Ponzi schemes are pyramidal in nature, but are they the same thing as a pyramid scheme? No, they are not, and here is why.
Ponzi schemes are investment frauds that share some characteristics of pyramid schemes but also have some different dynamics. A requirement of a Ponzi scheme is the promotion of what starts out to be, or appears to be, a real investment opportunity. It often involves the development of a valuable resource such as oil, gas, minerals or real estate. And what is being promoted often actually exists. The promoter does own a mine, or does own investment property. Where the resource actually exists, the promoter has grossly overvalued its worth. Other times, the asset or resource which is the basis for the investment opportunity is totally a figment of the promoter’s imagination. In either scenario, the promoter convinces investors that the asset can be further developed with more capital, and the promoter will share the profits with the investors.
Early on, substantial dividends are paid out to the investors. The representation is that these dividends are “profits” coming from the successful development of the investment assets. What is actually happening is that the promoter is merely returning a portion of the investors money to them. These early and substantial dividends produce two results. The early investors increase their share of the operation, and additional investors are attracted to the scheme. The process of paying dividends continues and more investors come forward until the fraud is uncovered or the promoter absconds with the investment proceeds.
Not all Ponzi schemes start out as frauds. Sometimes a promoter in good faith really believes the asset will prove profitable. Investment money comes in, but the returns are disappointing. To avoid loss of investor confidence lies are circulated and dividends paid. More money comes in and the possibility of millions of dollars of losses occurs but for the truth being told early.
The traditional method of dealing with Ponzi schemes in the U.S. is under the Securities Laws, including the Securities Acts of 1933, the Federal Securities Exchange Act of 1934, and state securities laws, (sometimes referred to as Blue Sky Laws). They are not pyramids however, and the pyramid laws we routinely associate with the regulation of multi-level marketing companies do not apply. There are several distinctions between Ponzi schemes and pyramid selling schemes.
The pyramid scheme involves a person making an investment for the right to receive compensation for finding and introducing other participants into the scheme. There is a clear understanding among the participants that the success of the opportunity is dependent upon attracting additional participants.. This is different from the expectations of the Ponzi scheme participant who believes the investment is dependent upon the successful development of a productive asset such as a mine or real estate complex. Pyramids must fail because, by their nature, they depend upon endless exponential growth to succeed. Ponzi schemes must fail because the underlying asset upon which the investment was based either never existed, or was grossly overvalued. Pyramid schemes require active participants who bring in more participants. Ponzi schemes can flourish even with passive investors without any responsibility to promote the opportunity. Pyramid scheme participants “go for the gold” by attracting others to the scheme. Ponzi scheme participants “go for the gold” by increasing their investment and hopefully their share of the profits from the successful development of the productive asset.
The author is indebted to John Brown, Senior Manager of Government Affairs at Amway, for developing these distinctions and articulating them clearly and often.