A brief history of pyramid schemes and of MLM
I will not attempt to provide here a thorough history of MLM (multi-level marketing) or analysis of all the problems with MLM (or what I like to call product-based pyramid schemes) but merely my observations as a qualified consumer advocate and business analyst. The history of pyramid schemes in this country is interesting, as you will see from the brief sketch below:
Ponzi schemes. When Charles Ponzi organized the Securities Exchange Company in Boston in 1919 and issued promissory notes payable in 90 days with 50 percent interest, he kicked off a storm of investment frenzy which duped just about everyone, including politicians, law enforcement officers, and reporters. He tricked speculators by using the money of new investors to pay old investors huge ‘profits.’
Ponzi took in over $15 million from this and other schemes before his house of cards collapsed, causing losses for thousands and leading to jail time and his eventual deportation to Italy in 1934. Incidentally, there were similar schemes prior to Ponzi (for example, John Law’s “Mississippi Bubble” scheme in France in 1719 and William Franklin Miller’s Franklin Syndicate in 1899—a.k.a. “520 percent Miller”), but the Ponzi name stuck for this type of phenomena.
Some consider Ponzi schemes as separate and distinct from pyramid schemes, but as one writer observed,
"Ponzi and pyramid schemes do have similarities. Both are fraudulent arrangements for the receipt and redistribution of money with early participants winning and those who enter later losing. In each case it is essential to continue the game with new infusions of money, for if the play ends and there is an accounting, there must be a deficit and cries of pain. But where Ponzi promised a definite return on one’s investment—albeit a huge one—the possibilities in a pyramid were almost limitless as new subscribers feed those who joined before.
"Furthermore, the machinery of the pyramid is always explained and is, in fact, one of its alluring features, whereas Ponzi plans invariably refer obscurely to exotic investments that are really irrelevant and usually nonexistent. In some cases the pyramid seems almost acceptable socially, as in the cases of chain letters or distributorship plans, but there has never been any question about the vice of Ponzi schemes.”
“Pay-to-play” chain letters. Later came chain letters, beginning with the “send-a-dime” letter widely appearing in Denver in 1935, which bore the heading “Prosperity Club” and the slogan “In God We Trust” This led to the $1 chain letter in Omaha, chain letter agencies or “factories, and the “Circle of Gold” which spread from California throughout the country in the late 1970’s – all of which used the postal system. Participants would send a dollar to the person at the top of a list of names that was mailed to you, add their name to the bottom of the list, and then mail copies of the letter to persons they know with instructions to do the same.
Many of these chain letters went underground because of aggressive enforcement of federal mail fraud statutes. Still other variations, such as chart and airplane games, emerged later.
Another variation appeared about the time the Internet was launched. What I call “report chains” encouraged you to buy reports listed on a list of names with addresses and then mail a report on anything of interest and add your name to the bottom before mailing it to your list of contacts. The reports were typically useless rehashes of readily available information – often money-making ideas.
“Chain selling” or “chain distribution” systems, or what eventually came to be called multi-level marketing, were an eventual offshoot from pyramid schemes, chain letters and report chains. With chain selling, the selling of products was made through multiple levels of distributors, each of whom received some type of compensation for the sales of those recruited at lower levels, or one’s “downline.”
Early direct selling programs. Parallel to these developments were direct selling programs which focused on door-to-door selling or in-home demonstration plans, or “party plans.” Some of the direct selling programs that were popular in the 50s and 60s included Stanley Home Products, Mary Kay Cosmetics, Fuller Brush, Shaklee, Nutralite, and of course Amway. Even Amway at this time was primarily focused on selling of unique cleaning products to friends and family, rather than primarily to downline participants.
In Chapters 2 and 7, I explained why it is essential to examine carefully the compensation or pay plans of direct selling programs in evaluating them. This, of course, would apply to any packaged home "business opportunity."
To help pay my way through college, I sold World Book Encyclopedia. When I made a sale, the largest commissions (from 20% to 30%, as I recall) from the company went to me as the person who produced the sale. My division manager got a smaller percentage, and his manager a still smaller percentage – but of course they were drawing commissions from many salesmen. I found a similar pay structure when I sold insurance many years later. The person who made the sale got the lion’s share of the commission. In sharp contrast, in MLM, the commissions paid by the company to the front line person making the sale is only a small percentage of the total commissions paid by the company for that particular sale.
No-product pyramid schemes. I use this designation to separate these schemes from product-based pyramid schemes, or recruitment-driven MLMs. It is difficult to determine when the first no-product pyramid schemes were promoted, but by the 1980s several were operating. One example was “The Airplane Game,” in which participants were recruited into four layers, or “tiers” – one captain, two “co-pilots,” four “crew” members, and eight “passengers.” Typically, one would pay up to USD$1500 to enter at the level of passenger, in the hopes of receiving a USD$10,000-plus payout when one 'piloted out' at the top of the scheme. The pyramidal structure is shown below:
The “captain” at the top walks away with the money and then either drops out – and the others each move up a level – or he/she either starts a new pyramid and repeats the process all over or enters at the bottom and recruits his/her way up to the top in order to cash in again. The problem is that at some point the game reaches a point of saturation in which no one wants to enter the pyramid and it collapses – or is shut down by authorizes. Then all those at the bottom levels lose money, which approximates 90% of participants. (For a breakdown of the loss rates, go to Chapter 7, “Appendix 7C: Winners & losers in no-product pyramid schemes “)
The Airplane Game: The "eight-ball" model contains a total of fifteen members. Note that unlike in the picture, the triangular setup in the cue game of eight-ball corresponds to an arithmetic progression 1 + 2 + 3 + 4 + 5 = 15. The pyramid scheme in the picture in contrast is a geometric progression 1 + 2 + 4 + 8 = 15.
It doesn’t matter how many times the pyramid has been recycled into other pyramids, the scheme will eventually collapse, leaving approximately 90% in a loss position. These schemes are widely considered to be unfair and deceptive practices. And though the FTC does not specifically address pyramid schemes, such schemes have been deemed unlawful under the above clause in the Federal Trade Commission Act.
Another recent genre of no-product pyramid schemes were the “gifting schemes,” such as “Women Empowering Women,” in which participants donated or “gifted” money to the operators of the scheme, who claimed it was legal since the money was paid as gifts, rather than investments. But authorities did not accept this distinction, and the gifting schemes were shut down.
“Affinity groups” were also promoted, in which close-knit groups were targeted to promote “Dinner Parties” with guests investing in a pyramid of participants similar in structure to the Airplane Game. These too were shut down by authorities. Periodically, others follow suit. However, most pyramid promoters today see little need to initiate no-product schemes which are easily recognized as pyramid schemes. The trend today is to introduce products to give them an air of legitimacy – and to deceive regulators, the media, and the public into accepting them as legitimate.
Multi-level marketing – or product-based pyramid schemes – evolved from no-product pyramid schemes. In about 1934, a company called Nutralite was founded and by 1945 developed multi-level marketing, a means of turning consumers into distributors. They learned they could sell far more products by selling to distributors than they could by selling direct to consumers. After all, it is easier to buy than to sell, and if a person can be convinced that he/she will make money by buying products to qualify for commissions from sales by those he or she recruited, the sale is an easy one.
The nutritional products were promoted as effective in treating a variety of ailments, including even cancer, heart disease, and depression. Sales exploded, but the FDA took notice and battled such spurious claims for four years. This led to other battles with regulatory agencies later.
In 1960, Rich DeVos and Jan Van Andel developed an MLM they named Amway – short for American Way. Their product was a unique biodegradable soap called Frisk that would avoid FDA scrutiny. They created a compensation plan that essentially re-warded those at the top of a pyramid of distributors at the expense of a continuing stream of recruits at the bottom, who bought the hype of promised riches if they followed their system – which included buying products on a monthly basis to qualify for commissions and advancement in the scheme.
Sales exploded from approximately $½ million in 1960 to $25 million in 1964. Amway also acquired Nutralite in 1972. The “recruiting machine” that Amway developed quickly attracted the interest of vulnerable prospects and of regulators as well – setting the stage for a later battle with the Federal Trade Commission. Thus Amway, and the contest between those advocating for consumers, and an industry promoting a flawed business model that featured an endless chain of recruitment, was born. It quickly moved through childhood and adolescence after FTC prosecutors were outfoxed and outgunned by Amway's high powered legal team. The FTC's Judge Pitofsky ruled in 1979 that Amway was not a pyramid scheme provided certain "retail rules" were followed - including a buyback provision, a minimum of ten retail sales every moth, and the requirement that most products must be consumed before reordering (to prevent "stockpiling").
The "retail rules" were never enforced, and theamway ruling opened a Pandora's box of new MLMs - thousands of them, multiplying like rabbits over the next 30 plus years.