Pyramid Schemes, Ponzi Schemes, and Related Frauds
I'm sure you've seen them dozens of times.
Messages which purport to tell you how, for a relatively small investment,
you can make huge amounts of money. There are countless variations,
but they all are based on the same fraudulent concept. With a typical
“chain-letter”-based pyramid scheme, the process is represented to go something
like this:
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You receive a copy of a letter or an email message, making
fabulous claims about how much money you can “earn” by participating in
it.
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You send some amount of money to some number of people who
have joined this scheme ahead of you. Typically, you may be asked
to send $5 each to four or five people.
-
You alter the list of previous participants, removing the
one at the top of the list, moving all the other names up one position,
and adding your own name to the bottom of the list.
-
You send out as many copies of this altered letter as you
can, to as many people as you can reach.
-
As new people join the scheme below you, in exponentially-growing
numbers, each one will send you $5, or whatever the requested amount was.
Because the number of new participants is growing at a fantastic, exponential
rate, you should collect this payment from a ridiculously large number
of people.
There are many variations on this basic scheme.
There are various ploys used to create an illusion of legality; some of
these involve a set of “reports” which you buy from those above you, and
sell to those below you. Others instruct you to create a mailing
list out of the names of people below you. Some use language which
describes the money exchanged as a “gift” or a “loan”. There are
even some software-based pyramid schemes, centered around a program which
is distributed down the chain; the program keeps track of the list of people
from which you must buy the “codes” to “unlock” the program, enabling you
to create a version of the program which lists you as one of the sources
from which others must buy these codes to unlock it. There are also
variations which involve selling “self-replicating” web pages.
In every case, the basic concept is the same — you
pay a relatively small amount of money to a few people above you, with
the expectation that later, very large numbers of people will be making
similar payments to you.
A deliberate effort is made, in many cases, to
confuse prospective victims with regard to the distinction between a legitimate
“multi-level marketing” (MLM) scheme, and an illegitimate pyramid scheme.
I'm no fan of MLM; I regard even “legitimate” MLM schemes as ethically
questionable at best. But there is a vital distinction.
The important distinction is this: With a legitimate
MLM, you have a real product, that is of significant value in and of itself.
Most of your profit comes from the sale of this product to people who will
use this product according to its own value and usefulness, and not just
try to sell it to someone below them. Though MLM encourages you to
build a “downline”, so that you can make some profit by taking a cut of
the sales made by those below you, you do not need to recruit even a single
person below you in the pyramid in order to profit; you can profit by selling
the product itself, even to people who have no interest in joining the
MLM.
In those pyramid schemes which try to pass themselves
off as MLM, your “product” is something that has very little inherent value,
if any at all, beyond the requirement that one must buy it from you in
order to join your “downline”. The “product” may consist of worthless
reports, or even electronic codes to unlock a software-based pyramid scheme.
Nobody would buy these “products”, except as part of joining the pyramid
scheme itself. The only opportunity for profit is in getting people
to join the pyramid in levels below you. As the U.S. Postal Service
warns, on one
of their own pages on the subject, “Do not be fooled if the chain
letter is used to sell inexpensive reports on credit, mail order sales,
mailing lists, or other topics. The primary purpose is to take your
money, not to sell information. “Selling” a product does not ensure legality.”
A Few Definitions
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Chain Letter: Strictly speaking, a chain letter
is merely a letter, an email message, or some other communication, which
asks the recipient to send copies of it to several other people.
In and of itself, chain letters are not illegal, but they are very annoying,
and very wasteful of whatever medium is used to carry them. When
a chain letter asks the recipient to send money to people through whom
the letter passed before, with the promise that the recipient will receive
money from those that the letter reaches after he sends it, then it has
become a form of a pyramid scheme. Though not all chain letters are
pyramid schemes, and not all pyramid schemes are chain letters, the term
“chain letter” is often used to mean a pyramid scheme. For example,
the U.S. Postal Service's official statement on “Chain
Letters” is really about pyramid schemes. Even if they're not
illegal, chain letters are, in any form, very annoying to most people,
and prohibited by most responsible ISPs.
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Pyramid Scheme: A scheme in which a hierarchy
is created by people joining under others who joined previously, and in
which those who join make payments to those above them in the hierarchy,
with the expectation of being able to collect payments from those who join
below. Pyramid schemes are prohibited by the laws of the United States
of America, by the laws of each of the fifty individual states, and by
the laws of most other nations. Pyramid schemes are variously defined
under these laws either as a form of gambling, or (more accurately, in
my opinion) as outright fraud . Most of my explanations on this page
are about pyramid schemes, but have some application to Ponzi schemes as
well.
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Administered Pyramid Scheme: A varation of a
pyramid scheme in which some central person or company is involved in “administering”
the scheme, in making sure that all participants have made the appropriate
payments to those above them, or even in collecting these payments and
redistributing them to the “upline”. The “Administrator” of such
a scheme usually takes some fee for himself. In this variation, the
“administrator” is assured of some profit, no matter how badly the scheme
may work for other participants, because he gets to collect his own fee
from every other participant. These schemes usually collapse much
more quickly than regular pyramid schemes, because of their dependence
on the administrator, who is easily identified and turned in to proper
law-enforcement authorities.
- Gifting Club: This term, as far as I've ever seen it used, is just another term for a pyramid scheme. The money you pay to join a “Gifting Club” is called a “gift”, and the claim is often made that any money you receive from such a scheme is not taxable, because the IRS does not tax gifts up to $10,000. This is a dangerous falsehood, because the IRS has always considered a gift, by definition, to be something given with no expectation of receiving anything in return. While the majority of gifting club participants really do get nothing in return, their “gifts” are certainly not given without the expectation of considerable return, so these payments cannot be considered gifts for income tax purposes. In addition to the legal problems you could face just from participating in a pyramid scheme, failing to report as income any returns you might get from such a scheme could subject you to tax evasion charges as well.
-
Ponzi Scheme: Named after Charles Ponzi, who
ran such a scheme in 1919-1920. A Ponzi scheme is an investment scheme
in which returns are paid to earlier investors, entirely out of money paid
into the scheme by newer investors. Ponzi schemes are similar to
pyramid schemes, but differ in that Ponzi schemes are operated by a central
company or person, who may or may not be making other false claims about
how the money is being invested, and where the returns are coming from.
Ponzi schemes don't necessarily involve a hierarchal structure, as in a
pyramid scheme; there is merely one person or company that is collecting
money from new participants and using this money to pay off promised returns
to earlier participants. An interesting site about Charles Ponzi
and his scheme can be found here.
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Straight–Line Matrix:
[Added 24 April 2004] This is a new form of fraud that I am seeing
in recent months. I have also seen these referred to as
“Elevator Schemes”. In these schemes, you are
offered the opportunity to buy some valuable product for a small percentage
of its usual cost, usually around 10%. These schemes are based on a
list of participants, in the order that they joined the scheme. Each
person pays the specified price when they join the scheme, and when so many
people (usually ten) have joined the scheme, the first person gets the
product being offered (it having been paid for out of the fees paid by all
ten who have joined so far). When ten (or whatever the number might be
more people join, then the second person gets the product. When ten
more join after than, then the third person gets the product; and so
on.
Though this scheme isn't based on the same sort of exponentially-growing
structure as a pyramid scheme, most of the same principles apply here as
to a true pyramid scheme. As with a true pyramid scheme, a
straight–line matrix scheme pays off only for a small percentage of
those who have joined, producing a number of people who have paid into the
scheme and not yet received any payoff that grows at a much faster rate
than the rate at which the number of people who have received the promised
payoff grows. As with a true pyramid scheme, a straigh–line matrix
will pay off quickly for those who get in the earliest, and will pay off
increasingly slowly for those who join later, with the vast majority of
of participants never receiving the promised benefit.
A Pyramid Scheme Dissected
Let's look at a hypothetical pyramid scheme, with
respect to how it is claimed to work. Suppose the list included in
this scheme contains six names. You are to send a dollar to each
person listed, remove the top name, move all the other names up one position,
and send it on to more people. Let us assume, that you get ten people
to join, and each of them gets ten people, and so on.
As the pyramid grows below you, here's what supposedly
happens:
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The first level below you has ten people. They each
send you a dollar, so you collect $10.
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The next level has a hundred people. (Each of your
first ten gets ten more.) You collect $100.
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The next level has a thousand people. You collect $1,000.
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The next level has 10,000 people, so you collect $10,000.
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The next level has 100,000 people, so you collect $100,000.
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The next level has 1,000,000 people, so you collect $1,000,000.
-
At this point, your name drops off the list, and you collect
no more.
So, for your initial investment of $6, (one dollar
to each of the six people above you), you collect a total of $1,111,110.
There are, of course, many variations on this concept.
It's very easy to understand how this kind of scheme
should
work. It all seems so simple and so obvious.
It is, unfortunately, somewhat more difficult to
understand why this kind of scheme does not work, and why it is
unethical and dishonest, and, in most cases, very much illegal.
The truth is, this scheme does not work, except
for those who get in at the first few levels. The vast majority of
participants in such a scheme will only lose their original investment,
and make no profit at all. In a moment, I'll get into why this is
so; but because it is so, every instance where a person is induced to join
such a scheme, based on the promise that he will make a profit by participating,
a fraud has been committed.
Nearly every nation, and every government, has
laws against fraud. Most have specific laws against pyramid schemes,
Ponzi schemes, and similar operations.
Even if the particular variation in which you might
participate happens to avoid running afoul of the laws which are relevant
in your situation, I ask you to consider that by participating in such
a scheme, you would be engaging in something that is dishonest and unethical,
and which is very unlikely to make you any profit.
In order to understand why pyramid schemes do not
work, there are two points which you must understand.
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The pyramid must fail because there is
a finite and limited number of potential participants.
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No new wealth is created, the only
wealth gained by any participant is wealth lost by other participants.
Now, let's see if I can explain these points.
The pyramid must fail because there
is a finite and limited number of potential participants.
Pyramid schemes depend on bringing in an exponentially-growing
number of new participants. I've used the term “exponentially” several
times already, perhaps I should explain it. Where n represents
some number, if you start with one person, who gets n people to
join, and each of those people gets n more people to join,
and so on, you have the total number of people growing by powers of n.
Even where n is a fairly small number, the total number of
people involved grows to amazingly huge numbers without very many steps
being required to reach these huge numbers. Indeed, it is these huge
numbers, which you are led to believe represent the number of people who
will each be sending you $5 or whatever, that makes pyramid schemes attractive.
But these huge numbers create a problem.
There are somewhere between five and six billion people in the world.
Let's suppose that every one of these people could be induced to join a
particular pyramid scheme. For how many levels could this scheme
run before it failed, for lack of new participants? You'll be amazed
when you see how quickly the number of required new participants grows
to exceed the population.
In the example above, I assumed that each person
who joined would bring in ten new people. How many levels can be
supported by a population of five to six billion? Let's count them...
| Level | People in Level |
|---|
| 1 | 1 |
| 2 | 10 |
| 3 | 100 |
| 4 | 1,000 |
| 5 | 10,000 |
| 6 | 100,000 |
| 7 | 1,000,000 |
| 8 | 10,000,000 |
| 9 | 100,000,000 |
| 10 | 1,000,000,000 |
That's ten levels, counting the one person at
the top who started it. By the time these ten levels are filled,
there will be a total of 1,111,111,111 participants. The eleventh
level would require 10,000,000,000, or ten billion new participants to
fill in. But there aren't that many people in the world. There's
only between five and six billion, minus the somewhat over a billion who've
already joined. Most of the billion people in the tenth level will
not be able to get any new participants below them, and will therefore
make no money at all. And of course, none of those who join in the
eleventh level will get any new participants below them. There aren't
enough people to fill in the eleventh level, much less to start a twelfth
level below that.
At this point, the pyramid collapses. And
when it does, a solid majority of those who had joined will not have made
any return at all. They will have paid their money to get in, but
the promise that they will profit as people join below them will never
be fulfilled.
Of course, the number of levels that can be filled
depends on how many new participants, on average, are brought in by each
previous participant. But even if each participant brings in only
two new participants, the pyramid will collapse in about 32 or 33 levels
(still assuming, of course, that you can get all five or six billion people
in the world to join) with most participants having lost money.
No new wealth is created, the only
wealth gained by any participant is wealth lost by other participants.
You need to understand that all legitimate business
activities, in some way, create wealth, or contribute to the creation of
wealth. When you create a product, that is worth more than what it
cost to produce, you've created wealth. When you perform a service,
which is worth more than it cost to provide, you've created wealth.
If you spend a dollar for a lemon, some sugar,
and some water; and then use this to make sufficient lemonade that you
can sell twenty servings for ten cents each, then you've created wealth.
You've taken ingredients worth a dollar, and used them to create a product
worth two dollars. You've created a dollar's worth of new wealth.
Pyramid schemes produce no goods of any significance,
and they provide no service. They create no wealth. All they
do is move existing wealth. Every dollar that one person gains through
such a scheme is a dollar that someone else has lost.
Do not be fooled if the scheme includes some form
of “reports” or lists or other pieces of “information” that you are supposedly
buying from those above you, and selling to those below you. In nearly
every case, these intangible products have no value imputed to them, other
than that which can allegedly be gained by copying and reselling them.
The purpose of these reports is not to provide valuable information, but
to provide a pretext by which one participant in a pyramid scheme collects
money from other participants.
[Added 23 April 2004]
Here's another way of looking at it. Suppose there was
a scheme where everyone who joins contibutes a dollar, which is then put into
a box. No money is put into that box except the dollar from each
person who joins the scheme. Is there any way to redisitribute the money
that is collected into this box so that everyone who contributed money into it
gets more back than what he put in? Let's suppose that a hundred people have
joined this scheme. This means that there is $100 in the box, and 100
people expecting some kind of payout. If the money in the box is equally
distributed among all the participants, then each will get back only $1, the
exact amount that he paid to join. You could give $10 to each of 10
people, but that would leave 90 people who get back nothing, and who have only
lost the dollar that each had paid to join. You could give the whole $100 to
one person, but that would leave 99 people who get nothing back. There is
simply no way for everyone to get back more than they paid in. In order
for anyone to get back more, someone else has to get back less. Anyone
who gains in such a scheme does so at the expense of others who have lost.
The same holds true of all pyramid schemes, Ponzi schemes,
straight–line matrix schemes, and anything else that is in any way
similar. It is mathematically impossible for more to be taken out of
any such scheme than what is put into it.
Conclusion
As the old saying goes, “If it sounds to good to be
true, it probably is.” Anyone who tells you you can make huge amounts
of money, with very little investment, and very little work, is almost
certainly not telling you the truth. Participating in any pyramid
scheme, ponzi scheme, or any other scheme which promises that you will
get rich quickly, with little effort is foolish at best. You will
most likely only lose money to such a scheme, and you may even find yourself
subject to legal prosecution for fraud. True wealth is only gained
through honest work, and honest investment, in enterprises which produce
goods and services of value to all. There are no shortcuts, and anyone
who tells you otherwise is almost certainly out to cheat you.
Some Relevant Links
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Here, I dissect a common chain letter, and provide a simulation, in the form of an Excel worksheet, to show how it fails..
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The MMF Hall of Humiliation
An excellent source of information and amusement about pyramid/Ponzi schemes,
or “Make Money fast (MMF)” schemes as this site likes to call them.
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The
U.S. Postal Service's official statement on “Chain Letters”.
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A USA Today story: Spam scam slams a chain of fools.
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An
excellent site discussing the exploits of Charles Ponzi, from whom the
“Ponzi scheme” gets its name.
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In
Ponzi We Tru$t An article in Smithsonian magazine about
Charles Ponzi, his scheme, and modern variations found today on the Internet.
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Here are a bunch of links to real news stories about real people, just like you, who've been arrested for participating in pyramid schemes. The same thing could happen to you, if you're foolish enough to get mixed up in these kind of schemes!
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As I've stated, I am no fan even of “legitimate” MLMs.
Though I fully understand the distinctions between them and illegal pyramid
schemes, I believe that even the most legitimate MLM has a lot more in
common with a pyramid scheme than with any honest, well-run business.
For a very well-researched and well-written article on the subject, follow
this link:
What's Wrong With
Multi-Level Marketing?
