Over the past five years, the Securities and Exchange Commission (“SEC”) has repeatedly exerted its regulatory will on multi-level marketing companies. In Part One of this two part series, I explained the basic elements of a “security” and the trouble surrounding the presence of unregistered securities in the context of network marketing. In this article, I provide some concrete examples of the SEC’s decision to intervene against MLM companies and the circumstances which brought about the ensuing actions. By studying the past, we can learn important lessons and shape the future.
Twice the Strength
Dating all the way back to the Koscot opinion in 1975, the Federal Trade Commission acted almost exclusively as the sole enforcement agency against pyramid schemes. This shifted in the past few years towards a responsibility of shared enforcement between the FTC and SEC. As business models grew more complex, particularly internet-based business models, the jurisdictions of both agencies started to overlap. From 2011 to 2016, the SEC brought more than eleven enforcement actions against pyramid schemes that fraudulently raised more than $4.2 billion from investors. $4.2 billion! The SEC even went so far as to form a Pyramid Scheme Task Force in 2014. As Andrew Ceresney, the Director of the SEC’s Division of Enforcement, stated in a 2016 speech,
“the goal of the Task Force is to target these schemes by aggressively enforcing existing securities laws and increasing public awareness of this activity.”
For pyramid-based MLMs in violation of securities laws, the SEC utilizes aggressive tactics like the filing of emergency actions, asset freezes, and the clawback of ill-gotten gains. To see what this looks like in real life and to better understand the specific laws the SEC applies, it’s worth the time to take a look at two cases against MLM companies who collectively raised over $400 million ill-gotten funds from its respective participants.
The SEC filed an enforcement action in April of 2014 against Telexfree, a Massachusetts-based multi-level marketing in the purported business of selling long-distance telephone plans through the Internet. Instead of focusing on the actual sales of these plans, the real money arose out of the purchasing of these sales plans with zero emphasis being placed on actually selling those plans. As alleged by the SEC, the more plans purchased (sometimes hundreds), the higher the percentage of “profit” from all sales activity in the scheme. It turns out that the majority of plans purchased were never activated by customers.
The SEC successfully argued Telexfree “sales” acted as “securities.” At the conclusion of the SEC’s litigation, the federal government’s pursuit of the Company and its key figures didn’t end there. Recently, Telexfree Chief Executive James Merrill received a six year prison sentence and a federal judge ordered key promoter Sanderley Rodrigues de Vasconcelos to pay $1.8 million in disgorgement for their roles in the Company. This is a stark reminder for network marketers of the inherent danger in financially benefitting from the promotion and operation of a fraudulent scheme.
Marketed as a successful Internet marketing and advertising company, eAdGear promised to help paying customers increase the visibility of their respective websites performed through popular search engines Google or Yahoo!. In reality, the SEC alleged eAdGear operated as a pyramid and Ponzi scheme which generated almost all its $300 million worth of revenue from investors.
eAdGear recruited so-called “Members” to pay between $300 and $6,000 to purchase “business packages.” In return for a Member’s passive investment of thousands of dollars, the company’s promises resulted in a clear expectation of profits. Members earned a share in the Company’s revenues in one of two ways: namely, viewing a specific number of ads run through the Company’s Ad Rotator program; or alternatively, through the sale of business packages to new members. The problem therein was that the business packages and ads viewed did nothing to improve an advertiser’s page ranking in popular search engines.
The SEC charged eAdGear with the sale of unregistered securities, citing as evidence company marketing materials that promised returns of up to a “thousand dollars a day” or an annual return of “3.6 million.” The SEC proved that the only way in which eAdGear could pay existing investors was through the solicitation and payment of funds by new investors (i.e., the tell-tale sign of a Ponzi scheme).
In addition to the SEC’s action forcing eAdGear to close its doors, a California court entered judgment against the company and its masterminds and required defendants to submit more than $26 million as a result of disgorgement, penalties, and prejudgment interest.
The demise of eAdGear was predictable: It was a business model that sold “advertisements” that were never actually used while promising to pay an ROI on ad “sales.”
The SEC’s Blueprint
The SEC wields numerous weapons when pursuing a company: Section 5 and 17 of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934.
Of the three specific laws, Section 5 is the easiest to understand. Often the lynchpin of the SEC’s case against a MLM company, Section 5 prohibits the offer and sale of any securities without the filing of a registration statement. To prove a violation of Section 5 occurred, the SEC must basically demonstrate that:
- A person or company, directly or indirectly, sold or offered to sell securities; and
- These securities were never registered with the SEC.
As a refresher, a “security” is basically defined as (1) an investment of money; (2) into a common enterprise; (3) with the expectation of returns based on the efforts of other people. Basically, it’s a payment of money with the expectation of making more money with minimal personal effort. Please read Part One in this series as a full refresher.
With the submission of sufficient proof, the SEC uses Section 5 as the gateway to more serious violations with greater repercussions. Upon asserting a Section 5 violation, the SEC may parlay this allegation into the request for a permanent injunction and civil penalties.
Akin to the approach by the FTC, oftentimes the SEC also asserts legal claims of fraud against a MLM Defendant through Section 17 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. Both Section 17 and Section 10(b) are general anti-fraud provisions. Unlike Section 5, both Section 10(b) and Section 17 require the government to fulfill a higher burden of proof in its case against a defendant. For Section 10(b), this burden of proof requires the SEC to show defendant knew or intended to defraud a person through the sale of a security.
The Lesson to be Learned
To paraphrase a favorite saying of mine, a wise man learns from his own mistakes but a wiser man learns from the mistakes of others. For network marketing companies, Telexfree and eAdGear provide examples of what not to do. At the heart of any scheme which features passive activity by participants, the promise of fixed, definitive returns will almost always incite a swift regulatory response. Even in the absence of buzzwords like “fixed returns, “ROI,” or “investors,” the SEC knows how to spot a security. After all, if it looks like a security (i.e., passive action) and makes promises typical of a security (i.e., fixed returns), then it’s a security.
While your company might be flying above the SEC turbulence, I suspect a number of your field leaders are being pulled into several of the suspicious programs that are out there. It’s important that the network marketing community familiarize itself with these concepts so it can inoculate itself from these sorts of programs.