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Ponzi Schemes: Taking Chances is Where Government Responsibility Ends

Date of publication: 30 July 2013

Yevgen Solovyov, Attorney at Law

Source: Dzerkalo Tyzhnia

A pyramid scheme or Ponzi scheme* is a fraudulent investing plan geared toward providing returns to early investors from the funds collected from later recruits. In most cases, the real source of income is hidden, with a fictious or minor one declared instead. A typical pyramid scheme will promise extremely high rates of return. These, however, cannot be sustained for a long time so the scheme is doomed to collapse. When it happens, most investors find themselves at the bottom, unable to recoup their losses.

Some pyramid schemes can be registered as commercial companies and raise funds to finance a certain project. The rest, however, go unincorporated (take, for example, the recent revival of MMM, the notorious Russian Ponzi scheme**). If the project generates little or no actual profits, it means that new investors essentially pay off the old ones. What expectedly happens in the end is the collapse of the project, with later enrollees unable to recoup their losses. Anecdotally, only 10 to 15 per cent of all funds raised can be recovered since the monies had not been used to purchase liquid assets but forwarded to pay the longer-standing members instead, fund advertising campaigns and to generate wealth for the instigators of the scheme. The longer a pyramid operates, the less money can be recovered after it collapses.

A key difference between a pyramid scheme and a real business project is therefore the source of profit. If payouts are sustainably higher than wealth created by a business, that business is a pyramid scam.

Many countries have laws that make practices of this kind illegal. Notably, in the United States where pyramid schemes are pursued and criminally prosecuted, there is a distinction between pyramids and multi-level marketing (abbreviated MLM***). This distinction, however, is shaped by the orders of the Federal Trade Commission (FTC) rather than by federal statutes. Various legislation governing the legal aspects of MLM operation is also enacted on state level. In a country where case law is the source of law, this approach can prove effective.

Canada has a Competition Act in place to combat pyramid schemes. MLM participants who fail to comply with the Act are sued for fraud and fined by CAD 200,000 or sentenced to one year in prison or up to 5 years in case if signs of a pyramid scheme are revealed.

In contrast to the United States and Canada, Ukraine has no legislation in place directly prohibiting this kind of fraudulent operations. Effort has been made to bridge this gap but when this is going to happen remains unclear. A Pyramid Schemes Bill was introduced into the Parliament by the Cabinet in early April 2013.

What liability does the promoter have towards the investors?

In most cases, when it comes to incorporated pyramid schemes, the liability of its subscribing members is limited to what they have originally invested in the company. In other words, any debt may be legally enforced only against the assets of such company which, if ever existed, are unlikely to remain there by the time enforcement is ordered.

One can attempt to prove the elements of fraud and sustain a criminal conviction but, anecdotally, trying to do so under current Ukrainian laws is an extremely challenging business.

Further, one needs to verify whether such company complied with all formalities at the time of incorporation and during its operation. Possible audit suggestions include whether it was put on the Register of Financial Institutions, whether it had obtained all necessary licenses and/or special permits, what purposes it had used the money for and what were the transactions it was engaged in, etc. The outcomes of these audits will enable to conclude whether the company did or were not commit any other crimes (say, trading as sham business, money laundering, embezzlement, causing damage by deception or abuse of trust, causing to become bankrupt, financial fraud).

For example, the revamped MMM scheme is not a financial institution. What it really is is a so called electronic pyramid which does not accept direct deposits, with people sending money to each other. According to the promoter, Sergei Mavrodi**, the money was not owned by him and kept on investors’ or agents’ accounts. In contrast to its like-named predecessor from nineties, Mavrodi had openly warned the investors that the scheme could collapse at any time. I believe that it is virtually impossible to identify all the beneficiaries, to track their spending and to prove there was fraud, conspiracy, misappropriation of money and willful deception and abuse of trust. Suppose even that the criminal case is brought and certain people (may be all accessories, may be even Mavrodi himself) are prosecuted given the high profile of the whole affair. Will the investors benefit from that, I doubt. The only relief they could possibly get is moral relief, since it is not practicable to recoup anything they lost as it was the previous time.

On the other hand, early nineties are gone, and there is hardly any one in the age of reason who is not aware of Ponzi schemes. In our days, pyramids and Ponzi schemes like the new MMM have turned into a kind of alternative to gambling business: the overwhelming majority of recruits are perfectly aware of all risks as they get involved in the scam. And they are careful not to invest all of their savings as it happened before. What they do is sacrificing reasonable amounts in exchange of adrenaline. Thus, the purpose of this investment is not just getting super-high returns with very little effort, but also taking chances guessing when it’s best time to withdraw. It also makes them seem smarter to themselves than those who missed and ended up with a loss.

What stands behind this way of thinking is clear. It is not clear, though, what on earth drives people to invest considerable percentage of their income and savings in these projects consciously believing them to be something like a bank deposit with immense returns.

A bank is an officially incorporated, fully-licensed and regulated financial institution that offers deposits by means of contract clearly setting depositor’s rights and bank’s obligations. The depositors also enjoy the security of being covered by Depositors Insurance Fund. And even in that case there is no 100% guarantee: a bank can fail or be «helped» to fail, or the government can cut restitution by adopting statues. And thinking of the schemes like MMM where there is initially no documentary guarantee of refund, not even an illusion of it, there are no reasons to hope for a happy end.

However, you can bet that it’s these «sound-minded» investors who will claim losses after a pyramid collapses. And, most surprising, their claims are likely to be addressed to the state, as it was with the notorious Elita Centre housing scam. It is worth noting that there is no such claims are going to be entertained as all transactions of this kind are at own risk and there is no reason why the government should pay restitution on a misfortunate investment from other taxpayers’ money.

Now, the weirdest thing is that people like these will always find a way to get cheated of their money blaming everyone around. Would there be no MMM 2011 or MMM 2012, they would be still waiting for, say, MMM 2025. And they will not just invest their savings. What they will do is borrow more money at 40% p.a. interest rate and with the mortgage on all of their property – let the banks be blamed after, too. Even though it takes the court to find a person lacking capacity to understand simple things, a better definition can hardly be found for some of us.

Summing up, there is nothing I could advise to gambler investors – they know how Ponzi scheme works and just take their chances.

Certainly, there is something I could advice to «sound-minded» investors. For example, try using time-proven types of keeping of investing your money that offer a higher degree of security, such as safe deposit boxes or interest bank deposits. Even more risky deals with mutual investment funds are a better option that investing in a Ponzi scheme. However, I believe that these people don’t actually need any advice – they keep ignoring it for 20 years now.

But there are many others who lack consumer education and awareness. So here are some tips that consumers might find helpful to avoid becoming a scam victim.

Key signs of pyramid and Ponzi schemes

1. Beware of any plan that makes exaggerated earnings claims. Remember that there’s no such thing as a free lunch. Underlying any business are common economic laws and rules according to which there is no getting big money coming quickly and with no effort.

2. Beware of any plan that can furnish no documented investment history. If the funds raised from the recruits are not invested anywhere, there is no source of profit, and the plan has to rob Peter to pay Paul. This cannot last long, and the scheme is doomed to collapse.

3. Beware of any plan offered by someone not incorporated as a financial institution with all necessary licenses, permits and other supporting documents.

4. Beware of any plan that has little or no positive history.

5. Beware of any plan that initially provides no contractual or documented guarantee of refund.

*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

**MMM was an infamous Ponzi scheme deployed in Russia by Sergei Mavrodi who issued investors shares of stock. Though referred to as a «pyramid scheme» in Russian, it is really characterized as a Ponzi scheme

***Unlike pyramid or Ponzi schemes, MLMs have a real product to sell. More importantly, MLMs actually sell their product to members of the general public, without requiring these consumers to pay anything extra or to join the MLM system. MLMs may pay commissions to a long string of distributors, but these commission are paid for real retail sales, not for new recruits