You Can't Cheat an Honest Man

by James Walsh

  The SEC claimed that WEG offered investors ownership in a freestanding ATM for up to $24,000, promising returns of 17 percent to 20 percent each year for five years. Between September 1995 and October 1996, more than 130 investors bought WEG cash machines for $23,950 each and immediately leased them back to Cash Systems for placement in retail locations. The investors poured more than $3.5 million into WEG. The company returned about $815,000 in lease payments. But the SEC claimed this came from proceeds generated by new investors.

  Most of the investment pitches were made by telephone salespeople. In typical Ponzi scheme fashion, WEG also held what it called “private investment seminars” and did mass mailings to potential investors. The company singled out retirement-age investors as targets. “All of these schemes tend to hit the retirement communities quite hard,” one SEC source said.

  Adding a high-tech twist, WEG set up an Internet site to display pictures of the ATMs it deployed, as well as other promotional materials. Potential WEG investors were encouraged to visit the Internet site and “see for themselves” what the machines looked like and how the WEG program worked. Many people took the advice—and foolishly considered the material in the Internet site independent verification of what the telemarketers pitched over the phone. “It was really kind of sad. You had a lot of these older folks saying they’d investigated [WEG] on the Internet, when all they’d done was have someone download promo material from the company’s own website,” said one SEC source.

  The SEC argued that, in return for the $3.5 million in investment dollars, WEG signed contracts to purchase 228 terminals. In fact, the company only purchased 119 machines and placed 41, most of them in retail locations in Florida. And only two of the machines in operation made enough money to cover expenses.

  While the company’s promotional materials had mentioned potential transaction volumes of 100 transactions per day and a break-even point of 25 daily transactions, some of the terminals were registering as few as eight transactions per day. As a result, WEG “had to resort to the paying investors with new investor money,” said James Howell, a litigator in the SEC’s Los Angeles office.

  In the same order, Judge King also froze the assets of four Cash Systems and WEG executives. These people were: Charles Rietz of Mesa, Arizona; Robert Parrish of Gilmer, Texas; Robert Struth and Stephen Edgel of southern California.

  Rietz had a long history of trouble with the law. In 1978, he had been enjoined from selling securities by the SEC for fraud allegations in an offering of investment contracts. (He’d tried the “it’s not an investment” argument then, too.) In 1982, he’d paid a fine to the Commodity Futures Trading Commission for running what one CFTC investigator said was “pretty much a Ponzi scheme.”

  Edgel denied that Cash Systems and WEG were a Ponzi scheme. “We vigorously deny each and every allegation of the SEC’s complaint,” he said. “We deny that the investment is a security—we have two qualified securities attorneys who say it is not a security. It is our opinion that the SEC has no jurisdiction in the matter.”

  The Feds weren’t impressed. “We were able to stop this offering at a point when it was still growing,” said one SEC lawyer. “A lot of times you only catch these schemes after they collapse.”

  CHAPTER 18

  Chapter 18: Make Friends with the Regulators

  Ponzi schemes are investigated and prosecuted by various local authorities and federal regulators. In 1995 alone, the Securities and Exchange Commission has discovered 24 Ponzi-inspired frauds, each of them multimillion dollar rip-offs.

  In a related market, the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) oversee commodities trading. These groups serve as a good model of a regulatory system that deals with a fair number of Ponzi schemes.

  Although the CFTC does not place stringent requirements on those who trade their own funds in the market, it does require anyone who handles customer funds to register with the NFA, the self-regulating body of the commodity futures market.

  Anyone who accepts orders, money or securities for the purpose of making a purchase or sale of a commodity futures contract must register as a futures commission merchant (FCM). Anyone who operates a “commodity pool” of third-party funds in order to buy and sell commodity futures contracts is required to register with the NFA as a commodity pool operator (CPO).

  Direct participation in trading is not required to fall under the purview of the CFTC. Anyone who advises others—for a fee—about trading futures contracts must register as commodity trading advisors (CTA). Anyone who solicits orders or customers on behalf of a FCM, CPO or CTA must register as an associated person (AP). The law also offers a higher level of protection for what it calls “vulnerable victims.” A Ponzi perp who steals from such investors—and gets caught—faces harsher punishment than the average crook.

  In this regulatory sense, vulnerable means a person whose “age, physical or mental condition” makes him or her weak. Of those three terms, age is the most difficult to define. The government has identified investors who are over 50 as “elderly” individuals...and vulnerable victims due to their age and their special financial needs.

  But this definition is somewhat vague. As one court, when sorting through a collapsed Ponzi scheme, wrote: “it is logical to assume the intended victims of any premeditated offense will be selected because something in his or her persona or circumstances will make successful the intended criminal act.”

  The Federal Government’s Ponzi-Fighting Tools

  Rule 9(b) of the Federal Rules of Civil Procedure outlines the requirements for making fraud claims. The fraud allegations in the complaint must be specific enough to allow the defendant “a reasonable opportunity to answer the complaint.”

  In order to satisfy the Rule 9(b) pleading requirement for fraud, most courts require that the person making the charges state:

  • precisely what statements were made in what documents or oral representations or what omissions were made,

  • the time and place of each statement and the person responsible for making (or, in the case of omissions, not making) it,

  • the context of such statements and the manner in which they misled the investors, and

  • what the perps obtained as a consequence of the fraud.

  When the charge is based on an offering memorandum or other document, these requirements are “somewhat relaxed.” The document satisfies the time, place and content requirement of Rule 9(b). If you dont have a document, the charges will be difficult to establish. In a similar vein, Section 10b-5 of the federal Securities Act prohibits fraudulent activities in connection with the purchase or sale of securities, whether or not those securities are registered. (This is important in cases involving Ponzi schemes, because the investments usually aren’t registered as securities.) Specifically, Rule 10b-5 states:

  It shall be unlawful for any person, ...by use of the mails or instrumentality of interstate commerce...or of any facility of any national securities exchange, 1) to employ any device, scheme or artifice to defraud; 2) to make any untrue statement of material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or 3) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person....

  To elaborate this point further, section 12(2) of the Securities Act of 1933 provides that:

  Any person who... offers or sells a security...by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact ...and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, shall be liable to the person purchasing such securities from him....

  There are limits to how these various rules can be applied. As one court has noted, “Congress did not intend the securities laws to be a broad federal remedy for all f
raud.” However, the Securities and Exchange Act covers not only the enumerated instruments but also “many types of instruments that in our commercial world fall within the ordinary concept of a security.” This generally includes private placement debt, participation notes, investment contracts and other familiar Ponzi tools.

  How State Regulators Fight Ponzi Perps

  The Feds aren’t the only regulators who battle Ponzi perps. State attorneys general and consumer protection groups have specific laws that they can use to shut down Ponzi schemes. One example: New York State General Business Law prohibits “chain distributor schemes” which are defined as:

  a sales device whereby a person, upon condition that he make an investment, is granted a... right to... recruit for profit... one or more additional persons who are also granted such... right upon condition of making an investment and may further perpetuate the chain of persons who are granted such... right.

  Another example: Under Texas law, a person who runs a pyramid scheme violates the Texas Deceptive Trade Practices and Consumer Protection Act, or may be convicted of a state jail felony.

  And then there’s Illinois, which takes a noticeably hard line against Ponzi schemes.

  Kevin Trudeau said he was an entrepreneur trying to build value— and start companies—at the grass-roots level. Regulators in half a dozen Midwestern states said he was a Ponzi perp who moved from pitch to pitch, leaving burned investors in his wake. In the mid-1990s, Illinois led an investigation into Trudeau’s operations.

  Trudeau fit the profile of a Ponzi perp. A convicted felon who had served two years in prison for credit-card fraud in the early 1990s, he had a personal history littered with troubles like a larceny conviction and personal bankruptcy.

  When he got out prison in 1992, Trudeau started an eponymous multilevel marketing company which used vitamins and food products made by a Texas-based company called Nutrition for Life as its premise. But Trudeau Marketing Group’s focus was on recruiting distributors more than selling vitamins.

  Trudeau and business associate Jules Leib also sold self-help and motivational tapes from a related company called Nightingale Conant.

  Nutrition for Life president David Bertrand tried to distance his company from Trudeau, referring to Trudeau as just one of several distributors the company used. He argued that none of his distributors were pyramid schemes. “You don’t have to sign anybody up to make money,” Bertrand said.

  But Trudeau was clearly a big part of Nutrition for Life’s growth. About one-third of the vitamin company’s 82,000-person salesforce had been brought on board by Trudeau—who remained a handsomely-compensated independent contractor. In an advertising campaign that aired on syndicated television and radio shows, he promised investors big money for recruiting new members into his program.

  Trudeau encouraged his distributors to recruit others to become socalled “instant executives.” The phrase itself suggested an illegal pyramid scheme to investigators. One Illinois lawyer said, “Unless you’re rolling out of Harvard Business School with honors, you don’t usually become an executive instantly anywhere. And these guys weren’t dealing with a lot of Harvard grads.”

  Regulators at both the federal and state level were watching Trudeau. Among the challenges his company faced: Two people associated with the marketing operation were also convicted felons. They’d met Trudeau in a federal prison in California.

  On a simpler business point, many of the regulators believed that— regardless of Trudeau’s background—relying so heavily on one distributor could spell serious trouble for the Nutrition for Life.

  The SEC wanted to know how Nutrition For Life recruited its distributors. Investigations on the state level were more aggressive. Illinois Attorney General Jim Ryan made a particularly pointed effort; part of a lawsuit he filed against Trudeau cited a state law that required anyone who sold marketing plans for $500 or more to register with the state and disclose any criminal convictions. The Instant Executive program required participants to buy a $35 Nutrition for Life distributor kit, $1,000 worth of products and allow automatic credit card or checking account debits of $135 a month for new products.

  In short, Ryan was accusing Trudeau of running an illegal pyramid scheme.

  In April 1996, Trudeau agreed to a temporary restraining order prohibiting him from recruiting instant executives until Ryan’s lawsuit was resolved. As part of the settlement with Ryan’s office, Nutrition for Life would no longer use Trudeau’s “instant executive” designation. “The confusion was that some people did not realize that to be in Nutrition for Life, the only requirement was to purchase a $35 sales kit,” Bertand said.

  But the agreement would hurt. Since Trudeau had become involved with the company, the Instant Executive program had accounted for well over half the company’s revenue.

  Close to a hundred of Trudeau’s distributors packed a courtroom in Chicago to hear the details of the temporary restraining order being hammered out. The distributors drew an early rebuke from the court when they responded angrily to the state’s description of the program as a pyramid scheme.

  Trudeau’s lawyer claimed that Trudeau Marketing Group was only a “shell corporation” that didn’t transact business. “It is therefore incapable of being a pyramid sales scheme,” he argued. However, the addled argument didn’t accomplish very much.

  Even though he agreed to the temporary court order, Trudeau insisted that: “the allegations are 100 percent totally untrue.” In messages on the Internet, Trudeau wrote, “There was NO HEARING before the court!!!!!” and “The court DID NOT rule that anyone is running an illegal anything!” And, technically, he was right.

  He put a positive spin on the changes in his marketing plan: “We encourage all distributors to continue selling Nutrition for Life products and recruiting others to do so.” As to whether they should continue to recruit for the costly instant executive program, he said, “that issue is one we are working out.”

  At the same time the Illinois agreement was being worked out, the State of Michigan issued a cease-and-desist order barring Trudeau from recruiting any more of its residents as Instant Executive distributors. The Michigan order was issued after months of negotiations failed to resolve the state’s complaints, according to Bob Ward, an assistant attorney general. The order restricted Trudeau from doing anything other than selling Nutrition For Life products in the state. Ward said that effectively shut him down, because “I’m not convinced there are any retail sales in Trudeau’s program.”

  A few months later, in July 1996, Illinois and seven other states entered an agreement with Trudeau that essentially applied the terms of the Illinois agreement to the other states. The multistate deal also required Trudeau and Nutrition for Life to pay a total of $185,000 to reimburse states for the cost of their investigations.

  The agreement meant the Instant Executive Program was abolished. Compensation in the Trudeau Marketing program would be based on sales rather than on recruitment. To receive a commission, an executive distributor would be required to make five verifiable sales each month. “[The agreement] provides a significant new layer of disclosure that gives participants a clear picture of how the program works and a realistic estimate of income possibilities,” Ryan said.

  Trudeau had a different take on the outcome. “With the legal issue resolved, I can now focus my full energies and marketing expertise in helping thousands of people achieve financial freedom through a home-based business of their own,” he said. He claimed that the agreement resolved the legal issues “without any determination of wrongdoing.” Again, this was technically true—but it missed the larger point made by the settlement.

  Trudeau wasn’t long on nuance. In the wake of the Instant Executive settlement, he celebrated the end to the legal skirmishes by throwing a party for employees and investors at Chicago’s Bismarck Hotel. He said he was about to begin “the largest advertising and marketing campaign in multi-level marketing history!”

  A State Re
gulator Forces Some Repayments

  Law enfrocement agencies don’t usually concentrate their efforts on making burned Ponzi investors whole. But, state agencies will often do more than the Feds to help the people who lose money recover at least some of it.

  In late 1986, an woman named Lynn Ridenhour introduced what she called an MLM program to residents of Topeka, Kansas. The program was called the Top Flight Success System (TFSS). It was marketed by Ridenhour on behalf of Products Management Corporation (PMC). TFSS participants joined the program by paying a $1,500 entry fee. The $1,500 entry fee was paid in two checks: One check for $1,250 was made payable to TFSS; the second check for $250 was made payable to PMC. The check made payable to TFSS was deposited into a TFSS account, and the money was eventually paid to participants. PMC kept its check.

  Payment of the fee entitled the participant to have his or her name placed on a chart in an entry level position as a passenger. The charts consisted of four levels organized in a pyramid fashion. At the base of the pyramid were eight passengers. Above this—in ascending order— were four crewmen, two co-pilots and one pilot at the top.

  Once eight passengers paid their money (or, as Ridenhour called it, “boarded the airplane”), the pilot cashed out for $10,000. The remaining participants split into two new pyramids with everyone advancing one level. Each new airplane then recruited eight new passengers—at which point, the pyramids multiplied again. Theoretically, the process continued ad infinitum. Participants were encouraged to re-enter the TFSS system multiple times. Many did.

  In addition to the pyramid scheme, TFSS ostensibly marketed two products:

  1) a Top Flight Vacation Card, which entitled the holder to use of a recreational facility near Missouri’s Lake of the Ozarks (to be developed later by a subsidiary of PMC) for 20 weeks a year for five years, and