Ponzi schemes and pyramid schemes are fraudulent schemes that have swindled, in some cases, billions of dollars from unsuspecting victims. You may have experience with one (or both) of these schemes. If so, you're not alone. I have some experience with them too.
As the scale and frequency of these scams grow, it's crucial that we understand how they work and the key differences so that we can protect ourselves.
In this article, we will dig into the nitty-gritty of these fraudulent schemes, their mode of operation, and how to steer clear by recognizing the warning signs.
Key Differences Between Ponzi Schemes and Pyramid Schemes
I'll go into more detail about each type of scheme below and include examples. But let's start by looking at some key differences between Ponzi Schemes and Pyramid Schemes.
First, they are similar. Both Ponzi schemes and pyramid schemes are illegal investment scams that rely on the constant flow of incoming funds from additional investors to pay returns on investment (ROI) to existing investors.
However, there are some significant differences between Ponzi and pyramid schemes, including…
In a Ponzi scheme, the scammer typically presents themselves as an investment professional with access to a special investment fund that generates high returns for investors.
In reality, the investment fund doesn't exist, and, as mentioned above, the scammer uses new investor money to pay existing investors.
In a pyramid scheme, however, participants invest in a “business opportunity”.
They are encouraged to recruit new members to join the scheme and, in most cases, pay an entry fee with the promise of receiving a portion of that fee from their downline.
The fee can often be associated with the purchase of products or services, but regardless of how it's allocated or labeled, it's an entry fee of some sort.
However, the real purpose of the product (or service) in a pyramid scheme is not to provide any significant value but to instead add complexity and obscure the fact that an illegal pyramid scheme is operating under the surface.
Using a product or service to add layers to the scheme (and compensation structure) is also to hide what's going on from the authorities and to appear legit.
Flow of Money
Both schemes rely on a constant flow of incoming funds from new investors to pay returns to existing investors, but the structure is different.
In a Ponzi scheme, the scammer typically controls the flow of funds and pays “investment returns” to investors directly from those funds.
Existing investor returns are not directly tied to the number of new investors. In other words, their income is not determined through recruiting or building a downline.
However, the flow of funds in a pyramid scheme comes from the entry fees, as mentioned above, which are often hidden in the sale of products and services.
Therefore, the amount of money each participant makes is directly related to the number of members they bring into the scheme.
Number of Participants
Ponzi schemes typically involve fewer participants, often just a few dozen or a few hundred people.
Pyramid schemes, on the other hand, can involve thousands of people, in some cases tens of thousands, who are organized into a hierarchical structure.
Pyramid schemes are illegal in many countries, including the United States, as they rely on fraudulent recruitment practices and false promises of financial independence and passive income.
However, they can be hard to prove because they are often promoted and operated as legitimate multi-level marketing programs (MLMs).
And not all multi-level marketing programs are illegal.
The legality of an MLM is determined by the percentage of sales that come from outside customers not involved in the scheme. Unfortunately, this is difficult to know unless you have access to the company's financials… which most people do not.
That makes it difficult for individual agents or members to know if they are part of a legitimate MLM or an illegal pyramid scheme.
Ponzi schemes are also illegal and possibly even harder to detect because there is no actual business activity occurring. Investors are not actively participating by recruiting others or selling products.
Instead, they are passive investors.
There are no complicated compensation structures or personal use products and services being bought or sold, nor are they connected to one another through an upline and a downline.
But at its core, the swindle is the same. A Ponzi scheme is legally defined as “A fraudulent investment plan in which the investments of later investors are used to pay earlier investors, giving the appearance that the investments of the initial participants dramatically increase in value in a short amount of time.”
Potential for Individual Financial Loss
Not always, but generally, Ponzi schemes lead to higher individual losses. While some pyramid schemes can cost several thousands of dollars to join and cause bankrupcies, there is a “hypothetical limit”.
That's because the cost of joining does not come with a guarantee. Instead, it's associated with the purchase of a business opportunity (inventory, marketing materials, etc.)
A Ponzi scheme, on the other hand, “promises” a high return based on the amount invested. Therefore, investors have an incentive to invest large sums of money, which can lead to millions, and in some cases, billions of dollars being lost.
Therefore, Ponzi schemes are generally more dangerous… although both can cause irreparable harm and financial loss to their victims.
What are Ponzi Schemes?
If you're just skimming and jumped to this section, I'll go over again what a Ponzi scheme is. As discussed above, it's an investment fraud where the operator pays returns to its investors from new capital paid to the operators by new investors rather than from genuine profits earned by investments.
It's an old-school, yet still very popular, way to scam people out of their money.
Also mentioned above, the key feature of a Ponzi scheme is that there is no actual business being conducted or any real products or services being exchanged. It's just a promise of unusually high ROI (return on investment).
Another common Ponzi scheme practice is paying off early investors to build hype and attract more investors.
Characteristics of a Ponzi Scheme
- Unusually high rate of return.
- Little to no risk for early adopters while providing a high risk/reward ratio for later investors.
- Extravagant “lifestyle” promises and claims.
- No reporting. There is usually a complete lack of transparency about how profits are being generated, and investors do not know how their money is being invested.
- Reliance on new investments by new investors to pay out existing investors. Therefore recruiting plays an important role in a Ponzi scheme.
- Emotion-induced decisions rather than solid financial analysis or research.
- Illegal activity that relies on secrecy and deception.
- It can keep going without losing footing ONLY if enough new investors keep coming in.
- It will eventually collapse before regulators catch on or take action.
How Ponzi Schemes Work
In a traditional Ponzi scheme, the perpetrator collects money from new investors and pays them “returns” using money collected from other investors. As mentioned earlier, these returns may appear legitimate, but no real profits are being made.
A lot goes on within the lifecycle of a Ponzi scheme and how it works, but at its core, the scheme relies solely on money from new participants to make good on its obligations to previous investors.
As long as more money is coming in than going out, the scheme continues. But even the most successful Ponzi schemes collapse because they can't bring in enough additional funds, or the law steps in.
Think of it like a house of cards, which it essentially is. A house of cards is built by stacking playing cards on top of each other. You can imagine that each card represents an investor in the scheme.
The higher the house of cards grows, the more unstable it becomes.
If it's a well-engineered and stable house of cards, you might be able to remove a few cards before it collapses. But the structure will weaken sooner or later, and a single card will bring down the entire house.
The same thing occurs with a Ponzi scheme.
At some point, early investors want their initial investment back, so they start pulling their money out. But, like the house of cards, one too many investors eventually pull out, and the scam crumbles.
The house collapses.
It might withstand some investors leaving, but it can only withstand so many until there isn't enough money to make monthly payments to the remaining investors.
Examples of Ponzi Schemes
Examples of Ponzi schemes are easy to find in the news, as they are one of the most popular money-making schemes out there. Here are a few…
Bernard (Bernie) Madoff
First on the list is probably the most famous Ponzi scheme (other than Charles Ponzi's original scheme), which is Bernie Madoff’s multi-billion dollar fraud. It lasted for nearly two decades before it finally unraveled in 2008.
Madoff promised returns of 18% or higher, while the S&P 500 only returned an average of 4%. One of the problems was an inevitable one. Madoff was using investors' funds to pay out promised returns rather than investing their money in legitimate investments.
Earlier in 2000, 2002, and 2005, forensic accounting and fraud investigator Harry Markopolos was investigating Bernie Madoff and alerted the SEC. But the SEC failed to follow through with the information Markopolos gave them.
Then in December 2008, Madoff's sons contacted the FBI and blew the whistle.
Another famous case was Wall Street entrepreneur Allen Stanford's massive scam that lasted for a decade before the FBI raided his offices on February 27, 2009.
Stanford promised high returns from certificates of deposits in his private bank based in Antigua. Instead, he was using investments from new investors to pay off older ones.
Stanford also took millions from investors and spent it on himself. But his story goes even deeper. He was also investigated for possible money laundering for Mexico's Gulf Cartel.
Tom Petters was a prominent businessman and philanthropist who operated a $3.7 billion Ponzi scheme. Petters convinced investors to buy large amounts of consumer electronics that he claimed would be resold to big-box retailers for a profit.
However, the products were either non-existent or never sold, and of course, the investors' funds were used to pay off earlier investors and finance Petters' lifestyle. In 2009, Petters was sentenced to 50 years in prison.
Scott Rothstein was a Florida-based attorney who operated a $1.2 billion (reported as $1.4 billion in some publications) Ponzi scheme. Rothstein convinced investors to invest in fake legal settlements that he claimed would provide high returns.
However, the settlements were fraudulent, and Rothstein used the investors' funds to finance his extravagant lifestyle and pay off earlier investors. In 2010, Rothstein was sentenced to 50 years in prison.
Novatech FX is currently a suspected Ponzi scheme, but it displays all the warning signs, which I'll go over below.
It promises exceptionally high returns of over 300% per year. There is also a complete lack of transparency, and investors have no idea how their money is being invested.
And to make matters worse, Novatech FX has recently suspended withdrawals, which likely indicates an impending collapse. If it does, current estimates suggest hundreds of millions will be lost.
Warning Signs of Ponzi Schemes
The most important thing you must do to protect yourself from falling prey to a Ponzi Scheme is to watch for the warning signs. It's not always clear whether an investment is legit, but if enough of these red flags exist, you can be relatively certain it's not.
- Promises of above-average returns with little or no risk
- Lack of transparency, specifically about the investment strategy
- Pressure to invest quickly before the opportunity disappears
- Complex or vague explanations of the investment opportunity
- Overly consistent returns, regardless of market conditions
- Limited or no access to account statements or records
- Claims of exclusivity or secrecy around the investment opportunity
- High-pressure sales tactics or emotional appeals
- Unregistered investment opportunity or unlicensed salesperson
- Lack of a credible or verifiable track record
- Promises of guaranteed returns or unrealistic profits
- A small group of individuals or a single person controlling the investment opportunity
- Lack of independent verification or outside audits
- Resistance to answering questions or providing more information about the investment opportunity.
What is a Pyramid Scheme?
Pyramid schemes are similar to Ponzi Schemes but with a key difference.
In a Ponzi Scheme, the returns are paid from an alleged investment. In a Pyramid Scheme, returns are based on recruiting new members to build a downline. Profits are often disguised through the sale of products.
The scheme's “mastermind” often masquerades as the CEO of a legitimate organization and promises freedom, independence, and passive income.
However, the money earned by upline members is not based on actual profits. Instead, it comes from new members.
It may appear as though product sales are the driving force, but if sales rely on new recruits, it's a pyramid scheme nonetheless.
That's why membership fees are necessary, although they might not look like membership fees. The cost of joining is often less obvious, hidden within product or service profit margins.
The key here is to get as many members buying the scheme's products and/or services.
For a pyramid scheme to be “legal” or considered a “real” multi-level marketing business, the members must establish independent retail businesses and generate profits from outside sales.
For example, when I was in Amway many (many) years ago, I had to establish a retail business. In my case, that meant selling boxes and boxes of products to neighbors, co-workers, and family friends.
Characteristics of Pyramid Scheme
The specific characteristics of a Multi-level marketing business include :
- Upfront fees to join the business. Fees may be disguised as starter packages that include products, marketing materials, etc.
- The primary focus is recruiting new members rather than selling products or services.
- Upline participants earn commissions from downline participants.
- Members are encouraged to buy and sell large amounts of products to “qualify” for commissions. This is a key component of pyramid schemes because its participants are usually the largest consumer group.
- There are no “retail” profits generated from the sale of products.
- High-pressure recruiting tactics.
- Promises of freedom and independence with limited effort or risk.
- Emphasis on selling the business opportunity and the lifestyle that comes with it, rather than the products.
- Like a Ponzi scheme, pyramid schemes collapse when recruitment slows and new members stop joining.
Examples of Pyramid Schemes
There are many examples of pyramid schemes. Here are several that the FTC has shut down.
Herbalife, a multi-level marketing company that sells health and wellness products, was investigated by the FTC in 2016 for operating a pyramid scheme. The company agreed to pay a $200 million settlement and to restructure its business to avoid operating as a pyramid scheme.
Equinox International was a multi-level marketing company that sold water filtration products. The FTC shut the company down in 1999 for operating a pyramid scheme.
Although the company's founder, William Gouldd, was barred Gouldd for life from ever participating in a multi-level marketing scheme, he still came out of the ordeal in good shape. Court documents claim that he kept nearly $10 million in assets, including two Florida houses, a Range Rover, a Rolex, and $8 million cash.
BurnLounge was an online music store that operated as a pyramid scheme, with participants earning money by recruiting new members. The FTC shut down the scheme in 2007 and ordered the company to pay $17 million in damages to its victims.
BurnLounge promoted its digital music product using multi-level marketing, but music sales comprised only a small part of its revenues. The agency alleged that BurnLounge drew in consumers from different parts of the country, saying they could earn substantial incomes.
Vemma Nutrition Company
Vemma was another multi-level marketing company that was shut down by the FTC (in 2015) for operating a pyramid scheme. The company claimed to offer health and wellness products, but most of its revenues came from recruiting new members rather than selling products.
Vemma attracted a lot of attention from consumer organizations, along with complaints from parents, because their recruiting practices focused on college-aged students. In 2014, the FTC reported 170 complaints about Vemma.
American Gold Eagle (Gold Unlimited, Inc.)
American Gold Eagle (AGE) was a multi-level marketing company that operated between 1989 and 1991. They ran a gold matching program, where participants would place a $200 down payment for $800 worth of gold. The balance would come from commission payments when they recruited new members into the scheme.
The original participant would have to pay the initial $200 and then recruit two separate investment groups (each group being three people). For each group, they would receive a commission of $300 toward the purchase of their gold, which added up to the $600 they still owed.
The FTC shut the company down, and the scheme operators, Martha and David Crowe were sentenced to 121 months and 135 months, respectively. Rather than reporting to prison, they fled.
In 2001 they were caught when police received a tip they were living in Long Key, Florida.
My Online Business Education (aka MOBE) was a multi-level marketing company that offered online business training. Participants were falsely told they could get rich quickly and live lavish lifestyles by using their “proven 21-step system”.
Once invested in the scheme, it was revealed that the “proven system” was simply selling the same program to others. Through these sales, they would earn commissions from new members, who would then go out and sell it again to more people.
Membership costs ran into the thousands, leaving consumers unable to recoup their costs and often putting them in severe debt. In fact, two good friends of mine were sued by MOBE for trying to expose them, but MOBE lost the lawsuit because it was clear they were a scam.
The FTC shut the company down in 2018 for operating a pyramid scheme.
Warning Signs of Pyramid Schemes
There are several
- Unrealistic or unsubstantiated claims about the potential returns or earnings.
- Promises of quick and easy money. Pyramid schemes often lure in victims by making big promises of fast and easy money.
- No real product or service. Pyramid schemes typically do not provide a product or service with any legitimate value. Instead, they rely on recruiting new members to generate income.
- It's not clear where the revenue is coming from. In any program or business opporunity, the revenue source should be transparent and easily verifiable.
- No real customers, only members. Illegal pyramid schemes often don't have real customers outside of the scheme itself. It instead relies solely on participants to generate revenue.
- Emphasis on recruitment and earning commissions rather than selling products or services to outside customers who are not part of the organization.
- Claims of no (or low) risk.
- High-pressure selling tactics, particularly when selling the business opportunity.
- Instead of the actual products or services, the REAL product the company sells is “lifestyle”. It may be a pyramid scheme if the main products are freedom, independence, and in some cases, belonging to a “family” of “business owners”.
- High entry fees. Pyramid schemes often require participants to pay high entry fees or make significant investments upfront. These fees are often disguised as starter kits or hidden in product inventory, samples, marketing materials, etc.
- Dodging your questions or bending over backward to explain why they are NOT a pyramid scheme, even though your main responsibility is to build a downline and earn commissions from new recruits.
Legal Implications of Ponzi and Pyramid Schemes
It's essential to understand that Ponzi schemes and pyramid schemes are not only morally wrong but also have legal consequences.
In many countries, including the United States, these schemes are punishable by law, and the perpetrators can face hefty fines, imprisonment, and other legal consequences. The reason for the severity of the law against these schemes is the significant financial harm they cause to the victims.
Ponzi and pyramid schemes often promise high returns with little to no risk, enticing investors to invest their money. However, as the schemes are fraudulent, there is no actual investment or return.
As the number of investors grows, the schemes become unsustainable, and the operators run away with the investors' money, leaving them with significant losses.
And the legal implications of Ponzi and pyramid schemes are not limited to the operators.
Investors who promote and participate in these schemes can also face legal consequences. If they are “net winners” in the scheme rather than victims, they could be charged with aiding and abetting fraud and even money laundering… although that's rare.
But it's important to know that ignorance is not necessarily a defense in a court of law. To be a safe investor, you must do your due diligence. Research and validate any investment opportunity thoroughly.
Do not fall for high-pressure sales tactics or promises of guaranteed high returns. If it sounds too good to be true, it probably is.