Tuesday, June 26, 2012

MLM Basic: what is a Ponzi scheme, and what is the difference between it and pyramid scheme?

Many defenders of potentially fraudulent business opportunities, when confronted with evidence that their opportunity may in fact be a Ponzi scheme, often immediately retort "Ponzi schemes are investments, but this is a business opportunity!"

However, a Ponzi scheme can easily be either an investment or a business opportunity. People
 are so familiar with the investment version of Ponzi scheme, few if any ever considered the possibility that a business opportunity can be a Ponzi scheme. Ponzi schemes can pretend to be work-related income opportunities, or an outright business... such as pigeon farming.

Ponzi in 1920
Ponzi in 1920 (Photo credit: Wikipedia)
It sure doesn't help the issue when in a MLM, recruiting and marketing are so intimately linked, that often people can't tell them apart. Instead of "investing", you are usually told you are buying a starter kit, or making a "down payment" on a discount card, and so on. So you are thinking you made a purchase, when in fact you have indeed "invested".

In fact, most people are completely ignorant of the law when it comes to what exactly *is* a Ponzi scheme.

So what is a Ponzi scheme?

What is a Ponzi Scheme?

In a Ponzi scheme participants are being paid with participant money (either their own or that of other participants), while no meaningful business is done, so any gains on the "investment" (i.e. money put in) actually came from other investors. As long as enough new investors come in than those leaving (or convince the existing investors to "reinvest" so little money leaves the system), the whole "scheme" can provide a profit to the participants.

Let's try an analogy.

Ten people each put in $10. There is $100. Right?

If one person takes out $11, the other nine people will have LESS money to share, right? After all, there's only 89 left, but there are 9 people.

Ah, but they CAN get more... if they can convince ANOTHER person to put in $10!
  • A invests $10 with company P. P now has $10. 
  • B invests $10 with company P. P now has $20. 
  • P pays A $11. P now has $9. 
  • C invests $10 with company P. P now has $19. 
  • P pays B $11, P now has $8. 
  • D invests $10 with company P. P now has $18
See the problem? As long as people join faster than people are leaving, P can continue to "pay profit" to participants, without doing any sort of business (to get "profit") or investing (to get "return") to generate additional money. because there is little (or in this case, no) money entering the system other than investments, it is ALWAYS in danger of running out of money. Indeed, if everybody wants their money back, there is not enough money to pay everybody, and the whole scheme collapses (which is what happened to Bernie Madoff, when several investors needed their money to cover losses elsewhere). 

Tracing the Money in the Ponzi Scheme

The simplest way to identify a Ponzi scheme is to check if additional sources of money enters the pool. Usually, there are NO additional sources of money that enters the pool. if there are, it would be very little and mainly as a disguise. Charles Ponzi claimed to be investing in International Reply Coupons, while Bernie Madoff claimed to invest in the stocks and bonds markets, but neither really did.

If there are no significant outside sources of revenue, then members are just paying themselves, even though there are no direct monetary contact among the members.

Difference between Ponzi Scheme and Pyramid Scheme

The main difference between Ponzi scheme and pyramid scheme is that in a Ponzi scheme, the participant do virtually nothing, let others manage the money and expect growth, while in a pyramid scheme, members are actively encouraged, and in fact, is usually REQUIRED to bring in new members in order to get paid. One is passive, while the other is active.

The business relationship is also different. In a Ponzi scheme, the participants are related to the COMPANY, whereas in a pyramid scheme, the participants are related to his/her upline / sponsor. 

In the above example, A has no relation with B, C, or D, despite each person who left (A, B, and C) are being paid with other members' money. 

There are some schemes that combine Ponzi and pyramid schemes, creating a hybrid scheme. You can either sit back and do virtually nothing, or you can earn by recruiting others (or do both). TVI Express scam, for example, is a matrix-based hybrid scheme that has aspects of BOTH pyramid scheme and Ponzi scheme. All transactions goes through the company, like Ponzi scheme, but the matrix, payoff, and cycle, are variants of the pyramid scheme.

Any who claims they are not a pyramid scheme, or they are not a Ponzi scheme, may in fact, participating in a hybrid scheme that combines feature(s) from both, and by emphasizing the differences of their variant from the "standard models". Both pyramid schemes and Ponzi schemes are illegal scams. So arguing it's not one or the other doesn't say much, yet that doesn't stop people from attempting so. The SpeakAsia scam in India is well known to have their "fans" (panelists) post long essays on why Speak Asia is not a pyramid scheme, when SpeakAsia is actually accused of being a Ponzi scheme.

How can Ponzi schemes be disguised

Ponzi schemes are usually disguised through secrecy, facade of success, and finally, amazingly consistent returns.

One way to disguise a Ponzi scheme with the false facade is by insisting that it is NOT an investment, but an income opportunity or business opportunity (with the implication that you "work" to earn the money). Unfortunately for the scammers, government saw through that a long time ago. In 2008, a bogus 'auto-surf' Ponzi called Ad Surf Daily was shut down by the Feds. It worked like this:
  1. Participant buys "ad unit(s)" from the company  (invest)
  2. Participants are encouraged to recruit additional participants, with bonuses  ("optional" recruit)
  3. Participants get "rebate" if they watch some of the ads, up to 1% per day  (get paid)
The participants are essentially paying each other / themselves. As long as more participants are coming in (i.e. buying the alleged "ad units") the company can continue to pay this 1% a day return on the money put in. It is a Ponzi scheme, albeit disguised as you having to "work" (i.e. watch the ads) to qualify for the "rebate". People are also encouraged to "roll over" their existing rebates to buy more ad units, "potentially increasing" their future payouts.

They claim they are not an investment by deliberately telling people NOT to use investment words to describe them (and did not do it themselves), insist that you are "buying ad units" from them, instead of investing, and your "return" are rebates for "watching ads".

This scam was shut down when it was raided by US Secret Service, IRS, FTC, SEC, and other agencies in 2008. And 55 million seized was eventually returned to the victims THREE YEARS LATER (in 2011).

The Pigeon King at Downtown Winnipeg
This is NOT the Pigeon King
you are looking for...
The Pigeon King at Downtown Winnipeg
(Photo credit: AJ Batac)
Another scheme, called Pigeon King, was also shut down in 2008. Participants are told that if they buy several hundred pairs of "breeding stock" of pigeons (at up to $500 per pair), and breed them, Pigeon King will buy back all baby pairs at up to $50 each pair. Farmers were told that the pigeons are "to be sold to Middle East for racing". Later, the story changed to "to be sold to Far East as food". However, as long as the Pigeon King, Arlan Galbraith, keep paying for the pigeons, nobody bothered asking questions... that is, until Arlan had too much pigeons, and nobody to sell them to (i.e. no more people would buy more "breeding stock" from him). US authorities in multiple states issued warnings not to deal with Pigeon King, and Canada did the same, and Pigeon King declared bankruptcy in 2008. Authorities estimated this particular Ponzi topped $40 million dollars. All across US and Canada you have farmers with barns holding hundreds of thousands of pigeons that had nowhere to go, with hundreds of thousands spent on the barns.

Why is this a Ponzi scheme? Because the farmers who did get paid are paid with purchases FROM the other farmers buying the pigeons. The new pigeon farmers are paying the old pigeon farmers. When no more buyers can be found to buy pigeons, no more farmers can be paid, and the whole thing collapsed.

In this case, Pigeon King have never actually sold any pigeon as racing or food. Even if they did, they would have to sell MASSIVE amounts, and generate HUGE profit from the sales to justify such profits. Squab are usually sold in Chinese restaurants for about $2 per bird, so wholesale cost is probably less than quarter of that, thus there is no "massive profit" even in the squab market. Entire enterprise is bogus.

So to summarize, if the members of a scheme are MOSTLY being paid by other members, it is a Ponzi scheme.

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