What Is a Pyramid Scheme?

A pyramid scheme is an illegal investment scam based on a hierarchical setup of network marketing. The most famous kind of pyramid scheme is, perhaps, the Ponzi scheme.

New recruits make up the base of the pyramid and provide the funding, or so-called returns, in the form of new money outlays to the earlier investors/recruits structured above them in the scheme. A pyramid scheme does not usually involve the selling of products. Rather, it relies on the constant inflow of money from additional investors that works its way to the top of the pyramid. This means that multilevel marketing schemes are not classified as pyramid schemes and are not necessarily fraudulent.

Key Takeaways

  • Pyramid schemes are based on tiers where new members are at the bottom and the members at the top make the majority of the money.
  • The Ponzi scheme is a popular well-known type of pyramid scheme.
  • Multi-level marketing businesses are not typically considered pyramid schemes because they involve selling products.

How a Pyramid Scheme Works

An individual or a company initiates a pyramid scheme by recruiting investors with an offer of guaranteed high returns. As the scheme begins, the earliest investors do receive a high rate of return, but these gains are paid for by new recruits and are not a return on any real investment.

From the moment the scam is initiated, a pyramid scheme's liabilities begin to exceed its assets. The only way it can generate wealth is by promising extraordinary returns to new recruits; the only way these returns receive payment is by getting additional investors. Invariably, these schemes lose steam and the pyramid collapses.

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What Is A Pyramid Scheme?

Basic Pyramid Schemes

A pyramid scheme is a variation of the Ponzi scheme, which offers a promise of high investment returns that are not available from traditional types of investment. In practice, the structure of pyramid schemes induces others to recruit victims and collect money that eventually makes its way to the top of the pyramid.

In a typical setup, one person recruits a second person to invest a certain amount of money. The second person recovers his investment by recruiting people under him to invest in the scheme.

The more people he can recruit under him, the greater his profit, and a certain percentage of the profits of all recruiters work their way up the pyramid to enrich the recruiters before him. Each person must recruit a certain number of people. The process continues until there are fewer people at the bottom of the pyramid, and it collapses under its own weight.

Generally, only the people near the top of the pyramid make any significant profits, and people near the bottom never recover their investments.

MLM companies are not considered fraudulent because they involve selling products and not just getting people to sign up.

Business Pyramids (Multilevel Marketing Schemes)

On their face, multilevel marketing companies are structured like a pyramid. Individuals have the opportunity to invest in their own businesses, which, ostensibly, distribute a product. However, with some companies, the real profit opportunity comes not from selling products but from inducing others into buying into their own business, with a percentage of the investment moving up the hierarchy of recruiters.

These companies include the likes of Amway, Rodan + Fields, and Tupperware. Among the more high-profile multilevel marketing companies to be investigated as a pyramid scheme is Herbalife Ltd. Herbalife distributors can make money just by selling the company’s products, but they must purchase and sell thousands of dollars' worth of the products before they realize a profit. Critics allege that the company's top recruiters receive the vast majority of profits.

Regulators have determined that a multilevel marketing structure is not fraudulent if the company makes most of its profits from selling products or services to end-user consumers, as opposed to recruiting new sales agents and requiring those agents purchase their own inventory.

Example of a Pyramid Scheme

A recent and well-known pyramid scheme involved the fall of Bernie Madoff, who promised and often fulfilled apparently extraordinary investment returns by enlisting new members to part with their money. Madoff has admitted to his crimes and is serving a jail sentence, but only after hundreds of investors collectively lost millions of dollars in the fraud.