WHAT IS MULTI-LEVEL MARKETING
What is ‘Multi-Level Marketing’
Multi-level marketing is a strategy that some direct sales companies use to encourage their existing distributors to recruit new distributors by paying the existing distributors a percentage of their recruits’ sales; the recruits are known as a distributor’s “downline.” All distributors also make money through direct sales of products to customers. Amway is an example of a well-known direct-sales company that uses multi-level marketing.
BREAKING DOWN ‘Multi-Level Marketing’
Multi-level marketing is a legitimate business strategy, though it is controversial. One problem is pyramid schemes, which use money from new recruits to pay the people at the top, often take advantage of people by pretending to be engaged in legitimate multi-level marketing. Pyramid schemes can sometimes be spotted by their greater focus on recruitment than on product sales.
Legitimacy of Multi-Level Marketing
An issue in determining the legitimacy of a multi-level marketing company is whether its products are sold primarily to consumers or to its members who must recruit new members to buy their products. If it is the former, the company is deemed a legitimate multi-level marketer. If it is the latter, it could be operating a pyramid scheme, which is illegal. The Federal Trade Commission (FTC)has been investigating multi-level companies for several decades and has found many that blur the lines between the two. According to industry data, there are 90 million members worldwide, but relatively few earn meaningful income from their efforts. To some observers, that reflects the characteristics of a pyramid scheme.
WHAT IS A PONZI SCHEME
A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn’t enough money to go around, and the schemes unravel.
BREAKING DOWN ‘Ponzi Scheme’
A Ponzi scheme is an investment fraud where clients are promised a large profit at little to no risk. Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments. This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. When this flow runs out, the scheme falls apart.
Origins of the Ponzi Scheme
The first notorious Ponzi scheme was orchestrated by a man named Charles Ponzi in 1919. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply.
With the constant fluctuation of postage prices, it was common for stamps to be more expensive in one country than another. Ponzi hired agents to purchase cheap international reply coupons in other countries and send them to him. He would then exchange those coupons for stamps that were more expensive than the coupon was originally purchased for. The stamps were then sold as a profit.
This type of exchange is known as an arbitrage, which is not an illegal practice. Ponzi became greedy and expanded his efforts. Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of actually investing the money, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until 1920, when an investigation into the Securities Exchange Company was conducted.
Ponzi Scheme Red Flags
The concept of the Ponzi scheme did not end in 1920. As technology changed, so did the Ponzi scheme. In 2008, Bernard Madoff was convicted of running a Ponzi scheme that falsified trading reports to show a client was earning a profit.
Regardless of the technology used in the Ponzi scheme, most share similar characteristics:
- A guaranteed promise of high returns with little risk
- Consistent flow of returns regardless of market conditions
- Investments that have not been registered with the Securities and Exchange Commission (SEC)
- Investment strategies that are a secret or described as too complex
- Clients not allowed to view official paperwork for their investment
- Clients facing difficulties removing their money
WHAT IS A PYRAMID SCHEME
A pyramid scheme is an illegal investment scam based on a hierarchical setup. New recruits make up the base of the pyramid and provide the funding, or so-called returns, the earlier investors/recruits above them receive. A pyramid scheme does not involve the selling of products. Rather, it relies on the constant inflow of money from additional investors that works its way to the top of the pyramid.
BREAKING DOWN ‘Pyramid Scheme’
An individual or a company initiates a pyramid scheme by recruiting investors with an offer of guaranteed high returns. As the scheme begins, the earliest investors do receive a high rate of return, but these gains are paid for by new recruits and are not a return on any real investment. From the moment the scam is initiated, a pyramid scheme’s liabilities begin to exceed its assets. The only way it can generate wealth is by promising extraordinary returns to new recruits; the only way these returns receive payment is by getting additional investors. Invariably these schemes lose steam and the pyramid collapses.
Basic Pyramid Scheme
A pyramid scheme is a variation of the Ponzi scheme, which offers a promise of high investment returns that are not available from traditional types of investment. In practice, the structure of pyramid schemes induces others to recruit victims and collect money that eventually makes its way to the top of the pyramid. In a typical setup, one person recruits a second person to invest a certain amount of money. The second person recovers his investment by recruiting people under him to invest in the scheme. The more people he can recruit under him, the greater his profit and a certain percentage of the profits of all recruiters work their way up the pyramid to enrich the recruiters before him. Each person must recruit a certain number of people. The process continues until there are fewer people at the bottom of pyramid, and it collapses under its own weight. Generally, only the people near the top of the pyramid make any significant profits, and people near the bottom never recover their investments.
On their face, multi-level marketing companies are structured like a pyramid. Individuals have the opportunity to invest in their own businesses, which, ostensibly, distribute a product. However, with some companies, the real profit opportunity comes not from selling products but from inducing others into buying into their own business, with a percentage of the investment moving up the hierarchy of recruiters. Among the more high-profile multi-level marketing companies to be investigated as a pyramid scheme is Herbalife Ltd. Herbalife distributors can make money just by selling the company’s products, but they must purchase and sell thousands of dollars’ worth of the products before they realize a profit. Critics allege that the company’s top recruiters receive the vast majority of profits.
WHAT IS SECURITIES FRAUD
Securities fraud is a type of serious white-collar crime that can be committed in a variety of forms but primarily involves misrepresenting information investors use to make decisions.
The perpetrator of the fraud can be an individual, such as a stockbroker, or an organization, such as a brokerage firm, corporation, or investment bank. Independent individuals might also commit this type of fraud through schemes such as insider trading.
BREAKING DOWN ‘Securities Fraud’
The Federal Bureau of Investigation (FBI) describes securities fraud as a criminal act that can include high yield investment fraud, Ponzi schemes, pyramid schemes, advanced fee Schemes, foreign currency fraud, broker embezzlement, hedge fund related fraud, and late day trading. In many cases, the fraudster seeks to dupe investors through misrepresentation and to manipulate financial markets in some way. This crime includes providing false information, withholding key information, offering bad advice, and offering or acting on inside information.
Securities Fraud Takes on Many Forms
There is no shortage of methods used to trick investors with false information. High-yield investment fraud, for example, may come with guarantees of high rates of return while claiming there is little to no risk. The investments themselves may be in commodities, securities, real estate, and other categories. Advance fee schemes can follow a more subtle strategy, where the fraudster convinces their targets to advance them small amounts of money that is promised to result in greater returns.
Sometimes the money is requested to cover processing fees and taxes in order for the funds that allegedly await to be disbursed. Ponzi and pyramid schemes typically draw upon the funds furnished by new investors to pay the returns that were promised to prior investors caught up in the arrangement. Such schemes require the fraudsters to continuously recruit more and more victims to maintain the sham for as long as possible.
The FBI warns that security fraud is often noted by unsolicited offers and high-pressure sales tactics on the part of the fraudster, along with demands for personal information such as credit card information and social security numbers. Allegations of securities fraud are investigated by the Securities and Exchange Commission (SEC) and National Association of Securities Dealers (NASD). The crime can carry both criminal and civil penalties, resulting in imprisonment and fines. Some common types of securities fraud include manipulating stock prices, lying on SEC filings, and committing accounting fraud. Some famous examples of securities fraud are the Enron, Tyco, Adelphia and WorldCom scandals.