Define: Investor Protection Guide: Pyramid Scheme

A pyramid scheme is an illegal business model that promises high returns on investment. It operates by recruiting new members who must invest money or pay membership fees. The initial recruiter and early investors are paid from the investments or fees of later investors. As the membership grows, the pyramid collapses because later investors cannot recruit more members. Only the initial recruiter and a few early investors make money, while the rest lose money. Pyramid schemes are unsustainable, and investors should be wary of signs such as unrealistic returns, high upfront fees, and unclear descriptions of products or investments.

A pyramid scheme is an illegal business model that guarantees high profits on investments but is not sustainable. It operates by recruiting investors who are required to pay membership fees or invest money. The person who initiates the scheme is at the top of the pyramid, and investors join at lower levels. To make profits, members must recruit new investors, and the initial recruiter and early investors receive payments from the investments or membership fees of later investors. Eventually, the pyramid collapses because later investors are unable to recruit new members, resulting in only the initial recruiter and a few early investors making money while the rest lose their investments. For instance, if the initial recruiter creates a pyramid scheme where each member must recruit nine new members, the number of members needed to sustain the pyramid at level 9 would be 387 million or more, exceeding the population of the United States. This demonstrates the unsustainability of pyramid schemes and their inevitable failure. People often confuse legitimate multi-level marketing (MLM) with pyramid schemes because MLM also involves a tiered compensation system where a member receives a portion of the sales commissions of a newly recruited member. However, MLM can be distinguished from pyramid schemes by examining the source of the profits. Profits from actual product sales or investment gains are likely to be legitimate, while profits from the investments of later investors are likely to involve illegal pyramid schemes. Investors should be cautious of warning signs indicating pyramid schemes, such as promises of unrealistic returns on investments, high upfront fees or investments, lack of clear descriptions of products, services, or investments, and absence of a genuine underlying investment. For more information, refer to the following resources: Pyramid Schemes, The Securities and Exchange Commission (SEC): Investor Alert: Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs, The Securities and Exchange Commission (SEC): Don’t Get Caught in a Pyramid Scheme, New York State Attorney General.

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This glossary post was last updated: 17th April 2024.