What is a Pyramid Scheme?

A pyramid scheme is a fraudulent investing plan that has unfortunately cost many people worldwide their hard-earned savings.  The concept behind the pyramid scheme is simple and should be easy to identify.  However, it is often presented to potential investors in disguised or slightly altered form.  For this reason, it is important to not only understand how pyramid schemes work, but also to be familiar with the many different shapes and sizes that they can take.

As its name suggests, a pyramid scheme is structured like a pyramid.  Its starts with one person – the initial recruiter – who is on top, at the apex of the pyramid.  This person recruits a second person, who is required to ‘invest’ M100.00 which is paid to the initial recruiter.  In order to make his/her money back, the new recruit must recruit more people under him/her, each of whom will also have to invest M100.00.  If the recruiter gets 10 more people to invest, this person will make M900.00 with just an M100.00 investment. The 10 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 100 new recruits is also obligated to pay M100.00 to the person who recruited him/her.  Recruiters get a profit of all of the money received minus the initial M100.00 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 (meaning there are no more recruits).

The problem is that the scheme cannot go on forever because there is a finite number of people who can join (even if all the people in the world joined).  People are deceived into believing that by giving money they will make more money (with an investment of just M100.00, you will receive M900.00 in return).  But no wealth has been created; no product has been sold; no investment has been made; and no service has been provided.

Pyramid schemes are in their nature fraudulent. 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 towards 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 most countries throughout the world. It is estimated that 90% of people who get involved in a pyramid scheme will lose their money.

Because people are attracted to the idea of making quick money with very little effort, many different forms of disguised pyramid schemes have succeeded in fooling people.  Despite the illusion of legality presented by these revamped schemes, they are still illegal.  It is thus 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 gift) is essentially a pyramid scheme in disguise.  No matter how they come, pyramid schemes are illicit because people don’t lose their money due to normal market forces, but because the system requires them to lose so that a few at the top will win.

Multi-Level Marketing (MLM) and Pyramid Schemes

Multi-level market (MLM) or network marketing is an American institution.  Companies like support huge networks of distributors and recruits who sell every type of product.  Salespeople are called independent business owners and generally work from their homes.   On the surface, it is hard to tell the difference between a legitimate MLM and a pyramid scheme.  That is because they are both built on the business model of “multiple levels” of distributors and recruits.  Some critics of MLMs claim that all of them, even the supposedly ‘legitimate’ ones, are pyramid schemes in disguise.   However, a ruling of a Trade Commission in the United States of America found in 1979 that they were not  pyramid schemes.  That ruling has paved the way for hundreds of MLMs to follow this business model.  The main difference between a legitimate MLM business model and a pyramid scheme is that a legitimate MLM focused on selling products, not recruiting more salespeople. In a legitimate MLM, it should be possible to make money by simply selling products directly to customers. With that criterion in mind, here are some other ways to identify product-based pyramid schemes:

-                      Pyramid schemes offer money for simply recruiting people.  This money can come as a commission from the sale of a starter kit or as a recruiting ‘bonus’

-                      Avoid any MLM that puts much more emphasis on recruiting salespeople than selling the actual product

-                      Pyramid schemes charge steep startup costs for joining, including mandatory training, a starter kit and a non-refundable membership fee

Here are some of the most famous pyramid scheme scams from the past and present:

Gifting Scheme

This often has names like dinner party, women empowering women, dinner club, circle of friends or women empowerment network.  This scheme is a naked pyramid scheme in which new participants ‘buy in’ with a set amount of money that is ‘donated’ to the person who recruits them.  They, in turn, are required to recruit more people.  As you collect more recruits, you move up the pyramid, sometimes with colourful names like the ‘salad level’ and ‘dessert level’.  Recruits are promised a substantial lump sum once they reach the peak level.  This scheme often targets women with the idea that through collective donations they are helping each other earn more money.

Ponzi Schemes

A Ponzi scheme is a fraudulent investment plan in which the money is not invested at all.  Instead, every new investment is used to pay off earlier investors.  In 1920, Charles Ponzi ran a scam promising New Englanders in the US a 50% rate of return in 45 days for a convoluted investment involving international mail coupons.  Ponzi ended up collecting $10 Million and paying back $8 Million, leaving $2 Million for himself.  He served back-to-back federal and state prison sentences for mail fraud.  A Ponzi Scheme is not a pyramid scheme because fraud is centralized – controlled by one person or entity – instead of being spread across a network of people who willingly or unwillingly perpetrate the crime.

Affinity Schemes

These target certain ethnic or religious groups.  The scammer presents him/herself as a member of that group and sells the pyramid scheme as a way for people to ‘give back’ to the community while providing job opportunities for other members.  Scammers try to lure in prominent members of the community first to set an example.

Conclusion

It is easy to see how a pyramid scheme can work, but participating in it (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 one may 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?  How come this business is able to generate so much more than other regular businesses are able to?

It is important to talk to professionals and conduct research before placing money anywhere.  Always remember that if a plan promises that people will get rich quick with no risk or does not tell you how people’s money will be invested, it is wise to raise a red flag and exercise caution before getting on board.

For further information, submission of enquiry, or to report a pyramid scheme please contact:

Mr. Thato Mohasoa  

Chief Public Relations (Acting)

Central Bank of Lesotho

Cnr. Airport and Moshoeshoe Road

P.O. Box 1184

Maseru 0100

Lesotho