What’s all the fuss about pyramid schemes?

If you don’t know why I’m asking that question, it may be a good thing. You really do need to know, whether you realise it or not. If on the other hand you do know why I’m asking that question, there could be three reasons. One is that you have picked up some knowledge already about the risks associated with pyramid schemes. Another is that you may be intending to operate a pyramid scheme, and wonder why a pyramid scheme is illegal. The third is that you are intending to operate a pyramid scheme, and you want to know how you can avoid getting caught. In the first two cases, welcome! If the third applies to you, you’re probably not reading this anyway.

So what is the problem, and why are those who operate legitimate Direct Selling Organisations, and those advising DSOs, concerned with the regulation?

The problem for legitimate direct selling organisations in the UK is that they are governed by law which was substantially designed to outlaw pyramid schemes. Whatever you might say about the law being an ass, it is fair to say that it is rarely perfect, and it’s very difficult for legislators to define law that is perfect, especially when they are dealing with criminal conduct. Perfect law will be defined differently by different people. One objective for those who draft law is of course clarity so that people know where they stand. In the context of dealing with people who are seeking to abuse their freedom to operate a business, possibly even to the extent of committing fraud, the problem with making legislation really clear is that it then becomes rather easier for clever people to circumvent it. Hence the law with which we are dealing aims to attack pyramid schemes without defining a pyramid scheme, but rather by attacking the perceived abusive aspects of such schemes.

If you ask yourself what’s this got to do with legitimate direct selling schemes, you would not be alone.

Many people have attempted to define direct sales as a channel to market, and many people have attempted to define pyramid schemes. To my mind this is a laudable but ultimately futile exercise, because both legitimate direct selling schemes and illegitimate pyramid schemes attract founders who are characterised by imagination and invention.

The principal vice of pyramid schemes is that they promise rewards in scale and extent that they cannot possibly deliver; many innocent people are incited to join, with no prospect of achieving any return on their “investment”, let alone anything on the scale promised.

There have been many examples of pyramid schemes over the years. The classic example is the Ponzi scheme set up by an American of that name in the early 20th century. With hindsight his was a simple investment scam, whereby he presented himself as an investment adviser and fund manager. He invited people to invest substantial sums with him by promising them very substantial and totally unrealistic rewards. The first people to invest were in a sense lucky because they received substantial rewards quite quickly. Naturally, this created a momentum around the scheme as word spread and more and more people invested. Unfortunately for all concerned, the substantial rewards paid to the initial investors had not been generated by the investment of their own subscription monies but merely represented the payment out to them of investment funds subscribed by the subsequent investors. There was no investment going on at all. Ponzi himself withdrew substantial sums until eventually the music stopped and his fraud was exposed.

There have been similar examples subsequently where there is absolutely nothing being sold, and at the moment Bernie Madoff is in a gaol in the United States serving a sentence of over 150 years for essentially the same crime.

Whatever one says about the initial success of Ponzi, Madoff and others, the scams were less sophisticated then, those of people who came after them and were, in a sense, inspired in a sense buy them.

A very common and supposedly innocent example of a pyramid scheme is a chain letter. I suspect many of us are familiar with chain letters from our youth. Somebody would write to us, with a standard-form letter, including a list of people’s names in a column. If we wanted to participate, we would send something – maybe a picture postcard from our locality – to the person at the top of the list. The letter would invite us to write in similar terms to a number of our own friends and family, but omitting the top name in the column and adding our own at the end. The letter we would send would follow the same pattern and invite the recipients to do likewise and so the chain would go on multiplying, rather like a virus.

If this were merely an early exercise in social networking and an attempt to build up a pen pal network, then who could object? If on the other hand the chain letter suggested that you send a £5 note with each of your letters, and that in return you would receive multiple £5 notes from multiple people once your own name reached the top of the list, and was being sent to goodness knows how many people, you might expect that your investment of £5 would be rewarded many times over.

There would of course be “breakage” in that some of the people to whom you sent your chain letter would decide not to participate, and some of the people to whom your participating correspondents in due course sent their version of the letter would themselves decide not to participate.

But even if there was no such breakage in the chains, the chain would inevitably reach a point at which there was nobody left to join. Thus, the last people in would incur a cost with little or no prospect of recovering their investment, let alone making a positive return on it. This sounds rather unsophisticated and childish as indeed I mentioned in the introduction. However, a few years ago a group of ladies established just such a scheme called “Women Empowering Women”, intended to benefit ladies only, whereby the initial investment was not £5 but £3,000, and the rewards generated by some of the early participants were as much as £30,000.

Fraudsters are often much more sophisticated than that. This is where it gets superficially close to the legitimate direct selling model. Fraudsters who wished to use the pyramid selling idea as the basis for their own scams thought that it would be possible to take advantage of people’s gullibility without breaking the law and without creating a pyramid scheme, simply by adding product. The product would have little if any cost or intrinsic value, and was merely a token used as a requirement of ”membership”. The law in the UK and many other countries can be characterised quite simply as prohibiting payment for recruitment, also known as “head-hunting”. The fraudsters seem to believe that the addition of a product means that the membership fee should be regarded as payment for that product. The law may often be an ass, but it isn’t usually THAT stupid!

The message for those wishing to set up a direct selling scheme is that they should sell products and services that meet genuine needs – ideally recurring needs – at reasonable prices, even ignoring discounts, with reasonable rewards for the sellers, based entirely on sales by themselves and others introduced by them, directly or indirectly. Follow those principles, and you will have a sustainable business.

The above is not legal advice of application to any particular situation. If you would like to discuss any aspect, please contact me via +44(0)20 3837 9727 or