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 PONZIs, Pyramids, MLMs, And Crypto 

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Michael Santos

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Introduction

Is crypto a scam, a Ponzi scheme? Many people are asking. 

This post covers the basics of federal Ponzi schemes and how they apply in the crypto space.

Discussion

In the most recent series on our blog, we discussed cryptocurrencies, including several ways in which people involved in the cryptocurrency markets can become defendants, targets, or witnesses in criminal prosecutions and investigations.

For example, fraud and money laundering conspiracy charges are the most common so far. Federal law enforcement will continue to bring fraud and money laundering charges where appropriate. 

In addition, many people wonder whether the federal government can prosecute cryptocurrencies and crypto-related businesses as Ponzi schemes or pyramid schemes

Can federal law enforcement prosecute crypto as illegal Ponzi schemes or fraud?

Federal law enforcement can prosecute cryptocurrency and related businesses as illegal Ponzi schemes. Ponzi schemes are white-collar fraud crimes. Indeed, a grand jury just indicted the founder of BitConnect, a crypto business, in a global $2.4 Billion cryptocurrency scheme.

This is not to say that all cryptocurrencies and crypto-related projects are scams, frauds, or Ponzis. Federal regulators have not suggested or concluded as much.

However, it is vital for people operating in this space to follow federal government developments in crypto investigations and prosecutions to understand the government’s boundaries and steer clear of trouble.

Indeed, even the most fervent crypto supporters admit that many scams and Ponzi schemes exist and have even thrived in the cryptocurrency industry for years. 

With the latest craze around speculative new coins, and new business applications for crypto surfacing daily, it is more important than ever to understand how federal investigators view the industry. The federal government is deploying massive resources to police and investigate the crypto industry. 

For sure, some observers dismiss crypto in general as a scam, believing that the entire industry is a scam or fraud. An economist from Boston University wrote his opinion that bitcoin is worse than Madoff in the Financial Times.

The reason this belief exists is that most people buy bitcoin expecting profits. If there is no legitimate economic activity around bitcoin, and the only way to profit is to cash out to someone else, those are features commonly associated with Ponzis. 

Federal law enforcement is not dismissing crypto as automatically fraudulent. But it is watching closely and investigating to weed out anyone involved in fraud, money laundering, and Ponzi schemes.

What is a Ponzi Scheme?

Ponzis are fraudulent investment schemes promising high rates of return with little risk to investors. In a Ponzi scheme, the perpetrator generates returns for earlier investors not from actual investing but with monies from later investors. 

One of the oldest scams on the books, Ponzi schemes rely on money flowing in from new investors to provide investment returns to older investors. 

Time magazine and Investopedia report that in 2019, there were 60 major Ponzi schemes in the US, with total investments of $3.25 Billion.

Examples of Ponzi Schemes

In 1920, Charles Ponzi guaranteed 50% returns on 45-day investments. The early investors could profit as long as there was fresh incoming capital. Less than a year later, Charles Ponzi’s scheme collapsed. Bernie Madoff ran the longest Ponzi scheme, which collapsed when a recession hit, redemption requests overwhelmed, and there was not enough fresh incoming capital. The key is that there is no legitimate economic activity, just a terminal perpetual-motion machine.

What is the difference between a Ponzi scheme and a pyramid scheme?

The main difference between a Ponzi and a pyramid scheme is that a Ponzi scheme only requires an investment, with promised returns paid later. Pyramid schemes offer people the opportunity to earn money from recruiting more people into the scheme.

However, the two schemes are very similar. Ponzi schemes are similar to pyramid schemes since both use money from new investors to pay the earlier investors. Both Ponzi and pyramid schemes eventually bottom out when the flood of new investors dries up and there is not enough money to go around, which is when the schemes unravel.

What are the Key Characteristics of an Illegal Ponzi scheme?

This checklist should help people consider whether a business might be operating as an illegal Ponzi.

What is an Illegal Pyramid Scheme?

The FBI states that pyramid schemes—also referred to as franchise fraud or chain referral schemes—are marketing and investment frauds where people are offered a distributorship or franchise to market a particular product, but the money comes primarily from sponsoring new members.

This is key: 

If people’s income opportunity comes primarily from recruiting more people to join — and not from selling a product — the plan may be illegal. Courts look to whether members who join are under tremendous pressure to sign up new recruits rather than selling a company’s products.

Another business model that often gets discussed together with Ponzi schemes and pyramid schemes is MLM or multi-level marketing.

What is MLM or Multi-Level Marketing?

Multi-level marketing, MLM, or network marketing uses independent representatives to sell products or services to family and friends. Independent representatives earn a portion of the retail sales they make, and also from retail sales made people they recruit.

What is the Difference Between a Pyramid Scheme and Multi-level Marketing or MLM?

The main difference between a pyramid scheme and a lawful network marketing MLM is whether compensation comes primarily from selling products and services to the ultimate consumer. If the main focus is recruiting, the calculus changes.

For entrepreneurs and consumers, it is often hard to tell the difference between an illegal pyramid scheme and a legitimate MLM business opportunity. Consumer protection and federal trade regulators emphasize that multi-level marketing is a legitimate business method in which a network of independent representatives sells consumer products or services. Compensation comes primarily from selling products and services to consumers. 

Pyramid schemes often claim to be selling consumer products to look like an MLM, so the analysis requires determining how much effort goes towards marketing the product versus recruiting other people. 

Is Crypto a Ponzi Scheme?

Not necessarily. Four signs to look to for include:

  • is profit or principal guaranteed?
  • are there free-floating price mechanisms?
  • are later investors always disadvantaged compared to earlier investors? and 
  • do later investors directly pay earlier ones? 

These signs can be the starting point for analysis, but this is not an exhaustive list. Remember that the space is undergoing rapid innovation and development, and we will learn more from regulators, law enforcement and the courts in the coming months and years.

In Ponzi schemes: 

  • promoters guarantee profits or investment returns;
  • promoters often claim that the principal is never at risk;
  • the entry market price is opaque, not determined via free-floating price mechanisms;
  • later investors come in behind earlier investors; and 
  • later investors have to pay the returns of earlier investors.

These are some of the red flags to consider when deciding whether to invest or work for a business in the cryptocurrency industry. Cryptocurrency businesses are under heavy scrutiny and will remain so for the foreseeable future.

Why Do Some People Call Cryptocurrencies “Ponzi-like” or “Ponzi-lite?”

Some analysts refer to crypto projects as “Ponzi-like” or “Ponzi-lite,” or even “Ponzi-esque,” because they share some features of Ponzi schemes. For example, some cryptocurrency projects often incentivize early participation by promising specific high returns. 

Using these monikers to refer to a cryptocurrency or crypto-related business is risky. For one, when regulators hear “Ponzi” in any way, they immediately think of fraudulent schemes in which victims are deceived to steal their money.

Remember that, in the end, these are just labels and marketing ploys. To determine the legality, what the federal government will look at is the economics and functioning of the underlying project.

General Warning Signs

Concerned about consumers and businesses alike, the federal government and states Attorneys General proliferate information and tips to avoid falling prey to scams either as a consumer, investor, or business owner.

Governmental alerts remind us that illegal pyramid promoters are masters of group psychology. They rely on group pressure, enthusiastic conventions, and promises of vast sums of money to capitalize on human greed, fear, and FOMO (the fear of missing out on a good deal). 

Promoters discourage people from thoughtful consideration, consulting lawyers or other advisors, or asking questions about the business. Victims often find themselves tricked into participating. 

Common recruiting phrases (no doubt also heard about crypto) in MLMs and pyramid schemes may include:

  •  “This is a once-in-a-lifetime chance to get in on the ground floor.”
  • “This will change your life.”
  • “Do this for your family.”
  • “Do this on the side so you can retire early.”
  • “You’ll never forgive yourself if you pass this up.”
  • “Look at my new car; it’s from the [business].”
  • “We’re like a family.”
  • “You’ll make thousands per week” or a “six-figure income.”

These are pressure tactics and common red flags when businesses rely mainly on new recruits to generate the bulk of the money. Ultimately, remember the old adage that when something sounds too good to be true, it probably is.

Pro-Tip: People must consult legal counsel for legal advice on whether a cryptocurrency investment or any other multi-level marketing opportunity is an illegal pyramid (let alone a Ponzi). Remember, illegal pyramid schemes disguised as acceptable multi-level marketing are not always easy to spot.

Consider all of these tips before participating in any multi-level marketing program (courtesy of the Michigan State Attorney General):

  • Avoid any opportunity that focuses more on recruiting new people rather than selling a product or service to an end-user consumer. 
  • The plan is probably illegal if the income opportunity derives primarily from recruiting more salespeople rather than selling a product or service. 
  • Several courts interpret higher levels of pressure on members to bring in new recruits rather than sell company products as evidence of an illegal pyramid.
  • Be skeptical of companies (or cryptocurrencies) claiming people will make money by growing their “downline” — referring to the commissions on sales made by newly recruited people — rather than by selling products to consumers.
  • Be cautious about specific income or earnings promises. Many companies tout the incredibly high earnings of a few top performers when in reality, most people recruited into the company will never make anywhere near those amounts. Indeed, most people will actually lose money in these organizations when it’s all said and done. (E.g., see most recently the documentaries about Lularoe.)
  • Be cautious and aware of other successful distributors’ life stories and exuberant testimonies. Some outliers are pressured and rewarded behind the scenes for providing enthusiastic testimonials. These super success stories do not always reflect the truth. At best, they reflect outliers.
  • Be cautious about participating in any company that asks distributors to purchase expensive inventory, especially up front. In the Lularoe cases that have recently been the subject of several documentaries, there are examples of the horror stories of people with a basement or garage full of worthless merchandise that no one will buy.
  • Make sure the product or service the company offers is worth buying even if there are no income opportunities. People should also make sure that the product or service has a competitive price. Illegal pyramid schemes and questionable MLMs often sell overpriced products of little to no value, including health and beauty aids, make-up and other cosmetics, new inventions, or “miracle” cures.
  • People should never sign a contract or pay any money to join an MLM or network marketing company without taking the time to review all of the materials carefully. Discussing the “opportunity” with a partner or spouse, a knowledgeable friend, accountant, or lawyer is always advisable. It is not good to make these decisions while under high-pressure sales tactics or under time pressure to make a decision. In those circumstances, it is best to walk away. The opportunity is not going to disappear overnight magically. 
  • When questions get raised about whether the business model is a pyramid scheme, people often hear comparisons to companies and businesses where one person at the top makes the most money. But corporations and businesses never recruit an unlimited number of employees or pay employees mainly based on recruiting other people. They are focused on selling a product or service.
  • Notice whether the products or services are simply vehicles for recruitment. Consider whether the products are overpriced or gimmicky. Also, consider that even high-quality products can serve merely as a cover for recruitment activities.
  • People who decide to become distributors in an MLM (possible pyramid) are legally responsible for the claims they make about the company, including its product or service, and the business opportunities it offers. That applies even when distributors simply repeat claims they learn in company brochures, meetings, or advertising flyers. 
  • People who decide to solicit new distributors are responsible for any claims they make to others about a distributor’s earnings potential. Distributors must be sure to represent the opportunity honestly and avoid making unrealistic promises. If those promises fall through, they could be held liable.
  • For people who decide to join a pyramid scheme disguised as a multi-level marketing program, their decisions will affect them and their friends and family, and everyone else they bring into the business. Many people devote a substantial amount of time marketing what are, in the end, worthless ventures at best, illegal frauds at worst. 

The BitConnect Founder’s Ponzi Scheme

The Department of Justice has unveiled a federal grand jury indictment charging Mr. Satishkumar Kurjibhai Kumbhani, a citizen and resident of India, with orchestrating a global Ponzi scheme

Mr. Kumbhani has yet to be apprehended.

The charges stem from his alleged role in a massive criminal conspiracy involving his cryptocurrency company BitConnect. BitConnect is an alleged fraudulent cryptocurrency investment platform that reached a peak market capitalization of $3.4 billion.

*Pro-Tip: An indictment is merely an allegation, and the defendant is presumed innocent until proven guilty beyond a reasonable doubt in a court of law.

According to the charges, the defendant misled investors about BitConnect’s “Lending Program.” 

BitConnect’s “Lending Program” claimed that BitConnect’s proprietary technology — known as the “BitConnect Trading Bot” and “Volatility Software” — was able to generate substantial profits and guaranteed returns by using investors’ money to trade on the volatility of cryptocurrency exchange markets. 

Instead, BitConnect operated as a classic Ponzi scheme by paying earlier BitConnect investors with money from later investors. In total, Kumbhani and his co-conspirators obtained approximately $2.4 billion from investors.  

The indictment further alleges that the defendant abruptly shut down the Lending Program after about a year. Kumbhani then directed his network of promoters to fraudulently manipulate and prop up the price of BitConnect’s digital currency, a commodity known as BitConnect Coin (BCC), to create the false appearance of legitimate market demand for BCC. 

To thwart law enforcement’s ability to trace, the DOJ alleges that Kumbhani and his co-conspirators concealed the location and control of the money obtained from investors. Specifically, the defendant engaged in commingling, cycling, and exchanging the funds through BitConnect’s cluster of cryptocurrency wallets. They also used various internationally-based cryptocurrency exchanges.

See below for our recent blog on Crypto commingling (mixing and tumbling).

Additional charges stem from the fact that Kumbhani avoided regulatory scrutiny and oversight of BitConnect’s cryptocurrency and evaded US regulations governing the financial industry, including those enforced by the Financial Crimes Enforcement Network (FinCEN).

 For example, although BitConnect operated a money transmitting business through its digital currency exchange, BitConnect never registered with FinCEN, as required under the Bank Secrecy Act.

 The DOJ’s Criminal Division is determined not to let these cases escape from its reach. Indeed, indicting the defendant in absentia sends a powerful message to others who might engage in similar criminal conduct. If a person’s crypto schemes victimize US citizens, the DOJ will claim a basis for exercising jurisdiction and file charges.

The DOJ will not spare any necessary resources to bring suspected Ponzi scheme fraudsters to justice. Moreover, the DOJ will not be deterred by their failure to come to the US. The DOJ is perfectly willing to put in the work to obtain indictments against crypto perpetrators and wait out their capture.

The press release announcing these charges adds the following statements from the DOJ’s Criminal Division and lead prosecutors, the FBI, and the IRS Criminal Investigations division:  

“The department is committed to protecting victims, preserving market integrity, and strengthening its global partnerships to hold accountable criminals engaging in cryptocurrency fraud.”

“This indictment alleges a massive cryptocurrency scheme that defrauded investors of more than $2 billion,” said US Attorney Randy Grossman for the Southern District of California. “The US Attorney’s Office and our law enforcement partners are committed to pursuing justice for victims of cryptocurrency fraud.”

From the Federal Bureau of Investigation, which is instrumental in these cross border financial investigations, we heard this: 

The “indictment reiterates the FBI’s commitment to identifying and addressing bad actors defrauding investors and sullying the ability of legitimate entrepreneurs to innovate within the emergent cryptocurrency space,” said Special Agent in Charge Eric B. Smith of the FBI’s Cleveland Field Office. “Dressing up a tried and true fraud scheme with a new twist and basing it overseas will not deter the resolve and dedication of the FBI to investigate and bring such fraudsters to justice.

“As cryptocurrency gains popularity and attracts investors worldwide, alleged fraudsters like Kumbhani are utilizing increasingly complex schemes to defraud investors, frequently stealing millions of dollars,” said Special Agent in Charge Ryan L. Korner of the IRS Criminal Investigation’s (IRS-CI) Los Angeles Field Office. “However, make no mistake, our agency will continue our long tradition of following the money, whether physical or digital, to expose criminal schemes and hold the fraudsters accountable for their illegal acts of trickery and deceit.”

The Specific Charges

Kumbhani’s specific charges are:

  • conspiracy to commit wire fraud, 
  • wire fraud, 
  • conspiracy to commit commodity price manipulation, 
  • operation of an unlicensed money transmitting business, and 
  • conspiracy to commit international money laundering. 

If convicted of all counts, Kumbhani faces a maximum penalty of 70 years in prison. Any actual sentence, which would only come if there is a conviction, is up to a federal district court judge who will determine any sentence after considering the US Sentencing Guidelines and other statutory factors.

*Pro-Tip: For anyone in a similar situation, we recommend preparing for a sentencing hearing by working with legal court counsel and experienced sentencing mitigation consultants. 

Agencies in This Investigation

The FBI Cleveland Field Office and the IRS-CI took the lead investigating the case. The Department of Justice Office of International Affairs provided necessary assistance to the investigation.

What About Executives Leaving Goldman to Work in Crypto? 

The thinking goes that with so many executives from top banks and Wall Street firms joining cryptocurrency operations, crypto must be legitimate.

Indeed, an executive at Goldman Sachs announced that he is joining the crypto exchange platform Coinbase after 16 years at Goldman. In his statement, the executive endorsed cryptocurrency innovations saying that the time is now to embrace the crypto economy. 

People see these experienced executive moves as giving crypto complete legitimacy, but the reality is that law enforcement will evaluate the crypto market on a case-by-case basis to evaluate fraud schemes.

The former Goldman Sachs executive posted on Linked In: “The inspiring purpose led mission to create economic freedom in the world, in a customer first, automation first approach is a once in a lifetime opportunity to be part of building the next stage of the digital evolution.”

Coinbase is a Nasdaq-listed cryptocurrency exchange platform, with 89 million verified users on its platform. At the end of last year, Coinbase had a number of monthly transacting users that reached 11.4 million at the end of last year. Coinbase claims that its trading volume last year grew more than 8.5 times compared to 2020.

The bottom line is that with the federal government, the industry is under scrutiny. No one has a blanket pass and there is no blanket ban either at this time.

Conclusion

One of the oldest scams on the books, Ponzi schemes rely on money flowing in from new investors to provide investment returns to older investors. Time magazine and Investopedia report that in 2019, there were 60 major Ponzi schemes in the US, with total investments of $3.25 billion.

Federal law enforcement can prosecute cryptocurrencies and related businesses as illegal Ponzi schemes. Ponzi schemes are white-collar fraud crimes. Indeed, a grand jury just indicted the founder of BitConnect, a crypto business, in an alleged global $2.4 Billion cryptocurrency Ponzi scheme. Ponzi schemes can subject a person to a maximum prison term of 20 years per count. 

There are some red flags to consider when deciding whether to invest or work for a business in the cryptocurrency industry.

Cryptocurrency businesses are under heavy scrutiny and will remain so for the foreseeable future.

Prison Professors, an Earning Freedom company, works alongside (not in place of) civil and criminal defense counsel to help clients proactively navigate through investigations and prosecutions. Our team also helps clients prepare mitigation and compliance strategies.

If you have any questions or are uncertain about any of the issues discussed in this post, schedule a call with our risk mitigation team to receive additional guidance.

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