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|The SEC and
the Question’s Answer, Simply Point and Click on the Question
can you tell the difference between an illegal pyramid, a Ponzi
scheme and a multi-level marketing venture?
between an illegal pyramid or Ponzi scheme and a legitimate
multi-level marketing (“MLM”) program is never
obvious, even to the most trained eye. Almost all of the present
illegal Internet pyramid or Ponzi schemes are posing as legal
Pared to their essence, MLM
programs akin to Amway survive legal scrutiny by making money
off product sales, not new recruits to the programs. In contrast,
“pyramid schemes” reward participants for inducing
other people to join the program. No clear line separates
illegal pyramid schemes from legitimate multi-level marketing
programs. This lack of a red line is the gray area that fraudsters
exploit to give their scams an image of legitimacy.
Very typically, in order to differentiate between an MLM and
an illegal pyramid, securities laws regulators evaluate the
marketing strategy of the issuer (e.g., emphasis on recruitment
of new investors versus sales) and the percent of product
sold compared with the percent of commissions granted.
The term “pyramid scheme”,
as used by securities laws regulators, refers to a pyramid-structured
program that chiefly exists to reward participants for inducing
other people to join. Pyramids that can be considered MLMs
are not ‘schemes’ at all, and are legal. All multi-levels
are not considered per se deceptive and unlawful. So, it is
possible that an Internet investment can have a pyramid structure
and not run afoul of the SEC or Federal Trade Commission's
(FTC) laws. But I don’t think it’s likely, nor
is it likely that the typical investor, can really tell pyramid
scams from legal MLMs on the Internet.
The term ‘Ponzi scheme’
typically means a program that pays earlier investors with
money tendered by later investors. The original scheme by
Carlo Ponzi in the 1920s was simple: investors paid him one
dollar on the first day of the month, and he would commit
to pay them two dollars on the last day of the month. To make
that last day of the month payment, Ponzi used new investors
money attracted to the program by the promised high returns.
After Ponzi’s program failed, he went to work for Mussolini.
In the original Ponzi scheme,
there was no recruitment down line and no commissions paid
for recruiting investors to join below the founders. For this
reason, securities law enforcement authorities, unlike the
general public (and some courts), do not use the terms ‘pyramid
scheme’ and ‘Ponzi scheme’ to mean the same
thing. The difference is in the contractual relationship:
all Ponzi’s investors had direct ‘privity,’
which means a contract connection, with his company, whereas
a pyramid has privity down line between the members and recruits,
and their recruits, on and on.
The legal differences in structure
between a pyramid scheme and a Ponzi scheme are indistinguishable
to investors: both schemes pay old investors with new investors
money. But because there is technically a difference, fraudsters
will huckster their program by declaring loud and clear: ‘this
is not a Ponzi scheme.’ Sometimes they may even have
legal opinions that state there is not Ponzi scheme, because:
a) there is no SEC definition of a Ponzi scheme and b) the
issuer’s program does not exactly replicate the terms
and conditions of Ponzi’s 1920s program. So the disclaimer
“This is not a Ponzi Scheme” is well nigh meaningless.
You see: a MLM pyramid is legal.
Coupled with the nuances of legality arising out of regulatory
decisions with respect to the famous Amway program, discussed
below, it is confusing but true to state that a Ponzi scheme
is not a pyramid scheme, and a pyramid may not be a scheme
how can I tell what I’m getting into?
With all due respect,
you likely cannot tell the legal differences between Ponzi
and pyramid scheme without great study. The FTC and SEC seek
to enjoin both Ponzi and pyramid schemes on the basis that
they will inevitably harm later investors. Very simply, the
money has to come from somewhere, and when it stops coming,
those who contributed last lose their investment. One Court
held that these investments are “nothing more than an
elaborate chain letter device in which individuals who pay
a valuable consideration with the expectation of recouping
it to some degree via recruitment are bound to be disappointed”.
The FTC, not the SEC, first
went to Court to combat the “serious potential hazards
of entrepreneurial chains” and urged the “summary
exclusion of their inherently deceptive elements, without
the time-consuming necessity to show occurrence of the very
injury which justice should prevent.” In a leading decision,
the FTC enjoined a promoter from “offering, operating,
or participating in, any marketing or sales plan or program
wherein a participant is given or promised compensation (1)
for inducing other persons to become participants in the plan
or program”. This FTC opinion had nothing to do with
the federal securities laws. The holding was based on common
law fraud concepts on the theory that such programs will inexorably
fail because eventually there are not enough people on earth
to support it.
The FTC test for determining
what constitutes an illegal pyramid scheme holds that they
“are characterized by the payment by participants of
money to the company in return for which they receive the
right to sell a product and the right to receive in return
for recruitment, rewards which are unrelated to sale of the
product to ultimate users”. The key concept is the ‘unrelated’
idea, that the program is so divorced from economic reality
or mercantile endeavor, as to be merely a chain letter passing
The FTC later recognized the
distinction of “saturation” between legitimate
pyramid structured programs and illegal pyramid schemes. In
1979, the FTC determined that the MLM program operated by
Amway was neither fraudulent nor illegal. The FTC found that
Amway is essentially structured as a pyramid, not a Ponzi
scheme, with an ever increasing down line privity of recruits.
Nonetheless, the FTC determined that the plan did not constitute
an illegal pyramid because certain Amway rules ensured a focus
on retailing merchandise over pyramiding of members. This
effort at retailing, the FTC found, meant that the program
would never be ‘saturated’ with members sending’
money to each other until there were no further people to
join. It was these ‘anti-saturation’ rules that
saved Amway’ from the ambit of the anti-Ponzi and pyramid
scheme rules, not the specific structure of the enterprise.
So, an Amway-like program that happened to pay participants
a small fixed fee for bringing in recruits probably could
constitute a ‘pyramid’, but such a program would
not constitute a scheme to defraud because saturation will
does the SEC get involved?
examine MLMs, pyramid schemes and Ponzi schemes for an investment
contract, and therefore, securities, as defined by Section
2(1) of the Securities Act and Section 3(a)(10) of the Securities
Exchange Act of 1934. The term “investment contract”
is defined as (1) an investment of money; (2) in a common
enterprise or venture; (3) premised on a reasonable expectation
of profits and (4) to be derived from the entrepreneurial
or managerial efforts of others. After the leading case on
the subject, this is the famous Howey test.
An investment contract analysis
considers each of these four factors:
Element - An Investment of Money
||The term “investment
of money” is where an investor commits assets to
a venture in a way as to subject himself to financial
losses. Under the usual investment vehicle, each investor
commits funds to the capital development of a plan. Should
a plan be unsuccessful, than the issuer will be unable
to return an investor’s money. This is always the
easy element to find.
- Common Enterprise
The common enterprise
element has been discussed in concepts known as ‘horizontal
and vertical commonality’. Horizontal commonality
requires the fortunes of each investor be linked to
the others. Vertical commonality requires a finding
that the fortunes of the investor are interwoven with
and dependent upon the efforts of those seeking investments
by new third parties. An investment plan is typically
a common enterprise under both the horizontal and vertical
common interest criteria. The fortunes of each investor
are dependent upon the success of the issuer in either
retailing merchandise in a legal MLM, or attracting
new recruits in an illegal pyramid scheme, or attracting
new investors’ money in a classic Ponzi scheme.
Investors have a “vertical” common interest
with the promoters of the plan, or third parties, and
a “horizontal” common interest with other
The concept of an investment
contract does not require that the efforts of promoters
or third parties be the sole efforts upon which the
failure or success of the enterprise is based. Historically,
there was some controversy on this point. The Supreme
Court wrote of this prong of the test as “with
profits to come solely from the efforts of others”.
The present general rule virtually ignores the adverb
“solely” in Howey and holds that investments
where decisions made by those other than the investors
are the essential, though not the exclusive, efforts
effecting the failure or success of the enterprise.
|Third Element -
Reasonable Expectation of Profits
||The Supreme Court’s
analysis under the Howey test of the term “profits”
emphasizes the economic realities of the transaction,
i.e., whether a purchaser is motivated by a desire to
use or consume the item purchased or whether the investor
is attracted solely by the prospects of a return on investment.
Almost certainly in typical Internet investments, expectation
of profit exists as the primary reason for the investment.
- Solely from the Efforts of Others.
||As discussed in element
two on commonality, the concepts are intertwined. Courts
today reject a literal application of the fourth element,
“solely from the efforts of others.” One SEC
enforcement action case held, in language that does not
make any sense to some readers: “whether the efforts
made by those other than the investor are the undeniably
significant ones, those essential managerial efforts which
affect the failure or success of the enterprise.”
Yet his quotation expresses the general test under the
fourth prong that is presently used by the SEC and state
securities regulators in their enforcement actions against
illegal pyramid and Ponzi schemes.
what about my efforts to recruit others? How can you tell the
difference between an illegal pyramid, a Ponzi scheme and a
multi-level marketing venture?
In any investment,
income is earned by raising money and then developing and
retailing the good or service, until ultimately, profit is
generated. Accordingly, returns are due to the results of
efforts by persons other than the investor. MLM defenders
often state that success is not due to the “efforts
of others”, and so not a “security” because
the member has to recruit others, and that takes work.
As to these “efforts”
by the investor, there is one very critical distinction. Efforts
to recruit new members to an MLM are not considered a bona
fide “effort” to take the program out of the realm
of an investment run by the “efforts of others ”.
The regulators consider that recruitment effort is not what
the normal investment contemplates. Why? Because they view
it as closer to a meal recipe swap chain letter, then a real
business. If the business is basically a system that sends
money up the pyramid, it’s not a business at all.
Playing on the needs of MLMers
to find new members, companies will sell them help. There
are magazines for MLM marketing. For example, you can see
for sale: “auto-pilot” advertising systems that
work while you’re at the beach, “hot” prospect
leads including 10,000 fax phone numbers, lists of other “networkers”
in peel and stick label format and – of course- cash
loans and “grants.” Here are some of the headlines:
|“Explode Your Downtime
On The Phone!”
|“We Pay Every Monday!”
|“Secret Bible Food
|“Make Big Money And
|“Join The #1 Team
And Top $$ Earners…”
There’s Money Everywhere!”
|“Make Hundreds, Even
Thousands Of Dollars A Month, Every Month!”
Grand? How About A Few Extra Grand A Month?”
|“Somebody Is Going
To Get Paid…Why Not You?”
|“Live In Your Dream
Home Earning $900 To $3,600 A Day…”
|And my personal
favorite: “Make Money Like A Gangster.”
Observation: how many Internet
investors can tell if an on line opportunity is a legal MLM
or an illegal Ponzi or pyramid scheme pretending to be a legal
MLM? Answer: few to none.
One person has come forward
with a very serious analysis questioning the Amway case logic
whereby it is not considered an illegal pyramid scheme. His
comments deserve serious consideration, because of his experience
and because of what appears at least to be, sincere motivation.
Bruce A Craig, an assistant attorney general for the State
of Wisconsin Department of Justice prosecuted a significant
amount of pyramid schemes, in his 30 years of service. The
list includes the Koscot Interplanetary case, which was the
major original case in this area of the law. Mr. Craig wrote
a letter to Robert Pitofsky, Chairman of the FTC, who was
the person who drafted the original Amway opinion in 1979.
Mr. Craig wrote that since the
Amway decision, “investments in pyramid type offerings
have resulted in billions of dollars over the years”.
I certainly agree with him there. He highlights that “the
FTC Amway decision has created a good deal of uncertainty
in respect to private and public legal efforts to deal with
abuses of pyramid plans” that “will only increase
with the onset of marketing over the Internet”.
Every time I prosecuted a pyramid
or Ponzi or whatever, the first words out of the founder’s
mouth were: “I set this up just like Amway”. Mr.
Craig has called for the FTC to re-examine the aspects of
Amway that make it legal because “the premise of ‘multi-level
vs. pyramid’ may well represent a distinction without
a difference”. I agree, as Mr. Craig is correct when
he asks “whether these exculpatory factors can be effectively
evaluated in time to prevent losses to the consuming public”.
In my experience, the fraudsters know that, and that is why,
unfortunately, when the SEC Enforcement Division comes in
with an asset freeze, the money is long gone.
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