The key elements of a Ponzi scheme

A brief history lesson shows you what to look for when trying to root out one of the most famous kinds of investment fraud.

July 23, 2014

Editor’s note: This is an excerpt from White Collar Crime: Core Concepts for Consultants and Expert Witnesses, Chapter 10 by Scott M. Richter, CPA/CIA, CFE, edited by Debra K. Thompson, CPA/CFF, CFE, and Randal A. Wolverton, CPA/CFF, CFE.

The Ponzi scheme is named after Carlo “Charles” Ponzi, who in 1919, devised a simple investment vehicle. Effectively, Ponzi planned to take advantage of weakening foreign currencies by purchasing international postal coupons overseas that could be redeemed for U.S. postage stamps. He would then sell the U.S. stamps and make a profit. However, Ponzi was unable to reap any meaningful profits due to the bureaucracy and administrative burden involved in redeeming these coupons.

Instead of abandoning this unsuccessful (but legitimate) investing method, Ponzi refined his pitch to potential investors, saying he could return a 50% profit on their investment in 45 days or double their money in 90 days. Ponzi advised investors that he would achieve such returns through a “network of international agents,” who would purchase the postal reply coupons on his behalf. He withheld further details of how he would achieve such returns “due to competitive reasons.” In reality, Ponzi was merely paying off early investors with new investors’ funds while making no new purchases of postal reply coupons.

In the short eight-month duration of his scheme, Ponzi collected as much as $15 million from 40,000 investors. News reports at the time described huge crowds lined up outside Ponzi’s Boston office waiting to invest. However, after the scheme unraveled, Ponzi was $7 million in debt, with assets that included a mere $61 in postal reply coupons. In the decades since Ponzi launched this brazen scam, thousands of other fraudsters have pursued schemes with the same common denominator: Earlier investors are paid off with funds from new investors.

Today, the legal definition of a Ponzi scheme is simply “a phony investment plan in which monies paid by later investors are used to pay artificially high returns to the initial investors, with the goal of attracting more investors” (Alexander v. Compton, 229 F.3d 750, 759 n.1 (9th Cir. 2000)).

Although many people tend to use the terms “Ponzi scheme” and “pyramid scheme” interchangeably, there is an essential difference between the two. In a Ponzi scheme, the fraudster (and perhaps his or her agents) serve as the operational hub into which all investor monies flow.

… A pyramid scheme is specifically designed for early investors (top levels of the pyramid) to collect their returns from new investors (lower levels of the pyramid). In fact, some operators of pyramid schemes even use that term with investors, telling them that their returns are solely dependent on the recruiting of new participants.

Because Ponzi schemes are dependent on new investors to pay earlier investors, by definition they are mathematically doomed to fail. Like pyramid schemes, they will eventually reach a point at which there are no more new investors in existence to fund investment returns and returns of capital to existing investors. But Ponzi schemes usually collapse sooner than that, largely because

  • the scheme reaches a point at which the fraudster can no longer recruit new investors and not enough funds are available to pay existing investors.
  • the fraudster decides to close the scheme and abscond with investors’ money before the fund fully collapses or is uncovered by outside parties.
  • the fraudster is exposed in some way, such as through investigation by regulators, by bad press, or by skeptical or suspicious investors. Market or economic conditions force investors to withdraw their returns or initial capital, which fatally destroys the liquidity of the scheme. In fact, many Ponzi schemes have unraveled within the past few years as a result of the global financial downturn.

Key elements
Because virtually all Ponzi schemes have the same characteristics, those elements can serve as red flags to potential investors. This section will discuss the most common key elements.

Above-market or guaranteed return
In order to entice prospective investors, the Ponzi schemer must offer an above-market or guaranteed investment return. However, the fraudster will likely offer only a “reasonable” above-market rate, so as not to attract suspicion or unwanted attention. One of the primary reasons Charles Ponzi’s scheme failed so quickly is the attention it received for guaranteeing outlandish returns.

To “sweeten the pot” for current investors, a fraudster may use some creative tools. For example, the Ponzi schemer will often encourage existing investors to provide favorable reviews to new investors in exchange for a commission or finder’s fee. And, the fraudster also makes sure to pay returns to existing investors, thus demonstrating that the operation is “legitimate.” The goal of this step is to encourage current investors to reassure prospective new investors that the “investment” is sound and that they too will be paid.

Appearance of illegitimacy or impeccable reputation
Large Ponzi schemes do not tend to be fly-by-night operations, run by operators with questionable or unknown pasts. In fact, a Ponzi scheme often grows out of a legitimate operation and is run by a person with impressive credentials. A well-publicized recent example is Bernie Madoff, who co-founded the NASDAQ, was chairman of the National Association of Securities Dealers, and founded Madoff Investment Securities. Before his longtime Ponzi scheme was exposed, he was one of the largest market makers on Wall Street. In addition, Allen Stanford of the Stanford Financial Group, once a well-respected financier and philanthropist, was recently convicted of running a multibillion-dollar Ponzi scheme.

Marketing and exclusivity
A Ponzi scheme is not typically marketed through high pressure sales tactics. Rather, the fraudster lets the scheme sell itself through allegedly attractive investment returns and through the word-of-mouth of initial investors who often help attract new participants. The fraudster does not necessarily want a wide and diverse pool of potential investors, because that increases the probability that someone might recognize red flags, ask too many questions, or report the scheme to regulators. Instead, the fraudster creates exclusivity by targeting potential investors with common affiliations, such as the similarities in religious or social circles. For example, some of Madoff’s favorite groups from which to recruit investors were the Florida-based Palm Beach Country Club and Boca Pointe Golf Club, in addition to a multitude of Jewish charitable organizations.

Investor greed
As a basic aspect of human nature, Ponzi schemes thrive on investor greed. It is important to point out that fraudsters do not need gullible or unsophisticated investors to leverage greed via a Ponzi scheme. Consider that many—if not most—of Madoff’s investors were well educated and financially prudent individuals or organizations. Thus, the more successfully a fraudster can build the illusion of above-market or guaranteed returns, the more frequently he or she can leverage greed to entice people or organizations to reinvest for even higher returns.

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