The Internet has dramatically expanded the universe of business models that rely on fast and cheap communications with a multitude of potential customers. This very characteristic, however, provides a fertile environment for unscrupulous marketers seeking to profit from illegal pyramid and Ponzi schemes. Imagine a “chain letter” that could be sent to tens of thousands or more recipients without postage costs, perhaps even through bots, or Ponzi schemes targeting the same number of potential investors. Simple “multi-level marketing schemes” (MLMs) in the realm of online commerce were indeed among the first to attract attention from enforcers seeking to apply familiar anti-fraud principals in the digital world. By and large those efforts were successful. Court decisions and governmental guidelines made clear that the old rules apply in the turbocharged world of the Internet as well. Business evolves, however, and many new models are raising the same potential enforcement issues. Paramount among these developments is the rise of “virtual currencies” or “cryptocurrencies,” whose acceptance has brought a new complexity and urgency to the analysis. Cryptocurrencies are speculative ventures, some entirely market-based and others not, whose structure and promotion lend themselves to fraudulent conduct. Significant regulatory attention has already been directed to cryptocurrencies in connection with the securities laws. This article describes the basic rules for determining whether online promotions are otherwise illegal frauds and discusses some of the current models to which that analysis might be applied.
Ponzi, Pyramid, and MLM Schemes
Although related, Ponzi, Pyramid, and MLM schemes differ in key ways and are treated differently by antifraud laws.
Ponzi schemes are based on a business model of robbing Peter to pay Paul. They typically involve proposed but illusory investments based on fraudulent promises of returns to be paid by an organizer to the investors. Maintaining the fraud depends upon an influx of new money, and it becomes untenable when (as mathematics requires) that influx cannot keep pace with an expanding base of investors to be paid. Ponzi schemes are always illegal.
A more general business model is the MLM, also known as multi-level referral or membership systems, in which new members of an organization pay an initiation fee for the right to make sales of a product or service and thereafter receive a share of the fees taken from, and sales made by, each additional member they themselves recruit. Early members at the top may well stand a strong chance of prospering, but the further down the pyramid a member finds itself the harder it will be for the scheme to be profitable. The legitimacy of the “sales” opportunity is key to finding that an MLM is lawful.
If the “sales” opportunity is not bona fide, MLMs take on certain characteristics of Ponzi schemes. Where participants’ income is principally derived from recruiting new members and receiving a share of their membership fees, opportunities for profit decline predictably as the supply of new recruits dwindles. Such ventures are called pyramid schemes, and generally are considered to be illegal.
Examples of Enforcement Actions Against Online Marketing Schemes
Pyramid scheme: BurnLounge
According to published judicial opinions, BurnLounge was a membership-based online music marketing program that operated between 2005 and 2007, and an early example of an MLM in the internet age. In addition to an online music store, BurnLounge promoted a business opportunity in which customers could themselves become resellers of the same music and music-related merchandise, and participate financially in the recruiting of new members. Customers could do business with BurnLounge by: (1) buying music and merchandise; (2) buying a membership package to become an “Independent Retailer,” which enabled resellers to earn money from direct sales as well as to earn music and merchandise credits for selling new membership packages; and (3) buying a membership package to become a “Mogul,” which enabled them to earn money from direct sales and by selling membership programs to new customers.
In 2007, the Federal Trade Commission filed suit against BurnLounge to enjoin its operations as an illegal pyramid scheme and seek disgorgement from the company and its operators to fund customer redress. In its two-year existence, BurnLounge generated more than $28 million in revenue, $26 million of which was attributable to sales of membership packages and membership fees. More than 90% of BurnLounge members never recouped their initial investment, and at trial the FTC expert testified that under the best possible circumstances, 87.5% of members would never be expected to do so.
The FTC prevailed in a 2012 trial against BurnLounge, and the district court’s judgment was affirmed by the U.S. Court of Appeals for the Ninth Circuit in 2014. In its opinion, the Ninth Circuit applied non-Internet law on MLMs to conclude that an MLM program is an illegal pyramid scheme where participants pay the company for: (1) the right to sell a product; and (2) the right to receive compensation for recruiting other participants into the program, where such rewards are unrelated to sale of the product to ultimate users and are the “focus” of the program. The Ninth Circuit agreed with the district court that BurnLounge required purchases of a membership package to participate in the sale of merchandise and music, and that the “focus” and primary motivation of the membership program was the recruitment of new members, rather than the sale of products or services to consumers.
Ponzi scheme: SEC v. Receiver for Rex Ventures Group LLC
According to a complaint filed by the SEC, Paul Burks formed ZeekRewards in 2011 as an “affiliate advertising division” of his penny auction website Zeekler.com, which offered customers the ability to place one-cent increment bids on merchandise. Participants were solicited to become investors, or “affiliates,” in ZeekRewards through investment contracts called the “Retail Profit Pool,” as well as a pyramid-like referral scheme called the “Matrix.” Neither of these investment opportunities was registered with the SEC or any state regulatory authorities.
The SEC accused the Retail Profit Pool of being a classic Ponzi scheme. In exchange for enrolling in a subscription plan, soliciting new customers, purchasing Zeekler “bids,” and placing a daily ad for Zeekler.com, participants were promised up to 50% of the company’s daily net profits through a profit-sharing system. Participants accumulated rewards points that could either be exchanged for cash or rolled over in an effort to compound future returns.
Despite ZeekRewards’ representations to investors that the scheme was extremely profitable, the SEC alleged that 98% of the company’s revenues and payments to investors were derived solely from funds contributed by new investors. Furthermore, the scheme only remained viable because current investors were actively encouraged to “roll-over” their “profit points” back into the scheme. By the time the SEC took action to stop the scheme in August 2012, the amount of outstanding “profit points” due to participants was nearly $3 billion. Beyond these outstanding liabilities, the SEC alleged that had investors chosen to receive “profit points” in cash rather than re-invest, ZeekRewards would have required daily cash outflows of $45 million, far in excess of its revenues, and would have been rendered insolvent in a matter of weeks, if not days.
After several years of litigation, Burks and several others at Zeekler and ZeekRewards ultimately pleaded guilty to running a Ponzi scheme, paid significant fines, and were sentenced to substantial prison terms. Burks himself was sentenced to 15 years in jail and ordered to pay $244 million in restitution for his role in the scheme. The SEC also seized all assets of both companies and appointed a receiver to distribute the companies’ assets to the nearly one million harmed investors.
FTC MLM Guidelines
The FTC issued new guidance on the lawfulness of MLMs in January 2018. Published in question-and-answer format, the guidance provides useful insight into the agency’s analysis under the FTC Act. Specifically, it highlights two factors the FTC is likely to consider critical in determining whether a particular operation constitutes a legal MLM campaign or an illegal pyramid scheme:
1. Whether the MLM’s compensation structure encourages or incentivizes participants to purchase products for reasons other than actual consumer demand, including their personal demand; and
2. Whether particular wholesale purchases by participants were made to satisfy personal demand, or amount to mere “inventory loading” in an attempt to advance in the marketing program.
Because the FTC believes that the compensation structure of a legal MLM program must be based on actual sales to legitimate customers, the guidance stresses the importance of MLMs properly documenting of actual sales.
The guidance also highlights the importance of MLM advertising and messaging being “truthful and non-misleading to avoid being deceptive under Section 5 of the FTC Act.” The FTC provides several “guiding principles” for representations by legal MLM programs. These include refraining from:
1. Advertising unachievable results to participants, such as that participants can achieve career-level income and “fire their bosses”;
2. Presenting the opportunity as a way to quickly get rich or lead a wealthy lifestyle, such as by using images of expensive houses, luxury automobiles, and exotic vacations;
3. Using misleading endorsements and testimonials that do not represent the realities of the opportunity for most participants; and
4. Featuring unrealistic hypotheticals in recruitment materials, such as by saying “if you recruit 30 people who each sell $1,000 of product each month, you will earn $1,500 a month,” where the assumption of recruiting 30 people to sell $1,000 each month is not realistic or reasonable.
The FTC guidance also notes that while orders obtained in settlements of FTC enforcement actions are not binding on the industry as a whole, they provide useful guidance and insights that industry members should consider voluntarily following.
A Primer on Cryptocurrencies
Cryptocurrencies are cryptographically-secured digital currencies built on the principle of a blockchain. The Bitcoin blockchain is a distributed ledger of cryptocurrency transactions. Transactions with the cryptocurrency are recorded in ledger entries, or “blocks” of the blockchain. The Bitcoin blockchain itself is publicly-visible and decentralized, and as transactions occur and blocks are added to the blockchain, the transactions are validated by individual users performing increasingly complex mathematical calculations. Users are incentivized to perform these calculations and validate additions to the blockchain by the reward of newly-issued cryptocurrency.
Bitcoin is the original cryptocurrency built on a decentralized blockchain model. Bitcoin is not designated as legal tender by any government and its value, in trade or for commerce, is derived solely through supply and demand. As such, and as anyone who has read the financial press in the past few years knows, Bitcoin has been a wildly successful, volatile, and speculative product.
Inspired by the success of Bitcoin and the impressive fortunes of its early and even recent investors, promoters have issued many other cryptocurrencies since the inception of Bitcoin—by one published estimate, 1574 as of April 2018—aided by the ease and low cost of issuing a new cryptocurrency. Bitcoin is by far the largest by market capitalization (approximately $137 billion as of April, 16, 2018), followed by Etherium ($50 billion), Ripple ($26 billion), Bitcoin Cash ($13 billion), and Litecoin ($7 billion).
Cryptocurrency Promotion Models
Bitcoin itself is not officially promoted, as its management and control is significantly decentralized. However, various third parties promote the acquisition and use of Bitcoin in a variety of ways. According to published sources, for example, MerchantCoin was introduced in 2014 as a payment service which issued its own cryptocurrency tokens (XMC) for the purpose of incentivizing consumers, advocates and businesses to acquire and use Bitcoin. Under MerchantCoin’s program, participants who use the MerchantCoin network to transact in Bitcoin are rewarded with XMC, a cryptocurrency issued by MerchantCoin which can then be exchanged for Bitcoin. MerchantCoin also introduced a “Social Media Mining Program” that “empowers advocates to earn immediate (XMC) tokens by encouraging their friends, family members and business associates to share MerchantCoin’s exciting news through Social Media,” such as by “sharing MerchantCoin updates on Facebook, re-tweeting, joining our Google+ group and educating the public about MerchantCoin at bitcoin meet ups.” Notably, Facebook has banned all ads promoting cryptocurrencies, including Bitcoin and all Initial Coin Offerings (“ICOs”).
Some cryptocurrency promotion models have come under scrutiny and criticism as potential pyramid or Ponzi schemes. One example is the now-defunct Bitconnect. Before it was shuttered in early 2018, Bitconnect was an anonymously-run site where users could loan their cryptocurrency to the company in exchange for outsized returns depending on the term of the loan, e.g., a $10,000 loan for 180 days would purportedly give the lender ~40% returns each month, with a .20% daily bonus. Bitconnect used investment funds to invest in Bitcoin by way of Bitconnect’s proprietary “trading bot and volatility software.” To participate, users were required to buy Bitconnect’s own currency, BCC, and so buying into the scheme naturally drove up the price of BCC. Bitconnect also had a thriving multi-level referral feature, under which participants were rewarded for using social media to drive signups for the program. In November 2016, the British Registrar of Companies served BitConnect with a notice for compulsory strike-off, threatening to shutter the company and dissolve its operation unless further action was taken. The Texas Securities Board and North Carolina Securities Division on served Bitcoin with cease-and-desist orders in January 2018. Both orders accused Bitconnect of fraud and characterized the operation in terms reminiscent of a Ponzi and pyramid scheme, with the North Carolina order even noting that Bitconnect’s large guaranteed annual returns constitute a “red-flag” for fraud, and specifically for the risk that the program may be a Ponzi scheme. Shortly thereafter, Bitconnect announced that it was shutting down its lending and exchange programs with immediate effect. Several arguably similar programs have been launched based on other cryptocurrencies. Some are now reportedly dead, including XRPConnect and NEOConnect, while others persist, such as EthConnect, based on Etherium.
Another model employed by some involves the launch of a cryptocurrency through funds raised by selling the currency at a significant discount (e.g. 75%). Thereafter, the promoter raises more money by offering the currency at smaller discounts that it sets over time. So long as the original buyers are free to dispose of their holdings at any time and new buyers continue to arrive, the early investors have an almost automatic and profitable cash-out. The lawfulness of these models has not been tested but, aside from potential securities law issues, would appear to warrant close scrutiny in connection with representations that are made to both early and subsequent investors and the reasonableness of the projections they make.
Enforcement Issues Raised by Cryptocurrencies and MLMs
Cryptocurrencies in general are not inherently pyramid or Ponzi schemes
Some commentators have argued that cryptocurrencies are inherently pyramid or Ponzi schemes. But it is difficult to find legal precedent supporting so sweeping a claim. Despite their novel structure, ephemeral nature, and lack of a tie to any inherent valuation, cryptocurrencies are in many ways a relatively straightforward speculative vehicle, perhaps akin to traditional assets subject to “bubbles” in which their market values become detached from underlying asset values. While these speculative bursts attract illegal promotion and marketing schemes, the baseline legal advice for the enterprise as a whole may well be “let the buyer beware.”
That said, several features of cryptocurrencies and derivative products are particularly susceptible to manipulative conduct by fraudsters. These include: (1) the decentralized structure of cryptocurrencies, with no central management or reporting; (2) the ready access to amateur investors provided by social media; (3) the ease with which amateur investors can invest in cryptocurrencies; (4) the apparent boom-and-bust nature of at least some cryptocurrencies; (5) the relative lack of specific regulation of cryptocurrency trading and marketing; and (6) the FOMO (“fear of missing out”) culture that has arisen around cryptocurrencies in general.
An interesting twist on enforcement issues is that the fervor surrounding cryptocurrencies and the dangers that they can pose are discussed on a daily basis in public as well as financial media, finding their way even into the comedy monologue of John Oliver on his HBO show, Last Week Tonight. Someday a cryptocurrency scheme under attack may cite these discussions to argue that no allegedly injured investor was unwary of risks, or even the potential for fraudulent conduct.
Key Questions to Ask About Crypto Sales and Marketing Programs
Those considering launching a new cryptocurrency or starting a venture that markets or promotes existing cryptocurrencies would be well advised to consider several key questions to avoid stepping into the legal minefield of pyramid and Ponzi schemes. These questions include the following:
1. How is the opportunity for profit being described?
This is perhaps the most important question of all. The promise of outsize profits is common to both Ponzi and pyramid schemes and a certain “red flag” for regulators, particularly when returns are characterized as certain or guaranteed. The same reasoning should apply to the promotion of cryptocurrencies. Risk factors should not be minimized to the point that they are misleading. While there is always room for some level of sales puffery, advertising unachievable results, or the likelihood of profit too widely shared is certain to attract enforcement attention. Promoters should also bear in mind that their statements would be reviewed after-the-fact, from the possible perspective of a failed investment. The use of unrealistic hypotheticals that do not represent what most investors will be able to achieve are particularly subject to being second-guessed in light of widespread losses.
2. Will participants make money through sales of the underlying cryptocurrency or product, or is the focus on referrals?
As the Ninth Circuit’s decision in BurnLounge makes abundantly clear, programs that “focus” on recruiting new members rather than delivering profit from the sale of products or services to actual customers are much more likely to fall afoul of laws prohibiting pyramid schemes. Referral programs are of course commonplace and not inherently unlawful, but the structure of such programs must be carefully considered so that the legitimate sale of products and services—sales reflecting genuine, organic demand—form the backbone of a venture’s promise of profitability.
3. Does the venture depend on an ever-increasing influx of new capital to remain solvent?
Any venture that will become insolvent or fail to make good on its representations absent an ever-increasing influx of new investors and capital raises serious concerns. Again, at one level the problem may be organic: Is the venture bound to fail, given the laws of mathematics or even reasonable assumptions? At another, problems are ones of unrealistic promises. Guaranteeing returns or projecting profits based on factors other than legitimate and defensible factors of supply and demand are sure to attract unwarranted attention. The fact that adherence to guidelines designed to reduce legal risk may make marketing an opportunity more difficult makes the point that the guidelines are sound.
In connection with cryptocurrencies, specifically, the need for an influx of new capital will likely be required for a currency to achieve a viable level of acceptance and scale. But this is not the same as a need for an ever-increasing influx of funds, and a disclosure of viability risks certainly does not immunize other misleading statements.
The Internet has delivered new products, new means of promoting products, and new means of transacting business. Increasing interconnectedness and frictionless commercial transactions are both a boon and a curse, opening the door to new takes on old frauds. Cryptocurrencies in particular, by their very nature speculative assets, show both the best and the worst of what the new digital world brings with it. The enormous surge in popularity they have experienced and the “fear of missing out” that has driven their growth are yellow if not red flags. Many unsophisticated investors have put their money into these unproven and risky assets, some number of them, no doubt, drawn to the game through conduct that likely would be judged illegal. The good news is that many important legal questions will be analyzed using relatively settled law. Conducting the necessary analyses, and heeding the lessons they teach, are the best defense for promoter and participant alike.
Rob Reznick is a Senior Counsel in the Complex Litigation and Dispute Resolution practice of Orrick, Herrington & Sutcliffe, and is resident in the Firm’s Washington, D.C. Office. He has written extensively on substantive and jurisdictional issues relating to Internet-based operations.
Evan Brewer is a Silicon Valley-based attorney in the intellectual property practice at Orrick, Herrington & Sutcliffe. Evan’s practice focuses on litigating patent, copyright, trademark, and trade secret disputes for technology companies. Beyond intellectual property matters, Evan also advises a wide variety of companies on data privacy and cybersecurity issues.