What is a Ponzi Scheme?

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Definition:

A Ponzi scheme is a type of investment fraud that promises investors a high rate of return without actually collecting legitimate earnings.

🤔 Understanding Ponzi schemes

Named after the famous scam artist of the 1920s, Charles Ponzi, Ponzi schemes lure in new investors by promising consistently high returns without much risk. Rather than collecting actual returns, the fraudster pays back the original investors by promising a new round of investors the same returns. The cycle continues until there isn’t enough money to pay back all of the investors, at which point the scheme begins to collapse. Ponzi schemes are similar to pyramid schemes in that they convince people of high returns for little money upfront compared to the returns they’ll see later. They’re typically only successful as long as new participants are joining.

Example

One of the best-known and largest Ponzi schemes in history was operated by Bernie Madoff. A former hedge fund manager and NASDAQ chairman, Madoff ran his scheme for 20 years, during which he provided returns to thousands of investors with the money coming in from new ones. It wasn’t until the 2008 financial crisis, when investors attempted to withdraw their principal investment, that people discovered what Madoff was up to. He had defrauded his victims out of more than $50B.

Takeaway

A Ponzi scheme is like living off credit cards…

Imagine you put all of your expenses on a credit card, knowing you didn’t have the money to pay it off. When it comes time to pay the bill, you pay it with a different credit card. Ponzi schemes work kind of like this, except instead of credit cards, you’re using the money of unsuspecting investors. Once you can no longer find new investors (or in the case of the example, can’t qualify for any more credit cards), the scheme falls apart.

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How does a Ponzi scheme work?

The Ponzi scheme’s namesake, Charles Ponzi, ran a fraud involving postage stamps in the 1920s. He promised his investors a return of 50% in just 90 days. Over a few months, he collected $20M from unsuspecting individuals. The scheme fell apart when he couldn’t bring in enough new investors to pay off the old ones. While Ponzi probably wasn’t the first person to commit such a fraud, he stood out because of the sheer amount of money involved in his scheme.

A Ponzi scheme is an illegal operation that hooks investors with the promise of high returns. Rather than putting the money into a legitimate investment, the operator takes the cash and recruits a new round of investors to pay off the original investors.

A Ponzi scheme grows through a constant cycle of incoming investors. In order to pay off one round of investors, the schemer has to bring in new ones, then repeat the process again. Investors think they’re earning the high returns they were promised, but the money is, in fact, coming from other unsuspecting victims.

Investors in a Ponzi scheme could unknowingly perpetuate it. For example, an original investor who is pleased with the returns may tell their friends about the huge profits, and convince them to join. Some Ponzi schemes have lasted by convincing investors to continue to invest again and again.

That said, most Ponzi schemes don’t last for long. With each round of investors, the schemer has to recruit more and more new investors to keep up the returns. Eventually, when they run out of investors, the scheme falls apart as it becomes clear that the investment was never there.

Not all victims of a Ponzi scheme end up losing their money. On the contrary, for a fraud that lasts many years, it’s likely those initial investors get back their principal investment and more. A later investor may not be so lucky. If an investor joins just before the scheme collapses, they’ll almost certainly lose their money.

What are some warning signs of a Ponzi scheme?

The U.S. Securities and Exchange Commission (SEC) publishes red flags common among Ponzi schemes and what investors should watch out for. Warning signs include:

  • The promise of high returns with little to no risk. Most investments come with an inherent risk. The general rule of thumb is that the higher the potential return, the higher the risk. Beware of anyone promising high returns without risk. In other words, if something sounds too good to be true, it probably is.
  • Overly consistent returns. The stock market ebbs and flows, and you should expect your investment returns to do the same. While it might seem like a good thing if your profits never decline, it could be a sign of fraud.
  • Investments that aren’t registered with the SEC or state regulators.
  • Investment professionals who aren’t licensed with the state or federal government.
  • Investments that are difficult to understand. If the investment process is overly complex or secretive, it’s a good idea to know why.
  • Missing or inconsistent paperwork. You should be able to review all of your investment information in writing. Be sure your advisor can provide proper documentation.
  • Issues with receiving payments or cashing out. If you ask your financial advisor to cash out and they drag their feet or keep giving excuses as to why you can’t, it may be a red flag.

The SEC has a page on its website where investors can report suspected fraudulent activity, including Ponzi schemes and other wrongdoings.

What is the difference between a pyramid scheme and a Ponzi scheme?

People often use the terms Ponzi scheme and pyramid scheme interchangeably. While they are similar, there are some differences worth noting.

In a Ponzi scheme, the person operating the scheme recruits investors and then continues to recruit new rounds of investors to pay the returns of the existing ones. In a pyramid scheme, the operator recruits participants to join the scheme; then each participant is pushed to recruit new members to work under them. The person running the scheme might reward participants financially for bringing in more participants.

The two types of schemes also tend to differ in what they claim offer to investors. In a Ponzi scheme, the fraudster typically lures people in with the prospect of an investment opportunity that carries low risk and high returns.

In a pyramid scheme, a company or individual might convince people to join the scheme by offering them an opportunity to sell an exclusive or profitable product (one that may or may not really exist). But to participate, the new member must first invest in a large supply of the product. Then, each participant is encouraged to recruit several other members, often with the incentive that they’ll receive a commission for each new recruit. Participants make commissions from the money that new members pay to join the scheme — And the cycle continues.

Unlike a Ponzi scheme, a pyramid scheme may offer a real product. But rather than make money through product sales, the schemer makes their money from the members who sign up. So while they may boast a high volume of sales, most or all of those sales likely result from new members buying the product.

A participant may quickly realize they’ve become a part of a pyramid scheme if they join and buy the product, then can’t find any recruits to enter under them. They may realize that the only real earning potential comes from recruiting more members.

Some multi-level marketing (MLM) companies operate in the same pyramid structure and reward participants for bringing in new members. That said, not all MLMs are pyramid schemes. Some do sell legitimate products and don’t require new members to buy a large amount of inventory upfront.

What are some examples of Ponzi schemes?

Bernie Madoff ran one of the biggest and most notorious Ponzi schemes in modern history. Madoff started his investment firm, Bernard L. Madoff Investment Securities, in 1960. In the 1990s, Madoff started to operate his firm as a Ponzi scheme. He recruited new investors and promised them consistently above-average returns.

Over the two decades that he operated the scheme, Madoff defrauded investors of more than $50B. Because of his good reputation in the investment world, Madoff was able to lure in many wealthy investors, including charitable organizations, celebrities, and banks.

During the 2008 US recession, investors wanted to withdraw their investments. Madoff’s scheme quickly unraveled as he wasn’t able to reimburse his investors for their principal and the returns they thought they accrued. Madoff was arrested in 2008 and later pleaded guilty to eleven charges, including fraud, money laundering, perjury, and false filings with the Securities and Exchange Commission. Madoff received a sentence of 150 years in prison.

The Department of Justice operates the Madoff Victim Fund, which helps victims of Madoff’s scheme to recover their losses, estimated at $50B or more. As of 2019, they have recovered 66.86% of the principal investments to return to victims.

Madoff might be the most infamous Ponzi scheme operator in modern times, but he’s not the only one. Lou Pearlman, whose initial claim to fame was producing boy bands including *NSYNC and The Backstreet Boys, ran a Ponzi scheme that scammed investors and banks out of more than $300M. Tom Petters, a former businessman, was sentenced to 50 years in federal prison for running a Ponzi scheme worth $3.65B.

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