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What is the difference between a Pyramid Scheme and a Ponzi Scheme?

August 5, 2014

 

Scams may take many forms, and fraudsters can turn on a dime when it comes to developing new pitches or come-ons for the latest fraud. With so many scandals and disingenuous "professionals" today, it can be challenging to distinguish a legitimate company or investment opportunity versus an illegitimate "Ponzi" or "Pyramid Scheme.

 

The primary difference between a Ponzi scheme and a pyramid lies in how the operation is promoted. 

 

Illegal pyramids announce themselves as pyramids: They hype levels or stages in their literature. The pyramidal structure helps draw new players, each believing that they will rise through the ranks of the pyramid to become “golden,” or “fully vested”- whatever hokey titles the fraudsters have concocted.

 

Some pyramid schemes promise that you can earn high profits by making one payment and finding others to become distributors of a product. The scheme typically does not involve a genuine product. The purported product may not exist or it may be "sold" only to other people who also become distributors.

 

While there are many multi-level marketing (MLM) organizations and programs that are legitimate, there are others that masquerading as a multi-level program and violate federal securities laws. If a program primarily focuses on recruiting others to join the program for a fee, it is likely a pyramid scheme. Be skeptical if you will receive more compensation for recruiting others than for product sales.

 

A Ponzi scheme, on the other hand, masquerades as some type of investment - in financial instruments, mineral rights, or some other form of speculation. The participants believe they’re buying mortgage-backed securities or partial interest in an oil well. They have no idea they’re funneling money into a bottomless pit. No one suggests moving on to the next level of the pyramid, because the pyramid is not part of the pitch.

 

These Ponzi schemes may offer high investment returns with little or no risk. EVERY investment carries some degree of risk and investment yielding higher returns generally involve more risk. Be cautious of an investment opportunity or "deal" that continues to generate positive returns regardless of market conditions. As the old saying goes, "If it sounds too good to be true, it probably is."

 

With little or no legitimate earnings, Ponzi schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.

 

Ponzi Schemes are fairly complex, even when they operate on a small scale. Unlike pyramid schemes, in which victims unknowingly rope in more targets, Ponzi schemes rely on a single person or group to coordinate every aspect of the fraud. To keep the scam going, the masterminds behind the plan convince numerous victims that they’re investing in a legitimate fund that promises great returns. Then the scam artists take money from new “investors” and use it to pay off existing investors. But for the scam to truly work to everyone’s benefit, the fraudsters would need access to an infinite supply of new victims.

 

Check Out Investment Professionals

Always ask whether the promoter of an investment opportunity is licensed to sell you the investment—and confirm which regulator issued that license, and if and when the license has ever been revoked or suspended. A legitimate securities salesperson must be properly licensed, and his or her firm must be registered with FINRA, the SEC or a state securities regulator - depending on the type of business the firm conducts. An insurance agent must be licensed by the state insurance commissioner where he or she does business.

Be sure to independently verify the salesperson’s or promoter’s answers as follows:

- For a broker or brokerage firm, use FINRA's BrokerCheck or call toll-free (800) 289-9999. BrokerCheck allows you to confirm not only licensing and registration, but also whether an individual or firm has a history of complaints or regulatory problems.

 

- For an investment advisor, use the SEC's Investment Adviser Public Disclosure website. Similar to BrokerCheck, you can check an individual or a firm's registration status and any history of disputes or regulatory issues.

 

- For an insurance agent, check with your state insurance department. You'll find contact information through the National Association of Insurance Commissioners (NAIC).

 

- For all sellers, be sure to call your state securities regulator. You can find that number in the government section of your local phone book or by contacting the North American Securities Administrators Association or (202) 737-0900.

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