The pyramid scheme is one of those investment world terminologies about which we hear a lot but understand a little.
There is always a pall of secrecy, and it will be remaining in mystery.
You know that it is illegal and normally when pyramid schemes are out, there is a lot of excitement in the market.
Here I’m going to explain the important characteristics of the pyramid program.
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But The Question Remains; What Is a Pyramid Scheme?
In very simple terms, it is a predominantly illegal investment scheme that is mostly based on a primarily hierarchical setup.
In this case, an individual or a business establishment starts off this scheme by bringing in new investors by a promise of returns.
The fundamental pyramid scheme definition
The earliest investors in the scheme start earning a relatively high rate of return as the scheme begins to take off.
But the question is from where this fund is coming in to pay off their returns.
Well, these gains are generally paid by the new recruits who join the pyramid scheme and form the base of the pyramid.
So, you can understand the return is not really a premium you earn on an existing investment.
On the contrary, it is just an adjustment of returns and liabilities.
Surprisingly the liabilities keep exceeding the assets in the absence of any real and dependable investment.
That is exactly why you can consider the pyramid more of a scam than a scheme.
Therefore the only way it stirs up more funds is by attracting and convincing more and more new recruits to join.
And promising them unrealistic returns on their investment.
So the return is the payment that they make.
Then they are constantly dependent on some new recruit joining the scheme to fund the return promised to other members.
What happens is invariably these pyramid schemes lose steam and collapse beyond a point.
Pyramid Scheme Definition
If you want a definition of the pyramid scheme, you could perhaps consider this as a variation of the commonly ‘Ponzi scheme’.
The reason that these schemes succeed is that the promise of phenomenal returns.
Those promises that are almost impossible to imagine in a conventional or traditional investment instrument.
What the pyramid scheme essentially banks upon is the average ignorance of the investors.
They only have a tunnel focus towards the high returns, and no attention is paid to the method applied to achieve that rate of return.
The members of this kind of scam convinces more and more unsuspecting investors into falling for that trap.
They recruit more of such victims and collect money.
This constant recruitment of new investors gradually push them up to the top of the pyramid.
At the end they tend to enable them to earn extraordinary profit numbers.
A typical pyramid scheme, person A recruits the member B to invest a certain minimum fund in the scam to recover his investment.
Similarly, B looks to recover his investment by recruiting more people under the same scheme.
This one by one recruit is what results in gradual expansion of the pyramid base.
More the number of people a person recruits, greater the returns he earns.
That said, every member has to recruit a certain minimum number of members to join the pyramid scheme.
The scam continues for as long as new people keep getting more to the base of the pyramid.
The moment this number dwindles, and the pyramid becomes top heavy, it collapses under its own weight.
As you can well imagine that only the people, who reach the top of the pyramid earlier and stay there for a longer while, earn a significant profit.
The later you join the pyramid, the amount of profit that you earn from this entire scheme will be less.
Pyramid Scheme Created By Big Businesses
You will be completely fooling yourself if you think that pyramid scheme created by one time and independent individuals.
In fact, you should know that there are also multi-level marketing companies that have the same structures as the principles of the pyramid structure.
This process enables individuals to not just invest in their own businesses to distribute a product, but also influence others to join their business.
Therefore, it comes as no surprise that the profit is more from inducing others to buy into the business rather than distributing or selling the products that the business is offering.
Given the overall returns, the initial members can earn from this type of a pyramid scheme.
It is obvious that there are several types of business who have the same structure to use this strategy for earning quick returns.
In some cases, the Government is able to identify the inherent scam and take actions.
One of the most high level pyramid scheme is the Herbalife.
In the case of this company, the distributors of Herbalife could earn money by selling the products of the company.
But they had to buy and sell products worth thousands of dollars before realizing any profit whatsoever.
This is essentially courtesy this pyramid scheme.
The company’s top recruiters are earning a massive profit while those at the bottom kept struggling with a huge inventory.
It was only in 2014 that the US FTC or the Federal Trade Commission had the overall probe in the business fundamentals of Herbalife.
After receiving allegations that the Herbalife nutritional supplement major is in a pyramid like investment scheme.
It could be brought to light only after two years of a non-stop crusade by Will Ackman of New York’s Pershing Square Capital Management.
They took a $1 billion short position on the Herbalife stock.
A Major Fraud at Work
The most striking fact about a pyramid scheme is the fact that the very factors that help in its growth are also the reasons for its eventual collapse.
The problem is that the success of this scheme is deeply dependent on the constant addition and expansion of the pyramid.
The moment this pyramid becomes top heavy, it collapses under the pressure of its own weight.
After all, there are only a finite number of people who could possibly join a particular pyramid.
The premise on which the pyramid is in deception at every level.
People join in believing that they will earn more money by putting in some money.
The facts are…
- There is no wealth
- No product is sold
- Zero profit gain
- Any investment was made
- Provides no services
It is almost like building a castle in the air knowing well that the pyramid cannot go on forever and will collapse at a certain point of time.
While some people will earn a huge profit, those at the bottom of the pyramid might end up booking severe losses.
They are in fact the most vulnerable ones
Often it becomes almost an impossible task to keep hiring a fresh set of recruits to pay off the returns of those who are among the last to put in money.
The pyramid scheme is classified as a fraudulent transaction and is illegal in the US and most other countries.
Studies have shown that almost 90% of the people who engage themselves in this kind of fraud, they end up losing money and book severe losses.
Only those at the extreme top are the ones that log in strong gains and extraordinary returns on the base amount.
Technically on the face of it, none of these is illegal;
And you need to dig deeper and read the fine print before identifying the inherent fraud in the entire operation.
What starts as a gift contribution as a result of an inconsequential chain mail actually is money paid to a potential recruiter.
Therefore, puts the obligation on you to recruit a certain minimum of numbers to recover the returns on your investment.
Common Types Of Pyramid Schemes
That says, investors and Ponzi scheme master’s never seem to deter from the path of creating this absolutely fraudulent pyramid schemes.
Most wonder, some get minimum returns while for a few, it results in an absolute windfall;
Therefore, perhaps this is the reason that they continue to keep surfacing every once in awhile.
In fact on a much basic level, the pyramid schemes prevalent almost at every type of investment destination.
The trick is to identify the fraud and shield your savings.
This is by far the most popular type of fraudulent pyramid scheme that you might have heard about.
In this investment plan, in reality, there is absolutely no money to invest.
A masterpiece fraud scheme, every new investment in this case is to pay off the prior investor.
It was run by the famous New Englander Charles Ponzi in 1920.
Charles Ponzi promised all investors in his scheme with whopping 50% return in just 45 days,.
Then the investment international mail coupon system.
By the end of it, Ponzi was able to collect a massive $10 million and paid back only $8 million.
Therefore, making a cool $2 million without investing a single penny anywhere or in anything.
But back to the Ponzi scheme, in strict investment parlance;
It is not exactly a pyramid scheme as a control, he is more organize and only one person is responsible for the payoffs.
However, this is the earliest version of the whole fraud that kept maturing at every stage.
Penny Stock Scam
With the passage of time, the pyramid scheme began gaining more stature and prominence.
In this context, one of the best known and the hottest current day pyramids is no doubt the penny stock scams that abound across the globe.
Most times, these penny stocks are send via innocent emails in your spam messages.
The emails have a very generic and catchy kind of opening lines and subjects like;
‘big investment opportunity’ ‘make 50% returns in 5 months’ and the like.
The reader kind of gets curious to these opening lines and what follows next is the unveiling of a massive level of deception at every step.
It follows a systematic trap that is laid out for unsuspecting investors keen to make a lot of money in a short time without any due diligence.
First and foremost the creators of these kinds of pyramid schemes make a shell company.
What Are Their Assets?
Almost always these companies do not have any type of asset or structure.
They are a mere stock and symbol on the stock exchange.
The stock is then offered to the investors with an assurance that this company will soon be merged with the existing public company that has definitive revenue and profit on the balance sheet.
Invariably not more than 20% of the stock is sold to the public.
Most of the founding members or the scammers hold a massive share as much as 80%.
As a result, when the IPO is floating, and the stock goes public, it ensures that this majority shareholding party gets a massive windfall.
Meanwhile, the stockholders of the 20% stake are paying more than regular and reasonable pricing even at penny level for these shell companies as there is only notional value in their investment.
The stock price invariably shoots up soon after the IPO, and the scammers try and buy back as much of the shares as possible.
Giving it a glimpse of credibility and letting those who exit early earn some basic profit.
The Bigger Fraud Starts Unfolding
But this is also where the fun starts or shall we say the bigger fraud starts unfolding.
As the stock price continues shooting upwards following basic stock market principles of demand and supply, they suddenly need more investors into the stock.
Chunks of stocks are then void through misleading statements about the stock via spam emails, especially the upcoming merger.
This buzz around the stock leads to overall price appreciation and investor demand.
More the investor demand you generate, higher the price goes resulting in many unsuspecting investors buying these stocks even at double or treble the fair value of the stock.
Eventually someone begins to probe and tries to ascertain fair value for the stock.
Eventually as usual, the real perpetrators have long sold their shares and enjoying the neat profit.
People who are left with the hugely expensive junks are those at the bottom of the pyramid.
The share price understandably plummets sharply leaving no exit options for these investors. Invariably they book deep losses.
These are another terribly popular kind of pyramid schemes that are often used by scheming fraudsters.
These essentially target specific religious groups or ethnic community and aim to take advantage of their affinity towards their fellow group members.
The most common ploy in this case is that the fraudsters present themselves as members of the group.
The he coax the target investor to contribute towards the community.
Targeting influential members to build more credibility is often the chosen mode of operation.
Famous Pyramid Schemes
Apart from HerbaLife, some of the most famous pyramid schemes that you must have heard or read about in recent times include many leading corporate.
Here is a quick lowdown on the ones that made headlines.
Nu Skin Enterprises
This public company founded in 1984 and net revenue of over $2 billion is a maker of skin supplements and skin care products.
The US regulatory authority, FTC probe this company in the 1990s on charges of creating pyramid schemes.
Along with the FTC, the states of Connecticut, Pennsylvania, Florida, Illinois, Ohio, and Michigan also joined the proceedings.
The company ended up paying close to $2.5 million to the FTC for settling all the cases against it.
But the matter did not end there.
The Connecticut Attorney General was not very happy with the original settlement terms and went to sue the company for operating pyramid scheme.
Nu Skin settled the case paying $85,000.
The company was then investigated by Chinese agencies as well for illegal pyramid scheme in 2012.
Another privately holds the company founded in 1959, this health and beauty company has often been subjected to pyramid scheme allegations.
With net revenue of close to $11 billion.
This is not just the most profitable direct selling firms and attracted the FTC probe because distributors are not paid for recruiting new salespeople.
In 2010, they settled a $100 million class action lawsuit.
Most famously known for the ‘Pink Pyramid Scheme’.
Mary Kay was highlighted in 2012 by the Harper Magazine for the following comments…
That the only way to generate revenue is by recruiting other people to sell products.
Though as per FTC norms, receiving commission in return of actual products sale is legal.
The reality is the majority of sales happen between company and sales people.
USANA Health Sciences
Another public company in the US that works in pyramid scheme allegations was the USANA Health Sciences.
Founded in 1992 and a nutritional supplements maker, their revenue was $790 million;
They’ve got into trouble when Barry Minkow a fraud felon an investigator sent a 500-page report against the company to SEC., IRS and the FBI.
In the report, he accused this firm of operating multiple pyramid schemes illegally.
The matter was that the company’s auditor suddenly quit soon after this.
He was serving a rather long term in the company.
Though the USANA filed a defamation suit against Minkow, they eventually settled the case in 2008 for an undisclosed amount.
While SEC and FBI both probed the company, it remains an active nutritional supplement manufacturer.
You would have notice that in most of these examples that have gotten in pyramid scheme allegations are often firms where the product itself does not do terribly well.
Therefor cannot be quite attributed to the huge revenue that they have been clocking on the overall balance sheet.
When the profit margin from the product is that slim, the only way to make quick money is through the fast recruitment of sales personnel.
The Profit Margin Remains Questionable
The eventual market saturation often spells the undoing for these firms.
While it is quite easy to understand how pyramid schemes work, identifying one can be a major challenge.
Often before a person realizes, a significant amount of time and money has already been lost and the fraud has already taken up a humongous proportion.
It mostly involves fraud and deception and breach of trust at every level.
This is because of the premise that everyone likes making some quick buck sand sometimes in a hurry to make a lot of money in a short time;
one tends to overlook the most obvious aspects of investment.
Therefore, caution is the keyword in the business districts.
You need to be extremely careful about how you handle every penny that you invest.
Pyramid schemes are often the result of word of mouth propaganda.
It is always better to invest in a scheme that has strong fundamentals rather than hypothetical assumption.
The common and average investor often makes the mistake of trusting more on what others have to say rather than what their brain tells them.
So as a result, the obvious confrontation with deception, fraud and absolute disappointment.
Remember what sounds too good to be real cannot be real, even monetary returns has a ceiling by the boundaries of what’s actually possible.
It Looks Like a Pyramid Scheme to Me
Sometimes pyramid scheme is not all about money.
A management system can also look like a pyramid scheme.
Of course this kind of pyramid scheme is not illegal because it is how the management systems work.
There is always someone at the top who is the CEO of the company.
Then there are lower levels like president, vice president, managers, supervisors, and finally the employees.
These systems look like a pyramid scheme but they are completely different from the illegal ones that we know.
However, there are some similarities between these management pyramid schemes with the investment ones.
The most important similarity that will finally cause this management systems to become illegal;
Is that it is only the top levels who are happy with the system and the lower levels, specially the employees, are always unhappy.
The other similarity is that there is no chance for an employee to upgrade and reach any of the higher levels.
Even if they are always been the hard-working employees.
It is like the investment pyramid schemes that those who join the program later, will be place at the lower levels and will never have the chance to go higher.
Always it is just the top levels that enjoy the money they make through the efforts, blood and sweat of the lower levels.
Why Pyramid Schemes Are Illegal?
The most important conclusion that we can have at the end of this lengthy article is includs in this fact that why pyramid schemes are illegal.
What is wrong with them that marks them as illegal activities?
Are they really bad enough to be illegal?
The answer is yes.
They are illegal.
There are some good reasons for this:
First, it is only the very top levels that make a lot of money without having to work.
The money they make is because of the effort of the lower levels who have to work hard while many of them either make no income.
Or they make a very small amount of money because they are so new and their downline is still small.
Second, when the pyramid system collapses, it is only the lower levels who lose a lot.
And the top levels get out of the game while they have already made a lot of money.
The member of the lower levels have spent lots of time and money to recruit more members to the scheme to build their down-line.
Then suddenly the systems collapses while they haven’t made any money yet.
Third reason is that nothing useful like a product or service gets buy and sell in the pyramid schemes.
Source of the money that the members make is only from a membership fee that the members pay.
I think this is the most important reason that a pyramid scheme has to be illegal.
It is scam because the money that floods to the system is because of no productive activity.
And it is only because some people who are up-line want to make money and become rich.
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