Ponzi schemes

Definition Fraudulent investment plans that offer a fast, high return on a seemingly low-risk investment but typically benefit only the promoter and some early investors; returns are paid out of capital provided by other investors

Since Charles Ponzi perpetrated his scheme on a large scale in Boston in 1920, many others have defrauded investors through what have become known as Ponzi schemes. The story of the scheme shows how easily individuals can be attracted by promises of large profits and serves as a cautionary tale for naïve investors.

The first example of the fraudulent investment plan known as a Ponzi scheme to reach widespread attention was perpetrated by Charles Ponzi in New England in the 1920s. Ponzi’s original scheme was based on a simple and seemingly credible way of making money with little risk. The idea that he sold to investors involved international reply coupons, created in 1906 as a way of sending return postage to someone in another country. The coupon could be bought in one country and redeemed for postage stamps in another. Due to changes in exchange rates following World War I, Ponzi discovered that he could exchange a dollar overseas to buy international reply coupons, which could be sent to the United States and redeemed for stamps worth more than one dollar. However, he did not have a way to convert the stamps back into dollars.

Undaunted, Ponzi set out to find investors willing to finance his idea. With an offer of 50 percent interest in ninety days, which he later changed to forty-five days, he was able to attract a few people willing to gamble modest sums on his scheme. As word spread that initial investors received the promised 50 percent, more investors, some willing to invest large sums, began to appear. Ponzi noticed that relatively few of the investors actually took their money at the end of the forty-five-day period, preferring instead to reinvest the initial sum and the interest earned. With increasingly more money being invested each month—very little of it being paid out, and none of it being used to buy international reply coupons—money began to accumulate, and Ponzi became a millionaire. Ponzi had started with nothing in December, 1919, and by the end of July, 1920, had been entrusted by investors with nearly $10 million.

Ponzi's Downfall and Legacy

For Ponzi’s scheme to continue to work, money from new investors had to cover the withdrawals of previous investors. For months that had not been a problem, as new people continued to invest and relatively few withdrew their investments. Questions arose early in July, 1920, however, when a furniture dealer from whom Ponzi had rented furniture sued Ponzi for $1 million, claiming that he was entitled to some of Ponzi’s profits for having loaned Ponzi money in December, 1919, at the outset of Ponzi’s enterprise. Although the lawsuit was without merit, it aroused suspicions at the Boston Post, which began investigating how Ponzi, and Italian immigrant, had come to enjoy such a meteoric rise. Evidence soon suggested his scheme was a form of investment fraud.

In the midst of the Post’s allegations that his business was a fraud and the attendant scrutiny he came under from a number of government agencies, Ponzi offered to close his business to additional investors until he had been fully investigated. His plan was to claim assets of the Hanover Trust, a bank he had come to control, as his own to prove that he was solvent, buying him time to devise a plan that would allow him to pay off all the investors. He was thwarted when the Massachusetts Bank Commissioner, Joseph Allen, took control of the Hanover Trust, and an audit of Ponzi’s business, the Securities Exchange Company, revealed that his obligations to investors exceeded his assets by about $3 million. By the middle of August 1920 Ponzi’s house of cards had collapsed.

For his crime Ponzi spent almost four years in a federal prison and seven years in a Massachusetts state prison before being deported to Italy. The man who had made getting rich quick look so easy died in the charity ward of a Rio de Janeiro, Brazil, hospital in 1949. Investors in his scheme who had not gotten their money out of his business before it was closed ended up with about 37 cents for each dollar they had invested.

Ponzi was not the first to perpetrate this type of fraud, but his name continues to be linked to it. Despite government regulatory efforts to prevent such schemes they remain a threat to investors and notable examples have defrauded people of large amounts of money. The most prominent case, and the largest known Ponzi scheme to that time, was revealed in December 2008 when respected financier Bernie Madoff was arrested and charged with multiple felonies. The Madoff Ponzi scheme had involved about $64 billion and in the end directly lost over $18 billion for investors. Though investigators had expressed suspicion regarding Madoff's business for years, only the onset of the global financial crisis in 2008 finally exposed the scheme; the case scandalized the financial world and led to many questions regarding the effectiveness of government regulations on Wall Street. Madoff was eventually sentenced to 150 years in prison for his crimes.

Recognizing Ponzi Schemes

The essence—and ultimate weakness—of Ponzi schemes is that they use funds provided by new investors, rather than profits, to pay returns to other investors (and the perpetrator). They therefore rely on a constantly growing stream of investment; if this is interrupted the scheme falls apart and investors lose money. Ponzi schemes are similar to pyramid schemes, as they both use new investments to pay returns, but there are some notable differences. Pyramid schemes involve a product (which may or may not exist) and require investors to recruit more distributors in order to earn returns. Money is collected in the form of a participation fee, which is then used to pay earlier participants a commission. Whereas in Ponzi schemes the original perpetrator typically interacts with each investor, participants in pyramid schemes may have no interaction with the developers of the scheme depending at what stage they are recruited. Finally, pyramid schemes tend to collapse rapidly, as they depend on exponential growth in the number of investors, while Ponzi schemes can last longer, especially if early investors reinvest their returns into the scheme.

When evaluating an investment opportunity there are several warning signs to look for to identify a potential Ponzi scheme. Investments that seem "too good to be true" may be just that; any plan that claims to offer high returns with no or very little risk is suspicious. Valid investments by nature carry more risk the higher the potential reward, and any guarantee of certain returns is a red flag. Similarly, any promise of totally consistent returns of any amount should be evaluated skeptically, as a legitimate investment will naturally fluctuate with the market. Other warning signs include complex or secret investment strategies, a lack of formal written information about the opportunity, sellers who are unlicensed or unregistered with the Securities and Exchange Commission (SEC) or state regulatory bodies, and unregistered investments.

Signs that an investment that has already been made may be part of a Ponzi scheme include irregularities or errors with paperwork and problems with receiving payments or cashing out. Many Ponzi schemes will strongly urge for investments to be "rolled over" and returns to be reinvested, often promising still higher returns on the new amount. Any suspected scheme can be reported to the SEC online or over the phone at (800) 732-0330.

Bibliography

Dunn, Donald H. Ponzi: The Boston Swindler. New York: McGraw-Hill, 1975. Print.

Dunn, Donald H. Ponzi: The Incredible True Story of the King of Financial Cons. New York: Broadway Books, 2004. Print.

Ponzi, Charles. The Rise of Mr. Ponzi. Naples, Fla.: Inkwell, 2001. Print.

"Ponzi Scheme." Investor.gov. US Securities and Exchange Commission, 2016. Web. 14 Jun. 2016.

"Ponzi Schemes." US Securities and Exchange Commission. US Securities and Exchange Commission, 9 Oct. 2013. Web. 14 Jun. 2016.

Sifakis, Carl. Frauds, Deceptions and Swindles. New York: Checkmark Books, 2001. Print.

Zuckoff, Mitchell. Ponzi’s Scheme: The True Story of a Financial Legend. New York: Random House, 2005. Print.