Multi-Level Marketing Companies Can Be Pyramid Schemes

On October 25, 2016, the SEC issued Litigation Release No. 23678 regarding the case Securities and Exchange Commission v. TelexFree, Inc. et al. In that action, the SEC brought a complaint against TelexFree and other defendants for “operating an elaborate pyramid scheme.”

TelexFree was a “multi-level marketing” company in the business of selling local and international telephone service plans that use “voice over internet” (VoiP) technology. At issue were “memberships”—the securities—that promised substantial returns, 200 percent per year or more for becoming promoters of the business. However, despite the appearance of having a legitimate VoiP business, revenues from the VoiP business were very small. TelexFree was paying its older investors, not with revenue raised from the sale of its VoiP product but with money received from its newer investors.

Pyramid schemes can violate Section l0(b) of the Exchange Act and SEC Rule 10b-5 because the perpetrator employs schemes to defraud the investors. He or she makes untrue statements of material fact or omits to state a material fact necessary.  Pyramid schemes can also violate Section 17(a) of the Exchange Act when money or property is obtained through the scheme. In this case, the SEC claimed for relief under Section l0(b) of the Exchange Act, SEC Rule 10b-5 and Section 17(a) of the Securities Act. For securities law practitioners, this case demonstrates that the SEC may treat a “multi-level marketing” scheme similar to traditional pyramid schemes when revenues generated from the business are minimal and in reality old investors are paid with money received from newer investors. 

_{Rory Zamansky is a partner at Zelle LLP in Minneapolis, Minnesota.}

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