The key reason that Pyramid Schemes are illegal is due to their negative impact upon consumers, as well as the distributors that work under them. Generally, the people at the bottom of the Pyramid are the ones who are impacted the most. Often left with thousands of dollars of useless stock that they can’t get rid of.

There is a key differentiation in the eyes of the law between MLM companies and Pyramid Schemes. Unfortunately, even if a company doesn’t fit the archetypal definitely of a Pyramid Scheme, you will often still see plenty of instances of individuals left laden with products they cannot sell or give back to the company.

The way around this isn’t to look at “what is legal” and what isn’t. There are plenty of well known MLMs who I believe are unethical and shouldn’t be running in their current format. This is why consumers and perspective distributors need to do their research and really look into the company they are considering involving themselves with.

There will always be negative stories online about everything you could possibly Google. However, if there are countless instances of people telling their story about losing time, money and sanity over their involvement with an MLM – you would be best to steer clear!

Legal Precedent of Pyramid Schemes

Historically, the first instance of legal action against a business for being a Pyramid Scheme happened in the 1970s. It was during the 70s that we experienced a “boom” in the working from home, MLM style business model. This boom resulted in a variety of different business offerings – from kitchenware to make-up and cosmetics.

While there are many legitimate MLM businesses, there are also some which lean more towards the definition of a Pyramid Scheme. Personally, I don’t agree with the vast majority of MLM style businesses, however, some are better than others.

As with the rise in MLMs, came the rise in Pyramid Schemes. Which led to an “anti-pyramid” bill being brought forward to the US Senate on two occasions during the 1970s – however, it never materialised as a law.

One of the first instances of Pyramid Schemes cracked down upon by the FTC was a business called Koscot Interplanetary inc. This was your typical stereotype for a Pyramid Scheme. They were a cosmetics company which allowed people the opportunity to become a “Beauty Adviser” and sell their cosmetic products. However, their setup wasn’t focused around selling their products to retail customers. Instead, there were pay-barriers to achieve certain levels within the business, and requirements to order a certain amount of product. On top of this, there was significant incentive for recruiting new advisers to the company.

The FTC found that Koscot was operating illegally where they were effectively creating a “chain” of individuals – and the higher up the chain you were, the greater the benefit you achieved. It was in this instance that the FTC set the legal precedent for what the definition of a Pyramid Scheme would be up to this very day.

Effectively, the FTC defined that these companies would force participants to pay money in return for “the right to sell a product” and would receive benefit and rewards for recruiting other individuals into the program. Ultimately, the rewards that they receive are unrelated to the sale of product to end retail users. The key here is product to end users. Quite often you will find in these companies that there is plenty of product moving hands, but only between members of the program. Member A will sell Member B some of their stock to sell to people, and then Member B will recruit someone and sell some stock to Member C. This chain continues and spreads…into the shape of a pyramid.

pyramid scheme layout

The reason the FTC are against the paying of bonuses for recruitment was stated as follows:

“. . . will encourage both a company and its distributors to pursue that side of the business, to the neglect or exclusion of retail selling. The short-term result may be high recruiting profits for the company and select distributors, but the ultimate outcome will be neglect of market development, earnings misrepresentations, and insufficient sales for the insupportably large number of distributors whose recruitment the system encourages.”

Another historical example can be found with infamous MLM, Amway Corporation. In the 1970s, the FTC made clear the difference between a Pyramid Scheme and a legitimate MLM. At the time Amway had something called the “Amway Plan” which allowed distributors to purchase products at wholesale prices from the person above them who recruited them to begin with. As I explained before, and I’m sure you can imagine, this just led to products being sold down the chain to the bottom of the Pyramid, and not a significant focus on retail customer sales.

The key here is that Amway distributors would receive a bonus for the amount of products sold to their sponsored distributors. This is the reason that the FTC decided to clamp down, as distributors were compensated for both selling products to the retail consumers, and to their recruited distributors. However, Amway was able to get around any criticisms by implementing a key policy

Amway required distributors to buy back any unused or unsold stock from their recruits upon their request. This meant that they could argue that distributors would not simply sell to their recruits in order to achieve their bonuses, as the recruits would just ask the distributors above them to buy back the stock.

The FTC found that this policy prevented distributors from forcing others to buy excessive or unneeded stock in order to achieve their bonuses, and therefore Amway did not fit into their legal definition of a Pyramid Scheme.

What is the Difference Between a Pyramid Scheme and a Legitimate Marketing Strategy

This depends on whether we look at the legal definition, or look at the reality in the marketplace. There are many companies. Many of whom are well known today, that are technically legal and not in breach of any laws. However, when you go back and look at their history, you realise that they have been dancing along the grey-line of what is legal/illegal for many years.

The majority of well known MLM companies have been embroiled in legal disputes over their legality and legitimacy over the years. They’ve never been so overtly illegal that they have been shut down, but merely tweaked their stance on something to the point to please the FTC and regulators.

Tips to Avoid a Pyramid Scheme

  1. Investigate the pricing of products. Do they seem overly inflated for what the product is? Is there a requirement to spend large amounts of money on these products in order to get “in” with the group? Probably a bad sign
  2. Beware of any program that claims to have a secret connection, special secret etc that cannot be fully verified. Many Pyramid Schemes will use lies and exaggerations to draw distributors and consumers in
  3. Beware of any program which promises increased bonuses based on the amount of people you recruit as a distributor. Don’t always assume that if the bonus isn’t cash, that it isn’t a Pyramid Scheme. I have seen instances where individuals receive huge product giveaways, cars, jewellery etc as incentives for recruitment
  4. Do your research on the earnings of the program. Often they will be exaggerated and make huge claims, but there is no underlying evidence to substantiate these claims.