What Is A Pyramid Scheme?
By Investopedia Staff | Updated November 17, 2015 |
On March 12, 2014, the United States Federal Trade Commission (FTC) launched an official investigation of the nutritional supplement company Herbalife, based on allegations that the company was running a pyramid scheme – a fraudulent investment scheme based on a hierarchical setup. The announcement came after a two-year, aggressive crusade by hedge fund manager William Ackman, whose fund – the New York-based Pershing Square Capital Management – had taken a $1 billion short position on Herbalife (NYSE:HLF) stock.
The FTC investigation followed an inquiry opened by the Securities and Exchange Commission (SEC) in January 2013. (See New York Times DealBook timeline, “Ackman vs. Herbalife: A History.”) Ackman and others are accusing Herbalife of running a pyramid scheme.
Pyramid schemes have cost many people their hard-earned savings. The concept behind them is simple; however, they’re often presented to investors in a disguised form. For this reason, it is important to not only be familiar with how pyramid schemes work, but also with the different shapes and sizes they can take. One of the best-known examples of a pyramid scheme was run by disgraced investor Bernard Madoff, who was arrested in 2008 after losing some $50 billion of his investor’s funds. (Many investors do not understand how to determine the level of risk their individual portfolios should bear. Read “Determining Risk and The Risk Pyramid.”)
As its name indicates, the pyramid scheme is structured like a pyramid. It typically starts with one person – the initial recruiter – who is on top at the apex of the pyramid. This person recruits a second who is required to “invest” a certain amount, which is paid to the initial recruiter. In order to make his or her money back, the new recruit must recruit more people under him or her, each of whom will also have to invest. If the recruit gets 10 more people to invest, he or she will make a profit with just a small investment.
Further, the new people become recruiters and each one is in turn required to enlist an additional 10 people, resulting in a total of 100 more people. Each of those new recruits is also obligated to pay their investment to the person who recruited him or her. Recruiters get a profit of all of the money received, minus their initial investment paid to the person who recruited them. The process continues until the base of the pyramid is no longer strong enough to support the upper structure, and there are no more recruits. (From pyramid schemes to envelope stuffing, there are a lot of scams masquerading as legitimate part-time work. Read more in “Recognize And Avoid “Work At Home” Scams.”)
The problem is that the scheme cannot go on forever, because there are a finite number of people who can join the scheme (even if all the people in the world were to join). People are deceived into believing that by giving money, they will make more money; however, no wealth has been created, no product has been sold, no investment has been made, and no service has been provided.
The fraud lies in the fact that it is impossible for the cycle to sustain itself, so people will lose their money somewhere down the line. Those who are most vulnerable are those toward the bottom of the pyramid, where it becomes impossible to recruit the number of people required to pay off the previous layer of recruiters. This kind of fraud is illegal in the U.S. and most countries throughout the world. It is estimated that 90% of people who get involved in a pyramid scheme will lose their money.
Despite the illusion of legality presented by these revamped schemes, they are still illegal. Therefore it is important to recognize the characteristics of such so-called investment plans.
Many schemes will adopt the guise of gift-giving or loans that take place in investment clubs because none of these activities are technically illegal. However, the practice of donating a gift to someone (the recruiter), then having to recruit people into the club in order to receive a return on your investment (or your gift, rather) is essentially a pyramid scheme in disguise.
Multi-Level Marketing (MLM)
Legal multi-level marketing (MLM) involves being recruited in order to sell a product or service that actually has some inherent value. As a recruit, you can make a profit from the sales of the product or service, so you don’t necessarily have to recruit more salespeople below you. While you may be encouraged to recruit other salespeople whose sales would give you more profit, you can stick to just selling the product directly to the consumer if you choose.
A pyramid scheme MLM, however, will most likely sell a product with no independent value. The product could take the form of reports of some kind, for example, or mailing lists. In this kind of pyramid scheme, you would be required to recruit new members into the MLM in order to make a profit and keep the MLM alive. Joining the MLM is the only reason anyone would buy the products sold by this pyramid scheme.
Named after Charles Ponzi, who ran such a plot from 1919-1920, the Ponzi scheme is a fraudulent investment plan; however, it is not necessarily a pyramid, which is hierarchical. In a Ponzi scheme, there is one person who takes people’s money as an “investment” and does not necessarily tell them how their returns will be generated. As such, the people’s return on investment could be generated by anything. It could come from money taken from new investors, which means new investors essentially pay off the old investors, or even from money made by gambling in Las Vegas.
Chain letters can be received electronically or through snail mail and are not illegal on their own. However, they can be a pyramid scheme when the letter asks you to donate a certain amount of money (even just $0.05) to the people on a list, then delete the name of the first person on the list, add your name, and forward the letter to a certain number of other people. The next people receiving the letter are then asked to do the same thing, so that you can receive your money as well. By forwarding the letter, you are asking people to give money with the promise of making money.
The Bottom Line
It is easy to see how a pyramid scheme can work, but participating in one (regardless of the form in which it is presented) involves deception and fraud because not everyone will receive the money that is promised in return. As with any other investment plan you consider entering, it is important to ask the right questions. How will this money be invested? What is the rate of return? Who will be investing it? Talk to professionals and do your research before placing your money anywhere. Always remember that if a plan promises you’ll get rich quick with no risk, or doesn’t tell you how your money will be invested, you should exercise caution before getting on board.