What Is a Ponzi Scheme?
Ponzi schemes are investment fraud schemes that offer huge returns with little risk. Money is stolen from later participants in a Ponzi scheme to produce profits for earlier investors. This system, like a pyramid scam, uses the funds of new participants to pay the previous investors.
Early Ponzi scheme victims receive large rewards, both as an incentive to spend more money and to tempt new investors as they inform their friends. People who join a pyramid scheme early have a better chance of making a profit than those who join later. It is still unknown if it is a pyramid scheme. There are numerous prospective contributors to be found, and the market is mostly untapped.
Both Ponzi and pyramid schemes will eventually fail when the influx of new investors dries up and there isn’t enough money to go around. At that moment, the schemes fall apart.
Understanding Ponzi Schemes
Ponzi schemes are financial schemes in which investors are guaranteed a high profit with little risk. Companies in Ponzi schemes focus all of their efforts on getting new clients to invest. They are typically advertised with a sense of urgency and frequently include a time-limited incentive.
There is usually some foreign or difficult element present. Although the idea is provided, the underlying elements are never completely clarified. If more information was provided, it would be evident that the program was not supported by a viable business.
This new money is utilized to pay out returns to original investors, which are deemed genuine profits. Ponzi schemes rely on a steady supply of new investments to continue providing returns to older investors. When this flow runs out, the plan collapses.
History of the Ponzi Scheme
Charles Ponzi was not the first Ponzi schemer, although he did give the scheme its distinctive moniker. The Securities Exchange Company, Ponzi’s company, guaranteed amazing returns of 100% in 90 days. He was apprehended and sentenced to 12 years in prison. Ponzi’s fraud resulted in the bankruptcy of six banks and losses totaling more than $20 million.
This time-tested fraud was known by several names before Ponzi became a household name. Devious personalities have always used deception to benefit themselves at the expense of others.
Ponzi schemes have existed in various forms from the beginning of bartering, getting more sophisticated as the notions of cash and investing expanded.
The age-old fraud is still being perpetrated on naïve investors today. You’ve most likely heard the expression “rob Peter to pay Paul.” To put it simply, the phrase means taking money from one person solely to satisfy a debt owed to another. This expression has been in use since 1450, and it most likely refers to the same ploy.
While today’s (and today’s English) is not the same as 1450 England, the statement accurately defines what a Ponzi scheme does. It repays early investors with funds contributed by later donors. The con artist provides you money that he claims is from your investment profits. And what profits they are—multiples of the best possible return everywhere else.
The investment earnings are a ruse designed to gain your trust and persuade you to part with even more of your money. The fraudster believes that as your confidence grows, you will increase your investment and persuade others to do the same.
In this old-fashioned confidence game, he combines illusion and psychological techniques to defraud you of your money.
More than one hundred large Ponzi schemes have been unearthed in the United States alone since Ponzi’s fraud in 1920. That amounts to more than one a year, if just the perpetrators are apprehended. Those discovered are just the tip of an iceberg in a sea of unseen scams. Ponzi scams are now more frequent than ever, and on a much larger financial scale than Ponzi’s $20-million plan.
Top 13 Signs of A Ponzi Scheme
While the following red flags alone do not confirm a fraudulent investment, they should stop you in your tracks. At the very least, you should do considerably more research and background checks on both the investment and the person offering it.
1. Unusually high returns with little or no risk
Risk and possible return are inextricably linked. Higher returns almost always imply taking on more risk. Risk, in addition to larger profits, increases the potential for loss. An investor often expects a larger long-term return in exchange for this heightened risk. The risk premium is the difference in return between a high-risk and a low-risk investment.
Government treasury bills (T-bills), for example, are given at what is known as the “risk-free” rate. This is because a stable government can usually be relied on to pay their bills (or pay the notes when due). Many investors are eager to lend money to the government. As a result, the government does not need to offer a higher yield to encourage investors. Of course, because the danger of default is low, the investment produces poor profits.
A corporation selling stock or debt typically has a rate of return that is higher than the T-bill rate, which represents the “risk-free” rate plus a risk premium that changes depending on the company’s creditworthiness and credit rating. A firm is more likely to go bankrupt than a country. To compensate for the added risk, an investor will seek a larger return than the risk-free rate.
While the globe is full of investing opportunities, they are not limitless. Supply and demand level the playing field as investors compete for a limited number of investments, ensuring that investments with equal risk profiles pay similar returns. A large return with ostensibly low risk is a red flag. So is any investment that provides a significantly better return than comparable investments in its class.
Allen Stanford provided a rate of return that was several percentage points higher than the market rate for Certificates of Deposit. Why couldn’t other banks copy his technique and deliver comparable returns? His assertion that the Stanford International Bank had invested in highly liquid financial securities was just one of several red flags.
2. Consistent Returns over Long Periods
Ponzi schemers appear to have an extraordinary capacity to consistently deliver positive returns. History has shown that such consistency is difficult to achieve over any time horizon other than a very short one. Our global and national economies are in flux. Investment returns are influenced by wars, recessions, resource availability, political stability, and even weather patterns. Uncertainty tends to raise or lower resource prices, currencies, and interest rates. As a result, all connected investments will fluctuate over time.
Bernard Madoff’s double-digit returns were particularly notable for their stability across decades, year after year. Despite many market crashes that devastated every other financial guru, this remains the case. Allen Stanford also delivered extremely steady investment returns. Stanford even had two years of identical 15.71% returns, which is statistically unlikely given his claim of a varied investment portfolio.
If you are making a 20% annual return while global stock markets are sinking, your earnings are most likely faked. Markets fluctuate in tandem with the global economy.
Investments that provide a guaranteed return, particularly attractive returns over lengthy periods, might be a red flag for fraud. While you can lock in your money in a guaranteed investment certificate (GIC) for the long term, the rate is often relatively low because the lender or seller must assume the risk of continuing to pay you in the future despite economic fluctuations. The longer the term, the less likely it is that anyone can accurately forecast the future.
Over time, even the most successful investors cannot outperform the market. They just cannot anticipate future occurrences with any degree of precision. In fact, most successful investors profit from investments that provide moderate but consistent returns with low volatility. A bigger overall profit is usually the result of a constant return over time.
If a fixed-rate investment is provided, the company offering it must deduct a portion of the expected return as insurance against unforeseen events. Furthermore, their fees must be deducted from the top. Although their long-term average return may be spectacular, it will include years when they won money and years when they lost money, just like everyone else. Great investment managers just lose less, or less frequently.
Even great investors like Warren Buffet and George Soros have a bad year or a loss on occasion. Ponzi schemers never do, at least not until they are discovered and their scheme falls apart.
Any stock investment with a guaranteed return or guaranteed minimum return is likely to be false. Similarly, guaranteed returns on long-term promissory notes or other debt should be scrutinized closely.
3. Significant return in a short period of time
Another red flag on investment return is a stellar return over a very short time frame. Sarah Howe’s Ladies Deposit Club not only paid a fantastic return, but it also advanced three months’ interest upfront.
Most Ponzi schemers know that this will not only hook you but will convince you to invest even more once you get that first check. They will typically offer you a quick payback to discourage you from looking elsewhere. Grab your money and run.
4. Time Limited or Sense of Urgency
Hooking you quickly is more critical to the scammer than ever before, now that so much information is available on the Internet. You might discover his earlier scams, or arouse suspicion with friends and family. He needs to limit the amount of research you can do before you hand over your money.
His success depends on your impulse decisions. Urgency is the number one fraud red flag. More time to think means a greater possibility of the scam being exposed.
5. Unregistered Investments
Most countries regulate investments. The Securities and Exchange Commission provides oversight in the United States, and similar regulatory organizations provide the same service in other countries. The investment firm and/or its representative must be registered, and cannot offer securities for sale without a prospectus. The prospectus is a very important document because it discloses the nature of the investment, important details, and related risks. Never invest without checking to see what documentation is required in your jurisdiction and whether the materials provided meet these requirements.
Only investments considered securities require a prospectus. Unregistered investments are generally limited to debt instruments. These fall outside the scope, scrutiny, or protection of securities regulators, which of course is exactly what a Ponzi operator wants.
Fraudsters often evade regulatory scrutiny by misrepresenting their supposed investment as debt. The investment is typically described as a promissory note, yet the investment returns will be derived from a source other than the debt itself. The Madoff accounting firm, Avellino and Bienes, claimed the returns were from the stock market. Alternatively, the investment profit may come from reselling a product where the investor shares in the profits, such as Marc Dreier’s grocery diverting scheme. Investments of this nature are considered securities, not debt.
As you can imagine from the above, it can be difficult for a non-expert to determine if an investment requires a prospectus or not. If you do not have the financial sophistication to easily determine this, do not invest. Do not trust or rely on the advice of a financial advisor, and don’t feel stupid about not under- standing it either. Remember that one of the most common tricks a fraudster employs is by describing the investment in complex terms. At best, the investment is too complex for you to monitor. At worst, it is outright fraud.
The SEC and other oversight organizations have a wealth of information to assist you. Ask yourself—why is this investment unregistered? What are they trying to hide?
6. Unlicensed sellers
Most Ponzi schemes involve unlicensed sellers, simply because they need to stay under the radar to perpetuate their scheme. Investment professionals typically have to abide by a code of ethics and other regulations to remain in good standing. Licensing and requirements vary by jurisdiction; your national securities regulator will have details on how you can verify this.
7. Complex strategies
If an investment cannot be explained well enough for you to understand it, do not buy it. At best, it is meant for a more sophisticated investor. At worst, and far more likely, the seller is trying to hide the true nature of the investment because it is a fraud. Never invest in something you don’t understand.
Fraudsters often describe complex strategies involving derivatives, insurance, or reselling. They may present themselves as experts in an obscure area. Paul Burks’ ZeekRewards and underlying penny auction business were based on a complicated system of points and referrals.
The more fraudulent the investment, the more complicated it will appear. The fraudster prevents you from discovering facts by layering on complicated methodology and terminology. He specifically attempts to make you feel too stupid to ask questions.
A foreign-based theme might or might not be present. It is closely related to the complex structure above, designed to seem legitimate, yet with enough unknowns in the foreign element that you cannot easily verify it. The country’s laws are foreign to you and the language likely is too. You are unable to do your own research. You simply must trust your investment advisor. This is not a sound investment strategy.
Charles Ponzi’s postal reply coupon scheme had a foreign aspect that was difficult to validate. Until the U.S. Postal Service indicated that the number of postal reply coupons in existence was a fraction of that needed for Ponzi’s scheme, no one questioned it.
9. Difficulty Getting Payment
If you are experiencing difficulty with redemptions, it could already be too late to recover your money. The Ponzi scheme may be about to collapse. Most Ponzi schemes will make less than a dozen payments before they stop entirely. That’s just enough time to convince most investors to invest and is also enough proof for many to convince a wider circle of friends and family to invest as well.
Redemptions should also be immediate. Many investors find that redemption terms suddenly change to requiring advance notice where none was required before. Investment redemptions may not pose a problem in the early days of the scheme but will be problematic later on when the fraudster is no longer flush with cash.
Sometimes redemptions can take a few days, in the case of very illiquid investments or large redemptions. This is normal if underlying assets must be sold in order to return funds. But never longer. Being “talked out” of redemption, or promised even higher returns is not a legitimate practice.
Especially worrisome is the promise of still higher returns if you roll over your investment. Remember, redemptions create cash flow problems for the fraudster. The promise of higher returns and the threat of not being allowed to reinvest after redemption is classic Ponzi ploys.
Finally, investment funds must be segregated from other funds held by the seller. If you do get your money, but the check is written from a person or an account other than where you invested, call the authorities. Commingling investment funds with general business or personal funds is another red flag.
Exclusivity is designed to make you feel indebted to the fraudster. You feel privileged for the opportunity to strike it rich—not to mention important when told you can get your friends in on the action too.
You are less likely to say no when you get the “inside track” on a surefire winner. After all, the ultra-successful investor has done you a favor by taking you under his wing. Your financial future suddenly brightens with this favor. How can you say no?
An opportunity to invest alongside a millionaire also feels like a gift. The prospective investor feels a sense of reciprocity or wanting to return a favor, which compels them to act. It is ingrained in our psyches to feel grateful to those who give us something for nothing. In turn, the Ponzi victim is likely to make allowances for their supposed benefactor. It quashes any suspicions that someone so nice would take advantage of you.
Bernard Madoff cultivated a sense of exclusivity by only allowing investors through intermediaries, and even then, only by referral. He usually rejected them the first time as well. He didn’t need your money, and if he let you into his fund he was doing you a favor. Not only did this create buzz, but it also helped him stay under the radar for a long time.
Some of the biggest scams in history have been based on affinity. Martin Sigilitto, an Anglican bishop and attorney based in St. Louis, perpetrated a Ponzi scheme starting in 2000 that he ran undiscovered for more than ten years. He took investor money and claimed to invest it in the British Lending Program with returns of 10% to 48% for one-year terms. He alleged the fund provided loans to a British real estate developer who was able to make such high returns by spotting undervalued properties and flipping them. In hindsight, the obvious questions are why the developer would not simply go to a British bank since the properties would be collateral.
Sigillito claimed to have the inside track on this opportunity due to his expertise in international law and said he was a lecturer at Oxford. Had anyone tried to verify his claim, they could have easily found it was a lie. Sigilitto’s foreign-based investment was a fraud red flag, but his scheme remained undetected until his suspicious assistant turned him in.
Aside from the investment itself, there are additional red flags you can look for in the organization offering the investment.
13. Shady Accountants
Accountants are a key part of any successful Ponzi scheme, simply because any competent accountant would see through a Ponzi scheme in short order. This is the case whether they are accountants within the firm preparing financial statements and analysis, or external auditors signing off on the financial results.
It is simply impossible to record or analyze the underlying transactions in any level of detail without uncovering the scheme. Therefore any accountant involved is likely complicit in the scheme.
Within the Ponzi schemer’s organization, recordkeeping usually requires maintaining two sets of books. Accountants know how to record transactions to pass the scrutiny of regulatory audits without raising suspicions. To keep the fraud going long-term, the accountants must reconcile the real cash with what they are reporting, so that they know how much (or how little) they can afford to pay out to investors without the fund going bust. As you can imagine, it all gets quite complicated and difficult to manage.
Most qualified accountants will not risk a lucrative career to engage in fraud. Instead, the fraudster typically uses unqualified accountants, who will have some experience but lack the necessary certifications and credentials. These uncertified accountants have much more limited career options available to them, and the Ponzi scheme pay is typically more than they could earn elsewhere. With such incentives to keep their mouths shut, they might play an even more active role if the compensation is right.
Most Ponzi schemes, or any scam, for that matter, will utilize second-tier accounting firms for their external audits. Both Stanford and Madoff used tiny ac- counting firms that simply rubber-stamped the financial statements instead of performing audits. Multi-billion dollar organizations would require at least a dozen accountants for an audit, yet both of these firms had only one practicing accountant.
Legitimate accounting firms and accountants generally have too much to lose by participating in or turning a blind eye to, illegal schemes. Non-certified accountants, however, have very little to lose. They will simply close up shop and disappear.
All Ponzi schemes will have most or all of these fraud red flags. Reputable investment firms will not object to further questions, and legitimate opportunities will still be around days, weeks, or years later.
If you do happen to miss an opportunity, there will be plenty of others. If you think about it, no one investment should outperform others by a mile, since they all invest in the same limited universe of opportunities. Trust your research and intuition. Anything that seems too good to be true most often is.
Examples of Ponzi Schemes
The top ten Ponzi schemes (by financial losses) of all time all occurred since 1990. Half of these were exposed during the 2008 financial crisis. Here they are, in U.S. dollars, in descending order of magnitude:
- Bernard Madoff – $65 billion
- Sergey Mavrodi – $10 billion
- Allen Stanford – $7 billion
- Tom Petters – $3.7 billion
- Scott Rothstein – $1.4 billion
- Damara Bertges – $1.1 billion
- Ioan Stoica – $1 billion
- Nevin Shapiro – $900 million
- Marc Dreier – $750 million
- Paul Burks- $600 million
They would make Charles Ponzi proud. And, no doubt, very envious.