Ponzi schemes and pyramid schemes are very similar. But there are at least three key differences. Knowing how these schemes work may help investors readily identify these ploys early on.
Ponzi schemes and Bernie Madoff
Named after the now–notorious 1920s new England stamp collector and seller Charles Ponzi, a Ponzi scheme is based on an investor giving money to someone who promises a very high- often 50% return on their investment in a short time. These new funds are used to pay off earlier investors. With a growing pool of new investors a Ponzi scheme can continue for a long time- years in fact. The Madoff investment scandal of 2008 was nothing more than a complex Ponzi scheme. As noted in the Business Insider article, Ponzi schemes eventually fall apart. This when one of three things happen: The operator takes out their money, there are few or no new investors or too many investors recoup their investment money or “returns” at the same time.
Modern-day pyramid schemes
Pyramid schemes are similar to multi-level marketing (MLM) businesses that are not legitimate. Most of the MLM companies we know today DO sell legitimate products, such as Amway or Melaluca. These schemes work by having investors pay a fee to be involved and recruit new investors or distributors. There is rarely a real product for investors and distributors to sell. If there is a product it is sold to other investors to get them to become distributors. As reported by the SEC, these schemes do not last long as it is impossible to maintain this financial house of cards with continual new recruits.
Two examples of modern-day pyramid schemes are eAdGear and Elite Activity. The first, eAdGear, used the front of an internet-marketing company that could help businesses attain greater social media visibility. In reality the company made money by having members recruit new members and then used those funds to pay the initial investors. The second, Elite Activity, promised investors a “cycle of abundance” when they recruited new investors. There was no real product and the founder insisted that the program was inspired by God.
Know the warning signs
Knowing the warning signs of a Ponzi or pyramid scheme is the first step in not becoming a victim. Watch for no product or service being offered, promises of outlandish returns, a required buy-in or recruitment and convoluted commissions practices. If you suspect you are being lured into a scheme, speak with a trusted securities attorney right away.