You Can't Cheat an Honest Man (11 page)

Another important point: Federal securities law holds that anyone involved in a fraudulent scheme must understand that the scheme is fraudulent. (Bad investments made in good faith aren’t illegal.) Courts refer to this knowledge as
scienter
.

While all courts agree that a scienter requirement exists in securities fraud cases, “at least to the extent that something more than ordinary negligence is required,” they don’t all agree on a single standard. Some courts require “knowledge” while others require “general awareness that [a party’s] role was part of an overall activity that is improper.”

Perhaps the best summary of the standard for establishing scienter is that “[s]ome knowledge must be shown, but the exact level necessary for liability remains flexible and must be decided on a case-by-case basis.”

In this context, the surrounding circumstances and expectations of the people involved are critical.

One of the purposes of the Investment Advisors Act was to protect the public’s confidence in the financial markets. As one Senate Report warned: “Not only must the public be protected from the frauds and misrepresentations of unscrupulous tipsters and touts, but the bona fide investment adviser must be safeguarded against the stigma of...these individuals.”

The Investment Advisors Act sought to regulate “investment contracts,” which it described as any of a variety of investment devices and securities.

In its 1946 decision
S.E.C. v. Howey
, the U.S. Supreme Court set up a test for courts to use in determining whether an investment contract was, in essence, a security and therefore within the reach of the act. The court ruled that an investment contract is a transaction:

[W]hereby a person [1] invests his money in a [2] common enterprise and [3] is led to expect profits [4] solely from the efforts of [others].

In the more than 50 years that have passed since the
Howey
decision, federal courts have had little difficulty applying the first and third elements of the test. They’ve had more trouble applying the second (“common enterprise”) and fourth (“solely from the efforts of others”) elements.

The confusion has centered on whether so-called
horizontal commonality
between one investor with a pool of investors is required, or whether a
vertical commonality
between an investor and a promoter will satisfy the common enterprise element.

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 automatically win a lawsuit—even if the people selling it fudge on the risk issues. In order to make a successful case under the SEC guidelines, a burned investor must “allege facts which give rise to a strong inference that the defendants possessed the requisite fraudulent intent.” That can be tough to pull off.

Loan Programs

One common variation on the standard investment Ponzi scheme is the loan program. In these schemes, investors are encouraged to put money into a fund which, in turn, makes profitable loans. The only problem: Often these loans are made to other investors in the scheme. The whole situation quickly becomes just one more pretense for spinning money.

In the late 1980s and early 1990s, Melvin Ford ran an operation called the International Loan Network. ILN’s pretenses were few and flimsy. It was a scheme to move money around quickly, so that a lucky few could siphon off enough to get rich quick.
Ford’s scheme shouldn’t have lasted more than a few weeks. Instead, it lasted several years. In revival-like assemblies targeting black and Asian-American investors, Ford promised huge returns on investment in foreclosed real estate properties around the country. Among other blustery things, he said, “ILN is a financial distribution network whose members believe that through the control of money and through the control of real estate you can accumulate wealth and become financially independent.”

True enough. But most people have to work for years in order to control enough money and real estate to be considered wealthy. Ford’s short-cut? The ILN mantra: “The movement of money creates wealth.” This was daring. The slogan came close to admitting ILN was a Ponzi scheme.

To become a member of ILN and have a chance of obtaining “the organization’s stated goal of financial independence,” a person had to pay a $125 basic membership fee. The basic fee entitled the investor to a variety of “benefits and services”—consisting mostly of discount coupons for travel, car rental and high-ticket consumer goods. It also allowed the person to become an Independent Representative of ILN.

Of course, the basic fee was only the beginning. ILN encouraged inverstors to join one of its select clubs. For an additional fee of $100, $500 or $1,000, an investor could become one of the cream of ILN’s sucker crop.

Club membership entitled a person to the benefits provided to basic investors plus newsletters and seminars on money management. As a member of the $500 or $1,000 Club, a person could participate in ILN’s Property Rights Acquisition program (PRA), which offered real estate investment training courses. And, finally, there were the bonus programs.

By recruiting friends and family to join, ILN investors could participate in the Capital Fund Bonus System and the Maximum Consideration program. These programs directed portions of new investors’ fees to the people who’d recruited them.

For each new investor recruited, an Independent Representative received 50 percent of the new member’s fee for whichever club he or she joined. The Independent Representative also received a descending percentage of the club membership fees paid by new investors recruited “downline” through recruits (and recruits of recruits) to the fifth level of recruitment.

ILN summed the recruitment process up in a slogan often repeated in its literature and at its meetings: “First you join. Then you bring your wife and kids.” Investors would invite potential recruits to so-called “President’s Nights.” These were the meetings that looked and felt like revivals.

Ford was always the featured speaker. He’d enter a crowded hotel ballroom to the soundtrack from the movie
Flashdance
. Then, he’d deliver a lengthy presentation—part motivational speech and part financial evangelism—rousing the crowd with chants like “I will not accept defeat” and “I’m the captain of my ship.”

In a complaint it filed during the peak of Ford’s activity, the SEC summed up his appeal with typical understatement: “He is both engaging and persuasive.” The engaging and persuasive man called ILN’s Capital Fund Bonus System “the most powerful financial system since banking.” And a disturbingly large number of his listeners agreed.

If Ford had stuck close to the original structure of his scheme, ILN would probably have continued on even longer than it did. Although ILN was pretty plainly a Ponzi scheme, Ford was cautious enough—at first—to avoid flagrant violations of investment and securities law. But, as time went on, he expanded his operation into an investment operation that would prove his undoing.

Offering Investments Instead of Advice

Ford had experimented with mechanisms for convincing ILN’s winners to keep pouring their money back into his schemes. Beginning in 1990, he expanded these efforts into what he called the Property Rights Assignment Program.

According to promotional materials, the PRA program offered investors “an opportunity to acquire property below market value.” Still part of ILN, the PRA program would assign tax lien sale certificates or rights to property acquired through foreclosures or government-assisted programs.
According to the PRA material, purchasers of $1,000 PRAs would be assigned property rights assessed at $10,000; purchasers of $5,000 PRAs would be assigned property rights assessed at $50,000; and purchasers of $10,000 PRAs would be assigned property rights assessed at $100,000. The property transfers would be made within 180 days of the purchase of the PRA investment units. If this weren’t tempting enough, ILN salespeople added a cash kicker. They promised potential investors the option of cash payment of five times the initial investment.

In other words, 180 days after making a $1,000 PRA investment, you could choose between $10,000 worth of real estate or $5,000 in cash.

Many of the ILN investors lucky enough to get money out of the recruitment scheme jumped at the chance to parlay their profits. Few cared much about property rights assignments—most wanted five times their money in cash. During the entire two-years-plus lifespan of ILN and the PRA programs, only one property selection list was ever distributed.

But Ford had stretched his persuasiveness too far. ILN declared bankruptcy in the summer of 1991, after the SEC filed a lawsuit charging that it was a giant Ponzi scheme. Of $110 million invested with Ford, only $1 million was recovered.

Much of the SEC’s complaint focused on the PRA programs. The Feds claimed that promises made in the programs amounted to guarantees, which meant the investment units were securities. Investors, most black and elderly, packed a Washington D.C. federal courtroom in June 1991 to hear the SEC make its case against Ford and ILN. They were there in support of the man who had taken their money. In this way, the trial felt like a replay of Carlo Ponzi’s trials in the 1920s.

After three days of live testimony and one day of argument, the court was still unclear about the mechanics of the ILN operation:

Programs as described in testimony and in written material are frequently incomprehensible.... As the Court understands Ford’s explanation, a person who purchases a $1,000 PRA, a $5,000 PRA, and a $10,000 PRA, for a total of $16,000, is eligible for...up to $80,000 because...“the velocity of money increases to such a point, the ability to create wealth expands to such a degree, that we could come back and give somebody an award for up to $80,000.”

Despite this gibberish explanation, the court found that the PRA programs fit relatively neatly into the framework established by the Supreme Court’s
Howey
decision. It concluded:

Clearly, each involved an investment of money. Similarly, each involved a common enterprise in the sense that the fortunes of investors were inextricably tied to the efforts of ILN management....