Cryptocurrencies and Online Marketing: Legitimate Business or Pyramid and Ponzi Schemes?

The Internet is a double-edged sword, presenting at once possibilities for business opportunities undreamed of twenty years ago – fast and cheap communications, multitudes of customers, “frictionless” commerce – and possibilities for fraudulent practices on a scale heretofore unimagined – Ponzi, pyramid, and illegal “multi-level marketing” (MLM) schemes that can use the reach of the Internet to victimize tens of thousands of people. Where do cryptocurrencies like Bitcoin (the most popular and well known), Ethereum, and Ripple and efforts to market them fit into this mix of legitimate and fraudulent activities?

Briefly, Ponzi schemes involve proposed but illusory investments based upon fraudulent promises of returns to be paid by an organizer to the investors. The returns, however, come not from market or other investments but from influxes of new money from new recruits to the investor pool. When these influxes can’t keep up with the expanding base of investors, the schemes collapse. Ponzi schemes are always illegal because they are based on fraud. MLMs, by contrast, involve a business model of multilevel referral or membership systems in which new members generally pay an initiation fee for the right to sell the organization’s products or services, and thereafter receive a share of the fees from, and sales made by, each additional member they themselves recruit. Courts and the FTC have stated that the legitimacy of an MLM depends on the extent to which members derive their incomes chiefly from sales of the product or service, or from the fees of the expanding membership. If the latter, an MLM may be considered a pyramid scheme, which are generally considered illegal.

So, are cryptocurrencies and their promotion legitimate or fraudulent? Help comes to us from the FTC’s recent (January 2018) guidelines on the lawfulness of MLMs, which can be extrapolated to cryptocurrencies and their marketing. The FTC considers two factors in determining the legitimacy or the fraudulence of an MLM: (1) whether its compensation structure encourages or incentivizes participants to purchase products for reasons other than actual consumer demand, including their personal demand; and (2) whether particular wholesale purchases by participants were made to satisfy personal demand, or amount to mere “inventory loading” in an attempt to advance in the marketing program. In brief, a legal MLM program, as opposed to a pyramid scheme, is based on actual sales of products or services to legitimate customers. Additionally, the FTC highlights the importance of “truthful and non-misleading” advertising and messaging in promoting a legitimate MLM, which includes refraining from (1) advertising unachievable results to participants, (2) presenting the opportunity as a way to get rich quickly, (3) using misleading endorsements and testimonials, and (4) featuring unrealistic hypotheticals in recruitment materials.

Some commentators have argued that cryptocurrencies are inherently pyramid or Ponzi schemes. But it is difficult to find legal precedent supporting so sweeping a claim. Despite their novel structure and ephemeral nature, cryptocurrencies are in many ways a relatively straightforward speculative vehicle, perhaps akin to traditional assets subject to “bubbles” in which their market values become detached from underlying asset values. While these speculative bursts attract illegal promotion and marketing schemes, the baseline legal advice for the enterprise as a whole may well be “let the buyer beware.”

But when it comes to promoting or marketing cryptocurrencies, several features of cryptocurrencies and derivative products are particularly susceptible to manipulative conduct by fraudsters. These include: (1) the decentralized structure of cryptocurrencies, with no central management or reporting; (2) the ready access to amateur investors provided by social media; (3) the ease with which amateur investors can invest in cryptocurrencies; (4) the apparent boom-and-bust nature of at least some cryptocurrencies; (5) the relative lack of specific regulation of cryptocurrency trading and marketing; and (6) the FOMO (“fear of missing out”) culture that has arisen around cryptocurrencies in general.

Those considering launching a new cryptocurrency or starting a venture that markets, promotes, or trades existing cryptocurrencies would be well advised to consider several key questions to avoid stepping into the legal minefield of pyramid and Ponzi schemes. These questions include: (1) How is the opportunity for profit being described? Avoid the promise of outsize profits, and do not minimize risk factors. (2) Will participants make money through sales of the underlying cryptocurrency or product, or is the focus on referrals? Programs that “focus” on recruiting new members rather than delivering profit from the sale of products or services to actual customers are much more likely to fall afoul of laws prohibiting pyramid schemes. (3) Does the venture depend on an ever-increasing influx of new capital to remain solvent? Any venture that will become insolvent or fail to make good on its representations absent an ever-increasing influx of new investors and capital raises serious concerns; return projections should be based on legitimate and defensible factors of supply and demand.

The Internet has delivered new products, new means of promoting products, and new means of transacting business. Cryptocurrencies in particular, by their very nature speculative assets, show both the best and the worst of the new digital world. Many unsophisticated investors have put their money into cryptocurrencies, some drawn by conduct that likely would be judged illegal. The good news is that many important legal questions will be analyzed using relatively settled law. Conducting the necessary analyses, and heeding the lessons they teach, are the best defense for promoter and participant alike.