Enforcement News: SEC Seeks Enforcement Actions Against Promoters of Pyramid Schemes and Ponzi Schemes

• Posted on: Jun 10 2019

Investing in the market or starting a business is hard. There are risks, of varying degrees, involved with such activities. Indeed, investors and entrepreneurs knowingly accept these risks in the hope of generating a high return on their investment. They do not, however, accept the risk that they are the victims of fraud.

Unfortunately, anyone is susceptible to falling victim to a Ponzi scheme or a pyramid scheme. Ponzi schemes and pyramid schemes ensnare people of all ages and income levels, bilking investors/recruits out of their hard-earned money. For this reason, the Securities and Exchange Commission (“SEC” or “Commission”), the Federal Trade Commission and state Attorneys General actively seek to stop promoters of these fraudulent schemes.

What is a Ponzi Scheme?

“A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. With little or no legitimate earnings, Ponzi schemes require a constant flow of money from new investors to continue. Ponzi schemes inevitably collapse, most often when it becomes difficult to recruit new investors or when a large number of investors ask for their funds to be returned.” See SEC Spotlight, “SEC Enforcement Actions Against Ponzi Schemes” (here).

Shutting down Ponzi schemes and holding the organizers accountable for such frauds is an important part of the SEC’s enforcement mission. In today’s post, this Blog looks at two SEC enforcement actions against Ponzi scheme organizers responsible for bilking investors out of tens of millions of dollars in collective losses.

What is a Pyramid Scheme?

A relative of the Ponzi scheme is the pyramid scheme. (See Debra A. Valentine, “International Monetary Funds Seminar on Current Legal Issues Affecting Central Banks.” Here.)  A pyramid scheme differs from a Ponzi scheme in that “it revolves around continuous recruiting” to sustain itself, while a Ponzi scheme “has no product to sell and pays no commission to investors who recruit new ‘members.’” Id. As noted, in a Ponzi scheme, the promoter “collects payments from a stream of people, promising them all the same high rate of return on a short-term investment.” Id. The promoter “uses the money from new recruits to pay obligations owed to longer-standing members of the program.” Id. In effect, the Ponzi scheme operator is robbing Peter to pay Paul. Id.

In contrast, “[a] pyramid scheme is an illegal investment scam based on a hierarchical setup.” (See Investopedia.com here.)  In the classic pyramid scheme, “participants attempt to make money solely by recruiting new participants, usually where: [t]he promoter promises a high return in a short period of time; [n]o genuine product or service is actually sold; and [t]he primary emphasis is on recruiting new participants.” (See SEC.gov, here.)

Promoters of a pyramid scheme often encourage investors to participate in the fraud through social media, company websites, group seminars, Internet advertising, YouTube videos, and other media. To lure recruits into the scheme, pyramid scheme promoters try very hard to make the operation look legitimate. But, as discussed below, they are not and ultimately collapse because the promoter cannot raise enough money from new investors to pay earlier ones.

A pyramid scheme begins with an individual or a company who recruits investors, typically by promising high rates of return. As the earliest investors in the pyramid, these individuals typically receive high returns. These gains are paid for, however, by new recruits, not by a return on any real investment. Because returns are dependent upon investment by new recruits, ultimately the pyramid becomes too big for new recruits to fund returns for those at the top of the pyramid. For this reason, it is mathematically impossible for every investor in the pyramid to make money. For example, if each investor needs to recruit 10 people to recoup his/her initial investment, the bottom levels of the pyramid would have to recruit over one billion people to break even – i.e., make back the money initially invested.

[Ed. Note: In New York, “Article 23A of the General Business Law … § 359-fff sets forth the criminality of initiating and participating in pyramid schemes (also known as chain distributor schemes).” See N.Y. AG, “Don’t Get Caught in a Pyramid Scheme.” Here.]

What is The Difference Between A Pyramid Scheme and A Multi-level Marketing Company?

It is often difficult to tell the difference between a legitimate multi-level marketing program (“MLM”) and a pyramid scheme. Both share the same or similar business models of “multiple levels” of distributors and recruits. A legitimate MLM relies on a network of distributors and recruits who sell the company’s product. Think of companies like Amway, Tupperware, Herbalife, Avon, and Mary Kay. The only way to make money in a legitimate MLM is by selling the company’s product directly to the consumer or by managing a team of salespeople. Managers receive a percentage of the sales made by each recruit under their management and supervision. A legitimate MLM does not require the recruit to buy a starter kit from which the earlier investor receives a commission or a recruiting “bonus” or require mandatory training and a non-refundable membership fee. In short, a legitimate MLM does not require investors to recruit new ones to earn money; the business is focused on selling the company’s products.

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Stopping pyramid schemes and holding their promoters accountable is also an important part of the SEC’s enforcement mission. In today’s post, this Blog looks at an SEC enforcement action against a pyramid scheme organizer responsible for bilking investors out of millions of dollars.

SEC Seeks Injunctive Relief to Stop a Ponzi Scheme Run by a Recent College Graduate

On June 3, 2019, the Securities and Exchange Commission (SEC) announced (here) that it filed an emergency action against a recent college graduate for operating a Ponzi scheme that targeted college students and young investors. The SEC is seeking, among other things, an asset freeze, a temporary restraining order, and preliminary and permanent injunctive relief.

In its complaint (here), the SEC alleged that Syed Arham Arbab (“Arbab”) conducted a Ponzi scheme from a fraternity house near the University of Georgia campus in Athens, Georgia. Arbab allegedly offered investments in a purported hedge fund called “Artis Proficio Capital,” which he claimed had generated returns of as much as 56% in the prior year and for which investor funds were guaranteed up to $15,000. Arbab also allegedly sold “bond agreements”, which promised investors the return of their money along with a fixed rate of return. The SEC alleged that at least eight college students, recent graduates, or their family members invested more than $269,000 in these investments.

According to the SEC, no hedge fund existed, Arbab’s claimed performance returns were fictitious, and he never invested the funds as represented. Instead, as money was raised, Arbab allegedly placed substantial portions of investor funds in his personal bank and brokerage accounts, which he used for his own benefit, including trips to Las Vegas, shopping, travel, and entertainment. Arbab also allegedly used portions of new investor money to pay earlier investors who had asked for their money back, the hallmark of a Ponzi scheme. Arbab even instructed some new investors to send their money – unwittingly – to existing investors through payment applications such as Venmo, Zelle, and Cash App, and misleadingly told them that the existing investors were either a “partner” or “manager” in the fund.

“We allege that Mr. Arbab used his college affiliations to operate a Ponzi scheme that drained valuable resources from current and former students. This is a reminder that investors of all ages and experience levels—whether long-time investors or recent graduates investing funds from their first few paychecks—should carefully research investment opportunities and the people offering them,” said Richard R. Best, Regional Director of the SEC’s Atlanta Office.

The SEC filed its complaint in the United States District Court for the Middle District of Georgia. The SEC charged Arbab, Artis Proficio Capital Investments LLC, and Artis Proficio Capital Management LLC, with violating the antifraud provisions of the federal securities laws. As noted, the SEC is seeking an order freezing certain assets of Arbab and his entities, as well as a temporary restraining order, preliminary and permanent injunctive relief, return of allegedly ill-gotten gains with prejudgment interest, and civil penalties.

SEC Seeks Injunctive Relief to Stop Ponzi-Like Scheme by Real Estate Developer

On May 23, 2019, the SEC announced (here) that it had filed an emergency action against Robert C. Morgan (“Morgan”), a New York residential and commercial real estate developer, and two of his entities, Morgan Mezzanine Fund Manager LLC and Morgan Acquisitions, LLC, with fraud for misappropriating investor funds. The SEC is seeking an asset freeze and other emergency relief.

In its complaint (here), the SEC alleged that Morgan financed his development projects in different ways, including through sales of securities directly to more than 200 retail investors, many of whom invested through their retirement accounts. Morgan represented to investors that their money would be used to improve multifamily properties. Based on these representations, Morgan raised more than $80 million. As alleged in the SEC’s complaint, Morgan and his entities diverted investor funds to facilitate Ponzi scheme-like payments to earlier investors. In addition, the SEC alleged that Morgan improperly used more than $11 million in investor funds to repay an inflated, fraudulently obtained loan for an unrelated apartment complex.

“In seeking this emergency relief, the SEC is acting to protect current and potential future victims of this elaborate scheme by halting Morgan’s fraud, which we allege involves the improper use of more than $25 million dollars in investor funds,” said Daniel Michael, Chief of the SEC’s Division of Enforcement’s Complex Financial Instruments Unit.

The SEC filed its complaint in the United States District Court for the Northern District of New York in Buffalo. The SEC charged Morgan and his two entities with violating the antifraud provisions of the federal securities laws. The SEC requested an order freezing Morgan’s assets and appointing a temporary receiver over the relevant funds. The SEC further sought permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, civil penalties, and a permanent receiver over the entities.

[Ed. Note: Earlier this year, the SEC announced that it brought charges, and sought an asset freeze, against Robert H. Shapiro  (“Shapiro”), a luxury real estate developer, and a group of unregistered investment companies called the Woodbridge Group of Companies LLC (“Woodbridge”), for bilking thousands of retail investors, many of them seniors, in a $1.2 billion Ponzi scheme. This Blog wrote about the SEC action here.]

SEC Files Action Against an Alleged Pyramid Scheme Organizer Who Promised Investors High Returns in Cryptocurrency Fraud

On the same day that the SEC announced the action against Morgan, the Commission announced (here) that it filed a civil injunctive action against Daniel Pacheco (“Pacheco”), a resident of San Clemente, California, and the alleged perpetrator of a multimillion-dollar pyramid scheme.

In its complaint (here), the SEC alleged that from January 2017 through March 2018, Pacheco conducted a fraudulent, unregistered offering of securities through two California-based companies he controlled, IPro Solutions LLC and IPro Network LLC (collectively, “IPro”). IPro raised more than $26 million from investors by selling instructional packages that provided lessons on e-commerce. Investors also received “points” that could be converted into a digital asset known as PRO Currency. Investors who contributed additional funds could earn a mixture of cash commissions and additional convertible points by recruiting new investors into the IPro network. As alleged in the SEC’s complaint, however, IPro was a fraudulent pyramid scheme. IPro’s collapse was hastened by Pacheco’s fraudulent use of investor funds, which included, among other things, the all-cash purchase of a $2.5 million home and a Rolls Royce. Pacheco’s misappropriation accelerated the rate at which IPro became unable to pay the commissions and bonuses due its investors.

The SEC further alleged that Pacheco’s offer and sale of IPro instructional packages constituted an unregistered sale of securities because the IPro instructional packages involved: (i) an investment in a pyramid scheme; and/or (ii) an investment in the PRO Currency digital assets, and therefore should have been registered with the SEC. Notably, alleged the SEC, no registration exemption applied to Pacheco’s offer and sale of IPro instructional packages.

“We allege that Pacheco hid an old fraud under the guise of cutting-edge technology,” said Michele Wein Layne, Director of the SEC’s Los Angeles Regional Office. “He enticed investors by offering them the opportunity to speculate in cryptocurrency, when in fact he was simply operating a pyramid scheme.”

The SEC’s complaint, filed in U.S. District Court for the Central District of California, charged Pacheco with violating Sections 5(a), 5(c), 17(a)(1) and 17(a)(3) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rules 10b-5(a) and (c) thereunder.  The complaint also named seven relief defendants for the purpose of recovering investor proceeds in their possession. The SEC did not allege wrongdoing with respect to those relief defendants.