You have likely heard the term “pyramid scheme,” but do you understand what a pyramid scheme is and how it works? Is a pyramid scheme the same thing as the multi-level marketing (MLM) that is used so effectively by companies such as Lularoe and Herbalife? Below, we will explore the topic more in-depth and reveal a list of companies that were shut down as a result.
What is a Pyramid Scheme?
A pyramid scheme is a fraudulent investment strategy, deemed illegal in the United States. According to the Federal Trade Commission, pyramid schemes “promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public.”
In a pyramid scheme, an initial investor recruits a second investor to work under him. This second investor is required to “invest” a certain sum of money to be paid to the initial investor.
He is also required to recruit another investor under him and another and so on. Each recruit is required to pay an “investment” to the recruiter above him and to recruit more investors. If any recruit can get just ten recruitments under him, he or she will make back his initial investment plus a small profit.
This process continues until there are no longer any recruits to be found and the lower level can no longer support the upper levels. There are some variations on this basic model.
How Do Pyramid Schemes Differ from Ponzi Schemes?
Experts disagree as to whether Ponzi schemes are pyramid schemes. Certainly, there are similarities between the two. While Ponzi schemes are certainly fraudulent, they are not necessarily hierarchical in nature, which is one of the defining characteristics of the pyramid scheme.
Additionally, in a Ponzi scheme, “investors” are not asked to recruit others, nor are they told where their payoff would come from. In this sense, Ponzi schemes operate at a level that is vaguer than the traditional pyramid scheme.
How Do Pyramid Schemes Differ from Multi-Level Marketing?
Although multi-level marketing (MLM) is similar to a pyramid scheme in that sellers are encouraged to bring in others who work under them, the key difference is that MLM companies offer a concrete product that is sold to consumers. This is a significant distinction and part of what sets MLMs apart legally.
Some MLMs, such as the Mary Kay Company, have been accused of being pyramid schemes in that the only way for sellers to make any real profit is for them to recruit other sellers; simply selling a product is not enough to generate any significant income.
Often, MLMs require sellers to purchase an initial package of some sort. This may be a set of articles of clothing which they then sell to customers, or this may be a package of samples that they distribute to potential customers. In many cases, however, an initial purchase, which should be distinguished from the so-called investment of the pyramid scheme, is required of new sellers.
Which Was the First-Ever Pyramid Scheme?
It is impossible to know historically which was the first ever pyramid scheme, since fraud has been around for as long as human civilization. However, in her talk to the FTC in 1998, Debra Valentine says that it was in the 1970s several factors pushed the FTC to get involved.
She says that
“one of the Commission’s first cases was In re Koscot Interplanetary, Inc., which involved a company that offered the opportunity to become a “Beauty Advisor” and sell cosmetics. The company’s incentive structure really did not encourage retail sales. Instead, it encouraged people to pay $2000 for the title of “Supervisor” and purchase $5400 in Koscot cosmetics, and then to earn bonuses by recruiting others to make the same investments.”
It seems, then, that this is the first example of an MLM shutting down because of being investigated by the FTC as a pyramid scheme.
Have any MLMs Been Investigated as Pyramid Schemes?
Several MLMs have been investigated as pyramids schemes. Recently, the huge MLM company Herbalife received much negative press amid allegations that it is a pyramid scheme. Though, in the end, the FTC determined that Herbalife was not a pyramid scheme but that they rather needed to change some of their business practices.
FTC Chairwoman Edith Ramirez announces the settlement with Herbalife. CNBC’s David Faber provides perspective.
What Companies Have Been Found to be Pyramid Schemes by the United States Government and Then Shut Down as a Result?
It’s difficult for the United States government to prosecute and shut down pyramid schemes, as there is no specific federal statute violated by pyramid schemes, although they are deemed to be fraudulent investments.
More often it is the case that rumors and investigations begin and companies simply dissolve under pressure. Here is a list of companies considered to be pyramid schemes, a pyramid scheme company list if you will.
This is one of the few companies investigated and sued by the Federal Trade Commission that was shut down as a result.
Founded as an MLM company in 2004, BurnLounge was an online music store. Customers were encouraged to purchase a subscription, then sell subscriptions and music through their own online sites. BurnLounge referred to this model as “concentric retail.”
The FTC argued that because BurnLounge paid more to these customers for selling subscriptions than for selling music, it is actually a pyramid scheme. Because “recruits” pay more than the actual product does, it is a pyramid scheme, per the FTC’s argument.
The FTC filed suit against BurnLounge in 2007. BurnLounge lost the suit in 2012 and lost an appeal in 2014. The company is currently dormant pending another appeal.
Founded in 1991 as an MLM by Bill Gouldd, Equinox first came under scrutiny in 1996. Investors filed civil and criminal claims against Equinox, saying they had been cheated out of money. In 2000, the FTC issued a notice that Equinox had settled a claim outside of court, agreeing to pay $40,000,000 in restitution.
Equinox dissolved in 2001, and Gouldd was barred from any participation in MLM in the United States.
Fortune Hi-Tech Marketing
Fortune Hi-Tech Marketing was founded as an MLM in 2001 by Thomas Mills and Paul Orberson in Lexington, Kentucky. It sold a variety of goods and services, including hair care products, mobile phone services, and satellite television services. Sellers were paid only a very small (.25% to 1%) on products they sold.
Fortune Hi-Tech faced charges brought by the state of Montana, and Fortune Hi-Tech paid $1 million to settle out of court. Fortune Hi-Tech was then sued by the FTC and the states of Kentucky, Illinois, and North Carolina.
The FTC argued that most profits made by the company and its members came from recruitment, not from sales of goods and services, making it a pyramid scheme. In 2013, the company’s offices in Kentucky were raided, and Fortune Hi-Tech was placed in receivership, effectively shutting it down.
In 2014, Fortune Hi-Tech reached a settlement with the state of Kentucky.
Founded in 1964 by William Penn Patrick, Holiday Magic was set up as an MLM, selling cosmetics and home-care products. Holiday Magic was sued by Avon Products in 1973. The Securities and Exchange Commission filed suit against Holiday Magic in June of 1973.
In 1973, the FTC found Holiday Magic to be in violation of section 5 of the Federal Trade Commission Act and Section 2(a) of the Clayton Commission Act.
Holiday Magic distributors were encouraged to purchase a number of seminars run by Patrick’s other companies Leadership Dynamics, Mind Dynamics and Sales Dynamics. Leadership Dynamics and Mind Dynamics ceased operation in 1974.
Founded as an MLM selling dietary supplements, Metabolife was founded in the early 1990s by Michael Ellis, a former law enforcement officer who was then on probation for charges relating to a methamphetamine lab.
Metabolife’s most popular product was Metabolife 360, an ephedra-based product. Partly because of a few deaths resulting from this product, the Food and Drug Administration (FDA) banned the sale of any dietary supplements containing ephedra in 2004.
Ellis was later convicted of lying to the FDA about the evidence regarding the dangers of ephedra, and he and the Metabolife company were both convicted of income tax evasion, leading to the dissolving of the company in 2005.
It is unclear whether Metabolife was a pyramid scheme or a legal MLM which simply went out of business for other criminal activity.
NexGen 3000 and Other “Internet Malls”
In 2003, the FTC issued a press release declaring NextGen and other “internet shopping malls” to be pyramid schemes. In this type of program, sellers were encouraged to purchase a package of goods and services to be resold on the internet. The profit margin for sellers was low.
The FTC argued that sellers were not told how much of their initial investment would be kept. Additionally, sellers were given materials that encouraged them to defraud others, per the FTC.
Nouveau Riche was a non-accredited learning institution specializing in real estate investment courses and a MLM. In February 2011, the Arizona Corporation Commission announced that Nouveau Riche had been fined nearly $6million for defrauding over 100 investors with unregistered deed of trust investments.
During expensive “courses” held by this “college,” students were encouraged to invest in these unregistered deeds of trust. This reeks of a pyramid scheme in that investors were sold neither goods nor services.
However, the classic “pyramid” structure seems to be missing in the case of Nouveau Riche. There is no indication of students being paid to recruit people to work under them. Nouveau Riche closed on its own on December 31, 2010.
Although it’s unclear whether Sunshine Empire is legally a pyramid scheme in structure, it’s certainly an MLM that operated as a Ponzi scheme. Based in Singapore and founded in 2006, Sunshine Empire was dissolved in 2009.
After being investigated by the Singapore Police’s Commercial Affairs Department, the directors of Sunshine Empire were found guilty of fraud and falsifying accounts. Although $189million was collected from investors, only $115 million was paid out to these investors. It’s believed that the remainder of the funds were taken by the directors themselves.
Even more shut down pyramid schemes
Here are a few more companies that have been deemed pyramid schemes and shut down.
- Koscot interplanetary
- Global Information Network (GIN)
- Trek Alliance
- Primebuy network
- 2extreme performance international
- Five star auto club
- Fortuna alliance
- National marketing company
- Mall Ventures
- Jewelway international
- World class travel
- Mentor network
- Drivers seat network
- Global assistance network for charities
- WCM 777
- YES International