What is a Pyramid Scheme?

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Definition:

A pyramid scheme is an illegal scam that is doomed to fail, because it mainly depends on income from new recruits, not the legitimate sale of products or services.

🤔 Understanding a pyramid scheme

A pyramid scheme is an illegal business that primarily depends on revenue from recruiting instead of selling products or services. These scams often promise new members high earnings with minimal work. Some pyramid schemes sell no legitimate products or services, while others sell overpriced goods that can’t compete in the market. Funds mainly come from new recruits paying the company for supplies, training, or other costs. Initial participants recruit others, who recruit others, creating a pyramid-like structure. These schemes are illegal because they inevitably collapse — You can’t add an infinite number of recruits.

Example

Suppose you receive an email from the fictional company Amazing Prosperity Vacations (APV) telling you about the “opportunity of a lifetime.” The email claims you can easily make $10,000 or more a month selling travel packages to friends, family, and coworkers, just working evenings and weekends.

You can earn even more money by recruiting people to sell trips for you. There’s just one catch: You must sign up for a $1,000 orientation package.

Doing some research, you find that the Federal Trade Commission (FTC) has opened an investigation into APV to determine if the business is legal. A few weeks later, a judge halts APV’s operations at the request of the FTC for allegedly running a pyramid scheme.

Takeaway

A pyramid scheme is kind of like a house of cards...

It’s only a matter of time before the whole structure falls apart. Just as a house depends on its foundation, this scam relies on new recruits at the bottom to pay people at the top. When the scheme falls apart, a lot of participants may lose money.

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What is a pyramid scheme?

A pyramid scheme is a scam that primarily makes money by recruiting new members rather than selling products or services. These scams generally go bust when the revenue from new recruits isn’t enough to cover costs.

Consider a pyramid: It’s narrow at the peak, but the base is very wide and supports the top. Pyramid schemes have a similar structure. Early members, who are at the top of the pyramid, may make a lot of money by charging recruits for initiation, training, or supplies.

New participants form the base of the pyramid. Recruiters often promise them extraordinary returns in a short time or with minimal work. Before new members start earning, they typically have to fork over money. People higher in the pyramid receive these funds.

Some fraudsters give pyramid schemes attractive labels, like “gift program” or “investment club” to try to lure in more people.

How does a pyramid scheme work?

A pyramid scheme redirects money from new recruits to founders and earlier investors. The pyramid scheme may sell some goods and services to make the business look legitimate. But genuine sales aren’t enough to support the business.

Founders typically recruit an early group of investors and require them to put in money. These investors then recruit more people who have to pay to join the company. They might have to purchase training and supplies, or pay an initiation fee. This money goes to earlier members, who are “higher” in the pyramid.

As the scam grows, more people expect to earn money, so more recruits are needed. New members may also rack up piles of products that they can’t sell. Mathematically, a pyramid scheme needs infinite growth, but the pool of potential recruits must eventually run out. Ultimately, incoming revenues won’t be enough to pay everyone, and the scam will fall apart.

Are pyramid schemes illegal?

Pyramid schemes are illegal in the US and many other countries because they inevitably fail. At some point, it’ll become impossible to recruit enough new members to cover costs. When this happens, people who put money into the company may lose their funds.

In the US, the Federal Trade Commission, the Securities and Exchange Commission, the Department of Justice, the Federal Bureau of Investigation, or state authorities may pursue perpetrators for mail fraud, tax fraud, securities fraud, money laundering, or other charges.

What are the types of pyramid schemes?

In a classic pyramid scheme, the promoter promises quick returns through a fantastic business opportunity. Revenue mainly comes from new members, and the company may not sell any products or services. These days, some fraudsters disguise pyramid schemes by selling genuine products and services. Still, most revenues come from recruiting.

A Ponzi scheme is similar to a pyramid scheme. Often, Ponzi schemes involve investments in securities, such as stocks. For example, a scammer might set up a company, falsify a stock portfolio, and then attract investors by promising high returns and low risks. Money from new investors goes to existing investors who withdraw funds. Investors might leave their funds parked in a Ponzi scheme for years, never realizing that it's a scam. Eventually, the funds from new investments aren’t enough to cover withdrawals, and the scam collapses. In a Ponzi scheme, investors simply hand over their money rather than pay for supplies or other expenses and recruit others.

Some people confuse multi-level marketing (MLM) strategies with pyramid schemes, but MLMs are typically legitimate companies. Often called networking businesses, these companies generally rely on people selling to and recruiting friends, family, and others they know. But the bulk of revenue comes from selling products, not recruiting.

What is the history of pyramid schemes?

The Federal Trade Commission started taking action against pyramid schemes in the 1970s. The rise of legitimate multi-level marketing businesses, like Tupperware parties, came with an influx of pyramid and Ponzi schemes. An early case was against Koscot Interplanetary, a company that supposedly sold cosmetics. In reality, the FTC found that the company was a pyramid scheme that forced participants to pay for the right to sell products and relied on recruiting instead of legitimate retail sales.

The FTC’s actions in the 1970s also distinguished legitimate businesses from pyramid schemes. The FTC investigated Amway, which sold household products, but determined that the company was a legitimate business and not a pyramid scheme. Amway used safeguards, including a rule that required distributors to sell to at least 10 different customers (not recruits) in a month. Distributors also had to sell 70% of their inventory each month and had to buy unsold goods if recruits requested it.

Pyramid schemes exploded in the 1990s with the spread of the Internet and globalization. Con artists could cheaply and easily target victims across the world. The FTC’s largest case in the 1990s was against Fortuna Alliance, which promised people that they could make $5,000 or more in profit per month after paying a $250 initiation fee. Thousands of people in over 60 countries lost money to the scam. Perpetrators eventually had to repay $7M to victims.

Pyramid schemes remain common today, with perpetrators often promoting their scams on the Internet and social media. Many companies disguise themselves as multi-level marketing (MLM) companies and may sell some legitimate products. However, revenues still depend on recruiting.

What are the most famous pyramid schemes?

In 2015, the Federal Trade Commission (FTC) accused Vemma Nutrition Company of operating a pyramid scheme. The company sold energy drinks and other products, targeting young adults, but most of its revenues came from recruiting. In 2016, Vemma settled with the FTC and agreed that it wouldn’t pay participants if a majority of their sales came from recruiting distributors.

In Canada, about 2,000 people lost millions of dollars to the travel company Business in Motion. Investors paid a $3,200 entrance fee so they could sell $9,000 vacation packages. But these packages were overpriced, and the company depended on fees from new recruits. In 2014, investors won a $5.8M judgment in a class-action suit against former CEO Alan Kippax, who was eventually deported to his native United Kingdom.

In 2013, regulators shut down Kentucky-based Fortune Hi-Tech Marketing, which recruited people to sell products made by companies like the Dish Network and Frontpoint Home Security. Sellers paid an annual fee to the company and received commissions for selling a variety of products, such as vitamins and security systems. In practice, associates made money off recruiting. An estimated 350,000 people in North America fell prey to the scheme. Operators settled with the FTC in 2014 and agreed to turn over $7.75M in assets for refunds to consumers.

Which companies have been accused of being pyramid schemes?

The Federal Trade Commission has reviewed some well-known multi-level marketing companies, like Herbalife and Amway, after critics alleged they were pyramid schemes.

In the 1970s, the FTC found that Amway was not a pyramid scheme, because it paid for both recruiting and selling health and beauty products. The company only required new members to buy an inexpensive sales kit and didn’t force them to buy large amounts of unmovable stock.

Some prominent investors, including billionaire Bill Ackman, have claimed that Herbalife, a company that sells dietary supplements, is a pyramid scheme. The FTC launched an investigation in 2014 and found that Herbalife was deceiving participants about how much they could earn selling its supplements and other products. The FTC alleged that Herbalife claimed distributors could make a career-level income, though most made little or nothing. It also claimed that the company primarily rewarded distributors for recruiting rather than retail sales.

In 2016, Herbalife agreed to pay $200M to compensate consumers, as well as restructure its business. For example, the company agreed to derive 80% of its sales from legitimate end users.

How do you spot a pyramid scheme?

If a firm is promising easy money, you may want to carefully review its business model and practices. A company that doesn’t sell genuine products or services is likely a pyramid scheme. Overpriced products are another red flag. Pyramid schemes also typically force you to “buy in” to the company by paying a hefty amount for training, seminars, or supplies up-front.

You may want to closely evaluate multi-level marketing opportunities, which are legal if revenues come primarily from end users. For example, you can ask for data about retail sales to end users. You may want to confirm that commissions are largely based on selling to customers outside the program, not other members. If recruiting is the primary focus, there may be a risk that it’s a scam.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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