People are always thinking up new ways to swindle others out of their hard-earned cash. Some schemes take on new and creative forms, but the pyramid scheme has not changed much in over 200 years.
The business models of pyramid schemes, Ponzi schemes, and multi-level marketing (MLM) companies bear a close resemblance. The first two schemes are illegal; MLM business may seem shady but are technically legal. This article defines pyramid schemes and explains how to distinguish them from legal multi-level marketing programs.
How Does a Pyramid Scheme Work?
A pyramid scam follows a predictable formula.
The first person, known as the "recruiter," will start the scam by recruiting others into a business or gifting circle. They will pay a fee to do so. These members then invite other people to buy in and they receive a percentage of those joiners' fees. And the recruiter gets a large cut. Every new member is encouraged to bring in more new people. As long as new people are entering the circle, the scam continues. When new member recruitment slows; the money stops coming in.
A pyramid scheme can have a legitimate business at its base. It may be a company selling an excellent product. It may have an excellent training program and provide great support for its resellers. But, if most distributors make their money recruiting new distributors rather than selling products, the business is operating on a pyramid scheme.
Examples of State Laws
Each state has its own laws addressing pyramid schemes and similar forms of marketing fraud (including Ponzi schemes). Below are a few examples:
Arizona: The state statute defines a pyramid promotional scheme as an operation in which participants receive compensation derived from other people's participation rather than from the sale of goods, services, or intangible property. Arizona makes it a felony to "establish, operate, advertise or promote a pyramid promotional scheme."
Florida: Florida's Deceptive and Unfair Trade Practices Act prohibits the use of "a chain referral sales technique to get a consumer to purchase a product or service over $100, where the consumer is promised money or commission to recruit more members." Soliciting membership is punishable as a first-degree misdemeanor.
Pennsylvania: Under the state's Unfair Trade Practices and Consumer Protection Law, Pennsylvania defines a pyramid scheme as:
- Any plan by which goods or services are sold to a person for a consideration (financial investment) and
- That the purchaser must attempt to help others join the plan, and
- Each purchaser is given the right to secure money, goods, or services depending on the number of persons joining the plan.
Pennsylvania distinguishes three terms: “Chain-Letter Plan," “Pyramid Club" and “Pyramid Promotional Scheme." Chain-Letter Plan and Pyramid Club do not limit the number of potential participants; a “Pyramid Promotional Scheme" limits participation either expressly or by the use of conditions. All three recruit others as a primary vehicle for earning.
A good example of the enforcement of this law is found in the 1989 case of First Financial Securities (564 A.2d 280). A pyramid scheme tried to skirt the letter of the law by offering a valueless participation option. Nobody seemed to choose that option because they were motivated to make a profit. Having that as an option did not negate the illegal aspects of the business.
The Pennsylvania law strikes at a scam reported many times to the Better Business Bureau: The Blessing Loom. It operates like a modern-day chain letter using technology to prey on desperate people. The victim is invited to participate in a "gifting circle" by a friend on social media. They send money — about $100 — through PayPal or Venmo. Then they wait to receive money.
While they wait, they recruit others. When the group runs out of recruits, the money stops flowing.
This scam is particularly effective during the holidays. It goes by many names: Secret Sister, Sou-Sou or Susu, or Money Board. Sometimes scammers create fake online profiles and "friend" people just so they can later invite them to participate.
Washington State: The Anti-pyramid Promotional Schemes Act targets enterprises that:
- Finance returns to participants with money taken from new participants
- Promise participants large returns for their investment or contribution
- Involve unfair and deceptive sales tactics that misrepresent the sustainability, profitability, and legality of the business or make false claims that the scheme is legal or approved by the government.
The Act makes it illegal to establish, operate, promote or participate in a pyramid scheme. It also makes clear that limiting participants or changing the words used to define the "consideration" (gift or donation versus membership fee) does not change the fact that it is a pyramid scheme.
Pyramid Schemes: Are They Legal?
Pyramid schemes are NOT legal. The Washington State Anti-Pyramid Promotional Schemes Act calls it "an unfair or deceptive act in trade or commerce and an unfair method of competition...."
Pyramid schemes still happen today. Many reasonable people fall for them because they sound like legitimate multi-level marketing businesses. These businesses are especially attractive to stay-at-home mothers who want to earn income but need flexibility to care for children.
These women are embedded in a network of families with the same needs for income and flexibility. That makes it easy for products to be sold through network marketing and easier for recruitment to spread through a community.
Earlier investors are visibly successful with the business. Those downline then wonder what they are doing wrong. They don't realize that those on the lower levels can never get the high returns that the company saw early on. There are simply too many distributors.
Multi-Level Marketing Businesses: Are They Legal?
An MLM business involves a central corporation that creates a product and then convinces other people to pay a fee in exchange for the right to sell its product. In this manner, they are similar to pyramid schemes.
Unlike a pyramid scheme, those who invest in a legitimate MLM business can make money by selling the company's products. They do not have to bring in new recruits. (Although they will make more money if they do.)
The distinction between legal business and illegal schemes can be difficult to distinguish. Several high-profile companies billed themselves as MLM organizations but were later sanctioned for running an illegal pyramid scheme. For example, Herbalife, the once-popular supplement and skincare company, ended up in trouble. The FTC investigated complaints that it provided deceptive information about how much money its distributors could earn selling products. The company eventually settled a lawsuit for $200 million and was forced to restructure, but it continued to operate.
How Pyramid Schemes are Prosecuted
There is no specific federal statute for the prosecution of pyramid schemes. The FTC has prosecuted pyramid schemes as deceptive trade practices or as fraud. States have their own laws designed to combat pyramid schemes. Many require the promoters - those at the top of the pyramid - to pay fines or spend time in prison if convicted.
The Washington state distributors for LuLaRoe, the clothing company, reported the company to their state attorney general's office. The attorney general sued the California-based company on behalf of some 3,000 distributors. The company settled for $4.75 million. Four million was distributed among those who had lost money to the pyramid scheme.
Can You Go to Jail for Participating in a Pyramid Scheme?
Those responsible for creating and operating a pyramid scheme can be charged in both criminal and civil court. Recruiting people to participate in a pyramid scheme is a felony. A person could face years in prison and hefty fines if convicted.
Those most likely to get ripped off are the members who joined and then induced others to join. They are both the victims and the perpetrators. Being a victim is not a defense in criminal court, although members typically face lesser charges.
Pyramid scheme members often say they did not know they were involved in a pyramid scheme and claim that they thought they were part of a legitimate multi-level marketing company. This has not been accepted as a defense in court.
Involved in a Pyramid Scheme? Get Legal Help
Many would-be entrepreneurs have unknowingly become involved in pyramid schemes disguised as business opportunities. If you suffered financial losses due to illegal business practices, talk to the attorney general in your state.
There is a fine line between an illegal pyramid scheme and a legal multi-level marketing business. If you've been charged with crossing that line in your business, contact an experienced criminal defense attorney.