John C. Frycek, PPS, CIS, LPD    

I'm sure you've seen them dozens of times.  Messages which purport to tell you how, for a relatively small investment, you can make huge amounts of money.  There are countless variations, but they all are based on the same fraudulent concept.  With a typical “chain-letter”-based pyramid scheme, the process is represented to go something like this:

• You receive a copy of a letter or an email message, making fabulous claims about how much money you can “earn” by participating in it.
   
• You send some amount of money to some number of people who have joined this scheme ahead of you.  Typically, you may be asked to send $5 each to four or five people.
   
   
• You alter the list of previous participants, removing the one at the top of the list, moving all the other names up one position, and adding your own name to the bottom of the list.
   
• You send out as many copies of this altered letter as you can, to as many people as you can reach.
   
• As new people join the scheme below you, in exponentially-growing numbers, each one will send you $5, or whatever the requested amount was.  Because the number of new participants is growing at a fantastic, exponential rate, you should collect this payment from a ridiculously large number of people.

 In every case, the basic concept is the same — you pay a relatively small amount of money to a few people above you, with the expectation that later, very large numbers of people will be making similar payments to you.
 

  A deliberate effort is made, in many cases, to confuse prospective victims with regard to the distinction between a legitimate “multi-level marketing” (MLM) scheme, and an illegitimate pyramid scheme.  I'm no fan of MLM; I regard even “legitimate” MLM schemes as ethically questionable at best.  But there is a vital distinction.

  The important distinction is this:  With a legitimate MLM, you have a real product, that is of significant value in and of itself.  Most of your profit comes from the sale of this product to people who will use this product according to its own value and usefulness, and not just try to sell it to someone below them.  Though MLM encourages you to build a “downline”, so that you can make some profit by taking a cut of the sales made by those below you, you do not need to recruit even a single person below you in the pyramid in order to profit; you can profit by selling the product itself, even to people who have no interest in joining the MLM.

 In those pyramid schemes which try to pass themselves off as MLM, your “product” is something that has very little inherent value, if any at all, beyond the requirement that one must buy it from you in order to join your “downline”.  The “product” may consist of worthless reports, or even electronic codes to unlock a software-based pyramid scheme.  Nobody would buy these “products”, except as part of joining the pyramid scheme itself.  The only opportunity for profit is in getting people to join the pyramid in levels below you.  As the U.S. Postal Service warns, on the subject, “Do not be fooled if the chain letter is used to sell inexpensive reports on credit, mail order sales, mailing lists, or other topics.  The primary purpose is to take your money, not to sell information. “Selling” a product does not ensure legality.”
 

A Few Definitions

• Chain Letter:  Strictly speaking, a chain letter is merely a letter, an email message, or some other communication, which asks the recipient to send copies of it to several other people.  In and of itself, chain letters are not illegal, but they are very annoying, and very wasteful of whatever medium is used to carry them.  When a chain letter asks the recipient to send money to people through whom the letter passed before, with the promise that the recipient will receive money from those that the letter reaches after he sends it, then it has become a form of a pyramid scheme.  Though not all chain letters are pyramid schemes, and not all pyramid schemes are chain letters, the term “chain letter” is often used to mean a pyramid scheme.  For example, the U.S. Postal Service's official statement on "Chain Letters" is really about pyramid schemes.  Even if they're not illegal, chain letters are, in any form, very annoying to most people, and prohibited by most responsible ISPs.
   
• Pyramid Scheme:  A scheme in which a hierarchy is created by people joining under others who joined previously, and in which those who join make payments to those above them in the hierarchy, with the expectation of being able to collect payments from those who join below.  Pyramid schemes are prohibited by the laws of the United States of America, by the laws of each of the fifty individual states, and by the laws of most other nations.  Pyramid schemes are variously defined under these laws either as a form of gambling, or (more accurately, in my opinion) as outright fraud . Most of my explanations on this page are about pyramid schemes, but have some application to Ponzi schemes as well.
   
  • Administered Pyramid Scheme:  A variation of a pyramid scheme in which some central person or company is involved in “administering” the scheme, in making sure that all participants have made the appropriate payments to those above them, or even in collecting these payments and redistributing them to the “upline”.  The “Administrator” of such a scheme usually takes some fee for himself.  In this variation, the “administrator” is assured of some profit, no matter how badly the scheme may work for other participants, because he gets to collect his own fee from every other participant.  These schemes usually collapse much more quickly than regular pyramid schemes, because of their dependence on the administrator, who is easily identified and turned in to proper law-enforcement authorities.
    
     
  • Gifting Club:  This term, as far as I've ever seen it used, is just another term for a pyramid scheme.  The money you pay to join a “Gifting Club” is called a “gift”, and the claim is often made that any money you receive from such a scheme is not taxable, because the IRS does not tax gifts up to $10,000.  This is a dangerous falsehood, because the IRS has always considered a gift, by definition, to be something given with no expectation of receiving anything in return.  While the majority of gifting club participants really do get nothing in return, their “gifts” are certainly not given without the expectation of considerable return, so these payments cannot be considered gifts for income tax purposes.  In addition to the legal problems you could face just from participating in a pyramid scheme, failing to report as income any returns you might get from such a scheme could subject you to tax evasion charges as well.
     
• Ponzi Scheme:  Named after Charles Ponzi, who ran such a scheme in 1919-1920.  A Ponzi scheme is an investment scheme in which returns are paid to earlier investors, entirely out of money paid into the scheme by newer investors.  Ponzi schemes are similar to pyramid schemes, but differ in that Ponzi schemes are operated by a central company or person, who may or may not be making other false claims about how the money is being invested, and where the returns are coming from.  Ponzi schemes don't necessarily involve a hierarchal structure, as in a pyramid scheme; there is merely one person or company that is collecting money from new participants and using this money to pay off promised returns to earlier participants.  An interesting site about Charles Ponzi and his scheme can be found here.
   
• Straight–Line Matrix: This is a new form of fraud that I am seeing in recent months.  I have also seen these referred to as “Elevator Schemes”.  In these schemes, you are offered the opportunity to buy some valuable product for a small percentage of its usual cost, usually around 10%.  These schemes are based on a list of participants, in the order that they joined the scheme.  Each person pays the specified price when they join the scheme, and when so many people (usually ten) have joined the scheme, the first person gets the product being offered (it having been paid for out of the fees paid by all ten who have joined so far).  When ten (or whatever the number might be more people join, then the second person gets the product.  When ten more join after than, then the third person gets the product; and so on.
   
  Though this scheme isn't based on the same sort of exponentially-growing structure as a pyramid scheme, most of the same principles apply here as to a true pyramid scheme.  As with a true pyramid scheme, a straight–line matrix scheme pays off only for a small percentage of those who have joined, producing a number of people who have paid into the scheme and not yet received any payoff that grows at a much faster rate than the rate at which the number of people who have received the promised payoff grows.  As with a true pyramid scheme, a straight–line matrix will pay off quickly for those who get in the earliest, and will pay off increasingly slowly for those who join later, with the vast majority of of participants never receiving the promised benefit.

A Pyramid Scheme Dissected

  As the pyramid grows below you, here's what supposedly happens:

1. The first level below you has ten people.  They each send you a dollar, so you collect $10.
2. The next level has a hundred people.  (Each of your first ten gets ten more.)  You collect $100.
3. The next level has a thousand people.  You collect $1,000.
4. The next level has 10,000 people, so you collect $10,000.
5. The next level has 100,000 people, so you collect $100,000.
6. The next level has 1,000,000 people, so you collect $1,000,000.
7. At this point, your name drops off the list, and you collect no more.

  It's very easy to understand how this kind of scheme should work.  It all seems so simple and so obvious.

  It is, unfortunately, somewhat more difficult to understand why this kind of scheme does not work, and why it is unethical and dishonest, and, in most cases, very much illegal.

  The truth is, this scheme does not work, except for those who get in at the first few levels.  The vast majority of participants in such a scheme will only lose their original investment, and make no profit at all.  In a moment, I'll get into why this is so; but because it is so, every instance where a person is induced to join such a scheme, based on the promise that he will make a profit by participating, a fraud has been committed.

  Nearly every nation, and every government, has laws against fraud.  Most have specific laws against pyramid schemes, Ponzi schemes, and similar operations.

  Even if the particular variation in which you might participate happens to avoid running afoul of the laws which are relevant in your situation, I ask you to consider that by participating in such a scheme, you would be engaging in something that is dishonest and unethical, and which is very unlikely to make you any profit.

  In order to understand why pyramid schemes do not work, there are two points which you must understand.

1. The pyramid must fail because there is a finite and limited number of potential participants.
2. No new wealth is created, the only wealth gained by any participant is wealth lost by other participants.

The pyramid must fail because there is a finite and limited number of potential participants.

  But these huge numbers create a problem.  There are somewhere between five and six billion people in the world.  Let's suppose that every one of these people could be induced to join a particular pyramid scheme.  For how many levels could this scheme run before it failed, for lack of new participants?  You'll be amazed when you see how quickly the number of required new participants grows to exceed the population.

  In the example above, I assumed that each person who joined would bring in ten new people.  How many levels can be supported by a population of five to six billion?  Let's count them...
 

Level	People in Level
1	1
2	10
3	100
4	1,000
5	10,000
6	100,000
7	1,000,000
8	10,000,000
9	100,000,000
10	1,000,000,000

That's ten levels, counting the one person at the top who started it.  By the time these ten levels are filled, there will be a total of 1,111,111,111 participants.  The eleventh level would require 10,000,000,000, or ten billion new participants to fill in.  But there aren't that many people in the world.  There's only between five and six billion, minus the somewhat over a billion who've already joined.  Most of the billion people in the tenth level will not be able to get any new participants below them, and will therefore make no money at all.  And of course, none of those who join in the eleventh level will get any new participants below them.  There aren't enough people to fill in the eleventh level, much less to start a twelfth level below that.

  At this point, the pyramid collapses.  And when it does, a solid majority of those who had joined will not have made any return at all.  They will have paid their money to get in, but the promise that they will profit as people join below them will never be fulfilled.

  Of course, the number of levels that can be filled depends on how many new participants, on average, are brought in by each previous participant.  But even if each participant brings in only two new participants, the pyramid will collapse in about 32 or 33 levels (still assuming, of course, that you can get all five or six billion people in the world to join) with most participants having lost money.
 

No new wealth is created, the only wealth gained by any participant is wealth lost by other participants.

  If you spend a dollar for a lemon, some sugar, and some water; and then use this to make sufficient lemonade that you can sell twenty servings for ten cents each, then you've created wealth.  You've taken ingredients worth a dollar, and used them to create a product worth two dollars.  You've created a dollar's worth of new wealth.

  Pyramid schemes produce no goods of any significance, and they provide no service.  They create no wealth.  All they do is move existing wealth.  Every dollar that one person gains through such a scheme is a dollar that someone else has lost.

  Do not be fooled if the scheme includes some form of “reports” or lists or other pieces of “information” that you are supposedly buying from those above you, and selling to those below you.  In nearly every case, these intangible products have no value imputed to them, other than that which can allegedly be gained by copying and reselling them.  The purpose of these reports is not to provide valuable information, but to provide a pretext by which one participant in a pyramid scheme collects money from other participants.

   Here's another way of looking at it.  Suppose there was a scheme where everyone who joins contributes a dollar, which is then put into a box.  No money is put into that box except the dollar from each person who joins the scheme.  Is there any way to redistribute the money that is collected into this box so that everyone who contributed money into it gets more back than what he put in?  Let's suppose that a hundred people have joined this scheme.  This means that there is $100 in the box, and 100 people expecting some kind of payout.  If the money in the box is equally distributed among all the participants, then each will get back only $1, the exact amount that he paid to join.  You could give $10 to each of 10 people, but that would leave 90 people who get back nothing, and who have only lost the dollar that each had paid to join.  You could give the whole $100 to one person, but that would leave 99 people who get nothing back.  There is simply no way for everyone to get back more than they paid in.  In order for anyone to get back more, someone else has to get back less.  Anyone who gains in such a scheme does so at the expense of others who have lost.
 
  The same holds true of all pyramid schemes, Ponzi schemes, straight–line matrix schemes, and anything else that is in any way similar.  It is mathematically impossible for more to be taken out of any such scheme than what is put into it.
 
Conclusion