What is a Pyramid Scheme and a Ponzi Scheme?
A Ponzi scheme, named after Charles Ponzi, is an investment scam where the earlier investors are actually paid from the money invested by the later investors. It is usually characterized by abnormally high returns or abnormally consistent returns even as the economy fluctuates. As such, it will collapse when the withdrawals exceed the deposits. As long as more money comes in (deposits) than goes out (withdrawals) it can continue working.
The most famous example in recent years is the ponzi scheme of Bernard Madoff, who ran a Ponzi scheme for almost two decades, swindling BILLIONS of dollars using his credibility as a stockbroker and investor (he was head of NASDAQ at one time).
A Pyramid scheme is even simpler. You pay to join the scheme, and you are rewarded for bringing in more people (who also pay to join the scheme). There is virtually no investment or sale of product or service to the public. It can be also called a "matrix plan", "gifting circle", or "airplane / stagecoach game".
Pyramid scheme has been around for well over 100 years, and in recent years have reached the Internet as well. In 2003, American Federal Trade Commission (FTC) shut down an operation called "Internet Mall" when it was discovered that most members do NOT actually sell anything from their online store, but instead, derive their income by recruiting new Internet Mall members. In 2006 an 8-ball scam hit Ireland, and in 2008, a similar scheme hit Colombia (the country).
Why Do People Fall for Scams?
Making money is complicated. Working hard may or may not provide a road to success. You also need a keen eye for opportunities and ability to seize them and act upon them, and the resources to do so at the right time. That is just too complicated for most people.
People want to believe in shortcuts. If there are "rules" people will want to see how rules can be bent, circumvented, exploited, and so on. However, when there is no rules, such as "be rich" and "be successful", where luck and circumstances have to do just as much as skills and determination, if not more so, people want to find such patterns, or learn such patterns from others.
The two way humans learn are "other-taught" and "self-taught". Other-taught is when you learn from your parents, your relatives, your siblings, your teachers, your friends... If you burned your hand on a stove, and learned never to touch something on a stove again, that's self-taught. If mommy grabbed your hand and told you don't touch that or you'll hurt yourself, that's other-taught.
The problem with other-taught is it where did the information came from? It must have started as "self-taught", but what exactly was learned? It could be superstition or logical fallacy, or just plain bad data and bad conclusion. If the veteran player told the young rookie that he always one black sock and one white sock and it had helped him hit homeruns, the rookie will "learn" the same pattern. After all, it couldn't hurt, right?
Scams prey on this innate need for simpler explanation. They present their "system"... Just do A and B and watch the money roll in! Pay me this $$$ and I'll show you how! And advent of telegraph, telephone, and now, Internet spread information faster, and also spread scam faster.
Some Scam Explanations
Scams often rely on lies, and logical fallacies to convince you their "shortcut" to riches is valid when it is not. Here are just some of the tactics they used:
Presenting dogma as fact
Scammers often present personal opinions as if they are fact, with no justification or evidence to back up the statement.
EX: Why? Because my upline said so.
(Why should we believe your upline?)
Misdirection and half-lies
Scammers often implies something, but reality is something else.
EX: XYZ cites Warren Buffet's quote "best investment I've ever made!"
(In reality the quote refers to one of Berkshire Hathaway's holdings, not XYZ company. )
Scammers often use false logic to explain why 1+1 is 3, not 2.
EX: XYZ paid my cousin, so XYZ cannot be a scam.
(XYZ can be a pyramid scheme, which pays a few people, but is still a scam)
"You don't understand us"
According to scammers, one must be in the scam to understand how the scam, and claim outside critics don't understand the scam at all.
EX: "How can you criticize _____ when you are not in it?"
(Police and justice system are not criminals, yet they understand the criminals well enough)
Attack the Critics
Scammers often accuse critics of everything, like "hostile to MLM", "work for a rival", "conspiracy to keep the poor poorer", "politically motivated", and so on, but completely without evidence to back up their claim.
Scammers often simply deny every bit of evidence they encounter, blame everything on a "conspiracy", and dismiss all damning evidence as "negativity" to be ignored.
It is the participant's fault
Scammers often dismiss personal testimony from the people who realized the system is a scam by declaring "the system is fine, it cannot be the system's fault, it must be the participant's fault".
and many more
If you need more examples, here are 13 documented excuses uttered by a scam's supporters, including the ones named above.
How an Internet Ponzi Scheme Is Created
There are a lot of variations on this. The simple ones just ask you to recruit people. The more sophisticated ones disguises itself as a MLM, use all the same terminology, but sells nothing significant. Here is how such a scheme would get started:
>>Create a "compensation plan", borrowing heavily from Network Marketing
* usually involves a "matrix", since a pyramid sounds so illegal already
* make up some fancy names and rules like "follow-me matrix" or "forced matrix"
* disguise the matrix to dividing into two or three different "boards", to disguise the total number of participants needed for payout
* define some sort of vague benefit, that is easy to get (probably free) elsewhere
* and/or define a benefit that the enrollee get instantly, but actually need to be redeemed
* there may be some sales involved, but if any, only a token amount
* add multiple "levels" of membership to make it sound more like MLM
* describe all aspects of a pyramid scheme, but separate the aspects into multiple questions, separated by various other misc. facts, so people will be slow to piece them together.
>>Incorporate a business in a tiny courtry on another continent
* it does not even have to be a country you have physical presence in, known as "off-shore" company
* the further the better: if you market the stuff in Asia or Americas, incorporate in a corner of Europe, like Cyprus, practically in the Middle East.
* incorporating makes you sound more legitimate, esp. if you use a sufficiently generic name that you can claim as initials for something better, and easily confused with a legitimate company
* have some distant cousin or someone serve as the figurehead president, but you control the finances.
* incorporating elsewhere also means you can use a payment processor like Liberty Reserve or Solid Trust Pay who will not issue refunds. There is no rescinding the payment once you get it.
>> Rent a small or virtual office at a prestigious location and advertise that as part of legitimacy claim
* if they supply phone lines that can be forwarded to somewhere else, even better
* You can move out in a few months if you wish, just claim "expansion pains"
>>Create a website about the business that describe it in glowing terms
* promise huge amount of money, such as "opportunity to earn $10000 per week!"
* be vague about your product, so your members will make up explanations for you
* use similar but not same terms, to create impression without saying so
* be vague about who runs the company, extremely vague, like "vice-admiral"
* cite some chopped quotes to make it sound like celebrities are endorsing you
* provide a script, presentations, and website kit so people can customize and spread it for you
>> Create the structure to "implement" the compensation plan
* buy a pre-made website from some coders in India where this is all pre-packaged and ready to go. Just hire some artists to put in some fancy graphics.
* when you join, you need to enter your upline's ID, and your enrollment voucher code (which cost $$$) and create your own ID. The underlying structure then generates the "matrix" genealogy
* when your "matrix" is complete, the computer credits the reward into your account
* add some vaguely defined "commission" / "residual payout" (again, borrowing from MLM)
>> Sign up yourself as first member, then invent some members with fake names (which are all you) to generate some fake payouts (to yourself)
>> Hire some phone drones to answer "customer service" lines, a few would be enough.
* Give them a script to read, but no real power to actually do anything.
* Hire some voice talent to put up incredibly exciting on-hold messages that say nothing useful, to encourage callers to hang up and query via e-mail, which can be ignored more easily.
>> Advertise the fact that you made money by simply signing up people, and provide "proof" (you generated) to sign up even more people
>> Pay out the early joiners automatically with the system. However, make it difficult to actually convert the money in their "account" into real cash.
* Remember, since you're paying out a small fraction of money coming in, all that extra money is yours.
>> Astro-turf support by creating multiple online identities specifically for this.
* Post on all the MLM, income, homebiz, and such websites (with different names) and offer testimonials "I made $$$$ with this _____!"
(astro-turf is artificial grass, and in this case, refers to a false "grass-root" support for a certain cause. Grass-root support should be spontaneous, but astro-turfing is secretly organized by someone else)
>> Astro-turf attack on critics, who spotted inconsistencies and problems with the scam
>> Once you past a certain threshold of members, the scam is self-perpetuating.
Your members will advertise your scam for you, as you've made them part of your scam. it's the snowball effect.
>> Periodically hold "conference calls" with top members and their downlines
* Die-hard followers are eagerly waiting to hear about the scam... I mean company. How fast it is expanding and all that.
* Make up some bull**** explanations if they ask you embarrassing questions, and tell them that you will ask the company leadership (since you are merely a "top member").
* Everything is great, ignore all problems, you'll get them answers later, if you ever get back to them.
>> Periodically hold "seminars" in vulnerable areas (where there are a lot of desperate people hoping to make $$$) by using the ill-gotten gains.
* The seminars are actually recruitment drives. You don't even have to show up, since video conferencing is so easy nowadays.
>> When the law comes knocking on the members' doors (i.e. when the consumer protection agencies start to prosecute members for running pyramid schemes)
* promise them moral support, and leave them hanging. If they lose, evacuate the country, and never mention them again.
>> When the heat is really on, take the money and run, leaving your cousin, the figurehead president, holding the bag, and millions of members around the world ****ed.
An Actual Scam Example
The following is from an actual scam that was already declared illegal in at least one state in the US, as well as several other countries around the world. Content was only edited in format and layout, and names are changed, but content is real.
Q: Do I need to sell any products?
A: No. You don’t need to sell any products. XYZ is a unique e-commerce opportunity allowing you to build the Business around the globe sitting at your home.
Q: What do I need to do to cycle out of the boards?
A: The first thing you need to do is sponsor two (2) people who join the XYZ Opportunity. This will qualify you to cycle out of the boards as you progress ahead in the Compensation plan. Secondly, you need to encourage and teach those two downlines (people you sponsored) to sponsor more people and duplicate the process. Following these two simple steps will have you making money even while you sleep
Q: What do I receive when I cycle?
You get the following commissions after you cycle out of the respective boards :
1) Y board : You receive $500 ($250 cash + an eVoucher worth $250)
2) Z Board : You receive $10,000 and a re-entry into the Z Board
So what can be concluded from the preceding FAQ items? Keep in mind the following definition:
...If a program compensates participants, directly or indirectly, merely for the introduction or enrollment of other participants into the program, it is a pyramid.
--cited from http://www.mlmlaw.com/library/guides/Primer.htm
The so-called "boards" are 2x3 "forced matrices", i.e. the 8-ball scam, or the 1-2-4-8 pyramid. So what can be conclude about the compensation package? You "cycle out" by filling the pyramid with recruits, either recruited by you directly, or by any of your downlines. Thus, to summarize:
- XYZ members sell nothing
- XYZ members need to recruit at least two people
- XYZ members cycle out the board/matrix by filling the board/matrix with recruits (each pyramid is 15 people)
- XYZ members get paid when they "cycle out" of the board/matrix
According to previously quoted definition, XYZ is a pyramid scheme.
The preceding FAQ items are directly quoted from the scam's website, and they were were separated with several other questions stuck in between the items to "dilute" your attention. If you weren't being skeptical, you probably would have missed the significance of those answers, as they basically described a pyramid scheme, but in a misleading way.
How to Avoid Internet Ponzi Scheme with 5 Questions
The five questions are What, Who, Where, When, How
1) What is the product?
In any real MLM business, there is always a primary product or product category. (a service, in this case, is considered a product)
* Amway = nutritional supplements and household stuff
* Avon, NuSkin = cosmetics
* Pampered Chef = cooking equipment
Such products are always sold by the member to the public (who are NOT members)
If there is no product, or when income does NOT depend on selling any products, it is VERY LIKELY a scam.
2) Who runs this outfit?
In any real business, the leadership should be highly visible. He or she may not take calls directly, but there should be enough information to verify the ownership and/or the CEO / President and you can find out a bit about him or her on the Internet and via public records. And the rest of the officers. You are essentially considering joining a company for a job. Why should you NOT look up the company information at all?
If there is NO information on who runs this outfit, it is VERY LIKELY a scam.
3) Where is this outfit?
Where is this outfit? Is it in some corner of the earth that you never heard of? Can you visit the office? Is it registered with local Chamber of Commerce or Better Business Bureau? Is it a real office or virtual office? What does Google Maps say? What sort of neighbors does it have?
The farther away the company is, the higher the risk. You don't want to join and find out that their "legal HQ" is on an island on the other side of the globe, so you couldn't touch them even if you tried.
4) When was this outfit founded?
Most MLMs do not survive beyond 2-3 years. Thus, you don't want to join a MLM just when it is about to go under.
There are many who advocate joining a MLM early on as "ground-level opportunity. However, consider the following: if the product is good, it should sell well at any time, thus joining early should have little effect on profit, but increases your risk tremendously.
5) How is the money made?
A legitimate MLM will only pay upon sales of products. It could be your own sales, or sales of your downlines, but it is based on SALES of products.
A pseudo-MLM scam will pay on recruiting only. They just need more members to feed the pyramid, not actual sales of products. In fact, many scams don't have products at all. They will "claim" they have products, but none of the products are sold to the public, and thus are irrelevant.
It is actually not that hard to tell a real MLM from a pseudo-MLM scam masquerading as one. However, you need to keep a skeptical mind.
Ask the 5 questions, keep in mind the REAL definition of a pyramid scheme (pay to join, then get paid to recruit others who do the same) and you should be able to avoid such schemes on the Internet.
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G. Diane Nelson Trotter from Fontana on November 10, 2012:
Great information! Hopefully you can spare some gullible people the pain.
Brinafr3sh from West Coast, United States on April 28, 2012:
Hi Kschang, This is true, people want money fast and quickly. Money pyramid schemes seems easy once they meet a quotas for new members. But it is illegal and many times too good to be true. Good information in this article, thanks. Voted up and useful.
vrajavala from Port St. Lucie on November 01, 2010:
Usually, I just go to a scam information site to find out about any new ones, but, I must say that years ago I did fall for a couple.
rafken from The worlds my oyster on November 01, 2010: