The Wide Net Cast By State And Federal Securities Laws: Pyramid Schemes


Over the years, pyramid schemes have been the source of undue misery and disillusionment.  All-too-often, they have served as a vehicle for promoting fraud and deceit; scores of forthright, trusting investors have fallen prey to the dishonest features thereof.  A typical pyramid scheme is originated by a small number of people who band together to create an organization.  Alternatively, a pyramid scheme may be created by a particular individual, acting alone.  In both scenarios, the primary objective will be geared toward the expedited realization of hefty profits.  For purposes of conferring an air of legitimacy upon itself, the enterprise may involve the sale of a product or service.  But, on a pragmatic level, the offer and sale of the underlying product or service will routinely operate as a “smokescreen” — it will often be designed so as to conceal a program aimed at the sale of investment products (many of which must be regarded as securities).


Now let’s bring these basic, general principles to life by examining a simplistic pyramid structure, which we will call “American Financial Wealth Program”, or “AFWP” for short.  The organization’s founder makes up the apex of the pyramid.  Those who are recruited directly by the founder make up the second level.  The people recruited by those occupying the second level make up the third level, and so on, down to the base of the pyramid.  For purposes of simplicity, let’s say our imaginary organization is created by one person, it reaches four levels, and every member recruits two people.  In that instance, Level 1, the highest level, has one member, Level 2 has two members, Level 3 has four members, Level 4, the lowest level, has eight members.


The application of basic logic shows that our imaginary organization is bound to take advantage of those on the bottom rung.  Suppose it costs $1,000 to join AFWP, and its members are promised an equal share of the money, across all the levels of the pyramid, for each new recruit.  When the two Level 2 members join, the Level 1 member makes $2,000.  When the four Level 3 members join, the Level 1 member makes another $2,000 and each Level 2 member makes $1,000 — and so on.  Regardless of the precise contours of the particular pyramid scheme, the ultimate result will remain constant: robust profits will flow toward the founder, but those at the bottom will be left “holding the bag.”  Even if everyone on the face of the earth joins in, the people occupying the lowest level will emerge as losers; all of the money they “invest” will be lost.


Many of the principles referenced above are illustrated by litigation the government initiated against Glenn W. Turner Enterprises, Inc. and a collection of other defendants.  Presumably, the defendants (or at least some of them) scored hefty profits at the outset.  Eventually, however, the U.S. Securities and Exchange Commission (SEC) caught wind of the practices that were being employed.  Upon doing so, the SEC filed a lawsuit in federal district court.  Seizing upon the flexible and elastic reach of the federal securities laws, the SEC argued that the underlying course of conduct involved the sale of securities.  In response, the defendants asserted that the instruments in question could be characterized as securities only if they constituted “investment contracts.”


In assessing that claim, the district court stressed that the Securities Act of 1933 broadly defined “security” so as to encompass “any note, stock, treasury stock, bond, debenture . . . investment contract . . . or . . . any interest or instrument commonly known as a ‘security’ . . . or right to . . . purchase[] any of the foregoing.”  On a parallel note, the trial court looked to the manner in which Congress expansively framed the definition of a “security” in the Securities Exchange Act of 1934 so as to reach “any note, stock . . . bond, debenture . . . participation in any profit-sharing agreement or in any oil, gas, or other mineral . . . lease, any . . . transferable share, [or] investment contract . . . .”


Against that backdrop, the district court rejected the Defendants’ contention that the instruments in question could be labelled as securities only if they could be viewed as “investment contracts.”  In the words of the trial court, the underlying promotional program involved the offering of securities “so long as any one or more of the terms used in the statutes are satisfied.”


Nonetheless, the district court then proceeded to gear its analysis toward SEC v. Howey, a venerable 1946 U.S. Supreme Court decision which examined the characteristics of an investment contract.  In Howey, the Supreme Court found, in pertinent part, that the Securities Act of 1933 embodied the fundamental principle of flexibility – which allows for the provisions thereof to be applied to numerous schemes that may be “devised by those who seek . . . the money of others on the promise of profits.”


While addressing the teachings of Howey, the district court closely scrutinized the definition of “investment contract” which was articulated therein.  Upon noting that a wooden construction of that definition would not support application of the “investment contract” label to the facts before it, the trial court found that it would make scant sense to literally apply the test which was set forth in Howey.  After all, the trial court reasoned, such an approach would be inconsistent with the manner in which the Supreme Court stressed the importance of “the economic realities behind transactions” – while also making it clear that “substance rather than form” must control.


Spurred by the significance of these pragmatic considerations, the district court concluded that the conduct which was targeted by the SEC involved the offering of securities.  Based on that consideration, the trial court granted the injunctive relief that had been sought by the SEC with respect to the corporate defendants (but not the individuals who were named as defendants).  The matter was then appealed to the Ninth Circuit Court of Appeals.  Due to space constraints, the analysis which was charted by the Ninth Circuit will appear in an ensuing blog.


If you believe you have been taken advantage of through the operation of a pyramid scheme or some other type of questionable sales practice, to include the sale of an interest in a ponzi scheme, contact attorney Chris Bebel at 903-843-5678.  A former attorney for the SEC and a former Assistant U. S. Attorney focusing on financial fraud cases, Mr. Bebel has over 30 years of experience; he is a skilled, polished lawyer who has repeatedly distinguished himself.  Unlike many other attorneys, Mr. Bebel represents investors in connection with cases that are filed in court, or in arbitration forum.  Mr. Bebel works in tandem with Bradley Ellison, a learned paralegal who battles to advance the interests of financial fraud victims.


Notice to Readers: By striving for brevity and simplicity, blog postings often lose precision.  Based upon the absence of precision, primary reliance must be placed on the underlying judicial opinions, not blog postings.  With respect to the factual and legal considerations addressed herein, it necessarily follows that readers must place primary reliance on the federal district court decision upon which this discussion is predicated, SEC v. Glenn W. Turner Enterprises, Inc., 384 F. Supp. 766 (D. Oregon 1972).