Because of the $50 billion Bernie Madoff investment scandal Ponzi schemes are receiving lots of news coverage. However, Ponzi schemes aren’t new; they have been around since the 1800s. Charles Ponzi simply perfected the scam.
With Ponzi frauds regularly surfacing it is worth your while to know how to recognize one. I’ll also explain the differences and similarities between Ponzi schemes and pyramid schemes.
Ponzi schemes are named after Charles Ponzi, a 1920s Boston, Mass., businessman who lured investors with promises of a 50 percent return in 45 days if you bought one of his corporate promissory notes. Ponzi told Bostonians he would invest their money in international postal reply coupons, when in fact he didn’t have a real business operation and never intended to invest their money in a legitimate business. His real plan was to “rob Peter to pay Paul.” He would simply pay investors their monthly interest with money he received from other investors.
Let’s say you are solicited to invest in the stock of a gold mining company with promises of huge returns. You might be told the mine is operational and producing lots of gold when in fact it is not. Instead, your monthly dividend comes from money solicited from other investors who were also convinced to invest in the gold mine. If there is no gold being extracted, and the company is not making money from the alleged business operation, they may be “robbing Peter to pay Paul.” This would be an example of classic Ponzi type of investment scheme, using one investor’s money to pay another. The fact is, Ponzi investment frauds take many shapes and involve a variety of products, including rare or collectible coins and other numismatic products.
Here’s another hypothetical example:
You are told a company you are thinking about investing in buys gold, silver and platinum from miners and sells the metals to jewelry manufacturers for a profit. As an investor your money is allegedly pooled with other investor funds to buy the precious metals. As a passive investor, you will share in the profits from the transactions. If you later learn that the company purchased no precious metals and instead paid your monthly interest from funds received from other investors, then this could be another example of Ponzi style investment fraud.
With Ponzi schemes, as the number of new investors grows, the supply of new investors available to solicit diminishes. Eventually the Ponzi bubble must burst under the pressure of meeting the promised interest payments to its ever increasing investor base. While some early investors do receive interest payments the newer investors lose all or most of their money when the scam is exposed. Again, that’s because there is no real business venture to generate legitimate income.
Unfortunately, Ponzi schemes can go on for years without detection. As long as investors receive their monthly interest payments they are happy and – they don’t question the legitimacy of the alleged business operation.
Pyramid schemes are not typically investment schemes. They involve multi-level marketing opportunities. An illegal pyramid scheme relies on an organizational structure (pyramid) whereby compensation is derived primarily from recruiting others into the organization, rather than from the sale of goods or services. What differentiates a legal multi-level marketing program from an illegal one is that a legal one generates profits mainly from the sale of merchandise.
Many illegal pyramids attempt to establish their legitimacy by purporting to sell a product. However, the merchandise or service to be sold is largely ignored. The pyramid scheme functions like a chain letter, and eventually collapses as participants try to recover their initial investment by recruiting more and more new investors from the ever decreasing number of prospects in a given area.
The chart below, published in a brochure distributed by of the Securities & Exchange Commission, shows the absurdity of a pyramid scheme if it is allowed to run its natural course. The chart assumes that the first participant brings in six new people under the pyramid and that each new participant brings in an additional six purchasers per month:
11 362,797,056 (exceeds U.S. population)
13 13,060,694,016 (exceeds world population)
Finally, here are red flags of Ponzi and pyramid schemes with tips on how to avoid becoming a victim:
• You are provided with “insider” or “secret” information.
• The investment has an unusually high rate of return.
• You are pressured to invest.
• You are told the investment has no risk.
• You are unable to get regular reports on the status of your investment.
• It sounds too good to be true.
• Be leery of multi-level marketing opportunities that require large start-up costs.
• With multi-level marketing offers be sure there is an actual product to sell.
• If there is a product be certain there is a consumer market for the product.
• With multi-level marketing opportunities be sure the sale of the product is the main focus of the marketing plan, not just bringing in new members.
Mark Mathosian is a financial frauds investigation manager with the Florida Office of Financial Regulation. He has an investigative background in banking, finance and securities. He can be reached at firstname.lastname@example.org, or (850) 410-9859.
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