Legal Definitions - Investor Protection Guide: Pyramid Scheme

A pyramid scheme is an illegal business model that promises high returns on investment but is unsustainable. It works by recruiting investors who must pay membership fees or invest money. The initial recruiter is at the top of the pyramid, and investors become members at lower levels. Members must recruit new members to make their returns, and the initial recruiter and early investors are paid from the principals of investments or membership fees from later investors. The pyramid eventually collapses because later investors are unable to recruit more members, and only the initial recruiter and a few early investors make money while the rest lose money.

For example, if an initial recruiter devises a pyramid scheme where each member must recruit nine new members, the number of members required to sustain the pyramid at level 9 would be 387 million or more than the population of the United States. This is unsustainable and shows how pyramid schemes are destined to fail.

Legitimate multi-level marketing (MLM) is often confused with pyramid schemes because MLM offers a tiered compensation system whereby a member who recruits a new member will get a cut of that new member's sales commissions. However, MLM can be distinguished from a pyramid scheme by determining the source of the returns. Returns from real product sales or investment gains are likely to be legitimate, while returns from principals of investments from later investors are likely to involve illegal pyramid schemes.

Investors should watch for warning signs of pyramid schemes, such as promises of unrealistic returns on investment, high upfront fees or investments, no clear descriptions of products, services, or investments being offered, and no real underlying investment.

For more information, see:

• Pyramid Schemes, The Securities and Exchange Commission (SEC):
• Investor Alert: Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs, The Securities and Exchange Commission (SEC):
• Don't Get Caught in a Pyramid Scheme, New York State Attorney General: