Chapter 2 - § 2.10 • PYRAMID AND PONZI SCHEMES

• Jurisdiction: Colorado

§ 2.10 • PYRAMID AND PONZI SCHEMES

"Ponzi" schemes and pyramid schemes are continuing even into the twenty-first century. Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40 percent return in just 90 days, compared with 5 percent for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period — and this was in 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons.¹¹²

In the classic pyramid scheme, participants attempt to make money solely by recruiting new participants into the program. The hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same. The fraudsters behind a pyramid scheme may go to great lengths to make the program look like a legitimate multi-level marketing program. But despite their claims to have legitimate products or services to sell, these fraudsters simply use money coming in from new recruits to pay off early-stage investors. But eventually the pyramid will collapse. At some point the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and many people lose their money.

Decades later, the Ponzi scheme and the pyramid scheme continue to work on the "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses. The Bernie Madoff scheme that was uncovered in December 2010, which cost investors worldwide more than $50 billion and spanned several decades, is among the more famous of Ponzi schemes.

These schemes are not new, and were held to involve the offer and sale of securities since before the 1973 case of SEC v. Glenn W. Turner Enterprises, Inc.¹¹³ There, earlier investors made money for themselves by bringing in subsequent investors, but there was no real underlying investment. The court said that the critical inquiry in the "solely from the efforts of others" requirement of Howey is "whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise."¹¹⁴

A type of pyramid scheme held to be a security is the offer and sale of investments in pay telephones. These include instances where investors purchased pay telephones and leased them back to the promoter who promised to return certain profits to the investor-owner in the lease-back and then a buy-back arrangement. In SEC v. Edwards,¹¹⁵ Edwards was the chief executive officer and sole shareholder of ETS Payphones, Inc., a company that sold payphones to the public through independent distributors. The payphones were part of a package that included a site lease, a five-year leaseback, a management agreement, and a buy-back agreement. Purchasers had no involvement in the management of the...