If it’s too good to be true… How to identify a pyramid or Ponzi scheme

Whenever a financial offer or investment sounds too good to be true, chances are you’re dealing with a pyramid or Ponzi scheme you should stay away from unless you want to part with your hard-earned money.

These schemes are illegal and any money you make from them will have to be paid back when they fold, and you could even risk being prosecuted if you participate.

Every week brings news of a new scheme that leaves consumers with empty bank accounts instead of ‘earning’ a large interest rate on their ‘investments’. So, why do still fall for whichever the next scheme is on the horizon?

Simple. Because they are desperate in a time of financial volatility and uncertainty.

The Financial Sector Conduct Authority (FSCA) often warns consumers about various money-making schemes that are usually not registered to render financial services. These schemes are usually pyramid schemes or Ponzi schemes, but few consumers know what that really means.

And not knowing means they are more likely to believe promises of ‘doubling’ their money within a few moths or interest of 50% per year.

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What is a Ponzi scheme?

According to Investopedia, a Ponzi scheme is investment fraud where funds from new investors are used to pay existing investors.

Ponzi schemes are named after Charles Ponzi who promised investors a 50% return within a few months, for what he claimed was an investment in international mail coupons. He used funds from new investors to pay fake returns to earlier investors.

With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes tend to collapse.

The National Consumer Commission also regularly warns consumers that they could face criminal punishment if they become part of a scheme, with section 43 of the Consumer Protection Act (CPA) prohibiting participation, whether they know it is illegal or not.

Encouraging other consumers to join the scheme is also a criminal offence.

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The Consumer Protection Act and pyramid schemes

According to section 43, ‘consideration’ refers to the meaning set out in the definition, but it does not include buying any goods at cost to be used in making sales, buying any goods in exchange for the seller buying your goods or your time and effort in pursuit of sales or recruiting activities.

‘Participant’ means a person who is admitted to a scheme for consideration.

This section stipulates that nobody is allowed to directly or indirectly promote, or knowingly join, enter or participate in a multiplication scheme, pyramid scheme, chain letter scheme, or any other scheme or cause any other person to do so.

Pyramid scheme: The CPA says an arrangement, agreement, practice or scheme is a pyramid scheme if the participants receive compensation for recruiting other people rather than from the sale of any goods or services and the emphasis is to get more members.

Pyramid schemes, unlike Ponzi schemes, usually offer a victim the opportunity to ‘make’ money by recruiting more people into the scam.

Multiplication scheme: In a multiplication scheme someone offers, promises or guarantees to any consumer, investor or participant an effective annual interest rate that is at least 20% above the repo rate.

Chain letter: A chain letter scheme is an arrangement, agreement, practice or scheme if it has various levels of participation and if existing participants canvas and recruit new participants.

It is also a chain letter if each successive newly recruited participant is required to pay an amount which is distributed to one, some or all of the previously existing participants, irrespective of whether the new participant receives any goods or services in exchange.

New participants are also assigned to the lowest level of participation in the scheme and upon recruiting new participants, or if these new participants recruit more new participants and so on in continual succession participate in the distribution of the amount paid by new recruits and move to a higher level within the scheme, until being removed from the scheme after reaching the highest level.