Guide to Understanding Pyramid
Schemes

A pyramid scheme is an unethical and unreliable investment pitch that depends on guaranteeing irrational returns on fictitious investments. It is a dishonest and deceitful way to make money that relies on enlisting a growing number of “investors.” The fact that the early investors receive these substantial returns prompts them to endorse the scheme to others, who then bring in more investors, and so forth. Because there are more investors at each level, the scheme is called a “pyramid.”

Returns to existing investors are paid from fresh capital coming in. In some schemes, investors charge initiation fees to the investors below them, who then pay them. Consequently, the top layers of the pyramid or initial investors also receive a portion of these fees. Over time, when no more investors are left, the pyramid eventually falls.

It is possible for pyramid schemes to include or exclude the sale of goods or distributorships. Attempts to demonstrate legitimacy often involve distributorships or product sales. This is done solely to get around the law because, according to most state laws, it is illegal to engage in marketing strategies where the profit potential comes primarily from attracting new investors rather than selling goods. Simply put, selling a product itself is much less significant in all pyramid schemes than acquiring new investors.

A Real-Life Example

A real-life example of a pyramid scheme is CKB 168, CKBMax, and Cyber Kids Best Education Limited in Hong Kong.

Daliang “David” Guo and his accomplices advertised and spread false information about their Hong Kong-based business, also known as CKB 168, CKBMax, and Cyber Kids Best Education Limited. The deceptive statements included assertions that their company generated sizable profits from selling online children’s educational courses and that investments could be quickly sold for sizable profits. They also told investors they would receive pre-IPO shares of CKB and that the business would go public via an IPO. In actuality, investors had to actively seek out new investors to generate any kind of meaningful returns.

Guo and his accomplices advertised CKB online through YouTube videos and other postings, in-person meetings with potential investors, and live presentations about the alleged investment opportunity.

A federal jury found Guo guilty in September 2018 of nine counts of wire fraud and conspiracy to commit wire fraud for his involvement in the scheme that sought investments primarily from Chinese-American community members. He received a 144-month sentence in federal prison for his role as the high-ranking promoter of the scam that solicited more than $200 million for a business that claimed to sell online courses for kids but was really just a pyramid scheme^[3].

Are Pyramid Schemes Illegal?

It is against the law to use marketing methods focusing more on luring new investors than selling actual products.

Because pyramid schemes are deceptive and deceitful, resulting in millions of Americans losing their money, they have been deemed illegal. 
In the U.S., recruiting individuals to join a pyramid scheme is a felony offense with a maximum sentence of four years in prison, a maximum fine of $5,000, or both. A lawsuit for twice the amount the recruit paid may be filed against anyone who brings another participant in the pyramid scheme on board. The court may also order the defendant to pay civil penalties and consumer restitution if a marketing system is considered a pyramid^[1].

Pyramid schemes are designed to encourage everyone to keep finding new distributors so the business can continue receiving its money. Even if you already have more inventory than you can use or sell, you will frequently be encouraged or forced to buy a minimum amount of products regularly. Before you can get paid or receive certain bonuses, you might need to purchase products again.

Additionally, you might need to pay ongoing costs for other things like expensive marketing materials or training sessions. The business may also claim you can earn opulent benefits like prizes, bonuses, exotic trips, and luxury vehicles. However, it frequently turns out that to be eligible for the rewards, you must achieve specific product purchases, training, recruitment, or other goals, which only a tiny percentage of distributors ever do.

Because of how similar their compensation structures are to a pyramid, that’s how pyramid schemes received their name. The scheme has a single point at the top where the original members are located, and it gets wider as it descends as each level of recruits draws more people in.

Here is an example of how a typical pyramid scheme works:

1. Imagine person A, the man behind the scam, is at the top of the pyramid.
2. He signs up ten people by promising them a significant return on their investment, say $100,000.
3. The ten new members or participants each pay person A a certain amount, like $300, to partake in the opportunity he provides them.
4. Subsequently, each of those ten members is urged to find ten additional members, bringing the total to 100.
5. Now that there are 100 new recruits, each one must pay a fee to the tier-two recruiters, who then must send person A a portion of their earnings.
6. This hiring and compensation cycle is repeated for as long as possible. Money keeps moving up to those in the levels above as it does this.

What Happens When They Collapse?

As long as new, paying members keep joining, the pyramid schemes will continue to operate. The base of the pyramid must keep expanding further. But according to mathematics, such a scheme can only ever collapse. Imagine if one participant had to find ten other participants, who then had to each find ten additional recruits. You would require more participants to keep the scheme going and add layers to the “downline” than there are people in the U.S. Therefore, the entire system crumbles when the pool of willing and able participants vanishes.

Pyramid schemes can never last over a long period; people will always lose money. And because lower-level recruits’ payments are delayed by waiting periods, even high-level early participants may experience financial loss near the end.

Fraudsters frequently use a variety of channels to spread the word of pyramid schemes, including group presentations, YouTube videos, company websites, conference calls, social media, and online advertising. Promoters of pyramid schemes may go to great lengths to make the scheme appear legitimate multi-level marketing (MLM) program or another type of business. However, the scammers use the cash new hires provide to reimburse early-stage investors. The schemes eventually grow too large, the promoter cannot find enough new investors to cover the earlier investors’ payments, and the participants eventually lose their money.

Some of the characteristics of a pyramid scheme include any or all of these:

Pressure to sign-up

There is intense pressure to enroll immediately. Scammers frequently employ carefully written scripts intended to make you lose your guard and become enthusiastic about the business. Before investing, do your research and ask a lot of questions. A good chance to invest in a trustworthy company will not vanish overnight.

A focus on recruitment

A program is probably a pyramid scheme if its sole goal is to entice people to pay a fee to join it. Instead of through the sale of goods to the general public, you primarily make money based on the number of people you recruit and the fees they pay to join. Be doubtful if you are told that recruiting new people will pay you more than selling products.

No real goods or services are offered for sale

Be careful if the business sells items that are difficult to value, such as goods like widely distributed e-books, so-called “tech” services, or online advertising on inactive websites. Some scammers select elaborate-sounding “products” to make it more difficult to demonstrate that the business is a fake pyramid scheme.

Promises of substantial returns in a short time

Be wary of promises of quick money because they may indicate that commissions are being paid with funds from new hires rather than with money from product sales.

Passive income or easy money

You might be a victim of an illegal pyramid scheme if you are offered payment in exchange for performing menial tasks like paying bills, recruiting others, or posting online advertisements on obscure websites.

Buy-ins and forced spending

When most of the products are sold to other distributors as opposed to the general public, you have to “buy in” to the business or spend money attending seminars or purchasing sales materials.

No evidence of retail sales revenue

Legitimate MLM businesses generally make more money from product sales than from member recruitment. However, in a pyramid scheme, CPA-audited financial statements that demonstrate the company makes money by offering its goods or services to customers outside the program’s scope are nonexistent.

An intricate commission structure

Be wary unless commissions are determined by the goods or services you or your recruits sell to clients outside the program’s scope. Be careful if you are unsure of how you will be paid.

Types of Schemes

Pyramid schemes are of many kinds. While simple schemes and MLMs are most common, others may also be masquerading as genuine schemes. Here are the common types of pyramid schemes:

Eight-Ball Model

The eight-ball, also known as the airplane game, is an unsustainable pyramid scheme with only a set number of participants. In contrast to other intricate and complicated models, this one only requires a small number of players. The scheme involves exchanging money with those who sign up for the pyramid and is used in financial and non-financial institutions to add value to the organization on both a social and a financial level. It is intended to depict some tactful business practices, such as setting up a trading system and other routines. However, in reality, no actual goods or services are traded, making the model illegal in most countries.

Multi-Level Marketing (MLM)

Multi-Level Marketing, commonly known as MLM, is an authorized form of business operation. Distributors or MLM participants sell actual goods or services using this business model and are then compensated for the MLM products and services they sell. Additionally, they may be compensated for sales made by distributors they have recruited and the individuals those recruits later refer.

However, some MLM-impersonating pyramid schemes exist. The Federal Trade Commission^[2] advises consumers to be aware of and stay away from MLM promoters who:

• make bold claims about your enormous earning potential.
• try to convince people that the real money is in recruiting others;
• compel participation without providing sufficient information about the organization; and
• make it clear that if people do not act right away, a chance will pass them by.

In many instances, existing distributors who continue to purchase goods they will never sell to be eligible for rewards is another red flag.

Ponzi Schemes

Investment frauds, known as Ponzi schemes, operate by robbing one to pay the other (like the proverbial robbing Peter to pay Paul). They may not always follow the hierarchical structure of a pyramid scheme, but they do assure current investors of high returns. Ponzi schemes frequently only require an initial, one-time investment from investors. These investors are then paid their promised investment return, funded by fresh capital raised from additional investors the scheme’s organizer successfully recruited. When funding for these types of schemes runs out, the majority of participants in Ponzi schemes lose everything.

Matrix Schemes

Matrix schemes are a type of pyramid scheme business model that is unsustainable. A person must pay a certain amount of money to enroll in such a system, after which their names are added to a waiting list. If a specific number of people sign up for this list, the person whose name is at the top should receive the desired result. When a new member joins, their name is added to the bottom of the list and moves up as more people sign up. Each new member adds a level, extending the pyramid scheme’s vertical reach. The desired result is typically an expensive good like electronics, travel, or even cars.

How Does Pyramid Schemes Differ From MLM Companies

Pyramid schemes and Multi-Level Marketing are not the same. MLMs are legitimate, lawful companies, and their distributors make money by selling actual products and receiving commissions on goods sold by distributors they have recruited. Pyramid schemes occasionally pass for MLMs, though, in an effort to draw in potential MLM recruits.

In a typical pyramid scheme, new investors or recruits must pay a fee in exchange for the right to sell the goods or services and the ability to entice new members into the scheme in exchange for benefits unrelated to the sales of goods or services. The promoters of the pyramid scheme frequently refuse to repurchase the unsalable goods or services the victim must purchase. On the other hand, reputable multi-level marketing businesses will buy back unsold goods, though frequently at a reduced cost.

Investors in pyramid schemes can be broadly divided into three groups: those who do so out of greed, those who belong to certain communities and groups, and retired people and senior citizens.

1. People in groups and college students – To put more pressure on participants, pyramid promoters frequently target close-knit groups like college students, sports teams, and religious or social organizations. They convince them that recruitment is easy because they are a part of these groups and they can make money without too much effort. Students are often soft targets because of their access to many people on or off campus.
2. People who are looking to make fast money – People hoping to profit quickly are easily swayed to join pyramid schemes and other get-rich-quick schemes.
3. Retired people and senior citizens – Those who have retired from work are often vulnerable to pyramid schemes because they feel they can do something with their time and earn money as well. Senior citizens may be easily swayed by the promise of a passive income or additional streams to fund their retirement.

It is very easy to fall into the trap of a pyramid scheme. The lure of quick financial gains and “ease of doing business” are enough for many to sign up for a scheme without fully understanding what they are getting themselves into. Ask lots of questions and find as much information as possible about the business and the products if you are considering investing in a pyramid scheme. Beware of shady marketing techniques and products that might be harmful or useless. Remember that if you join, your sponsor and those above your sponsor’s level will profit, so take your time and make an intelligent, informed choice. Here are a few steps to take to protect yourself from falling prey to scammers^[2]:

1. Examine the business – Look up the business name along with terms like “review,” “scam,” or “complaint” online. Does the business have a solid reputation for satisfying its customers?
2. Look into what distributors say – If distributors make earnings claims, tell you that hiring new people is the fastest way to make money, or imply that all you need to do to grow your downline is “find two people who find two people,” be wary. 
3. Examine the goods – MLM businesses might offer high-quality products at affordable prices. However, some sell overpriced products, questionable in their benefits or outright dangerous. Examine the offerings of the company. 
4. Recognize the expenses – Make sure you know the costs involved upfront and over time. Ask the company if you will lose your eligibility for bonuses or rewards if you choose not to participate in any of the additions, such as periodic product purchases or training.
5. Inquire about refunds – In many MLMs, you must first purchase the products from the company to begin selling them. So, request a written copy of the company’s refund policy. Make sure it outlines the conditions and penalties for returning any unused products.
6. Examine the paperwork and seek advice – The company’s sales materials, business plan, disclosure materials, and any contracts or agreements you must sign should all be read before signing. Consult a lawyer, an accountant, or another person you can trust to assist you in reviewing the MLM’s materials. Examine your potential earnings and the company’s ability to support its earnings projections.
7. Ask yourself relevant questions 

• Are you good at selling?
• Have you got a good sales strategy?
• What do you hope to earn?
• Do you have the time to sell?
• Can you afford the financial risk?