So the question then is, what is a Ponzi scheme? Well, a very simple definition for it would be a fake investment instrument that attracts many people on the promise of very high returns within a short period. What one completely misses out in this entire investment structure is that cash is not really generated in Ponzi scheme. Money from new investors is used to pay off the early investors, and the Ponzi scheme continues for as long as this monetary transaction is possible. The moment the cash outflow becomes more than the actual inflow into the scam, it collapses like a house of cards.
So in many ways, the Ponzi scheme is quite similar to the pyramid scheme. It keeps growing on the basis of new fund inflow, and this money starts to dwindle and exhaust itself when the funds dry up. Companies or individuals who float these Ponzi schemes direct their overall energy towards creating a larger client base and attracting more and more new customers (investors) who are ready to put their money into this scheme.
As the new income helps to pay off the earlier one, it is often marked as profit and seeks to be passed off as a legitimate transaction. The problem starts when the cash counter begins to dry out, and those at the bottom of the pyramid are left penniless. They fail to recover even the basic money that they might have put in the Ponzi scheme, let alone the promised returns.
Definition Of Ponzi Scheme
So how would you define this type of investment scam? Well, the Ponzi scheme definition would be then essentially “a fraudulent investment tool in which an operator or individual pays returns to the new customers through the new capital earned from them rather than any potential profit earned from a legitimate source or product sale.”Yes, indeed the lack of an actual product is perhaps the biggest difference when you define Ponzi scheme and try to point out the difference from a Pyramid scheme. Most times in a pyramid, you have a product to talk about, though sometimes, it is just a front. In the case of a Ponzi scheme, it is a pure money dealing driven by human greed to make some quick bucks.
The biggest bait for attracting new customers is the short time within which the high returns are assured. Who does not want to get rich quick and easy? Needless to mention that despite the questionable legal base, a Ponzi scheme almost always attracts money and investors who would like to believe that they will be able to get the high returns.
The Ponzi scheme in simple terms, therefore, can be any money dealing scheme that promises a high return within a short period and without any proper base to justify the quantum of that return. It is almost always understood the legitimacy of such a scheme is always questionable. The main perpetrators of this kind of scheme invariably disappear long before the eventual crash, and they are the only ones who make huge sums of money through it.
How Does a Ponzi Scheme Work?
So how does a Ponzi scheme work? Though Charles Ponzi did not really live to enjoy the spoils he earned and had to serve a prison sentence, it has not deterred others from trying out this wonderful channel to make some quick money. What really helped was that this kind of fraudulent scheme can easily be adapted to new and current realities and tweaked as per needed.The basic construct of a Ponzi scheme is such that it can be easily applied to a myriad of the situation with considerable ease. After all, essentially this scheme revolves around the simple theme of paying old investors using money from new ones and as long as the money chain continues, the scheme thrives. All that you have to do is just get a few investors willing to chip in money and kick off the process. Once the methodology is finalized, it continues on an auto pilot mode. The promise of the huge returns keeps people going and often that’s also the reason that they do not dig too deep into the details of the financial plan either.
The scamster or Conman simply convinces a few investors to fork out money for a particular scheme and the funds thus collected is then allowed to bankroll a new office, car and such infrastructure that can woo the next set of investors to put in more money into the system. Once the second set of investors come in, the scheme uses part of the fund to pay off the existing investors and keep aside a cool percentage as personal profit.
Slowly but gradually this circle keeps expanding as the next set of investors need to be paid. The process repeats itself like clockwork where again money from new investors is used to pay the second line of the Ponzi scheme. Along with the lead schemer, the first rung of investors also enjoys some profit from the fund inflow gathered from the third rung of investors. The cycle tends to continue but it no doubt gets more complicated as more participants join the circle.
Lack of fresh returns will make some players impatient, some will be curious about what’s going on, and many others could become suspicious too. In order to keep everyone happy, the money flow needs to continue, and for that, new members need to be added to the Ponzi scheme regularly. The pressure of this could be huge and can often take a toll on the entire schemes, and the collapse is pretty much obvious when the task of getting in new investors becomes almost impossible.
At this point, you might say that the Ponzi scheme is, after all, a pyramid. But there are some basic differences between how a Ponzi scheme works and a pyramid scheme. In a Ponzi, you are not
- Selling any product, so no revenue will be generated from retail sales.
- The Ponzi fraudster is the single person controlling the entire operation; there is no decentralization of power as seen in the case of a pyramid scheme.
- There are some pyramid schemes which operate legally, but a Ponzi scheme is always illegal.
The idea of quick money with minimum effort is what gets Ponzi schemes going, and these almost inevitably collapse leaving the unsuspecting investors with huge losses. The only person who makes money in a Ponzi is the schemer or some early level investors. This is unlike many pyramids which are legal and offer a respectable source of livelihood for many homemakers.
That said, people often use the term Ponzi and Pyramid interchangeably. In case you have been duped by either of these schemes the difference might after all not be huge. The idea is to understand its operations well to identify a potential one without suffering a huge loss.
History & Origin of Ponzi Scheme
That said, it is now time to delve a little deeper about how this scheme began to be known as Ponzi. The Ponzi scheme was named after Charles Ponzi who was one of the earliest known users of these schemes. The jury is still out whether he actually invented these. There is evidence that it was used with some success in the 1880s by Sarah Howe and William Franklin Miller. But even these predecessors quite like Charles Ponzi used Boston as their base.
Sarah Howe created an investment opportunity for women via a Ladies Deposit and managed to garner almost half a million dollars from many women who were keen to make some extra bucks. She used some amount for paying off to the investors and pocketed the rest. A few decades later, William Franklin Miller used the same scheme and promised fantastic returns and even delivered those. He in fact handed over million dollars before being exposed. Charles Ponzi made this one famous. So the question that comes to your mind is who was Charles Ponzi and how did he manage this feat?
After many failed attempts at working out a respectable living and trying to eke out gains across US and Canada, Ponzi returned to Boston. Here again, after marrying Rose Gnecco in 1918, he tried working at various positions, but nothing really lasted for long. It is during this phase around 1919 that he actually got the idea for the scheme, that later came to be known as Ponzi scheme.
He got a letter from a Spanish company, and the envelope had an international reply coupon in it. This coupon in those days could be exchanged for a many international priority airmail postage stamps. Ponzi decided to earn some profit by buying these IRCs in one country and then exchanging them for expensive postage in another country. He would send money to his agents in other countries, and they would buy IRCs and send them to him in the US. As decided, Charles Ponzi, exchanged these IRCs for stamps for lot more than he paid for them. Ponzi made close to 400% gains on these.
Now Ponzi was not satisfied by just this, he decided to expand his scheme and began to look for more investors to get even higher returns. As a means to attract for willing investors, he sometimes promised them outrageous returns, close to 50% in 45 days or even 100% in 90 days. The payoff was done mostly using the money acquired from fresh investors. At one point of time, Ponzi made close to $250,000 a day. In reality, however, there was no profit earned, and it was quite similar to the model employed by Bernie Madoff in recent times. It is by far one of the most telling Ponzi scheme examples till date.
But the Ponzi scheme soon became a victim of its own weakness. The scheme began to unravel by mid-1920 and the Boston Post started an investigation process. As a result many investors tried to pull out their investments. Charles Ponzi was eventually arrested in August 1920 and charged with 86 counts of fraud. He pleaded guilty and spent 14 years in prison. He died in 1949.
But Ponzi scheme criminals continue to take his legacy forward and keep fleecing any unsuspecting criminals. The particularly damaging ones include the 1996-97 Albania scheme. They managed to swindle close to $2 billion. Once the scheme was exposed, it led to massive riots and even caused several deaths.
Lou Pearlman is another notorious Ponzi scheme example. Till 2008, he was often considered the king of Ponzi schemers. He created and financially backed the boy bands, Backstreet Boys and ‘N Sync and only by 2006, the Ponzi scheme began to unravel, and authorities started to probe. But before that for a good 20 years, he convinced investors to invest in companies that did not exist. Eventually, Pearlman got a jail sentence for swindling almost $300 million.
The Bernie Madoff Incident
One
of the most famous Ponzi scheme examples is no doubt the Bernard
(Bernie) Madoff incident. In 2008, he shocked the world with his
revelations that his firm’s asset management arm was a major lie. He
swindled close to $65 billion over twenty years over the course of
nearly two decades. It was extremely striking about the scheme that the
scheme wasn’t revealed until Bernie Madoff himself confessed his crimes.
In March 2009, he pleaded guilty and was sentenced to 150 years of
imprisonment.One of the factors that was attributed to the scheme being so successful is Madoff was not just a very successful financial expert, but he even served a term as NASDAQ chief and even helped find the exchange. So, while he was part of a legitimate business, he was running this illegitimate scheme as well. Moreover, he did not promise fantastic returns either. The catalyst that Madoff attracted investors was the sheer consistency of the returns.
No doubt post these episodes, the US Securities Counsel has stepped up regulatory provision and fraud detection measures to get a better grip on the whole crime situation and nab Ponzi scheme criminals more actively.
The Regulatory Stance & Red Flags You Must Watch For
Given the widespread damage brought about by Ponzi Schemes, the US SEC has introduced some key guidelines to help investors safeguard themselves against the possible scams that might crop up in future. Some of these guidelines include:High Returns with No Risk
Every investment has a certain amount of risk associated with it. The higher the returns, more is the risk. So an investment that promises very high return (High-Yield Investment Program or HYIP) but entails zero or no risk is surely a red flag that investors need to watch out. It is never a good idea to blindly just look at the returns number only. The basics of investment instrument should not be negated, and one needs to be extremely suspicious of all investment opportunity that guarantees high returns with no risk.Consistent Returns
Well, we all know that every investment is subject to market risk and the returns can go up or down depending on market movement. Particularly when the interest rate is on the higher side, delivering consistently high returns is not particularly possible. So, any investment that delivers a consistently high return rate despite market conditions surely needs a lot more probing because this is a clear sign of Ponzi schemes. As an investor, you need to be suspicious of these types of schemes.Investments That Are Not Registered
It is very important to check the credibility of the investment instrument that you will be investing in. You would notice that the Ponzi Schemes typically always involve investment schemes that have not been registered with the SEC or any other regulatory body for that matter. Registration of the investment tool is an extremely important step. It is important because it provides investors access to the company’s credentials. It creates more transparency about the company’s products, services and finances.Seller’s License
The US Federal and state regulation makes licensing mandatory for all those who sell securities and any other investment tool for that matter. While a legal and registered investment firm would always ensure this, which is not the case with Ponzi schemes. They almost involve unlicensed sellers and firms peddling these illegal investment baits. As an investor, you must ensure that you check on the licenses of the firm and the individual who is selling you. Do not be swayed away by popularity claims.Approach with Regard to Strategies
The SEC advises that you should not commit your money to any investment blindly. The fundamental rule is ‘when in doubt, cut it out’. If you are not sure of a particular investment strategy, it is best to avoid it. It is never a good idea to invest in something just because someone told you to. There is no guarantee that this investment tool is not a Ponzi scheme just because someone suggested you to invest in it. Always look for complete information and comprehensive term document before you invest in them.Paperwork Is Crucial
The SEC says that you must always insist on reviewing information on paper. No excuse preventing you from accessing information on the investment tool on paper is good enough. Another factor that is a red flag in terms of identifying a ponzi scheme is receiving inconsistent statements and errors in your financial statement. This should make it amply clear to you that the funds are not being invested the way they were originally promised to be.Payment Delays
Often the first sign of a ponzi scheme collapsing is invariably difficulty or delay in payments. You need to be suspicious and probe deeper immediately. Remember most times it is the Ponzi schemes that encourage its investors to rollover the money and promise even higher returns (compound interest). I am sure you remember the adage, ‘too much greed is never good’. Beware that you do not lose out even the base investment in the hope of garnering greater returns.How to Be Aware of Ponzi Schemes?
So now the basic question that an investor would want to know is how to be careful about these schemes and how you can avoid getting involved in these types of Ponzi schemes?Well according to the SEC, whether you are a seasoned investor or a first-time investor, you need to ask some basic questions before you commit your money in a scheme. These would not only give you a greater insight into the investment tool but also help you avoid some obvious pitfalls. The US SEC says that investors can often safeguard their savings and investment by verifying the details before actually committing money. So here are the five mandatory questions that should precede any kind of cash commitment.
- Does the seller or the investment firm have the requisite licenses?
- Are you committing money to a registered investment?
- How is the average risk-reward ratio positioned?
- Are you able to grasp the investment strategy?
- Accountability of the investment scheme.
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