Pyramid Scheme Frauds

The pyramid scheme, in which promoters lure the unwary by extravagant promises of profit which are tied to an ever-expanding circle of new participants, is back on the American scene. State securities regulators and the Council of Better Business Bureaus warn that this classic get-rich-quick con game has returned in new and sometimes more sophisticated guises, leaving thousands of defrauded investors in its wake.

The recent renewed national interest in entrepreneurship has provided the cover for a new generation of unscrupulous pyramid scheme operators who combine a money-making variation of the age-old chain letter game with modern high pressure sales techniques. While the new pyramids often employ the use of a “product” to enhance the appearance of legitimacy, the bottom line is that the profits always come out of the next investor’s pocket.

A recent survey by the National Association of Securities Administrators Association (NASAA) and the Council of Better Business Bureaus (CBBB) revealed a myriad of pyramids operating throughout the U.S. and Canada.

• Over twenty states have issued Cease and Desist Orders against the principals of a company which used a pyramid sales scheme to promote sales of “lactic activator” kits. The kits contained a substance which purchasers would combine with milk to produce a type of mold culture which an affiliated company would allegedly repurchase for use in the manufacture of a new cosmetic product. The company selling the kits has filed for bankruptcy, claiming 27,000 creditors. Investors throughout the U.S. lost $6 million. Investigators discovered that the vast majority of cultures were simply being ground up and recycled into new activator kits and that each kit’s value was a fraction of the price being charged to investors.



• Two smaller versions of the lactic culture schemes have resulted in both civil and criminal actions against operators in Canada and Oklahoma. The latest schemes combine alleged new uses for the same old mold with a religious approach to investors.



• In a number of states, the latest fad is the pyramid party, in which the product is dispensed with altogether. A player puts up $1,000 to enter the bottom of the pyramid and then must recruit two more players to recoup his or her original investment. Heavy peer group pressure is employed in hopes that each new player will recruit enough others to produce a 64-person pyramid that puts the original player on top with $16,000. An operator running a similar scheme in Illinois was ordered to repay thousands of losers after the pyramid’s inevitable collapse.



• At least twelve states, including Tennessee, Texas and Minnesota have acted to halt sales of a pyramid scheme disguised as a “self-motivation” program. Participants, who pay up to $6,000 each to attend self-improvement and nutritional seminars, are then motivated to recoup their investment by introducing the program to new investors and receiving a commission on the fee. State actions followed numerous complaints that the seminars were difficult to sell and that the materials were not worth the price charged.



• The U.S. Postal Service obtained a consent order in late 1985 from an Arizona company it had alleged was falsely advertising large earnings from a multi-level credit card sales scheme in which participants could supposedly build up huge credit lines and never have to pay balances due. The State of New Mexico also obtained a consent agreement with the company after charging it with violating the state Pyramid Sales law.

Other questionable schemes that have come to the attention of securities regulators and Better Business Bureaus in recent months have included plans for multi-level sales of investment newsletters. One such program promises to provide new subscribers with part ownership in investment portfolios if they recruit new subscribers. Another offers commissions for new subscriber sales in the form of silver bullion, as well as cash.

What is a Pyramid Sales Scheme?

In its purest form, a pyramid sales scheme involves the collection of money from individuals on the bottom to pay other individuals further up the pyramid. The program appeals simply to the greed of individuals and their willingness to take the risk that the pyramid will last until they get to the top.

Many pyramids attempt to prove their legitimacy by the use of a product. The reason is that most state laws prohibit a program where the profit potential comes not primarily from the sales of products to consumers, but from the inducement of other investors to join the scheme. The Federal Trade Commission states that such pyramids display two essential elements: the payment of money for the right to sell the product and the payment for the right to recruit others into the program for rewards that are unrelated to sales of the product to ultimate users.

The classic model for such pyramid scams originated in the late 1960’s with Koscot Interplanetary, Inc., Glen Turner and Dare to be Great. Investors purchased individual distributorships for up to $5,000 which enabled them to sell mink oil cosmetics to the public or to participate in a self-motivation course. At revival-type meetings, investors were dazzled by Turner’s quasi-religious pitch and promises of enormous wealth.

However, the company provided limited advertising and product distribution, thus encouraging most investors to try to recoup their losses by selling distributorships to new investors. The scheme ultimately collapsed after thousands of people lost over $40 million. Turner was prosecuted and sued by investors, but the model was set and other schemes quickly followed.

In contrast, a legitimate multi-level marketing business emphasizes a solid product or service. Success is based on two factors, product quality and hard work based on the ability to sell the product. Recruiting new distributors is secondary.

Fraudulent Techniques -- No Room at the Top Unlike most economic activity, no new money is created in a pyramid sales scheme; those who get in on the ground floor take money from those who come later. Thus, for everyone who makes money, some other person must lose money.

Programs always produce promoters at the top of the pyramid who wave in front of prospects checks for thousands of dollars they claim to have received from pyramid payments. As more people come in, new levels of pyramid are created with the initial promoter and a few early participants on the top levels. Later recruits are on the bottom with little chance of getting the riches promised by the promoters.

Pyramid schemes are doomed from their inception. Like insatiable monsters, they demand more and more players to stay alive. A successful pyramid would eventually involve more people than live in North America. This is why pyramid schemes always collapse.

Furthermore, program operators often target closely-knit groups to increase peer-group pressure to participate. Such groups may be as diverse as religious and social organizations, football teams, and college students. A prospect is led to believe that if a program does not use the mails or is being promoted by a religious group, it must be legitimate and safe.

How to Avoid Being Swindled

The one sure way to avoid losing money in a pyramid is not to play the game. Pyramids are illegal and are thus not registered by any federal or state agency. However, in addition to securities laws many states do have business opportunity laws which may apply to any given promotional scheme. Prospective participants should check with their state securities regulator to see what kind of laws may apply to their situation. Here are some basic rules to follow in steering clear of pyramid schemes:

• Watch out if the start-up cost for the investment is substantial. Pyramid schemes pressure you to pay a large amount to become a “distributor.” Profits are thus based on the signing up of new recruits. Beware of promises of quick, easy and unreasonably high profits.



• Must you buy a product in order to become a distributor? Find out if the company will buy back inventory . . . you could be stuck with unsold products. Remember that legitimate companies should offer and stick to inventory buybacks for at least 80 to 90 percent of what you paid.



• What is the consumer market for the products? If the promoters seem to be making most of their money through sale of distributorships or through volume sales to new recruits, stay away.



• If the distributorship is providing a product for use in making a final product, make sure that whatever you are required to produce under the investment program is actually reaching the final manufacturer.



• Get all the facts about the company, its officers, and its products. Get written copies of the company’s marketing plan, sales literature, etc. Avoid promoters who fail to provide clear and detailed explanations of their plans.



• Resist the temptation to invest just because the person selling you the program is a friend or is part of your religious or social organization. Remember, that person may have been misled into believing he/she can make large amounts of money in a short time. Also remember that your participation in such a cash pyramid scheme may result in closer IRS scrutiny of your tax return.

For More Information

The securities administrator in your state, province, or territory is responsible for the protection of investors, insuring that complete information is available for many types of investments. If you have questions about possible pyramid sales schemes, contact your state securities administrator. For the phone number or address of your securities regulator, telephone the North American Securities Administrators Association (NASAA) at (202) 737-0900. Contact information is also available on the association’s web site at www.nasaa.org. Your prompt action could save you money.

The Council of Better Business Bureaus (CBBB) and the Better Business Bureaus of the U.S. and Canada answer inquiries on companies located in the areas they serve. Before putting money in an investment plan, it is a good idea to contact your local BBB for a reliability report on the company you intend to deal with.

Issued July 1986

This publication was compiled by the North American Securities Administrators Association and the Better Business Bureau and is furnished to you by the Texas State Securities Board.