Ponzi Schemes v. Pyramid Schemes
By Bill E. Branscum
Copyright 1999

Although the terms are frequently used interchangeably, a Ponzi Scheme is substantially different than a Pyramid Scheme. A clear understanding of the difference may be useful to the investigator who focuses his practice on financial fraud cases. In an effort to illustrate the distinction, this article cites classic examples of both followed by a review of the things an investor should be alert to.

The "Classic Ponzi Scheme"

In turn of the century Boston, an Italian Immigrant named Carlo "Charles" Ponzi established the Securities Exchange Company. Ponzi offered investors a choice between a fifty percent return on a 45 day investment and a 100% return on a 90 day investment. Ponzi claimed that this return on investment was possible due to his unique understanding of the international postal reply coupon system; by international agreement, postal reply coupons were recognized by all countries but the cost of these coupons varied dramatically from country to country depending upon their economy.

Although true in principal (an IPRC that cost a penny in Germany cost a nickel in the US), Ponzi was fully aware that the scheme did not work in actual practice because of importation restrictions. Nevertheless, the story sounded good.

Investors did receive the interest on their investments that they were promised and the investments poured in. This was not a revenue generating business enterprise supported by investors; there was no underlying business whatsoever. This was an investment generating scheme that relied entirely upon today's investors to meet the obligations due to those who had invested 45 days previously.

A Ponzi scheme's indebtedness increases as a function of geometric progression; however, the enterprise generates income so long as the pool of investment capital increases faster than the debt accrued. The reason that these schemes are illegal is that, as is the case with their pyramid cousin, they are mathematically doomed to collapse.

Due to the fact that there is no source of revenue other than the investment pool used to pay debt, the "Classic Ponzi Scheme" will be immediately exposed in any audit. According to generally accepted accounting procedures (GAAP), any Ponzi scheme is insolvent from the moment of its inception and becomes increasingly insolvent each day that it is in operation.

The essence of a Ponzi Scheme is investment. The Ponzi operator typically represents that he has some sort of "system" that is either incredibly complex, or a proprietary secret. His system makes it possible for him to pay incredible rates of return. The elaborate office, exquisitely tailored suits, involvement with the church, and generosity toward charitable organizations are all classic window dressing.

Ponzi schemes do not decline and fall; they are typically hugely successful until they collapse. Everyone is making money, everyone who wants their money out gets paid, and everyone is happy until the regulators shut it down or something precipitates a run on the bank.

The "Classic Pyramid Scheme"

A Pyramid Scheme is a multi-level marketing (MLM) program that cannot support itself. Note that all Pyramid Schemes are multi-level marketing programs BUT all MLM programs are NOT Pyramid Schemes. The distinction lies in the source of revenue - does the operation NEED new members to survive or can it stand on it's own?

The common chain letter is an example of a Pyramid Scheme. Note that in a Pyramid Scheme, the "investors" are often (but not always) aware of their role in the scheme. Fully aware that there is no underlying product, today's investors pay for their place on the pyramid and then solicit tomorrow's investors.

Many Pyramid Schemes are substantially more complex, constructed to look like a legitimate MLM operation such as Amway where people buy in and then benefit from their product sales and the sales of those that they recruit into the operation. In these cases, the only people who realize that the operation is a scam are those at the top of the pyramid; the other investors believe that they are involved in legitimate MLM; a scam of this nature rocked the state of Kansas in the mid 1980's.

In this scam, Activator Supply Company sold ''activator kits'' to investors to grow milk-based bacteria cultures for resale to Culture Farms who, according to the marketing hype, processed them and sold them to Cleopatra's Secret to make cosmetics. It was a real moneymaker until regulators shut them down.

Investigators determined that the program was a hoax - there was no market for the cultures and the companies involved were all part of a giant circle. In actuality, the cultures sent to Culture Farms were processed and returned to Activator Supply, Co. to be resold. The people who invested had no idea - they were making money, and lots of it, but they had no idea that the money they made was taken directly from the investments of subsequent investors.

Although it is often asserted that the social security program is a classic example of a Pyramid Scheme, this is not the case. People do not buy into the SS program believing that they can entice their friends to join and realize a major return on their investment and, unlike the classic pyramid, the SS program is not necessarily doomed to collapse since the government requires participation and the government can subsidize it as necessary.

Ponzi or Pyramid - either way, the con artists who perpetrate these scams are swindlers with sociopathic personalities who view everyone around them as bit part players in their own personal play. These people are devious beyond comprehension. Uninhibited by anything akin to conscience or remorse, they have no mercy and feel nobody's pain.

Charm and charisma can conceal a lot. It is hard to imagine that one of the most likeable people you ever met in your life, totally trusted by those you respect and admire, would destroy everything you worked your entire life to build while looking you in the eye and smiling in your face all the while.

Bill Branscum is a licensed Private Investigator and owner of Oracle International, an investigative agency he established in Naples, Florida following his career as a federal agent. His experience includes investigations related to narcotics smuggling, money laundering, securities fraud, the unlawful exportation of critical technology, the sexual exploitation of children and contract murder.

Oracle International maintains a web site at http://www.OracleInternational.com.

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