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Pyramid Schemes

What is Third Party Fraud?

This is a fraud committed against someone or some business by people other than their employees. They can be committed against individuals, businesses, companies, governments etc. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.

Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to get away. The fraudster may not care if the fraud is eventually discovered as there is no continuing relationship with the victim and they have made their getaway.

What are pyramid schemes?

Pyramid schemes are investment schemes that have two common elements:

(a) new people pay to enter the scheme, and
(b) people in the scheme get paid for convincing other people to enter the scheme.

Pyramid schemes are an old type of confidence frauds. They have been around for centuries, but still appear from time to time and still catch significant numbers of people.

Why are they called pyramid schemes?

Because they are structured in the shape of a pyramid. They have very few people at the top - who get a majority of the money - and many layers of people under them - who's job is to get ever more people into the scheme.

How do they work?

There are many variations, but they work on the common principles that:

(a) there is a hierarchy of investor levels;
(b) the investors are motivated to recruit more investors into the scheme (this is how they get their return); and
(c) new investors pay to get into the scheme.

Pyramid schemes usually do not invest in anything substantial and the sole purpose is to recruit more people who pay money to join the scheme. In order to attempt to hide their illegal nature, promoters sometimes describe them as shopping clubs or similar, where low cost items are 'sold' in consideration of the payments made. In most cases, these attempts at legality fail.

Most pyramid schemes allow the investors (the victims) to move up the levels of the pyramid as they introduce new people; some schemes require another payment to the promoters to move up the levels and some do not; and some have a combination through the different levels. But common to all pyramid schemes, it needs to be constantly fed with more investors to maintain the structure and the returns.

In essence, people pay to join the scheme and their job is to convince some more people to join. Once the have introduces the required amount of new people, they move up to the next level and help the people they previously recruited to get more recruits.

How do they spread?

They usually spread by word of mouth. As each investor has to find more investors, the scheme becomes self perpetuating. In finding more people to join,some investors (early victims) may recover some money, giving them the incentive to find even more victims.

They sometimes follow the same format as chain letters - the "send this letter to 10 friends and you will receive good luck" type. Though Pyramids Schemes are more like "convince 10 of your friends to give me money and you and I will become rich".

How does a typical scheme work?

The promoter commences the scheme and puts himself at the top of the pyramid. He would determine how many new investors would have to be introduced by each investor in order for them to move up the levels; and what amounts of money they would have to pay into the scheme to participate. He must also decide how much of that money he is willing to share to make the scheme work.

How far can these schemes expand?

Based on the above example, the seventh level would require 1 million people to join and the eighth level will require 10 million. In total, to get to eight levels you will need more than 11 million victims. That is about half of the population of Australia. The scheme will not last that long. To get to 11 levels on the above example, you will need to increase the world's population.

But even if the scheme collapses well before level 6, the promoter will have done very well, the top few levels may have done all right, but the vast majority of the investors would have lost their money.

Some people will lose their their money and write it off as bad luck. Some people, not being satisfied with a small investment would have entered the scheme several times and will loose a lot more money.

Why do people join?

The lure of easy money. The attraction of the scheme is that the victims themselves are motivated to find more victims. The thing that motivates people is the belief that they will be able to make their money back and profit from the introduction of new people. This may work for people that enter the scheme early and once these people start making money, most people believe that they can do it as well.

Many people seem to genuinely believe in the scheme - they believe the promotion material and, in anticipation of the expected results, close their eyes to the potential losses and never seem to realize that the scheme must eventually fail. The promoters are happy for these higher level people to make a little money. For every dollar that lower level investors make or recover, the promoters make many more.

What makes the schemes collapse?

The scheme is based on the "bigger idiot" theory. Eventually investors can not find any more idiots. The lack of new investors usually sees the end to the scheme because once the pool of investors dries up, the scheme has to end. The people at the lower level of the pyramid (the majority in number) are the losers, not being able to find a source of new investors to pay in funds that can be used to repay their "investment".

FOR EXAMPLE

Lets say that it is 10 people per level and the amount of money to be contributed is $1,000.

1. The promoter finds 10 investors that each give him $1,000 to enter the pyramid at the lowest level. The promoter has made $10,000. He is the top level. The new investors create the second level. There are now 11 people in the scheme.

2. Each of the 10 second level investors have to find 10 new investors (100 in all) who each pay $1,000 to the person that introduced them. This is split with the promoter; the promoter getting $900 and the second level person getting $100 from each of the new 100 investors. The new 100 investors are the third level of the pyramid. The total number of people in the scheme is now 111. The promoter has received $100,000 ($10,000 from the second level and $90,000 from the third level). The people in the second level have received their initial $1,000 investment back (10 x $100).

3. Each of the new 100 third level investors have to find another 10 investors (1,000 in all) who each pay $1000 to be split ($800, $100, $100) between the three higher levels. The promoter receives $800 from each of the new 1,000 people. There are now 1,111 people in the scheme and the promoter has received $900,000. This is now the fourth level of the pyramid. The third level have received their money back and the second level have made a tidy profit of $10,000 each.

4. Each of the new 1000 investors finds 10 more people, and 10,000 new people join the scheme for $1,000 each with a $700, $100, $100, $100 split. There are now 11,111 in the scheme and the promoter has received a further $7,000,000 (10,000 x $700). This is the fifth level.

5. The chances of the scheme lasting this long are very remote, but the sixth level is formed with 100,000 new people entering the scheme. The promoter will receive a further $60 million.

The theory now is that the promoter drops out of the scheme (and goes to Bermuda on an extended holiday) and the second level people each become a first level person in their own pyramid. This is the incentive for the lower level people to keep feeding new participants into the system.

LESSONS TO BE LEARNED

The promoters of the schemes are generally the only ones to benefit from the scheme. They will naturally deny that their scheme is a pyramid scheme and will attempt to present it as something else. It is therefore necessary for potential victims to look past the gloss of what they are told and to study the true substance of the "investment".

The best advice that we can offer is that "if an investment looks too good to be true, it is probably illegal" and should be examined very carefully.

Legislation prohibiting these schemes has been introduced throughout Australia under each state's Fair Trading Acts. Be particularly careful where:

(a) entering the scheme entails the payment of money to some person;
(b) any form of urgency is suggested by the promoter;
(c) documents (if any exist) are not left for your perusal;
(d) the salesman/consultant will not come to a meeting with your accountant, solicitor or other advisor;
(e) your primary role in the scheme is the introduction of other participants;
(f) you are entitled to receive money from new participants entering the scheme; and
(g) it just does not seem like a proper investment.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

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Last Updated: 31.3.2008