What Is a Ponzi Scheme? 13 Signs To Spot The Scam!

What Is a Ponzi Scheme?

Ponzi schemes are fraudulent investment scams that promise high returns with little risk. In a Ponzi scheme, money is taken from later investors to generate returns for earlier investors. Like a pyramid scheme, this scheme uses the funds of new investors to pay the earlier investors.

Early Ponzi scheme victims get good payouts, both as an enticement to invest more funds and to snare more investors as they tell their friends. Early pyramid scheme entrants also have better odds that the people entering the scheme after them will pay up. The fact that it is a pyramid scheme is still unknown. There are many potential contributors to recruit and the market is untapped.

It is inevitable that both Ponzi schemes and pyramid schemes will eventually fail when the flood of new investors dries up and there isn’t enough money to go around. The schemes unravel at that point.

Understanding Ponzi Schemes

Ponzi schemes are investment frauds in which investors are promised a large profit at low risk. In Ponzi schemes, companies concentrate all their efforts on attracting new clients to invest. They are usually marketed with a sense of urgency and often incorporate a time-limited offer.

There is usually the presence of some foreign or complicated element. The concept is presented, but underlying details are never fully explained. If the further background was provided, it would become clear that there was no meaningful business behind the scheme. 

It is this new income that is used to pay original investors their returns, which are considered legitimate profits. To continue to provide returns to older investors, Ponzi schemes rely on a constant flow of new investments. The scheme collapses when this flow runs out.

History of the Ponzi Scheme

Charles Ponzi wasn’t the first Ponzi schemer, though he did lend his catchy name to this age-old fraud. Ponzi’s company, the Securities Exchange Company, promised incredible returns of 100% in 90 days. He was eventually caught and sentenced to 12 years in prison. In all, Ponzi’s scheme caused the failure of six banks and losses of more than $20 million.

Before Ponzi became a household word, this time-tested swindle went by other names. Shady characters have always practiced the art of deception to enrich themselves at the expense of others. 

Ponzi schemes have occurred in one form or another since bartering began, becoming more sophisticated as the concepts of currency and investing evolved. 

The age-old con plays out repeatedly on unsuspecting investors today. You have probably heard the phrase “rob Peter to pay Paul.” Simply put, the phrase means to take money from one person only to pay a debt owed to another. This phrase has been in use as far back as 1450, and it likely referred to the same ruse.

While today (and today’s English) differs from 1450 England, the phrase describes exactly what a Ponzi scheme does. It pays returns to earlier investors with the money from later contributors. The schemer gives you money he claims is your investment profits. And what profits they are—multiples of the best return you could achieve anywhere else. 

The investment earnings are a fabrication, a ploy to build trust and convince you to part with even more of your money. As your confidence builds, the fraudster hopes you will increase your investment and convince others to invest too. 

He uses illusion and psychological tricks to cheat you out of your own money in this old-fashioned confidence game. 

Since Ponzi’s scam in 1920, more than one hundred massive Ponzi schemes have been uncovered in the United States alone. That equals more than one per year, counting only the ones where the perpetrators were caught. Those discovered represent the tip of an iceberg in a sea of undetected frauds. Ponzi schemes are now more common than ever and on a financial scale that dwarfs Ponzi’s $20-million scam.

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 potential return are highly correlated. Higher returns usually mean exposing yourself to additional risk. In addition to higher returns, risk also increases the likelihood of loss. For this increased risk, an investor generally expects a higher return over the long term. The difference in return between a high-risk investment and a low-risk investment is known as the risk premium. 

For example, government treasury bills (T-bills) are offered at what is considered the “risk-free” rate. This is because a stable government can generally be relied upon to honor their debt (or pay the notes when due). Many investors are willing to lend the government money. Therefore, the government does not need to add a premium return to entice investors. Of course, this means the investment provides low returns since the risk of default is low. 

A company selling stock or debt usually has a rate of return above the T-bill rate, which represents the “risk-free” rate plus a risk premium, which varies ac- cording to the company’s creditworthiness and credit rating. A company has a greater probability of bankruptcy than a country. All things being equal, an investor will want a higher return than the risk-free rate to compensate for this additional risk.

While the world abounds with many investment opportunities, they are not endless. As investors compete for a limited number of investments, supply and demand level the playing field so that investments with a similar risk profile will pay similar returns. A high return with a supposed minimal risk is a waving red flag. So is any investment paying a materially higher return than similar investments in its class.

Allen Stanford offered a return several percentage points higher than the going rate for Certificates of Deposit. Why couldn’t other banks replicate his strategy and offer similar returns? His claim that the Stanford International Bank invested in highly liquid financial instruments was only one of several red flags.

2. Consistent Returns over Long Periods 

Ponzi schemers seem to have an uncanny ability to produce positive returns, year after year. History tells us that such consistency is impossible over anything other than a very short time horizon. Our global and national economies fluctuate. Wars, recessions, resource availability, government stability, and even weather patterns impact investment return. Uncertain times tend to either in- crease or depress resource prices, currencies, and interest rates. Thus, all of the related investments will fluctuate over time also.

Bernard Madoff’s double-digit returns were also remarkable for their consistency year in and year out, over decades. This was despite several market crashes that decimated every other investment guru. Allen Stanford also provided investment returns that were unbelievably consistent. Stanford even had two years of identical 15.71% returns, statistically improbable when you consider his claim of a diversified investment portfolio. 

If you are earning a 20% return per year even while global stock markets are declining, there is a very good chance your returns are fabricated. Markets rise and fall with the global economy. 

Investments offering a guaranteed return, especially attractive returns over long periods, can be a fraud red flag. While you can lock in your money long-term in a guaranteed investment certificate (GIC), it is typically at a very low rate, since the lender or seller must assume the risk of continuing to pay you far into the future despite economic changes. The longer the term, the less likely anyone can predict the future with any certainty. 

The most successful investors cannot beat the market over the long term. They are simply unable to predict future events with great certainty. In fact, most successful investors profit from investments with lower but steady returns and low volatility. A consistent return over time usually results in a higher overall profit. 

If an investment is offered at a fixed rate, the company offering it must deduct some portion of that expected return as insurance to compensate against unforeseen events. In addition, their fees must come off the top. Although their average long-term return might be stellar, it will include years where they have made money and years where they have lost money, like everyone else. Great investment managers just lose less, or less often. 

Even legendary investors like Warren Buffet and George Soros have the occasional bad year or investment loss. Ponzi schemers never do, at least not until they are caught and their scheme unravels. 

Any guaranteed return or guaranteed minimum return for an equity investment is likely to be fraudulent. Similarly, guaranteed returns for long-term promissory notes or other debt deserve close scrutiny.

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.

8. Foreign-Based 

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.

10. Exclusivity 

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?

11. Reciprocity 

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.

12. Affinity 

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:  

  1. Bernard Madoff – $65 billion 
  2. Sergey Mavrodi – $10 billion 
  3. Allen Stanford – $7 billion 
  4. Tom Petters – $3.7 billion 
  5. Scott Rothstein – $1.4 billion 
  6. Damara Bertges – $1.1 billion 
  7. Ioan Stoica – $1 billion 
  8. Nevin Shapiro – $900 million 
  9. Marc Dreier – $750 million 
  10. Paul Burks- $600 million

They would make Charles Ponzi proud. And, no doubt, very envious.

Leave a Comment