Pyramid Schemes on the Rise: How Savvy Investors Get Stung

June 17, 2002

"Pyramid schemes," a type of fraudulent investment, are on the rise again. At the initial stage of a pyramid scheme, potential investors are approached — often through the business opportunity sections of newspapers or through friends and acquaintances — with promises of quick profits spawned by recruiting others to sell the promoter's product. For a start-up fee, an investor is promised a certain remuneration for bringing new recruits into the promoter's sales force.

The more recruits, the more the investor receives. The merchandise or service to be sold is irrelevant. The main focus is to get an investor to recruit three or more other participants, each of whom recruit three or more others, and so on.

Why don't pyramid schemes work? In order for everyone to profit in a pyramid scheme, there would have to be a never-ending supply of potential (and willing) participants. There is no such thing. When the supply runs out, the pyramid collapses and most participants lose their investments.

Here are some of the reasons these investors got stung:

1. They were lured into investing by promises of very high investment returns in a short time.

2. Their ordinary caution went astray because the promoter was connected to a charity, shared similar religious or political interests, or had connections to well-known individuals. (There are many examples of fraudulent activities masterminded by "pillars of the community").

3. They failed to ask the questions they ordinarily would have asked if approached by an investment promoter.

4. They succumbed to pressure to "reinvest" or let the money "roll over" instead of cashing out.

5. They failed to ask for a prospectus, offering circular, or similar document.