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A pyramid scheme is an illegal financial scam masquerading as a legitimate business. Pyramid schemes are similar to Ponzi schemes and multi-level marketing (MLM) companies, but there are important distinctions among these three structures.
What are the telltale signs of a pyramid scheme? Here’s a look at how pyramid schemes work, and how to tell them apart from an MLM or a Ponzi scheme.
What Is a Pyramid Scheme?
A pyramid scheme is a scam where a so-called marketing company promises to help you earn big profits in exchange for recruiting new participants into the scheme.
On the surface, a pyramid scheme appears to be a legitimate company selling products or services, but the core goal is always to grow the number of participants in the scheme rather than grow product sales. New participants are typically referred to as investors, salespeople, agents or distributors, or some variation on these titles.
In a legitimate business or an MLM, salespeople are compensated for selling products or services. The compensation structure tends to reward participants for recruiting an ever-growing number of new participants—not for growing product sales.
Typically, pyramid scheme participants are charged membership fees and commissions, and must buy set amounts of product inventory every month in order to remain in the company. Little attention is paid to actually marketing and selling products.
How Do Pyramid Schemes Work?
A pyramid scheme begins with one person or a small team recruiting participants to join a new business venture. The recruits are required to invest money into the venture, pay membership fees or purchase a certain amount of product each month.
The founders receive fees and sales commissions from the other participants, plus revenue from the sale of inventory. From that point on, successful pyramid schemes rely almost entirely on the continued acquisition and growing investments by an ever growing base of new participants.
The “pyramid” in the name comes from the structure of the scam, where one participant recruits several additional participants to work for them. These members then recruit more new participants beneath them … and so on.
The small number of participants at the top of the pyramid scheme make large amounts of money by harvesting commissions and fees from the layers of salespeople and distributors recruited to work below them.
“At the top of the pyramid, the founder or founders are essentially receiving fees from every participant below them,” said Jonathan Perlman, an attorney with the Miami law firm Genovese Joblove & Battista.
Pyramid Schemes vs MLMs
Multi-level marketing companies and pyramid schemes share similar business models. However, MLM companies may operate as legitimate businesses, whereas pyramid schemes are always illegal.
There are certain similarities between a legitimate MLM and an illegitimate pyramid scheme. Here are points where these two models resemble each other:
- Participants do not earn a regular salary, and are expected to purchase a certain amount of product per month in order to remain as part of the company.
- Participants may receive compensation or commissions for recruiting new salespeople to the business.
- Participants work as independent contractors who earn money by selling products and/or by earning commissions based on what their recruits sell.
- Participants are usually charged membership fees. They sell products or services through person-to-person sales, and pay commissions sales commissions up the chain.
Here are some key distinctions between a pyramid scheme and a MLM:
Both MLMs and pyramid schemes tend to charge membership fees. When MLM participants can cover some or even all of their own membership fees by recruiting additional participants, MLMs get dangerously close to operating as pyramid schemes, said L. Burke Files, a financial investigator and president of Financial Examinations & Evaluations Inc.
Perlman adds that while MLMs and pyramid schemes both share a pyramid-shaped structure, legitimate MLMs tend to focus more of the business on product sales than on building a team of salespeople to generate commissions.
“The FTC is the primary law enforcement agency for classic pyramid schemes, which often sell themselves as legitimate MLM enterprises,” Perlman said.
The FTC applies a multi-factor test to determine whether an enterprise is an unlawful pyramid scheme or a lawful MLM, including things like how the structure operates as a whole, marketing representations, participant experiences, compensation plans and the incentives baked into the compensation structure .
For an MLM to be considered legal and not a pyramid scheme, it must adhere to the FTC’s 70% rule. This rule states that “at least 70% of all goods sold must be purchased by non-distributors.”
Pyramid Schemes vs Ponzi Schemes
Bernie Madoff’s investment scam is probably the most famous Ponzi scheme in history. Madoff pooled money from over 5,000 investors without ever any of the funds in the market. All in all, he managed to defraud people out of over $65 billion dollars.
Pyramid schemes and illegal Ponzi schemes share certain similarities, but here are the big differences. In most cases, orchestrators of a Ponzi scheme only ask for a single “investment,” with big returns promised at a later date.
With pyramid schemes, victims “make money” by recruiting more people into the scam. Ponzi schemers don’t require their victims to rope in more participants or take further action to participate.
“In a Ponzi scheme, investors ‘profit’ from underlying mythical investments,” said Files. “The returns to current investors come from new money raised by the Ponzi organizer.”
Key Ponzi Scheme and Pyramid Scheme Differences
- Initial investment. Victims of a Ponzi scheme “invest” money in the scheme, and are led to believe that they will make a giant return from their investment in the future.
- Involvement. In a pyramid scheme, participants are expected to bring in new recruits on a continuous basis. But once the victim of a Ponzi scheme invests, they have little further involvement in the scheme.
- Income. Both Ponzi scheme and pyramid scheme victims earn money from new participants, but only participants in the pyramid scheme are aware of that.
Types of Pyramid Schemes
There is a wide variety of different pyramid schemes out there, which can make this type of fraud somewhat challenging to identify.
For example, poorly designed MLMs can devolve into pyramid schemes when they become impossible to sustain without continual recruitment. Some pyramid schemes actually sell products, while others work off the promise to sell products, or to make people money.
“Chain mail” has been around forever, but the chain email version—which promises to make participants a certain amount of cash—is an illegal version of the traditional pyramid scheme.
Different chain emails may come with varying instructions, but the gist is the same. Recipients send a certain amount of money to the first person listed in the group of emails. They then remove that person’s name from the list, add theirs to the bottom, and forward the email to another group of people with the intention for them to do the same.
Although many investment clubs present a legitimate forum to help people to pool their money for the purposes of making group investments, in some cases they function as pyramid schemes.
In fraudulent investment clubs, recruitment of new investors is a higher priority than actually choosing legitimate investments. There is usually a promise of fast returns, and the orchestrators of the scheme encourage initial investors who have already received “returns” to create their own investment clubs. Those investors invite their friends, business associates and relatives to join and invest in the scheme.
“For doing this, the schemer promises the investment club creator a cut of each dollar that club members invest,” says Perlman. “The club creator is also told to teach the investment club members how to start their own clubs, for which they will receive compensation and then pass on compensation to the initial club creator, and so on.”
In 2004, BurnLounge Inc was founded with the promise to make record store “owners” who opened rich storefronts website.
Participants paid a subscription fee and were getting paid in points that they could redeem for BurnLounge products. They were also paid bonuses for recruiting new members
The FTC eventually shut them down, and in 2015 mailed out 52,099 checks worth almost $1.9 million back to consumers who lost money in the scheme.
Fortune Hi-Tech Marketing
Agents were hired by Fortune Hi-Tech Marketing to sell products made by legitimate companies like Dish Network and Frontpoint Home Security, as well as different health and beauty products.
The problem was that salespeople made more money from their recruiting, while the annual fees they paid helped make the higher-ups rich.
The company eventually settled a lawsuit with the FTC and paid nearly four hundred thousand people who were scammed a total of more than $5.5 million.
The Bottom Line
In the end, pyramid schemes only benefit the people at the top of the pyramid. To avoid potential involvement in any iteration of these schemes, consider this advice: “If an opportunity does not have a product or service and you have to recruit members, consider it a pyramid scheme,” said Files. “If it promised astronomical returns and is not a licensed or registered investment, consider it a Ponzi scheme.”