Pyramid Scheme

January 24, 2016 by: Content Team

A pyramid scheme is a fraudulent business model that uses new recruits, who are promised payment to enroll others. The illegal investment scam begins when an individual or company recruits investors by promising high returns. These recruits are led to believe that the more people brought into the business, the higher the profits will be. Pyramid schemes only benefit the first few groups of recruits and they tend to end quickly. To explore this concept, consider the following pyramid scheme definition.

Definition of Pyramid Scheme

Noun

A dishonest business scheme in people pay to join, and profit from payments made by subsequent recruits.
which many people are convinced to invest in the business, their money is then used to pay the

Origin

1949 First known use of the term

What is a Pyramid Scheme

A pyramid scheme is a specific business model in which an individual or a company invests into the business, with a promise of receiving profits that increase as more members are recruited. Many pyramid schemes appear to offer products or services, but the true nature of the investors’ income is based on the number of new members recruited by each member.

Participants who recruit a “downline” below them receive a percentage of each of the new members’ earnings, which again increases when those members recruit, and so on. While each pyramid scheme is billed differently, they all have one thing in common: The investors make money by recruiting more investors, rather than on investment strategies, or the sales of products to the public.

Example Pyramid Scheme

Max is approached by a friend, Nathan, who has recently started a business offering organic cleaning supplies. He tells Max that he too can get in on the “ground floor” of a skyrocketing business, for only the cost of his demonstration kit and some product.

Nathan explains that, not only will Max earn a percentage of each product sold, but if he recruits new members, he will make a set fee for each of those members’ sales, and their recruitments as well. This pattern continues downline, with the earliest investor/recruiters making money off each member below him, including the people his recruits recruit.

Structure of Pyramid Scheme Profits

Each investor brought into a pyramid scheme profits by recruiting others.

Mark’s Initial Investment $200
Recruit levels	Profit from recruit 1	Profit from recruit 2	Profit from recruit 3
Level 1 $50 x 3 = $150	$50	$50	$50
Level 2 (Level one’s recruits)$30 x 9 = $270	$30 x 3	$30 x 3	$30 x 3
Level 3 (Level two’s recruits)$20 x 27 = $540	$20 x 9	$20 x 9	$20 x 9
Promised return after recruiting members on 3 levels	$960

In the example table above, Mark is brought in as an investor, on a promise that, if he invests $200, and follows the plan, he will make a high return. Mark is told that, for each of the first three recruits he brings in, he will receive $50 in payment.

He must then instruct each of his three recruits to bring in three new members, for which they will receive $50, and Mark will receive $30. Each of those nine recruits are instructed to bring in three new recruits, for which they will receive $50, Mark’s recruits will earn $30, and Mark will earn $20.

Characteristics of a Pyramid Scheme

There are certain characteristics of a pyramid scheme that sets it apart from other fraudulent activities. Generally, pyramid schemes are initially promoted through outlets such as social media sites, company websites, and videos. They often go to great lengths to ensure the business looks legitimate, making it easier to draw in investors. The distinguishing traits of such a scheme often include:

Emphasis on Recruiting – The program focuses primarily on recruiting additional members, for which recruiting members will make more money than they would for selling any product that might be offered. A pyramid scheme focuses on compensation for recruiting rather than for sales and services.
No Genuine Products or Services – Commonly, there are no actual products or services being sold. Some of these scams may claim to offer a “tech” service, and e-book, or other type of service, but in reality, there are no products sold.
Complex Commission Structures – Pyramid schemes often involve complex commission structures. These are often confusing, but sound terrific to potential investors, inducing them to join the program.
Offer of Easy Income – Pyramid scammers draw people in by convincing them they can earn a lot of easy money in a short amount of time. Offers of compensation for doing nothing more than recruiting others, are often fraudulent activities

Difference Between Multi-Level Marketing and a Pyramid Scheme

In a legitimate multi-level marketing (“MLM”) program, participants earn an income from the actual products or services that they sell. These participants, often referred to as “distributors,” may be encouraged to recruit additional distributors of the product, for which they earn a small percentage of those distributors’ sales as well. The defining characteristic, then, of an MLM, is that the distributors’ income comes directly from sales, even if a percentage comes from the sales of those in their “downline.”

Many pyramid schemes are promoted as multi-level marketing business opportunities. Many will even purport to sell a product or service. The difference between multi-level marketing and a pyramid scheme, however, is that the participants in the pyramid scheme are paid primarily from the recruitment of other people to participate in the scheme. The founders of the “money-making opportunity” use money from the new recruits’ entry fees to pay recruiting commissions, and pocket the rest.

Pyramid Scheme Fraud

There are no federal statutes that specifically address pyramid schemes. However, the Federal Trade Commission often prosecutes those involved with pyramid schemes for using deceptive trade practices, or for committing outright fraud. Each state has distinct laws aimed at preventing and combating pyramid scheme fraud.

If a person is charged with running, promoting, or being involved with, a pyramid scheme, he may be subject to fines, restitution, and imprisonment. Additionally, victims may file civil lawsuits in which, if successful, the fraudster may be ordered to repay their money.

When a person becomes involved in a marketing or sales business opportunity as a distributor, he is legally responsible for any claims he personally makes about the company, and the business opportunities available. This is how pyramid scheme fraud is perpetuated. It is true, even if the person is simply repeating information and claims learned by reading a brochure or manual given to him by the company, which makes it the distributor’s responsibility to thoroughly check out the legitimacy and legality of the company, as well as the marketing scheme.

That’s not all, if the individual engaging in the pyramid scheme solicits new distributors, he is then responsible for any claims made about the recruits’ earning potential. If the promises of earnings do not pan out, the individual can be held liable. Pyramid scheme fraud affects every person brought into the program. It is for this reason, that laws target every person perpetuating the ruse, and recruiting new people.

Example of Pyramid Scheme Fraud

John meets with Amy and her husband Paul, to demonstrate to them the exciting business opportunity he has invested in. John shows several products to the couple, then excitedly tells them what a wonderful earning opportunity the company provides. He confides in Amy and Paul that they too can earn money simply by purchasing a starter kit, which includes sample products and a training video, for $149.

Amy believes she could earn money while Paul is working, so they couple makes the purchase. When they receive the starter kit, Amy realizes that, to make any real money, she will need to build a downline by recruiting additional distributors, from which she will earn a percentage of their sales. In fact, as Amy becomes involved, she realizes that very little money is actually made selling what few products the company offers, but an emphasis is placed on recruiting new people.

This is the very definition of a pyramid scheme, and it is illegal. In this example of pyramid scheme fraud, Amy has unknowingly participated, just by recruiting new distributors, using the company-provided brochures and materials, she has engaged in pyramid scheme fraud herself.

The Truth About Endless Earning Potential

Operators of pyramid schemes promote recruiting, building up an elaborate tale of endless earning potential through downlines. It is not uncommon for participants to be advised to recruit a minimum number of additional participants, who are in turn encouraged to recruit that number of people, each participant earning money from everyone in their downline.

The truth about endless earning potential in such a scheme is that it is impossible, due to market saturation. For example, if the program’s founder recruits only two people, who are each required to recruit two people, and so on, it would take only about 30 levels to encompass every man, woman, and child in the United States. That is 30 levels from the founder, not from each recruit.

Warning Signs of a Pyramid Scheme

The U.S. Securities and Exchange Commission (the “SEC”) warns that the number of ways fraudsters have dreamed up to promote fraudulent pyramid schemes as MLMs and other money-making opportunities, is truly mind boggling. Consumers, who have become increasingly suspicious, are still duped by new tactics. There are, however, certain warning signs that a business opportunity may be a pyramid scheme, and bears further scrutiny. The bottom line is, if the promises and pitches seem too good to be true, they probably are.

According to the Federal Trade Commission, the warning signs of a pyramid scheme include:

Focus on Recruiting – The company drives participants to recruit others to join for a fee, or promises profits based primarily on income from a downline.
Requirement to Buy Large Amounts of Product – The company requires participants to purchase products in bulk, or on a regular schedule, to stay in good standing with the company.
Passive Income – The company offers to pay recruits for doing very little actual work, such as recruiting others, placing advertisements, or making payments.
No Genuine Product or Service – The program seems to offer no actual product or service, or offers something that is speculative, or is inappropriately priced. It may claim that others handle sales of actual products, while recruiting people who are paid to do more recruiting.
Unrealistic Promises of High Returns – The company promises recruits that they will earn fast cash, and a lot of it. These claims are often dressed in promises that recruits can be living a lavish lifestyle in a short period of time.
Complicated Commission Structure – If earnings are not based on products or services actually sold by recruits outside the program, or if recruits are not sure of how they will be compensated, closer scrutiny should be made before joining. Any additional investigation should be done outside the company, not relying solely on claims or information provided by company representatives or other recruits.

Amway Pyramid Scheme Claims

In 1959, Jay Andel and Richard DeVos formed an American company to sell health, beauty, and home care products through a multi-level marketing system. IBOs of Amway products become “independent business owners” (referred to as “IBOs”), who sell products to customers, as well as recruit and mentor more “independent business owners.” These participants earn income both from direct product sales, and from the sales and recruiting of their downlines, through Amway’s tiered distribution model.

In 1979, the U.S. Federal Trade Commission launched an investigation into Amway’s pyramid-like scheme, but ultimately ruled that the business model, which does not pay people to recruit others, was not illegal. The FTC did fine the company for price-fixing, and ordered it to change its practices.

In 2007, a group of Amway IBOs filed a class action lawsuit, claiming the company had misled them about their ability to make money, and how much it would cost them to be part of the business, and that they used other illegal and unfair business practices. The complaint alleged Amway was involved in fraud, racketeering, and operating an illegal pyramid scheme.

Three years into the lawsuit, the company entered into a settlement agreement with the plaintiffs, in which Amway would admit no wrongdoing, pay the plaintiffs $150 million, and change their business practices. Some of the changes to be made include greatly increasing the amount of money it invests in training of IBOs, expanding their money-back guarantee to include all products and training materials purchased by IBOs.

These and other changes are intended to address the plaintiffs’ claims that Amway placed an inordinate amount of emphasis on recruiting new IBOs, and selling training manuals and products to the new participants, rather than on the actual sales of products. These characteristics are classic indicators of a pyramid scheme.

Herbalife Settles Pyramid Scheme Lawsuit

Herbalife International is a multi-level marketing (MLM) company founded in 1980 by Mark Hughes. The company, which develops and sells nutritional supplements, including weight management, sports, and personal care products, grew rapidly expanding to operate internationally in 95 countries.

In April, 2013, former Herbalife distributor, Dana Bostic, filed a class action lawsuit against the company, claiming distributors had difficulty selling the products because distributors higher up on the chain were able to buy their products from Herbalife for less. Bostick’s complaint stated that Herbalife systematically rewarded distributors for recruiting new distributors, and placed an emphasis on recruiting over retail sales.

Recruits to Herbalife are required to buy a large stock of Herbalife products, which they are left to their own devices to sell. The question raised by Bostick’s lawsuit is whether the company, and its distributors, make money from consumers buying their products, or if new distributors are being lured into buying those products, and ultimately being unable to sell them.

In 2015, Herbalife agreed to settle the matter before trial. The settlement agreement included the following provisions:

Herbalife to create a $15 million settlement fund to compensate distributors who joined Herbalife as a business opportunity, and lost money as a result
Herbalife to create a $2.5 million compensation fund to reimburse distributors who returned unopened, unused Herbalife products
Herbalife to make significant changes to its business policies

Related Legal Terms and Issues

Civil Lawsuit – A lawsuit brought about in court when one person claims to have suffered a loss due to the actions of another person.
Class Action Lawsuit – A lawsuit filed by one person, on behalf of a larger group of people with a common interest in the matter.
Criminal Charge – A formal accusation by a prosecuting authority that an individual has committed a crime.
Damages – A monetary award in compensation for a financial loss, loss of or damage to personal or real property, or an injury.
Downline – A multi-level marketing term that refers to the members you have recruited, or who have joined the program after you did, and whose sales or referrals also generate income for you.
Federal Trade Commission – An independent federal agency tasked with protecting consumers and ensuring a strong, competitive market by enforcing antitrust and consumer protection laws.
Fraud – A false representation of fact, whether by words, conduct, or concealment, intended to deceive another.
Liable – Responsible by law; to be held legally answerable for an act or omission.
Plaintiff – A person who brings a legal action against another person or entity, such as in a civil lawsuit, or criminal proceedings.
Restitution – The restoration of rights or property previously taken away or surrendered; reparation made by giving compensation for loss or injury caused by wrongdoing.
Victim – A person who is cheated or deceived by the dishonest of another.