Ponzi Scheme vs. Pyramid Scheme: What's the Difference?

Arthur Pinkasovitch, CFA, has worked 5+ years as a financial analyst. He is an associate director at ATB Financial.

Types of Corporate Financial Crime and Fraud

1. Fraud: Definition, Types, and Consequences of Fraudulent Behavior
2. White-Collar Crime
3. Corporate Fraud
4. Securities Fraud
5. Insider Trading
6. Pump and Dump Scam
7. Money Laundering
8. Racketeering

Individual Financial Crime and Fraud

1. The Most Common Types of Consumer Fraud
2. What Is a Pyramid Scheme? How Does It Work?
3. Ponzi Scheme: Definition, Examples, and Origins
4. Ponzi Scheme vs. Pyramid Scheme: What's the Difference?

Detection of and Liability For Financial Crime and Fraud

1. Detecting Financial Statement Fraud
2. What Is Accounting Fraud? Definition and Examples
3. Financial Statement Manipulation
4. Who Is Liable for Credit Card Fraud?
5. How to Avoid Debit Card Fraud

Financial Crime and Fraud Examples

1. The Biggest Stock Scams of All Time
2. Enron Scandal
3. Bernie Madoff
4. Ethics Violations by CEOs
5. Rise and Fall of WorldCom
6. Scandalous Insider Trading Debacles

Control and Regulation

1. Securities Exchange Act of 1934
2. Securities and Exchange Commission (SEC)
3. Financial Crimes Enforcement Network (FinCEN)
4. Anti Money Laundering (AML)
5. Compliance Department
6. Compliance Officer

Ponzi Scheme vs. Pyramid Scheme: An Overview

A Ponzi scheme is a type of financial fraud in which the "success" of the entity is propped up by paying returns to initial investors from the money invested by subsequent investors. A pyramid scheme is a fraud that involves the continuous recruiting of investors by previous investors so that they get paid through new membership charges rather than actually selling a product or service.

Ponzi and pyramid schemes have many similar characteristics based on the same concept: unsuspecting individuals get fooled by unscrupulous investors who promise them extraordinary returns in exchange for their money. Unlike a regular investment, these schemes can offer consistent profits only as long as the number of investors continues to increase. Once the number tapers off, so does the money.

Ponzi and pyramid schemes are self-sustaining as long as cash outflows can be matched by monetary inflows. The basic differences arise in the type of products that schemers offer their clients and the structure of the two ploys, but both can be devastating if broken down.

Key Takeaways

• Ponzi and pyramid schemes involve unscrupulous investors taking advantage of unsuspecting individuals by promising them extraordinary returns in exchange for their money.
• With Ponzi schemes, investors give money to a portfolio manager and are paid out with the incoming funds contributed by later investors.
• With a pyramid scheme, the initial schemer recruits other investors to recruit others (and so on) where new recruits pay the person who recruited them for the right to participate or perhaps sell a certain product.
• These schemes promise big results and often fail to provide financial documents to investors.
• Contact local authorities, the SEC, and/or the FTC if you suspect you've been a victim of any type of financial fraud, including Ponzi and pyramid schemes.

Ponzi Schemes

Ponzi schemes are based on fraudulent investment management services. They promise investors higher returns than traditional investments by paying returns to investors from money taken from new investors.

Here's how it works. Investors contribute money to the portfolio manager (the person running the scheme) who promises them a high return. When those investors want their money back, they are paid out with the incoming funds contributed by later investors.

The person who organizes this type of fraud is in charge of controlling the entire operation. But rather than put the money into a type of investment that earns interest, they merely transfer funds from one client to another and forgo any real investment activities.

Warning Signs of a Ponzi Scheme

So how do you know if you're involved in a Ponzi scheme? There are several telltale signs, including:

• Promises of high returns. Be wary if your portfolio manager makes claims that your profits will net you substantially higher returns than those of traditional investments.
• Little to no risk. Every investment offers some degree of risk. So there should be some alarm bells when someone says you'll be completely shielded and your money is protected.
• Lack of registration and licenses. Legitimate investments are regulated and managers are licensed. Make sure you ask to see any documents and credentials of anyone who is offering big results for your money.
• Complicated investment strategies. If you can't understand how your money generates returns, it's probably too good to be true.
• Missing paperwork and payments. You should be concerned if you aren't receiving any statements and/or if you don't get the payments that you're promised.

Examples of Ponzi Schemes

• Bernie Madoff: The most famous Ponzi scheme in recent history—and the single largest fraud of investors in the United States—was orchestrated for more than a decade by Bernard Madoff, who defrauded investors in Bernard L. Madoff Investment Securities LLC. Madoff built a large network of investors from whom he raised cash, pooling his almost 5,000 clients' money into an account he withdrew from. But he never actually invested the money, and once the 2007-2008 financial crisis took hold, he could no longer sustain the fraud. The total loss to investors was estimated to be around $65 billion. The controversy sparked a period in late 2008 that is known as Ponzi Mania, in which regulators and investment professionals were on the hunt for other Ponzi schemes.
• JSG Capital Investments: The U.S. Attorney's Office of the Northern District of California said two men were indicted in 2016 by a grand jury for wire fraud. Jaswant Singh Gill and Javier Carlos Rios of JSG Capital Investments were accused of promising investors that they would buy pre-IPO shares of private companies. Instead, the two men used the money for their own use and paid them interest to prevent individuals from getting suspicious. More than $5.5 million was diverted while the two men were accused of raising $9.3 million from their investors.

Money managers should be able to offer verifiable financial data; true investments can be easily checked.

Pyramid Schemes

A pyramid scheme works a little differently than a Ponzi scheme. This scheme is structured so that the initial schemer must recruit other investors who will continue to recruit other investors, and those investors will then continue to recruit additional investors, and so on.

People at the top of the pyramid tend to profit the most. And because they earn more money, they're able to entice more people to join. As more people join, more money finds its way into the pyramid, which gets funneled in from new investors to the people higher up. But those at the bottom lose out, especially if they can't get others to join.

There may sometimes be an incentive that is presented as an investment opportunity, such as the right to sell a particular product or multilevel marketing (MLM). Each investor pays the person who recruited them for the chance to sell this item. The recipient must then share the proceeds with those at the higher levels of the pyramid structure.

Warning Signs of a Pyramid Scheme

You may be able to guess when you're in a pyramid scheme if the following is true:

• Recruitment. This is the main way of drawing people into the scheme. And you can't join (and thus, earn money) unless you pay a fee. In most cases, you'll also be promised more money if you recruit others.
• Fast cash. Most pyramid schemes promise to pay you big returns in a short amount of time. In many cases, these returns usually come from money paid by new recruits.
• Passive income. There are many schemes that promise to pay you money without any actual work. Again, this money is almost always coming from new recruits to the pyramid.
• Lack of documentation. Like the Ponzi scheme, there is almost never any documentation that proves how the revenue is generated. Be sure to ask for financial statements, which should be audited by a financial professional.
• Hard to understand the commission structure. If you can't understand where your profits are coming from or how anyone in the scheme is paid, then it's probably too good to be true.
  

Examples of Pyramid Schemes

• Business in Motion: This scheme required investors in Canada to pay $3,200 to join the scheme. This allowed them to purchase vacation packages that they could then resell to others for a higher fee, thus earning a bigger return. In order to keep the money coming for those at the top, the scheme required more people to join. But the vacation deals weren't even the cheapest on the market, which concerned many of the people involved. Canadian authorities charged the organizer, who was ordered to pay $6.5 million to roughly 2,000 people in a 2014 class action lawsuit.
• Herbalife: One of the largest accused pyramid schemes was with the nutrition company Herbalife (HLF). The company is an MLM that develops and markets dietary supplements with operations in more than 90 countries. Federal regulators in the United States said that the company deceived consumers about the potential for returns. The claim also stated that Herbalife compensated its distributors for bringing others into the scheme, asking these new players to purchase products before the program began. Even though it was labeled as an illegal pyramid scheme and paid out more than $200 million in damages, Herbalife's products still sell, and the stock price looks healthy.

Other types of investment fraud include affinity fraud, microcap fraud, and pump-and-dump scams.

Key Differences

Ponzi and pyramid schemes are both similar investment frauds perpetrated by one or more individuals seeking personal gain. They both involve deceiving others by promising substantial income or returns on an investor's initial investment. But there are inherent differences between the two.

One key difference is that pyramid schemes are harder to prove than Ponzi schemes. They are also better protected because the legal teams behind corporations are much more powerful than those protecting an individual.

Another thing that sets these two types of schemes apart is that the Ponzi scheme only requires investors to put up their money in exchange for returns. Pyramid schemes, on the other hand, require investors to pay a fee or purchase products in order to participate and earn returns.

What to Do if You Are the Victim of a Scheme

Don't allow yourself to be duped if someone asks you to invest your hard-earned money with promises of big returns. But if you are enthralled by the idea and there is a chance that it may be legitimate, get a second opinion. Use a lawyer or certified public accountant (CPA) to scour the documents for inconsistencies.

But it is equally as important to investigate those who manage investors' money. There are a number of ways that you can report the perpetrators of Ponzi and pyramid schemes—or any other type of financial fraud:

• Contact your local law enforcement agency and file a report.
• You can also call the Securities and Exchange Commission (SEC) to ask if there are open investigations into a money manager or prior instances of fraud.
• Check with the Federal Trade Commission (FTC) by phoning the agency or filing a complaint online.
  

What Are the Main Differences Between a Ponzi and Pyramid Scheme?

Ponzi and pyramid schemes are two different types of financial fraud. But there are key points that make them distinct from one another. Ponzi schemes can be easier to detect while pyramid schemes can be hidden to make them look legitimate.

Ponzi schemes simply require a cash investment to earn returns. Pyramid schemes, on the other hand, need you to pay a fee and/or purchase products and services in order to participate and earn income.

How Do You Tell if You're in a Ponzi Scheme?

There are several warning signs of a Ponzi scheme. First, the investment manager will promise you substantially higher returns than any traditional investment with little to no risk. The investment may not be registered and the individual may not even be licensed by state and federal authorities, which is a requirement. Investment strategies are often too complicated to understand and you may not receive any statements. Finally, if you begin missing any of your regular payments, you may be the victim of a Ponzi scheme.

How Does a Pyramid Scheme Work?

Pyramid schemes are a form of financial fraud. They can be disguised as financial opportunities that make them appear legitimate. Pyramid schemes offer big returns for little investment capital and often promise a way to earn income passively. They require individuals to pay an entrance fee and/or purchase products/services in order to participate. These people are then required to bring in more people to the scheme. People at the top are paid the most, receiving a portion of the money that the new recruits contribute. Those at the bottom of the pyramid make little to nothing, especially when no new individuals are recruited.

How Do You Report a Ponzi or Pyramid Scheme?

If you believe that you've been a victim of a Ponzi or pyramid scheme (or any other form of financial fraud), contact your local authorities. You can also file complaints with the Securities and Exchange Commission or the Federal Trade Commission by phone or through their websites.

The Bottom Line

There are two additional important factors to consider: The only guilty party in the Ponzi and pyramid scheme is the originator of the corrupt business practice, not the participants (as long as they are unaware of the illegal business practices). Secondly, a pyramid scheme differs from a multi-level marketing campaign, which offers legitimate products.