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How does the law achieve a just result in disputes involving illegal pyramid schemes?

Ponzi or pyramid schemes are illegal. Does this mean that the law will not assist a duped investor get his money back?

The dilemma faced by the court in disputes involving a Ponzi or pyramid scheme

The worst aspects of human nature come to the fore where so-called "ponzi" or "pyramid schemes" are involved - dishonesty on the part of the originator of the scheme and greed on the part of those who invest their money.

The elements of such a confidence trick are well-known.

A fraudster sets up a scheme in which he promises investors outrageously high returns on their money - returns that are simply unachievable in the market-place.

Nonetheless, experience shows that greedy and gullible investors flock to invest their money in such schemes.

When the first pay-out is announced, many of the original investors reinvest their money, hoping to compound their already astronomical returns. The originator of the scheme uses the capital invested by Peter to pay interest to Paul.

And so the scheme snowballs, until the inflow of new investments can no longer sustain the outflow of the fraudulently promised returns. At that point the scheme collapses, by which time the originator of the scheme has usually gone insolvent or has fled the country, and little of the invested money can be located.

How does the law deal with such schemes?

Will the law enforce an illegal transaction?

This raises issues of principle that go beyond the narrow confines of ponzi or pyramid schemes.

How does the law deal with the claims of persons who have engaged in illegal activities - for ponzi or pyramid schemes are an example of activities that are illegal in the eyes of the law.

The recent case of Moodaley v King, in which judgement was given by the Northern Cape High Court in October 2009, provides the answer.

Moodaley was a dentist in Kimberley. He, his wife, and his son invested some hundreds of thousands of rand in a ponzi or pyramid scheme operated by one King.

Unhappily for them, they were at the tail end of the many investors who put their money into the scheme, and they were one of the many left empty-handed when the scheme collapsed.

Moodaley sued King in the High Court. He demanded not only the return of the capital that he had invested, but asked for judgement for the astronomical amounts of interest that King's scheme had promised.

How was the court to deal with such a claim?

On the one hand, if the court were to say to Moodaley - you participated in an illegal scheme and the court will therefore not come to your aid, it would leave King, the fraudster, in possession of his ill-gotten gains.

On the other hand, if the court were to order King to pay Moodaley what had been promised by the scheme, the law would be lending its authority to, and enforcing, an illegal arrangement.

Ponzi or pyramid schemes are indeed illegal. Apart from their fraudulent basis, they transgress what used to be called the Usury Act of 1968 which has now been replaced by the National Credit Act of 2005. Both of these Acts limit the amount of interest that can be charged or paid in respect of a loan. The interest promised by a ponzi or pyramid scheme is far in excess of the maximum allowed by the law.

A Solomonic judgement: the capital must be repaid, but not the illegally promised interest

In the result, the court gave judgement against King for the capital amount that had been invested by Moodaley and his family, but refused to grant judgement for the exorbitant (and illegal) interest that had been promised by the scheme.

Whether King thereafter ever paid Moodaley and his family seems doubtful, for King filed a defence to their claim but, on the day of the hearing, did not pitch up at court to argue his case.


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