What they are, how to recognize one
- Pyramid schemes are a type of investment fraud where distributors are incentivized to recruit other distributors.
- The difference between a pyramid scheme and a multilevel marketing business is that pyramid schemes require the recruitment of its members to make a profit.
- Money from pyramid schemes goes to the top of the pyramid as later recruits struggle to find more people to onboard.
- Read more stories from Personal Finance Insider.
Your high school acquaintance sent you a message on Facebook trying to sell you an educational course or maybe a cosmetic product, offering you a chance to do what they do and get rich in a few years. You turn off your read receipts and ignore the message because it’s clearly a pyramid scheme, and it’s clearly illegal.
Surprisingly, in the eyes of the Federal Trade Commission, the difference between a completely legitimate multi-level marketing (MLM) company that is approved by the government – some have even gone public – and a predatory and illegal pyramid scheme is subtle.
What is a pyramid scheme?
A pyramid scheme, also known as chain referral fraud or franchise fraud, is an illegal network marketing business model that prioritizes recruiting over selling any product. “Your income will depend entirely on your success in getting other people behind you,” says Robert FitzPatrick, president of Pyramid Scheme Alert and author of “Ponzinomics: The Untold Story of Multilevel Marketing.”
True to its name, these schemes are structured like pyramids. At the very top is the operator of the pyramid scheme who recruits distributors, who often have to pay a fee for the right to join what they believe to be a legitimate business. These distributors buy inventory, often goods with no intrinsic value, from the trader at high prices, so they don’t make much from the sale itself unless you can reach certain quotas of sale, often inaccessible.
Essentially, the main source of their compensation comes from recruiting other distributors. When you recruit someone successfully, you get a portion of their entry fee and you can offload your inventory to those new distributors. New distributors, facing the same problems, are encouraged to continue the chain and recruit new members.
This creates an unsustainable cycle as the pool of willing participants dries up. If you were to recruit five people for a program, and each person you recruited also recruited five people, “you can only go through 14 levels and you exceed the population of the human race on Earth,” says FitzPatrick. “You don’t wait until Earth’s population is saturated to say, ‘Oh, damn, those last ones wouldn’t have anybody to recruit. “”
MLM vs pyramid scheme
A concrete definition of a pyramid scheme has never been articulated in federal law, much less an articulation of the difference between an MLM and a pyramid scheme.
Without status, pyramid schemes are usually sued for investment fraud or deceptive marketing practices. Most states have their own pyramid scheme laws, which offer stricter specifications. However, the FTC laid the groundwork for answering both of these questions in two landmark cases it prosecuted in the 1970s: Koscot Interplanetary and Amway Corporation.
Two indicators of a pyramid scheme: In 1972, the FTC filed a lawsuit against Koscot Interplanetary, a multilevel marketing cosmetics company. Koscot charged $2,000 for the role of “supervisor” in addition to $5,400 for the merchandise these supervisors were expected to sell.
The FTC identified two criteria that made Koscot a pyramid scheme: Distributors had to pay the right to sell merchandise, known as a “headhunting fee,” and they received rewards for recruiting others. participants completely separated from the sale of products.
How pyramid schemes differ from MLMs: A few years later, in 1979, another landmark case, this time against Amway Corporation, resulted in two unofficial rules an MLM could follow to avoid being classified as a pyramid scheme: the 10 retail customer rule and the 70% rule.
Amway’s business model had top distributors purchasing their supplies directly from Amway, who then sold their products to end users as well as the distributors they recruited. The more distributors you recruit, the easier it is to sell your own products and reach your monthly bonus quota, providing a strong incentive to recruit.
The FTC found that Amway made misleading claims when recruiting distributors, but stopped short of calling Amway a pyramid scheme because the FTC determined that certain policies sufficiently encouraged selling to end users rather than the recruitment. For one, there were no headhunting fees as Koscot required.
Amway also sufficiently incentivized end-user sales by requiring distributors to make an end-user sale to 10 separate customers to qualify for a monthly bonus. Distributors were also required to repurchase any merchandise their recruits purchased from them upon request. Additionally, distributors must also sell or consume 70% of the inventory they purchased to receive a bonus, which prevents distributors from hoarding too much merchandise just to meet certain quotas.
Both the 10 retail customer rule and the 70% rule have become common business practices among MLMs to avoid being called a pyramid scheme by the FTC. “If Amway was legal, then after that every other multilevel marketing company on Earth said, ‘We operate like Amway,’” says FitzPatrick.
How to detect a pyramid scheme
Being able to recognize a pyramid scheme is important not only so you don’t fall for the trap, but also so you don’t get involved in the lawsuit yourself. Recruiting people into a pyramid scheme is illegal and can land you in jail whether or not you were also a victim.
Membership costs you money: The most glaring feature of a pyramid scheme is that you will have to pay a fee for the right to sell anything a company offers, either to the company itself or to anyone who recruits you.
An MLM follows the endless chain model and prioritizes recruitment: Regardless of what the MLM claims, if you find there’s more incentive to recruit new members than to sell your inventory, chances are the MLM leans more heavily towards a pyramid scheme than there is. a legitimate business.
Climbing the corporate ladder comes from recruiting, not appointing: Normally, a promotion in a company is a deliberate decision made by an individual or a group of people. However, in a pyramid scheme, you move up the ladder by adding to the number of people below you.
Even if the MLM you signed up for isn’t legally a pyramid scheme, there’s a good chance you’ll lose money or break even rather than making money. A 2018 AARP report found that 25% of MLM participants made a profit. Meanwhile, 27% of participants broke even, leaving 47% with losses. In most cases, it is best to avoid this system altogether.
Ponzi scheme vs pyramid scheme
Ponzi schemes are similar in structure to pyramid schemes, particularly their use of the endless chain model. Both programs also come with huge promises about the kind of returns their victims will see down the line. Ponzi schemes promise high returns with little risk while pyramid schemes offer stable and passive income to the people they recruit.
FitzPatrick says the difference between the two schemes is that “pyramid schemes are fraud in disguise, Ponzi schemes are fraud in concealment.” In other words, Ponzi schemes must operate undetected because they are indisputably illegal. Once a Ponzi scheme is exposed, it’s game over.
On the other hand, the legal line between an illegal pyramid scheme and a completely legal MLM is nebulous, even with established precedents. MLM participants are usually left on their own to solicit sales or recruiting, so if they fail and lose money, an MLM can blame it on the individual participant’s failures instead of any structural issues. with the program. “You didn’t get screwed. No, you just failed in business,” FitzPatrick says.