Ponzi scheme


A Ponzi scheme is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. Named after Italian con artist Charles Ponzi, this type of scheme misleads investors by either falsely suggesting that profits are derived from legitimate business activities, or by exaggerating the extent and profitability of the legitimate business activities, using new investments to fabricate or supplement these profits. A Ponzi scheme can maintain the illusion of a sustainable business as long as investors continue to contribute new funds, and as long as most of the investors do not demand full repayment or lose faith in the non-existent assets they are purported to own.

History

Some of the first recorded incidents to meet the modern definition of the Ponzi scheme were carried out from 1869 to 1872 by Adele Spitzeder in Germany and by Sarah Howe in the United States in the 1880s through the "Ladies' Deposit". Howe offered a solely female clientele an 8% monthly interest rate and then stole the money that the women had invested. She was eventually discovered and served three years in prison. The Ponzi scheme was also previously described in novels; Charles Dickens's 1844 novel Martin Chuzzlewit and his 1857 novel Little Dorrit both feature such a scheme.
In the 1920s, Charles Ponzi carried out this scheme and became well known throughout the United States because of the huge amount of money that he took in. His original scheme was purportedly based on the legitimate arbitrage of international reply coupons for postage stamps, but it proved infeasible, and he soon began diverting new investors' money to make payments to earlier investors and to himself. Unlike earlier similar schemes, Ponzi's gained considerable press coverage both within the United States and internationally both while it was being perpetrated and after it collapsed – this notoriety eventually led to the type of scheme being named after him.

Characteristics

In a Ponzi scheme, a con artist offers investments that promise very high returns with little or no risk to an investor. The returns are said to originate from a business or a secret idea run by the con artist. In reality, the business does not exist or the idea does not work in the way it is described or the extent of returns is made up or exaggerated. The con artist pays the high returns promised to their earlier investors by using the money obtained from later investors. Instead of engaging in a legitimate business activity, the con artist attempts to attract new investors to make the payments that were promised to earlier investors. The operator of the scheme also diverts clients' funds for the operator's personal use.
With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes collapse. As a result, most investors end up losing much or all of the money they invested. In some cases, the operator of the scheme may simply disappear with the money.

Red flags

According to the U.S. Securities and Exchange Commission, many Ponzi schemes share characteristics that should be "red flags" for investors.
  • High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns normally involve more risk. Any "guaranteed" investment opportunity should be considered suspect.
  • Overly consistent returns. Investment values tend to go up and down over time, especially those offering potentially high returns. An investment that continues to generate regular positive returns regardless of overall market conditions is considered suspicious.
  • Unregistered investments. Ponzi schemes typically involve investments that have not been registered with financial regulators. Registration is important because it provides investors with access to key information about the company's management, products, services, and finances.
  • Unlicensed sellers. In the United States, federal and state securities laws require that investment professionals and their firms be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
  • Secretive or complex strategies. Investments that cannot be understood or on which no complete information can be found or obtained are considered suspicious.
  • Issues with paperwork. Account statement errors may be a sign that funds are not being invested as promised.
  • Difficulty receiving payments. Investors should be suspicious of cases where they don't receive a payment or have difficulty cashing out. Ponzi scheme promoters sometimes try to prevent participants from cashing out by offering even higher returns for staying put.
According to criminologist Marie Springer, the following red flags can also be of relevance:
  • The sales personnel or adviser are overly pushy or aggressive.
  • The initial contact took place by a cold call or through a social network, a language-based radio or a religious radio advertisement.
  • The client cannot determine the actual trades or investments that have been carried out.
  • The clients are asked to write checks with a different name than the name of the corporation or to send checks to a different address than the corporate address.
  • Once the maturity date of their investment arrives, clients are pressured to roll over the principal and the profits.

    Methods

Typically, Ponzi schemes require an initial investment and promise above-average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy to avoid giving information about the scheme.
The basic premise of a Ponzi scheme is "to rob Peter to pay Paul". Initially, the operator pays high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The schemer pays a "return" to initial investors from the investments of new participants, rather than from genuine profits.
Often, high returns encourage investors to leave their money in the scheme, so that the operator does not actually have to pay very much to investors. The operator simply sends statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns. Investors within a Ponzi scheme may face difficulties when trying to get their money out of the investment.
Operators also try to minimize withdrawals by offering new plans to investors where money cannot be withdrawn for a certain period of time in exchange for higher returns. The operator sees new cash flows as investors cannot transfer money. If a few investors do wish to withdraw their money in accordance with the terms allowed, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent and financially sound.
Ponzi schemes sometimes begin as legitimate investment vehicles, such as hedge funds that can easily degenerate into a Ponzi-type scheme if they unexpectedly lose money or fail to legitimately earn the returns expected. The operators fabricate false returns or produce fraudulent audit reports instead of admitting their failure to meet expectations, from which point on the operation can be considered a Ponzi scheme.
A wide variety of investment vehicles and strategies, typically legitimate, have become the basis of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. CDs are usually low-risk and insured instruments, but the Stanford CDs were fraudulent.

Unraveling

Theoretically, it is possible for certain Ponzi schemes to ultimately "succeed" financially, at least as long as a Ponzi scheme was not what the promoters were initially intending to operate. For example, a failing hedge fund reporting fraudulent returns could conceivably "make good" its reported numbers, for example by making a successful high-risk investment. Moreover, if the operators of such a scheme are facing the likelihood of imminent collapse accompanied by criminal charges, they may see little additional "risk" to themselves in attempting to cover their tracks by engaging in further illegal acts to try and make good the shortfall. Especially with investment vehicles like hedge funds that are regulated and monitored less heavily than other investment vehicles such as mutual funds, in the absence of a whistleblower or accompanying illegal acts, any fraudulent content in reports is often difficult to detect unless and until the investment vehicles ultimately implode.
Typically, however, if a Ponzi scheme is not stopped by authorities, it falls apart for one or more of the following reasons:
  1. The operator vanishes, taking all the remaining investment money. Promoters who intend to abscond often attempt to do so as returns due to be paid are about to exceed new investments, as this is when the investment capital available will be at its maximum.
  2. Since the scheme requires a continual stream of investments to fund higher returns, if the number of new investors slows down, the scheme collapses as the operator can no longer pay the promised returns. Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
  3. External market forces, such as a sharp decline in the economy, can often hasten the collapse of a Ponzi scheme, since they often cause many investors to attempt to withdraw part or all of their funds sooner than they had intended.
In some cases, two or more of the aforementioned factors may be at play. For example, news of a police investigation into a Ponzi scheme may cause investors to immediately demand their money, and in turn cause the promoters to flee the jurisdiction sooner than planned, thus causing the scheme to collapse much faster than if the police investigation had simply been permitted to run its course.