Can You Spot A Pyramid Scheme When You See One?

This is part five of a series on some of Wall Street’s biggest frauds and how to avoid them. Click here for part one on the “Wolf of Wall Street” and microcap stocks. Click here for part two on pre-IPO scams. Click here for part three on precious metals fraud. Click here for part four on binary options fraud.

One of the most notorious types of fraud experienced by investors is the pyramid scheme. There’s so much talk about pyramid schemes that you may feel you know what they are, but they may not be as easy to spot as you think they are. Pyramid schemes are similar to Ponzi schemes, but there are some differences. We will discuss Ponzi schemes in the next article in this series, but for now, let’s talk about pyramid schemes.

One famous pyramid scheme: BurnLounge

There have been many pyramid schemes over the decades, but one of the most famous recent examples was BurnLounge, an internet-based multi-level marketing scheme. Ars Technica explained how some of the company’s participants bilked thousands of people out of millions of dollars. The Federal Trade Commission sued some BurnLounge participants. The company now lies dormant as the legal process continues on appeal.

The company’s founders promised their victims that opening their own digital music stores would earn them stacks of cash. Customers paid $29.95 per year for the Basic package, $129.95 annually plus $8 monthly for the Exclusive package, or $429.95 per year plus $8 per month for the VIP package. In exchange, they received a pre-built online storefront to sell digital music.

As they sold music, they earned points. However, the points could only be used to purchase BurnLounge products unless they paid $6.95 per month for the Mogul program to turn the points into actual cash. Victims received only 50 cents if they sold a $9.90 album. The big money came from recruiting other members, which is the hallmark of a pyramid scheme.

Despite the founders’ claims that opening a BurnLounge page would make members rich, 94% of them lost money, according to the Federal Trade Commission.

How to spot a pyramid scheme

It’s important to emphasize that not all MLM companies are pyramid schemes. The Securities and Exchange Commission identifies some things to watch out for in a classic pyramid scheme. For example, promoters generally promise high returns in short periods of time. However, whenever a promise of fast cash is involved, it could mean that members are simply being paid out of recruitment fees for new members instead of from sales of products or services.

Additionally, pyramid schemes often don’t actually sell any product or service. This may seem like an obvious warning, but the problem is that these “companies” may sell something that’s simply difficult to assign a value to, like tech services or ads on websites few people visit.

Most importantly, the emphasis is on recruiting new members rather than selling products or services. Thus, most pyramid schemes will reward victims much more for recruiting other paying members than they will for selling products or services. This is perhaps the most obvious sign that a company might be a pyramid scheme instead of a multi-level marketing company. Another red flag is the promise of easy money or passive income.

The Federal Trade Commission adds two other red flags. The first being required to buy a lot of inventory to remain active. The second is being forced to purchase other things you don’t need or want just to remain in good standing with the company. Having to pay a fee to buy into the ability to sell products or services is also a red flag.

The problem with any pyramid scheme is that it’s not sustainable. Eventually, they find that they can’t recruit any more members, so the pyramid collapses. In most cases, any money that’s paid in is used to pay members at the top tiers of the pyramid.

The internet has made it easier than ever for pyramid schemes to spread, but if you know what to watch out for, you can avoid being taken in.

This article first appeared on ValueWalk Premium