One of the most common investment frauds utilized by swindlers to deceive investors is Ponzi Scheme. It involves investment products or solutions usually attached to low-risk and high-return guarantees. Nonetheless, it is now considered illegal in numerous countries.
Facts: Definition, Origin, and Notable Examples of a Ponzi Scheme
Definition and Origin
Ponzi Scheme is also known as Ponzi Game and Pyramiding or Pyramid Scam. It lures investors through low-risk and high-return guarantees. More specifically, it involves paying returns or profits to earlier investors with funds from more recent investors. The general premise of this scheme is to “rob Peter to pay Paul.”
The scheme was named after Charles Ponzi, a notorious Italian swindler and con artist in the United States and Canada. During the 1920s, he lured clients by promising 50 percent investment returns within 45 days and 100 percent investment returns in 90 days.
Ponzi used a system that was originally legit. He bought discounted postal coupons in other countries and redeemed them at face value in the U.S. He tapped individuals to invest in this buy-and-sell practice. However, to attract them, he provided high returns to older investors by using recently infused capital from newer investors.
It is important to note that Ponzi did not invent the scheme. He was only notorious for using the system that cost USD 20 million. He might have been inspired by other fraudsters to include Brooklyn-based bookkeeper William F. Miller who used the same scheme in 1899 to generate USD 1 million from his victims.
Examples of the Scheme
There are other notable examples of Ponzi Scheme. Some businesses based on network marketing model use a similar scheme in which individuals are recruited to become direct sellers of their products. However, instead of selling these products, the model promotes recruitment because individuals earn for every recruit. Note that recruits need to pay a one-time membership fee inclusive of products that they could sell.
During the 2007-2008 Financial Crisis, Bernard L. Madoff utilized the scheme in his own investment companies. Prosecutors estimated that his fraudulent activity was worth USD 64.8 billion, thus becoming one of the largest Ponzi Scheme in the world and the largest financial fraud in U.S. history.
Scammers have also tapped cryptocurrencies to lure investors using ill-marketed initial coin offerings or ICOs. Note that an ICO is theoretically a legitimate type of fundraising. However, scammers would use the appeal of cryptocurrencies to entice individuals to fund a startup company or products with questionable viability.
Red Flags: How to Identify and Stay Away from a Ponzi Scheme
The U.S. Securities and Exchange Commission have identified red flags or warning signs to look for to avoid being duped by a Ponzi Scheme. Take note of the following:
1. Low Risk and High Return Guarantees: Remember that investments have some degree of risks. High returns typically involve high risks, while low returns usually involve low risks. Guaranteed returns are almost always impossible.
2. Overly Consistent Returns: The values of investment usually go up and down over time. Those that offer high potential returns are susceptible to market fluctuations. An investment that initially provides consistent high returns despite market conditions should be flagged as suspicious.
3. Unregistered Investments: Ponzi Schemes typically involve investment models or businesses that are not registered and regulated by relevant government regulators. Note that registration safeguards the public from fraud by providing them access to key information about the management, finances, and products of an organization.
4. Unlicensed Sellers, Agents, and Advisors: Most governments to include the United States, require investment firms and professionals to be registered or licensed. These firms and individuals are subjected to a code of ethics and established fiduciary duties.
5. Secretive or Complex Strategy: Another way to determine if a business or individual is involved in a Ponzi Scheme is if the strategy used to operate the business, its model, or to generate revenues is too complex to be understood or unavailable to the public.
6. No Minimum Investor Qualifications: Most legitimate investment opportunities and investment firms require investors to meet specific standards. In most cases, these investors are subjected under a background check that includes a probe on their financial capacity and risk appetite to determine their suitability.
7. Issues with Paperwork: Fraudsters would also provide excuses when asked about papers or other written information related to the investment and transaction. It is important for clients to consider reviewing a prospectus or disclosure statement before investing. Errors in account statements may also be a sign of fraud.
8. Shared Affinity: Individuals or businesses that want to defraud individuals would exploit the trust derived from affinity or membership in a particular group such as nationality, ethnicity, religion, and community, among others.
FURTHER READINGS AND REFERENCES:
- Heydenburg, M. R. 2015. “The Ponzi Scheme as a Deception Operation: The Bernie Madoff Case Study.” American Intelligence Journal. 32(2): 27-34. JSTOR: 26202133
- Konsyse Staff. 2019. “Red Flags: The Warning Signs of Investment Scams.” Konsyse. Available online
- Securities and Exchange Commission. 2013. “Ponzi Schemes.” Fast Answers. U.S. Securities and Exchange Commission. Available online