Ponzi or Pyramid?

file-folders-4One question I get over and over again, especially when giving presentations on common frauds and scams to senior citizen groups  is, “What’s the difference between a Ponzi scheme and an illegal pyramid?”  Which is certainly an understandable question since seniors are prime targets for investment scams of all kinds.

Both Ponzi’s and pyramids use the money of investors to make promised payoffs to other investors.  But they’re run very differently by their promoters and legally they’re prosecuted under different laws.  A very important distinction to make is between legal and illegal pyramid schemes.  Ponzi schemes and illegal pyramids are the same, only somewhat different.

The promoter of an illegal pyramid generates revenue by continually recruiting new members.  The different operations may offer goods or services for sale, but it’s important to keep in mind that the only significant revenues come from new recruitments.  Some legitimate sales companies use a pyramid structure to rank their employee-owners and calculate their compensation.  So when does a legal pyramid structure become illegal?   That happens when the company makes its money primarily by recruiting people.  Instead of selling a product or service, the group deals primarily in new memberships.   Joining the group allows the new member to profit by personally signing up new members.  The process continues until the available pool of new members is drained, which always happens a lot faster than most people think.

As a rule of thumb, courts in the U.S. apply the 70% rule.  This requires that at least 70 percent of the distributor’s profit come from actual retail sales.  Is this rule hard to verify?  You bet.  Distributors often sign falsified compliance statements because promoters warn that if they don’t authorities will shut the whole thing down and everyone will lose.  So the bottom line as to legality hinges on what the pyramid operators emphasize… if the company emphasizes the recruitment of new members over the sale of products, and if the only way to recognize the promised return is through additional recruitment, then the operation will likely be classified as an illegal pyramid.

Illegal pyramids are promoted as pyramids… Ponzi schemes are promoted as investment opportunities.  The key element in the Ponzi is that initial investors are paid with subsequent investors’ money.  There is little, if any, legitimate commerce.  In an illegal pyramid no one is really selling that much of the product; they’re coaxing new people to put up money.  The original members of the pyramid get rich on subsequent investors’ money…so, a pyramid is a Ponzi scheme.  Is a Ponzi scheme a pyramid?  In the sense that it requires exponential growth to avoid a collapse, a Ponzi scheme is a pyramid scheme.  The difference is that in a pyramid scheme, each member financially gains from personally recruiting additional members, but in a Ponzi scheme, all proceeds are pooled and participants are not directly rewarded for recruiting additional members.

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