The phenomena of Pyramid Schemes and Ponzi Schemes are those that feed on our need for security and the desire to believe that all that it really is possible to find wealth with ease.. This despite evidence to the contrary in the form of scandals such as the Fidentia Scandal of 2007 in which businessman Arthur Brown defrauded, amongst others, approximately 50 000 widows and orphans of funds entrusted to the Living Hands Umbrella Trust by mostly blue collar mine workers, and recent allegations of engaging in a Ponzi Scheme levelled at the financial asset manager Jacobus Kellermann. The Pyramid Scheme and Ponzi Scheme phenomena and the harm suffered by the victims thereof beg the questions of how one is to avoid the harm and whether South African law is doing anything to protect those who suffer it.
In terms of Section 43 of the Consumer Protection Act 68 of 2008 (the “Consumer Protection Act”), an arrangement, practice or scheme is a Pyramid Scheme if participants in the scheme receive compensation derived primarily from their respective recruitment of other persons as participants, rather than from the sale of any goods or services. A Pyramid Scheme is a multi-level marketing programme that is incapable of supporting itself as advancing in the system or earning money is dependent on recruiting other people into the operation, rather than selling a product or providing a service. Significantly, while all Pyramid Schemes are multi-level marketing programmes in that they are systems of selling goods or services through a network of distributors, the converse is not true. Many multi-level marketing programmes are legitimate enterprises, rewarding members for recruiting more members in a manner that does not amount to the use the funds of today's investors to reward those who came before. A typical Pyramid Scheme is that where one person recruits, for example, 10 other people to participate in a "no-fail investment opportunity” in terms of which the 10 recruits each pay the recruiter ZAR100 and the recruiter then tells them to go out and recruit 10 more people to do the same so that if each recruit is successful, they will all end up with ZAR900 in profit from a ZAR100 investment. Initially, nothing seems problematic with this scheme until further analysis. If the initial 10 recruits each find 10 more people, those 100 new recruits will have to find 10 recruits each to make ZAR900. This means they have to find 1,000 people willing to sign up for the programme. If they somehow find 1,000 people, that next level of the pyramid will need to sign up 10,000 to make a profit. Eventually, there won't be enough recruits at the bottom of the pyramid to support the level above it. That's when the pyramid topples and everyone at the bottom loses their investment.
A Ponzi scheme may be defined as a form of fraud in which belief in the success of a non-existent enterprise is promoted by the payment of quick returns to the first investors from money invested by later investors. It may be distinguished from a Pyramid Scheme in that Ponzi Schemes have only one “official” promoter while all who participate in a Pyramid Scheme promote it for their own gain and the fact that the fraud lies in getting people to invest in a fraudulent enterprise as opposed to promoting the scheme for the investor’s own gain. The Ponzi scheme is named after Carlo “Charles” Ponzi who established the Securities Exchange Company in the 1920s. Ponzi offered investors a choice between a 50% return on a 45 day investment and a 100% return on a 90 day investment. Ponzi claimed that this return on investment was possible due to his unique understanding of the international postal reply coupon system. While there was truth to Ponzi’s assertions in principal, he was fully aware that the scheme did not work in practice because of importation restrictions. Ponzi’s scheme was not a revenue generating enterprise supported by investors as there was no underlying business at all. The scheme was an investment generating scheme that relied on today’s investors to meet the obligations due to those who had invested 45 or 90 days prior.
While Pyramid Schemes and Ponzi Schemes are distinguishable they share a host of similarities. Both schemes depend on new investors to satisfy their obligations to prior investors resulting in a need for a constant supply of new investors to fulfil the obligations of the schemes to their existing investors, typically encourage investors to reinvest their profits serving to prolong their respective shelf-lives by using the reinvested funds to fulfil their obligations to existing investors, are continually insolvent as their debts exceed their assets from their dates of inception and are fraudulent and thus against the law.
The devastating effect of Pyramid Schemes was evidenced in the Fidentia Scandal of 2007. Fidentia Asset Management Proprietary Limited was an asset management company whose two biggest clients were the Living Hands Umbrella Trust and the Transport Sector Education and Training Authority. The man behind it all was Arthur Brown, a Namibia-born businessman who established Brown Brothers, a company which had a 75% stake in Fidentia Holdings which in turn had a 100% stake in Fidentia Asset Management (“FAM”). Investigations conducted by the Financial Services Board revealed that Brown was conducting what it described as a Pyramid Scheme. No investment of funds FAM was given was made. To keep the operation going it has been reported that Brown drew his own salary from the Living Hands Umbrella Trust funds that were to be managed by FAM and motivated his large staff by offering 1% of all assets brought in. Fidentia was placed under provisional and then final curatorship while Brown merely received a fine for his part in the scandal. It has only been recently that his sentence has been changed to that of a fifteen year jail sentence. The victims of the Fidentia scandal included the government and, more dishearteningly, the widows and orphans of mine workers who had invested their money in the belief that it would be handled in good faith.
In response to the evident need to do more to protect consumers the South African Legislature promulgated the Consumer Protection Act in 2008 which includes a prohibition on engaging in a Pyramid Scheme. Section 43(2)(a) of the Consumer Protection Act provides that a person must not directly or indirectly promote, or knowingly join, enter or participate in a pyramid scheme as described in subsection (4) of that Section. Contravening the Consumer Protection Act by violating this provision may result in a person being charged with the criminal offence of fraud. The common law crime of fraud is defined in South African law as “the unlawful and intentional making of a misrepresentation which causes actual and or potential prejudice to another”. Those actively participating in the promotion of the Pyramid Scheme unlawfully and intentionally perpetuate a misrepresentation, that of participating in a “no-fail investment opportunity” where one is rewarded for recruiting others in a manner which causes prejudice or has the potential of causing prejudice to those others where they are unfortunate enough to fall at the bottom of the pyramid in that not only do they lose their initial investment to an earlier investor, but their promised returns also fail to eventuate.
Herbalife International of America, Incorporated (“Herbalife”), the multi-level marketing company that develops and sells nutrition, weight management and skincare products internationally and which was founded by Mark Hughes in 1980 before being expanded to operate in South Africa in 1995, has recently be accused by its shareholders of being a Pyramid Scheme. In a presentation in New York in 2014, Bill Ackman, hedge fund manager and “investor activist” argued that Herbalife’s “nutrition clubs” which are private settings where Herbalife’s distributors sell the company’s products and recruit new members, were by definition pyramid schemes. This is due to the fact that the focus was said to fall on recruiting members instead of selling products. Herbalife shareholders instituted proceedings in District Court in the USA in which they claimed that the business structure and marketing practices of the company violated the law and that they lost money because Herbalife was a Pyramid Scheme. It was held that, as no fraud by Herbalife could be proven, the shareholders could not show that losses suffered were caused by the alleged wrongdoing of Herbalife. While Herbalife may be cleared of all wrongdoing, its case is evidence of just how difficult it can be to cry “pyramid scheme” and have someone take action before it is too late.
Perpetrators of Ponzi Schemes, much like those of Pyramid Schemes, face being charged with the offence of fraud as well as other financial crimes. These include corruption, bribery and even money laundering. Perpetrators may also be faced with civil claims for damages for the often millions or even billions of Rands that they have squandered belonging to victims.
South African businessman and financial asset manager Jacobus Kellermann has also recently been accused of operating a Ponzi Scheme out of Mauritius-based business Belvedere Management Limited (“Belvedere Management”). Belvedere Management is a fund manager which manages billions of US Dollars in funds. The business is reported to be headed, together with Kellerman, by David Cosgrove and Kenneth Maillard. The concern centres on the fact that two of the Mauritius-based funds were shut down while others have been placed under investigation. OffshoreAlert has stated that Belvedere Management is “an essentially criminal enterprise” having “funds that are blatantly fraudulent” and “funds that simply disappear or fail in dubious circumstances”. Kellermann himself denies allegations of a Ponzi Scheme having being quoted as having said “I am focussed specifically on the South African businesses…Nothing in South Africa is a Ponzi Scheme”. Not much else has come to light to date and only further investigation into Kellemann and his business partners’ dealings will reveal if Kellermann is at the helm of one of the biggest Ponzi schemes to date.
Pyramid Schemes and Ponzi Schemes also have a profound effect on big business. Financial Services Providers are confronted with more sceptical consumers leaving them with no choice but to shape up, and comply with increasingly stringent regulations, or ship out. The Financial Advisory and Intermediary Services Act 37 of 2002 (the “Financial Advisory and Intermediary Services Act”) provides for the registration of Financial Service Providers. A Financial Service Provider means any person, other than a representative, who as a regular feature of the business of such person furnishes advice or renders an intermediary service. The Financial Advisory and Intermediary Services Act implements a risk-based supervision strategy, flagging the potential to breach its provisions and intervening accordingly at this stage, as opposed to a compliance-based supervision strategy which, by virtue of its focus on compliance, only results in intervention when there has already been a breach of the applicable rule. Financial Service Providers accordingly have a greater obligation to show exactly how today’s investment yields tomorrow’s return. While this introduces a new form of competition amongst Financial Service Providers as they compete to show themselves to be the most compliant, it is also evidence of the fact that the belief that one’s Financial Service Provider is acting in good faith has been eroded.
While the law seems to be catching up to criminal minds, the best way for consumers to protect themselves is by doing exactly that, protecting themselves. Investment opportunities in South Africa abound but consumers should steer away from commitment until they have done avid research. To avoid the harm caused by Pyramid Schemes and Ponzi Schemes, avoid investment schemes where one has to pay in order to participate and where moving up in the hierarchy of the scheme or achieving rewards from the scheme is dependent on the amount of recruits one is able to secure. Exercise caution or indeed scepticism when confronted with promises of miracle products or the opportunity to make large returns with minimum risk. Do not invest in a scheme based on “secret” or “confidential” strategies. Get all the information about the investment opportunity and how it works in writing and make sure to understand the scheme before committing to it. Make use of authorised Financial Services Providers to ensure that the schemes invested in comply with the provisions of the Financial Advisory and Intermediary Services Act. Remember, if it sounds too good to be true, it probably is.