You Can't Cheat an Honest Man (33 page)

The Internet combines various attributes of publishing, broadcasting, public space and private commerce. This melange confounds many legal theorists—to say nothing of law enforcement officials.

Among the specific issues that perplex law enforcement agents:

•
the distinction between advertising and fact (and what this means for free speech) on the Internet,

•
the liability of Internet Service Providers for fraud committed through their networks, and

•
what constitutes a “clear and conspicuous” on-line consumeralert warning.

At the state level, some regulators are more aggressive about Internet Ponzi schemes than others. Larry Cook, director of the enforcement division of the Kansas Securities Commission, explains that his agency looks at three kinds of Internet frauds:

You have the scams, you have the misinformed who need to find legal advice in putting together an offering to solicit investors, and then you have the pie-in-the-sky people who are not necessarily [Ponzi perps], but they don’t have a clue how to run a business.

The dilemma for regulators and law enforcement officials: It’s an impossible task to monitor every investment-related posting in the dozens of chat rooms, news groups, bulletin boards and Web pages on the net.

The SEC and the North American Securities Administrators Association have set up informal Internet surveillance programs, often cruising around user groups and examining the messages posted there. But this is—at best—a random sampling process.

The SEC admits there’s no way of knowing how many scams are operating on-line, so there’s no way to know for sure whether the fraudulent offers are increasing or decreasing. The only thing the regulators do know is that complaints are rising as Internet use increases.

SEC regulators say that Ponzi-type fraud is well-suited for the world of on-line computing, because a perp can easily send messages to thousands of people with the touch of a button. One example: An ad titled “How to Make Big Money From Your Home Computer,” in which a promoter claimed investors could turn $5 into $60,000 in three to six weeks, was sent to thousands of Internet users in a few days in 1996. The pitch was a crude six-level pyramid scheme.

MLM on the WWW
Multi-level marketing programs—both legit and not—abound on the Internet.

The Health Club Network, which called itself “A Price Club for Health,” used the Internet to accomplish the near-impossible. It combined sex and multi-level marketing. The company claimed that Internet users would get a special discount of 60 percent off the price of products and make money 24 hours a day, “even while you’re sleeping!” Among Health Club Network’s products: Passion Tonic, which was supposed to improve orgasms, overcome female frigidity and male impotence and release libidos. Though perhaps not in that order.

For Ponzi perps, the advantages of plying their trade on-line are many. For a few hundred dollars—and sometimes less—their scams are delivered straight into a person’s home or business with all the glitz of a Fortune 500 company.

California-based Dennis Enterprises told Internet users that its system of auto-responders could send out 10,000 e-mail messages a day for a single client. For an up-front fee of between $12 and $200, an aggressive Internet MLM entrepreneur could send out over three-and-ahalf million e-mails a year. This electronic version of junk mail is what on-line enthusiasts call “spamming.”

But one user’s spam is another’s filet mignon. With just a tenth-of-1 percent response rate, the e-mail barrage would mean 3,500 sales. The Dennis Enterprises pitch was for selling computer hardware, peripherals...and even the company’s own e-mail services. But some MLM programs don’t seem to care much about
what
they’re selling.

In general, Ponzi perps would rather focus on the size and shape of the pyramid—and the money at the top—than pestering details like product line specs. That’s why so many Internet Ponzi schemes involve surprisingly low-tech pitches.

Fortuna Alliance was an alleged pyramid scheme based on the Fibonacci numbers sequence (each number is the sum of the two preceding numbers). Fortuna—which started in Washington state and quickly spread through the Pacific Coast—promised investors profits of up to $5,000 instantly.

According to the FTC, Fortuna separated more than $6 million from roughly 17,000 members and diverted at least $3.5 million to a bank in the Caribbean.

Some Simple Issues Persist

However an investment is promoted—in person, by mail, telephone or over the Internet—the SEC recommends that an investor ask the following questions before plunging in:

•
Is the investment registered with the SEC and state securities regulators—or is it subject to an exemption?

•
Are the people pitching the investment registered with the securities regulators? If so, is there a record of any complaints against them?

•
Who is running the company? What experience do they have? Also, how long has the company been in business?

•
How liquid is the investment? Can an investor sell his or her position easily—without paying unusual penalties or premiums?

•
What level of detail does the company offer about itself in promotional literature? Also, does it make reviewed or audited financial statements available to investors?

Generally, if the answers to these questions are
no
,
not yet
,
it’s unclear
or
no one else in the business does that
, you should steer clear of the investment.

A note: There are many legitimate start-up companies that are using the Internet to raise development capital inexpensively. But, these companies tend to talk about themselves to a fault. They’ll usually post detailed biographies of principals, business plans (even if these are largely prospective) and information on money raised to date.

Be careful of any investment opportunity offered over the Internet that’s in any way vague about the people involved or how money raised will be spent. According to Russell Damtoft, an assistant regional director in the FTC’s Chicago office, “Most of the scams on the net are old wine in new bottles. They’re Ponzi schemes, creditrepair scams, vacation frauds.”

There are no laws specifically governing Internet use, so states are trying to use their laws to root out cyberspace hucksters who promote get-rich schemes, phony health cures and other scams. In 1996, Minnesota Attorney General Hubert Humphrey III became the nation’s first to file consumer fraud complaints against Internet firms. One involved a pyramid scheme that promised participants $157,900 in taxfree income. Illinois A.G. Jim Ryan, an established Ponzi scheme buster, described the Internet as an “unregulated and unmonitored territory where scam artists and other lawbreakers roam freely.”

Jim Jacobson, special assistant attorney general in the consumer division, said the state isn’t interested in regulating everything on the Internet, or in stifling free speech. “All we’re talking about here is exercising our normal powers to protect the public from fraud and false advertising in commercial activity,” he said.

Case Study: Western Executive Group

In October 1996, a federal judge issued a temporary restraining order against two Nevada companies for running an ATM investment Ponzi scheme that used an Internet website as part of its pitch for investment dollars.
U.S. District Judge George King froze the assets of Cash Systems USA Inc. and Western Executive Group Inc. (WEG). The SEC had asked for a court order to stop the two related companies from selling investor contracts for ATMs.

The suit, filed in federal court in Los Angeles, was one of the first SEC actions to implicate an Internet website with a Ponzi scheme. It was also one of the first to involve the newly deregulated ATM machines. A 1995 deregulation rule had allowed individuals to own the machines; until then, only banks and other financial institutions had been allowed to own them. “As of late 1995, you saw ATM’s only at banks,” said SEC spokeswoman Lisa Gok. “They had to be affiliated with a bank. Then there was deregulation and now you see these freestanding ATMs at even convenience stores.”

The SEC claimed that WEG offered investors ownership in a freestanding ATM for up to $24,000, promising returns of 17 percent to 20 percent each year for five years. Between September 1995 and October 1996, more than 130 investors bought WEG cash machines for $23,950 each and immediately leased them back to Cash Systems for placement in retail locations. The investors poured more than $3.5 million into WEG. The company returned about $815,000 in lease payments. But the SEC claimed this came from proceeds generated by new investors.

Most of the investment pitches were made by telephone salespeople. In typical Ponzi scheme fashion, WEG also held what it called “private investment seminars” and did mass mailings to potential investors. The company singled out retirement-age investors as targets. “All of these schemes tend to hit the retirement communities quite hard,” one SEC source said.

Adding a high-tech twist, WEG set up an Internet site to display pictures of the ATMs it deployed, as well as other promotional materials. Potential WEG investors were encouraged to visit the Internet site and “see for themselves” what the machines looked like and how the WEG program worked. Many people took the advice—and foolishly considered the material in the Internet site independent verification of what the telemarketers pitched over the phone. “It was really kind of sad. You had a lot of these older folks saying they’d investigated [WEG] on the Internet, when all they’d done was have someone download promo material from the company’s own website,” said one SEC source.

The SEC argued that, in return for the $3.5 million in investment dollars, WEG signed contracts to purchase 228 terminals. In fact, the company only purchased 119 machines and placed 41, most of them in retail locations in Florida. And only two of the machines in operation made enough money to cover expenses.

While the company’s promotional materials had mentioned potential transaction volumes of 100 transactions per day and a break-even point of 25 daily transactions, some of the terminals were registering as few as eight transactions per day. As a result, WEG “had to resort to the paying investors with new investor money,” said James Howell, a litigator in the SEC’s Los Angeles office.

In the same order, Judge King also froze the assets of four Cash Systems and WEG executives. These people were: Charles Rietz of Mesa, Arizona; Robert Parrish of Gilmer, Texas; Robert Struth and Stephen Edgel of southern California.

Rietz had a long history of trouble with the law. In 1978, he had been enjoined from selling securities by the SEC for fraud allegations in an offering of investment contracts. (He’d tried the “it’s not an investment” argument then, too.) In 1982, he’d paid a fine to the Commodity Futures Trading Commission for running what one CFTC investigator said was “pretty much a Ponzi scheme.”

Edgel denied that Cash Systems and WEG were a Ponzi scheme. “We vigorously deny each and every allegation of the SEC’s complaint,” he said. “We deny that the investment is a security—we have two qualified securities attorneys who say it is not a security. It is our opinion that the SEC has no jurisdiction in the matter.”

The Feds weren’t impressed. “We were able to stop this offering at a point when it was still growing,” said one SEC lawyer. “A lot of times you only catch these schemes after they collapse.”

CHAPTER 18
Chapter 18: Make Friends with the Regulators

Ponzi schemes are investigated and prosecuted by various local authorities and federal regulators. In 1995 alone, the Securities and Exchange Commission has discovered 24 Ponzi-inspired frauds, each of them multimillion dollar rip-offs.

In a related market, the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) oversee commodities trading. These groups serve as a good model of a regulatory system that deals with a fair number of Ponzi schemes.

Although the CFTC does not place stringent requirements on those who trade their own funds in the market, it does require anyone who handles customer funds to register with the NFA, the self-regulating body of the commodity futures market.

Anyone who accepts orders, money or securities for the purpose of making a purchase or sale of a commodity futures contract must register as a futures commission merchant (FCM). Anyone who operates a “commodity pool” of third-party funds in order to buy and sell commodity futures contracts is required to register with the NFA as a commodity pool operator (CPO).

Direct participation in trading is not required to fall under the purview of the CFTC. Anyone who advises others—for a fee—about trading futures contracts must register as commodity trading advisors (CTA). Anyone who solicits orders or customers on behalf of a FCM, CPO or CTA must register as an associated person (AP). The law also offers a higher level of protection for what it calls “vulnerable victims.” A Ponzi perp who steals from such investors—and gets caught—faces harsher punishment than the average crook.

In this regulatory sense,
vulnerable
means a person whose “age, physical or mental condition” makes him or her weak. Of those three terms,
age
is the most difficult to define. The government has identified investors who are over 50 as “elderly” individuals...and vulnerable victims due to their age and their special financial needs.

But this definition is somewhat vague. As one court, when sorting through a collapsed Ponzi scheme, wrote: “it is logical to assume the intended victims of any premeditated offense will be selected because something in his or her persona or circumstances will make successful the intended criminal act.”

The Federal Government’s Ponzi-Fighting Tools

Rule 9(b) of the Federal Rules of Civil Procedure outlines the requirements for making fraud claims. The fraud allegations in the complaint must be specific enough to allow the defendant “a reasonable opportunity to answer the complaint.”