Statement on “Pyramid Schemes” by Debra A. Valentine,
General
Counsel for the U.S. Federal Trade Commission
Presented
at the International Monetary Fund's Seminar on Current Legal Issues
Affecting
Central Banks, Washington, D.C., May 13, 1998
I would like to thank
you for the opportunity to speak about the growing international
problem of pyramid schemes. What is striking about these schemes is
that while they are very old forms of fraud, modern technology has
vastly multiplied their potential for harming our citizens. The
Internet in particular offers pyramid builders a multi-lane highway
to world-wide recruits in virtually no time.
Introduction
First, let me tell you
about the Federal Trade Commission.(1) The Commission is an
independent government agency that Congress established in 1914. We
perform a core function of government -- ensuring that free markets
work. This requires competition among producers and accurate
information in the hands of consumers in order to generate the best
products at the lowest prices, spur efficiency and innovation, and
strengthen the economy.
For competition to
thrive, consumers must be knowledgeable about available products and
services. Our Consumer Protection Bureau ensures that consumer
information in the marketplace is not deceptive or misleading. A free
market also means that consumers have a choice among products and
services at competitive prices. Our Competition Bureau ensures that
the marketplace is free from anti- competitive mergers and other
unfair business practices such as price-fixing or placing floors on
retail prices.
With the exception of
a few areas like air travel and insurance, the Commission has broad
law enforcement authority over virtually every sector in our economy.
Unfortunately, we now see pyramid schemes invading many of the
sectors that we oversee.
What is a Pyramid
Scheme and What is Legitimate Marketing?
Pyramid schemes now
come in so many forms that they may be difficult to recognize
immediately. However, they all share one overriding characteristic.
They promise consumers or investors large profits based primarily on
recruiting others to join their program, not based on profits from
any real investment or real sale of goods to the public. Some schemes
may purport to sell a product, but they often simply use the product
to hide their pyramid structure. There are two tell-tale signs
that a product is simply being used to disguise a pyramid scheme:
inventory loading and a lack of retail sales. Inventory loading
occurs when a company's incentive program forces recruits to buy more
products than they could ever sell, often at inflated prices. If this
occurs throughout the company's distribution system, the people at
the top of the pyramid reap substantial profits, even though little
or no product moves to market. The people at the bottom make
excessive payments for inventory that simply accumulates in their
basements. A lack of retail sales is also a red flag that a pyramid
exists. Many pyramid schemes will claim that their product is selling
like hot cakes. However, on closer examination, the sales occur only
between people inside the pyramid structure or to new recruits
joining the structure, not to consumers out in the general public.
A Ponzi scheme is
closely related to a pyramid because it revolves around continuous
recruiting, but in a Ponzi scheme the promoter generally has no
product to sell and pays no commission to investors who recruit new
"members." Instead, the promoter collects payments from a
stream of people, promising them all the same high rate of return on
a short-term investment. In the typical Ponzi scheme, there is no
real investment opportunity, and the promoter just uses the money
from new recruits to pay obligations owed to longer-standing members
of the program.
In English, there is
an expression that nicely summarizes this scheme: It's called
"stealing from Peter to pay Paul." In fact some law
enforcement officers call Ponzi schemes "Peter-Paul" scams.
Many of you may be familiar with Ponzi schemes reported in the
international financial news. For example, the MMM fund in Russia,
which issued investors shares of stock and suddenly collapsed in
1994, was characterized as a Ponzi scheme.(2)
Both Ponzi schemes and
pyramids are quite seductive because they may be able to deliver a
high rate of return to a few early investors for a short period of
time.Yet, both pyramid and Ponzi schemes are illegal because they
inevitably must fall apart. No program can recruit new members
forever. Every pyramid or Ponzi scheme collapses because it cannot
expand beyond the size of the earth's population.(3) When the scheme
collapses, most investors find themselves at the bottom, unable to
recoup their losses.
Some people confuse
pyramid and Ponzi schemes with legitimate multilevel marketing.
Multilevel marketing programs are known as MLM's,(4) and unlike
pyramid or Ponzi schemes, MLM's have a real product to sell. More
importantly, MLM's actually sell their product to members of the
general public, without requiring these consumers to pay anything
extra or to join the MLM system. MLM's may pay commissions to a long
string of distributors, ut these commission are paid for real retail
sales, not for new recruits.
How Pyramid Schemes
Operate
Let's look at how a
pyramid scheme operates from three points of view: the potential
investor, the promoter or con artist, and the victim. Many pyramid
schemes will present a payout formula or matrix much like this one:
This example
illustrates what is known as a three by four matrix. Each investor
pays $500 to the
promoter and is told to
build a "downline" by recruiting three new members, who
then each should recruit three more members. The investor is told
that he will be paid $150 for each of the three members whom he
enlists at the first level. The investor is also promised a $30
commission for each recruit at the next three levels. Thus, the
investor should receive commissions for four levels of recruits below
him, each of whom must recruit three more members, hence the name --
a three by four matrix.
To the potential
investor/recruit this may look like a very appealing opportunity. The
pyramid
promoter is likely to
persuade the investor that he is "getting in early" and
that he should consider himself at the top of the matrix. From this
perspective, it appears that he can earn $3,960 on an investment of
$500, a whopping 792 percent return. You can do the math easily: $150
from the first level of 3 recruits is $450; $30 from the next 3
levels of recruits is $270 ($30 x 9), plus $810 ($30 x 27), plus
$2,430 ($30 x 81). Not a bad deal.
Yet, consider the
matrix from the promoter/con artist's point of view. He is the person
at the top of the pyramid but in fact looks at the scheme from the
bottom. He views each new investor as a predicable set of revenues
and expenses, with the revenues flowing down to him. The con artist
receives $500 for each new member, and at most he will have to pay
$240 in commissions to earlier investors in the new recruit's
"upline," i.e. those people responsible for bringing him
into the system. So when an investor joins the system in the last
level, the promoter will receive $500, but he will pay only $150 to
the person who recruited the new investor, and $30 each to three
longer-standing members in the new investor's "upline," for
a total of $240. Thus, the con artist will keep over half of every
$500 membership fee paid.
Let's assume that this
scheme collapses after the fourth level of recruits is filled. The
con artist will have made $500 from the first investor in the pyramid
($500 with no commissions paid out), $350 from the 3 at the next
level ($500 minus commission of $150), $320 from the 9 at the next
level ($500 minus commissions of $150 + $30), $290 from the 27 at the
next level ($500 minus $150 + $30 + $30), and $260 from the 81 newest
investors ($500 minus commissions of $150 + $30 + $30 + $30). The
simple math -- $33,320 flowed down to the con artist -- and all he
did was attract one investor!
Now consider the
pyramid from the investor/victim's perspective -- after the entire
scheme has collapsed around him. The victim, like the first investor,
thought of himself at the top of the pyramid but suddenly realizes
that he is actually at the bottom, unable to find people interested
in the program to build out his downline. He is not alone because
mathematics shows that MOST investors will find themselves at the
bottom of the pyramid when it collapses. The very structure of this
matrix dictates that whenever the collapse occurs, at least 70
percent will be in the bottom level with no means to make a profit.
They all will be out $500. In our example, even those people one
level above the bottom will not have recouped their investment. They
each will have paid a membership fee of $500 and collected
commissions of $150 for each of three recruits, leaving each investor
in the second-from-the-bottom tier at least $50 shy of his break-even
point. In short, when the pyramid collapses all the investors in the
bottom two levels will be losers. Adding together the number of
victims from these bottom two levels shows that 89 percent of all the
pyramid's participants (108 of 121 investors) are doomed to lose
money.
A Ponzi scheme could
yield even worse results for investors, because it does not pay out
any
commissions at all.
This can have disastrous consequences, as exemplified by Charles
Ponzi's
infamous fraud in the
1920's. Charles Ponzi, an engaging ex-convict, promised the
Italian-American
community of South
Boston that he would give them a 50 percent return on their money in
just 45 to 90
days.(5) Mr. Ponzi
claimed that he could pay such a high rate of return because he could
earn 400 percent by trading and redeeming postal reply coupons. These
coupons had been established under the
Universal Postal
Convention to enable a person in one country to pre-pay the return
postage on a
package or letter sent
back from another country.
For a short time after
World War I, fluctuations in currency exchange rates did create a
disparity between the cost and redemption value of postal reply
coupons among various countries. However, Mr. Ponzi discovered that
he could only make a few cents per coupon and that handling large
volumes of coupons cost more than they were worth. He stopped
redeeming any coupons but continued to collect investors' money. When
he actually paid a 50 percent return to some early investors, his
reputation soared and more money flowed in from around the country.
Mr. Ponzi bought a stylish house in the best part of town and
purchased a large minority interest in his local bank, the Hanover
Trust Company.
Eventually his scheme
began to unravel, bringing ruin to the bank and thousands of
investors. When Mr. Ponzi began to overdraw his accounts at Hanover
Trust, the Massachusetts Banking Commissioner ordered Hanover Trust
to stop honoring Ponzi's checks. The bank refused and even issued
back-dated certificates of deposit to cover Mr.Ponzi's overdrafts. A
few days later, the Banking Commission took over Hanover Trust, and
Mr. Ponzi was arrested for mail fraud. In the end, Charles Ponzi owed
investors over $6 million, an enormous sum of money for that time. He
was convicted of fraud in both state and federal court and served ten
years in prison.(6)
Law
Enforcement Partners
The legacy of Mr.
Ponzi lives on as pyramid and Ponzi schemes continue to plague us and
challenge the law enforcement community. Fortunately, in the U.S.,
the Federal Trade Commission is just one among many agencies that
have the authority to file suit to stop this type of fraud. The
Securities and Exchange Commission also pursues these schemes,
obtaining injunctions against so-called "financial distribution
networks" which in fact sell unregistered "securities."(7)
The U.S. Department of Justice, in collaboration with investigative
agencies like the FBI and the U.S. Postal Inspection Service,
prosecutes pyramid schemes criminally for mail fraud, securities
fraud, tax fraud, and money laundering.(8)
State officials
independently file cases in state court, often under specific state
laws that prohibit pyramids. California defines pyramids as "endless
chains" and prohibits them under its laws against illegal
lotteries.(9) In a slightly different vein, Illinois classifies
pyramid schemes as criminal acts of deception directed against
property.(10) Some states like Georgia prohibit pyramid schemes under
a statutory framework that regulates business opportunities and
multilevel marketing.(11)
At the Commission,
we bring cases against pyramid schemes under the FTC Act, which
broadly prohibits "unfair or deceptive acts or practices in or
affecting commerce."(12) That Act allows the Commission to
file suit in federal court and seek a variety of equitable remedies,
including injunctive relief, a freeze over the defendants' assets, a
receivership over the defendants' business, and redress or
restitution for consumers.
FTC
Precedent from the 1970's
The Commission took
its first concerted action against pyramid schemes in the 1970's
during a boom in home-based business and MLM or direct selling.
One-on-one marketing became common for many consumer items -- from
cosmetics to kitchenware, and TupperwareTM parties became an icon of
the era. Unfortunately, the rise in legitimate multilevel marketing
was accompanied by a surge in pyramid schemes. Those schemes played
off the popularity of MLM or network sales but paid more attention to
networking than to selling actual goods. Pyramid schemes became so
notorious that then-Senator Walter Mondale sponsored a federal
anti-pyramiding bill. It passed the United States Senate twice in the
1970's, but never became law.(13)
One of the
Commission's first cases was In re Koscot Interplanetary, Inc.,(14)
which involved a company that offered the opportunity to become a
"Beauty Advisor" and sell cosmetics. The company's
incentive structure really did not encourage retail sales. Instead,
it encouraged people to pay $2000 for the title of "Supervisor"
and purchase $5400 in Koscot cosmetics, and then to earn bonuses by
recruiting others to make the same investments.(15) The Commission
found that Koscot operated an illegal "entrepreneurial chain"
and articulated a definition of illegal pyramiding that our agency
and the federal courts continue to rely on.(16) The Commission found
that pyramid schemes force participants to pay money in return for
two things. First is "the right to sell a product", second
is "the right to receive, in return for recruiting other
participants into the program, rewards which are unrelated to sale of
the product to ultimate users. (emphasis added)"(17) The
Commission explained that paying bonuses for recruiting
. . . will encourage
both a company and its distributors to pursue that side of the
business, to the neglect or exclusion of retail selling. The
short-term result may be high recruiting profits for the company and
select distributors, but the ultimate outcome will be neglect of
market development, earnings misrepresentations, and insufficient
sales for the insupportably large number of distributors whose
recruitment the system encourages."(18)
In In re Amway
Corp.,(19) another landmark decision from the 1970's, the FTC
distinguished an illegal pyramid from a legitimate multilevel
marketing program. At the time, Amway manufactured and sold cleaning
supplies and other household products. Under the Amway Plan, each
distributor purchased household products at wholesale from the person
who recruited or "sponsored" her. The top distributors
purchased from Amway itself. A distributor earned money from retail
sales by pocketing the difference between the wholesale price at
which she purchased the product, and the retail price at which she
sold it. She also received a monthly bonus based on the total amount
of Amway products that she purchased for resale to both consumers and
to her sponsored distributors.(20)
Since distributors
were compensated both for selling products to consumers and to
newly-recruited distributors, there was some question as to whether
this was a legitimate multilevel marketing program or an illegal
pyramid scheme. The Commission held that, although Amway had made
false and misleading earnings claims when recruiting new
distributors,(21) the company's sales plan was not an illegal pyramid
scheme.
Amway differed in
several ways from pyramid schemes that the Commission had challenged.
It did not charge an up-front "head hunting" or large
investment fee from new recruits, nor did it promote
"inventory
loading" by requiring distributors to buy large volumes of
nonreturnable inventory. Instead,
Amway only required
distributors to buy a relatively inexpensive sales kit. Moreover,
Amway had three different policies to encourage distributors to
actually sell the company's soaps, cleaners, and household products
to real end users. First, Amway required distributors to buy back any
unused and marketable products from their recruits upon request.
Second, Amway required each distributor to sell at wholesale or
retail at least 70 percent of its purchased inventory each month -- a
policy known as the 70% rule. Finally, Amway required each sponsoring
distributor to make at least one retail sale to each of 10 different
customers each month, known as the 10 customer rule.(22)
The Commission found
that these three policies prevented distributors from buying or
forcing others to buy unneeded inventory just to earn bonuses. Thus,
Amway did not fit the Koscot definition: Amway participants were not
purchasing the right to earn profits unrelated to the sale of
products to consumers "by recruiting other participants, who
themselves are interested in recruitment fees rather than the sale of
products."(23)
Pyramid
Schemes in the 1990's
The 1990's first
brought an important refinement in the law. As the Commission pursued
new pyramid cases, many defendants proclaimed their innocence,
stating that they had adopted the same safeguards -- the inventory
buy-back policy, the 70% rule, and the 10 customer rule -- that were
found acceptable in Amway. However, an appellate court decision
called Webster v. Omnitrition Int'l, Inc.,(24)pointed out that the
Amway safeguards do not immunize every marketing program. The court
noted that the "70% rule" and "10 customer rule"
are meaningless if commissions are paid based on a distributor's
wholesale sales (which are only sales to new recruits), and not based
on actual retail sales.(25) The court also noted that an inventory
buy-back policy is an effective safeguard only if it is actually
enforced.(26)
While new cases
were refining the law in the 1990's, radical changes were underway in
the marketplace. Pyramid schemes came back with a vengeance. Like
most economic activity, fraud occurs in cycles, and new pyramid
schemes exploited a new generation of consumers and entrepreneurs
that had not witnessed the pyramid problems of the 1970's. Also, the
globalization of the economy provided a new outlet for pyramiding.
Pyramids schemes found fertile ground in newly emerging market
economies where this type of fraud had previously been scarce or
unknown.(27) In Albania, for example, investors poured an
estimated $1 billion into various pyramid schemes -- a staggering 43%
of the country's GDP.(28)
In the U.S., probably
nothing has contributed to the growth of pyramid schemes as much as
Internet marketing. The introduction of electronic commerce has
allowed con artists to quickly and cost-effectively target victims
around the globe. After buying a computer and a modem, scam artists
can establish and maintain a site on the World Wide Web for $30 a
month or less, and solicit anyone in the world with Internet access.
Pyramid operators can target specific audiences by posting messages
in specialized news groups (e.g., "alt.business.home" or
"alt.make.money.fast"). In addition, through unsolicited
e-mail messages -- known on the Internet as "spam" --
pyramid operators can engage in cheap one-on-one marketing. Whereas
it might cost hundreds or thousands of dollars to rent a mailing list
and send 10-cent post cards to potential recruits, it costs only a
fraction of that to send out similar e-mail solicitations. On the
Internet, you can acquire one million e-mail addresses for as little
as $11 and spend nothing on postage.(29)
The Federal Trade
Commission's current law enforcement efforts reflect this new wave in
pyramiding. The Commission has brought eight cases against pyramid
schemes in the last two years,(30) and six of those have involved
Internet marketing.(31) One recent case,FTC v. FutureNet, Inc., is
particularly instructive because it starkly reflects the potential
for abuse in hi-tech and newly deregulated industries. FutureNet
allegedly claimed that, for payment of $195 to $794, investors could
earn between $5000 and $125,000 per month as distributors of Internet
access devices like WebTV. The FTC filed suit, charging that
FutureNet's earnings claims were false because the company really
operated an illegal pyramid scheme. Near the time of filing, FTC
investigators discovered that FutureNet had begun to sell electricity
investments as well, riding a wave of speculation in advance of the
deregulation of California's electricity market.
The Commission
obtained a TRO and an asset freeze over the defendants' assets and
eventually reached a $1 million settlement with the corporate
defendants and two individual officers. The settlement requires the
defendants to pay $1 million in consumer redress, bars them from
further pyramiding activity of any kind, requires them to post a bond
before engaging in any network marketing, and requires them to
register with state utility officials before engaging in the sale of
electricity. The Commission continues to litigate its case against
three non-settling individual defendants.(32)
The Impact of
Pyramids on Banking
Pyramid schemes not
only injure consumers. In many cases, they affect the daily
operations of banks and taint the banking industry's overall
reputation for safety and soundness. Many pyramid promoters disparage
the bank industry and promote their own program as a superior
alternative to traditional banking and investment. Melvin Ford, a
defendant in the SEC's recent case against International Loan
Network, stated that his company's bonus program was "the most
powerful financial system since banking."(33) At the height of
his popularity, Charles Ponzi actually proclaimed that he would form
a new banking system and divide profits equally between depositors
and shareholders.(34)
In FTC v. Cano,(35) the Commission observed first-hand the impact of pyramid schemes on the
banking system and
individual banks. In that case, the Commission targeted an alleged
Internet pyramid scheme that operated under the name Credit
Development International ("CDI"). For an initial
payment of $130 and
subsequent monthly payments of $30, consumers could join CDI's
"Platinum Infinity Reward Program" and become a participant
in its "3x7 Forced Matrix" -- a structure that promised
commissions going seven layers deep and that required each
participant to recruit just three new members. CDI represented that
participants could earn more than $18,000 per month in this program.
Besides the promise of
high profits, the real attraction of CDI was its offer of an
unsecured Visa or MasterCard, with a $5000 credit limit and a low
6.9% annual financing rate. This offer was especially attractive to
consumers with poor credit histories, to whom CDI advertised saying
"Guaranteed Approval, No Security Deposit! No Credit Check, No
Income Verification and Bankruptcies No Problem!"(36)
CDI representatives
claimed that they could offer such attractive terms because they had
a special marketing relationship with a large overseas bank, the
Banque Nationale de Paris (BNP). According to the transcript of a
taped sales meeting, CDI hinted that a broad conspiracy prevented
U.S. banks from offering such favorable terms. A CDI representative
claimed, "normal banks do not want people to know that they
could have a 6.9 [percent] credit card."(37) In the same
meeting, CDI painted itself an alternative to a regular bank and said
"our whole concept is to have the largest membership credit
union in the world."(38) "We're the bank."(39)
In fact, according to
the Commission's evidence, CDI had no business relationship with
Visa, MasterCard, or BNP, and no relationship with any bank willing
to issue credit cards to CDI members. Our evidence also showed that
the defendants likely misled the one bank with which they did have a
relationship. When investors paid by credit card to join CDI, the
defendants apparently processed these payments, not through CDI but
through a different "front" company with a VISA merchant
account. Consequently, the defendants put their own merchant bank at
risk for any charge backs that VISA might credit to angry investors.
In the end, CDI
members never received their credit cards, and according to a
Commission economist, at least 89 percent of them would never have
made enough money to recoup their initial investment. Last autumn,
the Commission obtained a temporary restraining order and a
preliminary injunction against the CDI defendants, as well as a
freeze over their assets. The Commission estimates that over the
five-month life of CDI, more than 30,000 consumers from the U.S.,
Europe, Australia, and Southeast Asia lost $3 to $4 million dollars
in this alleged scam. The matter is still in litigation; the
Commission is now seeking to amend its complaint and name additional
defendants.
In the largest pyramid
case brought by the Commission in the 1990's, we witnessed how
pyramid operators often try to use the international banking system
to hide their assets. In FTC v. Fortuna Alliance,(40) the defendants
allegedly promised consumers that, for a payment of $250, they would
receive profits of over $5,000 per month. The program spawned
numerous web sites on the Internet and victimized thousands of
investors across 60 different countries. Although the defendants
initially operated out of the United States, the Commission
discovered they had secreted millions of dollars to offshore bank
accounts in Antigua. But international cooperation saved the day.
With the aid of the courts and banks in Antigua, the Commission
obtained an order against the defendants, requiring them to
repatriate over $2 million in offshore assets and pay approximately
$7 million in redress to consumers from 60 countries.
Consumer
Education
Law enforcement is the
cornerstone of the Commission's fight against pyramid schemes;
however, we also try to educate the public so that they can protect
themselves. In our educational efforts, we have tried to take a page
from the con artists' book and use new online technology to reach
consumers and new entrepreneurs. For example, on the agency's web
site at "www.ftc.gov", the Commission has posted several
alerts regarding pyramid schemes and multilevel marketing problems.
The Commission records over 2 million "hits" on its home
page every month and receives several thousand visitors on its
pyramid and multilevel marketing pages.
The staff of the
Commission also has posted several "teaser" web sites,
effectively extending a hand to consumers at their most vulnerable
point -- when they are surfing areas of the Internet likely to be
rife with fraud and deception. The "Looking for Success"
site is one example. It advertises a fake pyramid scheme. The home
page of "Looking for Success" promises easy money and talks
in glowing terms about achieving "financial freedom." On
the second page, the consumer finds a payout plan common to pyramid
schemes, as well as typical buzz words like "forced matrix,"
"get in early," and "downline." Clicking through
to the third and final page in the series, however, brings the
consumer to a sobering warning: "If you responded to an ad like
this one, you could get scammed." The warning page provides a
hyper-text link back to FTC.GOV, where consumers can learn more about
how to avoid pyramid schemes.
Business
Education
In an effort to
provide information to new entrepreneurs, especially those who may
unwittingly violate the law, the Commission has conducted a number of
"Surf Days" on the Internet. The first Surf Day, conducted
in December 1996, focused on pyramid schemes. Commission attorneys
and investigators enlisted the assistance of the SEC, the U.S. Postal
Inspection Service, the Federal Communications Commission, and 70
state and local law enforcement officials from 24 states. This
nationwide ad hoc task force surfed the Internet one morning, and in
three hours, found over 500 web sites or newsgroup messages promoting
apparent pyramid schemes. The Commission's staff e-mailed a warning
message to the individuals or companies that had posted these
solicitations, explaining that pyramid schemes violate federal and
state law and providing a link back to FTC.GOV for more information.
In conjunction with
the New York Attorney General's Office and the Interactive Service
Association, the Commission announced the results of Internet Pyramid
Surf Day at a televised press conference in New York City. A month
later, the Commission's investigative staff revisited web sites or
newsgroups identified as likely pyramids during Surf Day and found
that a substantial number had disappeared or improved their
representations and claims made to consumers.
More recently in
October 1997, the Commission helped coordinate the first
"International Internet Surf Day." Agencies from 24
countries joined this effort and targeted "get-rich-quick"
schemes on the Internet, including pyramid schemes.(41) Australia's
Competition and Consumer Commission oversaw the world-wide effort
while the FTC led the U.S. team consisting of the SEC, the
Commodities Futures Trading Commission ("CFTC") and 23
state agencies.
In February of this
year, the Commission announced yet another innovative use of the Surf
Day concept, this time targeting deceptive e-mail solicitations. The
Commission collects unsolicited commercial e-mail from annoyed
consumers and other sources. A large percentage of these e-mails
contain apparent chain letters or pyramid schemes. The Commission
searched its e-mail database, topic by topic, and along with the
Postal Inspection Service sent a warning letter to over 1000
individuals or companies identified as potentially responsible for
promoting pyramids or other get-rich-quick schemes.
Looking
Ahead
Unfortunately, pyramid
schemes are likely to continue to proliferate both here and abroad in
the near future. However, we can all help stem the tide by working
together. Members in the the banking or financial sector can help law
enforcement agencies in several ways. First, if your country does not
have a law that makes pyramid schemes illegal, you should encourage
your government to enact the necessary legislation and provide
sufficient resources for enforcers to pursue pyramid schemes.
Associations of reputable bankers or insurers, whose businesses can
be jeopardized by the illicit schemes of unlicensed insurers or
securities dealers, can be effective allies.
Recent history in
Eastern Europe makes it only too clear that pyramid schemes exploit
the absence of a fully-functioning market, adequate supervision,
and/or an effective legal infrastructure. Second, you can report any
suspect investment programs or potential pyramid schemes. Any
information can help, and you may be able to provide valuable insight
into who is operating a pyramid, how it works, and whom it
victimizes. In the Cano case, it was the substantial assistance of
financial fraud investigators at VISA that enabled the Commission to
develop and bring its case. Third, help us and others foreign
enforcers to identify and freeze defendants' assets located in your
countries. Understandably, banks must observe their privacy laws, but
to the extent it is legally possible for you to provide assistance in
tracing and freezing the assets of pyramid operators, you will
benefit all our citizens. This is often the only way to halt an
illegal scheme and return money to victims. We hope that the Fortuna
Alliance case signals the beginning of a trend in obtaining valuable
help from foreign courts and banks.
Finally, you can
encourage the relevant officials in your countries to combat pyramid
schemes by educating consumers and businesses about how to recognize
and avoid this type of fraud. This can be particularly important in
emerging markets, where experience with investment opportunities may
be scarce.
Here are some tips
that consumers and business might find helpful.
1. Beware of any
plan that makes exaggerated earnings claims, especially when
there seems to be no real underlying product sales or investment
profits. The plan could be a Ponzi scheme where money from later
recruits pays off earlier ones. Eventually this program will
collapse, causing substantial injury to most participants.
2. Beware of any
plan that offers commissions for recruiting new distributors,
particularly when there
is no product
involved or when there is a separate, up-front membership fee. At the
same time, do not
assume that the
presence of a purported product or service removes all danger. The
Commission has
seen pyramids
operating behind the apparent offer of investment opportunities,
charity benefits, off-shore credit cards, jewelry, women's underwear,
cosmetics, cleaning supplies, and even electricity.
3. If a plan
purports to sell a product or service, check to see whether its price
is inflated, whether new
members must buy
costly inventory, or whether members make most "sales" to
other members rather
than the general
public. If any of these conditions exist, the purported "sale"
of the product or service
may just mask a
pyramid scheme that promotes an endless chain of recruiting and
inventory loading.
4. Beware of any
program that claims to have a secret plan, overseas connection or
special
relationship that is
difficult to verify. Charles Ponzi claimed that he had a secret
method of trading and
redeeming millions
of postal reply coupons. The real secret was that he stopped
redeeming them.
Likewise, CDI
allegedly represented that it had the backing of a special overseas
bank when no such
relationship
existed.
5. Beware of any
plan that delays meeting its commitments while asking members to
"keep the faith." Many pyramid schemes advertise that they
are in the "pre-launch" stage, yet they never can and never
do launch. By definition pyramid schemes can never fulfill their
obligations to a majority of their participants. To survive, pyramids
need to keep and attract as many members as possible. Thus,
promoters try to appeal to a sense of community or solidarity, while
chastising outsiders or skeptics. Often the government is the target
of the pyramid's collective wrath, particularly when the scheme is
about to be dismantled. Commission attorneys now know to expect
picketers and a packed courtroom when they file suit to halt a
pyramid scheme. Half of the pyramid's recruits may see themselves as
victims of a scam that we took too long to stop; the other half may
view themselves as victims of government meddling that ruined their
chance to make millions. Government officials in Albania have also
experienced this reaction in the recent past.
6. Finally, beware
of programs that attempt to capitalize on the public's interest in
hi-tech or newly deregulated markets. Every investor fantasizes about
becoming wealthy overnight, but in fact, most hi-tech ventures are
risky and yield substantial profits only after years of hard work.
Similarly, deregulated markets can offer substantial benefits to
investors and consumers, but deregulation seldom means that
"everything goes," that no rules apply, and that pyramid or
Ponzi schemes are suddenly legitimate.
Conclusion
As we continue to
pursue pyramid schemes, we would be delighted to coordinate our
efforts with law enforcement in your countries. It is only too
evident that the expansion of fraud across borders and on the World
Wide Web means that no one agency or country can work effectively on
its own. We must be collectively vigilant in order to protect the
integrity of our marketplaces and the pocketbooks of our consumers.
References
1. The views I give, of
course, are my own and do not reflect the official views of the
Commission or any particular Commissioner.
2. Barbara Rudolph,
Poof Go the Profits . . ., Time, Aug.
8, 1994 at 44.
3. Assume a pyramid
scheme in which each person recruits 10 new people. There would be
one person at the top, 10 beneath her, 100 beneath them, 1,000
beneath them and so forth. The pyramid would involve everyone on
earth in just 10 layers of people with one con artist on top. The
bottom layer would have more than 4.5 billion people. The Skeptic's
Dictionary at
"http://wheel.vcdavis.edu/nbtcarrol/skeptic/pyramid.html"
4. Some people also
refer to multilevel marketing as direct selling or network selling.
5. See Mark C. Knutson,
"The Ponzi Scheme," published online at
"http://www.usinternet.com/users/mcknutson/pscheme.ht
m".
6. Id.
7. See e.g., SEC v.
Int'l Load Network, Inc., 770 F. Supp. 678 ( D.D.C 1991), aff'd, 968
F.2d 1304 (D.C. Cir. 1992)..
8. See e.g. U.S. v.
Crowe, 4:95CR-13-C (W.D. Ky. 1995) (charging an alleged pyramid
promoters with mail fraud under 18 U.S.C. § 1341; securities fraud
under 15 U.S.C. § § 78j(b), 78ff, 17 C.F.R. § 240.10b-5, and 18
U.S.C. § 2; and money laundering under 18 U.S.C. § § 2, 1957.)
9. Cal. Penal Code §
327 (Deering 1996)
10. 720 Ill. Compiled
Stat. Ann. 5/17-7 (Michie 1997) (formerly Ill. Rev. Stat., ch. 38,
para. 17/7 (1993))
11. Ga. Code Ann. §
10-1-410 (1997)
12. 15 U.S.C. § 45
(1997)
13. See Thomas P.
Rowan, Report, Confronting the Pyramid Hazard in the United States 15
(submitted to Prof. Robert Vaughn, Wash. College of Law, Am. U.)
(1998) (citing Joseph N. Mariano & Mario
Brossi, Multilevel
Marketing: A Legal Primer 29 (2d ed.
1997)).
14. 86 F.T.C. 1106
(1975), aff'd sub. nom. Turner v. FTC, 580 F.2d 701 (D.C. Cir. 1978).
15. Id. at 1108-110
(complaint).
16. See e.g., Webster
v. Omnitrition Int'l, Inc., 79 F.3d 776, 781-82 (9th Cir. 1996),
cert. denied, 117 S. Ct. 174, __ U.S. __ (1996).
17. Koscot 86 F.T.C. at
1180.
18. Id. at 1181.
19. 93 F.T.C. 618
(1979)
20. Id. at 710-14.
21. Id. at 729-33.
22. Id. at 715-17
23. Id. See Rowan at
18-21 (analyzing the Amway decision).
24. 79 F.3d 776, 781-82
(9th Cir. 1996), cert. denied, 117
S. Ct. 174, __ U.S. __
(1996).
25. Id. at 783.
26. Id. at 783-84.
27. Tom Hundley, Always
Poor, Albanians Go for Broke, Chicago Tribune, Feb. 11, 1997 at 18.
28. Id. For an analysis
of the effect of pyramid and Ponzi schemes on Eastern Europe's
insurance market, see Int'l Chamber of Commerce, Pyramid sales of
insurance policies condemned, Business World, July 9, 1997 at
"http://www.iccwbo.org/html/pyramid.htm".
29. Ram Avrahami, FTC
Workshop on Consumer Information Privacy, Transcript of June 12, 1997
at 107.
30. See FTC v.
Affordable Media, LLC, Civil Action No.CV-S-98-00669-LDG) (D. Nev.
filed April 23, 1998); FTC v FutureNet, Inc., No. 98-1113 FHK (AIJx)
(C.D. Cal. filed Feb. 17, 1998); FTC v. Cano, No. (C.D. Cal. filed
Oct. 29, 1997); FTC v. Jewelway Int'l Inc., No. CV-97-383 TUC JMR (D.
Ariz. filed June 24, 1997); FTC v. World Class Network, Inc., No.
SAV-97-162 AHS (Ebx) (C.D. Cal.
filed Feb. 28, 1997);
FTC v. Mentor Network, Inc., No.SACV 96-1104 LHM (Eex), (C.D. Cal.
filed Nov. 5, 1996); FTC v. Global Assistance Network for Charities,
No. CIV 96-2494 PHX RCB (D. Ariz. filed Nov. 5, 1996); FTC v. Fortuna
Alliance, L.L.C., No. C96-799M (W.D. Wash. filed May 23, 1996).
31. Based on complaints
the FTC has filed, the Internet was a major recruiting tool used in
FutureNet, Cano, World Class Network, Mentor Network, Global
Assistance Network for Charities, and Fortuna Alliance.
32. See, FTC, FutureNet
Defendants Settle FTC Charges: $ 1 Million in Consumer Redress for
"Distributors",
Apr. 8, 1998 at "/opa/9804/futurenet.htm"
(press release).
33. Int'l Loan Network,
770 F. Supp. at 678.
34. Knutson, supra,
note 5.
35. Cano, supra, note
30.
36. Exhibits in Support
of Motion for TRO and Asset Freeze, Ex. 2, Attachments 2, 7, Cano,
supra, note 30.
37. Exhibits in Support
of Motion for TRO and Asset Freeze, Ex. 2, Attachment 5 at 141, Cano,
supra, note 30 (transcript of sales presentation) [hereafter
"Transcript"].
38. Id. at 86.
39. Id. at 110.
40. Fortuna Alliance,
supra, note 30.
41. International
participants included Australia, Austria, Belgium, Canada, the Czech
Republic, Denmark, Finland, France, Hungary, Ireland, Jamaica, Japan,
Korea, Mexico, New Zealand, Norway, the Philippines, Poland,
Portugal, South Africa, Spain, Sweden, Switzerland, and the United
Kingdom.
