Bernie Madoff’s arrest in December of 2008 brought renewed attention to the concept of a Ponzi scheme. The close cousin of the Ponzi scheme, named for Charles Ponzi who swindled investors in the 1920’s, is a “pyramid scheme.” Similar to a Ponzi scheme, a pyramid scheme is a form of fraud that promises participants payment for enrolling other people into the scheme, rather than from any legitimate investment or sale of services or products. It is important to distinguish between the characteristics of a pyramid scheme and a Ponzi scheme:
- In a Ponzi scheme, the schemer acts as a main point of contact for the victims (i.e., Bernard Madoff) while in a pyramid scheme, those who recruit additional participants benefit directly.
- A Ponzi scheme claims to rely on some obscure investment approach and usually attracts high-net worth individuals whereas pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.
- A pyramid scheme is prone to collapse much faster because it requires the number of participants to increase exponentially in order for it to be sustainable. A Ponzi scheme, by contrast, can survive simply by persuading most existing participants to “reinvest” money, and does not require as many new participants.
An example of a pyramid scheme is as follows: You are asked to make an initial investment of $500 to become an independent agent for a discount long distance phone company and earn hundreds or thousands of dollars a week. Your job is to sell the service AND recruit a sales force to increase returns. Under this scenario you would be required to sign up a certain amount of people for a specific period of time, such as six months or one year. Most agents usually find few new recruits and end up losing money because the amount of new agents needed for you to actually see a profit is massive.
So, how can you spot a pyramid scheme before it’s too late? Victims are often vulnerable to “get rich quick schemes” and include the elderly, recent college graduates, or new immigrants, all of whom are asked to recruit family and friends. Any company that presents itself as a multilevel marketing business (MLM) is worth taking a second look at. An MLM is a marketing strategy whereby a salesperson not only receives compensation for his/her sales but also for the sales of those he/she was responsible for recruiting, creating a down-line of distributors and a hierarchy of multiple levels of compensation (hence, the pyramid).
Additionally, these businesses also generate hype and frenzy in hopes that in the midst of the excitement, potential recruits will ignore the downside of the business model. In other words, be weary of a company that promises quick returns and thrives on high charged meetings. Many of the businesses engaging in pyramid schemes recruit on the Internet and lure victims to the table by selling high tech ideas or New Age health and environmental products.
Companies or participants that are guilty of pyramid schemes normally do not have a marketable service or product. In other words, if you cannot trace the company’s revenues back to tangible sales rather than just entry fees, training programs and recruitment, you are likely being taken for a ride. According to the Direct Selling Association of America (DSA) if agents of a business are not able to sell inventory, some states require buy-backs at a percentage of the original cost. If you are being recruited to sell products on behalf of a company, make sure to inquire whether the company will buy back unsold inventory. If not, this is a red flag.
Any business model that promotes “getting in on the ground level” and forces you to make a quick investment decision is probably attempting to distract you from what is really going on: a scam. Provided you do your research, it is easy to spot a pyramid scheme. The Better Business Bureau is a good place to start. The DSA also distributes brochures on how to spot pyramid schemes. Don’t let yourself be fooled. Getting rich quick is always worth dreaming about but chances are, it’s not likely to happen so easily.