25 September 2023

Making a point: What is a pyramid scheme and why won’t it work?

Start the conversation

Brian O’Connell* says pyramid schemes hook consumers with promises of big money, but usually just leave them holding the bag.

Photo: Just Another Photography Dude

Pyramid schemes are an especially notorious form of “get rich” scams perpetrated by a small group of individuals who stand to gain the most financially.

In a classic pyramid scheme, they are the “top of the pyramid” and get paid before other members of the scheme who stand lower on the pyramid.

The first pyramid scheme is credited to Charles Ponzi, who in 1919 engineered a “top down” scam involving promissory notes payable in 90 days and a promise to repay investors, at 50 per cent interest, who invested in the notes.

Ponzi, a Boston-based businessman, was the first large-scale pyramid scheme originator who leveraged the cash of new investors (lower down the pyramid) to pay back old investors (higher up on the pyramid) until there were no new investors left, and the cash had dried up for good.

Ponzi garnered $15 million from the scam, before being arrested and sent to jail.

While law enforcement officials don’t completely agree that a Ponzi scheme is technically a pyramid scheme, the two scams share basic similarities:

  • Both reward the early scheme participants and penalise the late arrivals.
  • Both require the oxygen of new cash to keep the scheme going.
  • Both are illegal and jail time for participants is commonplace.

There is one key difference between Ponzi schemes and pyramid schemes.

Ponzi actually promised his investors a defined, clear-cut rate of return.

With most pyramid schemes, investors aren’t sure how much cash they’re going to make — all they know is to keep recruiting other people into the scam and the money is supposed to follow.

How pyramid schemes work

Pyramid schemes seem to start innocently enough.

Often, friends, family or neighbours begin the recruiting process, usually by engaging potential sales partners in person.

Step 1: The originator

An individual or small group at the top of the pyramid puts up a small amount of money, or in many cases, no money at all, for a get-rich-quick opportunity, then charges other members of the group to join.

The idea is to sell a product or service, often of poor quality or actually fake, and convince outsiders to join in and charge them to do so.

Step 2: The ‘suckers’

Down the pyramid scale, newer investors plough money into the scheme, thus providing the cash needed to pay off the earliest investors.

Financial accounts are created, profit statements generated, and cheques cut to investors.

At this point, all seems on the up and up, although not a single product or service has been sold to back up the investment — though investors don’t know that yet.

Step 3: The collapse

Eventually, it gets more difficult to recruit new members into the scheme, so there is less money to pay back investors already involved in the pyramid.

When earlier investors in the scheme cash out, there’s not enough money to pay off the rest of the investors at the bottom of the pyramid.

When these investors try to cash out too, they find there’s no money left to pay them, and the pyramid scheme collapses.

In short, the idea with a pyramid scheme is to make your money not from a great product or service, but by recruitment — i.e., convincing others to pay money to participate in a “can’t miss” money-making opportunity, then having those participants recruit other people to join, until there’s nobody left to recruit and no more money to be made.

By that time, the pyramid scheme originators are likely long gone.

Examples of pyramid schemes

There is no shortage of real-world pyramid scams in action.

Wealth Pools:

Back in 2007, a company called Wealth Pools International claimed to be selling foreign-language DVDs through a network of sales representatives.

In actuality, the firm was paying its sales staff to recruit more sales reps, and wasn’t actually earning any money on the DVD sales, making it a product-based pyramid scheme.

The US Security and Exchange Commission wound up freezing the company’s assets, but only after scam participants lost $132 million of their own cash.

Fortune Hi-Tech Marketing:

In this pyramid scam, Fortune Hi-Tech Marketing claimed to act as a third-party marketing and sales arm of Dish Network, a global satellite TV provider, and for Frontpoint Home Security, a security products provider.

In actuality, individuals who bought into the opportunity wound up making more money recruiting other sales representatives than they did selling satellite television or home security products.

According to the US Federal Trade Commission, over 350,000 were drawn into the pyramid scheme, paying up to $300 each annually to get the chance to lure other people into the scam.

Fortune Hi-Tech was forced to pay back $7.7 million in penalties, and was barred by US regulators from future multi-level marketing campaigns.

Social Media Pyramid Scheme:

In 2017, a pyramid scheme bubbled up on Snapchat, where users were urged to send a one-time joining fee, paid via Snapcash, Snapchat’s online cash payments site.

They were promised to earn money every time a new user joined and paid the fee.

There was no product or service attached to the scam.

Instead, “members” were urged to get the word out and recruit more people — usually teenagers — to earn their cash.

Multi-level marketing companies vs pyramid schemes

Multi-level marketing companies — those that bring in sales associates and encourage them to recruit other sales associates to sell products and/or services — are different than pyramid schemes in one key way.

They usually offer products or services that actually exist and are sold in the consumer marketplace.

That’s a key distinction, as the law looks differently at companies which sell a concrete product or service, even if they use recruiting methods to rewards salespeople.

The problem with pyramid companies is that there is usually no product or service to sell — and that is against the law.

The takeaway?

If you’re ever offered the opportunity to join any sales or marketing group where the emphasis is on recruiting to earn your pay, and not selling a product or service, you are likely joining a pyramid — with all the risk of financial loss that entails.

* Brian O’Connell is a freelance writer and former Wall Street bond trader.

This article first appeared at www.thestreet.com.

Start the conversation

Be among the first to get all the Public Sector and Defence news and views that matter.

Subscribe now and receive the latest news, delivered free to your inbox.

By submitting your email address you are agreeing to Region Group's terms and conditions and privacy policy.