ponzi schemes and mlm companies

Ponzi Scheme and other allied fraudulent structures 2013

Contents

Introduction: Ponzi Scheme.............................................................................................................3

Introduction......................................................................................................................................3

ETYMOLOGY................................................................................................................................4

Ponzi scheme...............................................................................................................................4

Pyramid schemes.........................................................................................................................6

Multi-level Marketing or Network Marketing.............................................................................7

Platform : Modus Operandi.............................................................................................................9

Multi Level Marketing companies or Pyramid companies..............................................................9

Modus Operandi..........................................................................................................................9

Rob Peter to Pay Paul............................................................................................................10

Distinction..............................................................................................................................11

Structural operation in MLM or Pyramid..................................................................................11

Investor earnings....................................................................................................................12

Promoter earnings..................................................................................................................12

Post collapse of scheme.........................................................................................................13

Statutory and Regulatory framework.............................................................................................14

Introduction....................................................................................................................................14

India...........................................................................................................................................14

Legislature’s response...........................................................................................................16

Statutory Provisions...............................................................................................................17

United States of America...........................................................................................................21

1 | P a g eFoxmandal, Bengaluru


Law Enforcement in USA.....................................................................................................23

Judicial Precedents.........................................................................................................................28

India...............................................................................................................................................28

M/s. Apple FMCG Marketing (Pvt.) Limited v. UOI and Ors......................................................28

Facts...........................................................................................................................................28

Courts Observation....................................................................................................................29

Ruling........................................................................................................................................30

Amway India Enterprises, (a Private Company with unlimited liability) V. UOI........................31

Facts...........................................................................................................................................31

Scheme/ incentive by Amway Company...............................................................................31

Court’s Observation...................................................................................................................32

Court’s Ruling...........................................................................................................................32

M/S. SGI Research & Analysis Ltd...............................................................................................33

Facts...........................................................................................................................................33

SEBI’s Investgation...............................................................................................................33

SEBI’s Order.............................................................................................................................34

USA...............................................................................................................................................36

Re Koscot Interplanetary, Inc........................................................................................................36

Re Amway Corp............................................................................................................................37

Securities and Exchange Commission v. Madoff..........................................................................38

Background: Madoff..............................................................................................................38

Investigations Launched by SEC...........................................................................................39

Conclusion.....................................................................................................................................42



INTRODUCTION: PONZI SCHEME

INTRODUCTION

With the growing economy, in a capitalist mixed economy like ours there is bound to be growing

disparity between rich and poor, which is fuelled by high growth rate and cannot be shot down

instantly, as it takes natural pace. With growing disparity, there is a rise in aspiration among

people and to meet the rising living standards they start resorting to investment schemes which

offer them highest return, even though such schemes are risky. High returns are no problem, but

extraordinary high returns like return of 100-120% and sometimes return around 500% becomes

unbelievable, and certainly its raises apprehension among rational people, but unfortunately

common people are caught in the web of such schemes as they eye quick buck.

This is not only economic phenomenon but a socio-economic one. As observed by Apex Court in

K.K. Baskaran v. State of Tamil Nadu,1 financial swindling and duping of gullible

investors/depositors is not unique to India rather, it has been referred to in Charles Dicken's

novel `Little Dorrit', in which Mr. Merdle sets up a Ponzi scheme resulting in loss of the savings

of thousands of depositors including the Dorrits and Arthur Clennam.

In recent times there have been many such scandals e.g. the get- rich-quick scheme of the

scamster Bernard Madoff in which the estimated losses of investors were estimated to be 21

billion dollars. People have always liked the idea of getting large returns on small investments—

something for nothing.2 There have always been embezzlers, extortionists, and swindlers who

have offered to provide such investment opportunities. The purpose of this article is to describe

1 K.K. Baskaran v. State of Tamil Nadu , Civil Appeal No. 2341 of 2011.

2 Madoff faces life in prison on 11 criminal charges, Reuters, 11 March, 2009, Available at, http://www.reuters.com/article/topNews/idU SN10 46349920090311?pageNumber=2&virtualBrandChannel=0.

.



various unsavory investment schemes, especially pyramid schemes or Multi-Level Marketing

companies.

ETYMOLOGY

In this paper we will concentrate on fraudulent schemes mentioned above, we need to clear our

thoughts on legal jargon which is prevailing in the markets today. We will discuss in brief, terms

like Ponzi Scheme, Pyramid Scheme and Multi-level Marketing Companies.

Chambers 21st Century Dictionary 2007 edition does not provide for the above terms, so we have

to rely on various internet sources and precedents. Albeit, through various judicial precedents

Indian courts have included such schemes u/s Section 2(c) of the Prize Chits and Money

Circulation Schemes (Banning) Act, defines ‘Money Circulation’ as any scheme by whatever

name it is called whereby on a promise that one would receive or would make quick or easy

money by enrolment as members into the scheme is ‘money circulation scheme’.3

Ponzi scheme

The schemes are named after Charles Ponzi, who duped thousands of New England residents

into investing in a postage stamp speculation scheme back in the 1920s. At a time when the

annual interest rate for bank accounts was five percent, Ponzi promised investors that he could

provide a 50% return in just 90 days. With capital of $150, Ponzi began the business of

borrowing money on his promissory notes. He spread the false tale that he was engaged in

buying international postal coupons in foreign countries and selling them in other countries at a

100 percent profit. He claimed that this was made possible by excessive differences in the rates

of exchange.4

3 Section 2(c), Prize Chits and Money Circulation Schemes (Banning) Act, 1978.

4 A. Shields, Practices Forbidden by State Deceptive Trade Practice and Consumer Protection Acts—Pyramid or Ponzi or Referral Sales Schemes, American Law Reports, 6th 511.



With a written promise to pay $150 in ninety days for every $100 he borrowed, Ponzi induced

thousands to lend to him. Within eight months he took in over $9,500,000, for which he issued

notes for over $14,000,000. He made no investments of any kind. All the money he had at any

time resulted solely from loans made to him under his scheme. When notes became due, they

were paid off with money from new investors. Ever since, investments in which early investors

are paid off with monies from new investors are characterized as Ponzi schemes.5

US judiciary has defined Ponzi scheme as “an artifice to defraud that was insolvent from its

inception”.6 Ponzi schemes are frauds involving payment of artificially high returns, typically as

dividends or interest payments, to existing investors from funds contributed by new investors

with the intention of creating the illusion of profitability to help attract yet more investors.7

Among types of speculative financial events, Ponzi schemes are most closely related to pyramid

schemes and economic bubbles. Ponzi schemes are similar to both pyramid schemes and

economic bubbles because each involves fundamental asset price overvaluation and the potential

for the market to move positively or negatively, and the academic literature occasionally lumps

them all under a single type.

Indian Securities market regulator Securities Exchange Board of India (here in after referred as

SEBI) does not dedicate any section on its web portal to Ponzi scheme, but its American

counterpart Securities Exchange Commission (here in after referred as SEC) has dedicated a

whole page. SEC defines Ponzi scheme as, an investment fraud that involves the payment of

purported returns to existing investors from funds contributed by new investors. Ponzi scheme

organizers often solicit new investors by promising to invest funds in opportunities claimed to

generate high returns with little or no risk.8 In many Ponzi schemes, the fraudsters focus on

attracting new money to make promised payments to earlier-stage investors and to use for

5 Ibid.

6 Scholes v. Lehmann, 56 F.3d at 755

7 K. Sadiraj and A Schram, Informed and uninformed investors in an experimental Ponzi Scheme, 1999. Available at http://www1.fee.uva.nl/creed/pdffiles/Pyramid11.PDF.

8 Pareja, Sales Gone Wild: Will the FTC's Business Opportunity Rule Put an End to Pyramid Marketing Schemes? , 39 McGeorge L. Rev. 83 2008.



personal expenses, instead of engaging in any legitimate investment activity. Ponzi scheme is

bound to fall as, with little or no legitimate earnings, the schemes require a consistent flow of

money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult

to recruit new investors or when a large number of investors ask to cash out.9

Pyramid schemes

Traditional pyramid-shaped multilevel franchise structures should be distinguished from pyramid

sales schemes. Nearly every manufacturing firm uses a system of middlemen to distribute its

products. A pyramid shape emerges, with the manufacturer on top, supported by an ever-

widening group of wholesalers and retailers, with a broad base of consumers as the pyramid's

foundation. Multilevel franchises combine both traditional distribution and direct, door-to-door

selling techniques, with most such franchises having three or four levels.10

Pyramid selling schemes also involve three or four levels through which products are channeled

to the ultimate consumer. The higher levels of distribution resell their products to the next level

below at a percentage of cost. Often a salesperson will not be elevated to a higher level unless he

or she finds a replacement to fill the position that is to be vacated. Neither the existence of a

large direct sales force nor a market system that forms a pyramid shape indicates that a

distribution system is illegal.11

Whereas a multilevel franchise system focuses on the sale of products, a pyramid scheme also

sells distributorships. The essential element of a pyramid scheme is an intensive program to

recruit new members for a commission, rather than the sale of products to ultimate consumers. In

9 Supra note, 7.

10 M Granovetter, The Strength of Weak Ties: A Network Theory Revisited, Sociological Theory 1: 201–233, 1983.

11 Diego Gambetta, Can We Trust Trust?, University of Oxford, chapter 13, pp. 213-237, 2000.



a pyramid selling scheme, the real profits come, not from selling products, but from selling

distributorships. This can be illegal.12

An "endless chain" or an unlawful pyramid is a plan in which a person pays money or buys

merchandise for the chance to receive money when additional participants are introduced into the

scheme. For example, X pays $3,000 for cosmetics. He recruits Y who also pays $3,000 for

cosmetics, in order to have the opportunity to recruit others. X gets a commission of $500 from

Y's $3,000 purchase. Y recruits Z who also pays $3,000 for cosmetics. From this, Y gets $500

and X gets $200. Because there is no legitimate retail sale to an end user on which to base the

distribution of the commissions, it is an unlawful pyramid.

Western states like US have distinction between a pyramid scheme and normal multi-level

marketing program, India so far has not have any clear distinction and are clubbed as multi-level

marketing company only. Multi-level marketing can be a lawful business which uses a network

of independent distributors to sell consumer products.13 The difference between a pyramid

scheme and a legitimate multi-level marketing plan is that in the latter, money is only made

through the eventual retail sale of a product to an end user. It is unlawful if X and Y obtain

commissions by selling the cosmetics to another distributor, who is buying the cosmetics not for

their personal use, but merely to recruit others into joining the scheme.

Multi-level Marketing or Network Marketing

The concept behind network marketing is a distribution model that allows a company to sell their

products directly to the consumer. Choosing to use a word of mouth approach (networking)

instead of advertising through traditional streams. Therefore instead of paying the media for

advertising, network marketing companies are structured to reward distributors through

commission in return for selling their products and finding new customers.

12 J Stockstill, Multilevel Franchise or Pyramid Scheme?, Small Bus. Mgmt. 54, 54-56, 1985.

13 Available at, https://www.oag.ca.gov/consumers/general/pyramid_schemes.



Therefore the main focus of a network marketing company is product distribution. In fact, in a

legitimate network marketing company, distributors are not required to recruit new distributors

in order to earn a commission; they can earn money purely by selling the company’s product.

Although distributors can choose to sell the company’s products to earn their commissions, not

everybody wants to be a sales person and therefore choose to recruit more distributors into their

organisation as a means to build their referral base.14

Not only does this create a group of loyal customers, it also allows you to leverage the efforts of

others to create a residual stream of income. Therefore the recruiting element of a network

marketing business is merely a way of distributing more products and helping to build a

leveraged income. In later section of this paper we will see that Indian Courts do not recognize

such distinction between Pyramid Scheme and MLM companies

14 Supra note, 10.



PLATFORM : MODUS OPERANDI

As we have discussed the basic idea behind Ponzi scheme, we will now deal into mechanism,

that how it is carried out and what is the organizational setup that is used by frauds to lure people

into such schemes, subsequently leading to loss of millions of investors in hope of quick money.

In this chapter, we will try to explore the platform exploited by frauds so as to trap and lure

savings of common man. We will also try to differentiate between MLM Companies and

Pyramid Companies, as after reading so many case-studies this is one of the most preferred

choice of any con, because of the wide reach it offers through its network, without any kind of

investment in physical infrastructure.

MULTI LEVEL MARKETING COMPANIES OR PYRAMID COMPANIES

MLM or Pyramid Companies are difficult to identify but share one overriding characteristic, i.e.,

they promise consumers or investors large profits based primarily on recruiting others to join

their program, not based on profits from any real investment or real sale of goods to the public.

Some schemes may purport to sell a product, but they often simply use the product to hide their

pyramid structure, this is one of the reasons why MLM are confused as Pyramid Companies.15

Modus Operandi

There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme:

inventory loading and a lack of retail sales. Inventory loading occurs when a company's incentive

program forces recruits to buy more products than they could ever sell, often at inflated prices. If

this occurs throughout the company's distribution system, the people at the top of the pyramid

reap substantial profits, even though little or no product moves to market.16 The people at the

bottom make excessive payments for inventory that simply accumulates in their basements. A

15 Jon M. Taylor, The Case (For And) against Multi-Level Marketing: The Complete Guide to Understanding the Flaws – and Proving and Countering the Effects – of Endless Chain “Opportunity” Recruitment, or Product-based Pyramid Schemes, Consumer Awareness Institute, USA.

16 Ibid, at 10-50.



lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that

their product is selling like hot cakes. However, on closer examination, the sales occur only

between people inside the pyramid structure or to new recruits joining the structure, not to

consumers out in the general public. A Ponzi scheme is closely related to a pyramid because it

revolves around continuous recruiting, but in a Ponzi scheme the promoter generally has no

product to sell and pays no commission to investors who recruit new "members." Instead, the

promoter collects payments from a stream of people, promising them all the same high rate of

return on a short-term investment. In the typical Ponzi scheme, there is no real investment

opportunity, and the promoter just uses the money from new recruits to pay obligations owed to

longer-standing members of the program. 17

ROB PETER TO PAY PAUL

In English literature, there is an expression that nicely summarizes Ponzi scheme, i.e., "to rob

from Peter to pay Paul." In fact some law enforcement officers call Ponzi schemes "Peter-Paul"

scams.18 Both Ponzi schemes and pyramids are quite seductive because they may be able to

deliver a high rate of return to a few early investors for a short period of time. Yet, both pyramid

and Ponzi schemes are illegal because they inevitably must fall apart. No program can recruit

new members forever.

Every pyramid or Ponzi scheme collapses because it cannot expand beyond the size of the earth's

population, or total market. Total market is bound to be saturated as these MLM work on endless

chains and hence saturation point in a particular market is bound to be arrived, and as the

saturation points reached in a particular market such scheme is bound to fall.19 When the scheme

collapses, most investors find themselves at the bottom, unable to recoup their losses.

17 Debra A. Valentine, Statement on “Pyramid Schemes”, International Monetary Fund's Seminar on Current Legal Issues Affecting Central Banks, Washington, D.C., May 13, 1998

18 Sandra S. Benson, Recognizing the Red Flags of a Ponzi Scheme, CPA Journal; Jun 2009, Vol. 79 Issue 6, p18-25, 8p.19 Supra note, 17.



DISTINCTION

Some people confuse pyramid and Ponzi schemes with legitimate multilevel marketing.

Multilevel marketing programs are known as MLM's, and unlike pyramid or Ponzi schemes,

MLM's have a real product to sell. More importantly, MLM’s actually selling their product to

members of the general public, without requiring these consumers to pay anything extra or to

join the MLM system.20 MLM's may pay commissions to a long string of distributors, but these

commission are paid for real retail sales, not for new recruits.

Structural operation in MLM or Pyramid

Following is the classic illustration of 3 X 4 matrixes that prevails in MLM companies, but it is

not the only available option, and there exist numerous others which are difficult to identify, but

generally at a closer scrutiny facts may surface about companies which will prove that there

existing structure is that of Pyramid or MLM Companies.21

Potential Investor : $, payment made by investor to promoter Rs. 500

Level 1 150 Rs. X 3 = 450 $ $ $

Level 2 30 Rs. X 9 = 270 $$$ $$$ $$$

Level 3 30 Rs. X 27 = 810 $$$$$$$$$ $$$$$$$$$ $$$$$$$$$

Level 4 30 Rs. X 81 = 2430 $$$$$$$$$$$... $$$$$$$$$$$... $$$$$$$$$$$...

20 R Titus, F Heinzelmann and J.M. Boyle, The anatomy of fraud: report of a nationwide survey, National Institute of Justice Journal, August 1995, 28–34.

21 Supra note, 17.



Total: Rs. 3960

Above model illustrates what is known as a three by four matrix. Each investor pays $500 to the

promoter and is told to build a "down line" by recruiting three new members, who then each

should recruit three more members. The investor is told that he will be paid $150 for each of the

three members whom he enlists at the first level. The investor is also promised a $30 commission

for each recruit at the next three levels. Thus, the investor should receive commissions for four

levels of recruits below him, each of whom must recruit three more members, hence the name --

a three by four matrix.

INVESTOR EARNINGS

To the potential investor/recruit this may look like a very appealing opportunity. The pyramid

promoter is likely to persuade the investor that he is "getting in early" and that he should

consider himself at the top of the matrix. From this perspective, it appears that he can earn

$3,960 on an investment of $500, a whopping 692 percent return.

PROMOTER EARNINGS

Yet, consider the matrix from the promoter/con artist's point of view. He is the person at the top

of the pyramid but in fact looks at the scheme from the bottom. He views each new investor as a

predicable set of revenues and expenses, with the revenues flowing down to him. The con artist

receives $500 for each new member, and at most he will have to pay $240 in commissions to

earlier investors in the new recruit's "upline," i.e. those people responsible for bringing him into

the system. So when an investor joins the system in the last level, the promoter will receive $500,

but he will pay only $150 to the person who recruited the new investor, and $30 each to three

longer-standing members in the new investor's "upline," for a total of $240. Thus, the con artist

will keep over half of every $500 membership fee paid. Now if we assume that this scheme

collapses after the fourth level of recruits is filled. The con artist will have made $500 from the

first investor in the pyramid ($500 with no commissions paid out), $350 from the 3 at the next

level ($500 minus commission of $150), $320 from the 9 at the next level ($500 minus



commissions of $150 + $30), $290 from the 27 at the next level ($500 minus $150 + $30 + $30),

and $260 from the 81 newest investors ($500 minus commissions of $150 + $30 + $30 + $30).

$33,320 flowed down to the promoter of the company and, his efforts for this kind of earning can

be summed up as attracting a single investor, we can imagine easily if the promoter has fetched a

modest figure of 100 investors, he would have earned an astronomical figure without any real

contribution towards economy.

POST COLLAPSE OF SCHEME

Now we should consider the pyramid from the investor's perspective after the entire scheme has

collapsed around him. There is very high chances that victim is the first investor, thought of

himself at the top of the pyramid but suddenly realizes that he is actually at the bottom, unable to

find people interested in the program to build out his down line. He will not be alone because

mathematics shows that most investors will find themselves at the bottom of the pyramid when it

collapses. The very structure of this matrix dictates that whenever the collapse occurs, at least 70

percent will be in the bottom level with no means to make a profit.

Investors will be out at least $500 each; in our model and even those people one level above the

bottom will not have recouped their investment. They each will have paid a membership fee of

$500 and collected commissions of $150 for each of three recruits, leaving each investor in the

second-from-the-bottom tier at least $50 shy of his break-even point. In short, when the pyramid

collapses all the investors in the bottom two levels will be losers. Adding together the number of

victims from these bottom two levels shows that 89 percent of all the pyramid's participants (108

of 121 investors) are doomed to lose money.



STATUTORY AND REGULATORY FRAMEWORK

INTRODUCTION

Such schemes as discussed above can only be stopped if proper statutory and regulatory

framework is available along with proper enforcement agency. It is however observed, that due

to lack of jurisdiction or multiple authorities involved in law enforcement, such duping schemes

escape the scrutiny of law enforcement. Some have suggested bringing a super-regulator, which

will have implied jurisdiction over all such schemes, however both the jurisdiction which we will

discuss in these sections, i.e., India and USA both have multi-regulatory regime.

India

As discussed earlier, due to multiple regulatory regimes, investors are baffled as to which

regulator shall be responsible and even if there is any regulator appointed to deal with such

chaos. Recently in the light of Amway, Apple FMCG case, Stockguru.India Scam, Sahara etc.,

this issue have become a moot point in legal circle of our society. Even in our legislature, these

things have been clarified by government. Before we come to that, we should have basic idea

about India’s legal atmosphere.

Regulatory Jurisdiction Deposits norms for Firms Rules for NBFCs

Any company desirous of

engaging in any business must

register itself under the

Companies Act, 1956.

Companies should not accept

or renew deposits which are

repayable after less than six

months and more than 36

months.

An NBFC must be registered

with the RBI and have specific

authorisation to accept

deposits from the public.



The Reserve Bank of India, or

RBI, regulates non-banking

finance companies, or NBFCs.

These include loan companies,

investment companies, asset

finance companies and

residuary non banking

companies.

The Securities and Exchange

Board of India, or Sebi,

regulates listed companies,

mutual funds and collective

investment schemes (CIS). A

CIS invests money pooled

from investors in plantation

and real estate ventures.

They cannot offer interest that

is more than the approved rate,

which may change from time

to time (it is 12.5 per cent at

present).

They cannot pay agents

brokerage of more than 1 per

cent on deposits for one year,

1.5 per cent for one-two years

and 2 per cent for two-three

years.

NBFCs which accept deposits

should have at least an

investment grade credit rating

from an approved rating

agency.

NBFCs cannot offer an

interest rate that is more than

that approved by the RBI from

time to time (which is 12 per

cent at present).

Companies which have

defaulted on payment of

principal or interest in earlier

schemes cannot accept/renew

deposits.

NBFCs cannot accept deposit

for a period less than 12

months and more than 60

months.

Source: Business Today22

22 Dipak Mondal, Sleight of Hand, Business Today, March 2012, available at, http://businesstoday.intoday .in/story/ accounting-fraud-investment-schemes-ponzi-scheme-high-returns/1/22665.html.



LEGISLATURE’S RESPONSE

Now we should look towards legislative approach towards the recently surfaced scams. Finance

Ministry in its reply to question posed to it by Shree P Venugopal about Ponzi Scheme and

SEBI’s jurisdiction over it clarified that SEBI does have jurisdiction with respect to Collective

Investment Scheme (herein after referred as CIS), but most Ponzi scheme does not fall into the

ambit of SEBI as Mutual Funds, Nidhi Companies Deposits, or Money Circulation Scheme or

Chit Funds don’t come under the purview of CIS. Such schemes shall come under the purview of

respective state governments.23

A more specific question with regards to such scheme was put forward in last November to

Ministry of Corporate Affairs by Anandrao V Adsul in Lok Sabha to which Shree Sachin Pilot

replied that Ponzi Schemes and MLM Companies fall within the purview of ‘Money Circulation’

which was an offence under the Prize Chits and Money Circulation Schemes (Banning) Act,

1978. The said act is administered by Ministry of Finance (Department of Financial Services)

through the State Governments. He further stated that RBI has circulated Model Rules which are

to be notified by states, which amply make it clear that such schemes are illegal under the above

act and organisers of such schemes need to be prosecuted under the said act.

Jurisdictional Issues

It is already explained in previous chapter that generally Ponzi Scheme is carried out by opening

of MLM Companies, it is one of the most popular ways as it remains undetected by any

government surveillance for a longer period and also MLM Companies provide widest reach

with minimal cost to promoter. We should keep in mind that it is not the only way, any scheme

can be a Ponzi scheme if it collects money/funds for investment or saving etc., and promises

returns from such investments, but ultimately it just results in cycling funds received by new

investors to old investors, resulting in a chain out of which expenses of the promoter are also

23 Unstarred Question No. 3689. Answered in Lok Sabha on 27th April 2012, by Shree Namo Narayan Meena (Minister of State Finance Ministry)



incurred. No economic value is created, but only funds are re-cycled from one investor to other

and such scheme is generally characterized by high interest rate, to attract potential investors.

It becomes clear that it is not certain as to that Ponzi scheme’s modus operandi will be MLM

only, it can be by way of issue of shares, or debentures or deposits, or CIS, or even Mutual

Funds. So jurisdiction upon each Ponzi scheme will depend upon the Modus Operandi adopted

by the promoter of that company.24 If the promoter of that scheme has adopted MLM Company

to execute its operation then such scheme would be in Sate Government’s purview, and if

promoter adopts Capital Market for schemes execution then SEBI would have jurisdiction with

regards to that scheme.

STATUTORY PROVISIONS

Prize Chits and Money Circulation Schemes (Banning) Act, 1978

We should now look into relevant provision of legislation provided in MCA’s reply with regards

to Ponzi scheme in the parliament, i.e., Prize Chits and Money Circulation Schemes (Banning)

Act, 1978. Section 2(c) of the statute defines Money Circulation scheme as25:

“… any scheme, by whatever name called, for the making of quick or easy money, or for

the receipt of any money or valuable thing as the consideration for a promise to pay

money, on any event or contingency relative or applicable to the enrolment of members

into the scheme, whether or not such money or thing is derived from the entrance money

of the members of such scheme or periodical subscriptions.”

We should now break down the definition for the ease of understanding, so necessary requisites

of the scheme are26:

24 Supra note, 22.

25 Section 2(c), Prize Chits and Money Circulation Schemes (Banning) Act, 1978.

26 Amway Enterprise v. Union of India, Writ Petition Nos. 20470 & 20471 of 2006, Hyderabad High Court, Andhra Pradesh.



there must be a scheme;

there must be members of the scheme;

the scheme must be for the making of quick or easy money on any event or contingency

relative or applicable to the enrollment of members into the scheme or there must be a

scheme for the receipt of any money or valuable thing as the consideration for a promise

to pay money on any event or contingency relative or applicable to the enrollment of

members into the scheme;

the event of contingency relative or applicable to the enrollment of members into the

scheme will however not be in any way affected by the fact whether or not such money

or thing is derived from the entrance money of the members of such scheme or periodical

subscription.”

We can easily infer that any scheme, having members which offer quick or easy money on the

basis of any contingency or enrollment of members into the scheme, which accepts receipts of

any money or valuable thing as consideration will be construed as money circulation scheme.

This scheme do cover MLM Companies as most MLM company are characterized by similar

features with the veil of product selling requirement, but we will see in subsequent chapter how

judiciary has treated such veil as direct product selling as claimed by MLM Companies.

Notifications Issued

India is moving towards blanket ban over MLM Companies which can be witnessed by two

notifications issued by Government of Manipur and Government of Andhra Pradesh, which

provides complete ban on MLM Companies and there is no exception provided with regards to

legitimate MLMs as dome in western countries. This move is seen as curbing MLM completely

and is backed by not only legislature but also recent Judicial precedents, and MLM is now being

pitched as against public policy. Relevant portion of the notification issued by Government of

Manipur27:

27 Notification, Manipur Government, 2012.



“Government of Manipur hereby informs that Prize chits or benefit schemes benefit

primarily the promoters and do not serve any social purpose. Thus, the so-called Multi-

level marketing (MLM), though called by a very attractive name squarely falls within the

definition of “Money Circulation Scheme” under the Act and hence prohibited by the

Prize Chits and Money Circulation Schemes (Banning) (Manipur) Rules, 1978. The

general public should avoid and not enroll themselves into these schemes as they not only

destroy the economic fabric of our State/country, but also the fiscal system of the country.

It is also to inform that MLM schemes destroy the well knitted social fabric of our society

and therefore, general public should not associate with such con companies.”

Press note issued by Economic Offices Wing, CID, Hyderabad is on the similar lines and

explicitly appeals public to desist from such schemes as it is a crime and do not serve any social

purpose, which is claimed by these MLMs.

Company and Securities Laws

There are many regulations prescribed by RBI and SEBI which try to curb such practices of

Ponzi scheme directly or indirectly, few are discussed below.

The Companies Act, 1956

Companies Act, 1956 lays down strong foundation as to prevent such fraudulent schemes, which

is clear from Section 205. It provides that dividend is to be paid only from profits only out of

profits of the respective year.28 This prima facie does not hint towards any kind of Ponzi scheme

and prevention thereof, but at a closer look one can easily ascertain that it is provided dividend or

returns are to be provided to investors/shareholders only from profit, i.e., company can’t borrow

money and then pay investors. The divided has to be paid only out of profits of the respective

28 Companies Act, 1956, Section 205: No dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2) or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government.



financial year, albeit it is also provided that profits can also be paid from preceding years profits

subject to certain conditions. Even the Security Premium Account cannot be used for ascertain

distributable profits pursuant to section 78 of the said act. So the company management cannot

use security premium a/c etc., to pay dividends to the investor, thereby preventing any Ponzi

scheme like structure in companies. Further, any deposits solicited from public by such

companies have to be compulsorily listed u/s 73 of the Companies Act, 1956.

SEBI Regulations

SEBI (Securities Exchange Board of India) Act, 1992 establishes SEBI with statutory powers for

protecting interests of investors in securities, promoting the development of the securities market

and regulating the securities market. Its regulatory jurisdiction extends over corporates in the

issuance of capital and transfer of securities, in addition to all intermediaries and person

associated with securities market. SEBI has been empowered to frame regulations pursuant to

Section 30 of the said act for the proper functioning of securities market in India. SEBI’s

jurisdiction was recently substantiated over unlisted public companies by Supreme Court of India

in Sahara case.29

SEBI’s jurisdiction extends over CIS, Mutual Funds, Equity market, etc. and to safeguard the

interest of investors and proper functioning of markets. SEBI has also issue regulations

Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations,

2003 which also cover any deceptive practices carried out by individuals.30 SEBI issued a

circular on 15th March 2010,31 which required Mutual Funds to seize from utilizing the “Unit

Premium Reserve” from being distributed as dividend to the holders of these funds. Even though

circular does not state, it seems to be a conspicuous attempt by SEBI to prevent Ponzi scheme.

Unit Premium Reserve is actually the excess amount collected by the funds from the investors at

29 Sahara India Real Estate Corporation Limited & Ors. v. Securities and Exchange Board of India & Anr., Civil Appeal No. 9833 OF 2011.

30 Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003. 31 SEBI/IMD/CIR No 18 / 198647 /2010.



the time of investing in as much as the sale price of the units is higher than the face value of

these units. Post circular, Unit Premium Reserve has to be credited to separate A/C and such

amount cannot be utilized for the determination of distributable surplus to unit holder.32

United States of America

Various states have enacted legislation regulating the kind of business venture known as a

pyramid scheme, Ponzi scheme, multilevel sales, endless chains, or a referral sales plan, in which

participants are compensated based upon their recruitment of other participants.33

Under such statutes, a pyramid or chain promotion is defined as a device whereby a participant

gives a valuable consideration for the opportunity to receive compensation or things of value in

return for inducing other persons to become participants in the plan or program, or under which a

participant is to receive compensation when a person introduced by the participant introduces

one or more additional persons into participation in the plan, each of whom receives the same or

similar right, privilege, license, chance, or opportunity, and which is not primarily contingent on

the volume or quantity of goods, services, or other property sold or distributed to persons for

purposes of resale to consumers.

Accordingly, such statutes prohibit only those plans under which the right to benefit is based

primarily on recruitment of others rather than on sales of goods or services. The mathematical

reality in schemes of this type is that only early participants recoup. The investors make money

not through the sale of the product but through engaging others to invest in such schemes. Thus,

by its very nature, a pyramid scheme is an inherent fraud, in that all of the later investors must

lose their entire investment.34 The fact that the point where necessary further recruitment is

impossible has not as yet been reached at the time a given recruit is brought into an illegal

pyramiding scheme does not alter the fact that there must ultimately be someone deceived.35

32 Tarun Jain, Ponzi schemes and SEBI Circular on Mutual Funds, Law In Perspective, 13 June, 2010.

33 Goldberg v. Manhattan Ford Lincoln-Mercury, Inc., 129 Misc. 2d 123, 492 N.Y.S.2d 318 (Sup 1985).

34 Ibid.



A marketing plan which requires a person seeking to become a distributor to pay a large sum of

money as an entry or "headhunting" fee, or for the purchase of a substantial amount of

nonreturnable inventory, known as "inventory loading," is a characterization of an illegal

pyramid scheme.36 Under such statutes, a pyramid sales plan under which the compensation for

recruitment is limited to payment based upon sales to persons who are not participants in the

scheme and who are not purchasing in order to participate in the scheme is not prohibited

conduct, but when compensation is offered for introducing additional persons into participation

into the scheme based upon a sale to the person introduced, the plan is deceptive and

participation in it is prohibited, at least where there is a headhunting fee, product sales are not

made a precondition for receiving a performance bonus, unsold inventory is not bought back, and

a substantial percentage of products is not required to be sold to consumers at retail.37

A Ponzi scheme is a scheme whereby a corporation operates and continues to operate at a loss.

The corporation gives the appearance of being profitable by obtaining new investors and using

those investments to pay for the high premiums promised to earlier investors. The effect of such

a scheme is to put the corporation farther and farther into debt by incurring more and more

liability and to give the corporation the false appearance of profitability in order to obtain new

investors.38

Courts have determined the constitutionality of prohibitions of pyramid, Ponzi, or referral sales

schemes by state deceptive trade practice or consumer protection acts. Courts have determined

whether such provisions have unconstitutionally burdened interstate commerce, have infringed

upon the constitutional right of contract, were a constitutionally permissible exercise of the

35 Who is a "consumer" entitled to protection of state deceptive trade practice and consumer protection acts , 63 American Law Report 5th 1.

36 Supra note, 17.

37 C.J.S., Credit Reporting Agencies § 62.

38 Scams and Cons, 74 Am. Jur. Proof of Facts 3d 63.



state's police power, violated the constitutional right of freedom of speech, or were

unconstitutionally vague or overbroad.39

LAW ENFORCEMENT IN USA

And though the FTC does not specifically address pyramid schemes, such schemes have been

deemed unlawful under the above clause in the Federal Trade Commission Act. The Federal

Trade Commission Act provides for unfair methods of competition in or affecting commerce,

and unfair or deceptive acts or practices in or affecting commerce, to be declared as unlawful. 40

MLM can be said to be an extremely unfair and deceptive practice, which places MLM companies in a

position of being in direct violation of Section 5 of the FTC Act.41

Various State/provincial Statutes

USA has a federal structure of government, so states are free to enact legislations curbing

malpractices in Trade and Commerce. Following is provided few statute references for curbing

this malpractice by State legislatures:

California

An “endless chain” means any scheme for the disposal or distribution of property whereby a

participant pays a valuable consideration for the chance to receive compensation for introducing

one or more additional persons into participation in the scheme or for the chance to receive

compensation when a person introduced by the participant introduces a new participant.

Compensation, as used in this section, does not mean or include payment based upon sales made

39 Supra note, 35.

40 Re Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975)

41 Commission Act, 15 U.S.C. 45(a)(1), states that "Unfair methods of competition in or affecting commerce, and unfair or deceptive acts or practices in or affecting commerce, are hereby declared unlawful."



to persons who are not participants in the scheme and who are not purchasing in order to

participate in the scheme.42

Florida

A "pyramid sales scheme," which is any sales or marketing plan or operation whereby a person

pays a consideration of any kind, or makes an investment of any kind, in excess of $100 and

acquires the opportunity to receive a benefit or thing of value which is not primarily contingent

on the volume or quantity of goods, services or other property sold in bona fide sales to

consumers, and which is related to the inducement of additional persons, by himself or herself or

others, regardless of number, to participate in the same sales or marketing plan or operation, is

hereby declared to be a lottery, and whoever shall participate in any such lottery by becoming a

member of or affiliating with, any such group or organization or who shall solicit any person for

membership or affiliation in any such group or organization commits a misdemeanor of the first

degree, punishable as provided in s. 775.082 or s. 775.083. For purposes of this subsection, the

term "consideration" and the term "investment" do not include the purchase of goods or services

furnished at cost for use in making sales, but not for resale, or time and effort spent in the pursuit

of sales or recruiting activities.43

New York

As used herein a “chain distributor scheme” is a sales device whereby a person, upon condition

that he make an investment, is granted a license or right to solicit or recruit for profit or

economic gain one or more additional persons who are also granted such license or right upon

condition of making an investment and may further perpetuate the chain of persons who are

granted such license or right upon such condition. . . It does not include sales demonstration

equipment and materials furnished at cost for use in making sales and not for resale.44

42 California Penal § 327.

43 Florida State Ann. § 849.091

44 N. Y. Gen. Bus. Law § 359-fff.



Washington

“Pyramid schemes” means any plan or operation in which a person gives consideration for the

right or opportunity to receive compensation that is derived primarily from the recruitment of

other persons as participants in the plan or operation, rather than from the bona fide sale of

goods, services, or intangible property to a person or by persons to others.45

One of the disappointing features of all such definitions are that such there is no uniformity in

the enactments, albeit principle underlying is same but still some of the legislations are too vague

to provide any teeth to enforcement agencies to actually curb such practice.

Enforcement Agencies

Federal Trade Commission

The Federal Trade Commission (FTC) is an independent government agency that Congress

established in 1914. FTC performs a core function of government -- ensuring that free markets

work. This requires competition among producers and accurate information in the hands of

consumers in order to generate the best products at the lowest prices, spur efficiency and

innovation, and strengthen the economy. We already have discussed Section 5 of the FTC Act,

which is used to curb illegal Pyramid companies.

With the exception of a few areas like air travel and insurance, the Commission has broad law

enforcement authority over virtually every sector in our economy. Unfortunately, FTC is now

witnessing pyramid schemes invading many of the sectors that it has jurisdiction over. The

Commission took its first concerted action against pyramid schemes in the 1970's during a boom

in home-based business and MLM or direct selling. One-on-one marketing became common for

many consumer items -- from cosmetics to kitchenware, and Tupperware™ parties became an

icon of the era.46 Unfortunately, the rise in legitimate multilevel marketing was accompanied by

a surge in pyramid schemes. Those schemes played off the popularity of MLM or network sales

45 Washington Revenue Code Ann. § 19.275.02046 Supra note, 17.



but paid more attention to networking than to selling actual goods. Pyramid schemes became so

notorious that then-Senator Walter Mondale sponsored a federal anti-pyramiding bill. It passed

the United States Senate twice in the 1970's, but never became law.47

At the Commission, cases against pyramid schemes are dealt under the FTC Act, which broadly

prohibits "unfair or deceptive acts or practices in or affecting commerce." That Act allows the

Commission to file suit in federal court and seek a variety of equitable remedies, including

injunctive relief, a freeze over the defendants' assets, a receivership over the defendants'

business, and redress or restitution for consumers.48

Securities Exchange Commission

Securities Exchange Commission (SEC) is the counter part of what we in India have SEBI, and

is entrusted to look after Securities Market in USA.49 The Securities and Exchange Commission

also pursues pyramid schemes, and obtains injunctions against so-called "financial distribution

networks" which in fact sell unregistered "securities." SEC website provides curtailing Ponzi

schemes and holding those responsible for these scams accountable as a vital component of

SEC’s enforcement program. SEC has brought more than 100 enforcement action against nearly

200 individuals and 250 entities for carrying out Ponzi schemes. These actions have so far

resulted in barring of at least 65 people in US securities industry.

The U.S. Securities and Exchange Commission (SEC) has also come under fire for not

investigating Madoff more thoroughly; questions about his firm had been raised as early as

1999.50

47 Thomas P. Rowan, Confronting the Pyramid Hazard in the United States, 1997.

48 Joseph N. Mariano and Mario Brossi, Multilevel Marketing: A Legal Primer, 29 2d ed. 1997.

49 SEC v. Int'l Load Network, Inc., 770 F. Supp. 678 D.D.C 1991.50 Town sues Madoff, hedge funds over losses, Newsday.com, March 31, 2009. Available at, http://www.newsday.com/news/local/wire/connecticut/ny-bcct--madoff-fairfield0331mar31,0,3368851.story.



Other Partners in Law Enforcement

The U.S. Department of Justice, in collaboration with investigative agencies like the FBI and the

U.S. Postal Inspection Service, prosecutes pyramid schemes criminally for mail fraud, securities

fraud, tax fraud, and money laundering.51

State officials independently file cases in state court, often under specific state laws that prohibit

pyramids. As discussed in earlier section, California defines pyramids as "endless chains" and

prohibits them under its laws against illegal lotteries. In a slightly different vein, Illinois

classifies pyramid schemes as criminal acts of deception directed against property.52 Some states

like Georgia prohibit pyramid schemes under a statutory framework that regulates business

opportunities and multilevel marketing.53

51 U.S. v. Crowe, 4:95CR-13-C (W.D. Ky. 1995) (charging an alleged pyramid promoters with mail fraud under 18 U.S.C. § 1341; securities fraud under 15 U.S.C. § § 78j(b), 78ff, 17 C.F.R. § 240.10b-5, and 18 U.S.C. § 2; and money laundering under 18 U.S.C. § § 2, 1957.)

52 Illinois Compiled Stat. Ann. 5/17-7 Michie 1997.

53 Georgia Code Ann. § 10-1-410 (1997).



JUDICIAL PRECEDENTS

Judicial precedent form an important part in common law jurisdictions, as not only it is binding

on lower courts but it also helps legislature in drafting and enacting new legislatures. In common

law jurisdiction, judiciary is solely empowered to interpret the statute, hence judicial precedent is

an important source of law. We will first deal with Indian judicial precedent and then will

discuss American Judicial attitude towards such schemes.

INDIA

M/S. APPLE FMCG MARKETING (PVT.) LIMITED V. UOI AND ORS.

This is a Madras high Court judgment which arises from writ petition filed in year 2004, 54

pronounced by Hon’ble A. K. Ranjan Justice.

Facts

Company ran scheme of network marketing the company sells products to the customers and the

consumers in turn can sell the products to their peers and earn commission out of the sale. In fact

it avoids many middlemen and cost of advertisement, etc. The marketing process was carried out

directly by recruiting the customers themselves as distributors of the products and services; the

company regularly organised business development meetings and seminars, distributors

meetings, etc.

The participants of the meetings were encouraged to take up the distributorship of the products

and are suitably registered if they so desire. There was no service fee for registration as

distributor. Any person who is interested is given a product for the price fixed. The distributors

are encouraged to en-roll more distributors. The commissions are given only as per the volume

54 7.1.2005/W.P.No:22674 OF 2004 AND W.P.M.P.No:27411 OF 2004, Madras High Court.



of sales made by the individual distributor and his team. This system ensured that intermediate

distributors are not like a chain leading to the customer and the company.

The distributor pays a sum of Rs.550/-, whereas the distributor’s price is only Rs. 372/-.

Therefore, Rs.178 is charged extra from the distributors. This amount, the distributor pays to the

company because he is made to believe that when he sells these goods to others and enroll others

in the scheme, he gets commission from the petitioner company. Such Commission depends

upon the total volume of business that he generates by enrolling new distributors, it progresses

like a chain; the amount of commission depends on the subsequent “distributors” who is made to

join by the petitioner or a purchaser through him. The promise of the possible commission is the

reason for one’s enrolment. The form requires to be filled up with three “distributors” names

through whom the new entrant get into the scheme and their placement.

One has, to purchase one or more starter kit by paying the money as stated above; the starter kit

are valued at Rs.550/-, Rs.1000/- and so on; he must sell the product to two other persons and get

their application form filled up and sent to the company; those two persons in turn have to

purchase starter kits from the company and in turn they must sell and enroll two other persons

each. Each new entrant shall purchase the starter kit from the company and in turn sell enroll two

other persons. Like this, every new purchaser from whom the new entrant purchases shall enter

the three names of his predecessors in the chain. Like this, the chain progresses. The three names

filled up by each and every new distributor depending upon the rank of placement and volume of

the business, everyone in the chain gets the commission. If a person gets started with five starter

kits, he will sell it to ten persons and that ten will become twenty at the next stage and twenty

will become forty and so on. When it goes up to ten stages in this manner, the person who sold

first will get a commission.

Courts Observation

Anybody is free to fix any price and it is for the customers to accept or not. But, it is not an

ordinary sale of goods. The persons are lured to become a distributor only on the hope or

expectation that he may get more money by way of commission if he sells the products similarly



to others. Of course, many persons are earning lot of commission in this manner. This chain is

likely to progress for some time. At one point of time the progress of the chain will stop. On that

day persons who buy the product may not find any further distributor to purchase from them. By

the time, the company would have earned enormous profit. But a very large number of persons

would be left cheated. (i) To be a distributor of such product, it requires registration under the

TNGST Act, in case the value of turn over exceeds a particular limit. It is possible that a few of

the distributors may exceeds that limit. But, those persons are not registered under the TNGST

Act and also would not be pay to the Government the sales tax. (ii) That apart, this system is not

an ordinary business transaction, it exploits the personal influence an individual has in the

society. The distributors’ are found to influence their subordinates or friends. Many of such

distributors gets included because of such undue influence by their superiors. Many unwilling

purchasers would be forced to purchase only to obey their superiors or satisfy their friends or at

times under threat or coercion or inducement and so on. Therefore, the deemed agreement

became void under the Indian Contract Act. Therefore, it is duty of the law enforcing authorities

to prevent such undue influence being exercised.

Ruling

The progress of the chain of customers, at some point of time, would get saturated and the

distributor, who purchases the goods, will not find any purchaser/sub-distributor to sell or enroll

afresh. At that time, due to the progress of the chain, in the manner stated above, such persons

who would not fine new members may be in lakhs or even millions. Therefore, lakhs or even

millions of people are bound to lose their entire money of Rs.550/0 (value of one starter kit). At

the same time, major portion of 65% of the amount would be a gain to the petitioners-company

since there would be no one shares that money.

The definition provided in previous chapter about “money circulation scheme” makes it clear

that any scheme by whatever name it is called whereby on a promise that one would receive or

would make quick or easy money by enrolment as members into the scheme is ‘money

circulation scheme’. In this case, there is enrolment of members into the scheme; there is also a

promise made that on such enrolment of large number of persons into the scheme, one would



make quick money or easy money. There cannot be any doubt that by enrolling new members

and by the process of selling the goods to new distributors this chain progresses; the person who

became such members earlier get commission without doing any work; getting such a

commission is nothing but getting quick or easy money. Therefore, such schemes the so called

‘Multilevel Marketing’, definitely falls within the definition of ‘money circulation scheme’.

AMWAY INDIA ENTERPRISES, (A PRIVATE COMPANY WITH UNLIMITED

LIABILITY) V. UOI

This is Andhra Pradesh High Court Judgments arising out of writ petition,55 pronounced by Chief

Justice G S Sinnghvi and Justice C.V. Nagarjuna Reddy.

Facts

Amway Corporation of United States of America set up the wholly owned subsidiary in India, to

establish and develop a direct selling business of products which shall be sourced from local

independent Indian manufacturers particularly small scale units by providing technology support

to products of international standard, later on it carried out manufacturing process in India with

the approval of MCA.

SCHEME/ INCENTIVE BY AMWAY COMPANY

The purported theme behind the scheme appears to be direct selling which means sale of

products to the customers by the distributors of the company without there being any wholesaler

or retailer. It is explained in the affidavit filed in support of the writ petition that a person

becomes a distributor by purchasing a business kit at a cost of Rs.4,400/- comprising; a)

Rs.2,600/- towards the products and other material (sales aid and literature) and b) Rs.1,800/-

towards product literature and subscription fee. In this process, the distributors are provided with

incentives. Affidavit filed by the petitioner titled “Amway Sales and Marketing Plan in India”

55 Amway India Enterprises v. UOI, Writ Petition Nos. 20470 and 20471 of 2006, High Court of Hyderabad, Andhra Pradesh.



contained the entire scheme. It is explained therein that distributors can generate income in two

ways, namely; 1) by earning retail sales profit, and 2) through performance incentive; that the

distributors purchase products from Amway at distributors cost and then sell these products at

higher price (not more than printed MRP) which is the retail sales profit.

There was no wrong in earning by retail profits by sales, but 2nd point that is “through

performance incentive” was criticized by Court. Performance incentive was derived by Point

Value (PV), which was also derived from Business Volume (BV). Now 1PV sums as 45 (BV).

This BV was of course derived from the lower chains, i.e. a person lower in the chain, so if you

are higher at the cycle, you will definitely earn more and more profits, even though you are not

selling any product. Thus the money which the member at the top of the line gets depends upon

the members whom he enrolls or the members enrolled by him enroll.

Court’s Observation

Court held that the whole scheme is so ingeniously conceived that the inducement for aggressive

enrollment of new members to earn more and more commission is inherent in the scheme. By

holding out attractive commission on the business turned out by the downline members, the

scheme provides for sufficient inducements for its members to chase for the new members in

their hot pursuit to make quick/easy money. On the part of the promoter by pushing each

member to achieve the minimum sales worth Rs.2,000/- per month, (this sale includes enrollment

of new members) he is assured of about 1000 crores per annum. All this squarely satisfy the

description of quick/easy money. In addition to this, it is an admitted fact that each person in

order to continue to be the distributor, shall pay renewal subscription fee of Rs.995/- per annum.

Court’s Ruling

Court held that the money which the first petitioner is earning is quick/easy money. By

promising payment of commission on the business turned out by the down-line members

sponsored either directly or indirectly by the up-line members (which constitutes an event or

contingency relative to enrollment of members), the first petitioner is earning quick/easy money



from its distributors, apart from ensuring its distributor earn quick/easy money. Court further

stated that such quick-money was dependent largely on the contingency of adding new members

to such scheme, which satisfied the conditions mentioned in Section 2(c) which defined “Money

Circulation Scheme” of the Prize Chits and Money Circulation Schemes (Banning) Act, 1978.

M/S. SGI RESEARCH & ANALYSIS LTD.

This matter was taken by SEBI after receiving of complaint against the above for duping Lakhs

of Investors from their savings.56

Facts

Securities and Exchange Board of India (hereinafter referred to as "SEBI") received a complaint

with regard to the preference shares issued by M/s. SGI Research & Analysis Ltd. (hereinafter

referred to as 'SGI'). In the said complaint, it was inter-alia alleged that Shri Lokeshwar Dev

(promoter/director of SGI) had raised more than fifteen hundred Crore Rupees belonging to two

lakh investors and had vanished alongwith his entire staff.

It was also alleged in the complaint that SGI had offered 18% preference shares of face value

`10/- each at a premium of `1,500/- per share to investors. The investors were induced by the

promise made by SGI that the shares will be listed on the stock exchanges after SEBI approval

and the listing price would be around `2,000/- per share.

SEBI’S INVESTGATION

SEBI conducted an investigation into the matter and found that SGI is a company incorporated

on June 10, 2010 under the provisions of Companies Act, 1956. SGI had issued convertible

preference shares of `10/- each at a premium of `1,500 per share to 162 investors. This issue of

convertible preference shares by SGI was apparently to public and, thus, it was in violation of

regulations 4(2), 5(1), 5(7), 6, 7, 25, 26, 46 and 59 of SEBI (Issue of Capital and Disclosure

56 SEBI Order, M/s SGI Research & Analysis Ltd., WTM/RKA/IVD/NRO/ 01/2013.



Requirements) Regulation, 2009 (hereinafter referred to as 'ICDR Regulations') and regulations

3(b), 4(1) and 4(2)(r) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to

Securities Market) Regulations, 2003 (hereinafter referred to as 'PFUTP Regulations').

SEBI’s Order

After giving reasonable opportunity to be heard to promoters and director of company, SEBI

issued the following order.

SGI failed to apply to SEBI u/s 67(3) of the Companies Act, 1956 which in the backdrop of

Sahara India Real Estate Corporation Limited & Ors. v. SEBI (Sahara Case)57 has, vide its

judgment and order dated 31.08.2012 held that an offer to fifty or more persons becomes public

issue by virtue of first proviso to section 67(3) of the Companies Act and thereby attracts

compulsory listing as mandated under section 73 of the Companies Act.

SEBI’s investigation had observed that SGI had issued convertible preference shares. Thus,

SEBI held that, being 'convertible securities', these convertible preference shares were 'specified

securities' defined in regulation 2(1)(zj) of the ICDR Regulations and SGI was under obligations

to comply with all requirements prescribed for a public issue under the Companies Act and the

ICDR Regulations, which SGI clearly failed to comply with.

SGI failed to comply with following regulations of ICDR :

application for listing of specified securities on one or more recognized stock exchange

{regulation 4(2)},

appointment of merchant banker and other intermediaries {regulation 5}, filing of draft

offer document with SEBI {regulation 6},

obtaining in- principle approval from the recognized stock exchanges in which the

specified securities are to be listed {regulation 7},

57 Sahara India Real Estate Corporation Limited & Ors. v. SEBI, Civil Appeal No. 98833 of 2011.



satisfy the conditions of initial public offer {regulation 25 and 26},

keeping the public issue open for the specified period {regulation 46},

refrain from offering any incentive to any person making application for allotment of

specified securities {regulation 59}.

SEBI also found SGI violating Prohibition of Fraudulent and Unfair Trade Practices relating to

Securities Market Regulations, 2003 (PFUTP) issued by SEBI.58 Following are the concerned

regulations:

“3. Prohibition of certain dealings in securities No person shall directly or indirectly-

(b) use or employ, in connection with issue, purchase or sale of any security listed or

proposed to be listed in a recognized stock exchange, any manipulative or deceptive

device or contrivance in contravention of the provisions of the Act or the rules or the

regulations made thereunder;”

4. Prohibition of manipulative, fraudulent and unfair trade practices

“(1) Without prejudice to the provisions of regulation 3, no person shall indulge in a

fraudulent or an unfair trade practice in securities.

(2) Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if

it involves fraud and may include all or any of the following, namely:-

(r) planting false or misleading news which may induce sale or purchase of securities.”

58 SEBI Order, M/s SGI Research & Analysis Ltd., WTM/RKA/IVD/NRO/ 01/2013.



Weighing above regulations, SEBI ordered the directors of the company to be restrained from

accessing the securities market and further prohibited from buying, selling or otherwise dealing

in securities and being associated with the securities market in any manner whatsoever, directly

or indirectly through any person / entity including those for a period of 10 years; and directors

and entities shall, jointly and severally, forthwith, refund the money collected towards

subscription of convertible preference shares, to the subscribers of such preference shares

alongwith interest of 15% per annum from the date of receipt of money.

USA

RE KOSCOT INTERPLANETARY, INC

In re Koscot Interplanetary, Inc.,59 involved a company that offered the opportunity to become a

"Beauty Advisor" and sell cosmetics. The company's incentive structure really did not encourage

retail sales. Instead, it encouraged people to pay $2000 for the title of "Supervisor" and purchase

$5400 in Koscot cosmetics, and then to earn bonuses by recruiting others to make the same

investments. The Commission found that Koscot operated an illegal "entrepreneurial chain" and

articulated a definition of illegal pyramiding that our agency and the federal courts continue to

rely on. The Commission found that pyramid schemes force participants to pay money in return

for two things. First is "the right to sell a product", second is "the right to receive, in return for

recruiting other participants into the program, rewards which are unrelated to sale of the product

to ultimate users."60

The Commission explained that paying bonuses for recruiting: . . . will encourage both a

company and its distributors to pursue that side of the business, to the neglect or exclusion of

retail selling. The short-term result may be high recruiting profits for the company and select

distributors, but the ultimate outcome will be neglect of market development, earnings

59 Re Koscot Interplanetary, Inc. 86 F.T.C. 1106 1975; Turner v. FTC, 580 F.2d 701 D.C. Cir. 1978.

60 Re Koscot, Inc. 86 F.T.C. at 1180.



misrepresentations, and insufficient sales for the insupportably large number of distributors

whose recruitment the system encourages."61

RE AMWAY CORP

In In re Amway Corp.,62 another landmark decision from the 1970's, the FTC distinguished an

illegal pyramid from a legitimate multilevel marketing program. At the time, Amway

manufactured and sold cleaning supplies and other household products. Under the Amway Plan,

each distributor purchased household products at wholesale from the person who recruited or

"sponsored" her. The top distributors purchased from Amway itself. A distributor earned money

from retail sales by pocketing the difference between the wholesale price at which she purchased

the product, and the retail price at which she sold it. She also received a monthly bonus based on

the total amount of Amway products that she purchased for resale to both consumers and to her

sponsored distributors.63

Since distributors were compensated both for selling products to consumers and to newly-

recruited distributors, there was some question as to whether this was a legitimate multilevel

marketing program or an illegal pyramid scheme. The Commission held that, although Amway

had made false and misleading earnings claims when recruiting new distributors, the company's

sales plan was not an illegal pyramid scheme.

Amway differed in several ways from pyramid schemes that the Commission had challenged. It

did not charge an up-front "head hunting" or large investment fee from new recruits, nor did it

promote "inventory loading" by requiring distributors to buy large volumes of nonreturnable

inventory. Instead, Amway only required distributors to buy a relatively inexpensive sales kit.

Moreover, Amway had three different policies to encourage distributors to actually sell the

company's soaps, cleaners, and household products to real end users. First, Amway required

61 Ibid.

62 Re Amway Corp. 93 F.T.C. 618 1979.

63 Ibid. at 710.



distributors to buy back any unused and marketable products from their recruits upon request.

Second, Amway required each distributor to sell at wholesale or retail at least 70 percent of its

purchased inventory each month -- a policy known as the 70% rule. Finally, Amway required

each sponsoring distributor to make at least one retail sale to each of 10 different customers each

month, known as the 10 customer rule.

The Commission found that these three policies prevented distributors from buying or forcing

others to buy unneeded inventory just to earn bonuses. Thus, Amway did not fit the Koscot

definition: Amway participants were not purchasing the right to earn profits unrelated to the sale

of products to consumers "by recruiting other participants, who themselves are interested in

recruitment fees rather than the sale of products."

SECURITIES AND EXCHANGE COMMISSION V. MADOFF

BACKGROUND: MADOFF

Madoff is the founder of the Wall Street firm Bernard L. Madoff Investment Securities LLC in

1960, and was its chairman until his arrest. Alerted by his sons, federal authorities arrested

Madoff on December 11, 2008. On March 12, 2009, Madoff pled guilty to 11 federal crimes and

admitted to operating what has been the largest Ponzi scheme in history. On June 29, 2009, he

was sentenced to 150 years in prison with restitution of $170 billion. According to the original

federal charges, Madoff said that his firm had "liabilities of approximately US$50 billion".

Prosecutors estimated the size of the fraud to be $64.8 billion, based on the amounts in the

accounts of Madoff's 4,800 clients as of November 30, 2008. Ignoring opportunity costs and

taxes paid on fictitious profits, half of Madoff's direct investors lost no money.

Prior to the scam, Madoff Securities was one of the top traders of US securities, held

approximately $300 million in assets. The business occupied three floors of the Lipstick

Building, with the investment management division, referred to as the "hedge fund", employing a

staff of approximately 24. Madoff ran a branch office in London, separate from Madoff

Securities, which employed 28, handling investments for his family of approximately £80



million. Two remote cameras installed in the London office permitted Madoff to monitor events

from New York.

INVESTIGATIONS LAUNCHED BY SEC

The SEC investigated Madoff in 1999 and 2000 about concerns that the firm was hiding its

customers' orders from other traders, for which Madoff then took corrective measures. In 2001,

an SEC official met with Harry Markopolos at their Boston regional office and reviewed his

allegations of Madoff's fraudulent practices. The SEC claimed it conducted two other inquiries

into Madoff in the last several years, but did not find any violations or major issues of concern.

In 2004, after published articles appeared accusing the firm of front running, the SEC's

Washington office cleared Madoff. The SEC detailed that inspectors had examined Madoff's

brokerage operation in 2005, checking for three kinds of violations: the strategy he used for

customer accounts; the requirement of brokers to obtain the best possible price for customer

orders; and operating as an unregistered investment adviser. Madoff was registered as a broker-

dealer, but doing business as an asset manager. The staff found no evidence of fraud. In

September, 2005 Madoff agreed to register his business, but the SEC kept its findings

confidential. During the 2005 investigation, Meaghan Cheung, a branch head of the SEC's New

York's Enforcement Division, was the person responsible for the oversight and blunder,

according to Harry Markopolos, who testified on February 4, 2009, at a hearing held by a House

Financial Services Subcommittee on Capital Markets. In 2007, SEC enforcement completed an

investigation which began on January 6, 2006, into a Ponzi scheme allegation which resulted in

neither a finding of fraud, nor a referral to the SEC Commissioners for legal action.

The scheme began to unravel in December 2008, when the general market downturn accelerated.

As the market's decline accelerated, investors tried to withdraw $7 billion from the firm. To pay

off those investors, Madoff needed new money from other investors. Even with a rush of new

investors who believed Madoff was one of the few funds that was still doing well, it still wasn't

enough to keep up with the avalanche of withdrawals. In the weeks prior to his arrest, Madoff

struggled to keep the scheme afloat. In November 2008, Madoff Securities International (MSIL)



in London, made two fund transfers to Bernard Madoff Investment Securities of approximately

$164 million. MSIL had neither customers nor clients, and there is no evidence that it conducted

any trades on behalf of third parties.

Madoff received $250 million around December 1 from Carl J. Shapiro, a 95-year-old Boston

philanthropist and entrepreneur who was one of Madoff's oldest friends and biggest financial

backers. On December 5, he accepted $10 million from Martin Rosenman, president of

Rosenman Family LLC, who wanted to recover a never-invested $10 million, deposited in a

Madoff account at JPMorgan, wired six days before Madoff's arrest. Bankruptcy Judge Lifland

ruled that Rosenman was "indistinguishable" from any other Madoff client, so there was no basis

for giving him special treatment to recover funds. The judge separately declined to dismiss a

lawsuit brought by Hadleigh Holdings, which claims it entrusted $1 million to the Madoff firm

three days before his arrest.

Madoff asked others for money in the final weeks before his arrest, including Wall Street

financier Kenneth Langone, whose office was sent a 19-page pitch book, allegedly created by the

staff at the Fairfield Greenwich Group. Madoff said he was raising money for a new investment

vehicle, between $500 million and $1 billion for exclusive clients, was moving quickly on the

venture, and wanted an answer by the following week.64

On December 10, 2008, he suggested to his sons, Mark and Andrew, that the firm pay out over

$170 million in bonuses two months ahead of schedule, from $200 million in assets that the firm

still had. According to the complaint, Mark and Andrew, reportedly unaware of the firm's

pending insolvency, confronted their father, asking him how the firm could pay bonuses to

employees if it could not pay investors. Madoff then admitted that he was "finished," and that the

asset management arm of the firm was in fact a Ponzi scheme – as he put it, "one big lie." Mark

and Andrew then reported him to the authorities. Judge Chin sentenced Madoff to 150 years in

prison, as recommended by the prosecution.65 Chin said he had not received any mitigating

64 Dana Henriques, Prosecutors propose 150-year sentence for Madoff, The New York Times. Available at, http://www.nytimes.com/2009/06/27/business/27madoff.html, 26 June, 2009.65 Jack Healy, Madoff Sentenced to 150 Years for Ponzi Scheme, The New York Times, 29 June, 2009. Available at, http://www.nyt imes.com/2009/06/30/business/30madoff.html?_r=1&hp.



letters from friends or family testifying to Madoff's good deeds, describing that "the absence of

such support is telling". His overall asset at the day of sentencing were around $ 826 Million, and

were immediately freeze.66

CONCLUSION

Unfortunately, Ponzi and pyramid schemes are likely to continue to proliferate both here and

abroad in the near future. However, we can all help stem the tide by working together. Members

in the banking or financial sector can help law enforcement agencies in several ways. We have

66 Madoff-Linked Asset Freeze Lifted in Connecticut Suit, 16 March, 2010. Available at, http://www.bloomberg .com/apps/news?pid=20601087&sid=apLMJ4p8DYyY&refer=home.



discussed Ponzi scheme and its origin; we also dealt with Pyramid scheme and MLM Companies

and tried to distinguish them from each other. Albeit, as regards to India due to subsequent

judgment pronounced by High Courts and Supreme Court of India and notification issued by

various state governments based on RBI model rules, there remains no distinction between

illegal pyramid schemes and legitimate MLM companies. Some might say that India is moving

towards blanket ban on such schemes, and unfair it may sound to direct selling associations, but

it is the need of the hour as Indian dynamics are very different from any western country as still

most of the population is not educated enough to understand the complexities offered by these

MLMs. Further MLM keeps on evolving developing various methods to provide incentives to

the member of schemes and it becomes difficult to ascertain or detect such under takings.

We also went through the modus operandi adopted by promoters of such fraudulent schemes and

concluded that it is not limited to only MLM companies, as ML is only one of the many platform

available to such frauds. Frauds might adopt equity market or securities market or for that matter

even Mutual Funds to target potential investors; only criteria for any deposit scheme to qualify it

as a Ponzi scheme is that such scheme should provide returns out of collected funds, i.e. a

recycling of funds has to be there. We also deduced in the second chapter of the report that what

is the difference between Pyramid Structure or illegal Pyramid scheme and MLM companies.

In next chapter we went through statutory interpretation of both Indian and American legislature,

we discussed Indian substantive law i.e., Prize Chits and Money Circulation Schemes (Banning)

Act, 1978 that is being used by judiciary as a tool to curb mal-practice of MLM Companies in

India. Also we went through some of the regulations prescribed by Securities Exchange Board of

India, the regulator of Indian Securities market. We also discussed American legislations that

look after American Securities market, which were enacted to ensure free trade across the

country, like Federal Trade Commission and other state specific laws. SEC’s role was also

elaborated and later criticized as even after receiving so many tips SEC was not able to detect

Madoff $ 50 Billion scam, which went through two decades.



High interest rate is one of the common features offered in all Ponzi scheme, but Madoff has

proved this belief to be false. Madoff kept offering around 12%-20% return which were quite

modest, although these returns were consistent irrespective of markets attitude, whetehr bearish

or bull it had little or no impact on Madoff’s securities return. Albeit, many investment advisors

issued red flag over Madoff’s fund as according to them it was impossible to replicate Madoff’s

investment and return, until and unless they carry out or are involved in Ponzi scheme or front

running. So this is a fallacy that Ponzi scheme offers high interest rates, as witnessed in Madoff

scandal.

We also tried to cover judicial precedents, and this is one area from where we can really start to

distinguish two jurisdictions on legal points. Amway Corp. was allowed in USA as a legal MLM

or legal Pyramid structure in USA by Federal Trade Commission while on the other hand it was

declared to execute its operation in violation of statutory provisions of Prize Chits and Money

Circulation Schemes (Banning) Act, 1978. Amway decision in US opened doors to thousand

other organizations to carry out similar structure, many of which are setup for the sole purpose of

duping investors, while in India decision is quite an accomplishment, but the real problem in

India arises when enforcement is in question. India does have pretty strict laws, but until and

unless they are implemented or enforced, this decision would remain meaningless. This is why

SEBI is asking for increased jurisdiction, so as to cover deposits by unlisted non-companies can

be under proper scrutiny of law.

SEC, is doing a commendable job in USA due to lack of redtapeism and bureaucracy that exists

in USA. We also need to increase funding towards investor education programs, so that gullible

investors are saved from such frauds in the near future. Stockguru.india and SpeakAsia are recent

examples of how promoters of these Ponzi schemes have duped investors from their life time

savings, of around Rs. 1500 Crore.

As we continue to pursue pyramid schemes, we would be delighted to coordinate our efforts with

law enforcement in your countries. It is only too evident that the expansion of fraud across

borders and on the World Wide Web means that no one agency or country can work effectively



on its own. We must be collectively vigilant in order to protect the integrity of our marketplaces

and the pocketbooks of our consumers.


ponzi schemes and mlm companies

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