Ponzi Games, Pyramid Schemes and MLM's

It's easier to fool a man than to convince him that he has been fooled - Mark Twain

Ponzi games got their name from Charles Ponzi, who was the first to serve prison time after trying to profit from such a scheme in the early 20th century in the US (Such schemes existed in the past as well. In Charles Dicken's 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit similar schemes were described). The now notorious con-artist promised a 50% return to his investors by engaging in post stamp arbitrage. This proved to be much costlier than Ponzi expected thus he began to paying off older investor with the proceed he got from new ones. Although he was finally apprehended and served 10 years in jail, his idea had (unfortunately) caught on.

One of the most serious cases, and the largest to-date, has been Bernie Madoff's investment fund, with a life span of 48 years (was founded in 1960) and amounts ranging to approximately $65 billion, obtained from 4,800 clients. Madoff was sentenced in 2009 to 150 years of prison time and forfeiture of $18 billion. In another example of the size such schemes may reach, a pyramid scheme in Albania reached approximately 43% of the country's GDP.

Pyramid schemes are of similar characteristics with the Ponzi ones. Their two important differences is that in a pyramid scheme there exists a product which is supposedly sold to bring in the money and the pyramid participants have to recruit others to join the scheme if they wish to have a return on their "invested" capital. (In the Ponzi scheme, the initiator finds new investors on his own, in contrast to pyramids where participants are "obliged" to do so if they wish to make a profit. In a sense, participants of a pyramid scheme are co-conspirators and not innocent victims like most of the Ponzi scheme investors are) While it is obvious why Ponzi schemes are illegal (the con-artist is taking from Peter to give to Paul) many fail to see the reason why pyramid schemes are doomed to fail. The answer is simple mathematics: if the participant has to recruit 4 people under him then after 10 levels the amount of people who have to be recruited exceeds 1 million. At the 16th level, the number of those who have to be in the scheme is approximately the number of person alive in the world today (and we are also making the very bold and untrue assumption that everyone would be interested in participating)

Many also assume that they are one of the "first persons in" since they are being told so. According to the Federal Trade Committee (FTC) when a participant has to recruit 3 more people, a whooping 89% of total inductees end up in the red. If they have to recruit 4, then under the same regime the percentage of losers is almost 94% (the probability of losing grows with the number of new recruits a member has to get). In addition, the people on the top of the pyramid earn from each individual who enters the scheme after them; and these people never do really change.

Enter Multi-Level Marketing (MLM). The difference between MLM's and both the above-mentioned schema is that MLM's do actually have and sell a real product to members of the general public without requiring the consumers to pay anything extra to join the MLM system. Notable, legitimate MLM's include Avon and Tupperware. Amway Corp is another famous example: the company was accused of being a pyramid scheme, yet the FTC decided that although Amway's earnings claims when recruiting new distributors were false and misleading) the company's selling plan was not an illegal pyramid scheme.

Two very important characteristics of the Amway Corp were the ones which tilted the case to it's favour: it required each distributor to sell at wholesale or retail at least 70% of its purchased inventory each month (known as the 70% rule) while it also required each sponsorship distributor to make at least one retail sale to 10 different customers each month (the 10-customer rule). In addition, Amway participants were not purchasing the right to earn profits unrelated to the sale of products to consumers by recruiting other participants, who themselves are interested in recruitment fees rather than the sale of products (known as the Koscot definition).

Nevertheless, the Amway rules are not definitive of non-pyramiding: Omnitrition had claimed to abide by these rules yet the court noted that they are meaningless if commissions are paid based on a distributor's wholesale sales (i.e. effectively on new recruits) and not based on actual retail sales. To this end, note the importance of David Einhorn's question in a Herbalife meeting(page 17)

"(...) first is how much of the sales that you make in terms of final sales are sold outside the network and how much are consumed within the distributor base?"

The reply Einhorn received was the 70% rule, yet on subsequent questioning the spokesman commented that the company had no such knowledge. A 2009 FTC publication mentions the following: "Do distributors sell more product to other distributors than they do to the public? Does the amount of money distributors make depend more on recruiting? Does the money made depend mostly on selling to other distributors than sales of the product to the public?" If the answer is yes, then you are looking a pyramid scheme. (In fact, Herbalife has already been deemed as a pyramid scheme by a court in Belgium in 2011. An appeal has been made to that end and the final decision is awaited eagerly by investors.)

Signs

The most important question in the Ponzi/Pyramid world is "how can I know if what I am about to do is a real, legitimate MLM and not some devious scheme?" The FTC document provides a list of potential red flags:

1. Beware of any plan that makes exaggerated earnings claims, especially when there seems to be no real underlying product sales or investment profits. 

2. Beware of any plan that offers commissions for recruiting new distributors, particularly when there is no product involved or when there is a separate, up-front membership fee.

3. If a plan purports to sell a product or service, check to see whether its price is inflated, whether new members must buy costly inventory, or whether members make most "sales" to other members rather than the general public.

4. Beware of any program that claims to have a secret plan, overseas connection or special relationship that is difficult to verify. 

5. Beware of any plan that delays meeting its commitments while asking members to "keep the faith." 

6. Finally, beware of programs that attempt to capitalize on the public's interest in hi-tech or newly deregulated markets. 

In addition, what an investor/distributor should do is have a look at the compensation plan. The more complicated, the more chance of scheme being either Ponzi or pyramid there is. As The Observer states, the World Ventures compensation plan runs approximately 26 pages. Even if you close your eyes to all the aforementioned guidance lines, there are two things which an investor should keep his eyes open to:

1. Recruitment fees

2. Promises of lavish returns/grand lifestyle to participants

The latter guideline is what investors should always be aware about any asset manager or business opportunity: there are no fast solutions, no get rich quick formulas. Even Warren Buffett did not get rich in a day. His returns exceed the S&P 500 by 10.3% on average yet even he has had years in which the S&P did materially better than him or faced losses (for details on how hard it is to be Warren Buffett have a look at Cullen Roche's interesting article here). Ken Fisher's must-read "How to Smell a Rat" points out some other important aspects and notably that "due diligence is your job and yours only. Don't be impressed by marbles, lavish parties, claims of exclusivity or anything that does not matter". Another issue is the investment strategy followed. If people can explain their strategy simply (or as stated before if their compensation plan is not easy to understand) then there is less chance of being a fraud.

The bottom line is that pyramid schemes, Ponzi games and other con plans which will be conceived in the future will not disappear. The main reason is greed: people want to believe that they can get rich in a very short period of time without having to work much. The truth is this is never true unless you are breaking the law. I do not wish to delve into the various psychological and societal dangers one will come to after being involved in such schemes (everybody is a potential client, people start to mistrust you thinking that you have a hidden agenda every time you talk to them, etc) as this is beyond the scope of this article. 

The final note to readers is what Ken Fisher says: do your homework and keep your eyes open. Many may try to persuade you, and they can be very persuasive with presentations and live "examples" of success. Yet, after lifting the veil of "pureness" and the promises of great life and riches, what is left is nothing but a simple scheme designed to part money from their owners and pass it on up the pyramid.

UPDATE: The Albania case has been very well described in this article by an IMF economist. Being the largest scheme ever (with regards to GDP) it makes this a must-read