep Your Insurance Coverage Current. The start of a new year is a good time to assess whether your insurance coverage aligns with your needs. You want to make sure that recent life changes have not left you under- or over-insured. If your children have left the home and you have paid off your house, you might need less life insurance than someone who is financially responsible for others, or has a mortgage. 
10. Diversify Your Investments. Volatile markets can make investing a challenge, but spreading your investments both among different asset classes—meaning stocks, bonds and cash—and within each asset class can reduce your risk. For more on risk and smart diversification strategies, read FINRA’s Managing Investment Risk. 
11. Save for College Using Tax-Advantaged Accounts. If you have children, save for college using tax-advantaged savings accounts such as a 529 plan or Coverdell Education Savings Account. The FINRA Foundation’s state-by-state survey found that less than one-third (only 31 percent) of respondents with financially dependent children have money set aside for college. Of those who are saving for college, less than one-third reported having used a tax-advantaged savings account. The earlier you start—the more financially prepared you will be to cover the rising costs of higher education. Compare college savings options, analyze 529 plan expenses and more at FINRA’s Smart Saving for College resource center. 
12. Find Free, Reliable Financial Education Resources in Your Community. In communities across the country, the FINRA Foundation’s partnerships with organizations like the American Library Association and United Way Worldwide have made it easier to find the help you need to keep your finances on track. The Foundation’s grant-making programs have built a network of hundreds of partnerships with libraries, social service organizations, schools, universities and others to expand access to research-based financial and investor education information. For additional information and resources, visit Smart Investing@Your Library and Financial Education in Your Community.

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

As reported by FINRA.org on November 10, 2011.

Would you turn down free money? Many employers match an employee’s 401(k) contributions up to a certain percent of salary. If you contribute less than your employer is willing to match, you may be passing up free money.

According to a recent report,¹ 29.4 percent of 401(k) participants do not contribute enough to their 401(k) to receive their full employer match—with higher rates of foregone matches seen among younger workers age 20 to 29 (43 percent) and those automatically enrolled into an employer-sponsored defined contribution plan (41 percent). An earlier report showed that 40 percent of employees making less than $40,000 fall short of contributing the full extent of their employer’s match.² Millions of workers are leaving money—free money—on the table.

FINRA is issuing this alert to educate investors about the substantial boost to their retirement savings that can come from taking full advantage of an employer’s matching contribution. As more and more companies reinstate matches that were cut or eliminated during the economic downturn, workers whose companies offer a match should make the most of it.

The Value of a Corporate Match

A 401(k) or similar employer-sponsored retirement plan can be a powerful resource for building a secure retirement—and an employer match can add a substantial amount to an employee’s nest egg. Let’s assume you are 30 years old, make $40,000 and contribute 3 percent of your salary ($1,200) to your 401(k). And, for the sake of this example, let’s also assume you continue to make the same salary and same contribution each year until you are 65. After 35 years, you will have contributed $42,000 to your 401(k).

Now let’s assume you get a match from your employer. One of the most common matches is a dollar-for-dollar match up to 3 percent of the employee’s salary. Taking full advantage of the match literally doubles your savings, even assuming no increase in the value of your investments: Instead of having set aside $42,000 by the time you retire, you will have set aside $84,000.

That’s $42,000 in free money. Looked at another way, it’s a no-cost way for you to increase your contributions by 100 percent.

Tax Advantages

In addition to offering the potential for free money through a match, employer-sponsored retirement plans can give you significant tax advantages. With a traditional 401(k), for instance, your contributions are made with pre-tax dollars—meaning the money goes into your retirement account before it gets taxed. In addition, your contributions, any match your employer provides and any earnings in the account (including interest, dividends and capital gains) are all tax-deferred. That means you don’t owe any income tax until you withdraw from your account, typically after you retire.

With pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year. But your take-home pay will go down by less than a dollar. Here’s how that works. Building on the example above, the $1,200 you contribute to a traditional 401(k) lowers your federal income tax bill for the year because you owe taxes on only $38,800 rather than $40,000. If you’re single, your total federal tax bill using the 2010 IRS tax rate schedule is $5,881.25 instead of $6,181.25—a tax savings of $300. And, for those in the 25 percent tax bracket, $1,200 in pre-tax dollars equals $900 in post-tax dollars—so the “cost” of your contribution measured as the impact on your paycheck might be less than you expected.

Matches and Roth 401(k)s

A growing number of employers offer a Roth 401(k) option, where employees make contributions with after-tax money—and neither the contributions nor any earnings they generate are taxed down the road when the money is withdrawn. While employers can match Roth-directed contributions, IRS rules require that all matched funds reside in a pre-tax account, just like employer-contributed matching funds in a traditional 401(k) account. As a consequence of this rule, the matching funds your employer contributes to your Roth 401(k) (and any earnings on those funds) will be taxed as ordinary income when you withdraw them. If you contribute to both a Roth and a traditional 401(k), the match is applied first to the traditional 401(k) amount and then, if necessary, to any Roth-directed funds.

Key Points to Remember

Not all employers provide matches—so if you are uncertain, ask your company’s human resources or benefits department. It’s also a good idea to find out what the maximum percent of salary your company will match.

Also be aware that even contributing at the match threshold may not be enough to fund a secure retirement. Most investment professionals recommend a savings level of 10 percent or more to generate enough replacement income during retirement to maintain your standard of living—and to start saving at this level as soon as you begin working.

The bottom line is that it makes no sense to pass up free money. A company match:

• Works out to a 100 percent increase in the amount of money you set aside each year that is matched, without incurring any risk—and remember you can, and probably should, contribute more than the match threshold.
• Offers the potential for tax-deferred compounding of that larger sum over time—specifically, your contributions plus the amount of the company’s match. 
• Reduces the risk of falling short of the savings necessary to fund a secure retirement.

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

Turbulence in the stock market and an extended period of low interest rates have contributed to investors seeking products offering attractive yields. One such product is the publicly registered non-exchange traded real estate investment trust (REIT) or “non-traded REIT” for short. While non-traded REITs and exchange-traded REITs share many features in common, they differ in several key respects. Most significantly, as the name implies, shares of non-traded REITs do not trade on a national securities exchange. For this reason, non-traded REITs are generally illiquid, often for periods of eight years or more. Early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. Furthermore, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal. This is in contrast to the dividends investors receive from large corporations that trade on national exchanges, which are typically derived solely from earnings.

FINRA is issuing this alert to inform investors of the features and risks of publicly registered non-exchange traded REITs. If you are considering a publicly registered non-exchange traded REIT, be prepared to ask questions about the benefits, risks, features and fees.

What Is a REIT?

A real estate investment trust, or REIT, is a corporation, trust or association that owns (and might also manage) income-producing real estate. REITs pool the capital of numerous investors to purchase a portfolio of properties—from office buildings and shopping centers to hotels and apartments, even timber-producing land—which the typical investor might not otherwise be able to purchase individually.

REITs can offer tax advantages. For instance, qualified REITs that meet Internal Revenue Service requirements can deduct distributions paid to shareholders from corporate taxable income, avoiding double taxation. The REIT must also distribute at least 90 percent of its taxable income to shareholders annually. These distributions are taxable to the extent of any ordinary income and capital gains included in the distribution. 

There are two types of public REITS: those that trade on a national securities exchange and those that do not. REITs in this latter category are generally referred to as publicly registered non-exchange traded, or simply non-traded REITS, which are the focus of this alert.

Features of Non-Traded REITs

Like exchange-traded REITs, non-traded REITs invest in real estate. They are also subject to the same IRS requirements that an exchange-traded REIT must meet, including distributing at least 90 percent of taxable income to shareholders. Like exchange-traded REITS, non-traded REITs are registered with the Securities and Exchange Commission and are required to make regular SEC disclosures, including filing a prospectus and quarterly (10-Q) and annual reports (10-K), all of which are publicly available through the SEC’s EDGAR database. While these two types of REITs share these similarities, there are also numerous differences between them, as illustrated in the chart below.

*Broker-dealers involved in the sale of these products to investors are required to provide valuations within 18 months after cessation of a non-traded REIT’s offering of shares, and they must comply with FINRA Rule 2340 and FINRA’s Notice to Members (09-09) regarding timeliness of data supporting account statement valuations. Non- traded REITS must also provide annual valuation guidance for ERISA custodians to comply with IRS and Department of Labor rules. 

Private REITs
There is another type of REIT—a private REIT, or private-placement REIT—that also does not trade on an exchange. Private REITS carry significant risk to investors. Not only are they unlisted, making them hard to value and trade, but they also generally are exempt from Securities Act registration. As such, private REITs are not subject to the same disclosure requirements as public non-traded REITs. The lack of disclosure documents makes it extremely difficult for investors to make an informed decision about the investment. Private REITS generally can be sold only to accredited investors, for instance those with a net worth in excess of $1 million. As with any private investment, it is a good idea to have the investment reviewed by an investment professional who understands the product and can offer impartial advice.

Complexities and Risks

When it comes to investing in non-traded REITs, selling points such as the opportunity for capital appreciation, diversification and the allure of a robust distribution can be enticing. But investors should balance these selling points against the numerous complexities and risks these investments carry. 

• Distributions are not guaranteed and may exceed operating cash flow. Deciding whether to pay distributions and the amount of any distribution is within discretion of a REIT’s Board of Directors in the exercise of its fiduciary duties. Distributions can be suspended for a period of time or halted altogether. Many factors may influence the composition of these payments. For example, in newer programs, distributions may be funded in part or entirely by cash from investor capital or borrowings—leveraged money that does not come from income generated by the real estate itself, such as rents or hotel occupancy fees. The REIT’s articles of incorporation often allow it to increase debt, dip into cash reserves and apply proceeds of the sale of new shares to sustain or even increase distributions. Some REITS even allow borrowing in excess of 100 percent of net assets. Leveraging, including the use of borrowed funds to pay distributions, can place the REIT at greater risk of default and devaluation, which can result in investment losses when it comes time to redeem or liquidate shares, as well as a reduction in, or suspension of, distributions.  
  • Tip: Understand the REIT’s borrowing policies, outlined in the prospectus, and use the SEC’s EDGAR database of company filings to research how heavily leveraged the REIT may be, as well as how it is financing distributions. If Net Cash from Operations (what the company earns through its real estate alone) is less than the distribution (usually found in the Financing Activities section), then other sources, including borrowed funds, may be supporting the distribution. Before investing, be sure to ask the person offering the investment how much the REIT may have borrowed and whether the distributions include, or are likely to include, a return of principal. Ask how these factors might impact your investment. Keep these same factors in mind when deciding whether or not to reinvest distributions.

• Distributions and REIT status carry tax consequences. Distributions for all REITS that are from current or accumulated earnings and profits are taxed as ordinary income, as opposed to the tax rate on qualified dividends, which generally carries a maximum tax rate of 15 percent (0 percent for people whose other income is taxed at a rate of 10 or 15 percent). If a portion of your distribution constitutes a return of capital, that portion is not taxed until your investment is sold or liquidated, at which time you will be taxed at capital gains rates.  
  • Tip: Take steps to obtain an understanding of the tax consequences associated with this investment. Consider speaking with a tax advisor prior to inve sting and on an ongoing basis.

• Lack of a public trading market creates illiquidity and valuation complexities. As their name implies, non-traded REITs have no public trading market. However, most non-traded REITS are structured as a “finite life investment,” meaning that at the end of a given timeframe, the REIT is required either to list on a national securities exchange or liquidate. Even if a liquidity event takes place, there is no guarantee that the value of your investment will have gone up—and it may go down or lose all its value. Indeed, valuation of non-traded REITS is complex. Many factors affect the pricing, including the portfolio of real estate assets owned, strength of the trust’s balance sheet (assets versus liabilities), overhead expenses, cost of capital and more. The boards and managers of non-traded REITs might even rely on third-party sources to estimate a per-share value.  
  • Tip: Ask your financial professional to explain the risk of illiquidity. Review the Risks section of the prospectus to find out more about the investment’s expected holding period and potential liquidity events. Also ask if the offering has concluded—and, if not, when it is expected to conclude. Check your brokerage statements or with your financial professional to see if there has been a fluctuation in the per-share price. Whether the value fluctuated or not, ask the brokerage firm how—and how recently—the share price was valued.  
  • Advisory: If the value of the REIT’s portfolio has changed materially during the offering period, then new investors may be paying a per-share price above or below the per-share net value of the underlying real estate.

• Early redemption is often restrictive and may be expensive. Most public non-traded REIT offerings place limits on the amount of shares that can be redeemed prior to liquidation. Redemption provisions can be as restrictive as 5—or even 3—percent of the weighted average number of shares outstanding during the previous year. In addition, shares may have to be held for some period, typically one year, before they can be redeemed. Redemption programs may be terminated or adjusted, so investors should not count on them, even as an emergency exit strategy. While a redemption program may allow you to sell your shares prior to a liquidity event, the redemption price is generally lower than the purchase price, sometimes by as much as 10 percent.  
  • Tip: When investing in non-traded REITs investors must consider their short-term needs for capital before investing in a long-term, illiquid security and should carefully review the section explaining the terms and limitations of the REIT’s share redemption plan.  
  • Advisory: Investors may be solicited to sell a stake in their non-traded REIT investment outside of the sponsor’s redemption program through a process known as a “mini-tender offer.” Mini-tender offers are offers for less than 5 percent of a company’s stock, and they typically carry far fewer protections to investors than traditional tender offers. For instance, there is no requirement to identify who the buyer is, provide disclosures to the SEC or provide competing bids. Investors can wind up receiving a price well below the sponsor’s estimated per-share value or, if available, the early-redemption program price. For more information, see the SEC’s information on Mini-Tender Offers.

• Fees can add up. Non-traded REITs can be expensive. Front-end fees generally come in two parts:  
  1. Selling compensation and expenses, which cannot exceed 10 percent of the investment amount; and
  2. Additional offering and organizational costs, sometimes referred to as “issuer costs,” which are also paid from the offering proceeds.
  3. According to state regulatory guidelines, the total for both types of fees cannot exceed 15 percent.  FINRA guidelines also limit the total for both types of fees to 15 percent in offerings that are sold by an affiliated broker-dealer. All investments carry fees, and they add up, reducing the amount of capital available for investment. For example, a 15 percent front-end fee on a $10,000 investment means that $8,500 is going to work for you at the time of investment. By comparison, the underwriting compensation associated with exchange-traded REITS is normally seven percent of the offering proceeds. 
     • Tip: Non-traded REITs are rarely, if ever, suitable for short-term investors and even long-term investors must be willing to bear the risks of illiquidity. You should consider the front-end cost relative to the sales costs you would incur to buy and sell other securities during the same holding period as the life of the REIT. You may also want to consider how much share price appreciation and distributions you will need to receive to overcome these front-end charges.

• Properties may not be specified. Most non-traded REITS start out as blind pools, which have not yet specified the properties to be purchased. Others may specify a portion of the properties the REIT plans to acquire, or they may be in various stages of acquisition. In general, the more properties that have been specified for purchase or that have actually been acquired the less risk an investor incurs because the investor has the opportunity to assess the nature and quality of the assets of the REIT before investing.
  • Tip: Ask what percentage of a non-traded REIT’s properties have been specified for acquisition or actually acquired.

• Diversification can be limited. While REITs as an investment class may help diversify your portfolio, putting all of your intended real estate investment in one REIT—including investments in different issuances or phases of the same REIT—can expose you to the risk of underdiversification.
  • Tip: Review the offering document relating to the REIT’s investment policies to evaluate the intended diversification of the REIT’s portfolio. Read ongoing disclosure documents to track how well the REIT is executing its business plan. As with any investment, avoid putting all your eggs in one basket.

• Remember Real Estate Risk. There are risks associated with both the real estate market as a whole and any specific subset of the real estate market on which a particular REIT concentrates.
  • Tip: Understand risks associated with the types of properties the REIT holds (for instance, hotels have a different set of risks than shopping malls), the geographical area it concentrates in and the strategies the REIT uses, including leveraging to acquire assets. Have an in-depth discussion with your financial professional about risks and carefully read the prospectus.

Before You Invest

Be wary of pitches or sales literature offering simplistic reasons to buy a REIT investment. Sales pitches might play up high yields and stability while glossing over the product’s lack of liquidity, fees and other risks. Ask whoever is recommending that you purchase a REIT how much they (and their company) are receiving in selling commissions or other fees. Also ask them to explain why they think the REIT is the right investment for you and how will it help you achieve your specific investment objectives and goals.¹

Always ask to review the initial prospectus and any prospectus supplements, as these documents will contain a more extensive and balanced discussion of the risks involved than any sales material you receive or pitches you hear. You can obtain a prospectus by going to the SEC’s EDGAR database of company filings and typing in the name of the REIT, then search for entries titled “Prospectus.” Remember that the fact that a company has registered its securities or has filed reports with the SEC does not mean that it will be a good investment—or that it will be right for you.

Ask about fees associated with the product. Also ask how the distribution is being funded and whether a portion of that distribution is comprised of a return of investor capital. Make sure you understand that you will be locking up your investment, with only limited avenues for redemption. If the REIT offers a share redemption program, make sure you understand how the repurchase price for your shares will be determined and, most importantly, the limitations of the plan. Review with your financial professional the risks associated with real estate investment and evaluate other products that could meet your investment objectives (investment income, for instance). Understand the various liquidity events specific to the REIT you are considering.

Remember to only invest if you are confident the product can help you meet your investment objectives and you are comfortable with the associated risks. 

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

The price of gold bullion—which recently touched an all-time high—has sparked considerable interest in gold investing, not to mention aggressive marketing and advertising of gold investments, including gold stocks. And even a cursory Internet search will pull up numerous websites, blog posts, investment newsletters and social media posts (including YouTube videos and Tweets) devoted to the topic of investing in gold. 

But some of the stocks and opportunities being promoted have precious little value, and others are outright frauds. This spring, for example, the Commodity Futures Trading Commission (CFTC) took three separate actions against precious metals firms engaged in various schemes involving investments in gold, silver and other precious metals. In one action, the CFTC charged a precious metals firm in Florida with running a boiler room fraud that bilked investors out of more than $23 million.

As with other commodities, there are prudent and not-so-prudent ways to invest in gold. We are issuing this Alert to warn investors about investment scams that promote the latest “hot” gold stock and to provide information on how to invest wisely in gold.

Spotting “Gold” Stock Scams

Many gold-related investment scams involve the stocks of gold mining and/or exploration companies. The stock value is often based on gold reserves that are difficult to estimate, much less verify. While stock promoters regularly cite the potential value of a gold reserve, some statements can be deliberately misleading. For example, in 2010, the Securities and Exchange Commission (SEC) took legal action against a mining company based in Florida for false press releases and other misleading statements associated, in part, with a mining project in Ecuador. The releases claimed the gold reserves were worth more than $1 billion. The SEC noted that the exact value of those reserves could not be known “without further detailed exploration.”  

Warning signs related to gold stocks include:

• Price targets or predictions of swift and exponential growth. These predictions often are based on gold reserves, the actual existence and true size of which are next to impossible to verify. A company recently claimed that its mine in Nevada contained “approximately 2.14 million ounces of gold equivalent resources,” with an estimated market value of over $2 billion. Based on these reserves, the company touted in one of its promotions that an investment “Could turn $10,000 into $384,600.” 
• References to being a “buyout target” for other mining companies. One company claiming gold reserves valued at more than $112 billion declared in an Internet promotion that it was a “PRIME BUYOUT TARGET” at a buyout price that was 15 to 35 times its current value, which was around a dollar. 
• Claims that tie stock performance to the general rise in gold prices. Stock prices tend to rise or fall for a host of reasons, such as overall market conditions, sector performance and an individual company’s earnings. A rise in gold prices does not guarantee a rise in the price of a gold company’s stock—there might be little or no correlation between these two things. 
• Scare tactics such as the threat of inflation or an economic meltdown. While some investors might hold gold as a hedge against inflation or economic uncertainty, owning a gold stock does not automatically serve that same function. Scare tactics are often used to push an investor to make a quick decision. 
• Speculative claims based on a new reserve’s proximity to an existing reserve.  A company recently stated in one of its promotional materials that its mining property could be worth “billions in unrecovered gold” based “on the success of its neighbors.” Without more information, such an assertion amounts to little more than idle speculation. 
• A change in the company’s name or trading symbol to align it more closely with gold. One company that currently purports to engage in gold mining and exploration was originally incorporated with a business strategy to provide golfing opportunities on private courses to nonmembers.  Another’s original focus was to establish health spas in urban areas. Yet another cited its original business plan was to develop, manufacture and sell commercial feed to nurture the Chinese mitten-handed crab. Name changes are reported through SEC Form 8-K, which you can find by using the SEC’s EDGAR database.

Fool’s Gold for Lunch

Be wary of “free lunch” programs that purport to provide educational information about gold investing. In June 2010, the SEC charged six individuals with running a Ponzi scheme that bilked more than 3,000 investors out of $300 million. The fraudsters, none of whom were registered to sell securities, claimed to represent an independent financial education firm that had discovered a way to earn up to 36 percent annual returns by investing in mining investments that were “fully collateralized by gold.” Rather than invest the money, the firm’s salesmen used the assets on lavish home renovations, mortgage payments for members of their extended family and the purchase of a luxury fishing resort in South America.

In addition, be mindful of warning signs common to many stock scams:

• Claims that making profits in gold are “easy.” 
• The use of headlines from respected financial news sources regarding gold, which can easily be taken out of context. 
• Mention of the names of major investors or investment institutions that provide an air of credibility. 
• Statements about how much easier it is for lower-priced stocks to skyrocket in value in comparison to higher-priced stocks. 
• Pressure to invest immediately. 

Smart Tips

To avoid potential gold stock scams:

• Investigate before you invest. Never rely solely on information you receive in an unsolicited fax or email. It’s easy for companies or their promoters to make exaggerated claims about new products, lucrative contracts, or the company’s revenue, profits, or future stock price. Be wary of claims about significant mineral reserves or mining operations in countries far removed from the U.S. that make it difficult to verify such claims through independent research. 
• Always ask: “Why me?” Why would a total stranger tell you about a really great investment opportunity? The answer is that there is no such opportunity. In many email, fax and online scams, those who tout the stock are corporate insiders, paid promoters or substantial shareholders who stand to profit handsomely if the company’s stock price goes up. 
• Read a company’s SEC filings, if available. Most public companies file reports with the SEC. Check the SEC’s EDGAR database to find out whether the company files with the SEC. Read the reports and verify any information you have heard about the company. But remember that just because a company has registered its securities or has filed reports with the SEC, it doesn’t mean that it will be a good investment. 

Alternatives to Gold Stocks

While you may be tempted to invest in a single stock, it is very risky to put all your “golden eggs” in one basket. Investing through a mutual fund or exchange traded fund (ETF) that focuses on gold companies or gold itself can help spread out and potentially lower your risk. Take the time to research fees and other expenses. Review the underlying securities that make up a given fund. You can do so by going to the issuer’s website, reviewing the latest quarterly report showing the fund’s major holdings or, in the case of an ETF, the exchange on which the ETF trades. Research the fund’s manager or management team and read the prospectus carefully, and consider enlisting the help of an investment professional before you invest.

If you are considering a mutual fund that focuses on gold, be aware that most gold mutual funds primarily hold mining stocks, many of which are international, but some hold physical gold, as well. Mutual funds do not allow investors to take possession of physical gold.

If you are considering investing in an ETF that focuses on gold, understand its structure, including whether it uses futures strategies—and whether or not it holds the physical gold, invests in gold futures contracts or tracks a gold-related index. Be aware that ETFs that are backed by physical gold are not the same thing as a direct investment in gold. While some ETFs that are backed by physical gold allow individual investors to redeem shares for bullion, the ones that do may only allow physical redemptions under certain limited circumstances. So while they may be effective at offering exposure to gold prices, most are not an efficient way to obtain an ownership interest in physical gold. Therefore, if you are investing in a physical gold ETF, make sure you understand your redemption rights. Depending on its legal structure, a gold commodity ETF can be subject to varying tax treatments. Be sure to check with your tax advisor about the consequences of investing in a gold commodity ETF.  

If you are thinking about investing directly in bullion or gold coins, similarly research your options. For a basic how-to overview, questions to ask and additional resources, read the Federal Trade Commission’s Investing in Bullion and Bullion Coins.  Investors should be aware that while some gold promoters and dealers deliver what they promise, others don’t. Also, verify that a ready market exists to liquidate personal holdings of bullion and coins at current market prices and the related transaction costs. 

Finally, be advised that while legitimate gold and ETF investments may be an acceptable diversification strategy, these investments can be quite volatile. A heavy concentration of gold investments can leave you overly exposed and at risk of losing a substantial percentage of your money.

Touts and outright scams come in many forms and involve many types of investments. Right now, you would do well to avoid unsolicited promotions of low-cost “gold” stocks. They are likely to mine a hole in your pocketbook. 

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

As reported by FINRA.org.

Investors currently find themselves in a difficult investing environment. Yields on fixed-income investments are at historically low levels, and stock returns have been quite volatile. What’s an investor to do? Some investors are “chasing return,” meaning they are putting their assets into riskier and sometimes esoteric products that promise higher yields and returns than they can obtain in more traditional investments.

A number of investment products that may be appealing to investors interested in increasing their return have seen significant inflows as of late. For example, high-yield bond funds had $75 billion in new sales in 2010, and floating-rate loan funds grew from $15 billion in 2008 to $60 billion as of April 2011, a fourfold increase. Similarly, sales of structured retail products in 2010 rose by 38 percent over 2009, from roughly $33 to $54 billion¹.

FINRA is issuing this alert because investors may not realize that they could be taking on more risk if they invest in products with higher returns. This alert discusses different ways investors are trying to increase their return—ranging from easily understood investments like high-yield bonds to complex vehicles like structured products and floating-rate loan funds.  More importantly, this alert serves to remind investors that when they invest in products that promise higher returns they are nearly always taking on more risk.

A Challenging Environment

Investors face a challenging environment. Not only have monthly stock market returns been more volatile since the 2008 market drop than they were before, but investors have experienced two significant bear markets over the last decade. And yields on many fixed-income investments are at historically low levels. For example, the yield on a 10-year U.S. Treasury Bill is currently about 3 percent, a level last seen in the 1950s. Thirty years ago, yields on T-bills were nearly five times as high as they are currently.

This combination of low interest rates, stock price volatility and multiple bear markets has sent many investors looking for higher and more consistent returns. However, before moving your assets to another investment, there are several questions you should ask.

Questions to Ask Before Changing Investments

• Does the higher return from the investment come with increased risk? Invariably the answer is yes. The relationship between risk and return in the investment world is quite robust. The promise of higher return is almost always associated with greater risk and an increased possibility of investment losses. 
• Do you understand how the investment operates?  The quest for higher return could lead you to very complex investments, a sampling of which we describe below. If you do not fully understand how your investments function, you could find yourself surprised by outcomes you didn’t expect, such as illiquidity, exit fees, loss of principal or the return of your investment in a form other than cash. 
• What are the costs and fees associated with the new investment? Not only is the promise of higher return associated with greater risk, but some of these investments have higher costs as well. For example, hedge funds and structured products can be very costly, and since some of the costs are built into their return, it can be difficult to know what you are truly paying. 
• Is the product callable? Some investments are callable after a period of time, which means that the issuer can redeem the investment prior to the investment reaching maturity. For example, if interest rates fall, the issuer can save money by buying back an investment from you and issuing a new investment at a lower interest rate. If the issuer chooses to call the investment and you want to reinvest, you may find it difficult or impossible to find an equivalent investment paying rates as high as the original rate, a phenomenon known as reinvestment risk. 
• Could the new investment be fraudulent? Legitimate investments that promise returns of 30, 50 or even 100 percent per year without any risk to your principal simply do not exist. Always independently verify who you are dealing with and whether the seller of the investment is licensed to do business with you. You can confirm the status of an individual broker or firm using FINRA’s BrokerCheck, and you can check on the status of an investment adviser or firm using the Investment Adviser Public Disclosure database. 

Increasing Return—A Multitude of Choices

There are many ways investors could try to increase their return, and below we have listed and briefly described a number of these approaches. Some of these products are easily understood while others are quite complex, and not all are appropriate or relevant for every investor. What they do have in common is that they are all products that you might encounter if you are looking for higher returning investments.

High-Yield Bonds

A common method of chasing return is to move from investment grade bonds to high-yield bonds. However, when investors seek more robust returns in high-yield bonds, they are not escaping the fundamental tenet of investing we alluded to earlier—that is, higher returns are associated with higher risk.

High-yield bonds are bonds with lower credit ratings and a higher risk of default. As a result, the bond issuer has to pay a more attractive interest rate to compensate the investor for the additional risk. High-yield bonds can make sense in many portfolios, but remember that the higher yield may come with the increased possibility that you could lose money on your investment. For more information on high-yield bonds, see FINRA’s Smart Bond Investing.

Investor Tip—Individual Bonds vs. Bond Funds

If you are trying to increase your yield by investing in a bond mutual fund or Exchange Traded Fund (ETF) as opposed to individual bonds, remember that the value of your investment is not only affected by prevailing interest rates, but also by the willingness of investors to remain in the fund. For example, in a rising equity market, other investors might choose to leave the bond fund and seek higher returns by purchasing equities. As a result, the fund manager could be forced to liquidate bonds at a loss in order to pay out departing investors, which could drive down the value of the fund. So, even though you may have no intention of selling your bond shares, the decision of other investors to sell their positions could impact your overall yield.

For more important information about the differences between holding individual bonds and investing in one or more bond funds, see FINRA’s Smart Bond Investing.

Floating-Rate Loan Funds

Floating-rate loan funds have garnered a significant share of assets and attention during the past year. These funds invest in loans extended by financial institutions to entities of below investment-grade credit quality. They are sometimes called “leveraged” loans because companies that are extended these high interest loans usually have a significant level of debt relative to equity. Funds that invest in floating-rate loans may be appealing products to investors seeking greater returns because, in order to compensate lenders for taking on additional credit risk, the loans’ yields tend to be higher than investment grade bonds.   

As their name implies, the interest rates on floating-rate loans adjust by a pre-determined spread over a reference rate, like the London Interbank Offered Rate (LIBOR). Funds that invest in floating-rate loans may be attractive in a low or rising interest rate environment because, in addition to having higher yields, the floating rate feature allows the fund’s interest rate to increase when rates rise. This is because the underlying interest rate on most floating-rate loans reset after a relatively short period of time, like 30, 60 or 90 days.

Unlike traditional fixed-income bonds, the market for floating-rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation and liquidity risk.

Structured Retail Products

Structured retail products are, generally speaking, unsecured debt with payoffs linked to a variety of underlying assets. These products can be attractive to investors because they can offer higher returns and might even feature a level of principal protection—meaning some or all of your initial investment may be guaranteed by the issuer if the investment is held to maturity or called, subject to the credit worthiness of the issuer. However, these products can have significant drawbacks such as credit risk, market risk, lack of liquidity and high hidden costs. In addition, they may be callable after a fairly shortperiod of time, like one year.

One example of a structured product is a “steepener,” which allows investors to bet on the shape of the yield curve. The return on this type of product is linked to the spread between longer- and shorter-term interest rates—that is, the so-called steepness of the curve. For example, the return on one widely available product increases when the yield curve steepens and decreases when the yield curve flattens. Steepeners can be appealing to investors chasing return because some of these products have initial fixed interest rates that are high, and these products are often principal protected, but they do have their drawbacks. The fixed rates often convert to floating rates that typically change in concert with the steepness of the yield curve, as described above, so your return can vary or fall over time. Moreover, they usually have longer maturities, the secondary market for these products may be illiquid and they are often callable.  

Another example is a structured note with principal protection. These investments typically offer full or partial principal protection and reflect the combination of a zero-coupon bond with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. Structured notes with principal protection have the potential to outperform the total interest payment that would be paid on typical fixed interest rate bonds, so they may be attractive to investors seeking higher yielding investments. However, these notes also might underperform a typical fixed interest rate bond and could earn no return for the entire term of the note, even if you are holding the note to maturity. For more information on see FINRA’s Structured Notes with Principal Protection: Note the Terms of Your Investment.

Leveraged Products

Another category of investments some investors turn to when looking to boost returns is leveraged products. Whether the investment vehicle is an ETF or a mutual fund, the approach is the same. Leveraged products seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives. “Inverse” leveraged products seek to deliver the opposite performance of the index or benchmark they track. For example, a leveraged ETF might seek to return two times the daily return of the S&P 500 while an Inverse ETF would seek to return minus two times the return of the index. So, if the S&P 500 returned 2 percent on a given day, the leveraged ETF would return 4 percent and the Inverse ETF would return -4 percent.

An important and sometimes misunderstood aspect of leveraged products is that they often “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time—over weeks or months or years—can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. That said, there are other versions of these products that have monthly resets or no resets, but they can also be difficult to understand. For more information on leveraged and inverse ETFs see FINRA’s Leveraged and Inversed ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.

Other Products

There are many ways investors can chase return. The list of products described above is aimed at introducing you to a range of investments—from straight-forward to complex—that might be used for this purpose, but it is not an exhaustive list. For example, other investments that can be used to boost returns include preferred stock, private equity, funds of hedge funds and reverse exchangeable securities—and the list goes on. Regardless of what investments you are interested in, it is important that you take time to understand them and the risks involved.

Fraudulent High-Yield Investments

All of the categories of investments discussed to this point are legitimate investments that hold the possibility of higher return—and, as an investor, you need to weigh the possibility of earning a higher return against the higher risk and costs often associated with them. However, investors looking for higher returning investments may also come across fraudulent investments, including high-yield investment programs (HYIPs).

HYIPs are unregistered investments created and touted by unlicensed individuals, and they, typically, dangle the contradictory promises of safety coupled with very high, unsustainable rates of return. For more information about High-Yield Investment Programs and how to avoid falling prey to them, check out FINRA’s Investor Alert entitled HYIPs—High Yield Investment Programs Are Hazardous to Your Investment Portfolio.

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

Employers are getting out of the retirement insurance business. This could be worrisome for American workers who want to retire, before hitting the Medicare-eligible age of 65.

A majority of large employers today offer some form of retiree insurance — both to early retirees and to retired workers who are Medicare eligible.

As reported by FINRA.org

The retail market for structured notes with principal protection has been growing in recent years. While these products often have reassuring names that include some variant of “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms, they are not risk-free. Any promise to repay some or all of the money you invest will depend on the creditworthiness of the issuer of the note—meaning you could lose all of your money if the issuer of your note goes bankrupt. Also, some of these products have conditions to the protection or offer only partial protection, so you could lose principal even if the issuer does not go bankrupt. And you typically will receive principal protection from the issuer only if you hold your note until maturity. If you need to cash out your note before maturity, you should be aware that this might not be possible if no secondary market to sell your note exists and the issuer refuses to redeem it. Even where a secondary market exists, the note may be quite illiquid and you could receive substantially less than your purchase price.  

While structured notes with principal protection have the potential to outperform the total interest payment that would be paid on typical fixed interest rate bonds, these notes also might underperform a typical fixed interest rate bond and could earn no return for the entire term of the note, even if you hold the note to maturity. Their terms and structures also can be more complex than traditional bonds, making them more difficult for investors to evaluate. Finally, as with structured products generally, structured notes with principal protection may have hidden or imputed costs that can be relatively high and difficult to understand.

FINRA and the SEC’s Office of Investor Education and Advocacy are issuing this alert to make investors aware of these risks and to help them better understand how structured notes with principal protection work. The alert includes questions investors should ask when considering structured notes with principal protection and provides links to helpful resources, including a recent FINRA Regulatory Notice on these products. In particular, the terms related to any protections to or guarantee of your principal require a careful review.

What Are Structured Notes With Principal Protection?

For the purposes of this alert, the term “structured note with principal protection” refers to any structured product that combines a bond with a derivative component—and that offers a full or partial return of principal at maturity. Structured products in general do not represent ownership of any portfolio of assets but rather are promises to pay made by the product issuers. Structured notes with principal protection typically reflect the combination of a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. The underlying asset, index or benchmark can vary widely from commonly cited market benchmarks to foreign equity indices, currencies, commodities, spreads between interest rates or “hybrid” baskets of various asset types. For example, a note might be based on the performance of an equally weighted basket composed of the Russell 2000, an exchange-traded fund tracking a real estate index, the Brazilian Real-U.S. Dollar exchange rate and the price of copper. These products are designed to return some or all principal at a set maturity date—typically ranging up to 10 years from issuance. The investor also is entitled to participate in a return that is linked to a specified change in the value of the underlying asset.

How Do These Notes Protect My Investment?

If you hold a structured note with principal protection until maturity, you typically will get back at least some—and perhaps all—of your initial investment, even if the underlying asset, index or benchmark declines. Be aware that protection levels may vary. While some products return 100 percent of principal at maturity, others return as little as 10 percent. In some cases, the principal protection does not apply unless some contingency is met—sometimes called “contingent protection”—so it may provide no protection at all, even if the sales materials suggest otherwise. 

Also, any guarantee that your principal will be protected—whether in whole or in part—is only as good as the financial strength of the company that makes that promise. In other words, the principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. In the event the issuer goes bankrupt, investors who hold these notes are considered unsecured creditors and might recover little, if anything, of their original investment. This is what happened to investors who purchased structured notes with principal protection issued by now bankrupt Lehman Brothers Holdings.

How Do Structured Notes With Principal Protection Calculate the Return on My Investment?

Some structured notes with principal protection make periodic interest payments while others don’t. The return on your investment—over and above any principal guarantee and assuming you hold the note to maturity—will depend on a host of factors, including the method the issuer uses to calculate gains (or losses) linked to the performance of the underlying asset, index or benchmark (the “market-linked” returns), the note’s participation rate and any minimum guaranteed return.

Market-linked gains (or losses).  As with other complex financial products, there can be varying and often complicated methods of calculating a market-linked gain or loss. For example, one product might compare the change in an index at two discrete points in time, such as the beginning and ending dates of the note’s term (point-to-point). Another product might look at the index value at various points during the life of the investment, for example at annual anniversaries, and then compare the highest value with the value of the index level at the start of the term (high water mark). Some products base your return on the number of days during the holding period that the underlying index stayed above (or below) a pre-specified level (accrual)—or within a range of pre-specified levels (range). And still others use complex, conditional formulas that allow you to participate in some or all of the index’s gain up to a set level—but significantly limit your return if, at any time during the holding period, the index rises above that level (shark fin).

Participation rates.  A participation rate determines how much of the gain in the underlying asset, index or benchmark will be credited to the note. For example, if the participation rate is 75 percent, and the asset, index or benchmark increases 10 percent, then the return credited to your note would be 7.5 percent.   

Minimum guaranteed returns. If a structured note with principal protection offers a “minimum guaranteed return,” be sure to carefully read the prospectus to understand how the issuer defines that term. In some instances, the term includes not only the principal guarantee but also a fixed overall investment return. For example, a note with 100 percent return of principal at maturity and a 2 percent minimum guaranteed return would pay out 102 percent of your initial investment at maturity, regardless of how the underlying asset, index or benchmark performed. In other cases, however, an issuer might use the term to refer only to the level of principal protection.

The bottom line for investors is that structured notes with principal protection can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth. In addition, depending on how the note is structured, the distinct possibility exists that you could tie up your principal for upwards of a decade with the possibility of no profit on your initial investment. While your principal might be returned at maturity, that might be all you get back after this lengthy holding period—and, in the meantime, inflation could erode your purchasing power.

The chart below illustrates a hypothetical example of one of the more complex pay-out structures, sometimes referred to as a “shark fin” pay-out. 

Shark Fin Pay-Out Assumptions:

• Principal protection of 10 percent of initial investment
• 100 percent participation in index gains up to 40 percent, so the maximum return is 140 percent of principal
• Automatic 110 percent return at maturity if the index gains more than 40 percent at any time during the life of the note

In other words, the performance of the underlying asset impacts what the investor gets as follows:

As the shark fin hypothetical above demonstrates, a note might be structured in a way that your upside exposure to the underlying asset, index or benchmark is limited or capped, which is generally a tradeoff for offering the principal protection. Although it might seem counterintuitive, in the example above, a 40 percent gain in the underlying index results in the return of 140 percent of principal invested, while a 41 percent gain (achieved at any time) would automatically result in the return of only 110 percent at maturity. This shows why reading and understanding the terms of these notes is so important.

Can I Get My Money When I Need It?

Potential lack of liquidity is one of the disadvantages of structured notes with principal protection. These products tend to be longer-term investments, tying up your money for several years. Some issuers might allow investors to redeem their notes before maturity under certain circumstances, such as expiration of a “lock-up period” (a period of time during which you cannot access your funds), payment of a redemption fee or both. Other issuers might (but are not obligated to) provide a secondary market for certain notes. However, depending on demand, the notes might trade at significant discounts to their purchase price and might not return the full guaranteed amount. In addition, the value of the note before maturity might be difficult to calculate and can vary depending a wide array of factors (including prevailing interest rates and the volatility of the underlying asset, index or benchmark). You might also have to pay a penalty for early redemption, further reducing any return of your principal.

Be aware of call risk. Call risk refers to the possibility that the issuer could call or redeem your note before maturity. This generally happens when it is in the issuer’s—rather than the investor’s—best interest to do so, such as when interest rates fall. While the bond’s principal is repaid early, you might be unable to find a similar investment with as attractive a yield.

Do Structured Notes With Principal Protection Have Fees?

Yes, even if the sales materials suggest otherwise. Virtually every investment has either implicit or explicit fees, whether they are described as selling commissions or concessions, management fees, structuring fees, early redemption fees or by some other term.

What Other Costs or Tradeoffs Are Involved?

Depending on their terms and the way they are put together, structured notes with principal protection can have hidden or imputed costs, which in some cases may be relatively high. These stem from the way a product is “bundled” or “packaged.” At issuance, any given note will have an estimated fair value based on its structure. The issuer generally raises this value by a spread to arrive at the offering price of the product, which captures costs to the issuer associated with the note over its life, such as costs of hedging, as well as the issuer’s profit. The hidden costs of purchasing virtually any structured product include the possibility that you could have assembled a similar bundle of investments on your own at a lower cost—and potentially with higher returns. The maximum return of any particular structured note with principal protection will typically reflect (and account for) the issuer’s costs of manufacturing and maintaining the note as well as its own profit margin. These costs generally are not transparent to investors.

Other costs of investing in structured notes with principal protection include the opportunity cost involved with sacrificing a potentially higher yield to obtain some downside protection. It is also important to note that the principal protection generally relates to nominal principal and does not offer inflation protection. And, for any underlying investment that would ordinarily pay dividends, structured notes, like other equity or index-linked investments, typically exclude dividends.

How Are These Products Taxed?

In most cases, if you invest in a structured note with principal protection, you must pay federal taxes while you own the product, even before maturity or during any lock-up period and even if you haven’t received any cash payments. This can occur if the interest on the product’s zero-coupon bond holdings (resulting from the principal guarantee) is considered to be imputed interest for federal income tax purposes. You should read the tax consequences description in the prospectus and consult your tax advisor to know how a particular structured note might be taxed and when you must report any income or loss.

What Questions Should I Ask Before Investing?

When you evaluate a structured note with principal protection, be sure to do your research to find answers to the following questions, among others, or ask your investment professional:  

• How do I know whether this product is appropriate for me given my overall investment objectives?
   
• What is the level of principal protection offered? There is a big difference between 100 percent return of principal and 10 percent return, or something in between. Know your protection percentage.
   
• Are there conditions to the principal protection? For example, is the protection contingent on the occurrence of specified events?
   
• What are the fees and other costs? Products offering principal protection can be expensive. You should pay particular attention to the fees of any product you invest in, including those that offer principal protection. Ask your investment professional to explain all of the fees and costs associated with the investment. 
   
• How long will my money be tied up? Structured notes with principal protection are meant to be held to maturity and are often designed for long-term investors. If you need your money back early, you could pay a significant penalty. Furthermore, any downside protection offered might only kick in after a long lock-up period—or it might require you to hold the note until maturity.
   
• Can I sell or liquidate before the maturity date? While it is easy to turn many investments into cash, liquid markets for some structured products might not exist. If you need to sell your structured note with principal protection before it matures, you might have to do it at a price less than the amount you paid for it, or you may not be able to sell it at all. This is true even if the product has a ticker symbol or has been approved for listing on an exchange.
   
• Is there a call feature? If so, be sure you understand what can trigger the call and when is the earliest the investment may be called. You will also want to ask your investment professional what might be your game plan in the event your note gets called.
   
• Are potential gains limited? Some structured notes with principal protection may have limits or caps on the gains you can earn based on the performance of the underlying asset, index or benchmark.
   
• What are the tax implications? You might wish to consult with a tax advisor to understand the consequences of any particular investment, including imputed interest and any foreign tax consequences.
   
• How does the pay-out structure work? Is it possible to lose money, or not have any gain at all, even if the underlying asset, index or benchmark goes up? Purchasing a structured note with principal protection does not guarantee positive returns. For example, the underlying asset, index or benchmark might not increase in value—or even if it does, there may be conditions, which in some cases can be counterintuitive, that limit your gains. And, if the entity backing the principal protection at maturity goes bankrupt, you could lose your entire principal.
   
• What unique risks will I take on as a result of being exposed to the underlying asset, index or benchmark?
   
• What is the credit risk of the note? Remember that any principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. Be sure to find out as much as you can about the financial condition of the issuer and read its disclosures as carefully as you would for any other bond investment.
   
• What other risks are associated with this particular product? Be sure you understand how the derivative component of the note impacts the pay-out structure—and ultimately your return.
   
• What other investment choices are available to me? Carefully consider what might be a good fit for you, and whether there are alternatives to the product you are considering. 

Even the simplest sounding products can be pretty complex. Always read a product’s prospectus or disclosure statement carefully. If you can’t understand how the product works, ask your investment professional for help. If you still can’t understand the product, you should think twice about investing in it. 

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at info@molaw.com

Bernard Madoff’s Ponzi scheme left thousands of victims in its wake — and lawyers and consultants are reaping millions in payments from the financial devastation.

“The only winners in the Madoff scandal are the lawyers,” said Ronald Colombo, associate law professor at Hofstra University in Hempstead, N.Y. “But that’s the nature of the beast.”

The Securities Investor Protection Corp. (SIPC), an industry-sponsored insurance organization, has paid more than $290 million to law firms and consultants since Madoff’s scheme fell apart in 2008. The lawyers and consultants are tasked with tracking down and recovering Madoff’s stolen assets so they can be distributed back to the victims of his scam.

This includes fees of nearly $128 million for Baker & Hostetler, the law firm that is spearheading the recovery of stolen property. The firm’s Irving Picard, who was appointed to serve as trustee by the federal bankruptcy court overseeing the case, is being paid an additional $3.2 million.

SIPC said it has paid another $10 million to additional law firms “around the world.”

In addition, the organization has paid nearly $150 million to consultants, including $84 million to FTI Consulting, $48 million to AlixPartners, $2.5 million to Renaissance Associates and about $10 million to others.

The $290 million in legal and consultant fees is in addition to the $790 million that SIPC is paying to victims of Madoff’s fraud. The organization covers up to $500,000 in losses for individual investors with legitimate claims.

So far, the trustee has determined 2,402 Madoff investors to be eligible for SIPC coverage. These investors have received payments of up to $500,000, or are in the process of receiving those payments.

These fees do not come from the $10 billion in assets already recovered from the $20 billion estimated lost in Madoff’s scheme. Instead, the money comes from Wall Street brokerage firms, which SIPC’s president says are required to pay 0.25% of their net revenue into a insurance fund.

“In the Madoff case, SIPC has shouldered all the administrative expenses,” said Stephen Harbeck, president and CEO of SIPC. “Any money that Picard and his firm has recovered goes 100% into the customer property pool. Customer property is never used to pay legal fees.”

But, according to Hofstra’s Colombo, these “eye-popping” legal fees are a bargain rate for services rendered, considering the success rate of the recovery process. “[SIPC] is paying more than ever before by enormous amounts, but they’re recovering more than ever by enormous amounts,” he said.

Investors thought that Madoff was investing their money in the markets, but in reality he was orchestrating one of the most elaborate pyramid-style scams in history. He pleaded guilty in federal court in 2009 and is serving a 150-year prison sentence.

Madoff, for his part, said in his first comments to journalists since being imprisoned that he’s cooperating with Picard in helping ex-clients get their assets back.

“I would have loved for them to not lose anything, but that was a risk they were well aware of by investing in the market,” Madoff wrote in an e-mail to The New York Times that was quoted as part of an interview published Wednesday.

In December, Picard and Preet Bharara, U.S. Attorney for the Southern District of New York, cleared a major hurdle in dealing with Madoff’s mess. They announced a $7.2 billion settlement with Barbara Picower, the widow of Jeffry Picower, considered the biggest beneficiary of Madoff’s scheme.

According to the trustee, Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. His widow agreed to hand over the difference, $7.2 billion, to benefit Madoff’s victims, many of whom were left destitute in the wake of his fraud.

Of the 16,266 Madoff investors who filed claims with the trustee, only 2,402 are considered legitimate. The majority of rejected claims are from “third parties” who invested through feeder funds. In cases like that, only the direct investors — the feeder funds themselves — are protected by SIPC.

There are also hundreds of investors who were rejected on the basis that they, like Picower, withdrew more from Madoff’s firm than they deposited. Even though many of these investors claim to have known nothing of the Ponzi scheme, the trustee is suing them for benefiting from it.

This group includes the owners of the New York Mets baseball team and JPMorgan Chase.

Madoff told the Times that Mets co-owners Fred Wilpon and Saul Katz did not know about his scheme, and that lawsuits against banks such as JPMorgan Chase (JPM, Fortune 500) should recover enough money without having to sue private investors.

The trustee’s drive to sue investors who took profits from Madoff’s scheme is one of Picard’s more controversial moves. Many of these investors claim to be innocent, with little or no money, since they were living off their withdrawals instead of socking them away.

Ron Stein, a certified financial planner with the Network for Investor Action and Protection, said these “clawback” lawsuits wouldn’t be necessary if SIPC had raised its rates and extracted more money from the brokerage firms.

“The enormous amount of money being used to go after small investors is not money well spent,” he said. “In fact, it’s doing more damage. It’s basically telling investors that their money is not protected.”

In his interview with the Times, Madoff said Picard is overextending his reach with the clawback lawsuits. He said in e-mails to the paper that the trustee’s only concern should be to return the $20 billion in out-of-pocket cash that investors lost in the scheme. 

(This is only a selection of laws pertaining to our practice, not all new laws for 2011)

Business and Professions

AB2764: (Committee on Judiciary): Continues the State Bar’s authority to assess and collect dues from licensed attorneys in California, and authorized the Bar to continue to collect active membership dues of up to $410 for the year 2011, maintaining 2009 dues levels.  Business and Professions Code, 6140, 6140.35, 6140.36, 6001.2, 6001.4, 6140.01

SB0055: (Corbett): Requires the State Bar to comply with standards applicable to state agency contracts when awarding a contract for information technology goods, services, or both, only when the contract is for an aggregate amount in excess of $100,000.  It also requires the State Bar to have a preference for using in-house employees for information technology projects.  Business and Professions Code, 6008.6, 6140, 6140.37, 6161.2, 6140.38, Article 10.2 of Chapter 4 of Division 3

SB1155: (Dutton and Price): Amends the Capital Access Company Law, by changing the definition of a small business and adding a definition for a smaller business, exempting Capital Access Companies from the Corporate Securities Law of 1968, exempting businesses from the Capital Access Company Law, if they are approved as Small Business Investment Companies by the federal Small Business Administration, replacing existing law conflict of interest provisions with conflict of interest provisions utilized by the federal Small Business Administration for its licensees, and making related changes, as specified. Corporations Code, 25102, 28047, 28100, 28152, 28154, 28400, 28404, 28047.1, 28111, 28401, 28402, 28403, Article 2 (commencing with Section 28820) of Chapter 12 of Division 3 of Title 4

SB1254: (Leno): Authorizes the registrar of the Contractors State License Board (CSLB) to issue a stop order to any unlicensed or licensed contractor who as an employer has failed to secure workers’ compensation insurance coverage for his/her employees, establishes procedures to request a hearing to protest a stop order, and authorizes the Director of the Department of Consumer Affairs to designate 12 persons as peace officers for assignment to the special investigations unit of CSLB.  Business and Professions Code, 7127; Penal Code 830.3

Family Law/Probate

AB229: (Calderon): Clarifies that when a separate fund payer does not provide the value of the internal income of the separate fund to the trustee and the trustee cannot otherwise determine the value of the separate fund, the internal income of the separate fund is deemed equal the produce of the interest rate and the present value of the expected future payments.  Probate Code, 16361

AB1986: (Silva): Makes several minor clarifications to the statutory will form. Probate Code, 6240

AB2271: (Silva): Expands a court’s ability to protect a trust against loss when an order is on appeal.  It also allows a court to appoint a temporary trustee when an appeal is pending in order to prevent injury or loss to a person or property.  Probate Code, 1310

AB2493: (Fuller): Requires that, upon establishing a conservatorship and each year thereafter, a conservator (someone to act on behalf of a person who is unable to provide for his or her personal needs, or incapable of managing his or her financial resources) shall maintain a photograph of the conservatee for identification purpose.  Probate Code, 2360

AB2674: (Block): Provides that, when a spouse is convicted of soliciting the murder of another spouse, the injured spouse shall be entitled to an award of 100 percent of the community property interest in the retirement and pension benefits, and a prohibition of any awards for spousal support or medical, life, or other insurance benefits or payments from the injured spouse to the convicted spouse.  Family Code, 782.5, 4324.

SB0202: (Harman): Provides that a trustee has the power to terminate a trust if the principal does not exceed $40,000 in value, raised from $20,000.  Also provides that on reasonable request the trustee shall report to the beneficiary information relating to the administration of the trust, and on request of the beneficiary the trustee shall provide the terms of the trust, unless it is during the period when a revocable trust can be revoked, as provided, or if the beneficiary and the trustee are the same person.  Probate Code, 5408, 16061, 16061.5, 16061.7, 16061.8, 16064, 16336.4, 17200, 6060.7, 16068, 16069

SB1038: (Harman): Deletes existing laws exemption providing that an attorney-in-fact is not liable for losses to the principal’s property when the attorney-in-fact in not compensated.  Provides the circumstances under which an attorney-in-fact is chargeable with breaches of duty.  Probate Code, 4231, 4231.5

Miscellaneous

AB2619: (Block): Authorizes wage garnishments against defendants convicted of elder or dependent adult financial abuse.  Civil Procedure Code, 706.011, 706.023, 706.121, 706.125

SB0105: (Harman): Establishes an express presumption of fraud or undue influence when a donative instrument makes a gift to the person who drafted or transcribed the instrument, and certain other disqualified persons.  Business and Professions Code, 6103.6; Probate Code, 2583, 15642, 16062, 21310, 21355, Part 3.7, Division 11

SB1041: (Harman): Allows evidence at a hearing or trial of a statement made by an unavailable declarant that he/she made or did not make a revocable trust.  Evidence Code, 1260