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Understanding Pyramid Schemes, Ponzi Schemes, and Network Marketing

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Many articles have been written on this subject. Despite all this, borders between these three concepts remain fuzzy in many minds. This lack of clarity in general public is important because it leads to unfair criticisms pointed out to legitimate businesses.

Below I will explain how I differentiate these three ways of making a “business” thus, why I am clear on them.

Pyramid Schemes

First, a few definitions of a pyramid scheme from trusted sources:

According to the World Federation of Direct Selling Associations – WFDSA ), “Pyramid schemes  are illegal scams in which large numbers of people at the bottom of the pyramid pay money to a few people at the top. Each new participant pays for the chance to advance to the top and profit from payments of others who might join later.”

In her speech at an International Monetary Fund – IMF Seminar in 1998, Debra A. Valentine, a former General Counsel at the U.S. FTC, says, “They (pyramid schemes ) all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public.”

In an article dated 2014, FTC’s Aditi Jhaveri advocates  if “income is based mainly on the number of people one recruits, and the money those new recruits pay to join the company — not on the sales of products to consumers”, this is a sign that the company is operating a pyramid scheme.

Reading all this, it sounds pretty straightforward: If a participant’s income is not based on exchange of goods or services, but is earned against bringing in new people, then it is a pyramid.

So, where does the confusion stem from? From the existence of those that are called “disguised pyramid schemes”. These businesses try to operate in a deceptive way in an effort not to be caught by the authorities. Typically, participants are forced to buy large amounts of inventory that they can neither sell nor consume or worthless products that no other people buy under normal conditions. If these exist, it is obvious that organization members earn money not based on the products sold to end users but merely on people recruited.

A related issue here is “internal consumption”. This concept refers to products being bought by direct sellers not for the purpose of retailing them to end-users. When considered together with the previous paragraph, this is obviously an important issue. From another perspective though, existence of internal consumption is inevitable. At the end of the day, direct sellers would naturally buy and consume the products that they recommend to others. In fact, the U.S. Court of Appeals announced its Burnlounge Appeal Decision in June 2014 and recognized  personal use of products and services by distributors as a legitimate end destination in which distributors are accepted as “ultimate users”. It is definitely a necessity to draw a line between what is a normal amount for personal use and what is inventory loading. In my opinion, common sense is a powerful guide.

Within this context, you might also want to take look at the two brilliant articles Jeff Babener wrote for The World of Direct Selling, following the FTC – Herbalife settlement: FTC v. Herbalife Settlement: First Take and FTC v. Herbalife: Post-Settlement Legal Guidance for the Direct Selling Industry .

Ponzi Schemes

These are named as such after Charles Ponzi ’s fraudulent scheme in the U.S. in the 1920s. In broad terms, a Ponzi scheme is an investors’ pyramid. Here, the scheme’s operator promises unreasonably high returns to attract new investors. These returns are so high that the founders know from the beginning that they are not economically sustainable. And the source of income for investors is not the real return generated by the funds invested by themselves, but is the new investments coming in.

Needless to say, the chain breaks at a certain point soon after a few people make huge amounts money and after many lose whatever they have.

The most famous Ponzi scheme of the last decades was led by Bernard Madoff  who was a former Chairman of NASDAQ stock exhange. The investors were estimated to lose about $18 billion in his scheme. In June 2009, Madoff was sentenced to 150 years in prison.

Another interesting but just as sad example to a “Ponzi” was what had happened in Albania in 1996-1997 . After all settled in this small Southeastern European country, people’s losses in the schemes totalled to $1.2 billion and more than 2,000 people were believed to have been killed in the country-wide chaos.

Network Marketing

Both pyramid and Ponzi organizations are fraudulent, illegitimate and illegal. They are prosecuted and shut down wherever spotted. Network marketing on the other hand, is a legitimate way of making business.

First and foremost, the participants in network marketing earn money not based on others’ losses. It is a micro-entrepreneurship model, in economic terms. I think this draws a clear line.

Members take their shares from the commissions pool that accumulates from the sales of goods or services in the network marketing model. Looking from another perspective, if the products are not sold, nobody will be able to earn anything. Taking this a step further, registration fees, starter kit sales or anything that a new member is required to make a payment for do not and should not generate income for those who joined before.

So, where to stand on the issues of “personal use”? In my understanding and as the courts have decided too, participants’ purchases for themselves in reasonable amounts are just as legitimate as the purchases made for the purpose of retailing. And to me, there is nothing wrong with the upline or the member himself / herself earning commissions on them.

Unlike a pyramid or a Ponzi, network marketing is a sustainable business model. As long as managed well, just like in any other industry, network marketing companies successfully survive for decades. While there is no such an example to this among pyramid schemes, there are numerous examples  in the direct selling industry.

As a last point, I think whether a compensation plan is a multi-level or not, or whether it pays to a limited depth or infinitely are not relevant discussions within this context. The depth of the plan in this sense is not a valid argument to me.

Note: This article was originally published on The World of Direct Selling in January 2016. It was received with acclamation and so re-posted it for those who had missed it that time, with the addition of Jeff Babener’s articles.


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The post Understanding Pyramid Schemes, Ponzi Schemes, and Network Marketing appeared first on The World of Direct Selling .

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Attraction Marketing System
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