SECURITIES 101: FOR LAW ENFORCEMENT

OFFICIALS

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION“Because Every Investor Deserves Protection”

Prepared by the NASAA Investor Education Coordination Project Group

Securities Products, Schemes and Scams

Introduction

Have you ever been presented with a potential securities fraud case and thought:

“what’s the best way to proceed with this?”

Introduction Financial fraud prosecutions are not the typical cases you

probably handle on a routine basis.

If investigated correctly, cases can result in: Felony convictions Lengthy prison sentences Opportunities for victims to recover some lost money

through: Restitution orders Asset freezes Forfeitures

Purpose of this Presentation

To make you aware of some of the elements of securities products and financial crimes;

Provide you with information on resources available to you with these cases; and

Strengthen your investigative techniques in regard to financial fraud cases.

In the United States, BILLIONS of dollars are lost each year to investment fraud and scams.

These scams affect both the rich and poor; the sophisticated and the unsophisticated; the timid, the greedy, and the elderly.

Investment fraud affects everyone!

VICTIM IGNORANCE:VICTIM IGNORANCE:

The best friend of financial criminalsThe best friend of financial criminals

Frauds succeed because people hear and Frauds succeed because people hear and believe the promises of the promoter, believe the promises of the promoter, and don’t investigate either the and don’t investigate either the promoters or investments being sold to promoters or investments being sold to them.them.

Registration of Securities

With few exceptions, every offer or sale of a security must, before it is offered or sold in a state, be registered or exempt from registration under the securities laws of the state or province in which the security is offered and sold.

Some securities sales that are exempt are self-executing and require no securities filings with a state or provincial regulator.

Other exemptions are available depending on the manner in which the securities are sold, and include various factors.

Background Information:Who needs to be licensed to sell securities?

1. Brokerage Firms: Also known as broker-dealers. Investors maintain their securities accounts with these

firms, which need to have licenses to do such business.

2. Securities Salespersons: Commonly referred to as stockbrokers; work for the

broker-dealer firms. Individuals with whom investors deal directly when

effecting transactions in their accounts. They typically receive commissions when investors

purchase or sell securities.

Background Information:Who needs to be licensed to sell securities?

3. Investment Advisers: A person who, for compensation, is engaged in the

business of providing advice, making recommendations, issuing reports or furnishing analyses regarding securities.

Either a natural person or a business entity can be an investment adviser.

4. Investment Adviser Representatives: A natural person who gives advice on behalf of an

investment adviser to a certain minimum number of natural person clients through regular meetings or communications.

Central Registration Depository (CRD)

A computerized database for securities regulators that holds qualification, employment, and disclosure histories of registered/licensed securities individuals and firms.

Also contains information on enforcement actions taken against unregistered/unlicensed individuals and entities.

Contact your state securities regulator for information contained within the CRD.

Concept of “Full Disclosure”

Investors are entitled to complete, accurate and detailed information about the offering.

Salespersons and issuers have an affirmative obligation to provide complete disclosure.

Securities Products

Products commonly referred to as securities: Stocks, Bonds, Notes, Options, Debentures, Convertible

Certificates

Products not commonly referred to as securities, but still subject to the laws governing securities: Fractional undivided interest in mineral / oil rights Certificate of interest in profit-sharing agreement Transferable share, voting trust certificate Investment contracts consisting of precious metals and fine arts

Stock Certificates

Shares of stock represent a fraction of ownership in a corporation.

A stock certificate of a corporation provides written evidence that the named person on the certificate is the owner of a designated number of shares of that corporation’s stock.

Stock Certificate (Front)

Stock Certificate (Back)

Bonds

A holder of a bond has loaned his money to a company or governmental unit (the “borrower” or “issuer”).

In return, the company or governmental unit promises to repay the amount borrowed plus a specified amount of interest at a future date.

Bond (Front)

Bond (Back)

Convertible Certificates

A bond, debenture, or preferred share which may be exchanged by the owner for common stock or another security, usually of the same company, in accordance with the terms of the offering.

Convertible Certificate (Page 1)

Convertible Certificate (Page 2)

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Warrants and Options

Warrants are certificates that are usually issued along with a bond or preferred stock entitling the holder to buy a specified amount of the security at a specific price.

Stock options are similar to warrants, however they would not be issued along with a bond or preferred stock certificate. Call options give the holder the right to buy and put options give the holder the right to sell a specific number of shares at a stated price.

WarrantCOMMON STOCK WARRANT

THE SCO GROUP, INC.

NEITHER THIS WARRANT NOR THE SHARES OF STOCK ISSUABLE UPON EXERCISE HEREOF HAVE BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "ACT"). NO SALE, TRANSFER OR OTHER DISPOSITION OF THIS WARRANT OR SAID SHARES MAY BE EFFECTED WITHOUT (i) AN EFFECTIVE REGISTRATION STATEMENT RELATED THERETO, (ii) AN OPINION OF COUNSEL SATISFACTORY IN FORM AND SUBSTANCE TO THE COMPANY THAT SUCH REGISTRATION IS NOT REQUIRED UNDER THE ACT OR (iii) RECEIPT OF A NO-ACTION LETTER FROM THE SECURITIES AND EXCHANGE COMMISSION TO THE EFFECT THAT REGISTRATION UNDER THE ACT IS NOT REQUIRED. THE WARRANT EVIDENCED HEREBY IS NON-TRANSFERABLE

Right to Purchase 25,000 Shares of Common Stock

The SCO Group, a Delaware corporation (the "Company") hereby certified that, for value received, S2 Strategic Consulting, LLC, a Delaware LLC ("S2"), is entitled, on the terms set forth below, to purchase from the Company at any time during the period commencing on J uly 1, 2003 (the "Exercisability Date") and, subject to the provisions of Section 1 below, ending at 5:00 p.m., Mountain Standard time, on J uly 2, 2005, Twenty five Thousand (25,000) fully paid and nonassessable shares of the common stock, par value $0.001 per share (the "Warrant Shares"), of the Company, at a price of $8.50 per share, subject to adjustments as provided below (the "Purchase Price"). As used herein, the term "Stock" shall mean the Company's presently authorized common stock or any stock into or for which such common stock may hereafter be converted or exchanged prior to or concurrent with the exercise of this Warrant.

1. Expiration. This Warrant shall expire upon the first to occur of the following: (i) 5:00 p.m., Mountain Standard time, on J uly 2, 2005; and (ii) the sale of all or substantially all of the assets of the Company or an acquisition of the Company by another corporation or entity by consolidation, merger or other reorganization or series of related transactions in which the holders of the Company's outstanding voting stock immediately prior to such transaction own, immediately after such transaction, securities representing less than fifty percent (50%) of the voting power of the surviving corporation, the surviving entity or the entity that controls such surviving entity (such sale of assets or acquisition, a "Merger or Consolidation").

EXHIBIT A

NOTICE OF EXERCISE

TO: THE SCO GROUP, INC.

1. The undersigned hereby elects to purchase 25,000 shares of Common Stock of The SCO Group, Inc. pursuant to the terms of the attached Warrant.

2. Exercise (Please initial the blank):

The undersigned elects to exercise the attached Warrant by means of a cash payment, and tenders herewith payment in full for the purchase price of the shares being purchased, together with all applicable transfer taxes, if any.

3. Please issue a certificate, or certificates representing said shares of stock, in the name of the undersigned or in such other name as are specified below

(Name)

(Address)

4. The undersigned represents that the aforesaid shares of stock are being acquired for the account of the undersigned for investment and not with a view to, or for resale in connection with, the distribution thereof and that the undersigned has no present intention of distributing or reselling such shares. In support thereof, the undersigned has executed an Investment Representation Statement attached hereto as Exhibit B.

Name of Warrantholder

Signature of Authorized Signatory

Print Name and Title

Promissory Notes

A written promise to pay or repay a specified sum of money, either at a stated date or on the demand of the holder.

Most promissory notes sold to the general public must either be registered or exempt with the State’s Securities Regulator, and also with the federal Securities and Exchange Commission (SEC).

Promissory Note

Investment Contracts

To be considered a security and be subject to securities laws, an “investment contract” must have these four elements:

1. An investment of money2. In a common enterprise3. An expectation of profits 4. Profits are derived from the efforts of

others

This can entail mutual fund interests or other securities products such as coin deals and artwork.

Investment Contract (Page 1)

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Investment Contract (Page 2)

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Investment Contract (Page 3)

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Viatical Settlement Contract

An investor purchases the right to receive a portion of the death benefit of a life insurance policy or pool of policies.

This type of investment is referred to as a “viatical settlement” when the insured suffers from a terminal illness.

It is referred to as a “life settlement” when the insured is a healthy senior citizen.

Viatical Settlement Contract

Fractional Interest in Oil and Gas Wells

A “fractional interest” is a portion of the payment of a lease for land on which one or more wells are or will be located.

Investors share proportionally in the profits of the well.

Fractional Interest in Oil and Gas Well

Limited Partnership Agreement

Contract which creates a partnership between the manager or operator, called the “general partner,” and those who finance the business, called the limited partners.

“Limited partners” receive a return (profit) based on the ratio of their investment to the total amount of all the investments in the business.

Limited Partnership Agreement

Interest in a Limited Liability Company (LLC)

Structured similarly to a limited partnership.

Advantage of a LLC over a limited partnership applies only to the managing member, who under this form of business structure cannot incur any personal liability beyond the amount of his or her investment.

Interest in a LLC

Mutual Funds

Mutual funds pool investors’ money to purchase the securities of other companies, resulting in a portfolio of many different companies.

Individual investors own shares of the portfolio and are paid dividends based on the funds’ earnings after expenses.

A fund manager buys and sells securities for the funds’ shareholders.

Mutual Fund Prospectus

Common Scams and Schemes

Ponzi Schemes Pyramid Schemes Offer and Sale of

Securities by Unlicensed/Unregistered Individuals

Offer and Sale of Unregistered Investment Products

Affinity Fraud Nigerian Letters Prime Bank

Instruments Churning Lack of Suitability Theft in Brokerage

Accounts

Common Scams and Schemes

Internet Investment Fraud

Promissory Notes Bogus Investments Boiler Rooms Equipment Leasing Viatical Settlement

Fraud

Coins and Precious Metals

Oil and Gas Schemes Misrepresentations Omissions of Material

Fact

Traits of a Typical Perpetrator

Very friendly, appears to take a personal interest in victim.

Professional persuader, takes control of conversation, builds relationships.

Plays on victims confusion about the variety and complexity of financial products.

Brings out one of our worst traits – greed. Attempts to make the victim feel inadequate if

they question him or her.

Scheme in which a person makes payments to investors from money obtained from later investors.

“Rob Peter to Pay Paul” is the principle of the scam.

The scam is kept rolling by constantly recruiting newcomers.

High interest is paid to the earliest investors who

recruit others, often by word of mouth.

Ponzi Schemes

Ponzi Scheme

Ponzi CompanyPonzi Company uses a portion of Investor A’s investment as the return on investment

Investor A invests

Chart 1

Other investors start investing after Investor A gets a return on investment.

Ponzi Scheme

Ponzi CompanyPonzi Company pays Investor A’s next return from Investor B’s investment of money.

Ponzi Company returns part of Investor B’s investment from either Investor A’s or Investor B’s investments of money.

Investor A invests

Additional investors invest based on the returns that prior investors receive which demonstrates that it’s a safe and profitable investment.

Investor B invests

Chart 2

Ponzi Scheme

Ponzi CompanyPonzi Company pays Investor A’s next return from Investor A’s or B’s or C’s investment of money.

Ponzi Company returns part of Investor A’s or B’s or C’s investment from any other investors money that is available.

A invests

And the beat goes on and on until all the money is depleted and there are no new investors willing to

invest.

C investsB invests

Chart 3

A “pyramid scheme” is an illegal form of multi-level marketing where the product (if a product exists) is only of secondary importance.

Investor pays some type of initial fee

which gives them the right to recruit others.

Pyramid Schemes

For each person recruited into the pyramid scheme, the recruiter receives money or other bonuses.

In turn, the new participants must make their initial fee payments, which are larger than the earlier participants’ payments, in order to get the right to recruit.

Pyramid Schemes

Pyramid Scheme (Page 1)

Pyramid Scheme (Page 2)

The Offer and Sale of Securities by Unlicensed/Unregistered Individuals

Unlicensed individuals who sell securities is a common securities crime.

In hundreds of cases from Washington state to

Florida, scam artists are using high commissions to entice individuals, such as independent insurance agents who are not licensed to sell securities, into selling investments they may know little or nothing about.

The Offer and Sale of Unregistered Investment Products

With few exceptions, every offer or sale of a security must be registered or have an exemption.

Criminals: Claim their products are exempt. If asked, can’t provide a legitimate exemption. Salespeople selling unregistered, non-exempted

securities can be subject to criminal charges.

Affinity Fraud

Scams that target religious, ethnic, and/or professional groups, among others.

Criminals use statements as: “You can trust me because I’m like you,” or “We share the same background and interests so let me help you make money.”

In short, the tight-knit structure of many groups is a perfect environment for criminals.

Affinity Fraud Document (Page 1)

Affinity Fraud Document (Page 2)

Nigerian Letters

"Advanced Fee" Fraud Operation 4-1-9 “419” Advanced Fee

Fraud

Nigerian Fraud “419” Fraud “419” Letter

Nigerian "Advanced Fee" 4-1-9 Fraud is named after the 4-1-9 penal code in South Africa.

Also Known as:

Common Characteristics of a Nigerian Letter

Involve requests for "up-front" money to secure investor’s involvement in their transaction.  

Millions of dollars are promised in return for investor’s help, but only to be paid once the transaction has been completed.

Has a supposed reason for needing the investor’s help:  an inheritance that is tied up;  millions of dollars in cash or diamonds that are in boxes they need to get out of the country; huge amounts of cash in accounts that are "frozen" by the government; excess oil; or other merchandise, etc.

Need a foreign "partner" to help them. These cases are usually referred to the U.S. Postal

Inspectors.

Nigerian “419” Letter (Page 1)

Nigerian “419” Letter (Page 2)

There is no such thing as a prime bank!

Three common elements in all Prime Bank Schemes:• An offer designed to appear to be an exclusive

investment.

• A reportedly fail-safe way to protect the investor’s principal while realizing huge returns.

• Access to offshore institutions, overseas markets, or foreign “traders” to realize extremely high returns.

Also referred to as “bank debenture trading program,” “high yield,” or “prime bank note.”

Prime Bank Instruments

High Yield Instruments

Churning

Unnecessary or excessive buying and selling of securities by a broker.

Brokers’ earnings are based upon sales commissions or markups.

If there is suspicion that a broker has made recommendations to an investor which caused an unusually high number of trades, the state or provincial securities regulator should be contacted.

Lack of Suitability

Brokers must consider whether an investment is suitable based on: Assets Income Investment goals Current financial circumstances Age

Theft in Brokerage Accounts

Investor statement shows unauthorized activity. Broker tells investor to make checks out to another

entity or firm. Investment objectives are not followed. No action is taken after talking to branch manager or

compliance department. Investor is put into products not associated with the

broker-dealer firm.

Internet Investment Fraud

Con artists take advantage of the anonymity of the Internet to promote stocks and other types of “investments.”

Post tips online or in chat rooms to influence the price of stock.

Use tools such as unsolicited emails (“spam”) to spread false information.

Potential investors should be aware that the Internet is worldwide; you do not know who is sending the information or where it is coming from.

Promissory notes are loans evidenced by a Note.

Investors are told they will receive high, quick returns, such as 90 days on their investment.

These scams are pitched as a simple and safe alternative to volatile stocks and bonds.

Promissory Note Scams

Promissory Note Scams

The promoter may try to use legitimately licensed or registered insurance producers, investment advisers or other professionals to sell the notes to their trusting customers.

The sales pitch may include a statement saying the note is “guaranteed” by an off-shore insurance company.

Bogus Investments

Sometimes an adviser or broker will sell promissory notes or other securities issued by companies that do not exist.

Boiler Rooms

Earn their name from the “heat” and high pressure generated by callers as they try to convince investors to part with their money.

A boiler room is often just a short-term rented apartment or office with multiple phone lines and an impressive sounding address.

Telephone pitches are read from prepared scripts, with quick answers to the most common objections.

Boiler Rooms

The victim’s phone number may have been obtained from phone directories, purchased lists, or newspaper articles.

Boiler-room operators have even been known to call recent widows and widowers or people who have lost large sums of money, offering to “help” recover the losses quickly and effortlessly.

In many cases, either the company or the product does not really exist or it doesn’t operate as represented.

Equipment Leasing

In a typical equipment leasing scam, a company sells a piece of equipment through a middleman. As part of the sale, the company agrees to lease back and service the equipment for a fee.

Investors are promised high returns with little or no risk. High commissions are paid to salespeople, and promised returns are unrealistically high.

Some equipment leasing deals may be legitimate, but individuals selling interests in equipment such as payphones, ATMs or Internet kiosks have scammed thousands of investors.

Viatical Settlement Fraud

Investments are very speculative and highly risky.

A great likelihood of fraud because it’s hard to predict when someone will die.

Coin Deals

So called “rare coin deals” are often sold to unwary investors who are led to believe that they are a good investment that will increase in value over the years.

Salespeople misrepresent the value of the coin, its scarcity and where it was obtained. For example, a victim may be misled into

believing that the coins were recently obtained through an exclusive estate sale and are in very short supply.

Coin Deals

A common tactic used by these scam artists is to falsely promise to re-broker or re-sell the coins to another investor for a profit so that the victim is led to believe that he or she cannot lose money.

“Rare coin deals” are investment contracts and are subject to securities laws.

Oil and Gas Schemes

Investments are frequently sold by phone or boiler rooms to investors across the country.

Promoters offer “new” and “secret” methods for reclaiming oil reserves on previously drilled oil fields.

Promoters invent false or misleading information about the properties and drilling.

Common Misrepresentations

Use of proceeds History of promoters Safety of investment Mechanics of

investment Financial condition of

firm or promoter

Profitability of company operations

Ludicrous projections Compliance with

applicable laws This is not a security Insider information

Common Omissions

True risk of investment Details regarding how

investment works History of criminal

promoters Criminal history Work history Judgments or liens Who are the

promoters

Insider transactions Self dealing Payments to family

Compensation Who How much

Failure to provide any financial information

Who to Contact for Assistance/Referral

Locate your state/provincial securities administrator on the North American Securities Administrators Association (NASAA) web site at:

www.NASAA.org