To: Iowans inquiring about the laws relating to "gifting pyramids"
From: Steve St. Clair, Consumer Protection Division
Date: August 24, 2000
Re: Laws and rulings of interest
The Consumer Protection Division recently has been contacted by people who have lost money in so-called "gifting pyramids" and who want to try to obtain refunds from other participants. The Consumer Protection Division cannot provide personal legal advice and representation to individual consumers. Even if we could, efforts to obtain refunds often pit one consumer against another, which creates a situation better handled by private remedies. We therefore suggest that consumers seeking legal representation contact a private attorney. In doing so, consumers may wish to provide their attorneys with the information in this memo, to assist in analyzing the issues and options. PLEASE NOTE that this memo should not be considered an exhaustive treatment of the law or the issues relating to such schemes, and it does not constitute an attorney general's opinion, formal, informal, or otherwise.
Gifting Pyramids: Iowans have reportedly seen a few different versions in recent weeks and months, going by such names as "The Winning Team," "Life Changes," and "Private Gifting Boards," among others. Earlier versions of gifting pyramids were known as "Friends Helping Friends" and "Friends Network," among other names. Although there may be endless variations on the central themes, here's an example of how such operations work: A person is solicited to participate in a "gifting activity" by paying some established amount, say $2,000, to a senior person at the top of a four-layer pyramid. The new person is told that by recruiting two more people who will each do the same (i.e., pay their money and recruit two more participants), he or she can rise to the top and collect $16,000, for a profit of $14,000. [Note added November 2001: Recent illegal versions of these gifting pyramids require $5,000 to participate, and go by such names as "Seasons of Sharing," "Women Empowering Women," and "The Original Dinner Party."]
Promoters may claim that this scheme is legal because all payments are designated "gifts," and participants may even be asked to sign a paper stating that they are making gifts. Promoters often claim that this "gift" angle makes the scheme legal, and that the pay-outs don't have to be reported as income at tax time. These claims are false. Many other false representations may be made in promoting such schemes, including the claim that pay-outs are easy and quick, and that a refund will be readily available if requested. These pyramids ultimately collapse, leaving a lot of disappointed participants scrambling to get refunds from the person who got them to participate and/or the person who received their money.
1. Theft by deception (Iowa Code sections 714.1(3) & 702.9) This law makes it a crime to obtain money or property through the use of deception. The written materials used to promote
gifting pyramids may make deceptive claims regarding: (a) the fact that the initial payment is a gift rather than an investment; (b) the tax status of these "gifts"; (c) the speed with which a large pay-out will be generated; and (d) the legality of the scheme itself.
2. Securities violations (Iowa Code section 502.102 (19) Securities laws control the promotion of various types of investments. Gifting pyramids have been determined by courts in other jurisdictions to constitute "investment contracts," a form of security under Iowa law. (See the Nebraska Supreme Court ruling in State v. Irons, below). The sale of securities in Iowa is subject to a variety of registration and licensing requirements, as well as prohibitions regarding misrepresentations under Iowa's Blue Sky Law, Iowa Code Chapter 502. See e.g., State v. Kraklio, 560 N.W.2d 16 (Iowa 1997).
3. Lottery (Iowa Code section 725.12) Iowa's lottery law prohibits prize schemes where a person pays to participate and the winners are determined by a process involving a substantial element of chance. With gifting pyramids, one makes a "gift" in order to participate; one participates in order to receive the pay-out (the prize element); and whether a pay-out comes about involves a great deal of chance, since it depends on matters outside the participant's control (the activities of strangers, and whether the pyramid has already saturated the region).
4. Tax Evasion (Iowa Code sections 422.25(8) & 703.1) Persons who do not report any pay-outs they receive through this scheme as income on their tax returns risk being prosecuted for tax evasion, and persons who inform others that pay-outs are not counted as income risk being prosecuted for aiding and abetting tax evasion.
In Hall v. Montgomery Ward. 252 N.W.2d 421 (Iowa 1977) the Iowa Supreme Court ruled that crime victims can sue the person who committed the crime. Those who are victimized by this pyramid scheme may be able to use this legal precedent to recover money damages from promoters.
The Iowa Supreme Court case of State ex rel. Miller v. Santa Rosa Sales and Marketing, Inc., 475 N.W.2d 210 (1991) discussed the characteristics of illegal pyramid schemes in relation to the Consumer Fraud Act, which prohibits deception in connection with the sale of merchandise. Note, however, that in Molo Oil v. River City Ford Truck Sales, 578 N.W.2d 222 (Iowa 1998) the Iowa Supreme Court ruled that individuals could not file suit under the Consumer Fraud Act.
CASES OF INTEREST FROM OTHER JURISDICTIONS
In State v. Irons, 574 N.W.2d 144 (1998), the Nebraska Supreme Court found that promotion of a gifting pyramid constituted the sale of unregistered securities, namely investment contracts, in violation of Nebraska's securities laws. A criminal conviction and jail term based
on such conduct was found to be proper. (As noted above, Iowa law also defines securities to include investment contracts.)
In People v. Sanchez, 62 Cal.App.4th 460, 72 Cal.Rptr.2d 782 (Ct of Appeals, 2d Dist., Div. 2, 1998), a California appeals court described a "Friends Helping Friends" scheme closely resembling the example set forth in the introduction above, and found that promoters were in violation of the state's "endless chain" criminal statute.
In Pacurib v. Villacruz, 705 N.Y.2d 819, 830 (Civil Ct., City of NY 1999), the court ruled that promotion of a gifting pyramid constituted fraud. Noting that "most recruits ... are willing participants as well as victims," the court found that one victim/participant could not be sued by another who was equally at fault. However, victim/participants could sue those who were more responsible for the promotion and active spread of the pyramid scheme.
In Whitemore v. Jones, 1999 WL 455433 (Tenn.Ct.App.), the Court of Appeals of Tennessee dealt with a "Friends Helping Friends" pyramid scheme. The plaintiff sued to get a refund from the person who introduced her to the scheme based on breach of contract, but the court noted that she had paid her money to someone else, namely the person at the top of the pyramid. The court ruled that under these circumstances the plaintiff could not make the person who introduced her to the scheme provide a refund on the basis of contract theory.
FEDERAL LAW (Note that some of these statutes may give individuals the right to file their own lawsuits for violations.)
1. Wire Fraud (15 USC section 1343) and Mail Fraud (15 USC section 1341) Prohibit the use of telephone or fax (in the case of wire fraud) or the mails or courier services (in the case of mail fraud) as part of a scheme to obtain money through false representations or promises.
2. Lottery (39 USC section 3005(a)) This law relates to the federal government's authority over the postal system, and it prohibits the use of mails in connection with the promotion of a lottery or "gift enterprise."
3. Unfair Practice under the Federal Trade Commission Act (15 USC section 45(a)(1)) The Federal Trade Commission has brought enforcement actions against comparable pyramid schemes.
4. Tax Evasion Failure to report pyramid pay-outs as income in federal tax returns may result in federal prosecution for tax evasion, and urging others that they do not have to report such income may result in aiding-and-abetting charges.
5. Federal Securities Law (15 USC section 77b(a)(1)) This law regulates many aspects of the sale of "investment contracts" in a manner similar to Iowa's security laws. (See the reference to state securities law above.)