From the October 25, 2004 North Carolina Lawyers Weekly.
Investors Recover $1.5 Million In Pyramid Payphone Scheme
Securities Law – Payphone ‘Ponzi’ Scheme – Retirees Persuaded To Cash In Guaranteed Investments – $2 Million Losses – $1.5 Million Mediation Award
Type of Action: Investment losses
Injuries Alleged: $2 million in investment losses
Name of Case: Confidential
Case No.: Confidential
Tried Before: Mediation
Name of Judge: n/a
Special Damages: $2 million
Verdict/Settlement: Mediation award
Award Date: June 2004
Plaintiff’s attorneys: George Francisco, Winston-Salem
Person Submitting: George Francisco
Description: Twenty-four, mostly elderly, retiree plaintiffs on fixed incomes invested their life savings in approximately $2,000,000 of web booth kiosks and ETS payphone lease back agreements. Individual investors paid from $6,000 to $24,950 for a private pay phone or web booth kiosk and then entered into a management or leasing agreement with the promoters to manage the phones for them. Defendants convinced plaintiffs to cash in guaranteed investments by promising a high annual return; and falsely claiming that profits were guaranteed and that there was no way they could lose their money. The lease back agreements were, in fact, highly risky.
Investors were told they were purchasing a fine, safe alternative for low interest CDs, bonds, annuities and other income producing investments. Bold headlines invited owners to “Watch the Profits Add Up.” Investors were told the lease back agreements would pay 15 percent, guaranteed for five years and that they could get their principal invested returned to them at any time. The defendant sales agents told investors that they would make up losses for surrender charges and penalties by getting higher dividends from the leaseback agreements. The sales practice involved purporting that the promoters were religious people. Sales brochures contained color photographs of the American flag.
The sellers did not tell the plaintiffs that the investments were multi-level marketing (pyramid) schemes where you have up line sales agents who also make commissions and that the companies had to attract an ever-larger number of investors to meet their obligations to existing investors. Investors were not told that the commissions of up to 25 percent were being deducted from the money when reinvested. The National Association of Securities Dealers (NASD) recommends that commissions for brokers generally not exceed five percent and prohibits charging a customer excessive commissions on the purchase of securities. The NASD also prohibits guaranteeing customers that they will not lose money on a particular securities transaction or misrepresenting or failing to disclose material facts concerning an investment. Examples of information that may be considered material and that should be accurately presented to customers include: the risks of investing in a particular security; the charges or fees involved; and company financial information.
The primary individual defendant was an insurance agent recruiter who exclusively recruited his insurance subagents to sell payphones and web booths. This defendant testified that he individually sold more than $6 million worth of payphones in North Carolina. He also received an override commission for the sales made by his subagents.
The payphone company filed for Chapter 11 bankruptcy protection in September of 2000 after an investigation by the federal Securities and Exchange Commission. Nationally, 10,000 people invested a total of $300 million in the payphones from 1996 through September 2000. More than 2,200 investors were Carolinians, and many of them put up their life savings. The Securities Division of the North Carolina Secretary of State had previously entered a cease-and-desist order in May of 2000, which prohibited these unregistered security agents from selling these unregistered securities.
The agents then switched from selling payphone investment contracts to web booth investment contracts. The principal owner of the web booth company absconded after withdrawing funds from the web booth company’s bank account. The Federal Bureau of Investigations is investigating the web booth owner’s disappearance. The web booth company also filed for bankruptcy. The investors lost all of the money they invested in the payphones and web booths.
Plaintiffs’ attorney filed suit. The defendants adamantly denied any wrongdoing. One defendant sought Rule 11 sanctions based on the contention that the individual defendant sales agent could not be liable because she was a member of a limited liability corporation. The trial court denied the motion. Defendants’ attorneys wrote defendants’ professional liability insurers and requested a defense and indemnification based on the allegations of the complaint. The insurers refused to defend in some cases and defended under a reservation of rights in other cases.
Plaintiffs obtained judgments by default and at summary judgment. Plaintiffs then filed suit against the insurers for payment of the default judgments. These actions were removed to federal court. One insurer then sought to have one default judgment set aside. The Superior Court denied the insurers’ motion. More than 35 witnesses were deposed in the combined actions. All cases then settled in mediations.
Securities regulators from at least 25 states, including North Carolina, filed scores of actions against companies and insurance agents selling these types of investment contracts. State securities regulators had issued more than 45 cease-and-desist orders and other actions against more than 1,100 insurance agents. Regulators saw a pattern of risky investments sold by insurance agents to their neighborhood clientele.
The United States Supreme Court ultimately stated that although the payphone marketing materials trumpeted the “incomparable pay phone” as “an exciting business opportunity,” the payphones did not generate enough revenue for the payphone company to make the payments required by the leaseback agreements, so the company depended on funds from new investors to meet its obligations” (a ponzi scheme). The court held that investment scheme offering contractual entitlement to fixed rate of return can be an “investment contract” and thus a “security” subject to federal securities laws.
On June 08, 2004, the U.S. Attorney’s Office for the Northern District of Georgia announced that the founder of the payphone Ponzi scheme was indicted on 82 counts of wire fraud and money laundering. The press release stated that the founder sought to raise capital to grow his coin-operated payphone business by selling fictitious payphone investment packages offered as recession-proof with a guaranteed profit. The indictment further charges that he sold approximately 21,000 more payphones than actually installed.
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