Why Are Pyramid Schemes Illegal?
Pyramid schemes are not legitimate enterprises—recruiters take new recruits’ buy-in “investments” to pay the people who recruited them, instead of investing the money in any legitimate business enterprise. Only people who got in on the ground floor—the people who end up at the top of the pyramid—will make money. Most recruits into pyramid schemes will lose their entire investment, despite their recruiters’ enticing offer of a work-from-home opportunity with limitless earning potential.
Fraudsters who run pyramid schemes often claim they can turn a small investment into substantial profits in a relatively short period. Unfortunately, that investment only serves to enrich the recruiters. The schemers behind these investments are typically very charismatic and go to great lengths to conceal their fraud and make the “business opportunity” appear legitimate.
Why Do Pyramid Schemes Fail?
Pyramid schemes fail because of market saturation. Pyramid scheme recruits usually start by recruiting from their inner circle of friends and family, then branch out to acquaintances and social media contacts, and eventually turn to total strangers. Ultimately, too many people will have joined the pyramid scheme, and there will be no one else to recruit. Simple math reveals why pyramid schemes always fail: If a pyramid scheme starts with four people, and each person recruits another four people, after 13 rounds of recruitment, the pyramid will have run out of people to recruit from the Earth’s population of approximately 7 billion. This principle is called exponential expansion.
To be clear: individuals at the top of a pyramid scheme often do make money. Their success, however, requires that a large group of people at the base of the pyramid lose their entire investment.
Pyramid schemes usually do not involve the sale of a product or something with intrinsic value. If the pyramid scheme does incorporate a product, it will often cut corners and create a product that representatives will find difficult to sell. If the company takes the merchandise back, they often do not fully reimburse the distributor.
Famous Pyramid Schemes
In the wake of Covid-19, “blessing circles” started to pop up on social media accounts in increasing numbers. This classic pyramid scheme goes by many different names – blessing looms, gifting tables, sou-sou, Mandala, The Circle Game, and Money Board are all versions of the same scheme. Blessing-circle type pyramid schemes invite participants to pay a small initial amount toward people already in the circle, promising their $100 payment could result in an $800 payment down the road once they receive payments from their recruits. As in every pyramid scheme, blessing circles fall apart once the latest recruits cannot find people who want to participate.
These “blessing circles” often circulate using chain mail, with messages that encourage readers to forward the email to their contacts.
Signs of a Pyramid Scheme
Pyramid schemes usually feature the same red flags, in addition to the promise of a huge work-from-home income.
- To hide the scheme from the IRS, recruiters hide investments by instructing participants to use digital payment services, like Venmo or Amazon gift certificates.
- Pyramid schemes will focus most of their efforts on pressuring members to recruit new participants rather than sell a product.
- Investors should always be wary of spending money to participate in a business. Working for a pyramid scheme is not the same as setting out on an independent business venture.
- Pyramid schemes that involve a product require recruits to make recurring inventory purchases, even if the recruits still have unsold merchandise from their last round of purchases.
What is the Difference Between Pyramid Schemes and Multi-Level Marketing?
Multi-level marketing companies and pyramid schemes often employ the same language when recruiting new distributors, promising fulfilling, work-from-home careers and potentially enormous incomes. According to the FTC, legal multi-level marketing companies focus their energies on selling legitimate products rather than recruiting new members.
The FTC is cagey about the exact differences. A New York Times opinion piece quoted Frank Dorman, the spokesman for the Federal Trade Commission, saying in response to that question: “Lots of reporters have asked that question. Our final response is, we’re not going to answer it.”
Multi-Level Marketing schemes (MLMs) skirt the law by selling actual products. They claim that recruiting is secondary to their business. If a company representative focuses their efforts on recruiting rather than selling a product, they may be participating in an illegal pyramid scheme. Potential recruits should steer clear even if a company is technically a legal multi-level marketing scheme and not a pyramid scheme. According to a Federal Trade Commission Report, less than 1% of MLM participants will make money.
MLM participants should be aware: Companies that represent themselves as legal multi-level marketing schemes may be pyramid schemes that the FTC has yet to investigate. On the flip side, many companies accused of being illegal pyramid schemes have restructured to function as legal multi-level marketing companies after paying the FTC a fine.
For instance, AdvoCare settled with the FTC for $4 million and exists today as a legal multi-level marketing company. In 2019, the FTC announced that AdvoCare, a dietary supplement company, had operated as a pyramid scheme. AdvoCare received endorsements from professional athletes and entertainers, which helped legitimize its promise of performance-boosting supplements and shakes. The FTC found that participants spent thousands of dollars on their inventory. Instead of managers encouraging them to sell the product, they encouraged recruits to recruit more distributors.
Herbalife paid a $200 million settlement in 2016. An FTC complaint stated that “The amount of compensation a Distributor receives from Defendants is not based on retail sales of Herbalife products, but rather is based on the volume of product purchased by the Distributor’s recruits, and by their recruits.” Now that Herbalife has settled with the FTC, however, it has continued to function as a multi-level marketing company.
What is the Difference Between a Ponzi Scheme and a Pyramid Scheme?
Many confuse Ponzi schemes and pyramid schemes since they both require a continuous flow of money from new investors. In a Ponzi scheme, investors are not promised compensation in exchange for finding new recruits, although they may be encouraged to tell their friends about the investment opportunity. Ponzi schemes only serve to enrich one fraudster, who uses money from new investors to pay previous investors instead of pursuing a legitimate investment strategy.
How Can I Spot the Signs of a Pyramid Scheme?
FINRA published an Investor Alert that advises investors to look out for the following:
- Guarantees: Nothing is guaranteed in a legitimate investment. Guaranteed profits should raise suspicion.
- Overly consistent returns: Profits cannot be guaranteed, and neither can the exact amount of the returns.
- Complex strategies: Investors should avoid investments they do not understand and should be wary of hard-to-follow investment strategies.
- Missing documentation: Look for the prospectus–the document filed with the SEC that describes the investment.
- Pushy salespeople: Salespeople should not pressure investors. Be especially wary if a salesperson or broker expresses a time limit for new investors to buy shares–fraudsters often stress a limited timeframe to boost their sales.
How Do I Get Out of a Pyramid Scheme?
If you were involved in a pyramid scheme at the recommendation of your broker or financial advisor, contact Kurta Law. Our securities attorneys can help hold your brokerage accountable for failing to supervise their representative.
Victims should also report suspected pyramid schemes to the SEC: https://www.sec.gov/tcr