Pyramid Scheme: What Is it and How Does It Work?

Pyramid schemes are one of the world's most well-known forms of financial fraud. For many years, they have victimized people who trust the promises of quickly making easy and significant profits. The frightening thing about these schemes is that they are built on a "business model" doomed to collapse.

It is essential to understand what principles the pyramid operates in to be able to reveal and then avoid involvement in such a scam. Common misconceptions include clarification on pyramid schemes with legitimate multi-level marketing (M.L.M.) businesses and underestimating the risk involved. This article helps the reader become more confident in assessing cases and the degree of risk in dealing with unknown trading companies.

What is a Pyramid Scheme?

A pyramid scheme is an investment plan that pays returns to earlier investors using the investments of recruits, not through actual business operations. This model is unsustainable as it relies on continuous recruitment. Unlike legitimate businesses that generate revenue from selling products or services and pay commissions based on sales performance, pyramid schemes make money primarily from recruiters' entry fees. Participants often buy starter kits or pay fees to join, with the promise of earning commissions by recruiting others. The scheme collapses once recruits stop joining, making it inherently unsustainable.

Historical Context

The actual operation of the pyramid structure can be traced back to the early 20th century. Among the first and the most well-known is the Ponzi scheme, named after Charles Ponzi, who defrauded numerous investors in the mid-1920s with the promise of high returns due to non-existent international post reply coupons and coupons' arbitrage.

More well-known pyramids recently identified include the Madoff investment scam, which involved defrauding investors of a whopping $65 billion. These examples should be understood as signs of the danger of pyramid schemes and their influence on particular persons and even the whole economy.

How Does a Pyramid Scheme Work?

Pyramid schemes operate on a simple yet deceptive principle: they offer a very high rate of returns to all first investors and operate on recruits' funds. This leads to increased participation of players in the markets and businesses, as it gives the impression of earning profits.

Basic Structure

Generally, a pyramid scheme is a pyramid compound of people who share a payout matrix whose keys are recruited by other individuals who recruit others, and so on, as shown in the diagram below. The participants normally need to pay an entry fee or even purchase a particular product that is on sale, and in return, they are supposed to be paid commission from the other people that they have managed to attract into the program.

Money Flow

The pay structure in a pyramid scheme is simple and illogical regarding cash movement. Initial participants get their share from the fees or capital of subsequent participants. This gives the impression of profit-making and mandates continuous recruitment. However, having hit the limit of participants, fewer and fewer people are eager to participate, which eventually leads to the scheme's failure.

Fresh entrants are central to the perpetuation of the scheme since the money of new members is used to pay the promised returns of the old members. Whenever recruitment stagnates, the scheme cannot generate adequate revenues to compensate its members, leading to the collapse of the particular scheme.

Red Flags

A red flag from a pyramid scheme should get you to avoid it and stop yourself from losing a financial investment.

• Most of the emphasis is on recruiting other individuals instead of selling legitimate services or products.
• It assures you of very high or even guaranteed returns you will unlikely lose.
• It has compensation plans that need to be revised and call for more emphasis on recruitment alone.
• Pressure on you to recruit friends and family in the program; high-pressure tactics. 

Types of Pyramid Schemes

Pyramid schemes vary in their makeup, but the essence is similar.

Classic Pyramid Scheme

In this type of pyramid scheme, individuals must make an initial investment by paying an entry fee and are then supposed to recruit others for which they receive commissions.

Multi-Level Marketing (M.L.M.) Pyramid Scheme

Most legitimate multi-level marketing(M.L.M.) companies emphasize product sales. In contrast, a fraudulent M.L.M. the pyramid scheme has its facade as a legitimate business. Still, it stresses recruitment, making people purchase high-priced product packages and then recruiting others to buy in and achieve commissions.

Chain Letters

These include forwarding money or gifts to people on a given list, believing that more money or gifts will be received once others join the process. These schemes require people to enroll in an ongoing manner and are bound to fail once people cease to enroll.

Ponzi Scheme

A Ponzi scheme, named after Charles Ponzi, is fraudulent investing in which returns are paid out of the investments from the new investors. This gives an impression of profitability, but the structure is built to fail as new investments dry up.

Internet-based Schemes

Such programs are now executed online, mainly focusing on investing in cryptocurrencies, pay-per-click advertising, or any other affiliate Internet business.

Pyramid Schemes vs M.L.M.s

Determining the difference between pyramid schemes and legitimate M.L.M. may take much work. However, key differences can help identify each model:

• As we have seen, legitimate M.L.M.s focus their operations on product sales and pay participants based on the volume of sales made, while pyramid schemes rely mainly on recruitment.
• M.L.M.s have valuable products or services to sell; pyramids have unreasonably high and low-quality products.
• Standard legitimate M.L.M.s are product-based organizations that make sustainable businesses, while pyramids are primarily based on add-ons and are, hence, unsustainable.

Pyramid Schemes vs Ponzi Scam

Pyramid schemes and Ponzi scams share similarities but differ in key aspects:

• Pyramid schemes are a type of deception based on creating a large network of participants, while Ponzi scams involve obtaining investments and returning the money without conducting business activities.
• Pyramids depend on recruitment fees, and Ponzi schemes use the money of newly arrived investors to pay the earlier participants.
• Most pyramid schemes focus on recruiting people, while Ponzi scams are aimed at conning investors with fake prospects of high returns.

Legal Aspects

Pyramid schemes are unlawful business models that are fraudulent and highly destructive to consumers. Different laws and regulations are in place to combat these tricks and shield consumers.

Laws and Regulations

Pyramid schemes in the United States are unlawful due to the provisions of the federal law regarding the Federal Trade Commission (F.T.C.) Act. The F.T.C. and the Securities and Exchange Commission (S.E.C.) are usually used to regulate and investigate pyramid schemes. Such laws are also present in other jurisdictions to try and curb the spread of such cons.

Consequences

There is always a legal penalty if one organizes a pyramid scheme or joins another's scheme. The organizers are likely to be charged with a criminal offense, charged with very high amounts, and even imprisoned, while the participants stand to lose their investment and even face the law.

Real-Life Examples

Analyzing real-life examples of pyramid schemes is likely to yield detailed information about their effects and can help warn people against them.

Famous Pyramid Schemes

Some well-known pyramid schemes include:

• Bernie Madoff's Investment Scandal: Madoff swindled his investors out of billions of dollars through a Ponzi scheme, which led to his arrest and 150-year imprisonment.
• Albanian Pyramid Schemes: In the 1990s, numerous pyramids in Albania caused an economic crash and political agitation that affected hundreds of thousands of citizens.

Case Studies

A.C.N. Scam

In 2003, A.C.N., a telecommunication company, was alleged to be a pyramid marketing firm in disguise by offering people the opportunity to earn money by selling its products online. People were attracted to this type of position by paying an initial cost of approximately $500, which regarded them as independent sales agents who were paid commissions on sales and recruits.

However, many participants still needed to regain their initial investment, not to mention making any profit since recruitment was a primary focus at the expense of sales.

The Fortune Hi-Tech Marketing Scheme (F.H.T.M.)

F.H.T.M., a well-established M.L.M. company, was functioning from 2001 until it was closed by the F.T.C. in 2013. The company was said to generate massive income from selling the products and recruiting members. The F.T.C. analyzed working participation in the M.L.M. schemes, revealing that most of the participants worked for less than the price of entering the program, and most of the profits generated in the pyramid went to the owners. Some of the participants experienced anxiety and depression due to stressing issues that accompanied losses in finances and being involved in scams.

In conclusion pyramid schemes are a global issue with severe consequences. It is crucial to understand their operation, recognize scam signs, and distinguish them from legitimate businesses. To protect yourself, educate yourself about these schemes, research investment opportunities thoroughly, and be skeptical of high returns with low risk. Verify a company's legitimacy by ensuring its revenue comes from product sales, not recruitment fees. Consult with financial advisors if uncertain, and report suspected schemes to authorities. Increasing awareness and developing critical thinking skills can help individuals avoid scams and protect their economic well-being. Staying informed and cautious is the best defense against these deceptive schemes.