Multi Level Marketing

Why Amway case is similar to a ponzi scheme

amway-logo111

Vivek Kaul 

William S Pinckney, the chief executive officer of Amway India, was arrested yesterday by the crime branch of Kerala Police along with two other directors of the company.
A report in the Daily News and Analysis (DNA) quotes a top official of Economic Affairs Wing (EOW), Kerala as saying “With the call of easy money, they have been luring people to come and invest. And in turn, the new members had to get more people and this was leading to illegal money circulation. As a result, we had received several complaints against the company and we decided to arrest the officials.”
The company is said to have been violating the Prize Chits and Money Circulation Schemes (Banning) Act. More specifically, Pinckney and the two other directors were arrested in connection with a case filed by a certain Visalakshi of Kozhikode. She claimed to have incurred losses of Rs 3 lakh in trying to sell the products of Amway through its multi-level marketing network.
A report in The Mint quotes P A Valsan of the EOW of Kerala Police as saying “They were charging 10 times the value of their product. For instance, they sold product priced at Rs 340 at anywhere between Rs 2,700 and Rs 3,400…Also, they were involved in money chain, which is prohibited under the Prize Chits and Money Circulation Schemes (Banning) Act 1978.”
So there are multiple reasons behind the arrest. It is for the Police and the Courts to establish whether the products were being sold at many times their price. But the other part about whether Amway is a money circulation scheme or not, needs some discussion.
A money circulation scheme is essentially a Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
Before we get into a detailed discussion on whether Amway is a Ponzi scheme or not, it is important to understand how Amway and other multi-level marketing(MLM) companies go about their business.
An MLM company like Amway appoints independent distributors to sell its products. Amway sells products like diet supplements, toothpastes, shampoos, multi-purpose liquid cleaners, soaps, grooming products etc. These distributors are not employees of the company. They make money by selling Amway products.
As per the Amway Business Starter Guide there are three ways a distributor can make money. First and foremost he makes what the company calls the retail profit margin. “Distributors buy Amway products at Distributor Acquisition Price (DAP) and may resell products at a retail price, not to exceed the maximum retail price, as published. In this case, the Distributor’s income would be the difference between the DAP and retail price,” the Business Starter Guide points out.
This is the way almost any distributor for any company makes money. He buys goods directly from the company at a certain price and then sells them at a higher price, which cannot be more than the maximum retail price.
The second way a distributor makes money is through what Amway calls the commission on personal purchases. “Distributor may earn commission on the volume of the Distributor’s individual purchases of Amway products during the month,” the Business Starter Guide points out.
The third way a distributor makes money is through earning commissions on group sales. “A Distributor may recruit a sales group and based on the success and productivity (as defined by product sales) of the sales group, a Distributor may earn commissions. It is important to note that a Distributor only earns commissions on the volume of Amway products actually sold,” the Business Starter Guide points out. So a distributor can sponsor other distributors and then make a certain commission on the amount of Amway goods sold by those distributors. The new distributors can appoint more distributors and so the chain grows. The original distributor gets a commission on all the products sold under his chain.
Prima facie this sounds like a perfectly legitimate though not a normal way of doing business. Amway products are not available in shops. If you want them, you have to buy them directly from Amway distributors.
There are many multi-level marketing companies in the market which claim to sell a certain product. These products include gold coins, holiday memberships and so on. These MLM companies appoint distributors who in turn appoint new distributors, with the idea of selling the product of the company.
The catch here is that the product is just a façade. Nobody really interested in selling the product. The money is made by distributors by appointing new distributors who are a charged a certain commission for joining the MLM scheme. The new distributors in turn appoint newer distributors and so the chain continues.
The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels. So these MLM schemes are essentially Ponzi schemes where money being brought in by newer distributors is paid off to older distributors. There is no legitimate business activity going on.
The Federal Trade Commission in the United States looked at Amway in the 1970s and tried to answer the question whether Amway was a legitimate business or a Ponzi scheme?  The Commission held that, although Amway had made false and misleading earnings claims when recruiting new distributors the company’s sales plan was not an illegal pyramid scheme (another name for a Ponzi scheme). “Amway differed in several ways from pyramid schemes that the Commission had challenged. It did not charge an up-front “head hunting” or large investment fee from new recruits, nor did it promote “inventory loading” by requiring distributors to buy large volumes of nonreturnable inventory,” said Debra A Valentine, a general counsel for the FTC, in a seminar organised by the International Monetary Fund in May 1998.
So that’s another point in favour of Amway not being a Ponzi scheme.
But there is one thing that we need to understand here. Like in an MLM scheme which is a Ponzi scheme, the business that an Amway distributor does, depends on finding new distributors and then hoping that these new distributors sell Amway products and at the same time are able to appoint newer distributors. If a distributor is successful at this he makes more and more money.
The trouble is that we go along it becomes more difficult to appoint new distributors. Lets t
ry and understand this through an example. Lets say the first distributor that a genuine MLM company appoints, in turn appoints five distributors.
These five distributors now appoint five distributors each. So we now have 25 distributors at the second level. Each of these distributors now in turn appoints 5 distributors.

Table explains the number of distributors.
So we now have 125 distributors at the third level. If the chain continues, at the 12th level we will have around 24.45 crore distributors. This is equal to around 20% of India’s population. The total number of distributors will be around 30.51 crore.
What this simple example tells us is that it is difficult to keep appointing more and more distributors. This is similar to a Ponzi scheme, where for the scheme to keep going more and more newer investors need to keep coming in, so that the older investors whose money is falling due can be paid off. The trouble of course is that that the number of people is not infinite, as the above example shows us.
The problem for Amway distributors (or any other genuine MLM company) entering the game late is that it is difficult for them to sponsor new distributors. It is also difficult for them to sell Amway products given that there are so many distributors already operating in the market and they have selling relationships in place. Also, products sold by MLM companies typically tend to be more expensive than similar products being sold in the open market, making it more difficult to get customers willing to buy.
Hence, even in a legitimate MLM business like Amway, it is important to enter early. Those entering the business at the lower levels, find it difficult to get on new distributors and also end up with a lot of unsold inventory, thus leading to losses.
Amway requires its distributors to buy back unsold inventory from the new distributors that they sponsor. But that is easier said than done.
To conclude, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it. To that extent, even legitimate MLM businesses are similar to Ponzi schemes, where it is important to enter the scheme early. Also, like Ponzi schemes even legitimate MLM businesses project the prospect of unrealistically high returns while soliciting new distributors.

The article originally appeared on www.firstpost.com on May 28,2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

 

Sahara and Ponzi schemes: What are the parallels?

 J164133002

Vivek Kaul

Dr K M Abraham of Securities Exchange Board of India (Sebi), in his June 23, 2011 order, against two Sahara group companies, Sahara India Real Estate Corporation Limited and Sahara Housing Investment Corporation Limited, had alluded to the possibility of a Ponzi scheme.
In his order Abraham had said “The Learned Counsel, at one point in the submissions before me, mentioned the fact that there are no investor complaints at all, from any investor in the OFCDs (optionally fully convertible debenture) raised by the two Companies. Going by the history of scams in financial markets across the globe, the number of investor complaints has never been a good measure or indicator of the risk to which the investors are exposed. Most major ‘Ponzi’ schemes in the financial markets, which have finally blown up in the face of millions of unsuspecting investors, have historically never been accompanied by a gradual build up of investor complaints.”
A Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses. (For a more detailed and historical treatment of Ponzi schemes click here).
So does that mean that Sahara is a Ponzi scheme where money is simply being rotated? While there is not enough information available in the public domain to come to this conclusion nevertheless several interesting points can be made.
One of the characteristics of a Ponzi scheme is that the scheme appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. The optionally fully convertible debentures that the two Sahara group companies issued to raise money from nearly 3 crore investors do fall into this category of investment which sounds genuine enough and at the same time is obscure enough to prevent any scrutiny by investors. Further, Sahara raises its money from the lowest strata of the society, a lot of whom do not even have bank accounts. So the chances of questions being asked are very low.
Another characteristic of a Ponzi scheme is that the operators of the Ponzi Scheme persuade the investors to roll over the profits into the next investment cycle. So the returns remain on paper. Since the money remains with the operator the Ponzi scheme keeps running.
This is exactly what was done by a host of Non Banking Financial Corporations (NBFCs) in the nineties. Billboards promising exorbitant rates of return started showing up all over small town India. Money from the later investors was used to pay off the earlier investors. In many cases, once their investments matured, the investors were persuaded to reinvest the principal and interest on the investment back into the scheme.
This seems to be true in case of Sahara by their own admission. As their spokesperson recently told the Business Standard “Right from last 30 years, we have observed that our field workers try their best to pursue the depositors/investors to reinvest in some other scheme of the group because they get their livelihood from that since they earn commission on it. They always impress and hold their introduced depositor/investor by giving best human service throughout the tenure of the scheme.”
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru claimed to be making money by investing in the stock market.
Similarly Sahara is into a variety of businesses from running hotels to making films and television serials and building homes, which are all legitimate. The money raised by Sahara supposedly finances these businesses. What is questionable however is that are any of these businesses making money? Also has all the money that has been raised put to use?The film business of the company has been scaled down majorly over the years. The listed businesses of the group can’t be said to be doing terribly well either. Very little financial information regarding the group is available in the public domain to perform any reasonable financial analysis on it. (You can access some financial information regarding the group here).
Brand building is also an inherent part of a Ponzi Scheme. MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and became very famous in Russia. Hometrade also used the mass media to build a brand image for itself. It launched a high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was.
Sahara is the official sponsor of the Indian cricket team. Given this the entire Indian team has been advertising the new Q shop venture of the group. So who are investors more likely to believe while parting with their hard earned money? Sachin Tendulkar, cricketing great and a Member of Parliament, or dull advertisements put out by SEBI asking investors not hand over their money to Sahara Q shop?
In an advertisement headlined “Don’t be forced, don’t be misguided” the Securities and Exchange Board of India (SEBI) had asked investors “not to yield to any pressure from any person, including Sahara or its agents, for converting or switching their existing investments in the bonds to any of the other schemes like Q-shop, etc.”
Sahara also owns the Pune IPL team. It also has a stake in an F1 racing team Sahara Force India, whose other high profile owner is Vijay Mallya.
A final point to remember about Ponzi schemes is that the finally become too big and collapse under their own weight. Let us say someone decides to start a Ponzi scheme with the intention to defraud people.
He gets 100 members to start with and each one of them contributes Rs 10,000 to become a member of the scheme. The members in turn are promised Rs 50,000 back in a period of one year. Given that the scheme is a Ponzi scheme, there is no business model to generate returns and give out the Rs 50,000 promised to each investor. So the guy running the Ponzi scheme has to take the money being brought in by the newer investors to pay off these original investors.
Now every investor has been promised Rs 50,000. To enter the scheme Rs 10,000 is required. Hence to get Rs 50,000 to pay off one original investor, five new investors have to be roped in. Each one of them pays Rs 10,000 each and thus Rs 50,000 is raised to pay off the original investor.
The point to note here is that the Rs 50,000 that each original investor gets is basically the money being brought in by five new investors. Hence, the money gained by the original investors is basically the money brought in by the five new investors. And that is what makes a Ponzi scheme a zero sum game. The original investors gained only because the latter investors were willing to pay. No new wealth has been created.
This also means that to pay off the 100 original investors 500 new investors need to be brought in.
So that’s the first level of the Ponzi.
What happens next?
After the original lot has been paid off, the 500 investors who entered the second level of the Ponzi need to be paid off, to keep the scheme going. To pay off each of these investors five new investors are required, which in total means 2500 investors. If the fraudster running the Ponzi manages to get 2500 or more investors, the scheme continues.
Let us say the fraudster manages to get 2500 investors and each of these investors pays Rs 10,000. The money thus collected is used to pay off the 500 investors of the second round. In the third round 2500 investors have to be paid, for which 12,500 investors need to invest money in the Ponzi scheme.
If the scheme continues successfully by the ninth round nearly 19.5 crore new investors need to be brought in to keep the Ponzi scheme going. India’s population as per the latest census is around 120 crore. This means that for this hypothetical scheme to continue nearly 16% of the population of India needs to invest in it.
So any Ponzi scheme if it becomes sufficiently big has to collapse because the number of people required to keep it running it simply way too big. One way to avoid this to keep get investors to reinvest their money back into the scheme and live to fight another day.
But all Ponzi schemes collapse in the end under their own weight. A mutli level marketing(MLM) kind of Ponzi scheme is a very good example of a Ponzi scheme that ultimately collapses under its own weight.
In an MLM scheme a company appoints independent distributors, who are not employees of the company. The products of the company are sold to the distributors, who not only sell these products to make a profit, but also appoint more distributors and so the cycle goes on.
The company goes about appointing distributors but the catch is that the products the distributors buy rarely get sold and is just there to build a façade of a business model.
A major part of the commission earned by a distributor comes from appointing new distributors to the company, and thus creating a new level. And so the scheme goes on, with newer levels being created. The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels.
Like any other Ponzi Scheme there are only a finite number of people who can enter the scheme. So after some time the number of people required to keep the scheme going becomes very large and the scheme goes bust.
As Debashis Basu wrote in a recent column in Business Standard “Now they(MLM schemes) come under the garb of selling you some expensive products or some vague services: gold coins (Gold Quest), lifestyle products (QNet), surveys (Speak Asia), and so on. So, at any time, they have the fig leaf of providing some “value”. Even Amway, Oriflame and Tupperware rely on a model with recruitment and ever-expanding chain. For those at the end of the chain to get some crumbs and to sustain the whole chain, products have to be hugely expensive. Even then, most people make no money. New recruits are shown a dream — what people in the second link of the chain have achieved. But they are not told that no one beyond the top two or three layers really makes any money.”
While Ponzi schemes keep going bust newer ones keep coming and taking their place. This is sad because for the economy as whole, they are undesirable. Every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down. Investors become reluctant to part with their money. This in turn hampers the ability of the capitalist system to raise capital for newer ventures.
The attraction of easy wealth is something that investors cannot resist. Ponzi Schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense.
Greed also results when investors see people they know make money through the Ponzi Scheme. As economist Charles Kindleberger wrote in his all time classic Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. In a country like India where the per capita income is low the chances of people falling for Ponzi Schemes continue to remain high.
The only way out of this menace is by punishing people who run Ponzi schemes quickly. Rather than assuming investors are knowledgeable about investment opportunities, and instead of providing investors with more information about particular investments, disseminating information about investments gone awry may be a better bet to control this problem.
As Basu writes in his column “The ministry of finance and financial regulators may like to believe that they oversee the financial sector well. They are really deluding themselves. The money people lose in pyramid schemes is a few times the size of equity mutual funds or life insurance plans, on which millions of words are written and thousands of regulatory man-hours are spent. And all the literacy workshops funded by the government and industry would seem such a joke if pyramid schemes are allowed to flourish.”
Hence, its time the government woke up to this and did something about this menace, starting by punishing some of the big boys.

The article originally appeared on www.firstpost.com on December 12, 2012.

(Vivek Kaul is a writer. He can be reached at [email protected])