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Understanding Pyramid Schemes: A Cautionary Guide for Investors

Updated: Jan 29


In the world of investing, it's essential to be aware of potential scams and pitfalls. Among the most notorious forms of investment fraud is the pyramid scheme. Pyramid schemes promise high returns and rely heavily on recruiting new participants into the scheme, rather than legitimate business activities or investments. Let's delve into the mechanics of pyramid schemes, the inherent risks they carry, and how to identify and avoid them.



What is a Pyramid Scheme?


A pyramid scheme is an unsustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services. In essence, it is a structure where each person is primarily profiting from the fees of those they recruit, rather than from any business transactions or investments.


An Example: To illustrate, let's consider an example: A person (let's call them Person A) starts a “business” and recruits people by promising a 200% return on their investment within a month. This means if you invest $100, you will receive $200 at the end of the month. This seems appealing, and hence Person B and Person C decide to join the “business”, each investing $100. At the end of the month, Person A pays them their promised returns, which totals $400, using the money they themselves invested ($200) and the funds from the new recruits ($200). Then, to continue the scheme and pay the promised returns, Person A needs more people to join the scheme. Therefore, Persons B and C are encouraged to recruit more participants. This cycle continues, with each level needing to be significantly larger than the last to fulfill the promise of high returns. Eventually, when new recruitment is insufficient, the pyramid collapses.


Why are Pyramid Schemes Dangerous?


  • Unsustainable: Pyramid schemes are inherently unsustainable. As mentioned above, they rely on the constant influx of new members. Due to this structure, the number of required members increases exponentially and soon exceeds the number of potential investors, leading to the collapse of the scheme.

  • Most Participants Lose Money: As the scheme progresses, the number of losers far outweighs the winners. The only people who earn money are those at the very top of the pyramid, who got in early. Most people, especially those who join later, lose all of their investments.

  • Illegal: In most countries, including the United States, pyramid schemes are illegal because they're fraudulent by nature. They deceive participants about the likelihood of profits and are often disguised as legitimate investment opportunities or multi-level marketing programs.


How to Identify and Avoid Pyramid Schemes?


Pyramid schemes are often dressed up as legitimate investment opportunities, making them hard to spot. However, some key signs can help you identify potential pyramid schemes:


  • Promises of High Returns with Little Risk: Investments typically involve a degree of risk, and it's rare to find opportunities that offer consistently high returns with little risk. If an investment opportunity promises this, it could be a pyramid scheme.

  • Focus on Recruitment: If the main way to earn profits is through recruitment rather than through the sale of a product or an investment in a business, this is a red flag. Pyramid schemes often use recruitment of new participants as their primary source of revenue.

  • Complex Commission Structure: Pyramid schemes often have a complicated commission structure that emphasizes recruiting new members rather than selling a product or service. If the commission structure is hard to understand or focuses mainly on recruitment, be wary.

  • No Genuine Product or Service: If there's no legitimate, marketable product or service being sold, or if the product sold is vastly overpriced, it could indicate a pyramid scheme. Legitimate multi-level marketing (MLM) companies, for example, have tangible products that distributors sell.

  • Pressure to Invest: If you're feeling pressured to invest, especially if the pressure involves "limited time offers," it's a significant red flag. Real investment opportunities are based on performance, not the speed of participation.

  • Unregistered Investments: Pyramid schemes often involve investments that are not registered with the Securities and Exchange Commission (SEC) or with any state regulators. Always check whether the investment and the seller are properly registered.


Examples of Pyramid Schemes


  • Zeek Rewards: Zeek Rewards, an alleged investment opportunity connected with Zeekler, a penny auction website, was shut down by the SEC in 2012. The SEC described Zeek Rewards as a $600 million Ponzi scheme on the verge of collapse. While it had some elements of a Ponzi scheme, it also showed characteristics of a pyramid scheme by its reliance on new participant funds and its tiered recruitment system.

  • BurnLounge: BurnLounge Inc. offered an online music store opportunity from 2005 to 2007. However, the Federal Trade Commission (FTC) charged BurnLounge with operating a pyramid scheme in 2007, which was later confirmed by a court ruling in 2014. The company’s participants bought packages costing up to $430 in the hope of earning bonuses for selling music and recruiting others into the program. However, the compensation was mainly tied to recruitment, and most participants lost money.

  • AdvoCare International: AdvoCare, a multi-level marketing company that sells energy drinks and dietary supplements, was forced to shut down its MLM operations in 2019 after being charged with operating a pyramid scheme. The FTC alleged that AdvoCare offered people the chance to quit their day jobs and gain financial freedom by selling its products, but the vast majority of AdvoCare distributors earned no or very little income. The company agreed to a $150 million settlement and a ban on multi-level marketing to resolve the charges.

  • Herbalife: Herbalife, a multi-level marketing company that sells nutritional supplements and personal care products, has faced allegations of being a pyramid scheme. The most vocal critic was Bill Ackman, a hedge fund manager, who in 2012 bet $1 billion against the company, claiming it relied more on recruitment than on product sales. While the FTC opened an investigation into Herbalife, they ultimately did not label it a pyramid scheme. However, in 2016, Herbalife agreed to a $200 million settlement for its deceptive practices and restructured its business operations to differentiate itself from pyramid-like activities.

  • Vemma Nutrition Company: Vemma, a company selling energy drinks and nutritional beverages, was shut down by the FTC in 2015. The FTC alleged that Vemma was running an illegal pyramid scheme by focusing more on recruitment than on retail sales. Distributors were required to make regular purchases to qualify for bonuses and were incentivized to recruit others. Most participants earned no money, and most of those who did made less than what they had invested.

  • Fort Ad Pays: Fort Ad Pays was an online traffic exchange program that offered digital products and ad services. The company promised high returns for buying ad packs and clicking on ads. However, the main way to earn substantial income was through the recruitment of new members. While it operated internationally, in 2016, the company stopped paying its members, leading to widespread allegations of it being a pyramid scheme. Most members ended up losing their investment.


While not all of these companies were legally declared pyramid schemes, they faced significant allegations and legal action because of their business practices. This demonstrates the need for potential investors and participants to be vigilant, to understand the business model, and to be cautious about businesses promising high returns primarily based on recruitment. These examples underline the harm that pyramid schemes cause to participants, most of whom lose money. They also demonstrate how pyramid schemes can sometimes appear as legitimate businesses, reinforcing the need for thorough due diligence before investing or participating in any business opportunity.


To avoid falling victim to a pyramid scheme, it's crucial to do your research before investing. Understand what you're investing in, ask questions, and verify the answers you receive. Consult with a trusted financial advisor, and never invest more than you can afford to lose. It's essential to stay skeptical of investments that seem too good to be true because they usually are. Investing wisely requires a keen understanding of the landscape, including the ability to identify and avoid pyramid schemes. They are insidious traps that promise high returns with little risk, relying on continual recruitment of new participants to sustain the scheme. When the recruitment inevitably dries up, the scheme collapses, and the vast majority of participants lose their money. Therefore, it's essential for investors to be aware of the signs of pyramid schemes, to conduct thorough due diligence before investing, and to be wary of offers that seem too good to be true.


 

An interesting fact about pyramid schemes is that they are named after their structure, which starts with one person at the top, followed by a second level with two people, a third level with four people, and so on. Each new level requires exponentially more participants. As an example, if we look at the 10th level of such a structure, it would require over 1,000 participants, and by the 20th level, it would need over a million. This quickly becomes unsustainable as it surpasses the total population of the Earth by the 33rd level. This fact illustrates why pyramid schemes are inherently flawed and destined to collapse: they are based on exponential growth, which is impossible to maintain indefinitely.

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