Pyramid Schemes



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What is a Pyramid Scheme?

Pyramid schemes, also referred to as "chain referral", "binary compensation" or "matrix marketing" schemes, are marketing and investment frauds which reward participants for inducing other people to join the program. Ponzi schemes, by contrast, operate strictly by paying earlier investors with money deposited by later investors without the emphasis on recruitment or awareness of participation structure.

Pyramid schemes focus on the exchange of money and recruitment. At the heart of each pyramid scheme there is typically a representation that new participants can recoup their original investments by inducing two or more prospects to make the same investment.

For each person you bring in you are promised future monetary rewards or bonuses based on your advancement up the structure. Over time, the hierarchy of participants resembles a pyramid as newer, larger layers of participants join the established structure at the bottom.

They say you will have to do "little or no work because the people below you will". You should be aware that the actual business of sales and supervision is hard work. So if everyone is doing little or no work, how successful can a venture be?

The marketing of a product or service, if done at all, is only of secondary importance in an attempt to evade prosecution or to provide a corporate substance. Often there is not even an established market for the products so the "sale" of such merchandise, newsletters or services is used as a front for transactions which occur only among and between the operation's distributors.

Therefore, your earning potential depends primarily on how many people you sign up, not how much merchandise is sold.

Pyramid schemes are not the same as Ponzi schemes which operate under false pretences about how your money is being invested and normally benefit only a central company or person along with possibly a few early participants who become unwitting shills. Pyramid schemes involve a hierarchy of investors who participate in the growth of the structure with profits distributed according to one's position within the promotional hierarchy based on active recruitment of additional participants.

How are Pyramid Schemes Disguised?

These illegal money-making ventures are modified and adapted to suit the victims. They may be disguised as games, chain letters, buying clubs, motivational companies, mail order operations, or investment organizations.

Because of the similarity in structure to legitimate multi-level marketing plans, which survive by making money off product sales to actual customers, not new recruits, pyramid schemes may occur when you are offered a distributorship or franchise to market a particular product. Your investment contract will also authorize you to sell additional franchises.

For each person you bring into such a company, you receive, or are promised, future monetary rewards or bonuses based on the number of people below you (commonly referred to as a "downline") which ( and this is the key factor in pyramid schemes ) are unrelated to the sale of the product to consumers. The real profit is earned, not by the sale of the product, but by the sale of new distributorships.

Promoters of pyramid schemes stress the selling of additional franchises for a quicker return on your investment. Investors, therefore, expend their energies selling franchises rather than the product. At some point, the supply of potential investors is exhausted, leading to the inevitable collapse of the pyramid. The sale of the actual product often fails because it is overpriced or no real market exists for it.

Once the number of actual product buyers diminishes new recruits will focus primarily on recruiting others into the system without any realistic expectation that they can profit from retailing alone.

This lack of actual retail sales may be hard to determine as many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.

Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. Legitimate multilevel marketing plans actually sell their product to members of the general public, without requiring these consumers to pay anything extra or to join the MLM system. MLM's may pay commissions to a long string of distributors, but these commission are paid for real retail sales, not for new recruits.

Such incentive purchases, which are tied to a higher distributorship level position in the "business opportunity", lead participants to stockpile or give away unneeded product purchases, all the while chasing the elusive rainbow of imminent success. Often the costs of even long term participation far exceed the payments received.

One indication of a pyramid structure is one which pays override commissions on more than five levels of participation. Even the largest corporations can not stretch the markups on products beyond the hierarchy of sales person, branch manager, district manager, regional manager and national manager without becoming uncompetitive with standard retail outlets.

According to Jon M. Taylor of the suggested retail prices for MLM products are almost always too high to be competitive because huge margins have to be built in to allow for commissions to be paid to down-line distributors for item sales without compromising the company's overly generous profits.

This need to avoid retail competition is achieved by the marketing of unique or miraculous new products which are unavailable elsewhere or presented as cutting edge technology accessible only to those with the vision to appreciate its benefits to humanity or the American Way.

Many pyramid schemes will also advertise that they are in the "pre-launch" stage, yet they never can and never do launch.

Why do Pyramid Schemes Fail?

Pyramid schemes are inherently injurious to consumers because as a mathematical certainty, they are doomed to collapse. As in the case of chain letters that require a payment, only the people at the very top make any money.

The only way anybody can make money through a pyramid scheme or chain letter is if participants in levels below them are defrauded into giving money based upon a rapidly diminishing promise of eventually getting something in return.

Eventually they must break down because the pool of possible recruits becomes exhausted and recruitment stops. Those at the bottom of the pyramid, the vast majority of the participants, lose money because there is no one below them.

They won't get their money back or earn their promised fortune because no one is beneath them in the pyramid adding new money to the pot. All pyramid schemes will begin to die when later recruits don't sign on in numbers large enough to pay off the earlier recruits.

An infinite number of people is the weak link in the required "endless chain" of new participants. In order for a pyramid scheme to profit, there would have to be a never-ending supply of potential, and willing, participants. In reality, however, the supply of participants is limited, and each new level of participants has less chance of recruiting others and a greater chance of losing money.

The diminishing odds of making money with a pyramid scheme make it a losing proposition because each time a new level rises to the top, a new level must be added to the bottom, each one at least twice as large as the one before.

Pyramid schemes are based on simple mathematics: many losers pay a few winners. A nine-level pyramid, which is built when each participant gets six "friends" to join, would involve over ten million people!


Who are the Victims?

Most pyramid schemes seem intent on exploiting people with limited means and limited knowledge of business such as individuals who have little experience in direct sales, distributorships, or franchise enterprises or who have limited money or credit with which to establish their own businesses.

They rely on widespread ignorance of basic mathematics. Participants are promised large rewards for putting up a certain amount of money and then recruiting the next level of members. But the schemes always collapse because the supply of potential recruits quickly runs out, making many participants both victims and perpetrators.

Many victims of these scams sell first to their friends. When the supposed money-making opportunity goes belly up, most lose not only their money but also their friends. The Pentagono promotions have apparently targeted deaf people in some states while the main focus appears to be on senior citizens in others.

Why Would Anyone Pay to Join a Pyramid?

They're sold to investors with the assurance that they are perfectly legal, approved by the IRS or a CPA, and that they are definitely "not" a pyramid scheme. Promoters may even flaunt the fact that they are illegal and are therefore secret and exclusive. This adds to the allure and mystery of this larcenous, but seemingly harmless, act. Pyramid promoters are masters of group psychology. At recruiting meetings they create a frenzied, enthusiastic atmosphere where group pressure and promises of easy money play upon people's greed and fear of missing out on a good deal. It is difficult to resist this kind of appeal unless you recognize that the scheme is rigged against you.

When the expected wealth does not materialize, participants often blame their own lack of recruiting skills for the failure, rather than the original promoters who have benefited most, and almost exclusively, from their deception.

The pyramid promoter is likely to persuade the investor that he is "getting in early" and that he should consider himself at the top of the matrix. Most participants don't envision themselves anywhere near the bottom layer of the pyramid.

Even the greediest person on the planet would probably see that if one is near the bottom layer it will be very hard to get new recruits. They have to see themselves near the top in order to envision the immense wealth, from minimal effort, that is going to come their way.

The con artist at the top views each new investor as a predicable set of revenues and expenses, with the revenues flowing directly to him. He happily pays out commissions for the recruitment efforts of others.

Investigators say pyramid schemes come in waves of three to six years and rise during times of economic boom by playing upon the greed and envy among those who are eager to participate in moneymaking ventures.

As the losers rarely advertise the truth of their folly, the myth of their success resurfaces with each new outbreak.

Legal Aspects

Pyramids are deceptive and participants in a pyramid, whether they mean to or not, are deceiving those they recruit. Few would pay to join if the odds stacked against them were fully explained.

Because pyramid sales plans are by their very nature deceptive, they are illegal. There is a real risk that a pyramid operation will be closed down by police and the participants subject to fines and possible arrest.

In Canada, the Competition Act explains the differences between multi-level marketing and pyramid selling, and sets out the responsibilities for operators and participants in these types of plans. Multi-level marketing, when it operates within the limits set by the Competition Act, is a legal business activity, while pyramid selling is a multi-level marketing plan that incorporates various deceptive marketing practices, making it a criminal offence under the Competition Act.

It is illegal to:

Pay money for the right to receive compensation for recruiting new participants;
require a participant to buy specific products before he/she is allowed to join the plan;
sell unreasonable quantities of the product or products to participants (this practice is called inventory loading); and refuse to allow participants to return products on reasonable commercial terms.

People who break the law relating to multi-level marketing or pyramid selling can be convicted and sentenced to a fine or a prison term. Amendments to the Act passed in 1999 now allow the court to impose a fine of up to $200,000 or a prison term of up to one year, or both, for a less serious offence. For a more serious offence, the court may set its own fine or a prison term of up to five years, or both.

The Bureau conducts its investigations in private and keeps confidential the identity of the source and the information provided. However, if someone has important evidence about an offence under the Act, that person may be asked to testify in court.

Sometimes, no clear line separates illegal pyramid schemes from legitimate multilevel marketing programs. To differentiate between the two regulators in the U.S. evaluate the marketing strategy (e.g., emphasis on recruitment versus sales) and the percentage of product sold compared with the percentage of commissions granted.

A business venture that meets all three of these descriptions is an illegal pyramid:

You must make an investment to get the right to recruit others into the program...and

When you recruit another person into the program, you receive what the law calls "consideration." That usually means money, but can be anything of value...and

Your new recruits must make an investment to get the right to recruit, and they receive "consideration" for getting others to join. An investment includes any money paid to enter the venture. Though it may be called a "membership fee" or "bookkeeping charge," the law still considers it to be an investment. And an inventory of products you must buy to re-sell is also considered to be an investment. Giving of your time or talents, or buying demonstration samples at cost is not considered to be an investment under the law.

Blaming the Government For a Pyramids Downfall

To survive, pyramids need to keep and attract as many members as possible. Thus, promoters try to appeal to a sense of community or solidarity, while chastising outsiders or skeptics. Often the government is the target of the pyramid's collective wrath, particularly when the scheme is about to be dismantled.

FTC attorneys now know to expect picketers and a packed courtroom when they file suit to halt a pyramid scheme. Half of the pyramid's recruits may see themselves as victims of a scam that they took too long to stop; the other half may view themselves as victims of government meddling that ruined their chance to make millions.


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