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Capital Markets: Pyramid Schemes

Tyler Maroney

What reporters need to look for:

WHAT ARE THEY?

Pyramid schemes have been used to swindle money out of everyone from housewives in Glasgow to internet addicts in Minneapolis. But people in developing countries are often the most vulnerable since they aren’t accustomed to free-market economics and aren’t protected by strong market or legal regulations. When people have only a vague understanding of what capitalism is and believe all capitalists are wealthy, they are often quicker to believe in the get-rich-quick promises of a pyramid investment scheme.

A pyramid scheme is a fraudulent investment instrument with which unscrupulous promoters intentionally mislead unsophisticated people. In general, the promoters will ask people to give them money with a false guarantee that they will give the investors a very high rate of return. But the scheme doesn’t actually earn money in any way. Instead, the promoters take money from each new investor and use it to pay the return they have guaranteed to previous investors. As time goes on and more people join, it becomes impossible to keep paying the same rate of return. If anyone decides to withdraw their money, the entire scheme will collapse. What’s more, when the scheme fails to attract newcomers, its only source of revenue disappears and it collapses.

Only those who invest money at the early stages of a pyramid scheme stand to gain anything, and then, only because the promoters must create this initial “profit” to get the plan into action. It is the continuous flow of new deposits on which the entire system depends. This type of scheme inevitably ends in financial ruin due to its inherent insolvency: A pyramid scheme’s liabilities always outweigh its assets.

Compare this with a normal, legal investment plan, where an investor may put money into a bank deposit, or they may buy shares in a company. The bank, in exchange for being able to use the depositor’s money to make loans to other clients, promises to pay a rate of interest on the money. The bank generally makes a profit on the loans it has made. It is then able to use those profits to give the depositor back the initial sum of money, plus the interest it has earned. Strong government regulations ensure that the bank does what it has promised.

In another example of normal business practices, consider investors who buy shares in a company. They expect to receive dividends if the company is able to sell its product and make a profit. Or, if the company is successful, the price of the shares themselves may increase and the investor could make a profit by selling them. If the company isn’t successful then it may not be able to pay dividends and the price of its shares may fall. In that case, the investor may lose money. Strong regulations would ensure that an investor would be aware of the risk they were taking; that no returns were guaranteed for them.

Pyramid schemes have been common in Eastern European countries that are making the transition from a communist-controlled economy to a free market. They prey on people who are under the illusion that the high promised return of a pyramid scheme is a part of the capitalist system to which they so desperately want to belong. Mired in decades of strict state-controlled politics and economics, Eastern Europeans have scant understanding of the risks that accompany the potential for prosperity that capitalism affords. It is the vulnerable, the poor, the greedy, and often the elderly, who are most susceptible to the empty promises of these sophisticated swindles.

In a typical pyramid scheme, a company may be disguised as a bank, a mutual fund or some other kind of private investment business. It lures investors with promises of high returns, or unnaturally high interest rates due to a special system the promoters have invented.

The schemes often operate outside of the law or they exploit existing legal loopholes to flourish for a brief time before the authorities can enforce poorly written laws. Once pyramid schemes collapse, the founders often liquidate any assets, stash them in offshore accounts and flee.

COUNTRIES THAT HAVE HAD PYRAMID SCHEMES

Millions of victims in such countries as Bulgaria, Latvia, Slovakia and Romania have watched their life savings, their mortgages-even money borrowed from loan sharks-disappear in byzantine pyramid schemes.

Probably the most famous single pyramid scheme was the MMM scandal. Run by Sergei Mavrodi, the notorious Russian entrepreneur, MMM ran a massive advertising campaign that lured money away from hungry investors with promises of unprecedented returns. At its peak in 1994, MMM was valued at roughly $1 billion. The MMM scheme was founded in the wake of the collapse of the Soviet Union when poor Russians were at their most vulnerable. When the bubble burst, massive losses followed, sparking skepticism of capitalism itself.

But the most catastrophic collapse of an entrenched network of pyramid schemes occurred in the mid-1990s in Albania. At the time, Albania was the most isolated country in Europe with a population that was slow to adjust to the government’s transition from centralization to a market economy.

Albania cut the typical profile of a country most susceptible to pyramid schemes: the people had a weak grasp of capitalist workings, and the few private banks that did exist were unable to satisfy the private sector’s demand for credit. And so a web of informal, deposit-taking companies was born. Many of these companies were based on family ties and financed solely by remittances, money sent home by relatives working overseas.

In 1997, both the Albanian government and the country’s entire financial structure caved in following the implosion of the myriad pyramid schemes. So many people had joined the schemes that roughly two-thirds of the population suffered massive losses and hundreds of thousands were left penniless and debt-ridden when they collapsed. To have so many people from all walks of life lose all their money so quickly caused anarchy: entire battalions of military and police officers deserted; over a million guns and mortars were looted from army depots; foreigners fled the country; and the president, whose government had failed to intervene in time, was forced to resign. To add to the chaos, most government revenues couldn’t be collected and civil servants couldn’t be paid to keep the order because customs buildings and tax offices were looted and burned. After months of rioting and panic-induced heart attacks, more than 2,000 people lay dead.

WHAT TO LOOK FOR

A transition economy

The most destructive pyramid schemes have sprouted up in Eastern Europe where the population is unfamiliar with capitalism. In countries like the Czech Republic and Romania, there is a legacy of central planning and, therefore, a well-entrenched reliance on the government for financial help. When that security disappears, naïve investors are lured by promises of quick profits that never materialize.

  • How much does the general population understand about the workings of the free market?
  • Is the government or any other body attempting to educate people in any way about capitalism and its risks?

A weak regulatory framework

Pyramid schemes in Albania flourished because, in the early 1990s, the country was emerging from decades of a brutal communist dictatorship. In this transitional stage, there were very few control mechanisms in place to ensure that companies were run according to shareholders’ interests. Many of the schemes grew organically out of personal relationships and wrapped themselves in the veil of legitimate businesses with little or no history. It is difficult to regulate what cannot be defined or even identified.

  • A reporter should ask what regulatory body exists and how stringent are its controls on the economy?
  • Find out if regulators are independent and experienced. A regulatory environment that is made up of inexperienced bureaucrats with little experience overseeing capital markets is a good breeding ground for pyramid schemes.

Corruption

In a country in which government officials are easily bribed and who are severely underpaid, pyramid schemes will flourish longer than they should. Any delay in holding thieves accountable may lure the unsuspecting masses, allowing them to be caught up in pyramid schemes.

  • Are there signs of cronyism between government officials who are responsible for regulating financial activities and those people who are setting up investment schemes?
  • Have there been any cases where government regulators have prosecuted any illegal financial activities?

Lack of investing alternatives

In the 1990’s, Albania had no stock market at all, the banks were undercapitalized and there was no way for the people to really “invest” in anything. Pyramid schemes offered an alternative for those thirsting for a taste of capitalism. What’s more, when interest rates are low, money seeks higher returns.

  • Is there anywhere for people to invest their money?
  • Are banks charging sky-high high fees to open and maintain accounts?
  • What is the barrier to investing in the stock exchange?

Unrealistic promises

Legitimate investment managers cannot and will not guarantee any returns. A bank may offer a fixed interest rate on deposits, but that will almost always be in line with the rate being offered by other banks and must be backed up by strong government regulations on bank activity. Any usually high rate of return that is guaranteed is suspicious. When returns are promised to a naive public, this is the first sign that something is wrong.

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