INTRODUCTION

A pyramid scheme is an unsustainable business model that involves promising

participants payment or services, primarily for enrolling other people into the
scheme, rather than supplying any real investment or sale of products or services to
the public.
These types of schemes have existed for at least a century, some with variations to
hide their true nature. Some multilevel marketing plans have also been classified as
pyramid schemes. In a pyramid scheme, an organization compels individuals to
make a payment and join. In exchange, the organization promises its new members
a share of the money taken from every additional member that they recruit. The
directors of the organization (those at the top of the pyramid) also receive a share
of these payments. For the directors, the scheme is potentially lucrativewhether
or not they do any work, the organization's membership has a strong incentive to
continue recruiting and funneling money to the top of the pyramid.
The words Ponzi and Pyramid are often used interchangeably but they are
different the principal difference being that a Ponzi scheme has only one official
promoter. Otherwise, they have much in common. Both are fraudulent investment
schemes promising unrealistic returns on investment capital, both typically
encourage investors to reinvest their profits, both depend upon new investors to
satisfy their obligations to prior investors, both are continually insolvent and both
are against the law.
Pyramid selling schemes also involve three or four levels through which products
are channeled to the ultimate consumer. The higher levels of distribution resell their
products to the next level below at a percentage of cost. Often a salesperson will
not be elevated to a higher level unless he or she finds a replacement to fill the
position that is to be vacated. Neither the existence of a large direct sales force nor
a market system that forms a pyramid shape indicates that a distribution system is
illegal. The essential element of a pyramid scheme is an intensive program to
recruit new members for a commission, rather than the sale of products to ultimate
consumers.

India so far has no clear distinction between pyramid schemes and multi-level
marketing. They are clubbed as multi-level marketing company only. Multi-level
marketing can be a lawful business which uses a network of independent
distributors to sell consumer products.

ROLE OF SEBI IN CURBING PONZI SCHEMES

SEBI has been granted greater powers during year 2013 to crackdown on illegal
money-pooling schemes and other frauds. To curb the growing menace of frauds,
the government has ordered Serious Fraud Investigation Office (SFIO) probes
against 76 companies during 2013-14 (till December 2013) the highest count in
three years. Besides, an inter-ministerial group was also set up with the mandate to
frame regulations for clamping down on ponzi schemes in the year 2013.
The new Companies law also has strong measures to prevent as well as clamp down
on corporate misdoings and protect the interest of investors.

HISTORY
Pyramid schemes have long been considered illegal under the FTC Act, and the laws
of most states, including the state. The fundamental problem with the pyramid
structure is that, inherent in its design, at any point in time and no matter what the
size, most participants will be out the money they have contributed to the pyramid.
A few people at the top of the pyramid make large sums, but the vast majority loses
their investment. This inherent characteristic of pyramids - rewarding recruitment
with no relationship to retail sales - inevitably leads to a situation where only a small
number of participants can ever even recover their money. There can never be
enough new entrants to ensure that everyone recovers their investment (pyramid
schemes are illegal because they "will inevitably harm later investors"). Indeed,
pyramid schemes might be more aptly explained as icebergs. No more than a small
percentage of an iceberg is above water, no matter what the size. The inevitable
consequence of a pyramid scheme, akin to an iceberg, is that most participants will
remain "underwater." In a simple pyramid scheme, each person who joins pays

money which goes to those at a higher level of the pyramid. New people then
recruit additional people under them (their "downline") who each pay money
upstream to a smaller group of people. The recruiters typically get a cut not only
from the people they recruit, but of the money paid in as new recruits are signed up
further downline. Although they are distinct, pyramid schemes commonly disguise
themselves as legitimate MLMs. In most MLMs, participants can be paid for two
different types of efforts - selling products and, at least indirectly, recruiting new
members.84 The key difference is that, in a pyramid scheme, the recruiting
predominates, and there is little evidence of sales to consumers outside the
enterprise. Participants in a pyramid scheme are frequently forced to buy products
they would ordinarily not buy simply as a cost of participating in the business
opportunity. In such situations, it makes no difference in an economic sense whether
people simply send cash to the people higher in the pyramid or if they pay money
for products they do not really want- the end result is the same: the participants at
the bottom lose money.
The Commission found that Koscot operated an unlawful pyramid scheme,
articulating the legal test upon which courts continue to rely.
An example of a pyramid scheme popular in the 1980s was known as the "airplane
game." In its simplest form, the airplane game consists of 15 people - 1 pilot, 2 copilots, 4 crew members, and 8 passengers. Each person invested a certain sum and
was responsible for recruiting two new members.
Once the airplane was full (I x 2 x 4 x 8), the pilot would receive a payment and
then be rotated out of the scheme. Typically, even when it operated optimally for
participants, the promoter retained half of the money paid into the scheme.
The determination of whether an enterprise is an illegal pyramid then focuses on
whether the primary purpose of the enterprise is to reward recruitment over sales.
Once the Plaintiffs establish that a program satisfies the Koscot test, it has met its
burden of proving that the enterprise constitutes an illegal pyramid scheme. Gold,
177 F.3d at 482 ("Given the grave risks imposed on investors in illegal schemes, the
government should have to do no more than prove that the program satisfies the
defmition of Koscot.").

CASE

The FTC brought a case similar to Koscot against the Amway Corporation in 1975.
The Amway case consumed four years of litigation, thirty contested pretrial orders,
a lengthy trial before an administrative law judge with over 150 witnesses and over
1,000 exhibits, and a subsequent appeal to the Commission. The Commission
ultimately ruled that although Amway was using a pyramid structure, it would not
be considered an illegal pyramid because it had adopted, and enforced, certain
internal rules which were believed to prevent the problems recited in Koscot.
The Commission's decision cited the Koscot definition, as well as two other
pyramid/MLM cases, In re Ger-Ro-Mar, 84 F.T.C. 95 (1974), aff'd in part, rev'd in part
sub nom, Ger-Ro-Mar v. F.T.C., 518 F.2d 33 (2d Cir. 1975) and In re Holiday Magic,
Inc., 84 F.T.C. 748 (1974). The Commission then distinguished the "Amway Plan"
from these cases:
The Koscot, Ger-Ro-Mar, and Holiday Magic cases all involved 'marketing' plans
which required a person seeking to become a distributor to pay a large sum of
money, either as an entry fee (usually called a 'headhunting' fee) or for the
purchase of a large amount of nonreturnable inventory (a practice known as
'inventory loading'). In exchange, the new distributor obtained the right to recruit
others who would themselves have to pay a large sum of money--some of which
would go to the recruiting distributor--to join the organization.
By contrast, a person is not required to pay a headhunting fee or buy a large
amount of inventory to become an Amway distributor. The only purchase a new
distributor is required to make is a $15.60 Sales Kit, which contains Amway
literature and sales aids; no profit is made in the sale of this Kit, and the purchase
price may be refunded if the distributor decides to leave the business. Initial
Decision, p. 12, Findings 34-37. Thus a sponsoring distributor receives nothing from
the mere act of sponsoring. It is only when the newly recruited distributor begins to
make wholesale purchases from his sponsor and sales to consumers that the
sponsor begins to earn money from his recruit's efforts.
93 F.T.C. at 715-16. We are not privy to the evidence which was presented to the
Administrative Law Judge and the Commission in Amway over thirty-five years ago,
but we note that the findings concerning the initial "Sales Kit" and subsequent

wholesale purchases generating commission to the "sponsor" do not justify

distinguishing the Amway plan from Koscot and the other pyramid cases. As
discussed above in the section on the "purchase element," it appears that Amway
simply employed a more sophisticated structure, which involved an initial, nominal
fee to become a distributor and disguised the subsequent payments as inventory
purchases. This error, if it was the only one, would not have had any lasting impact
on MLM law, but the Commission then took a serious departure from Koscot in
dealing with the "retail sales" element:
And Amway has prevented inventory loading at this point with its 'buy-back rule,'
which states that a sponsoring distributor shall '[p]urchase back from any of his
personally sponsored distributors leaving the business, upon his request, any
unused, currently marketable products. . . .' By this rule, a sponsoring distributor is
inhibited from pushing unrealistically large amounts of inventory onto his sponsored
distributors in order to increase his Point Value and Business Volume, and thereby
increase his Bonus.
Two other Amway rules serve to prevent inventory loading and encourage the sale
of Amway products to consumers. The '70 percent rule' provides that '[every]
distributor must sell at wholesale and/or retail at least 70% of the total amount of
products he bought during a given month in order to receive the Performance Bonus
due on all products bought . . ..' This rule prevents the accumulation of inventory at
any level. The '10 customer' rule states that '[i]n order to obtain the right to earn
Performance Bonuses on the volume of products sold by him to his sponsored
distributors during a given month, a sponsoring distributor must make not less than
one sale at retail to each of ten different customers that month and produce proof of
such sales to his sponsor and Direct Distributor.' This rule makes retail selling an
essential part of being a distributor.
93 F.T.C. at 716. Here is the crux of the problem with the Amway decision: In
endorsing these "Amway rules" the Commission failed to enforce the requirement in
Koscot that the compensation paid to distributors be based solely on consummated
retail sales. Moreover, the Commission did not even seem to recognize that it was
changing the rules of the game.

Perhaps the Commission was led astray by the factual finding of the Administrative
Law Judge that the Amway rules were effective in ensuring that retail sales were
actually being made. It noted that:
The ALJ found that the buy-back rule, the 70 percent rule, and the ten customer rule
are enforced, and that they serve to prevent inventory loading and encourage
retailing. Initial Decision, p. 26, Findings 72-75, and p. 58, Findings 145-47. Given
these facts, the Amway plan is significantly different from the pyramid plans
condemned in Koscot, Ger-Ro-Mar, and Holiday Magic. Specifically, the Amway Plan
is not a plan where participants purchase the right to earn profits by recruiting other
participants, who themselves are interested in recruitment fees rather than the sale
of products.
75. The buy-back rule, the 70% rule, and the ten-customer rule encourage retail
sales to consumers. (Van Andel, Tr. 1999-2000, 2010; Halliday, Tr. 6231-33; Lemier,
Tr. 176; Cady, Tr. 5795-97) (27)
93 F.T.C. at 646. And here are findings 145, 146 and 147:
145. Amway's buy-back rule deters inventory loading by sponsoring distributors.
(Van Andel, Tr. 1999-2000; Halliday, Tr. 6231-32; S.Bryant, Tr. 4062-63)
146. Amway's 70% rule deters inventory loading by sponsoring distributors. (Cady,
Tr. 5795-97; Halliday, Tr. 6231; Lemier, Tr. 176)
147. Amway's ten customer rule deters inventory loading by sponsoring
distributors. (Max, Tr. 5996-97)
93 F.T.C. at 668. These are rather thin factual findings on which to premise the
critical judgment that Amway was only paying compensation based on actual retail
sales. Significantly, however, it was Amway that bore the burden of proof on this
issue. Amway, sued as a pyramid, had the burden of proof not only that it had these
"retail sales rules" but that they effectively prevented the abuses listed in Koscot
and resulted in actual retail sales. See Omnitrition, 79 F.3d at 783; SEC v.
International Heritage, Inc., 4 F.Supp.2d 1378, 1384 (N.D.Ga.1998) ("[T]he critical

determination of the legality of [defendant's] operations will not be based on the

written plan but on the actual practices of the company."). As the Sixth Circuit has
held:
We find it more appropriate, however, that a defendant carry the burden of
establishing that it has effective anti-saturation programs. Given the grave risks
imposed on investors in illegal schemes, the government should have to do no more
than prove that the program satisfies the definition of Koscot.
The Amway decision immediately and dramatically changed the legal landscape of
the MLM world. MLM firms were provided with an attractive alternative to complying
with the onerous definition of "retail sales" in the Koscot injunction. Instead of
limiting compensation to consummated retail sales, MLM firms could pay
compensation on purchases by downline participants, provided that they followed
the "Amway rules." Every sophisticated MLM firm promptly adopted some variant of
the Amway rules. The decision also made billionaires of the Amway owners and
funded a highly effective lobby which has successfully insulated endless
entrepreneurial chain schemes from effective regulation and meaningful
enforcement.

Are the Amway Rules Sufficient to Prevent MLM Pyramid Schemes?

The Amway rules which supposedly encourage retail sales are impotent when faced
with the overwhelming incentives of MLM plans to encourage recruiting profits in
return for required inventory purchases. Aside from the conflict inherent between
the incentives of the MLM compensation plan and the encouragement of retail sales,
there is a notable absence of data to support the proposition that substantial retail
sales are actually taking place. MLM firms have data only as to sales made to their
distributors. Any proof of actual retail sales would have to be collected from their
"independent" distributors. Because the distributor's status is dependent on the
proof of compliance, the potential for inaccurate responses is virtually assured. This
is particularly relevant in light of the fact that all available evidence, in the form of

Dr. VanderNat's affidavits, is that actual, profitable retail sales are minimal. As
stated in Koscot:
"That these schemes so often do not allow recovery of investments by means of
retail sales either merely points up that there is very little positive value to be lost
by not allowing such schemes to get started in the first place."
"Prohibited Marketing Scheme" means an illegal pyramid sales scheme (see e.g.,
Webster v. Omnitrition Int'l, 79 F.3d 776, 781 (9th Cir. 1996), Ponzi scheme, chain
marketing scheme, or other marketing plan or program in which participants pay
money or valuable consideration in return for which they obtain the right to receive
rewards for recruiting other participants into the program, and those rewards are
unrelated to the sale of products or services to ultimate users. For purposes of this
definition, "sale of products or services to ultimate users" does not include sales to
other participants or recruits or to the participants' own accounts.

References:
http://www.nasdaq.com/article/the-pyramid-scheme-industry-examining-some-legaland-economic-aspects-of-multi-level-marketing-cm340786