Are Pyramid Schemes Inherently Fraudulent?

| About: Herbalife Ltd. (HLF)


Ponzi schemes must be fraudulent, because multiple valid claims are created for the same funds. Pyramid schemes are unsustainable, because they are erroneous and wasteful.

There is no necessary connection between enterprise sustainability and fraud.

The California U.S. District Court's justification for Bostick's case against Herbalife is shown to be invalid.

The supposed indicators of pyramid fraud - high churn rates and "excess" inventory - can or could be explained by general or particular aspects of market uncertainty.

Shorting Herbalife shares at this time is not recommended.

Most everyone who has paid any attention to Wall Street's machinations over the past year is by now aware of the controversy surrounding Herbalife (NYSE:HLF). In a nutshell, Pershing Square's Bill Ackman has accused Herbalife of operating an illegal pyramid scheme, one that profits principally at the expense of unsophisticated minority groups within the United States and across the world. This is the basis of Ackman's "short thesis," wherein various national regulatory bodies are expected to recognize this urgent moral imperative and force the shutdown of Herbalife's operations. More recently, it appears that these allegations have inspired a former Herbalife distributor (Dana Bostick) to seek legal redress by asserting that Herbalife's business model violates California's "Endless Chain Scheme Law." The essential claim is that Herbalife's sales network is an "inherently fraudulent" pyramid scheme in which a majority of participants must necessarily fail. Herbalife's prospects in the United States would be dealt a serious blow if California's U.S. District Court upholds this claim, and Pershing Square's "short" position in Herbalife shares might ultimately be monetized.

As far as financial analysis is concerned, the law is taken as a given, something that cannot be questioned by those outside the lawmaking circle. Current legal reasoning holds that pyramid schemes are inherently fraudulent, because they are unsustainable and unfairly enrich the originators at the expense of the latecomers. Accordingly, most Herbalife discussions focus on whether or not its distribution network fits the definition of pyramid scheme. It seems that no one in this debate disagrees with the idea that individual property rights are properly secured by shutting down pyramid schemes whenever they are found to exist.

In my view, this debate's focus is misplaced - it needs to be shifted to the more fundamental question of whether or not pyramid or "endless chain" schemes really are inherently fraudulent. For this analysis, we will need to review the technical meaning of fraud, along with the concepts of sustainability, uncertainty, and entrepreneurial error. The crucial distinctions between the pyramid and the Ponzi schemes must be highlighted as well. Unfortunately, these two terms are used almost interchangeably within popular discussions. That they are both labeled as "schemes" tends to cement the view that they are equally dishonest programs of self-enrichment. If it is possible to show that a pyramid scheme can exist exclusively as the consequence of ordinary entrepreneurial error, then it can neither be inherently fraudulent nor an intrinsic danger to individual property rights. After completing this analysis, I shall consider its bearing on the Herbalife controversy.

Ponzi Schemes are Inherently Fraudulent

It is commonly believed that both Ponzi and pyramid schemes are inherently fraudulent, because at some point, the new participants required to sustain the operation will not be found. As a result, the majority of the scheme's participants must suffer losses. Wikipedia's definition of the Ponzi scheme can be construed as being consistent with this view:

A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from existing capital or new capital paid by new investors, rather than from profit earned by the individual or organization running the operation. Operators of Ponzi schemes usually entice new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the high returns requires an ever-increasing flow of money from new investors to sustain the scheme.

Let's parse this view into the following statements:

  1. Human populations are finite.
  2. Wealth flows from the latest to the earliest participants.
  3. Late participants are more numerous than early participants.
  4. The resulting wealth redistribution is fraudulent, because the recruitment process is unsustainable (i.e. it is a process that is incompatible with economic equilibrium).

The first three propositions are justifiably true a priori. This is just a fancy way of saying that each fact is independently deducible and that there is no conceivable observation or experience that one could make or have that could falsify the fact. Note that in legal matters, the facts of interest do not have this character - they are facts that only certain people (with the right experience) can possibly know.

The final proposition stands out, because it is really a value judgment disguised as a factual statement. It derives from the normative view that anti-equilibrium economic activity is morally suspect and worthy of suppression. But since economic equilibrium implies the absence of uncertainty and error, this view, strictly speaking, implies that no economic activity should be conducted if it cannot be executed flawlessly! Clearly, the criterion of sustainability is not decisive when it comes to identifying fraudulent activity.

To pinpoint the source of Ponzi fraud, we must examine the first sentence in the Wikipedia definition. But first, let's review the components of fraud. Again, Wikipedia outlines the elements that generally constitute fraud within the United States:

  • a representation of an existing fact;
  • its materiality;
  • its falsity;
  • the speaker's knowledge of its falsity;
  • the speaker's intent that it shall be acted upon by the plaintiff;
  • the plaintiff's ignorance of its falsity;
  • the plaintiff's reliance on the truth of the representation;
  • the plaintiff's right to rely upon it; and
  • consequent damages suffered by the plaintiff.

Note too, that the omission of certain facts not knowable to the plaintiff can also qualify as factual misrepresentation.

Again, the "existing fact" referred to in this listing is one whose justification is beyond the reasonable reach of all possible plaintiffs. In other words, the plaintiff has no reason or right to rely on the truth of the speaker's representation of any "fact" that the plaintiff can readily confirm or refute independently.

To see why Ponzi schemes must be fraudulent, let's consider the simplest and most benign example. This is the case where the income provided by new investors exactly balances the payments to the early investors, and the Ponzi operator makes no money. If it can be shown that this operation is fraudulent, then all related instances where the operator does profit (i.e. new income exceeds outflow) must also be fraudulent. Note that identifying the "speaker's" gain is not a necessary aspect of fraud.

The representation made to each investor by the Ponzi operator is that over some time interval in which the investor must forgo the right to use his property, he will be compensated by deriving a return on his investment at some level [rp] against the current market rate of interest [r0]. The implication of this statement is that the investor will hold the sole claim to the augmented property at the end of the interval. Also of note is the fact that the scheme is centralized, in the sense that all of the investors only hold claims against the operator and not amongst each other. Furthermore, each investor is unaware that other new investors are needed to fund his "guaranteed" return.

Now, let's assume that the original investors do not withdraw their principle from the operation, but do take out their periodic "interest" payments. After [n] payment intervals, the operator's fund [F] will remain unchanged so long as the new "income" equals these interest payments.

The level of payment at the end of a given interval is a function of the apparent fund value [An], which is also the total exchange value of the investors' claims on the fund. Of particular interest is the ratio of claims to available funds at any point [n]. Given this highly simplified example, it can be shown that this ratio is:

It is clear that as long as rp > r0, the legitimate property claims exceed the available funds at any point (n >0) into the operation of the scheme. This is the direct proof that the Ponzi operator's representation of the operation is always injuriously false during its lifetime, independent of the question of ultimate sustainability.

At this point, certain readers may be tempted to argue that these "investors" should have known better than to trust someone offering guaranteed excess returns over extended periods of time. But while the principle of market efficiency can be a helpful "rule of thumb" when considering the behavior of popular markets over the long term, it is still an equilibrium concept that does not apply at all times within all markets. Since the operator's true method cannot be disclosed, any purported method must be false. All the operator has to say is that he has discovered some previously unnoticed inefficiency in some sufficiently obscure but tradable market. Moreover, the investors will be unaware of the magnitude of the apparent fund value [An], and so, it is impossible for them to make any judgments as to the appropriateness of a purported method within a purported market.

So, the Ponzi operator's misrepresentation of fact must involve at least two components:

  1. Falsely stating that the investor will maintain the exclusive claim to his "guaranteed" property.
  2. Falsely stating (or failing to state) the method used to achieve excess returns.

Once again, the operator's fraud does not depend on the scheme's inevitable failure. The scheme's end merely exposes the existing fraud - it does not create it. The scheme could collapse because of a diminishing pool of new investors (e.g. a finite population), or from the withdrawal of too many early participants.

Error and Sustainability

Before turning to the pyramid scheme, let's first clarify the relationships between enterprise sustainability, uncertainty, and entrepreneurial error. The close connection between error and uncertainty should be intuitive: Planned activities do not always achieve their intended outcomes in an uncertain world. Error and uncertainty are really just the opposite sides of the same coin - a coin that prohibits the existence of general economic equilibrium. Qualitatively, we should expect that the likelihood of committing error increases with one's sense of uncertainty.

Sustainability and entrepreneurial error are linked through their common connection to wealth destruction. It is the tendency of a free market to minimize the destructive social impact of entrepreneurial error. Even though any particular error does not guarantee a monetary loss, entrepreneurs who commit serial errors typically suffer losses and eventually lose their command over productive resources. Their existence as entrepreneurs is not sustainable, as the free market regulates itself against the compounding of error.

Complications arise when this self-regulation is hampered. Whenever erroneous activities are allowed to persist (through government intervention), the eventual social impact of error is amplified. Once revealed, these errors create disturbances (i.e. crises) that feed back into the economy to magnify the market uncertainty. Unfortunately, these spikes in market uncertainty provide a convenient excuse for further market intervention, allowing a new and more damaging error cycle to begin. When "politically approved" forms of error are sustained, the market's error-damping tendency is thwarted.

Economic sustainability implies continuous wealth creation within economic equilibrium. This does not mean, however, that all unsustainable activities imply error and wealth destruction. (Efforts devoted to natural resource extraction, while technically unsustainable, are currently essential for the production of new wealth.) But it does mean that activities that cause wealth to be destroyed must be unsustainable and inherently erroneous.

Pyramid Schemes are Inherently Erroneous

Pyramid schemes differ from Ponzi schemes in several important respects. This becomes clear once we compare the Wikipedia definitions:

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.

First, the pyramid scheme is a business model and not a passive investment. This means that there is no central operator who "guarantees" excess returns by either obscure or unspecified methods. Everyone engaged in the pyramid scheme has freely made the decision to become an entrepreneur. This role is vastly different from that of an investor, consumer, or employee: the entrepreneur's raison d'etre is the realization that he or she can combine the available factors of production more profitably than the competition. It is the responsibility of the entrepreneur to discover and evaluate all of the information that is relevant to this decision, and then to proceed in a way that leads to the greatest psychic profit. The entrepreneur commits error whenever the consequences of his or her actions are inconsistent with this goal. Perhaps the most common error example is the decision to become an entrepreneur in the first place.

Second, the flow of funds within the pyramid structure is transparent to all of the participants. At no point within the model are there multiple legitimate claims created for the same funds. Therefore, pyramid and Ponzi schemes cannot be fraudulent for the same reason. (Of course, if the pyramid scheme is selling a Ponzi scheme "investment," then the pyramid scheme would be fraudulent through its connection to the underlying Ponzi scheme.) With its open design, the "unsustainability" of a pyramid scheme can be deduced (either directly, or with hired assistance) by all of its participants. No participant need rely on any promoter's claim that the scheme is sustainable. It is the responsibility of each participant entrepreneur to assess whether or not any given product or service can be sold with a sufficient profit margin under the available terms. By assuming this responsibility, the scope for fraud against the participant is narrowed considerably.

And finally, for this definition to be self-consistent, we must assume that any product or service produced by the scheme cannot, in large part, be consumed by the participants themselves. For if the participants are also the majority consumers, then it is possible for the scheme to be sustainable even if the participant income does not come primarily from the public through traditional retail sales. The extreme example of this situation would be a perfectly sustainable discount buying club.

In order to simplify matters, let us examine the least sustainable cases where the scheme participants consume none of its products or services, either because they are tokens or because they do not exist. If it is possible to show that such schemes can grow in the absence of fraud, then we can say that even the most extreme pyramid schemes are not inherently fraudulent.

So how can a pyramid scheme actually grow in the absence of fraud? Clearly, error must be involved for the scheme to propagate, but what can be said about the nature of this error? Because repetitive entrepreneurial error is quashed in a free market, inherently erroneous pyramid schemes tend to be self-extinguishing, and they will almost certainly die out long before population saturation is realized.

Consider the following example, where no product is involved (e.g. a chain letter):

Individual "A" seeks to initiate a pyramid scheme. "A" proposes to "B" that he find his own set of recruits "C," for which "B" is to give "A" some level of consideration. If "B" does not think he can find "C," then "B" will not contract with "A" and the propagation of the scheme through "B" does not occur. If "B" guesses that he can find "C," but in the end cannot, then he commits entrepreneurial error, suffers a loss, and again this branch of the scheme is cut off. However, if "B" believes from the outset that he can find "C," then he must question his connection to "A." If "B" contracts with "A" to propagate the scheme, then he commits error, because he can always improve his outcome by ignoring "A" and placing himself at the top of his own structure.

Therefore, the propagation of the scheme seems somewhat contradictory: it requires that the recruits be competent at finding their own recruits, but also be incompetent at avoiding error. If the scheme is to propagate, then all of the recruits must fit this description. Since the subset of individuals who meet these criteria is bound to be much smaller than the working-age population, the short-term sustainability of the scheme will be of much greater practical relevance than the long-run saturation of the eligible population.

The character of the error changes if "A" offers to sell "B" a token product. That "A" would waste productive factors to create a product that cannot be sold profitably is erroneous on its face. The same can be said of "B" if he decides to ignore "A" to create a token product of his own. Of course, in this case, it is not clear whether "B" will improve his outcome relative to contracting with "A." If "B" understands that "A's" product is a token, then his strategy is essentially the same as if there were no product involved. In effect, the only way to "sell" the product profitably is to bundle it with the recruiting "business opportunity." His success will depend upon his ability to recruit others who themselves must have a high capability to recruit similar people. If, on the other hand, "B" believes that "A's" product is not a token, then his error is obvious. By adopting the role of entrepreneur, "B" must rely ultimately on his own judgment as to whether he can work within the terms of his contract to produce his greatest psychic profit.

In summary, no matter how short-lived, it is possible for a pyramid scheme to grow via a concatenation of individual errors in the absence of fraud. (Of course, "A" could fool "B" by intentionally misrepresenting the nature of the token product, but this fraud would not be specific to the networked sales structure.) That these pyramid schemes effectively destroy wealth means that their existence, within a free market, must depend on persistent entrepreneurial error. In the absence of any product, the consequent redistribution of wealth is unsustainable so long as other wealth-producing activities are not diverted to support the scheme's waste. This conclusion is all the more true if additional resources are consumed for the creation of token services or products.

Application to the Bostick Case

The Bostick complaint revolves around Herbalife's alleged violation of California's "Endless Chain Scheme Law." Under this law, an endless chain scheme is defined as:

[A]ny scheme for the disposal or distribution of property whereby a participant pays a valuable consideration for the chance to receive compensation for introducing one or more additional persons into participation in the scheme or for the chance to receive compensation when a person introduced by the participant introduces a new participant. Compensation, as used in this section, does not mean or include payment based upon sales made to persons who are not participants in the scheme and who are not purchasing in order to participate in the scheme.

The connection between this definition and the Wikipedia definition for the pyramid scheme becomes clear once we identify those outside of the scheme as being the "public." The "Koscot test" is then invoked as a means to indicate the possible existence of an endless chain scheme. This test is based upon the following two criteria:

  1. Participants pay for the right to sell a service or product.
  2. Participants pay to obtain recruiting rewards unrelated to product sales to ultimate users.

Notice that this test is sensitive to operational sustainability, so long as all of the ultimate users are included in the test. With this stipulation, networks in which most of the product consumption occurs internally would be recognized as being sustainable. But the sensitivity of the Koscot test is weakened if traditional retail customers are considered to be the only legitimate end-users. California's Endless Chain Scheme Law appears to have incorporated this limitation, even as many other states have adopted "reasonable personal use" clauses for compensation derived from internal consumption. The Koscot test also implies that consumption is the only ultimate product use. This assumption ignores the possibility that the products could be demanded by distributors for speculative purposes, especially under extraordinary circumstances. Price speculation could be an ultimate use given that many of Herbalife's products have limited shelf lives.

Now that the "offending" entity has been described, along with a method for its detection, what is the court's justification for intervention in these matters? More specifically, why must an endless chain scheme be considered offensive with respect to individual property rights?

Beverly Reid O'Connell, the United States District Judge in California's Central District, points to prior court rulings to provide the law's justification:

"Pyramid schemes are considered inherently fraudulent, because they must eventually collapse. Like chain letters, pyramid schemes may make money for those at the top of the chain or pyramid, but must end up disappointing those at the bottom who can find no recruits."

By now, it is evident that this justification fails. The certainty of the scheme's collapse means that any denial of this certainty would be an "existing fact" that lies beyond the scope of fraud. The evanescence of the pyramid scheme derives from its erroneous nature, and the errors that allow the scheme to grow need not be caused by the commission of fraud within the scheme. Those at the bottom who end up disappointed will suffer psychic losses, but the same would be true of any entrepreneur who does not organize his own productive factors in a way that produces a psychic profit.

Anyone who remains unconvinced by this reasoning should consider the legal consequences of participating in an inherently fraudulent operation. In such a circumstance, someone who freely acts to propagate the operation is just as guilty of committing fraud as anyone else in the scheme, including its originator. By arguing Herbalife's inherent fraudulence, Bostick, who recruited for Herbalife, implicates himself as a fraudulent actor with no right to sue his non-coercive partner in crime. The fact that Bostick has been given standing in this matter means that the court has already concluded that Herbalife's operation is not inherently fraudulent!

Although entirely separate from the Bostick claims, certain Herbalife critics (such as Ackman) would ignore this conclusion and press the point that Herbalife profits unfairly by overselling its "business opportunity" to various credulous and unsophisticated segments of the working-age population. In other words, they believe that Herbalife is just an elaborate wealth-redistribution scheme, because no one would purchase and consume their products (at a profitable price) if not for the connected lure of a spectacular business success. But would it not be the height of hypocrisy for the authorities to shut down Herbalife for this reason? After all, how can the overselling of a wealth-redistribution scheme via fantasies of easy wealth to these same unfortunate groups be considered fraudulent or even unethical, when state-sponsored lotteries do so every week?

Churn Concern

According to its critics, Herbalife's grand deception is suggested by the high failure rates of its new recruits: If large numbers of ignorant people are being misled into the program, then we should expect that a very high early failure rate will result. But is this the only possible explanation for high levels of churn?

Unfortunately, the high churn rate can be explained by the high degree of uncertainty within today's labor markets. As discussed earlier, elevated uncertainty is connected with the more likely commission of error. Of course, the first error to be made is to overestimate one's entrepreneurial abilities. The elevated levels of under-employment over the past five years have surely tempted many to explore the life of self-employment. Programs such as Herbalife provide a low-cost means to sample this lifestyle. So, if we view the Herbalife "business opportunity" recruits as conducting their own experiment with entrepreneurship during hard economic times, it should not be surprising to see high churn rates even in the absence of intentional deception.

Inventory Irony

The accepted hallmark of the pyramid scheme is the practice of inventory "loading." Here, the scheme participant is thought to feel compelled into purchasing "unreasonable levels" of product inventory to advance through the network hierarchy in order to qualify for better terms on future purchases and/or to be eligible for placement within the stream of upline rewards. It should be obvious that if a participant purchases more than he can ultimately resell (and consume), then he has acted erroneously and nothing more. What objective sense does it make for such a participant to redirect the blame by using "The Devil made me do it" excuse?

An overlooked aspect of the Ackman/Herbalife drama has been its impact on the inventory question. Even if we were to accept as a fact that Herbalife's compensation structure causes inventory loading, it now can no longer do so exclusively since Ackman has declared his scorched-earth offensive. Any Herbalife distributors who wish to hedge against an Ackman victory will have the incentive to acquire "excess" inventory. In this way, Herbalife products would still be available (at an elevated price) once product production is interrupted or halted. One can't help but think that Ackman failed to foresee the underlying irony in his action: The public drive to annihilate Herbalife undermines the principal legal pillar needed to destroy it.

Investment Implications

Readers may take from this analysis the following practical points:

1) Shorting Herbalife shares on purely ethical grounds is not justified.

2) Pershing Square's public war declaration against Herbalife works against the realization of its "short thesis."

The first point is directed at those investors who may be tempted to follow Ackman's lead and short Herbalife shares as a means to occupy some supposed moral high ground. As always, emotional investing is not likely to produce superior returns.

Any law to restrict pyramid schemes must be arbitrary. Such laws are also likely to confuse all those concerned. Apart from the most egregious cases where actual (not imputed) acts of fraud can be established, government regulators should not be overly anxious to involve themselves in these murky matters. Add to this the special situation between Pershing Square and Herbalife, and the potential morass becomes very uninviting.

Beyond Ackman's thesis, Herbalife shorts will languish so long as the levels of world under-employment remain high. A stagnant world economy would ensure that the supply of experimental entrepreneurs continues to grow.

The "risk asymmetry" from the Bostick case is an obvious exception to my anti-short thesis. The negative impact of a Herbalife loss would most likely outweigh the benefit of a win or draw.


As a statute, California's "Endless Chain Scheme Law" is flawed, because it assumes that the only way such schemes can propagate is by the commission of fraud. Instead, I have shown that the pyramid scheme's lifeblood is participant error, and this error need not be caused by fraudulent activity within the network. The uncertainty associated with high rates of under-employment could account for experimental entrepreneurial error within direct marketing operations, as it leads many new participants to overestimate their marketing skills. Such laws attempt to identify unsustainable business practices, but the constraints in their application can undermine even this limited goal. The lack of enterprise sustainability is not a sufficient condition for fraud. Plaintiffs such as Dana Bostick should have the burden, therefore, to cite and prove specific acts of fraud to justify their damage claims.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.