A Ponzi scheme is a type of investment fraud that promises large profits at little to no risk. The pitch for a Ponzi scheme is always the same: The promoter of such fraud tells investors they will earn outstanding profits at low to no risk and mostly with a secret investment strategy he can not talk too much about.
Then the promoter’s focus is in convincing more new investors and using their funds to pay off earlier investors including their “fictive profits”. The Ponzi scheme is sustainable as long as new investors contribute new funds and do not demand full repayment. But when the money flow runs out, the scheme gets into trouble and falls apart.
The father of all “Ponzi Schemes” was Italian born Charles Ponzi’s. Ponzi worked as a labourer, clerk, fruit peddler, smuggler and waiter. He was not a Wall Street high-flyer or Harvard educated entrepreneur. He was just over 5 ft tall, slim, self-ensured, quick-witted and above all that, he could talk and was convincing.
It was no coincidence that Ponzi started his scam in the roaring ’20s when money flowed easily. His investment vehicle invested in obscure coupons that made money in an exchange transaction conducted with the U.S. Postal Service. Ponzi offered to pay investors 50% interest in 45 days and 100% in 90 days. Of course, his scheme was “risk-free”.
Investors had no clue about the details of this “investment” and cared only about the promise of quick riches. He did not only convince the layman, widows or uneducated but a lot of them should have known much better: stockbrokers, businessmen and highly educated academics among many others.
Ponzi’s success was very simple: The money flowed, first in drops, then in buckets. There was an endless flow of cash (at a rate of $1 million per week) plenty with which to pay interest and the few redeeming investors. But this endless flow of cash was precisely what Ponzi needed to pull off his scam. As long as the money kept coming, he kept paying what he’d promised.
But it was all too good to be true. The Boston district attorney’s office began to investigate Ponzi and the Boston Post revealed that Ponzi had been involved in a remittance racket in Montreal 13 years earlier. All this should have sparked panic among his investors. But like all good promoters, Ponzi upped the ante. He promised to double investors’ interest payments. So, money continued to flow in.
Finally, Ponzi was arrested by federal authorities on August 12, 1920, and was charged with 86 counts of mail fraud. In only 8 months, Ponzi had taken in $10 million and issued notes for more than $14 million. That’s the equivalent of $180 million today. Authorities recovered less than $200,000 from his accounts. Ponzi eventually pleaded guilty to charges of larceny and mail fraud. He spent over 12 years in jail. When he was released in 1934, he was deported to Italy.
The modern Charles Ponzi was Bernie Madoff who was convicted of running a Ponzi scheme in the form of a hedge fund in 2009. His firm falsified trading reports to show profits from investments that didn’t exist. Madoff kept going for decades, despite many red flags and warnings that go back as long as 1991.
So, how can it be that people who should know better fall for such fraudulent schemes? The motivation is simple: greed!
Here are the red flags of a Ponzi schemes:
1. Guaranteed promises of high returns with little risk
2. Consistent returns regardless of market conditions
3. Investments that have not been registered with the Securities and Exchange Commission
4. Investment strategies that are secret or too complex to explain
5. Lack of paperwork for clients’ investments
6. Difficulties withdrawing clients’ money.
Sven Franssen