Investor Protection Guide: Pyramid Scheme

A pyramid scheme is an unsustainable, illegal business model where investment returns are typically from principals of investments or membership fees instead from the underlying investment gains.  It is often marketed as a foolproof way to turn a small amount of money into big returns. 

A typical pyramid scheme begins with an initial recruiter attracting investors by promising high returns on their investments.  The initial recruiter is at the top of the “pyramid.”  After investors give their investment money or membership fees to the initial recruiter, they become “level-1” members.  They must recruit a certain number of “level-2” members to make their returns.  The “level-2” members in turn must recruit “level-3” members and so on.  All the members must make investments or pay membership fees.  The initial recruiter and early investors are paid from the principals of investments or membership fees from the later investors.  As the membership size grows, the pyramid eventually collapses because later investors are unable to recruit more members.  Only the initial recruiter and if any, a very few early investors make money while the rest lose money.

Although a pyramid scheme may sound tempting, it is unsustainable.  To illustrate, assume that an initial recruiter devises a pyramid scheme, where each member must recruit nine new members.  In such a scheme, the number of members required to sustain the pyramid at level 9 would be 387 million or more than the population of the United States.  The following table shows the number of members required to sustain the pyramid at each level:

LevelNumber of Members
Required to Sustain
the Pyramid
  1                      9
  2                    81
  3                  729
  4               6,561
  5             59,049
  6           531,441
  7        4,782,969
  8      43,046,721
  9    387,420,489
10 3,486,784,401

 

Legitimate multi-level marketing (MLM), also known as network marketing, is often confused with pyramid schemes because MLM offers a tiered compensation system whereby a member who recruits a new member will get a cut of that new member's sales commissions.  It can be distinguished from a pyramid scheme by determining the source of the returns.  Returns from real product sales or investment gains are likely to be legitimate, while returns from principals of investments from later investors are likely to involve illegal pyramid schemes.

Investors should watch for the following warning signs of pyramid schemes:

  • promises of unrealistic returns on investments
  • high upfront fees or investments
  • strong emphasis on the legality of the business
  • no clear descriptions of products, services, or investments being offered
  • no real underlying investment

For more information, see: