No other investment vehicle can lay claim to more investor losses than the self-directed IRA. The reason is simple; self-directed IRAs are used by scammers and fraudsters to separate investors from their money, and the IRA Custodians do nothing to stop this abuse.
While they serve a legitimate purpose in the investment world, and allow people to purchase nontraditional investments in their IRAs, such as precious metals and real estate, self-directed IRAs provide virtually no protections to investors, and attract a rogue’s gallery of censured stock promoters, disbarred stockbrokers and unregistered salespeople. The typical self-directed IRA investment is an unregistered security sold by an unlicensed individual with the money going to a company or promoter who is the subject of multiple cease and desist orders.
This happens because many investors wrongly believe that the IRA Custodian plays a role similar to a traditional brokerage firm, which is obligated to supervise its representatives, and perform due diligence on the investment being offered. This isn’t the case. Typically, the salesperson has no affiliation with the IRA Custodian, not even as an independent contractor, and therefore no relationship exists between the two that could give rise to liability (or protections to investors). Most of the time, the salesperson is an unregistered individual, often someone who has been barred from the brokerage industry, and the only way he can make a living is by using a third party IRA Custodian to process the transaction.
Understanding the role IRA Custodians plays is key. Their sole function is to report the value of the investment to the IRS on an annual basis as a means of ensuring that you – the investor and the taxpayer- haven’t gained access to the money. And even this de minimis accounting obligation is subject to abuse. The IRA Custodian can fulfill its reporting obligations by simply asking the investment company to provide it with a value to be used for reporting purposes. Sort of like asking Bernie Madoff if the values on the account statements he sent are correct. And, if the company doesn’t report back to the IRA Custodian, the Custodian can use the prior year’s value. This is misleading, and lulls investors into a false sense of security, implying that the investment has value, when in fact, what is being reported is a totally arbitrary valuation.
Another misconception is that the IRA Custodian holds the investment, like a bank or a brokerage firm would. In reality, the IRA Custodian typically holds only a promissory note or some other evidence of the investment. When an investor agrees to make the investment he has a transfer set up to wire funds from his existing IRA or 401k to the IRA Custodian. The Custodian then wires the money to the investment company, which issues a promissory note or stock, which is then held by the IRA Custodian. Investors seeking their money back or access to funds on deposit receive a rude awakening when they learn that all the custodian has is a worthless piece of paper.
So when a salesperson comes along and tells you the great investment he is pitching can be purchased using IRA funds, ask him the following questions:
- Do you have a license to sell securities?
- Has the IRA Custodian performed any due diligence into the investment?
- Is the investment registered for sale in the state?
If you receive a “no” answer to any of the questions, it’s time to hang up the phone. Far better to receive a lower rate of return on a legitimately sold investment purchased through a traditional IRA at a licensed broker dealer, than to strive for a couple extra percentage points in yield on a scam investment sold by unregistered salesmen.