The “investment opportunity” someone just pitched could be a legitimate way to get in on the ground floor of a soon-to-be profitable business. However, it could also be a pyramid, Ponzi or similar fraudulent multi-level marketing scheme. How can you tell the difference between a real investment and a scam?

Don’t get scammed

Pyramid schemes can be relatively straightforward, such as recruiting people to sell vitamins or cleaning supplies and recruiting family and friends to also sell the products. Or they can take the form of extremely complicated swindles that offer no actual product or service. But in general, both simple and complex schemes are sustained by constantly recruiting new participants rather than earning a return on the actual sale of the products.

One lucrative scam involved a Florida lawyer who sold fake legal settlement agreements to investors (including hedge fund managers and other sophisticated buyers). In classic pyramid scheme fashion, the fraudster used the money from new investors to pay off earlier investors, make political and charitable donations and, of course, fund his own expensive lifestyle.

Sometimes, such schemes are couched as “clubs” or “gift programs” and promoted through social networks, including by social media “friends.” Increasingly, they involve “sales opportunities” for online marketplaces. Whatever they’re called, they usually end the same way: When the pyramid collapses, only the founder walks away with any money. The previously mentioned Florida lawyer stole at least $1.2 billion before getting caught.

Ask for disclosures and details

To assist potential investors, the Federal Trade Commission (FTC) has established a Business Opportunity Rule. Among other things, the rule requires sellers to produce a disclosure document in the language in which the buyer and seller discuss the opportunity. Sellers also must:

• Detail any earnings claims in a separate statement,
• Disclose prior civil or criminal litigation involving claims of misrepresentation, fraud, securities law violations, or unfair or deceptive business practices,
• Outline any cancellation or refund policy, and
• Provide references nearest to the potential buyer’s location.

For more about the rule, visit ftc.gov and search for “Business Opportunity Rule.”

Complete a checklist

You can protect yourself by studying the disclosure document, earnings claim statement and proposed contract. Look for potential loopholes to close. For example, are start-up costs reasonable? Is the seller required to buy back inventory you’re unable to sell?

Also research the seller’s history and reputation online and check for complaints with the Better Business Bureau (although an absence of complaints doesn’t necessarily mean the seller is honest). And as with any business proposal, research the market for the business’s goods or services. Talk to current investors or participants and have legal and financial advisors review any documents you don’t understand — particularly the contract.

When a friend isn’t a friend

If anything doesn’t check out or if your advisors are wary of the opportunity, decline it — even if the person pitching it is a friend. After all, perpetrators of many of history’s biggest pyramid schemes targeted their family members, friends and business associates.

(This is Blog Post #1370)