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The Pyramid Schemes Prohibition Ordinance Cap 617.

11 February, 2012

 

Legal News & Analysis – Asia Pacific – Hong Kong

 

The Pyramid Schemes Prohibition Ordinance (New Ordinance) came into effect on 1 January 2012. The purpose of the New Ordinance is to eradicate pyramid schemes. It repeals the 30 year old Pyramid Selling Prohibition Ordinance Cap 355 (Old Ordinance), which was no longer effective in combating various forms of pyramid selling.

 

What is a pyramid scheme?

 

Generally, a pyramid scheme is one whereby new participants are required to make a payment, at the time of joining, in return for the right to receive benefits when they recruit other people into the scheme. The scheme might be promoted as a club supported by fabricated testimonies about the financial returns to the participants. Although pyramid schemes might take different forms to disguise their true nature, they share a number of features. For example, no matter how a pyramid scheme is promoted, there is no genuine underlying business and the only way a profit can be generated is to use the investments contributed by new participants. Provided that a certain number of new participants are recruited within a specified period of time, the scheme can afford to pay profits to its participants with new money coming in. Hence, the promoter of the scheme makes money by recruiting more people, rather than by running a legitimate business. However, as the number of participants increases, so does the liability. Depending on the rate of increase of new participants, there will come a time when there are insufficient new participants to sustain the payouts. At that point, the scheme will collapse. Participants will lose their investments, as the money would have disappeared by then. Some people might incur substantial liability because they were lured into or forced to take out loans to fund their payment into the scheme. People most vulnerable to these types of schemes are those who are unsophisticated in making investment decisions. They are more likely to yield to aggressive sales tactics and be misled about financial returns in joining the scheme.

 

A pyramid scheme is very similar to a ponzi scheme. In both cases, there is no genuine underlying business and the payout is made to the earlier investors with money from new investors. The difference between the two schemes is that a ponzi scheme usually involves the promotion of an investment opportunity where the fraudster collects all the investments and then distributes dividends to investors. Under a pyramid scheme, each participant can directly benefit from the scheme, depending on how many new investors are introduced into the scheme.

 

As between a pyramid scheme and a legitimate multi-level marketing scheme, the rewards in the latter case are tied in with the sale of products and/or services rather than with the introduction of new participants. Also, the products and/or services sold are genuine with real market value rather than products and/or services that do not exist or are priced at an unrealistic level.

 

Loopholes under the Old Ordinance

 

Under the Old Ordinance, the "pyramid selling scheme" prohibited was one whereby:

 

 

1. a participant in the scheme was granted a licence or right to introduce another participant into the scheme who was also granted such licence or right and who may further extend the chain of persons who were granted such licence or right, notwithstanding that there may be a limitation to the number of participants or that there may be any further conditions affecting eligibility for such licence or right; and
2. a participant received a reward on, or at any time after, the introduction into the scheme by him of another participant, which reward was based, whether wholly or in part, otherwise than on the fair market value of goods or services actually sold by him or by or through that other participant.

 

Where an offence under the Old Ordinance had been committed by a body corporate, a director, secretary, principal officer or manager of that body corporate, or any person acting or purporting to act in any such capacity, also committed a like offence. It was a defence if that person could prove that the offence was committed without his or her consent or connivance, and that he or she exercised such diligence so as to prevent the commission of the offence as the person ought to have exercised, having regard to the nature of his or her functions and to all other circumstances.

 

In the decisions of HKSAR v Yau Mee Kwan [2004] 1 HKC 526 and HKSAR v Li Chi Yung [2004] HKCU 652, two loopholes in the Old Ordinance were identified, as follows:

 

 

1. the definition of "pyramid selling scheme" implied that the operation of a pyramid selling scheme must involve the selling of goods or services. Accordingly, the Ordinance would not apply if there was no sale of goods or services; and
2. the definition of "pyramid selling scheme" also implied that such scheme must involve the sale of goods and services by participants. If goods or services were not sold by participants but rather by a company directly to new participants, the Ordinance would not apply to such schemes.

 

In both cases, convictions were quashed on appeal, due to the loopholes. Accordingly, it was necessary to update the Old Ordinance because the definition of a "pyramid selling scheme" did not sufficiently cover the essence of a pyramid scheme.

 

Amendments Introduced by the New Ordinance

 

The objectives of the New Ordinance are to :-

 

 

1. address the loopholes and revise the definition of "pyramid scheme";
2. impose criminal liability on people who induce other persons to join a pyramid scheme, with the knowledge that the benefits they may receive are entirely or substantially derived from the introduction of further new participants; and
3. enhance deterrence, by increasing the maximum penalty for offences.

 

The provisions of the New Ordinance, aimed at achieving the above objectives, are outlined below.

 

New definition of "pyramid scheme"

 

The definition of "pyramid scheme" has been revised to mean a scheme with all of the following characteristics:

 

 

1. to participate in the scheme, any or all new participants must provide either of the following (participation payment):
  a. a financial or non-financial benefit to, or for the benefit of, any participant or any promoter of the scheme;
  b. a financial or non-financial benefit partly to, or for the benefit of, any participant or any promoter of the scheme and partly to, or for the benefit of, another person;
2. the making of the participation payment is entirely or substantially induced by the prospect held out to the new participant that the new participant will be entitled to either of the following (recruitment payment):
  a. a financial or non-financial benefit to, or for the benefit of, the new participant;
  b. a financial or non-financial benefit partly to, or for the benefit of, the new participant and partly to, or for the benefit of, another person;
3. the recruitment payment referred to in paragraph (b) is entirely or substantially derived from the introduction to the scheme of a further new participant.

 

Under the New Ordinance, a scheme may be a pyramid scheme regardless of:

 

 

1. who holds out to a new participant the prospect of entitlement to a recruitment payment;
2. who is to make a recruitment payment to a new participant; and
3. who is to introduce a further new participant to the scheme.

 

Further, a scheme may be a pyramid scheme even if it has any or all of the following characteristics:

 

 

1. the scheme involves the marketing of goods or services (or both);
2. a participation payment may or must be made after a new participant begins to participate in the scheme;
3. making a participation payment is not the only requirement in order to be eligible to participate in the scheme;
4. making a participation payment is not the only requirement in order to be eligible to receive a recruitment payment under the scheme;
5. the holding out of the prospect of entitlement to a recruitment payment does not give any new participant a legally enforceable right;
6. the arrangement for the scheme is not recorded in writing (whether entirely or partly).

 

The New Ordinance provides that in deciding whether a scheme that involves the marketing of goods or services (or both) is a pyramid scheme, a court must have regard to the following matters in determining whether a participation payment under the scheme is entirely or substantially induced by the prospect held out to a new participant of entitlement to a recruitment payment:

 

 

1. whether the participation payment bears a reasonable relationship to the value of the goods or services that the new participant is entitled to be supplied with under the scheme, having regard to the price of comparable goods or services available elsewhere;
2. the relative emphasis given in the promotion of the scheme to the new participant’s entitlement:
  a. to the supply of goods or services; and
  b. to a recruitment payment.

 

The new definition of "pyramid scheme" is much wider under the New Ordinance and covers schemes irrespective of whether they involve any sale of goods or services. This should directly deal with the loopholes in the Old Ordinance. However, pyramid schemes are sometimes disguised as legitimate multi-level marketing schemes involving the sale of goods and/or services. The "participation fees" might take the form of "training fees" or "payment for products". In practice, it may not be easy to prove that the participation payment was induced entirely or substantially by the prospect held out to the participants that they will receive a benefit substantially relating to the introduction of new participants. The factors to be considered by the court to determine whether a scheme that involves the marketing of goods or services (or both) is a pyramid scheme, are intended to deal with this difficulty. If the goods and/or services paid for by a participant, when they join the scheme have little value or the value has been substantially exaggerated, the court may find that the true consideration for the participation fee is to confer a right to benefit from the introduction of new participants. Furthermore, if the emphasis on the return is focused on the recruitment of new members, rather than on the sale of the products and/or services, this will be a factor in support of the existence of a pyramid scheme.

 

There are of course risks to operators of genuine multi-level marketing schemes, who might find their schemes falling within the scope of the revised definition of "pyramid scheme". A genuine scheme should avoid a substantial link between the reward and the introduction of new participants. The link should be between the reward and the sale of genuine goods and/or services. After all, the law seeks to prohibit multi-level marketing schemes which do not involve a genuine underlying business. Such schemes are bound to fail and the participants will lose their investments.

 

Criminal liability for participants and those who induce others to join a pyramid scheme

 

To curb the proliferation and expansion of pyramid schemes, persons who induce other persons to join a pyramid scheme, with the knowledge that the benefits they may receive are entirely or substantially derived from the introduction of further new participants, are now caught by the provisions of the New Ordinance, in addition to those who knowingly establish, advertise or manage pyramid schemes or assist in such. Under the New Ordinance, the following persons will commit an offence:

 

 

1. A person who knowingly promotes a pyramid scheme;
2. A person who:
  a. participates in a pyramid scheme;
  b. knows or ought reasonably to know that any benefit that the person may get from participating in the scheme would be entirely or substantially derived from the introduction to the scheme of new participants; and
  c. induces or attempts to induce another person to participate in the scheme, commits an offence.

 

The New Ordinance provides that where an offence has been committed by a body corporate (or member of a body unincorporate), and it is proved that the offence has been committed with the consent or connivance or is attributable to the neglect of a director, secretary, principal officer or manager of the body corporate (or partner, office holder or manager of a body unincorporate) or any person purporting to act in such capacity, such person also commits a like offence.

 

The rationale for revisions making participants in a pyramid scheme potentially liable (as well as promoters i.e. persons who establish, advertise and manage pyramid schemes or assist in such), is that a pyramid scheme cannot be sustained if not for the introduction of new participants by existing participants. One view is that if a participant knows that the benefit he or she obtains is derived from the introduction of new participants, he or she should not induce others to join. Otherwise, that person is similar to a promoter of the scheme and should be penalised. One of the key components of a pyramid scheme under the revised definition is the holding out to participants of the prospect that they will be entitled to receive a benefit entirely or substantially relating to the introduction of further new participants. As a result, those who have been recruited to the scheme would have been told that the benefit that will flow to them would relate to the introduction of new participants. If the participant then asked their friends to join the scheme, they are potentially liable to prosecution. The fact that money has been lost upon the collapse of the pyramid scheme would not in itself be a defence available to the participant. In practice, it is going to be difficult, in some cases, to distinguish between an innocent participant and one who has the requisite knowledge. Also, some schemes might have hundreds of participants and it will be challenging for the law enforcer to decide who should be prosecuted. Hong Kong has decided not to follow other jurisdictions, such as Mainland China and Singapore, which have a total ban on multi-level marketing schemes. Instead, Hong Kong is to rely on legislation that prohibits pyramid schemes. The fact that criminal liability is to be imposed on participants of pyramid schemes means that the public has the burden to assess whether a scheme is legitimate or not. In reality, due to the different tactics adopted by fraudsters, it will be hard for ordinary members of the public to tell whether what has been marketed to them is a pyramid scheme. As the principle behind a pyramid scheme is to exploit the naivety of the participants, it is likely that unsophisticated participants might find themselves losing their investments, as well as being prosecuted for knowingly inducing others to participate in a pyramid scheme.

 

Maximum penalties increased

 

To enhance the deterrent effect, the maximum penalty for an offence has been increased under the New Ordinance from a fine of HK$100,000 and imprisonment for three years, to a fine of HK$1,000,000 and imprisonment for seven years.

 

Power to award compensation

 

As under the Old Ordinance, the New Ordinance provides that if a person is convicted of an offence, the court may (in addition) to imposing the penalties referred to above, order the person to pay compensation to any person who has suffered financial loss resulting from that offence and such compensation is recoverable as a civil debt.

 

Conclusion

 

Only time will tell whether the New Ordinance will be effective in eradicating pyramid schemes. The fact is that the number of prosecutions against promoters of pyramid schemes is small. From 2007 to September 2010, there were 10 complaints of suspected pyramid schemes. Although 27 people were arrested as a result, none were prosecuted, due to insufficient evidence. Despite the New Ordinance, it will be challenging for law enforcers to obtain sufficient evidence to prove cases to the criminal standard of "beyond a reasonable doubt".

 

The new definition of "pyramid scheme" is much wider under the New Ordinance and will cover schemes irrespective of whether they involve any sale of goods or services. If you are conducting any business involving a multi-level marketing schemes, you should ensure that it does not violate the New Ordinance. As participants may also commit an offence under the Ordinance, individuals should approach multi-level marketing schemes with caution.

 

 

For further information, please contact:

 

Joseph Kwan, Partner, Deacons

 
 

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