Understanding Pyramid Schemes, Ponzi Schemes and Network Marketing
Countless articles have been written on this subject and numerous speeches have been given. Yet, borders between these three concepts have generally remained fuzzy in minds. This lack of clarity is important because it leads to unfair criticisms on legitimate businesses.
First, a few definitions from trusted sources:
According to the World Federation of Direct Selling Associations – WFDSA), “Pyramid schemes are illegal scams in which large numbers of people at the bottom of the pyramid pay money to a few people at the top. Each new participant pays for the chance to advance to the top and profit from payments of others who might join later.”
In a speech, Debra A. Valentine, a former General Counsel at the U.S. Federal Trade Commission (FTC), said, “They (pyramid schemes) all share one overriding characteristic: They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public.”
In an article, FTC’s Aditi Jhaveri advocates if “income is based mainly on the number of people one recruits, and the money those new recruits pay to join the company — not on the sales of products to consumers”, then, this is a sign that the company is operating a pyramid scheme.
Reading all this, it seems pretty straightforward: If a participant’s income is not based on exchange of goods or services, but is earned against bringing in new people, then what we see is a pyramid.
So, where does the confusion stem from? From the existence of those that are called “disguised pyramid schemes”. These businesses operate in a deceptive way in an effort not to be caught by the authorities. Typically, participants are forced to buy large amounts of inventory that they can neither sell nor consume. In some other cases, they are expected to purchase worthless products that no other people would buy under normal conditions. If these exist, it is obvious that organization members earn money based not retailing the products but merely on people recruited.
A related issue here is “internal consumption”. This concept refers to products being bought by direct sellers not for the purpose of retailing them to end-users. When considered together with the previous paragraph, this is obviously an important issue. From another perspective though, the existence of internal consumption is inevitable. At the end of the day, direct sellers would naturally buy and consume the products that they recommend to others. Within this context, you might want to take look at the two brilliant articles Jeff Babener wrote following the FTC – Herbalife settlement: FTC v. Herbalife Settlement: First Take and FTC v. Herbalife: Post-Settlement Legal Guidance for the Direct Selling Industry.
These are named as such after Charles Ponzi’s fraudulent scheme in the U.S. he ran in the 1920s. In broad terms, a Ponzi scheme is an investors’ pyramid. Here, the scheme’s operator promises unreasonably high returns to attract new investors. These returns are so high that the founders know from the beginning that they are not economically sustainable. And an investor’s source of income is not the return generated by the funds invested by themselves. Income here is derived from the new investments coming in from others.
Needless to say, the chain breaks at a certain point soon after a few people make huge amounts money… and after many lose whatever they have.
The most famous Ponzi scheme of the last decades was led by Bernard Madoff who was a former Chairman of NASDAQ stock exchange. It was estimated that the investors had lost about $18 billion in his scheme. In June 2009, Madoff was sentenced to 150 years in prison.
Both pyramid and Ponzi organizations are fraudulent, illegitimate and illegal. They are prosecuted and shut down wherever spotted. Network marketing on the other hand, is a legitimate way of making business.
First and foremost, the participants in network marketing earn money not based on others’ losses. It is a micro-entrepreneurship model, in economic terms. I believe this draws a clear line.
Members take their shares from the commissions pool that accumulates from the sales of goods or services in the network marketing model. Looking from another perspective, if the products are not sold, nobody will be able to earn anything. Taking this a step further, registration fees, starter kit sales or anything that a new member is required to make a payment for do not and should not generate income for those who joined before.
So, where to stand on the issues of “personal use”? In my understanding, participants’ purchases for themselves in reasonable amounts are just as legitimate as the purchases made for the purpose of retailing. And to me, there is nothing wrong with the upline or the member himself / herself earning commissions on them.
Unlike a pyramid or a Ponzi, network marketing is a sustainable business model. As long as they are managed well, just like in any other industry, network marketing companies successfully survive for decades. While there is no such an example to this among pyramid schemes, there are numerous examples in the direct selling industry.
Hakki Ozmorali is the Principal of WDS Consultancy, a management consulting and online publishing firm in Canada, specialized in providing services to direct selling firms. WDS Consultancy is a Supplier Member of the Canada DSA. It is the publisher of The World of Direct Selling, global industry’s leading weekly online publication since 2010. Hakki is an experienced professional with a strong background in direct sales. His work experiences in direct selling include Country and Regional Manager roles at various multinationals. You can contact Hakki here.
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