A pyramid scheme is a fraudulent and unsustainable investment pitch that promises unrealistic returns from imaginary investments. Early investors receive payouts from the growing pool of new recruits, leading them to bring in more victims. Ultimately, without new investors, the pyramid collapses.
A variation involves charging initiation fees that the next layer of investors pays. Portions of these fees are allocated to higher levels. Inevitably, recruitment dries up, collapsing the scheme.
Often labeled as scams, these operations are illegal in the U.S.
Key Takeaways
- Pyramid schemes divert earnings from lower-level recruits to those at the top.
- In the U.S., it is illegal to recruit participants into pyramid schemes.
- Schemes rely on income from recruitment fees, not sales of tangible goods or services.
- Multi-Level Marketing operations (MLMs) are legal business models involving income from products and commissions.
- Pyramid schemes often disguise themselves as MLMs, focusing on recruitment fees over product revenue.
How Pyramid Schemes Work
Pyramid schemes are named for their structure resembling a pyramid. The original members occupy the top point, with levels of recruits broadening at the base. Below is an illustration for visualization:
For example, Founder Mike recruits 10 members with promises of high returns. These 10 members each recruit 10 more, and the cycle continues as each new recruit pays fees that funnel up. The emphasis remains on recruitment, with minimal actual product or service outings.
According to recruitment event pitches, new members expect substantial earnings from those below them. However, once recruitment wanes, the pyramid collapses, leaving the majority empty-handed while a few at the top walk away rich.
Key Signs of a Pyramid Scheme
Investors should be wary of these red flags:
- Absence of genuine products or services
- Promises of quick, high returns
- Boasts of easy or passive income
- No real income from retail sales
- Required buy-ins
- Complex commission structures
- Heavy focus on recruitment
Types of Pyramid Schemes
Multi-Level Marketing Pyramid Scheme
Multi-level marketing (MLM) programs involve valid business practices where participants earn from selling real products. However, some pyramid schemes masquerade as MLMs, emphasizing recruitment over product sales.
Chain Emails
These schemes persuade recipients to donate money and forward the email to join a donation list, expecting a higher return from new participants.
Ponzi Schemes
Ponzi schemes promise returns to investors from subsequent investors’ money without adopting a pyramid’s structure. High-profile cases like Bernard Madoff’s demonstrate the extensive losses and ultimate collapse of such schemes.
Example of a Pyramid Scheme
The SEC recently halted a pyramid scheme posed as an MLM called CKB, targeting Asian-American communities. Although claiming success in selling educational courses, its primary revenue came from new investor fees.
How Pyramid Schemes Collapse
A pyramid scheme survives as long as it recruits new paying participants. The moment this pool shrinks, the scheme collapses, resulting in widespread financial loss.
Legality in the United States
In the U.S., it is a felony to recruit for a pyramid scheme. Convictions result in up to four years in prison and fines up to $5,000.
Why Some Pyramid Schemes Succeed
Founders and early members succeed by attracting fee-paying participants lured by steep returns. Recruitment ends when no more paying members are found, collapsing the scheme.
MLMs Vs. Pyramid Schemes
MLMs are legal businesses where distributors sell products, earning from direct sales and commissions. Pyramid schemes pretend to be MLMs but focus solely on membership fees.
The Bottom Line
Pyramid schemes, illegal across many regions, often strain personal relationships as participants recruit friends and family. A wise investor avoids such damaging financial traps.
Related Terms: Ponzi Schemes, MLM, Investment Fraud, Scam Awareness.
References
- Legal Info. “Crime Overview Pyramid Scheme”.
- Investor.gov. “Pyramid Schemes”.
- U.S. Securities and Exchange Commission. “Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs”.
- Federal Trade Commission. “Multi-Level Marketing Businesses and Pyramid Schemes”.
- Federal Bureau of Investigation. “Bernard Madoff Sentenced to 150 Years in Prison”.
