MLM Dictionary: Pyramid scheme

A pyramid scheme is a type of financial fraud that usually disguises itself as a business, but the participants earn compensation by first paying into the system some sort of fee, in exchange of right to recruit additional participants and sell the product / service, and will be compensated primarily by the number of additional participants they recruit (who also pay the fee). Little if any of the compensation will be based on actual sale of the product or service.

The earliest pyramid schemes, and modern HYIP matrix schemes, are investment frauds, in that you pay in (buy a position), recruit others, then when enough people joined, you are "cycled out" and get the big payout. This has lead to much confusion in modern times where scammers insist on using the original definition of pyramid scheme and insist their business cannot possibly be a pyramid scheme (by the old definition).

In the US, pyramid scheme is defined by the Koscot Test.

Pyramid scheme is related to Ponzi scheme, but pyramid scheme requires participants to recruit in order to be compensated, whereas the Ponzi scheme do not require recruiting.  There are many other differences between pyramid scheme and Ponzi scheme.

Pyramid schemes are known by several names to law enforcement, including franchise fraud, chain referral / endless chain, matrix scheme, and pyramid selling.

Franchise Fraud 

Franchise fraud is mainly used by the US Federal Bureau of Investigations (FBI), it stated:

pyramid schemes — also referred to as franchise fraud or chain referral schemes — are marketing and investment frauds in which an individual is offered a distributorship or franchise to market a particular product. The real profit is earned, not by the sale of the product, but by the sale of new distributorships. Emphasis on selling franchises rather than the product eventually leads to a point where the supply of potential investors is exhausted and the pyramid collapses

Basically, this sort of pyramid scheme sells the opportunity itself, rather than the products. Thus, it is a disguised pyramid scheme.

Note that franchises are governed by franchise laws, under the purview of the Federal Trade Commission (FTC), which also prosecutes pyramid schemes on the Federal level as consumer fraud.


Chain Referral / Endless Chain

In many US states, including California, "endless chain" is the same as pyramid scheme. The California Office of the Attorney General (OAG) writes:

Millions of Americans have lost money participating in pyramid schemes which are also known as "endless chains" - - because they cannot work unless the chain is endless and, of course, it cannot really be endless because at some point there are no more people willing to join the scheme.... An "endless chain" or an unlawful pyramid is a plan in which a person pays money or buys merchandise for the chance to receive money when additional participants are introduced into the scheme.

Chain referral scheme can also describe a fraudulent sales plan, where you order an item at the given price, but if you can make friends and family to also buy the same item, your price of the item will be reduced (possibly all the way up to free).  However, in reality, the item is vastly overpriced, and the demand for the item is vastly exaggerated. This was prosecuted many times by Postal Inspectors as mail fraud in the 1970's.

Please note that referral sales is ILLEGAL in the US, and if a company offers such a plan... It may be in legal trouble.


Matrix Scheme 

Matrix scheme is variant of pyramid scheme with chain referral.  Let's say there's a "matrix" for a PS4 (street value of $400). You can buy a position in the 2x4 matrix (total of 31 positions) for $20. Sometimes, something with negligible value is a part of the position (free PS3 game!). When sufficient people have purchased positions after you (30), you get your PS4.

As this is referral sales, it is generally illegal, as the item is of tiny or negligible value, and people are buying a "position". Though this scheme has a bit more in common with Ponzi scheme in that no recruitment is required (though highly encouraged).

Pyramid Selling

The term pyramid selling is mostly used in Asia and Australia. Australian "Trade Practices Act (1974)" (revised in 2010 into "Competition and Consumer Act (2010)" )specified the following:

pyramid selling scheme means a scheme with both the following characteristics:
  (a)  to take part in the scheme, some or all new participants must make a payment (a participation payment) to another participant or participants in the scheme;
  (b)  the participation payments are entirely or substantially induced by the prospect held out to new participants that they will be entitled to a payment (a recruitment payment) in relation to the introduction to the scheme of further new participants.

Hong Kong has very similar language in their 2012 update to the anti-pyramid laws, but functionally it is the same as the US definition, albeit, with looser language to allow it to apply to broader range of schemes, as several prosecutions resulted in acquittals when the lawyers found loopholes in the old laws.

In China and Hong Kong, pyramid selling also describes a new hybrid scheme, where buyers of a company's product are told they are eligible for "virtual stock options" (based on their purchases) for the company stock and if the company ever goes through IPO the buyers can realize vast profits by selling the options back to the company. In reality the products are way overpriced and IPO never happens.


Pyramid Shape has nothing to do with Pyramid Scheme

Many network marketers, trying to coerce readers into having a better opinion of network marketing, often claim that all businesses are pyramid-shaped, therefore pyramid schemes are all around us. This is disingenuous and relies on equivocation of words, as pyramid-shaped organization is completely different from a pyramid scheme. Pyramid scheme is a type of financial fraud, not an organization shape.


Please also read

Having a Product Does NOT Make a Company Not a Pyramid Scheme

Pyramid Schemes Myths Busted

Why is MLM NOT a Pyramid Scheme (at first glance)