Due Diligence in your Self Directed Retirement Plan

Recently I have had a number of calls from clients and readers who have lost money in alternative investments they selected for their own self directed plan. My first question when I get a call  like this is, "what Due Diligence did you do to determine if the investment sponsor was legitimate and what calculations did you base your decision on?"  In almost every case, the decision to buy was made in the heat of a selling event and almost no Due Diligence was conducted prior to the purchase. The purchase of local hard assets, like real estate you can physically see, touch and inspect is one way to avoid an investment fiasco.

We are in tough times and tough times often bring out the best in human nature, but also nuture the worst. People under financial pressure will do and say just about anything to make a commission. It is our responsibility as investors to know who we are doing business with and how they are doing business.

People have endured brutal and perhaps insurmountable financial losses in their corporate 401k plans, which were invested primarily in stocks and mutual funds. Now they are in pain and realize that their retirement dreams have been changed, or realize they may never be able to fully retire. As a result, many people are opening Self Directed Retirement Plans and then investing in schemes that promise to quickly return the monies lost in the stock market through very high, "safe" compounded yields and the promise of near term appreciation. All with little or no effort and little or no risk on the part of the investor.  Passive investing with stellar results. Sounds like a Bernie Maddoff pitch to me.

So many people have bought into these schemes that I have categorized these types of investments as "TOHOR" investments, which stands for "Triumph of Hope Over Reason". People need to realize that unscrupulous promoters know the mental state of their marks very well and design their sales pitch to appeal to emotion over reason.

SDRP investing can be tremendously successful and the best SDRP investors will retire with dignity, but the best investors are characterized by an almost obsessive need to understand what they are investing in, what it costs now and will cost in the future, who they are buying from and they have a plan for the duration of the investment.

What Should Your Custodian/Administrator Do regarding Due Diligence?

The primary function of a Self Directed Retirement Plan (SDRP) custodian or administrator, other than providing Administration and Record keeping for your SDRP Assets, is to help educate their clients on the best ways to maximize their results from Self Direction.

SDRP custodians and or administrators do not give tax, legal or investment advice or help clients select investments or investment sponsors, but they do want clients to make sound investments and they benefit when client investments increase in value.  Since they cannot give advice on specific investments or recommend investment sponsors, I think it is imperative to let my clients know how important it that they thoroughly research the background of referral sources, individual sponsors and the investments that they sell. This process is commonly referred to as “Due Diligence” in the investment world.

As Americans, we have become very trusting of financial advice given by providers who earn commissions on every transaction they make. Of course people need to get paid for their work, but it is ultimately up to you as an investor to see that they have earned the commissions you pay and you have a right to ask what those commissions are and how they are paid.

Every investor should do much more than rely on the representations made by sales people and their sponsors.  The logic for this is simple, the people selling you an investment rely on the income from that sale to make their living and times are tough.  This makes it very hard for them to be objective about the true value and future prospects of whatever they may be selling. You need to do your homework to the fullest to avoid losing your hard earned pension money in bad investments and consult with your tax and legal professionals before committing more than just a few percent of your assets to any one investment.

To do this fully can be complicated and time consuming, but at a bare minimum, consider doing the following:
For any investment, whether in Real Estate, Precious Metals, Notes, Tax Liens etc., take time away from the heat of the moment (just after a presentation promising exceptional results from an investment). Go home, sit down at your computer and go to sites like these to check on the investment sponsor. After asking the sponsor what legal structure they operate under request copies of all documents relevant to the offering.

1. Better Business Bureau – www.bbb.org – look at the national site, not just locally for complaints against the investment sponsor and the organization that referred them to you.
2. Rip Off Report – www.ripoffreport.com  - look for the names of sponsor companies, the names of principals of the companies and the organization that referred you.
3. Google Search – www.google.com  – Do multiple searches with search terms including the name of investment sponsors, the organization that referred you and add search terms to help complete your due diligence for example “John Doe Investment Club, lawsuits” or Jane Doe Properties, fraud claims” Legal complaints, fraud alerts, consumer complaints and as many other search terms as you can think of.
4. The department of Real Estate in your state will have status of licences and complaints against Brokers or Agents
5. The Department of Corporations in your state should be checked to determine if a Corporation is in good standing and if there are any complaints.
5. The Securities and Exchange Commission – www.sec.gov – help@sec.gov  Phone (202) 942-7040. It also pays to do a search for any SEC litigation under the name of Principals of any company you are considering investing with to see if there is any history with the of litigation with the SEC.  A history of litigation does not necessarily indicate any current wrongdoing, but should be considered carefully in evaluating the company you are considering doing business with and the people who run it.  The link to research SEC litigation is at http://www.sec.gov/litigation.shtml 
6. The Insurance Department in your state can be contacted to check the licences of Agents or Brokers and to see if there are any complaints.

Other Red Flags
• A company that has only been in business for a short time (less than two years) offering very high compounded returns (over 10%)with little or no risk
• Any company that says they cannot provide referrals from existing clients
• Sponsors who say they work because they love to help people
• Complex investment structures without direct control of an investment (Private Placements, Small Syndications
• Inability to see and touch your investment before buying
• Pressure to make a decision in a narrow time frame “today only”, “price will increase tomorrow”
• Little or no documentation of cash flows
• No paperwork you can take home
• LLC's should have ready access to copies of operating agreements for your review and for your files
• Corporations soliciting investments in shares should have a Share Purchase agreement or similiar instrument for your review and such documents should be reviewed by your tax and legal counsel before execution of the investment.
• No discussion of Exit Strategies, no liquidity, high fees to exit an investment, high ongoing fees for management that impact net returns
• Where out of state Real Estate involves outside management for the collection of rents be sure to research the management company. One way to do this is to call large local real estate offices in the area you are buying and ask if they know the firm being recommended. If the management firm also does real estate, check with the state regulatory agency for Real Estate transactions.
• Any company that suggests a specific rate of return but says they are not offering a security. If real estate is involved be sure to run your own calculations for returns using different occupancy rates. At some point, any real estate can be un-occupied and certain types of real estate, (for example, blue collar residential real estate) can have high vacancy rates due to economic conditions. Remember to research the overall employment factors in the areas where you are considering a purchase.

If everything checks out to your satisfaction and the answers to your questions are acceptable to you and your tax and legal professionals, you can move forward with the knowledge that you did not act in haste. Remember that your grandparents always said “haste makes waste”.

Watch for an upcoming webinar on Due Diligence my site at www.botbseminars.com .