Chapter

I 1 6 Pyramid Schemes

DEBRA A. VALENTINE

What is striking about pyramid schemes is that while they arc very old forms of fraud, modern technology has vastly multiplied their potential for harming our citizens. The Internet in particular otlers pyramid builders a multilane highway to worldwide recruits in virtually no time.

Introduction

First, let me tell you about the Federal Trade Commission. The Commission is an independent government agency that Congress estab­lished in 1914. We perform 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. For competition to thrive, consumers must be knowledgeable about available products and services. Our Consumer Protection Bureau ensures that consumer information in the marketplace is not deceptive or misleading. A free market also means that consumers have a choice among products and services at competitive prices. Our Competition Bureau ensures that the marketplace is free from anticom­petitive mergers and other unfair business practices such as price-fixing or placing floors on retail prices.

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, we now see pyramid schemes invading many of the sectors that we oversee.

What Is a Pyramid Scheme and What Is Legitimate Marketing?

Pyramid schemes now come in so many forms that they may be diffi­cult to recognize immediately. However, they all share one overriding characteristic. 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. There are two telltale signs that

42 1

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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. The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A 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. In English, there is an expression that nicely summarizes this scheme: It's called "steal­ing from Peter to pay Paul." In fact some law enforcement officers call Ponzi schemes "Peter-Paul" scams. Many of you may be familiar with Ponzi schemes reported in the international financial news. For example, the MMM fund in Russia, which issued investors shares of stock and sud­denly collapsed in 1994, was characterized as a Ponzi scheme.l

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

1 Barbara Rudolph, PoofGo the Profits . . . , TIME, Aug. 8, 1994, at 44. 2 Assume a pyramid scheme in which each person recruits ten new people. There would

be one person at the top, ten beneath her, 100 beneath them, 1 ,000 beneath them, and so forth. The pyramid would involve everyone on earth in just ten layers of people with one con artist on top. The bottom layer would have more than 4.5 billion people. The Skeptic's Dictionary at http:/ /wheel.vcdavis.edu/nbtcarrol/skeptic/pyramid.html.

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Some people confuse pyramid and Ponzi schemes with legitimate mul­tilevel marketing. Multilevel marketing programs are known as MLMs,3 and unlike pyramid or Ponzi schemes, MLMs have a real product to sell. More important, MLMs actually sell their product to members of the general public, without requiring these consumers to pay anything extra or to join the MLM system. MLMs may pay commissions to a long string of distributors, but these commissions are paid for real retail sales, not for new recruits.

How Pyramid Schemes Operate

Let's look at how a pyramid scheme operates from three points of view: the potential investor, the promoter or con artist, and the victim. Many pyramid schemes will present a payout formula or matrix much like this one:

Level 1 $150 x 3 = $450

Level 2 $30 x 9 • $270

Level 3 $30 x 27 • $810

0

0 Payment of $500

0

ODD ODD

DOD DOD ODD DOD DOD DOD DOD DOD DOD

Level 4 $30 x 81 • $2,430 .- DOD ODD DOD DOD DOD DOD ODD DOD �

$3,960

This example illustrates what is known as a three by four matrix. Each investor pays $500 to the promoter and is told to build a "downline" by recruiting three new members, who then each should recruit three more members. The investor is told that he will be paid $ 1 50 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.

To the potential investor/recruit this may look like a very appe•lling opportunity. The pyramid promoter is likely to persuade the investor th•lt he is "getting in early" and that he should consider himself •lt th�· t11p of the matrix. From this perspective, it appe.us th•lt h�· C;\1\ �·.un $�,'.)f\0 '\" an investment of $500, a whopping 792 l"-'r'-''-'nt r\.'turn. You .. :.m '"\ th'"· math easily: $ 1 50 trom the tlrst kwl of .� r'-·,·ruits is S-4:;0; S.�O th\m th'"·

424 • Pyramid Schemes

next 3 levels of recruits is $270 ($30 x 9), plus $810 ($30 x 27), plus $2,430 ($30 x 8 1 ) . Not a bad deal.

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 $ 1 50 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.

Let's 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 $ 1 50), $320 from the 9 at the next level ($500 minus commissions of $ 1 50 + $30), $290 from the 27 at the next level ($500 minus $ 1 5 0 + $30 + $30), and $260 from the 8 1 newest investors ($500 minus commissions of $ 1 50 + $30 + $30 + $30). The math is simple-$33,320 flowed down to the con artist-and all he did was attract one investor!

Now consider the pyramid from the investor/victim's perspective-after the entire scheme has collapsed around him. The victim, like 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 downline. He is not 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. They all will be out $500. In our exam­ple, 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 $ 1 50 for each of three recruits, leaving each investor in the second-from-the-bottom tier at least $50 shy of his break­even 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 ( 1 08 of 121 investors) are doomed to lose money.

A Ponzi scheme could yield even worse results for investors, because it does not pay out any commissions at all. This can have disastrous conse-

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quences, as exemplified by Charles Ponzi's infamous fraud in the 1920s. Charles Ponzi, an engaging ex -convict, promised the Italian-American community of South Boston that he would give them a 50 percent return on their money in just 45 to 90 days.4 Mr. Ponzi claimed that he could pay such a high rate of return because he could earn 400 percent by trad­ing and redeeming postal reply coupons. These coupons had been estab­lished under the Universal Postal Convention to enable a person in one country to pre-pay the return postage on a package or letter sent back from another country. For a short time after World War I, fluctuations in currency exchange rates did create a disparity between the cost and redemption value of postal reply coupons among various countries. However, Mr. Ponzi discovered that he could only make a few cents per coupon and that handling large volumes of coupons cost more than they were worth. He stopped redeeming any coupons but continued to col­lect investors' money. When he actually paid a 50 percent return to some early investors, his reputation soared and more money flowed in from around the country. Mr. Ponzi bought a stylish house in the best part of town and purchased a large minority interest in his local bank, the Hanover Trust Company.

Eventually his scheme began to unravel, bringing ruin to the bank and thousands of investors. When Mr. Ponzi began to overdraw his accounts at Hanover Trust, the Massachusetts Banking Commissioner ordered Hanover Trust to stop honoring Ponzi's checks. The bank refused and even issued back-dated certificates of deposit to cover Mr. Ponzi's over­drafts. A few days later, the Banking Commission took over Hanover Trust, and Mr. Ponzi was arrested for mail fraud. In the end, Charles Ponzi owed investors over $6 million, an enormous sum of money for that time. He was convicted of fraud in both state and federal court and served ten years in prison.s

Law Enforcement Partners

The legacy of Mr. Ponzi lives on as pyramid and Ponzi schemes con­tinue to plague us and challenge the law enforcement community. Fortunately, in the United States, the Federal Trade Commission is just one among many agencies that have the authority to file suit to stop this type of fraud. The Securities and Exchange Commission also pursues these schemes, obtaining injunctions against so-called "financial distribu-

4 See Mark C. Knutson, "The Ponzi Scheme," published online at http:/ /www.usinter­net.com/users/mcknutson/pscheme.htm.

s Id.

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tion networks," which in fact sell unregistered "securities."6 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.7

State officials independently file cases in state court, often under spe­cific state laws that prohibit pyramids. California defines pyramids as "endless chains" and prohibits them under its laws against illegal lotter­ies.s In a slightly different vein, Illinois classifies pyramid schemes as crim­inal acts of deception directed against property.9 Some states like Georgia prohibit pyramid schemes under a statutory framework that regulates business opportunities and multilevel marketing. IO

At the Commission, we bring cases against pyramid schemes under the FTC Act, which broadly prohibits "unfair or deceptive acts or practices in or affecting commerce."l l 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.

FTC Precedent from the 1970s

The Commission took its first concerted action against pyramid schemes in the 1970s 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 TM parties became an icon of the era. 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, but paid more attention to networking than to selling actual goods. Pyramid schemes became so notorious that then-Senator Walter Mondale spon-

6 See e.g., SEC 11. Int'l Load Network, Inc., 770 F. Supp. 678 ( D.D.C. 1991 ), aff'd, 968 F.2d 1 304 (D.C. Cir. 1992).

7 See e.g., U.S. 11. Crowe, 4:95CR-13-C (W.D. Ky. 1995) (charging an alleged pyramid promoter 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).

8 Cal. Penal Code § 327 (Deering 1996). 9 720 Ill. Compiled Stat. Ann. 5/17-7 (Michie 1997) (formerly Ill. Rev.

Stat., ch. 38, para. 17/7 ( 1993)) . 10 Ga. Code Ann. § 10-1-410 ( 1997). 1 1 1 5 U.S.C. § 45 ( 1994 & Supp. II 1997).

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sored a federal anti-pyramiding bill. It passed the U.S. Senate twice in the 1970s, but never became law. l2

One of the Commission's first cases was In re Koscot Interplanetary, Inc., 1 3 which 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 $2,000 for the title of "Supervisor" and purchase $5,400 in Koscot cos­metics, and then to earn bonuses by recruiting others to make the same investments. l4 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. l S 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."l6 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 misrepresentations, and insufficient sales for the insupportably large number of distributors whose recruitment the system encourages. l 7

In In re Amway Corp.,ts another landmark decision from the 1970s, 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

12 See Thomas P. Rowan, Report, Confronting the Pyramid Hazard in the United States 1 5 (submitted to Prof. Robert Vaughn, Wash. College of Law, Am . U.) ( 1998) (citing Joseph N. Mariano & Mario Brossi, Multilevel Marketing: A Legal Primer 29 (2d ed. 1997)).

1 3 86 F.T.C. 1 1 06 ( 1975 ), aff'd sub. nom. Turner v. FTC, 580 F.2d 701 (D.C. Cir. 1978) .

14 Id. at 1 108-1 10 (complaint). IS See e.g., Webster v. Omnitrition Int'l, Inc., 79 F. 3d 776, 781-82 (9th Cir. 1996), cert.

denied, 519 U.S. 865 ( 1996). 16 Koscot 86 F.T.C. at 1 180 (emphasis added). 1 7 Id. at 1 18 1 . Is 9 3 F.T.C. 6 1 8 ( 1979).

428 • Pyramid Schemes

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. l9

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,20 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 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 percent rule. Finally, Amway required each sponsor­ing distributor to make at least one retail sale to each of ten different customers each month, known as the ten-customer rule.21

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. "22

Pyramid Schemes in the 1990s

The 1990s first brought an important refinement in the law. As the Commission pursued new pyramid cases, many defendants proclaimed their innocence, stating that they had adopted the same safeguards-the inventory buy-back policy, the 70 percent rule, and the ten-customer rule-that were found acceptable in Amway. However, an appellate court

19 !d. at 7 1 0-14. 21! !d. at 729-33 . 2 1 /d. at 7 1 5- 1 7. 22 /d. See Rowan, mpra note 1 2 , at 11!-2 1 (analyzing the A mwn.v dc.:ision ).

Debra A. Valentine • 429

decision called Webster v. Omnitrition Int'l, Inc.,23 pointed out that the Amway safeguards do not immunize every marketing program. The court noted that the "70% rule" and "10 customer rule" are meaningless if commissions are paid based on a distributor's wholesale sales (which are only sales to new recruits), and not based on actual retail sales.24 The court also noted that an inventory buy-back policy is an effective safe­guard only if it is actually enforced. 25

While new cases were refining the law in the 1990s, radical changes were under way in the marketplace. Pyramid schemes came back with a vengeance. Like most economic activity, fraud occurs in cycles, and new pyramid schemes exploited a new generation of consumers and entrepreneurs who had not witnessed the pyramid problems of the 1970s. Also, the globalization of the economy provided a new outlet for pyramiding. Pyramid schemes found fertile ground in newly emerging market economies where this type of fraud had previously been scarce or unknown.26 In Albania, for example, investors poured an estimated $ 1 billion into various pyramid schemes-a staggering 4 3 percent of the country's GDP.27

In the United States, probably nothing has contributed to the growth of pyramid schemes as much as Internet marketing. The introduction of electronic commerce has allowed con artists to target victims quickly and cost-effectively around the globe. After buying a computer and a modem, scam artists can establish and maintain a site on the World Wide Web for $30 a month or less, and solicit anyone in the world with Internet access. Pyramid operators can target specific audiences by posting messages in specialized news groups (e.g., alt.business.home or alt.make.money.fast) . In addition, through unsolicited e-mail messages-known on the Internet as "spam"-pyramid operators can engage in cheap one-on-one marketing. Whereas it might cost hundreds or thousands of dollars to rent a mailing list and send ten-cent postcards to potential recruits, it costs only a fraction of that to send out similar e-mail solicitations. On the Internet, you can acquire one million e-mail addresses for as little as $ 1 1 and spend nothing on postage.28

23 79 F.3d 776, 78 1-82 (9th Cir. 1 996), cert. denied, 5 1 9 U.S. 865 ( 1996). 24 Id. at 783. 25 Id. at 783-84. 26 Tom Hundley, Always Poor, Albanians Go for Broke, CHICAGO TRIBUNE, Feb. 1 1 ,

1 997, at 1 8 . 27 Id. For an analysis of the effect of pyramid and Ponzi schemes on Eastern Europe's

insurance market, see lnt'l Chamber of Commerce, Pyramid sales of insurance policies con­demned, BusiNESS WoRLD, July 9, 1997, at http:/ jwww.iccwbo.org/html/pyramid.htm.

28 Ram Avrahami, FTC Workshop on Consumer Information Privacy, Transcript of June 1 2 , 1 997 at 1 07.

430 • Pyramid Schemes

The Federal Trade Commission's current law enforcement efforts reflect this new wave in pyramiding. The Commission has brought eight cases against pyramid schemes in the last two years,29 and six of those have involved Internet marketing.30 One recent case, FTC v. FutureNet, Inc., is particularly instructive because it starkly reflects the potential for abuse in hi-tech and newly deregulated industries. FutureNet allegedly claimed that, for payment of from $195 to $794, investors could earn between $5,000 and $125,000 per month as distributors of Internet access devices like Web1V. The FTC filed suit, charging that FutureNet's earnings claims were false because the company really operated an illegal pyramid scheme. Near the time of filing, FTC investigators discovered that FutureNet had begun to sell electricity investments as well, riding a wave of speculation in advance of the deregulation of California's elec­tricity market. The Commission obtained a temporary restraining order (TRO ) and an asset freeze over the defendants' assets and eventually reached a $ 1 million settlement with the corporate defendants and two individual officers. The settlement requires the defendants to pay $1 mil­lion in consumer redress, bars them from further pyramiding activity of any kind, requires them to post a bond before engaging in any network marketing, and requires them to register with state utility officials before engaging in the sale of electricity. The Commission continues to litigate its case against three nonsettling individual defendants.3l

The Impact of Pyramids on Banking

Pyramid schemes not only injure consumers. In many cases, they affect the daily operations of banks and taint the banking industry's overall rep­utation for safety and soundness. Many pyramid promoters disparage the bank industry and promote their own program as a superior alternative to traditional banking and investment. Melvin Ford, a defendant in the

29 See FTC v. Affordable Media, LLC, Civil Action No. CV-S-98-00669-LDG) (D. Nev. filed April 23, 1998); FTC v. FutureNet, Inc., No. 98-1 1 13 FHK (Al]x) (C.D. Cal. filed Feb. 17, 1998); FTC v. Cano, No. Civ. 97-7947-IH (A}Wx) (C.D. Cal. filed Oct. 29, 1997); FTC v. Jewelway Int'l Inc., No. CV-97-383 TUC JMR (D. Ariz. filed June 24, 1997); FTC v. World Class Network, Inc., No. SAV-97-162 AHS (Ebx) (C.D. Cal. filed Feb. 28, 1997); FTC v. Mentor Network, Inc., No. SACV 96-1 104 LHM (Eex), (C.D. Cal. filed Nov. 5, 1996); FTC v. Global Assistance Network for Charities, No. ClV 96-2494 PHX RCB (D. Ariz. filed Nov. 5, 1996); FTC v. Fortuna Alliance, L.L.C., No. C96-799M (W.D. Wash. filed May 23, 1996).

30 Based on complaints the FTC has filed, the Internet was a major recruiting tool used in Future Net, Cano, World Class Network, Mentor Network, Global Assistance Network for Charities, and Fortuna Alliance.

31 See, FTC, Future Net Defendants Settle FTC Char;ges: $1 Million in Consumer Redress for "Distributors, " Apr. 8, 1998, at http:/ /www.ftc.gov /opa/9804/futurenet.htm. (press release).

Debra A. Valentine • 431

SEC's recent case against International Loan Network, stated that his company's bonus program was "the most powerful financial system since banking. "32 At the height of his popularity, Charles Ponzi actually pro­claimed that he would form a new banking system and divide profits equally between depositors and shareholders. 33

In FTC v. Cano,34 the Commission observed firsthand the impact of pyramid schemes on the banking system and individual banks. In that case, the Commission targeted an alleged Internet pyramid scheme that operated under the name Credit Development International (CDI) . For an initial payment of $ 130 and subsequent monthly payments of $30, consumers could join CDI's "Platinum Infinity Reward Program" and become a participant in its "3x7 Forced Matrix"-a structure that promised commissions going seven layers deep and that required each participant to recruit just three new members. CDI represented that par­ticipants could earn more than $18,000 per month in this program.

Besides the promise of high profits, the real attraction of CDI was its offer of an unsecured VISA or MasterCard, with a $5000 credit limit and a low 6.9 percent annual financing rate . This offer was especially attrac­tive to consumers with poor credit histories, to whom CDI advertised saying "Guaranteed Approval, No Security Deposit! No Credit Check, No Income Verification and Bankruptcies No Problem! "35

CDI representatives claimed that they could offer such attractive terms because they had a special marketing relationship with a large overseas bank, the Banque Nationale de Paris (BNP). According to the transcript of a taped sales meeting, CDI hinted that a broad conspiracy prevented U.S. banks from offering such favorable terms. A CDI representative claimed, "normal banks do not want people to know that they could have a 6.9 [percent] credit card."36 In the same meeting, CDI painted itself as an alternative to a regular bank and said "our whole concept is to have the largest membership credit union in the world."37 "We're the bank."38

In fact, according to the Commission's evidence, CDI had no business relationship with VISA, MasterCard, or BNP, and no relationship with any bank willing to issue credit cards to CDI members. Our evidence also

32 Int'l Loan Network, 770 F. Supp. at 678. 33 Knutson, supra note 4. 34 Cano, supra note 30. 35 Exhibits in Support of Motion for TRO and Asset Freeze, Ex. 2, Attachments 2, 7,

Cano, supra note 30. 36 Exhibits in Support of Motion for TRO and Asset Freeze, Ex. 2, Attachment 5 at 141,

Cano, supra note 30 (transcript of sales presentation) [hereafter "Transcript"] . 37 Id. at 86. 38 Id. at l lO.

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showed that the defendants likely misled the one bank with which they did have a relationship. When investors paid by credit card to join CDI, the defendants apparently processed these payments, not through CDI but through a different "front" company with a VISA merchant account. Consequently, the defendants put their own merchant bank at risk for any charge backs that VISA might credit to angry investors.

In the end, CDI members never received their credit cards, and accord­ing to a Commission economist, at least 89 percent of them would never have made enough money to recoup their initial investment. Last autumn, the Commission obtained a temporary restraining order and a preliminary injunction against the CDI defendants, as well as a freeze over their assets. The Commission estimates that over the five-month life of CDI, more than 30,000 consumers from the United States, Europe, Australia, and Southeast Asia lost $3 to $4 million in this alleged scam. The matter is still in litigation; the Commission is now seeking to amend its complaint and name additional defendants.

In the largest pyramid case brought by the Commission in the 1990s, we witnessed how pyramid operators often try to use the international banking system to hide their assets. In FTC v. Fortuna Alliance,39 the defendants allegedly promised consumers that, for a payment of $250, they would receive profits of over $5,000 per month. The program spawned numerous web sites on the Internet and victimized thousands of investors across 60 different countries. Although the defendants initially operated out of the United States, the Commission discovered they had secreted millions of dollars to offshore bank accounts in Antigua. But international cooperation saved the day. With the aid of the courts and banks in Antigua, the Commission obtained an order against the defen­dants, requiring them to repatriate over $2 million in offshore assets and pay approximately $7 million in redress to consumers from 60 countries.

Consumer Education

Law enforcement is the cornerstone of the Commission's fight against pyramid schemes; however, we also try to educate the public so that they can protect themselves. In our educational efforts, we have tried to take a page from the con artists' book and use new online technology to reach consumers and new entrepreneurs. For example, on the agency's web site at www.ftc.gov, the Commission has posted several alerts regarding pyra­mid schemes and multilevel marketing problems. The Commission records over 2 million "hits" on its home page every month and receives several thousand visitors on its pyramid and multilevel marketing pages.

39 Fortuna Alliance, supra, note 30.

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The staff of the Commission also has posted several "teaser" web sites, effectively extending a hand to consumers at their most vulnerable point­when they are surfing areas of the Internet likely to be rife with fraud and deception. The "Looking for Success" site is one example. It advertises a fake pyramid scheme. The home page of "Looking for Success" promises easy money and talks in glowing terms about achieving "financial free­dom." On the second page, the consumer finds a payout plan common to pyramid schemes, as well as typical buzz words like "forced matrix," "get in early," and "downline ." Clicking through to the third and final page in the series, however, brings the consumer to a sobering warning: "If you responded to an ad like this one, you could get scammed." The warning page provides a hypertext link back to ftc.gov, where consumers can learn more about how to avoid pyramid schemes.

Business Education

In an effort to provide information to new entrepreneurs, especially those who may unwittingly violate the law, the Commission has conduct­ed a number of "Surf Days" on the Internet. The first Surf Day, conduct­ed in December 1996, focused on pyramid schemes. Commission attorneys and investigators enlisted the assistance of the SEC, the U.S. Postal Inspection Service, the Federal Communications Commission, and 70 state and local law enforcement officials from 24 states. This nationwide ad hoc task force surfed the Internet one morning, and in three hours, found over 500 web sites or newsgroup messages promoting apparent pyramid schemes. The Commission's staff e-mailed a warning message to the individuals or companies that had posted these solicitations, explaining that pyramid schemes violate federal and state law and providing a link back to ftc.gov for more information. In conjunction with the New York Attorney General's Office and the Interactive Service Association, the Commission announced the results of Internet Pyramid Surf Day at a tele­vised press conference in New York City. A month later, the Commission's investigative staff revisited web sites or newsgroups identified as likely pyra­mids during Surf Day and found that a substantial number had disappeared or improved their representations and claims made to consumers.

More recently, in October 1997, the Commission helped coordinate the first "International Internet Surf Day. " Agencies from 24 countries joined this effort and targeted "get-rich-quick" schemes on the Internet, including pyramid schemes.40 Australia's Competition and Consumer

40 International participants included Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Hungary, Ireland, Jamaica, Japan, Korea, Mexico, New Zealand, Norway, the Philippines, Poland, Portugal, South Africa, Spain, Sweden, Switzerland, and the United Kingdom.

434 • Pyramid Schemes

Commission oversaw the worldwide effort while the FTC led the U.S. team consisting of the SEC, the Commodities Futures Trading Commission ( CFTC), and 23 state agencies.

In February of this year, the Commission announced yet another inno­vative use of the Surf Day concept, this time targeting deceptive e-mail solicitations. The Commission collects unsolicited commercial e-mail from annoyed consumers and other sources. A large percentage of these e-mails contains apparent chain letters or pyramid schemes. The Commission searched its e-mail database, topic by topic, and along with the Postal Inspection Service sent a warning letter to over 1 ,000 individ­uals or companies identified as potentially responsible for promoting pyramids or other get-rich-quick schemes.

Looking Ahead

Unfortunately, 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 the banking or financial sector can help law enforcement agencies in several ways. First, if your country does not have a law that makes pyramid schemes illegal, you should encourage your government to enact the necessary legislation and provide sufficient resources for enforcers to pursue pyramid schemes. Associations of reputable bankers or insurers, whose businesses can be jeopardized by the illicit schemes of unlicensed insurers or securities deal­ers, can be effective allies. Recent history in Eastern Europe makes it only too clear that pyramid schemes exploit the absence of a fully functioning market, adequate supervision, and an effective legal infrastructure. Second, you can report any suspect investment programs or potential pyramid schemes. Any information can help, and you may be able to pro­vide valuable insight into who is operating a pyramid, how it works, and whom it victimizes. In the Cano case, it was the substantial assistance of financial fraud investigators at VISA that enabled the Commission to develop and bring its case. Third, help us and others foreign enforcers to identifY and freeze defendants' assets located in your countries. Understandably, banks must observe their privacy laws, but to the extent it is legally possible for you to provide assistance in tracing and freezing the assets of pyramid operators, you will benefit all our citizens. This is often the only way to halt an illegal scheme and return money to victims. We hope that the Fortuna Alliance case signals the beginning of a trend in obtaining valuable help from foreign courts and banks.

Finally, you can encourage the relevant officials in your countries to combat pyramid schemes by educating consumers and businesses about how to recognize and avoid this type of fraud. This can be particularly

Debra A. Valentine • 435

important in emerging markets, where experience with investment opportunities may be scarce.

Here are some tips that consumers and business might find helpful.

l . Beware of any plan that makes exaggerated earnings claims, espe­cially when there seems to be no real underlying product sales or invest­ment profits. The plan could be a Ponzi scheme where money from later recruits pays off earlier ones. Eventually this program will collapse, caus­ing substantial injury to most participants.

2 . Beware of any plan that offers commissions for recruiting new dis­tributors, particularly when there is no product involved or when there is a separate, up-front membership fee. At the same time, do not assume that the presence of a purported product or service removes all danger. The Commission has seen pyramids operating behind the apparent offer of investment opportunities, charity benefits, offshore credit cards, jewelry, women's underwear, cosmetics, cleaning supplies, and even electricity.

3 . If a plan purports to sell a product or service, check to see whether its price is inflated, whether new members must buy costly inventory, or whether members make most "sales" to other members rather than the general public. If any of these conditions exist, the purported "sale" of the product or service may just mask a pyramid scheme that promotes an endless chain of recruiting and inventory loading.

4. Beware of any program that claims to have a secret plan, overseas connection, or special relationship that is difficult to verify. Charles Ponzi claimed that he had a secret method of trading and redeeming millions of postal reply coupons. The real secret was that he stopped redeeming them. Likewise, CDI allegedly represented that it had the backing of a special overseas bank when no such relationship existed.

5 . Beware of any plan that delays meeting its commitments while ask­ing members to "keep the faith. " Many pyramid schemes advertise that they are in the "pre-launch" stage, yet they never can and never do launch. By definition pyramid schemes can never fulfill their obligations to a majority of their participants. To survive, pyramids need to keep and attract as many members as possible . Thus, promoters try to appeal to a sense of community or solidarity, while chastising outsiders or skeptics. Often the government is the target of the pyramid's collective wrath, par­ticularly when the scheme is about to be dismantled. Commission attor­neys now know to expect picketers and a packed courtroom when they file suit to halt a pyramid scheme. Half of the pyramid's recruits may see themselves as victims of a scam that we took too long to stop; the other half may view themselves as victims of government meddling that ruined

436 • Pyramid Schemes

their chance to make millions. Government officials in Albania have also experienced this reaction in the recent past.

6. Finally, beware of programs that attempt to capitalize on the pub­lic's interest in hi-tech or newly deregulated markets. Every investor fan­tasizes about becoming wealthy overnight, but in fact, most hi-tech ventures are risky and yield substantial profits only after years of hard work. Similarly, deregulated markets can offer substantial benefits to investors and consumers, but deregulation seldom means that "every­thing goes," that no rules apply, and that pyramid or Ponzi schemes are suddenly legitimate.

Conclusion

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.

COMMENT

HENRY N. SCHIFFMAN

The paper on Corporate Governance and Commercial Banks presents a discussion of the key elements for proper governance of a financial insti­tution-active oversight by the board of directors, including by an audit committee of the board, clear policies and procedures for the institution's operations, risk measurement and reporting systems, and internal audit and controls. This paper presents some practical legal provisions for bank­ing laws to reinforce these measures to seek to ensure proper governance of banks or any financial institution, but first I would like to relate some general observations concerning corporate governance.

As the paper indicates, there are various constituencies for good corpo­rate governance-shareholders, creditors, employees, regulators, the gov­ernment. An article published last year assessed corporate governance in different countries from the point of view of protection of interests of investors-shareholders and creditors-according to the origins of com­mercial laws of various countries, whether English or common law, French civil law, German civil law, or Scandinavian civil law. I For shareholders, it considered their ease in exercising voting rights and rights of minority shareholders. For creditors' rights, it considered the ability of creditors to realize collateral and to affect corporate financial reorganizations, in effect, what the law provided if internal governance fails and the company is unable to meet its liabilities. For both shareholders and creditors, it found that common law countries offered the best protection and French civil law systems the worst. The study then asked whether enforcement of the laws for investors compensated weaknesses in substantive provisions. Enforcement included efficiency of the judicial system, rule of law and absence of corruption, and quality of accounting standards. It concluded that the quality of enforcement was highest in Scandinavian and German civil law countries and weakest in French civil law countries. Whether the income level of a country affects these factors was also considered. The con­clusion was that there was no correlation between income level and share­holder rights and that some creditors' rights are weaker in richer countries, but that richer countries have a higher quality of law enforcement.

1 Rafael La Porta et a!., "Which Countries Give Investors the Best Protection?" Private Sector (The World Bank Group, June 1997) at 29.

437

438 • Comment

I would like to dispel what I believe is a myth concerning corporate governance, and that is that generally shareholders have a significant role to play in the adoption of policies for the governance of companies that they own. The theory is that a company should be managed in the inter­est of shareholders. In recent years there has been much written in the Western financial press about shareholder activism, and while this move­ment has had some notable successes, it is still the management that con­trols the management and policies of the vast majority of banks and other enterprises throughout the world, and there is no real prospect for sig­nificant change. The relatively small amount of corporate income that is distributed as dividends to shareholders attests to this. In the United States in the past five years or so, often led by CALPERS, the pension fund for California civil servants, there have been changes in the boards of directors or ownership of some three dozen companies that have received significant publicity, but this is the exception rather than the rule. Reportedly in the United Kingdom and in Canada shareholder gov­ernance has also had significant influence in many cases.

But in widely held companies, shareholders are usually powerless to effect significant change. It is expensive and complicated to mount chal­lenges to existing boards of directors. The fact that voting on proxies is not secret and management knows who voted for and against them means that pension funds and money managers often fear retaliation by management and are reluctant to vote against them. Thus, the basic choice is that shareholders can vote for the slate of directors proposed by the existing board or by management or they can sell their shares if they are discontent with the way their company is governed. But it is very dif­ficult to challenge entrenched management and a board of directors. One would expect that with publicly traded companies, raiders would buy control of a company whose share price is depressed when new manage­ment could better enhance the value of the company's assets, but this occurs infrequently.

Another area of governance that I would like to briefly address is the two-tier board structure found in many European countries. In my expe­rience in economies in transition I have observed that some banks have had difficulty in governance with a two-tier structure. This is under­standable because the joint stock company has only been used for the first time in at least 40 years in Central and Eastern Europe, and the separa­tion of ownership and decentralized management is relatively new. But when it comes to a supervisory board and a management board, in some countries either the company law is not sufficiently clear or in practice there have been tensions between the two boards concerning their respective spheres of influence. I expect that two-tier board structures function well in countries where there has been such tradition, although

Henry N. Schiffman • 439

I understand that in France a few years ago the law was changed so that companies have an option to have either one or two boards. Even in Western Europe there can be difficulties in assessing responsibilities as was evidenced in the cases of Metallgesellschaft A. G. after huge losses in oil trading and in fraudulent real estate loans to Jurgen Schneider. In both cases, each board blamed the other for failure to fulfill oversight responsibilities that should have prevented large losses. In the Schneider case, the lead bank's boards traded accusations.

Banking Law Provisions

What can banking laws provide to ensure that banks are properly gov­erned? Banking laws should contain various provisions to ensure good governance of banks. These include provisions for prior approval by the bank supervisor of significant changes in share ownership of a bank and of significant equity investments by a bank, provisions for and exceptions to bank secrecy, provisions to prevent money laundering, and provisions to prevent anticompetitive practices. However, the discussion below is intended to focus on other provisions that more directly affect gover­nance of a bank by those responsible for management at the level of the board of directors or that affect selection of directors on such matters as qualifications and dismissal of board members and significant sharehold­ers, preventing exploitation of conflicts of interest, and transactions of banks with related parties.

As a preliminary matter, banks should be organized in the corporate form that is most conducive to good governance, forms of business that are required to publish periodic financial statements and have an inde­pendent external audit, at the least. The form with these requirements is usually the joint-stock company, yet some banking laws permit a bank to be organized as a partnership, a limited liability company, or a public enterprise, all of which have fewer governance requirements than a joint stock company.

Qualified Directors and Significant Shareholders

Second, there should be requirements for qualifications for directors and for significant shareholders of a bank on an ongoing basis. While most laws require approval of the proposed board of directors and prin­cipal shareholders at the time of licensing, some laws merely provide for post facto notification to the bank supervisor of a change in directors and often no provision is made for disqualification and removal of directors or shareholders who have been approved but who no longer meet the qualification requirements. Thus, the law should contain provisions sim­ilar to the following.

440 • Comment

Article [ ]. Quality of administrators and principal shareholders; dis­qualification and removal

l . All persons elected or appointed as administrators of a bank must be of good repute and must meet the criteria established by regulation of the Central Bank regarding qualifications, experience, and integrity. Prior to their assuming office they must be approved by the Central Bank.

2. A person shall not be eligible to become a member of the Board of Directors of a bank, or shall by decision of the general or special meeting of shareholders of the bank be relieved of his membership on the Board of Directors of the bank, or, if it fails to act within 30 days of notice of the dis­qualification, by the Central Bank, in the event that

a. he has by law been deprived of the right to sit on the board of direc­tors of a juridical person;

b. he serves, or he served at any time during the immediately preceding twelve-month period, on the administrative body of the Central Bank;

c. he has been convicted of a crime;

d. the Central Bank determines that he has been a party to a transaction that violates the [Banking Law] or a regulation issued under that law;

e. he has been subject to an insolvency proceeding as debtor; or

f. [he holds a position in the Parliament or in the Government].

3. The Board of Directors of a bank and its members cannot delegate their responsibilities to others.

4. Members of the Board of Directors, except those who have filed a writ­ten objection against the proposed credits, shall be jointly and severally liable for losses sustained by a bank from credit extended in violation of [the Article on limits on credit to one or related borrowers] . Such liabilities may not be paid directly or indirectly by the bank which they serve or by the pro­ceeds of any professional liability insurance or other indemnity policy.

5 . A natural person who is (i) a principal shareholder of a bank or (ii) a prin­cipal shareholder of a juridical person that is a principal shareholder of a bank who is described in subparagraphs a, c, d, or e in paragraph 3 shall divest his interest in voting shares of a bank to below the level of a principal share­holder. If he fails to do so within 60 days of becoming disqualified, his shares shall lose the right to vote and to receive a capital distribution. Afrer such period, the Central Bank may order that all his shares in the bank be trans­ferred to a trustee for sale at auction and the net proceeds, less expenses of sale, will be remitted to the disqualified shareholder.

Committees of the Board

Third, there should be requirements in the banking law for obligatory committees of the Board. This should include an audit committee, which

Henry N. Schiffman • 441

is often required in the company law. The basic functions of such a com­mittee should be specified in the law and could, of course, be supple­mented by regulations. In addition, there should be an asset and liability management committee and a credit committee. For small banks that may not have the managerial resources for several board committees, the functions of a credit committee and an asset and liability management committee could be combined in one committee . Thus, provisions for the banking law like the following could be considered.

Article [ ]. Audit Committee

l . The Audit Committee shall consist of three members appointed by the general meeting of shareholders of the bank for periods of [three] years. Members of the board of directors, if executive directors, shall not concur­rently serve on the Audit Committee . The Audit Committee shall

a. establish appropriate accounting procedures and accounting controls for the bank, including those prescribed by the Central Bank, super­vise compliance with such procedures, and, as it deems appropriate, commission audits at the expense of the bank of some or substantially all of the bank's accounts and records;

b. approve the strategy and budget for the bank's internal auditing;

c. monitor compliance with the laws and regulations applicable to the bank and report to the supervisory board thereon; and

d. deliver opinions on any matters submitted to it by the management or supervisory board or that it wishes to address.

2 . The Audit Committee shall meet ordinarily once per quarter and extraor­dinarily when convened by two of its members or by the board of directors. Decisions shall be taken by a majority of the members present and no abstentions shall be allowed.

Article [ ] . Risk Management Committee

l . The Risk Management Committee shall consist of one member of the supervisory board and two members of the management board who shall serve for a minimum period of one year, which term shall be renewable. The Risk Management Committee shall

a. establish and implement or monitor implementation of policies and procedures for credit appraisal, loan administration, and asset and lia­bility management, including those prescribed by the Central Bank, including such matters as underwriting standards, approval of large extensions of credit and all equity investments, requirements for col­lateral for credit, classification of and provisioning for assets, pursuit of borrowers in default, and managing interest rate and market risk;

b. monitor compliance with the laws and regulations applicable to cred­it and other risks and report to the supervisory board thereon; and

442 • Comment

c. deliver opinions on any matters submitted to it by the supervisory board or that it wishes to address.

2. The Risk Management Committee shall meet ordinarily once per month and extraordinarily when convened by the supervisory board or by two of its members. Decisions shall be taken by a majority of the members present and no abstentions shall be allowed.

3. Banks whose total assets are more than [ ] must establish separate com­mittees to perform (i) asset and liability management and (ii) the other func­tions described in this article.

External Audit

The basic scope of the audit by independent external auditors approved by the bank supervisor should be specified in the law. This would empha­size the need for an assessment for the quality of internal audit and con­trols and a duty to report to the board and to the bank supervisor about any condition or policy of the bank that can be expected to result in a material loss for the bank.

Article [ ] . External audit

Banks shall each appoint an independent external auditor approved by the Central Bank who shall:

a. assist it in maintaining proper accounts and records, including in the manner that may be prescribed by the Central Bank in accordance with Article [ ] ;

b. prepare an annual report together with an audit opinion as to whether the financial statements present a full and fair view of the financial con­dition of the bank in accordance with the provisions of this Law;

c. review the adequacy of internal audit and control practices and proce­dures and make recommendations for remediation; and

d. inform the board of directors and the Central Bank about any irregu­larity or deficiency in the administration or operations of the bank or any of its subsidiaries, including any fraudulent act by an administra­tor or employee that should be expected to result in a material loss for the bank or such subsidiary.

Fiduciary Duty

In some civil law jurisdictions the concept of fiduciary duty of compa­ny directors does not seem to be as ingrained as in some common law jurisdictions. For example, I have been told that in some countries there is nothing in the banking law or in the company law that would make ille­gal the receipt of special compensation from the borrower by a director

Henry N. Schiffman • 443

of a bank who sits on the credit committee for voting in favor of credit to such borrower. In fact it was not until l989 in the United States in the Financial Institutions Recovery, Reform, and Enforcement Act (FIRREA) that an explicit fiduciary duty was added to the banking law. The basic concept of fiduciary duty is simple-a bank officer or director must place the interest of the bank and its customers before his or her personal interest. In the banking law, provisions like the following would be appropriate:

Article [ ]. Fiduciary duty

l . Administrators and employees of banks have a fiduciary duty to the bank that they serve and to the bank's customers to place the bank's interests and its customers' interests before their own pecuniary interest.

2. Banks shall introduce suitable arrangements and procedures so that they and their administrators and employees are not placed in a situation where their duty to one customer conflicts with their duty to another, or where their own interest conflicts with their duty to a customer.

Prevention of Exploitation of Conflicts of Interest

To seek to ensure that the fiduciary duty is implemented, the banking law can benefit from specific provisions to prevent exploitation of con­flicts of interest. Conflicts of interest will arise. There is nothing abnor­mal about the presence of conflicts of interest. But they must be managed properly so that they do not lead to the detriment of the bank or its cus­tomers. Thus, there should be requirements in the banking law for administrators to disclose their financial interests, to refrain from deliber­ations concerning a matter in which they have a direct or indirect pecu­niary interest, for a court to set aside any transaction that is violative of this provision, and for such persons responsible for violations to be sus­pended or dismissed from office. An article for a banking law containing these provisions would be as follows:

Article [ ]. Disclosure and management of conflicts of interest

l . An administrator of a bank who ( i ) is a party to a material contract or a pro­posed material contract with the bank or (ii) is an administrator of, or has a material interest in or a material relation to, any person who is a party to a material contract or a proposed material contract with the bank shall disclose in writing to the bank the nature and extent of the material interest or relation.

2. The disclosure required by paragraph l shall be made by the administra­tor when the contract or proposed contract comes or ought reasonably to come to the attention of the administrator.

3. A general notice in wri ring to the board of directors of the bank by an administrator, disclosing from time to time, but no less than annually, the

444 • Comment

names and addresses of the administrator's associates and reasonably full particulars of every material commercial, financial, agricultural, industrial, or other business or family interest that such person has at the time, and stating that the person is to be regarded as interested in any material transaction between the bank and any person named in the disclosure, shall be a sufficient declaration of conflict of interest in relation to any such transaction.

4. An administrator who has a material interest or a material relation with­in the scope of paragraphs l or 3 shall leave any meeting at which the trans­action is discussed and shall refrain from voting on any matter related thereto that becomes the subject of action by the board of directors of the bank, provided that such an interest, if so disclosed, shall not disqualifY the interested person for purposes of constituting a quorum.

5. For the purposes of paragraphs l and 3, an interest shall be material if it is material with reference to the wealth, business, or family (any person who is related by marriage or to the second degree of consanguinity) interests of the person having the interest, and a person has a material interest in (i) any company if the person owns, directly or indirectly, a significant interest in the company, or is an administrator of the company and (ii) any partnership if the person is a partner.

6. When an administrator fails to disclose a material conflict of interest in accordance with this article,

a. a court of competent jurisdiction may, on the application of the bank, a shareholder, or the Central Bank, set aside the transaction on such terms as it thinks fit, and

b. the Central Bank may, by written order, suspend the administrator from office for any period not exceeding one year, or remove the administrator from office permanently.

Other provisions to ensure the undivided loyalty of bank administrators could be considered, depending upon what is appropriate in light of local customs.

Article [ ]. Conflicts of interest

l . While holding office, bank administrators shall devote the whole of their professional services to the bank, and none of them shall occupy any other office or employment, whether remunerated or not, except as nominee of the bank.

2. No employee of the bank shall simultaneously have other employment, whether gainful or not, without the prior written approval of the bank.

3. No member of the Board or employee shall accept any gift or credit for him­self, or on behalf of any person with whom he has family, business, or financial connections, if the acceptance thereof would result, or give the appearance of resulting, in a diminishment of his impartial devotion to his duties to the bank.

Henry N. Schiffman • 445

4. [For state-owned banks: No member of the Board or employee above the level of department director shall act as a delegate of any commercial, financial, or other business interest, or otherwise put himself in a position where his personal interest conflicts with his duties to the bank . ]

Special provisions can be included in the law in furtherance of the gen­eral fiduciary duty to a bank's customers in connection with securities transactions. When banks and their affiliates conduct a range of securities activities like distribution, underwriting and placement of securities, portfolio investment management, and investment advisory activities, there are various opportunities to exploit conflicts of interest. For exam­ple, a bank's securities affiliate may underwrite or place securities to enable the issuer to repay a loan to a bank when the issuer is otherwise unable to repay the loan. In such a case the credit risk is transferred from the bank to the investors in the securities. Worse, if the securities affiliate is unable to find members of the public in general to buy such securities, the bank may purchase the securities for the account of investment port­folios that it manages. Thus, to prevent inappropriate tandem transac­tions in securities activities, the law should contain an article like the following:

Article [ ]. Prohibited securities activities

l . No bank and no financial institution affiliate of a bank shall

a. extend credit to a person or underwrite or place securities or arrange financing from third parties to that person to enable the person to repay his obligation to the affiliate;

b. underwrite or place securities of a person and extend credit to that person to enable him to pay the principal, interest, or dividend on such securities; or

c. underwrite, place, or distribute securities and within sixty days of the initial sale, purchase or recommend the purchase of such securities in the capacity of asset manager or investment advisor.

2 . No bank shall purchase from an affiliate of the bank (i) assets of that affil­iate or (ii) securities to be underwritten, placed, or distributed by that affil­iate or that have been so underwritten, placed, or distributed within the past year.

3 . No bank shall (i) provide credit enhancement for or (ii) extend credit to facilitate the purchase of securities underwritten, placed, or distributed by an affiliate of the bank.

Related Party Transactions

In some countries a significant source of losses for banks has been transactions of the bank with officers or principal shareholders of the

446 • Comment

bank or with companies owned or controlled by family members or com­panies in which such insiders have financial interests. Thus, the banking law should contain provisions to restrict if not prohibit such transactions. Restrictions would relate to quantitative limits on all such transactions with related parties, perhaps limiting credit to any one related party to amounts considerably less than the legal lending limit, and would specify that transactions may not be on terms more favorable than those of trans­actions with unrelated parties. Some banking laws prohibit credit trans­actions with related parties. However, if the banking law is coherent and enforced, bank directors who have been approved for their personal and financial integrity and their related interests should be among the best customers of a bank. Provisions in this regard would be the following:

Article [ ]. Transactions with related persons

l . Banks shall not enter into a transaction with or for the benefit of a per­son who is related to the bank, if such transaction would be entered into on less favorable terms and conditions, or not at all, with or for the benefit of persons who are not so related to the bank. For the purposes of this para­graph, persons who are related to a bank shall include without limitation (i) any administrator of the bank, ( ii) any principal shareholder of the bank, and (iii) any person who is related to such administrator or principal sharehold­er by marriage, consanguinity to the second degree, or business interest. Notwithstanding the foregoing, no bank shall extend credit to or for the benefit of a person so related to the bank if as a result thereof the aggregate amount outstanding on all credits extended by the bank to persons so relat­ed to the bank would exceed an amount in relation to the bank's regulato­ry capital as prescribed by regulation by the Central Bank.

2. Credit extended by any bank to any related bank or financial institution shall be subject to such additional conditions or restrictions as shall be pre­scribed by regulation of the Central Bank. For the purposes of this para­graph, a related bank or financial institution shall include, without limitation (i) any private or governmental person or institution, or any number of such persons or institutions acting in concert, that has a direct or indirect signif­icant interest in the bank extending the credit and (ii) any juridical person or undertaking in which the bank holds a significant interest.

Enforcement Action Concerning Directors

Some banking laws contain sanctions for violation of the law or regu­lations or orders or conditions of the bank regulator that are against the bank itself but not its officers, directors, or principal shareholders. It is appropriate for the law to provide for dismissal by the bank regulator of bank officers and directors upon a finding that the person has been sig­nificantly responsible for the infraction in question. While some laws con­tain provisions on dismissal of such person they do not provide for

Henry N. Schiffman • 44 7

replacement by the bank supervisor of a dismissed bank official. This is based on the policy that the regulator should not be indirectly responsi­ble for the management of the bank and that shareholders or other direc­tors should fill board vacancies. However, if the chief executive officer or chief financial officer is dismissed, it may be important to have a new per­son in place quickly to take charge, and corporate formalities may be too slow. Where the laws provide for the appointment of a provisional admin­istrator by a bank regulator as an extreme enforcement measure, that action may be taken as a substitute, and for countries that have such laws banks may understand that if they do not find a suitable replacement for a dismissed official quickly they risk becoming subject to the management of a provisional administrator.

COMMENT

ROBERT D. STRAHOTA AND LUCEE S. KIRKA

P onzi and pyramid schemes steal people's money today by making false promises of wealth tomorrow. They are as old as money itself and can be found in one form or another in all countries. These schemes are a cruel hoax. Millions of people worldwide have lost their life savings in these schemes.

All Ponzi and pyramid schemes have one thing in common-someone will steal your money! Here are some examples of how these schemes work.

The Ponzi Scheme-Using New Money to Replace Old Money

In a Ponzi scheme, the promoter takes your money and promises you an extremely high rate of return. The promoter's promise depends on attracting new investors and recycling some of their money back to you. The scheme "works" only as long as new investors can be recruited. In fact, a Ponzi scheme depends upon the promoter's ability to find an ever­increasing number of new "investors" to give the false appearance that earlier investors have been successful. It doesn't take long before these new investors can't be found. That's when the promoter either disappears or has to admit that he can't pay you back. These swindles are often dis­guised as complicated investment products, such as precious metals or exotic commodities .

Chain Letters or Multilevel Distribution Plan Schemes

You can also be swindled by a pyramid scheme in which the promoter collects funds from persons at the bottom of the "pyramid" to pay per­sons higher on the pyramid. These schemes often involve "chain" letters or multilevel distribution plans. They depend more on the recruitment of new victims than the distribution of any product or service. A new investor (let's call her Ms. A) pays a fee or commission to the promoter for the right to distribute the promoter's product or service. Ms. A will not get any money back until she convinces additional investors to pay her for the right to sell the product or service . Just like the Ponzi scheme, an ever-increasing supply of money from new investors, rather than the product or service, is needed. These schemes often spread so quickly that

448

Robert D. Strahota and Lucee S. Kirka • 449

the chances of an investor finding a sufficient number of new investors are mathematically impossible.

For example, if each investor is required to find six new participants each month, each of whom, in turn, must find six new participants the next month, and so on, the numbers of new investors needed increases as follows:

Month Number of Participants

1 6

2 36

3 216

4 1 ,296

5 7,776

6 46,656

7 279,936

8 1 ,679,616

9 10,077,696

These are common examples of fraudulent schemes. Some schemes are less complex and simply involve a promoter asking you for an initial pay­ment to assure your participation in a "get rich quick" scheme. The pro­moter then simply disappears with your money, never to be seen again.

Warning Signs for Ponzi and Pyramid Schemes

Here are some things to watch out for:

• Promises of high returns to be received quickly. If you have invest­ed, resist pressure to reinvest before you have actually received your profits. Be suspicious of promoters who are reluctant to let you have your money back. Remember, just because the promoter gives you a statement showing how much you've made, it doesn't mean that the statement is true, or that you'll ever receive the money.

• High pressure sales tactics, including statements that you must get involved quickly or you'll miss a "once in a lifetime" opportunity.

• Guarantees that you will not lose money or that you will make a sub­stantial amount. Remember, just because something is written in the newspaper or said on television or radio doesn't always mean it's true.

450 • Comment

• People who try to get you to invest just because the person selling the investment is part of a religious or social organization to which you belong.

• Promoters who fail to provide clear and detailed explanations of what will be done with your money, or who give you vague or over­ly complicated explanations about the investment. Never invest in something that you don't understand.

• Recommendations to invest based on "inside" or "secret" information.

• Statements made by other persons who claim to have made money from an investment scheme being offered to you. Remember, these persons may have been paid by the promoter to make these state­ments, or they may be persons who invested earlier and need new investors to recover their money.

Even if people you know have invested in a particular scheme and received great returns, it doesn't mean that success will continue. That's exactly what the promoter wants you to believe.

If someone offers you a bargain, be skeptical. Remember, if it sounds too good to be true, it probably is.