You Can't Cheat an Honest Man - James Walsh [35]
Horizontal commonality exists whenever “the fortunes of each investor in a pool of investors [are tied] to the success of the overall venture.” Strict vertical commonality exists whenever “the fortunes of the investors [are tied] to the fortunes of the promoter.” Broad vertical commonality exists whenever “the fortunes of the investor [are linked] only to the efforts of the promoter.”
In the 1973 federal appeals court case SEC v. Glenn W. Turner Enterprises, Inc., the court held that a pyramid scheme involving the sale of certain “Adventures” and “Plans” constituted the sale of investment contracts within the meaning of federal securities law.
In the case, a program called Dare to Be Great offered investors four different Adventures and a $1,000 Plan. For Adventures I and II, at a cost of $300 and $700 respectively, participants received tapes, records, and other self-motivation material, as well as the right to attend group sessions. For Adventures III and IV and the $1,000 Plan, purchasers received the same things received by the purchasers of Adventures I and II, plus the opportunity to sell the Adventures and the $1,000 Plan to others in return for a commission.
The court held that Adventures III and IV and the $1,000 Plan were investment contracts because they met the tests established in Howey. Obviously, the Adventures involved an investment of money. The court found that the money was invested in a “common enterprise,” in which “the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment of third parties.”
It was with the final element, requiring profits “to come solely from the efforts of others,” that the court had the most difficulty. Because the income opportunities through Dare to Be Great required individuals to sell Adventures and Plans to others, the income was not based solely on the efforts of others.
Still, the court held that the word solely “should not be read as a strict or literal limitation on the definition of an investment contract, but must be construed realistically, so as to include ... those schemes which involve in substance, if not form, securities.” The court concluded that the Dare to Be Great scheme was “no less an investment contract merely because [the investor] contributes some effort as well as money to get into it.”
So, this is how the courts connect Ponzi schemes to investment and securities laws. But it’s just a technical connection. The practical applications take various forms.
Projections
Many investors are swayed by ambitious projections—which paint seductive pictures of big riches to be had in six months...or six years. For this reason, projections are heavily regulated in most legitimate financial markets.
Ponzi perps know both of these things—that projections are compelling and that they are regulated. So, they find artful ways to use projections without running afoul of regulations.
According to the SEC, financial projections are fraudulent if:
1) the promoter “disseminated the forecasts knowing they were false or that the method of preparation was so egregious as to render their dissemination reckless,” and
2) the investors reasonably relied upon these projections in making their investment decisions.
That reasonably can be a tricky matter. In general, reliance on projections as a forecast of the future is unreasonable as a matter of law if those projections are accompanied by language that clearly discloses their speculative nature. That’s why so many ads for financial services or investment opportunities will include disclaimer language that reminds investors that past performance is not a guarantee of future performance, that certain investments are speculative and that some investors do lose money.
The Ponzi perp’s challenge is to make the stuff that comes before these disclaimers so appealing that investors don’t pay attention to the “legal mumbo-jumbo.”
But there’s more than just this. Just because an investment goes bad, the investor doesn’t