__This essay is part of a series exploring the importance of allowing flexible business models in the American economy.__
鈥淧yramid scheme鈥� sounds sinister. The term is used so routinely and casually that it is easy to imagine it has long been codified as illegal in the United States. It turns out, however, that the concept is a rather recent American legal construct that has yet to be codified in federal statutes.
To many people, 鈥減yramid鈥� evokes marvelous images of an ancient and bygone era. The Great Pyramid of Giza was one of the Seven Wonders of the Ancient World. The ancient Aztecs also had pyramids鈥攚orks of profound engineering and beauty.
After maintaining a positive and wondrous connotation for millennia, 鈥減yramid鈥� acquired a decidedly negative financial meaning in early twentieth-century America. The Oxford English Dictionary credits the American Samuel Reinsch with its first usage.1
In his Readings on American Government, published in 1909, Reinsch uses the term 鈥減yramid鈥� to discuss 鈥渁n illicit, unstable financial scheme.鈥� Later, in 1920, the Oakland Tribune described Charles Ponzi鈥檚 infamous scheme as a 鈥減yramid.鈥�
The OED also credits Americans with originating the term 鈥減yramid scheme,鈥� which first appeared in the Oakland Tribune in 1949. It gives three examples of the use of 鈥減yramid scheme,鈥� each of which involves financial transactions.
Perhaps surprisingly then, the term 鈥減yramid scheme鈥� does not appear in the U.S. Code. The term appears only four times in the Code of Federal Regulations, exclusively in reference to the illegal sale of government bonds.2 There is no federal statutory definition or regulatory definition of 鈥減yramid scheme,鈥� and efforts to write a statutory definition have not passed Congress.
Nevertheless, the term has such evocative and pejorative connotations that it is frequently used as a term of art in federal complaints, including under Section 5 of the Federal Trade Commission Act and under securities law. Recent examples include FTC cases against AdvoCare 3 and Neora (formerly Nerium).4 According to the Association of Certified Fraud Examiners, the FTC shuts down approximately ten pyramid schemes annually.5
Despite the lack of a standard definition, various federal agencies have web pages warning consumers about the differences between illegal pyramid schemes and legitimate multilevel marketing businesses. The table below presents various informal indicia of pyramid schemes, as determined by the Securities and Exchange Commission, the FTC, and the FBI.
Although these are not formal legal definitions, it is surprising how little overlap there is across federal agencies, whose only point of agreement is that pyramid schemes emphasize recruitment. Moreover, these indicators provide little clarity to consumers because 鈥渞ecruitment鈥� is normally associated with jobs and regarded as a legitimate business activity.
Nor are the other indicators unambiguously and uniquely related to pyramid schemes. 鈥淧romises of high returns in a short period of time鈥� are common for many legitimate business opportunities, whether the claims are substantive or mere puffery. So too are promises of 鈥渆asy money or passive income鈥�; indeed, long-term personal investing is a largely passive endeavor. 鈥淣o demonstrated revenue from retail sales鈥� is not a reasonable indication of a pyramid scheme, or else every business in the United States without retail sales might qualify. Many legitimate businesses, such as franchises, require 鈥渂uy-ins,鈥� and others, such as real estate, retail clothing, and insurance agencies, have 鈥渃omplex commission structures.鈥� Patrons of used car dealerships understand the prevalence of 鈥渉igh-pressure sales tactics鈥� in legitimate businesses all too well. And consumers purchasing 鈥渕ore products than they want to use鈥� is perhaps puzzling, but hardly unambiguous evidence of a pyramid scheme. Moreover, many pyramid schemes involve purely financial transactions in which there is no purchase of 鈥減roducts鈥� whatsoever.
Ultimately, the federal agencies鈥� lists of supposed pyramid scheme indicators do not allow us to distinguish a pyramid scheme from a legitimate business activity on the federal level.
Many states, including California 6 and New York,7 also have similar lists, bound up, respectively, in endless chain and chain distributorship laws. These lists are equally insufficient. That said, many states have been aggressively moving to update their pyramid scheme laws in recent years by enacting strong definitions and banning the schemes.
No doubt, some fraudulent business plans warrant government scrutiny, but current federal efforts to define some business practices as pyramid schemes do not clearly distinguish between harmful and wholesome businesses.
Ancient pyramids, built to withstand adverse elements, have lasted millennia. In contrast, pyramid schemes do not withstand the slightest scrutiny. They are little more than a house of cards, quickly falling apart and hurting those who have 鈥渋nvested鈥� in them.