What's Next For TelexFree Victims?

Last week was a busy week for TelexFree.  After filing for bankruptcy protection on Monday in a Nevada bankruptcy court, state and federal securities regulators filed civil actions accusing the company of operating a massive pyramid and Ponzi scheme that, by one estimate, may have raised $1 billion from investors worldwide.  That same day, federal agents from the FBI and the Department of Homeland Security raided the company's headquarters in Marlborough, Massachusetts, which later drew headlines after authorities discovered TelexFree's Chief Financial Officer attempting to remove $38 million in cashier's checks from the offices. (The company later claimed there was no nefarious purpose behind this effort.)  

Now, one week after TelexFree's bankruptcy filing and as reality begins to set in to an estimated 700,000 company "affiliates," the focus turns to the next steps.  This includes not only the various pending court and regulatory proceedings, but also the future of those "affiliates" that made substantial investments based on promises of extravagant returns.  

Court Proceedings

Currently, there are three pending court proceedings that interested parties should consider following.  The first is a Chapter 11 bankruptcy proceeding pending in the District of Nevada Bankruptcy Court (the "Bankruptcy Case").  The second and third are civil actions pending in Massachusetts: one, an administrative action filed by the Enforcement Section of the Massachusetts Securities Division (the "Massachusetts Case"), and the other an enforcement action filed by the Securities and Exchange Commission pending in U.S. District Court (the "SEC Case") (collectively, the "Civil Cases").  There are no current pending criminal cases, although it has been reported that criminal authorities were involved in the search warrant executed on the company;s headquarters last week.

Civil Cases

Both the Massachusetts Case and the SEC Case are enforcement actions premised on alleged violations of state and federal securities laws.  As civil regulatory actions, the purpose of these proceedings is purely remedial -- each seeks injunctive relief prohibiting future violations of securities laws by the TelexFree entities (and in the SEC Case, by TelexFree principals and top promoters), civil penalties, and disgorgement of ill-gotten gains from the violative conduct.  The respective defendants will be entitled to varying forms of discovery (likely more in the SEC Case due to the administrative nature of the Massachusetts Case), and will then likely file dispositive motions seeking a court order finding in their favor without the necessity of trial.  If necessary, a trial could be held. Notably, neither the Massachusetts Case nor the SEC Case includes a request for the appointment of a receiver to secure and marshal assets; rather, as explained below, the consensus seems to be that responsibility for the recovery of assets is properly in the realm of the Bankruptcy Case.

Bankruptcy Case

While the Civil Cases contain a somewhat predictable path to finality, the Bankruptcy Case is not as certain.  On April 14, 2014, TelexFree Inc., TelexFree LLC, and TelexFree Financial, Inc. (collectively, "TelexFree") each filed voluntary bankruptcy petitions under Chapter 11 of the U.S. Bankruptcy Code.  Under a Chapter 11 proceeding, the filing entity seeks to continue operating during and bankruptcy and ultimately emerge from bankruptcy after restructuring various aspects of the business, including debts.  In comparison, a Chapter 7 bankruptcy involves the cessation of operations and a complete liquidation of a business, with the proceeds being distributed to company creditors.  

In the press release announcing its bankruptcy, TelexFree cited "certain operational challenges," and indicated it intended to "restructure its debt obligations."  In a subsequent bankruptcy filing, the company sought approval from the Bankruptcy Court to reject "all agreements between the debtors and the promoters under both the Original Comp Plan and the Revised Comp Plan."  According to the Commission, this included at least $174 million in compensation demands submitted by "promoters" after the company drastically revamped its compensation plan.

Of note, while bankruptcy filings under other Chapters, including a Chapter 7 or Chapter 13 bankruptcy, includes the appointment of an independent trustee, a Chapter 11 bankruptcy typically features only a U.S. Trustee associated with the Department of Justice.  This is explained by the theory that the debtor, which is seeking bankruptcy protection not to liquidate but rather to continue operations, is best equipped to oversee day-to-day operations and is thus tasked with the duties of a case trustee.  However, pursuant to 11 U.S.C. 1104, the court may order the appointment of a case trustee:

for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.

According to Kathy Bazoian Phelps, a California attorney with significant experience in Ponzi scheme bankruptcy cases and the author of The Ponzi Book, "the first step is to see what both the assets and liabilities of the debtor entities are, which is information that will be included on the Schedules and Statement of Financial Affairs to be filed in two weeks."  This information is important, because this information will ultimately influence the Bankruptcy Court's decision whether a Chapter 11 bankruptcy - rather than a Chapter 7 - is ultimately approved.  According to Phelps, a successful reorganization under Chapter 11 requires that "the companies will need to generate profits from a legitimate business operation that are sufficient to pay the creditors more than they would receive in a Chapter 7 liquidation."  

The allegations in the Massachusetts Case and SEC Case could pose a problem to this determination.  As Phelps observed, "The Massachusetts regulatory action [and subsequent SEC Case] has labeled the businesses as a pyramid or Ponzi scheme, calling into question whether there are legitimate business operations sufficient to fund a plan of reorganization."  Indeed, the Commission alleged that TelexFree had only approximately $1.3 million in VoIP sales revenue from August 2012 to March 2014 - approximately 1% of the $1.1 billion in accrued obligations to "promoters."  Factoring in the other allegations, including that (i) TelexFree transferred over $30 million to company principals and promoters, and (ii) tens of millions of investor funds remain unaccounted for, this could be a difficult showing for TelexFree.  Thus, one of the main issues decided in the interim will be whether the company will be permitted to reorganize or forced to liquidate.

Currently, several preliminary TelexFree motions are pending before the Bankruptcy Court, including the motion seeking court approval for the company to "reject" all agreements (and resulting compensation obligations) with "promoters" under the former compensation plans.  The Bankruptcy Court has asked for objections from interested parties, including the SEC and Massachusetts regulators, by April 21, 2014, and a hearing is scheduled for May 2, 2014.

Asset Recovery

One of the primary concerns posed by those interested parties is the extent and likelihood of any compensation for losses.  Unfortunately, it is much too early to offer an informed answer to that question. Several factors will influence whether that question may be answered in the affirmative or negative.  The first factor, logically, is the existence of assets.  As Phelps alluded to earlier, various financial statements and schedules must accompany a bankruptcy petition within two weeks of the initial filing, and the assets disclosed on those statements will provide a glimpse into the "operational challenges" facing TelexFree. The second factor is the form of bankruptcy ultimately employed by the Court - will TelexFree seek to set aside certain assets and/or a portion of future revenues under a court-approved reorganization plan, or will the companies be forced to liquidate all assets.

What Can Victims Do?

Unfortunately, neither the Civil Cases or the Bankruptcy Case are expected to have an immediate resolution; rather, it is likely that the cases (and recovery efforts) could take several years.  While this may be difficult for some to fathom, the reality is that such a a duration is likely due to the complexity of the alleged scheme, the worldwide nature of the business, and the sheer number of victims.  It is anticipated that simply gaining an understanding of TelexFree's true operations could be a complicated task that could take several weeks, if not months.

One step that those affected parties can take today is to begin gathering all evidence of their relationship and investment with TelexFree.  This includes agreements, negotiated checks and credit card statements, and bank statements showing any deposits and/or withdrawals.  This information will be necessary, if not required, in connection with submitting claims to the Bankruptcy Court.

Regarding claims, each interested party will most likely have the opportunity to submit Proof of Claim Forms to the Bankruptcy Court to properly document their entitlement to any earmarked funds.  Perhaps the most crucial guidance surrounding these claims is that attention must be paid to the deadlines imposed by the Court for submission of Proof of Claim forms and any other documents - untimely or tardy claims fare a much less chance of being approved than a timely claim.  A copy of a blank Proof of Claim Form is embedded below and downloadable here.  While the filing of a Proof of Claim may not be required if the case proceeds as a Chapter 11 proceeding and the particular debt is listed in the correct amount in the schedules filed with the Court, the submission of a Proof of Claim may still be advised.

All interested parties are advised to pay close attention to the proceedings.  Some other sites that have been covering TelexFree in detail include BehindMLM, PatrickPretty, ASD Updates, and MLM Help Desk.

A copy of the Proof of Claim Form is below:

04-2013 b10 Form Court Version

TelexFree Asks Bankruptcy Court To Eliminate Promoter Obligations

On the date it filed bankruptcy in a Nevada federal court, and just days before Massachusetts regulators and the Securities and Exchange Commission accused the company of being a massive pyramid and Ponzi scheme that had raised at least hundreds of millions of dollars from investors worldwide, TelexFree LLC filed a rather innocuous-sounding motion to "Authorize the Debtors to Reject Certain Executory Contracts Nunc Pro Tunc As Of The Petition Date."  Cloaked in bankruptcy parlance, the title of the motion holds little meaning to the estimated hundreds of thousands of "promoters" that, until recently, were promised lucrative returns for placing daily advertisements and recruiting new investors.  

However, a casual read of the Motion makes clear that the company accused by regulators of being an "egregious" pyramid scheme seeks now to use the Bankruptcy Court's power to eliminate the obligation to pay accrued compensation likely totaling hundreds of millions of dollars to "promoters" - under the theory that elimination of these obligations will allow the company to "ultimately prove successful and profitable."  Ironically, one of the chief concerns cited by TelexFree related to questions "raised as to whether the Original Comp Plan is compliant with law, which jeopardized the Debtors' business."  

Background

The Motion was filed on April 13, 2014 - the same day that TelexFree and two of its affiliates filed for bankruptcy in the Nevada bankruptcy court.  While TelexFree's main business centered on the sale of its voice over internet protocol (“VoIP”) program, 99TelexFREE, the company also operated a passive investment program.  By the terms of the previous compensation plan, an investor making an initial investment of either $289 or $1,375 would be required to so spend several minutes per day in an "effortless" path to astronomical gains - at least 200% per year.  These massive returns quickly resulted in a scenario where obligations to promoters drastically outpaced company revenues - indeed, according to the Commission, this compensation program racked up more than $1.1 billion in obligations to promoters.

As the Commission recognized, the $1.1 billion in promoter obligations was 100x larger than the $1.1 million realized in revenue from the sale of 99TelexFREE.  In March 2014, TelexFree announced a drastic revamp to its compensation plan.  Rather than simply place a daily advertisement and earn $20 per week on a $289 investment, the new compensation plan effectively required the purchase or sale of five $49.90 VOIP packages in order to be eligible for a return.  As BehindMLM recognized, the compensation plan suddenly shifted from previously allowing the passive investment program to function independently of the VoIP product to now integrating the two programs and counting on the viability of the VoIP product as a standalone product.

The Motion

The Motion positions TelexFree as a "telecommunications business that uses multi-level marketing to assist in the distribution of voice over internet protocol telephone services."  Touting 99TelexFree, the Motion claims that customer usage increased each month since its introduction in 2012.  For the first time, the Motion disclosed that TelexFree has "over 700,000 promoters" worldwide, and referenced the recent discontinuation of its compensation plan in favor of a revised compensation plan.  However, the "discretionary" payments owing to promoters under the original compensation plan soon allegedly "became a substantial drain on the Company's liquidity," and the company soon ceased making those payments prior to filing bankruptcy.

Despite experiencing "exponential" growth in revenue (which it claimed was over $1 billion), TelexFree claimed that it filed Chapter 11 bankruptcy due to "substantial asserted liabilities" against the company due to previous compensation arrangements.  Citing its belief that the soon-to-be released TelexFree mobile app and other products would propel the company to profitability, the Motion sought court approval  to reject "all agreements between the debtors and the promoters under both the Original Comp Plan and the Revised Comp Plan."  According to the Commission, this included at least $174 million in requests for payment by promoters submitted after the change in the compensation plan.

Of note, the Motion takes great pains to characterize the relationships between the promoters and the company as contractual, reciting a number of obligations that each owed one another.  While the company's obligations primarily consisted of paying the promoters, the promoter's obligations were characterized as adhering to the rules, agreeing to receive messages in their inboxes, and providing true and accurate information - primarily passive obligations.

The likelihood of success for the Motion is unknown.  Indeed, a case cited to in the Motion specifically cautions that such a "business decision" should not be granted if the decision was the product of "bad faith, whim, or caprice." In re Trans World Airlines, Inc., 261 B.R. 103, 121 (Bankr. D. Del. 2001). One bankruptcy authority recently recognized the difficulty the company would face in trying to discharge its obligations to creditors, noting the Bankruptcy Code's prohibition under 11 U.S.C. 523 against the discharge of debts arising from the debtor's bad acts:

1) debts arising from fraud by the debtor as a fiduciary, embezzlement, or larceny; (2) debts obtained through false pretenses, false representations, or actual fraud; (3) consumer obligations – credit card debts and luxury goods – owed to a single creditor over a certain threshold; and (4) willful and malicious injury caused by debtor to another’s property.

While in a vacuum the request might not appear as questionable, the recent allegations by Massachusetts regulators and the Commission paint a picture of widespread fraud - indeed, the recently-appointed Chief Financial Officer of TelexFree was caught trying to leave the company's headquarters with nearly $40 million in cashier's checks after federal authorities raided the office.  Moreover, the Commission alleged that approximately $30 million has been transferred in the last 5 months to company principals and related entities.  

There has been no ruling as of yet on the Motion.

Ponzitracker coverage of TelexFree to-date is here.  

The Motion is below:

Motion to Reject Certain Exec Ks

As Regulators Closed In, TelexFree Execs Scrambled To Move Assets

It reads like a spy thriller you would expect out of Hollywood.  As authorities closed in on a massive fraud, one of the company's top executives sought to elude a raid on the company's headquarters by walking out the front door with nearly $40 million in cashier's checks concealed in his briefcase.  Except this series of events actually occurred - albeit not as successfully as a Hollywood story might pan out.  

Earlier this week, both the Securities and Exchange Commission (the "Commission") and Massachusetts securities regulators filed civil fraud charges against TelexFree, LLC and several related entities, alleging the operation was a massive pyramid and Ponzi scheme that had raised at least several hundred million dollars from investors worldwide.    The companies, which filed bankruptcy the beginning of the week, were also the subject of an asset freeze by the Commission in an effort to prevent the dissipation of investor funds.  

On Tuesday morning, the same day civil charges were filed against TelexFree, federal authorities executed a search warrant on the company's Marlborough headquarters.  In a sworn statement filed by a Commission attorney, the following events were detailed.  During the course of the search, sheriff's deputies noticed that a man named Joseph H. Craft was attempting to remove a laptop and laptop bag from an office, claiming they were personal items.  Craft claimed he was a "consultant" helping TelexFree file for bankruptcy.  

However, deputies informed Craft that he would not be permitted to remove his "personal items" from the premises, and subsequently searched the bag.  During the subsequent search, no "personal items" ere discovered.  Instead, nearly $40 million in recently-issued cashier's checks were discovered.  These included (i) multiple cashier's checks totaling over $25 million payable to TelexFree's current President; (ii) a $2 million cashier's check to a TelexFree principal's wife; and (iii) a $10.39 million cashier's check to a TelexFree subsidiary.  With the checks bearing issue dates of April 11, 2014, just three days before TelexFree would declare bankruptcy, the checks likely served as a source of liquidity for insiders gearing up for possible civil and criminal charges.  

After authorities discovered the cashier's checks, it also turned out that Craft was not being forthright about his occupation.  Rather than a lowly "consultant" assisting with the company's bankruptcy, Craft was actually the Chief Financial Officer of TelexFree.  

Meanwhile, recently-appointed Chief Executive Officer James M. Merrill, to whom more than half of the cashier's checks discovered in Craft's possession had been payable to, was also trying to ensure he had access to unfrozen funds.  The SEC Declaration recounted a conversation with a representative of Waddell & Reed, where Merrill maintained a brokerage account, revealing that Merrill had placed an unsolicited order to sell $1.15 million of his mutual fund holdings on the same day of the TelexFree raid.  

 

A copy of the SEC's Declaration is below:

Telex Free Declaration

 

Authorities Charge Rothstein CFO With Conspiracy

Federal authorities continued their quest to prosecute those connected to the massive $1.2 billion Ponzi scheme perpetrated by Scott Rothstein, with Rothstein's former CFO becoming the 18th person to face charges to date.  Irene Shannon, f/k/a Irene Stay, was charged with a single count of conspiracy to commit money laundering and bank fraud.  The charge carries a maximum prison term of five years as well as up to a $250,000 fine.  Shannon was charged in a criminal information, which suggests that a plea agreement is likely.  

According to authorities, Shannon was Rothstein's "trusted agent," carrying out Rothstein's directions to shuffle hundreds of millions of dollars between investors, sustain the law firm's operations, and keep the scheme afloat.  This even included collaborating with Rothstein to determine the fictitious returns that investors thought were derived from lucrative purported legal settlements that, in reality, did not exist.  

Shannon's name has come up frequently since Rothstein's sentencing, including testimony from former chief operating officer Debra Villegas that Shannon played the most important role in the scheme. Additionally, Rothstein himself testified at a deposition that Shannon definitely knew what she was doing when he asked her to move around millions of dollars.  Of course, Rothstein has made it no secret that he is actively cooperating with prosecutors in an effort to eventually win a reduction in his 50-year prison sentence.  

With the charges, Shannon becomes the 18th person to be charged in connection with Rothstein's fraud - ranking even above the prosecutions in the Bernard Madoff Ponzi scheme, which to date has resulted in 14 convictions. 

Judge Revokes Bond For Accused Ponzi Schemer After Contact With Victims

A federal judge has revoked bail for a Florida man accused of orchestrating a $70.9 million Ponzi scheme, siding with prosecutors' allegations of "brazen" violations of a "no-contact" condition of his bail.  Joseph Signore, previously free on $100,000 bail after being charged with twelve counts of mail fraud and wire fraud, was "regretfully" remanded into custody by U.S. Magistrate Judge Dave Lee Brannon.  In revoking Signore's bail, Judge Bannon found that Signore's contact with several investors violated the terms of his release, but also conceded that some responsibility for the violations lay with the attorneys that crafted the terms.  Unless Signore is able to obtain new bail terms, it is possible he could remain incarcerated until the case goes to trial.

Background

According to authorities, Signore and Paul Schumack solicited potential investors to participate in JCS Enterprises' ("JCS") Virtual Concierge program, which involved the purchase of a virtual concierge machines ("VCM") through a one-time fee ranging from $2,600 to $4,500 per VCM.  The VCM, which resembles an ATM, is a free-standing or wall-mounted machine placed in various businesses that purportedly allowed the advertisement of products or services and even the ability to print tickets or coupons.  Potential investors were told that the VCMs generated substantial returns, which in turn would allow the payment of annual returns to investors ranging from 80% to 120%. In addition, investors were provided with the location of the VCMs they had purportedly purchased, and even given the ability to track the VCM activity online.

Investors were solicited in several ways, including several websites controlled by the entities and through videos posted on popular video-sharing website Youtube.  The videos promised that the VCM would "generate income for years," and promised that a $3,500 investment could produce "huge returns."  Potential investors also received emails from Schumack, who touted his graduation from West Point Military Academy in 1979 and whose email signature also featured a Bible passage intended to create a false sense of security for investors.  

However, authorities allege that the outsized returns touted by the defendants were the result of a Ponzi scheme.  According to the SEC, the production of VCMs was not close to the amount of VCMs purportedly sold to investors, and the guaranteed returns were "a farce."  Instead, investor funds were commingled and used for a variety of unauthorized purposes, including the unauthorized transfer of more than $2 million to Signore and his family.  An additional $56,000 in investor funds were used for expenses including restaurants, stores, and a tanning salon.  Finally, approximately $4 million in investor funds were transferred to an unrelated account from which Schumack and others allegedly made more than 100 cash withdrawals of nearly $5 million. 

Signore's Release and My Gee Bo 

Following the pair's arrest last Tuesday, Judge Brannon set bond for each at $100,000.  As part of the conditions of release, Signore was permitted, to no objection, to continue operating My Gee Bo ("My Gee Bo"), another company Signore operated from his same address.  However, it soon emerged that Gee Bo had been operated in tandem with JCS, and the receiver subsequently filed an emergency motion seeking to include Gee Bo as part of the entities placed in receivership.  In that motion, the receiver detailed Gee Bo's ties to JCS, disclosing that Gee Bo had received at least $770,000 in transfers from JCS or for Gee Bo's benefit - including the payment of hundreds of thousands of dollars in JCS funds for a celebrity sponsorship from Shark Tank's Barbara Corcoran.  The Court granted the motion to include Gee Bo.  

In addition to the close ties between Gee Bo and JCS, Judge Brannon was also informed by prosecutors that Signore had engaged in contact with several individuals, including scheme victims and Gee Bo employees, in violation of a "no-contact" condition of his release.  This included communications with a JCS shareholder, Gee Bo investors, and the JCS records custodian.  According to Judge Brannon, these "evidence gathering" activities were sufficient cause to revoke Signore's bail.

A copy of Signore's motion opposing the government's motion to revoke bond is below:

Defense Response to Govt's Motion to Revoke Bond (1)