You Can't Cheat an Honest Man - James Walsh [10]
It would be far easier to turn straw into gold than to turn $5,000 into $40,000 legally under this scheme. The fact that [investors] had knowledge of the pyramid scheme is not in dispute. The promotional materials made it plain that the investment idea was a pyramid scheme from the beginning. They participated in promoting the “airplane” by recruiting new members to perpetuate the scheme. [They], therefore, may not seek relief.
“Commonality” and “Efforts of Others”
In the 1974 federal court decision SEC v. Koscot Interplanetary, Inc., the Fifth Circuit Court of Appeals defined some basic issues and terms. Koscot was a subsidiary of Glenn W. Turner Enterprises (an umbrella organization that owned a number of Ponzi and pyramid operations). Through Koscot, investors could make money both by selling cosmetics and by recruiting them as “supervisors” and “distributors” to sell cosmetics and recruit others.
To obtain the right to make money through the recruitment of others required an investment of at least $1,000. That investment qualified a person as a “supervisor” who could then recruit other supervisors. For every supervisor recruited, the recruiting supervisor received $600 of the $1,000 paid by the new supervisor. For $5,000, an investor could become a “distributor” who could then recruit both supervisors and distributors in return for a share of their investments.
The details of the scheme were fairly standard. But the court decided that it was important to distinguish whether the Koscot distributorships counted as a security—like a stock, bond or promissory note— and, therefore, whether Ponzi scheme precedents could be applied.
In order to be a security, an investment needs to be made in a common enterprise in which investors give over control of assets to another entity. In discussing the common enterprise element of the scheme, the court recognized that “[t]he critical factor is not the similitude or coincidence of investor input, but rather the uniformity of impact of the promoter’s efforts.”
It quoted an earlier appeals court decision which held:
A common enterprise managed by...third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments.
This may sound like a pretty generic description of any investment vehicle—but, in the context of a Ponzi scheme, it’s what distinguishes an elegant con from simply sticking a gun in someone’s face and taking his money.
Using this analysis, the Fifth Circuit ruled that “the requisite commonality is evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy of the Koscot meetings and guidelines on recruiting prospects and consummating a sale.” These meetings and guidelines were very much like those of most pyramid schemes— they were almost evangelical in their intensity and they focused more on getting paid than on the substance of the investment.
This left one other key pyramid scheme issue for the Koscot court to consider. Ponzi perps often argue that an investor’s losses are the result of investors not working hard enough to keep the scheme going. In other words, the reason that Grandma lost the $20,000 she pumped into her cosmetics distributorship is that she didn’t do enough to sell lipstick or recruit salespeople. She deserved to lose the money. And, technically, the fact that she had to do some work to keep the scheme afloat means that the cosmetics distributorships didn’t count as securities in the first place.
In this narrow sense, the perps might have a point. The Securities and Exchange Acts of 1933 and 1934 defined securities in part as investments whose success or failure came “solely from the efforts of others.” But some courts had allowed broader interpretations of that phrase.
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