From MLM to Ponzi and Pyramid Schemes: Recognizing the Red Flags

Key Takeaways

• A pyramid scheme is a kind of fraudulent system of generating income based on the recruitment of an ever-rising number of “investors.”

• Perhaps the most well-known Ponzi scheme was run by investment manager Bernie Madoff, whose scheme cost investors as much as $65 billion and wiped out the life savings of many unwitting participants.

• A Ponzi scheme, meanwhile, is a fraudulent system in which investors are paid with funds from new investors. Organizers of such schemes commonly pledge to invest one’s capital and produce high returns with minimal risk, if any. 

As it is, many investors must regularly comb through unsolicited “invitations” to take advantage of some opportunity or another. Beyond being a nuisance, though, some of these offers could pose a real danger in the form of a Ponzi, pyramid, or multilevel marketing scheme. Thus, diligence is always required.

Here is an exploration of common financial schemes and how to recognize the red flags to avoid being taken.   

What is a Pyramid Scheme?

A pyramid scheme is a kind of fraudulent system of generating income based on the recruitment of an ever-rising number of “investors.”

Such schemes generally involve the initial promoters recruiting investors who subsequently lure more investors, and on and on. While some techniques are generally conservative, rendering them only minimally risky, others can be aggressive and involve more risk.

The scheme is dubbed a “pyramid” since the number of investors increases at every level. In addition to causing financial loss, pyramids also have participants scam recruits, thereby themselves committing fraud.

How Pyramid Schemes Operate

Say, for example, a scheme requires a $2,000 “buy in” from each participant. The first participant gets paid from new recruits’ receipts. The new recruits bring in others. With each payment made by a new recruit, the people above them get a cut. As the enterprise grows, as promises of big payouts also grow.

Early scheme participants do make money, while those who come in later get increasingly less. Why? Because it becomes more challenging to find individuals amenable to paying $2,000.    

Legality of Pyramid Schemes

Such schemes are illegal under federal law and in most states. In Connecticut, for example, the law says that if the program’s method of making money is based on membership recruitment, and not on a product or service, it is a pyramid, which is a felony.

While no federal statute exists for the express prosecution of pyramids, the nation’s Federal Trade Commission’s Division of Enforcement has gone after them for fraud or deceptive trade practices.

Pyramid Scheme Case Studies

There have been some prominent case studies i volving pyramids. A couple of them are:

• Energy drink pyramid scheme. In 2015, federal regulators halted operations of the energy drink company Venma that used college students to sell the beverage called Verve. Venma was found to be running a pyramid scheme that recruited the students with the potential of gaining wealth. Instead, most left with no profits. At length, business bank accounts and assets were frozen. Venma, which posted $200 million in sales in 2013 and 2014, had marketed its “business opportunity” to students as a college alternative.  
• Insurance pyramid scheme. Business Review at Berkeley columnists in 2019 were asked to attend a World Financial Group branch where they were told how to become wealthy by selling life insurance. This occurred as the attendees’ recruiter attempted to also sell each of them an insurance policy and hit them with pricey license fees. While WFG used a direct selling strategy, such products were only occasionally used to conceal its pyramid structure, according to the Federal Trade Commission.   

Ponzi vs Pyramid Schemes

A Ponzi scheme, meanwhile, is a fraudulent system in which investors are paid with funds from new investors in what appears to be a legitimate security or some other investment product.  Organizers of such schemes commonly pledge to invest one’s capital and produce high returns with minimal risk, if any. 

Perhaps the most well-known Ponzi scheme was run by investment manager Bernie Madoff. He perpetuated a scheme that cost investors as much as $65 billion and wiped out the life savings of many unwitting participants.

The main difference between Ponzi and pyramid schemes is that with the former, victims simply invest. With pyramid schemes, though, investors are expected to help recruit new participants.

MLM vs Pyramid Schemes

Direct sales companies, seeking to promote their goods or services while keeping sales costs minimal, often employ what is called multilevel marketing to generate sales.

The strategy calls for a network of distributors to sell directly to consumers – in person or online — and recruit other salespeople on whose sales they make commissions. Such sales people can work as direct sales representatives, contractors, participants, or independent business owners. Whatever the title, a share of the profits they generate goes to the frontline distributor, who now has two income streams. 

Most such programs are legitimate – though there are always exceptions — with top MLM companies including Amway, Avon, and Herbalife. What makes MLM controversial is primarily the use of a commission-based or non-salaried workforce. 

While the MLM general structure is often likened to pyramids, the difference between the two is that, with a pyramid scheme, there is no actual product for sale.  

Red Flags for Investors

There are common signs or red flags that should make full- or part-time investors cautious about potential scams. Those include:

• Offers that require money up front with guarantees of large profits in a short period, with no product but a dependency on recruitment, should be viewed as a possibly pyramid scheme.
• Extravagant promises about potential earnings.
• High-pressure sales tactics or an attempt to play on emotions.
• Promises of compensation in exchange for little work.
• No demonstrated revenues from retail sales.
• A complicated and murky commission structure.

Investing with Trusted Partners

In this day and age, particularly given technological advances that enable scams, it can be challenging and burdensome to stay ahead of financial schemes.

However, accredited as well as retail investors must continue to be diligent to avoid making costly investment decisions. A chief way to do that is by only investing with those who are reputable, credible, and experienced.

Take Yieldstreet, for example. For nearly a decade, the platform on which almost $4 billion has been invested has offered opportunities in “alternative” assets such as art, real estate, private debt, and more. In fact, Yieldstreet has grown to offer more asset classes than any other platform. 

What is also notable is that Yieldstreet’s offerings are highly vetted and that while every investment carries risk, they are backed by assets, which can help shield against default.

In addition to a proven track record, Yieldstreet offers opportunities in a burgeoning private market that serves a crucial purpose: portfolio diversification. Intermingling holdings with assets with low correlation to public markets can mitigate overall portfolio risk, reduce volatility, and potentially offer better returns.

Portfolio Diversification and Alternative Investments

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

When it comes to investing, it is a fact of life that scams abound. Ultimately, investors must be diligent about their investment choices. The good news is that there are red flags that, if heeded, can keep investors from making potentially very damaging investment decisions.