How about an example of fraud?

MoviePass was launched in 2017 when the average cost of a movie ticket was $8.97. A subscription to MoviePass let you go to as many movies as you could pack into your busy schedule for a cost of $9.95 per month.

Like you have done in the last 10 seconds, MoviePass subscribers figured out that MoviePass was a great deal if they went to at least two movies a month. This economic concept is known as moral hazard.

Purchase an airline ticket for $300 and the airline will deliver you from Atlanta to Chicago. Not much room for one party to take advantage of the other.

But what about Red Lobster restaurants? It offered “unlimited shrimp” nights. Guess what happened? Shrimp lovers flocked to Red Lobster and literally ate them out of house and home. The shrimp debacle put Red Lobster into bankruptcy. Red Lobster created a situation of moral hazard by telling its customers to “eat as much as you want for one fixed price.” Attracting them for the shrimp did not lead to the expanded buying of other menu items as predicted.

MoviePass did not understand this concept and was victimized by a situation of moral hazard that it created. The users that selected the MoviePass option instead of buying tickets each time they went to a movie felt no financial pain. MoviePass was shouldering all of the financial risk for the user’s decision to go to the movies. In other words, people that went to a lot of movies bought MoviePass.

MoviePass was betting that people would subscribe and not use the service much. Instead, the service was used vigorously and MoviePass had to pay for all those tickets when movie-goers swiped their MoviePass rather than buying tickets.

To dig out of the hole it created and to sustain its stock price, MoviePass resorted to fraud.

The SEC charged MoviePass and its CEO, Ted Farnsworth, in 2022 with making materially false and misleading statements about MoviePass's business model and technology.

The key fraudulent activities, and this is a great list, included:

1. Subscriber Count Manipulation: Executives falsely claimed MoviePass had sophisticated technology that would prevent subscription sharing and ensure profitability. In reality, they knew their technology was ineffective and couldn't prevent abuse.

2. Misleading Investors: The company made false claims about its data monetization capabilities and partnerships with major studios, suggesting additional revenue streams that didn't exist. The company misled investors about its cash burn rate and financial sustainability, while continuing to sell stock to the public.

3. Customer Obstruction: (This one is my favorite.) When the company ran low on money, executives implemented various schemes to prevent subscribers from using the service, including:

   • Secretly changing passwords of heavy users

   • Creating an elaborate "trip wire" system that would shut down all users' access once the company reached certain daily monetary thresholds and implementing technical disruptions disguised as system issues.

Whew, talk about liar liar pants on fire! 

Former CEO Farnsworth faces up to 20 years in prison after pleading guilty to fraud and conspiracy.

But a little homework makes all of this unsurprising. Let’s take a quick look at Farnsworth’s resume:

• He ran a psychic hotline company in Florida called Psychic Discovery Network that faced customer complaints and regulatory scrutiny

• He was CEO of a company called Purple Beverage Company that lost millions and saw its stock price collapse

• He led a company called Millennial Media Ventures that promoted "video email" and lost significant investor money before folding

Many of these companies were penny stocks that ended up losing most or all of their value. There were also multiple instances of his companies being accused of making misleading claims to investors.

In an ironic twist, MoviePass was relaunched in 2023 under new ownership and management, attempting to create a more sustainable business model with tiered pricing and limited monthly tickets.

Key Takeaways

• It sounds so obvious, but do a little background checking on leadership at any company you consider for employment or investment. Yes, I know I repeated this in other posts, but its something we all fail to do many times. A simple Google search would have provided a rich trove of information about Farnsworth — none of it was positive.

• Make sure you can understand how a company’s business model will work. If you bought into the MoviePass thesis that “people will subscribe and not use the service much,” then OK, at least you took the time to think about the company’s fundamental business proposition. We all make bad decisions at some point.

• Fraud is a “deliberate deception.” If you have the slightest uncomfortable feeling about a situation, prove to yourself that there is NOT fraud before moving ahead.

Things I think about

More than 90% of penny stocks fail.

Recommended Reading

Think Remarkable
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Wizard of Lies: Bernie Madoff and the Death of Trust
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When Genius Failed
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Too Big to Fail
Definitive account of the 2008 financial crisis that still reverberates today.