Before we get into the legitimacy of pyramid schemes, let’s first understand what pyramid schemes actually are.
Pyramid schemes are a type of business model that runs solely on the ability of the members to recruit more members under them. Each member pays to be recruited and in turn, has to onboard more such people to get an incremental commission.
What makes pyramid schemes susceptible to illegitimacy is the fact that these do not have any tangible or intangible product or a service to sell. They earn utterly on the basis of exploiting people that pay to be a part of the scheme, rather than selling a product.
The top-level members of the organization lure people to get more under them by giving them a share of the new payments, keeping the maximum percentage with themselves. These returns are usually extremely high and are promised in a short duration of time, acting as a seduction for more and more people to jump onboard.
However, eventually, since there are only so many people you can continue to recruit, the recruiters will run out of more people and the pyramid will collapse.
Now, let’s answer the pertinent question.
Are Pyramid Schemes Illegal?
The short answer is yes, pyramid schemes are illegal in a lot of countries and multiple states have formulated their own legal framework that criminalizes the scheme creators.
The FBI, Federal Bureau of Investigation, has established that franchise fraud is a pyramid scheme, also known as chain referral scheme. It recognizes that the actual profit earned in a pyramid scheme is not through the sale of a product but through the recruitment of more distributors.
There are different laws in different states protecting people to get cheated through pyramid schemes. For example, the state of Pennsylvania has enforced the Unfair Trade Practices and Consumer Protection Law to take legal action against pyramid schemes.
Similarly, the state of Texas has brought the pyramid schemes under the purview of Texas Business and Commerce Code statute which prosecutes anyone involved in advertising, selling, promoting or contriving in the scheme with a jail time of a minimum 6 months to 2 years and a fine of up to $10,000.
Legitimate investment schemes revolve around actual goods and services while illegal investment models depend on multiple levels of recruitments to earn their profits.
Why Are Pyramid Schemes Illegal?
Pyramid schemes, in general, can often confuse the common investor about whether it’s legal or not, considering the fact that it promises a more than decent return in a short span of time.
However, the Federal Trade Commission, FTC, distinguishes the illegitimacy of pyramid schemes due to the fact that they often hinder the legal course of investment and do not deliver on their claims. The businesses running the pyramid scheme lure people into the web under a ruse of having a valid product to sell while the entire mechanism works on commissions from new recruitments.
The pyramid schemes are illegal because they emphatically come to an end. Their course is finite.
Here’re a couple of primary reasons why pyramid schemes are considered illegal:
● Unreasonably Lucrative Returns: People get attracted to any investment scheme because of the returns they are promised. Pyramid schemes, in their essence, promise extraordinarily high returns, that too within an unreasonably short duration of time.
There is also a case of misleading advertising wherein the scheme is promoted by inciting people by saying that all they have to do is join the programme to earn loads of money without mentioning the fact that they need to further get multiple people under them and make sales to earn the said commission.
While the new members are left clueless, the people on the higher end of pyramid end making piles of money by raking in the payments by new recruits. This opacity in the dissemination of knowledge is one of the primary reasons why pyramid schemes are considered illegal.
● Definite Failure: Pyramid schemes are inherently a failure in the sense that they have to end at some point in time, leaving a myriad people on the lower level of the pyramid in huge losses.
As the FTC mentions, no pyramid scheme can carry on forever as they can’t recruit people eternally and have to fall apart after a certain stage is reached. When the scheme fails, it leaves a maximum number of the investors at the bottom levels of the pyramid with no new recruits and thus no way of recovering their initial investment.
How to Spot a Pyramid Scheme?
Pyramid schemes can take multiple forms and it can get really difficult to identify them as illegal programmes.
According to the Federal Trade Commission, there are several ways to spot an illegal pyramid scheme. Let’s check them out.
● Absolute Focus on Recruiting: If a scheme blatantly says that you’ll get paid depending on the number of people you can recruit into the business and not the quantity of the product you sell, it’s definitely a red sign.
● No Tangible Offering: Pyramid schemes usually do not have any real offering to sell. They have no product or service they are selling to customers. Therefore, they emphasize more on the number of members than on the sales.
● No Retail Sales: A company that has no retail avenues for selling its product to the public in general and still claims of generating high revenue in sales is more often than not a pyramid scheme. It might just be selling its products among the members of the pyramid.
● Inventory Loading: Inventory loading implies that the company mandates the recruits to purchase its products to stay in the line of business, often a quantity beyond their scope of selling. The question also arises here about the treatment of unsold stock, which the company does not take back.
● Lavish Returns, Minimum Time Duration: A company that promises its members unrealistically high returns in an extremely short duration of time is most likely running a pyramid scheme by seducing people, giving them a false hope of a luxury life.
Laws Governing Pyramid Schemes
While there are multiple awareness articles being disseminated by central law enforcement agencies like the FBI and FTC, there is no federal law established to monitor illegal pyramid schemes.
Every state has its own law against these schemes which are often clubbed under the umbrella of other money laundering schemes and marketing scams. For example, the state of Florida’s Deceptive and Unfair Trade Practices Act protects the citizens against pyramid scheme, defined under the law as chain referral sales scheme that forces a member to purchase products worth more than $100 and is assured commissioned in return for recruiting new members.
In the state of California, pyramid schemes are entailed as “endless chains” and are prosecuted by state agencies. On the other hand, the state of Illinois understands the pyramid schemes as ‘criminal acts of deception directed against property’. There are also several states which take pyramid schemes under the acts that regulate businesses like multi-level marketing.
Even though there is an absence of a federal law against these fraudulent schemes, there are various law enforcement agencies that hold the power to bust these illegal ventures and prosecute those found guilty.
In one of the most cases handled by the FTC, the FTC vs Koscot Interplanetary (1975), the following four points were defined by the body for a company to be identified as a pyramid scheme.
The company asked its members to pay a hefty sum of $2,000 to get to the level of ‘Supervisor’ along with purchasing $5,400 worth of products, while it only paid commission on the basis of the number of members they recruited.
Here’s what the FTC observed:
● An individual became the member of the company by paying a certain sum of money.
● The company gives the individual the right to sell its product or service.
● The individual is asked to recruit more such members under him to receive his commission.
● The commission received is completely unassociated with the sale made and solely relies on the number of new recruits.
Actions in such cases can be taken by the FBI, the Security Exchange Commission (SEC) for securities fraud, the Federal Trade Commission (FTC), the U.S. attorney, the state attorney as well as the local attorneys for general consumer fraud.
Apart from the consumer fraud handled by the FTC, the U.S. Department of Justice also criminally prosecutes those involved in pyramid schemes related to mail, securities, tax and other money laundering methods. The Department of Justice often works in conjunction with the FBI and the SEC, as well as the U.S. Postal Inspection Service to this effect.
The Federal Trade Commission monitors the pyramid schemes under its FTC Act that is an umbrella under which all deceptive business practices affecting trade and commerce are covered. It has the power to file a case in the federal court against those guilty.
Being a contriver in a pyramid scheme is a punishable crime in the U.S. and the abetters can be both jailed up to 4 years as well as fined up to $5,000.
Consequences of Pyramid Schemes
Pyramid schemes work on the concept of deceiving and exploiting naive individuals by luring into a world of quick and massive returns. However, as we discussed above, these schemes are exceptionally misleading and are inherently structured as a failure.
When the schemes fail, people at the lowest level of the pyramids are the ones who suffer the most. They never recover their initial payments and more often than not end up going bankrupt.
Here’s why pyramid schemes are bad for the society and the dire consequences they have:
● The biggest and the most sensitive consequence is the loss of people’s hard-earned money. There have been cases where people have committed suicide after being deceived by these fraudulent schemes. Therefore, there is a loss of life as well as financial loss.
● Post the scheme has been busted and people have been informed, there is a general skepticism that builds among them when it comes to making investments, even if they are genuine. India is a classic example of this where multiple such scams made people lose trust and the negative effect is still being borne by the legitimate network marketing businesses.
● There can be agitations and strikes by those scammed, causing civil unrest and disruption of regular trade.
● The pyramid schemes also deter the image of the banking system and make them appear to be unsafe, along with hampering the bank’s operations on an everyday basis.
What to Do in Case You Are a Victim of a Pyramid Scheme
If you think you have unintentionally, or intentionally, become a part of a pyramid scheme, you need to report the entire system to the law enforcement agencies on an immediate basis to prevent yourself from coming into the section of offenders.
The first thing to do is to completely detach yourself from the scheme, no matter how many recruits you got onboard and absolutely refrain from conducting any monetary transactions with the company by blacklisting their account with your bank.
Report it to the fraud detection agencies, like the FTC or other action forums. You should also keep all communications you did with the company, right from the beginning. While this is important in every type of investment, it is particularly important in such schemes.
To avoid being the victim in the first place, do not fall for the fairytale showed by these companies. It’s highly unlikely to double your initial investment in any instrument within the first month of investing. Therefore, do your research and only enter the business with sound evidence.
The Final Word
It can be difficult to judge the illegality of a pyramid scheme due to its promises of a lavish life and high returns in a very short period of time. You need to remember that every investment comes with a risk, but the risk taken should be calculative and not promise unrealistic results.
Always be apprehensive about such schemes that offer too-good-to-be-true returns. There are ways to identify illegal pyramid schemes from legitimate MLM businesses, the main being the presence of an actual product to sell and receiving a commission on the number of sales you do rather on the line of distributors you recruit.
Before accepting any offer of such schemes, make sure you have done your financial research of the firm. If it is making some unreasonable promises, it is highly likely that it is scamming you!