Don't Get Caught in a Pyramid Scheme

In recent years many companies have successfully utilized  so-called "multi-level marketing"  practices. It is important, therefore, to address the differences between a pyramid scheme and a legitimate multi-level marketing company.  Initially, it should be noted that pyramid schemes always fail, while multi-level  marketing companies sometimes survive.  

What Is A Pyramid Scheme?

A pyramid scheme is a fraudulent system of making money based on recruiting an ever-increasing number of  "investors."  The initial promoters recruit  investors, who in turn recruit more investors, and so on. The scheme is called a "pyramid" because at each level, the number of investors increases. The small group of initial promotors at the top require a large base of later investors to support the scheme by providing profits to the earlier investors.

Pyramid schemes are illegal in New York State, as well as in many other states. Article 23A of the General Business Law of the State of New York §359-fff sets forth the criminality of initiating and participating in pyramid schemes (also known as chain distributor schemes).

Pyramid schemes may or may not involve the sale of products or distributorships. The trend is to involve sales of products or distributorships in an attempt to show legitimacy. This is done solely to sidestep the regulatory agencies, as most state laws prohibit marketing practices where the potential for profit stems primarily from recruiting other investors and not from the sale of products. The bottom line, however, is that in all pyramid schemes, the selling of a product itself is much less important than the recruiting of new investors.

What Is Multi-Level Marketing?

Multi-level marketing is a method of selling products directly to consumers without intermediary retail stores. Products are sold through a network of distributors or salespersons set up to resemble a pyramid: each distributor recruits and trains additional distributors and will earn commissions on their sales, as well as on the sales he or she makes. Because of their pyramidal structure, multi-level marketing companies can sometimes be pyramid schemes.

What Are The Differences Between A Legitimate Multi-Level Marketing Company And A Pyramid Scheme?

A legitimate multi-level marketing company emphasizes reliable products or services. A pyramid scheme uses products or services to disguise its quest for collecting money from the investors on the bottom levels to pay other investors further up the pyramid.

In a typical pyramid scheme, new investors must pay a fee for the right to sell the products or services as well as for the right to recruit others into the pyramid for rewards unrelated to product sales or services. Very often the products or services the victim must buy are unsalable, and the pyramid's promoters refuse to repurchase them. On the other hand, legitimate multi-level marketing companies will buy back unsold merchandise, although often at a discount from the original price.

Success in multi-level marketing is based on two factors: product and service quality, and the hard work involved in being able to sell the products or services. Recruitment of new investors is secondary.

Why Do Pyramid Schemes Always Fail? And Why Do Legitimate Multi-Level Companies Sometimes Survive?

Pyramid schemes are doomed to fail because their success depends on the ability to recruit more and more investors. Since there are only a limited number of people in a given community, all pyramid schemes will ultimately collapse. The only people who make money are those few who are on the top of the pyramid.

Legitimate multi-level marketing companies, on the other hand, can be around for a long time. Although the recruiting of additional investors is an essential part of the marketing practice, since legitimate multi-level marketing companies involve solid products or services, participants in these companies are not subject to huge losses.

Why Do People Invest In Pyramid Schemes?

If all pyramid schemes fail, why would anyone invest in them? There are three basic categories of people who invest in pyramid schemes: those who participate out of greed; those who are misled into thinking that they are joining an "investment club" or a "gift program"; and those who believe that the products or services are legitimate.

The people who participate in pyramid schemes out of greed often know that they are illegal. They nevertheless participate, hoping that the scams will last long enough for them to make a profit. However, the end result of a pyramid scheme is inevitable. At best, a few people, usually the promotors, walk away with a lot of money, leaving the bulk of the investors to lose all of the money they put into the scheme. In fact, the only way anyone could make money from pyramid schemes, is if other people are defrauded into giving money upon the promise that they in turn will be repaid

Pyramid promoters often target closely knit groups such as religious or social organizations, sports teams, and college students to increase pressure to participate. They give some pyramid schemes attractive names such as "investment clubs" or "gift programs." These clubs or programs are usually presented to these investors with assurances that they are perfectly legal, approved by the Internal Revenue Service or a Certified Public Accountant. Some even expressly state that they are not a pyramid scheme.

Participants of these clubs or programs are required to characterize their investments as "unconditional gifts" by signing waivers. The truth of the matter, however, is that by making these "gifts," everyone expects those further down on the pyramid to do the same. The intention is not to make an unconditional gift. Consequently, not only are these people involved in illegal pyramid schemes, they may also be violating tax laws.

Those investors who actually believe that the products or services which the promoters sold to them are legitimate, inevitably realize that they have been scammed. It is only when these products and services are unsaleable, and the promoters refuse to repurchase them, that they finally become aware that they have participated in an illegal pyramid scheme.

How Can You Avoid Being Defrauded?

The easiest way to avoid being defrauded is obviously not to participate in any promotion that appears to be a pyramid scheme. The following are some additional tips to help you steer clear of pyramid schemes:

  • Gather all information regarding the company, its officers, and its products or services. Get written copies of the company's marketing plan, sales literature, contracts, etc. Avoid promoters who fail to explain their plans clearly and in detail. In particular, read the company's prospectus or other written material. (A prospectus is a legal document that gives prospective investors information about a company.) If you don't understand it, get someone independent of the company to explain it to you.
  • Find out if there is a demand for the product or service. Is there a similar product or service on the market? If so, how well does it sell? If the promoters seem to be making most of their money by selling distributorships or large start-up inventories to new recruits, stay away.
  • Ask if you must buy a product to become a distributor. Find out if the company will buy back your inventory --you could get stuck with unsold products. Legitimate companies will buy back inventory for at least 80 to 90 percent of what you paid. Get all promises in writing.
  • Beware if the start-up cost is substantial. Some pyramid schemes pressure you to pay a large amount to become a "distributor." What are you getting for your money? Beware of promises of quick, easy and unreasonably high profits.
  • If the distributorship is providing a product for use to make a final product, make sure that whatever you provide reaches the final manufacturer. If you can, call or visit the manufacturer and ask for a list of its customers. Call the customers and ask if they are satisfied with the product.
  • Resist the temptation to invest just because the people selling you the program are friends or are part of your religious or social organization. They may have been misled into believing that they could make large amounts of money in a short time.
  • Check out any opportunity with the proper agencies. Contact
    • The New York State Attorney General's Office, Investor Protection and Securities, 28 Liberty Street, New York, NY 10005
    • The Federal Trade Commission
      Northeast Region
      1 Bowling Green, Suite 318
      New York, NY 10004
      Consumer Response Center: 1-877-382-4357
    • The Better Business Bureau, 257 Park Ave. South, New York, NY 10010.