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Types of Fraud Continued

Used with permission from The United States Securities and Exchange Commission. 

Frauds come in many types and varieties. Whether you are a first-time investor or have been investing for many years, here are some basic facts you should know about the different types of fraud.

Pyramid Scheme

In the classic "pyramid" scheme, participants attempt to make money solely by recruiting new participants. The hallmark of these schemes is the promise of sky-high returns in a short period of time.

Pyramid scheme promoters may go to great lengths to make the program look like a multi-level marketing program selling legitimate products or services. But these fraudsters use money from new recruits to pay off early stage investors until eventually, the pyramid collapses. At some point, the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and people lose their money.

Ponzi and pyramid schemes are closely related. Here is how to tell them apart:

  Pyramid Scheme Ponzi Scheme
Typical “hook” Earn high profits by making one payment and finding a set number of others to become distributors of a product. The scheme typically does not involve a genuine product. The purported product may not exist or it may only be “sold” within the pyramid scheme. Earn high investment returns with little or no risk by simply handing over your money; the investment typically does not exist.
Payments Must recruit new distributors to receive payments. No recruiting necessary to receive payments.
Interaction with original promoter Sometimes none. New participants may enter scheme at a different level. Promoter generally acts directly with all participants.
Source of payments From new participants – always disclosed. From new participants – never disclosed.

“Prime Bank” Investments

If someone approaches you about investing in a so-called "prime bank" program, "prime World Bank" financial instrument, or similar high-yield security, you should know that these investments do not exist. They are all scams.

Prime bank programs often claim investors' funds will be used to buy and trade "prime bank" instruments. Promoters make the schemes seem legitimate, using complex, sophisticated and official-sounding terms. The investment may be described as debentures, standby letters of credit, bank guarantees, an offshore trading program, a high-yield investment program, or some variation.

To reassure investors, promoters may claim that the instrument is issued, traded, or guaranteed by a well-known organization such as the World Bank, the International Monetary Fund(IMF), a central bank, such as the U.S. Federal Reserve or the International Chamber of Commerce (ICC).

Secrecy is another tip-off. Prime bank scheme promoters frequently claim that investment opportunities of this type are by invitation only and limited to select, wealthy customers. They cite secrecy if potential investors ask for references, and sometimes ask investors to sign non-disclosure agreements.

Some promoters are audacious enough to advertise in national newspapers. They may avoid using the term "Prime Bank note," and tell prospective investors that their programs do not involve prime bank instruments. Regardless of what they’re called, the basic pitch remains the same, and investors should remain vigilant against offers to invest in high-yield, risk-free international finance programs.

Promissory Notes

Promissory notes are a form of debt that companies sometimes use to raise money. They typically involve investors loaning money to a company in exchange for a fixed amount of periodic income. Although promissory notes can be appropriate investments for many individuals, some fraudsters use promissory notes to defraud investors, especially the elderly.

Pump and Dump Schemes

"Pump and dump" schemes have two parts. In the first, promoters try to boost the price of a stock with false or misleading statements about the company. Once the stock price has been pumped up, fraudsters move on to the second part, where they seek to profit by selling their own holdings of the stock, dumping shares into the market.

These schemes often occur on the Internet where it is common to see messages urging readers to buy a stock quickly. Often, the promoters will claim to have "inside" information about a development that will be positive for the stock. After these fraudsters dump their shares and stop hyping the stock, the price typically falls, and investors lose their money.

Pump and dump schemes typically involve little-known microcap companies.