Ponzi Schemes - Frequently Asked Questions, Bernie Madoff

Revised-edited, by Bachir El Nakib, Senior Consultant, Compliance Alert (LLC)

For some reason, this guy you just met at a party has suddenly taken a liking to you. To him, you seem sharp and able to recognize a gold mine when you see it. He only offers this tip to his closest friends, but he's willing to make an exception for you. He says if you get in on this opportunity now, you'll be an early investor in the next big thing. Not only that, it's fail-safe and will return your investment in no time. If you're skeptical, why not ask your friends at the party -- they invested last month and have already seen returns. You do ask them, and it's true. So why not hand over a few thousand dollars before it's too late? Despite what your trustworthy friends say, it's better to walk away. This guy is probably selling a Ponzi scheme

Unfortunately, not all financial schemes look the same, which makes it hard to spot one when you're victimized. In true Darwinian style, clever scammers are able to thrive by consistently adapting and evolving their schemes to come up with new ways to con others out of their life savings. The Ponzi scheme is just one type of con. And, although it's based on a classic formula, the idea can be applied in countless ways to deceive unsuspecting victims.

Ponzi schemes pop up frequently, though not all of them are big enough to make headlines. But every few years, a news story comes out telling how authorities have exposed an extensive and long-running Ponzi scheme. Two such exposed schemes (one that broke in 2006 and the other in 2008) were each reportedly bigger than any before them. Bernard Madoff, who orchestrated the most massive Ponzi scheme to date, conned about $65 billion from investors who came from all walks of life.

Why is the scheme so effective? And how is it that your victimized friends in the earlier example actually did make some money? We'll examine the formula behind a Ponzi scheme as well as the recent instances that have popped up in the news. But first, let's take a look at Charles Ponzi, the notorious schemer whose name became so synonymous with the scam that it now bears his name.

What is a Ponzi scheme? 

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.

The ruse is named after Charles Ponzi, a 1920s crook who promised investors in New England a 40pc return on their investment in just 90 days, compared with 5pc in a savings account.

Ponzi had planned to make money by taking advantage of the difference in exchange rates between the dollar and other currencies to buy and sell international mail coupons at a profit.

Why do Ponzi schemes collapse?

With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.

How did Ponzi schemes get their name?

The schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors.

His scheme was an amazing success, and by May 1920, he had made $420,000 ($5.13 million in 2017 money).

By June 1920, people had invested $2.5 million in Ponzi's scheme and by July, he was raking in a million dollars per week and rising. By the end of July, he was approaching a million dollars per day.

When the house of cards inevitably collapsed, it turned out he had only ever purchased about $30 worth of the mail coupons on which the scheme was based.

Who is Bernie Madoff?

In Bernard 'Bernie' Madoff's case, he told FBI agents he had been paying investors "with money that wasn't there". Regulatory filings show he managed money for hedge funds, banks and wealthy individuals.

Bernard L. Madoff, who is currently serving a 150-year sentence in federal prison, orchestrated a multi-billion dollar Ponzi scheme that swindled money from thousands of investors. Unlike the promoters of many Ponzi schemes, Madoff did not promise spectacular short-term investment returns. Instead, his investors’ phony account statements showed moderate, but consistently positive returns — even during turbulent market conditions.

In December 2008, the Security Exchange Commission - "SEC" - charged Bernard Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for the multi-billion dollar Ponzi scheme he perpetrated on advisory clients of his firm for many years. The SEC filed emergency motions to freeze assets and appoint a receiver, and worked to return as much money as possible to harmed investors.

Madoff had been a prominent member of the securities industry throughout his career. He served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He was also a member of NASDAQ Stock Market’s board of governors and its executive committee and served as chairman of its trading committee. Madoff founded his investment advisory firm in 1960.

How is the SEC responding to its Office of Inspector General’s reports on the Madoff fraud?

In August and September 2009, the SEC’s Office of Inspector General issued three reports on the Madoff fraud, including one entitled investigation of failure of the SEC to uncover Bernard Madoff’s Ponzi Scheme. The SEC has closely analysed the reports.

Even before the release of these reports, major efforts were underway to make improvements and address the shortcomings that were identified in the reports. A list of decisive and comprehensive steps the SEC is taking to reduce the chances that similar frauds will occur or be undetected in the future is available on the SEC’s Post-Madoff Reforms web page.

What are some Ponzi scheme “red flags”?

Many Ponzi schemes share common characteristics. Look for these warning signs:

• High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
• Overly consistent returns. Investments tend to go up and down over time, especially those seeking high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions.
• Unregistered investments. Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators. Registration is important because it provides investors with access to key information about the company’s management, products, services, and finances.
• Unlicensed sellers. Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
• Secretive and/or complex strategies. Avoiding investments you don’t understand or for which you can’t get complete information is a good rule of thumb.
• Issues with paperwork. Ignore excuses regarding why you can’t review information about an investment in writing, and always read an investment’s prospectus or disclosure statement carefully before you invest. Also, account statement errors may be a sign that funds are not being invested as promised.
• Difficulty receiving payments. Be suspicious if you don’t receive a payment or have difficulty cashing out your investment. Keep in mind that Ponzi scheme promoters sometimes encourage participants to “roll over” promised payments by offering even higher investment returns.

What steps can I take to avoid Ponzi schemes and other investment frauds?

Whether you’re a first-time investor or have been investing for many years, there are some basic questions you should always ask before you commit your hard-earned money to an investment.

When you consider your next investment opportunity, start with these five questions:

• Is the seller licensed?
• Is the investment registered?
• How do the risks compare with the potential rewards?
• Do I understand the investment?
• Where can I turn for help?

What are some of the similarities and differences between Ponzi and pyramid schemes?

Ponzi and pyramid schemes are closely related because they both involve paying longer-standing members with money from new participants, instead of actual profits from investing or selling products to the public. Here are some common differences:

 

	Pyramid Scheme	Ponzi Scheme
Typical “hook”	Earn high profits by making one payment and finding a set number of others to become distributors of a product. The scheme typically does not involve a genuine product. The purported product may not exist or it may only be “sold” within the pyramid scheme.	Earn high investment returns with little or no risk by simply handing over your money; the investment typically does not exist.
Payments/profits	Must recruit new distributors to receive payments.	No recruiting necessary to receive payments.
Interaction with original promoter	Sometimes none.  New participants may enter scheme at a different level.	Promoter generally acts directly with all participants.
Source of payments	From new participants – always disclosed.	From new participants – never disclosed.
Collapse	Fast.  An exponential increase in the number of participants is required at each level.	May be relatively slow if existing participants reinvest money.

 

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