Announcements like this appear in newspapers, flyers stuck onto utility poles, and even shul parsha sheets. They seek to be offering intriguing business propositions that could provide either the answer to all your problems or a healthy supplementary income. You may hear of them via e-mail, a friend or relative, or an old-fashioned letter in your mailbox. For many frum people, pressed for time, money, and school bills, they appear attractive. But what do they really offer?

Most such schemes are by definition frauds (both in the legal and halachic sense), and the only way of profiting by them is by others losing. Those that are not clear frauds are suspect in some other way, and should be avoided by a ba’al nefesh.

The schemes fall into three categories: Ponzi Schemes, Pyramid selling, and Multi-Level Marketing (MLM). Lets look at each of them in turn.

Ponzi Schemes

Charles Ponzi immigrated to North America from Italy in 1903. His colorful career included convictions for forgery in Canada, smuggling aliens into the United States in Atlanta, real estate fraud in Florida and dying penniless in a Brazilian charity ward! In between he developed a form of fraud that bears his name.

Ponzi claimed to have discovered a quirk in the international postal system that would allow him to buy postal coupons in one country and redeem them at a 400% profit in another. In order for the scheme to work he needed "investors" and so offered promissory notes paying "fifty percent. profit in forty-five days." In the end 10,000 people put up over nine million dollars in one year, after which the scheme collapsed . There were, in reality, no postal coupons, so where did all the money come from? Simply put, a Ponzi scheme runs like this:

Shimon asks Levi to lend him $100, and promises to repay him $150 in forty-five days. In the meantime, Shimon borrows – on the same terms — $100 each from Gad and Naftali. Shimon keeps $50 for himself, and pays back Levi. He then has forty-five days to find four more people to borrow from. As news of the profits spread, Shimon no longer has to seek out prospective "investors", they come to him. In the end, Shimon will run out of people to recruit and the "bubble" will burst, leaving those who have not yet been repaid cheated.

Merciless Mathmatics

Why does the bubble always burst? And old Arab folk tale describes a simple but clever man who did a valuable service for the Chalif. The Chalif asks what he can do to repay him, and the man asks for a chess board. He asks the Chalif to place a single grain of rice on the first square, and twice that number (two) on the second square. He asks that twice <I>that</I> number (four) be placed on the third, square, and so on till the last square of the chess board. The Chalif thinks him a fool for seeking such a modest reward, until he works out that not enough rice exists in his empire to fulfill the wish!

As you can see from the diagram and table, in the end the Chalif would have had to come up with a staggering quantity, more than 9 million trillion  grains of rice!

Square

Grains of Rice

 

Square

Grains of Rice

1

1

 

33

4.294.967.296

2

2

34

8.589.934.592

3

4

35

17.179.869.184

4

8

36

34.359.738.368

5

16

37

68.719.476.736

6

32

38

137.438.953.472

7

64

39

274.877.906.944

8

128

40

549.755.813.888

9

256

41

1.099.511.627.776

10

512

42

2.199.023.255.552

11

1.024

43

4.398.046.511.104

12

2.048

44

8.796.093.022.208

13

4.096

45

17.592.186.044.416

14

8.192

46

35.184.372.088.832

15

16.384

47

70.368.744.177.664

16

32.768

48

140.737.488.355.328

17

65.536

49

281.474.976.710.656

18

131.072

50

562.949.953.421.312

19

262.144

51

1.125.899.906.842.620

20

524.288

52

2.251.799.813.685.250

21

1.048.576

53

4.503.599.627.370.500

22

2.097.152

54

9.007.199.254.740.990

23

4.194.304

55

18.014.398.509.482.000

24

8.388.608

56

36.028.797.018.964.000

25

16.777.216

57

72.057.594.037.927.900

26

33.554.432

58

144.115.188.075.856.000

27

67.108.864

59

288.230.376.151.712.000

28

134.217.728

60

576.460.752.303.423.000

29

268.435.456

61

1.152.921.504.606.850.000

30

536.870.912

62

2.305.843.009.213.690.000

31

1.073.741.824

63

4.611.686.018.427.390.000

32

2.147.483.648

64

9.223.372.036.854.780.000

 

The "doubling at each level", when applied to the Ponzi scheme, shows that after only 28 levels it would have taken in more people than the entire population of the United States in 1920 when the scheme ran! A few steps after that it would have exceeded the population of the world.

This is the astonishing power of geometric progression, and we will see its effect in all of the schemes we are going to look at.

Pyramid Schemes and Chain Letters

Shimon offers Levi and Gad the chance to "invest" by purchasing "distributorships" at $1,000 each. The "distributorships" give Levi and Gad the "exclusive" right to sell "distributorships" to others for $1,000 each and to sell certain products to the public. However, each $1,000 that Levi and Gad receive from their sales of "distributorships" must be divided with Shimon, say 50-50. Thus, theoretically, Levi and Gad can realize $500 on each "distributorship" they sell and can completely recover their initial $1,000 "investment" by selling only two "distributorships." Shimon, however, has received not only Levi’s and Gad’s $1,000 each, but also $500 for each "distributorship" that Levi and Gad sell.

Initially, it appears that this can go on forever, with no one being hurt and everyone making money. But the chart below shows that the number of investors needed to keep the pyramid scheme working quickly exceeds the population of the United States. (The chart assumes Shimon initially sells "distributorships" to six persons, each of whom brings in an additional six "purchasers" per month.)

Month Participants  
1 6  
2 36  
3 216  
4 1.296  
5 7.776  
6 46.656  
7 279.93
6
 
8 1.679.616  
9 10.077.696  
10 60.466.176  
11 362.797.056 Exceeding US population
12 2.176.782.336  
13 13.060.694.016 Exceeding World population
14 78.364.164.096  
15 470.184.984.576  

The chart also shows why such a scheme is called a "pyramid" – the promoters are at the top of a pyramid-shaped flow of money. Money coming from later investors flows upward to the top. Being at the top may result in your receiving a lot of money quickly, but it is virtually impossible to determine, at the beginning, where in the pyramid you stand.

A pyramid is really an improvement on the classic Ponzi scheme. Shimon no longer has to search for new "investors" – his victims do so for him!

Chain letters are the written (or increasingly e-mail) versions of pyramids. You receive a letter with, typically, five names in a list. You are instructed to send a certain amount of money – usually $5 – to the person at the top of the list, and then eliminate that name and add yours to the bottom. You are then instructed to mail copies of the letter to five more individuals who will hopefully repeat the entire process. The letter promises that if they follow the same procedure, your name will gradually move to the top of the list and you’ll receive money – lots of it.

There’s at least one problem with chain letters. They’re illegal if they request money or other items of value and promise a substantial return to the participants. In the United States they are a violation of Title 18, United States Code, Section 1302, the Postal Lottery Statute. In other Western countries they are also illegal.

Pyramid schemes are also illegal in most of the Western world. They are a fraud since:

    They are guaranteed to fail (and usually quicker then you would imagine), and Those who do make money on the scheme can only do so since a much greater number of people lose. Since the overwhelming likelihood of loss is never made clear the transaction is a fraud.

Multi Level Marketing

A number of pyramids schemes try to mask their more obviously fraudulent nature by claiming to be distribution networks for products. Each investor receives the right to sell a product of questionable utility and value. Of course, much more money is promised if one sells "distributorships" rather than the product itself. The products are frequently obscure financial instruments, quack "medicines" or "health products", or strange household appliances. Of course no one in their right mind wants the product, and if they did they could probably buy it in a store for much less! But the purpose of the endeavor is not to sell the product, but to recruit people into the scheme.

This use of products is intended to obscure the differences between pyramid schemes – which are always frauds – and multi-level marketing (MLM) schemes, some of which may be legitimate.

MLM claims to be a form of retailing. Distributors purchase stocks of products, which they can then sell at a profit. In addition, they can recruit more distributors (their "downline") and receive a share of the profits they make. One’s own downline may extend for several levels, allowing you to make profits from the sales of many people. Since this would far exceed the income you could make from selling the product, there is an obvious incentive for all concerned to put their efforts into recruiting rather than selling. The similarity to pyramids becomes clear at once.

Legitimate MLMs can be recognized by a single litmus test: would you be willing to work in this framework even if you never recruit anyone? If the answer is "yes", then you are selling a real product that you can reasonably expect others to buy for their own benefit. If the answer is "no" then all you are selling is the right to sell someone else the right to sell someone else… etc.

Large, well known corporations like AMWAY and Shaklee market their products via MLM, and their operations have been judged legal in the United States. Yet even legal MLMs have real moral drawbacks.