What Is A Ponzi Scheme?

Charles Ponzi [Image via WikiPedia]

Charles Ponzi [Image via WikiPedia]

Charles Ponzi [Image via WikiPedia]

We’ve all heard of Ponzi Schemes. Anyone with an Internet connection has been inundated with reports of Bernie Madoff since his record-breaking scheme was uncovered in late 2008 after garnering more than $65 billion for its perpetrator. A search of Google News on any given day reveals reports of dozens of Ponzi schemes, and the Securities and Exchange Commission has brought more than 100 enforcement actions against almost 200 people accused of carrying out Ponzi schemes in the past three years. How do so many people get conned when so many reports of similar scams are so abundant? Perhaps it’s because few of us really understand what a Ponzi scheme is and how it works.

Charles Ponzi may not have been the first to run the scheme that ultimately took on his name, and he may have even begun with a legitimate plan, but the sheer amount of money he accumulated in the 1920s made him the most infamous schemer of the day. At the time, people who mailed letters internationally had the option to purchase an accompanying international reply coupon, which could be returned by the recipient with the postage already paid. Ponzi, an Italian immigrant to the United States, realized he could purchase reply coupons in other countries at a cheaper price, then sell them in the United States to forge a profit. But he needed investors to support his endeavor.

Ponzi, however, had erred in his calculations. Once he set out to purchase the coupons overseas, he discovered the time and cost of conducting business, transporting the coupons and selling them at a profit were greater than he’d anticipated. But at this point he’d promised quick, positive returns to several investors and couldn’t bring himself to relay the bad news. So what did Ponzi do? He took on more investors and used that money to pay the promised returns to earlier investors. Of course, he took a hefty cut for himself, as well. As long as the earlier investors were taking their returns from an endless stream of new investors, no one complained and interest in the opportunity continued to grow.

Eventually—after Ponzi had been living a life of luxury for several months—authorities busted his scheme. Someone had finally noticed that to earn the money it did, Ponzi’s “business” would have needed to sell about 160 million international reply coupons. But only 27,000 were available to purchase in the entire world. Ponzi may have been a schemer, but details apparently weren’t his strongest suit.

So how do people get caught up in Ponzi schemes? Meet Mr. Smith. He’s a well-to-do professional who’s been fortunate with his investments. Then he meets John, a friend-of-a-friend who says he’s willing to cut him in on the deal of a lifetime. The investment opportunity is based on a “proprietary formula” that is guaranteed to provide a return of at least 50 percent in 90 days. Mr. Smith, however, remembers that anything too good to be true probably is, and politely turns down John. But soon he speaks to some mutual acquaintances who rave of the incredible returns they’ve already received on the investment. Mr. Smith, not wanting to be left out, invests his life’s savings into John’s firm.

Fast-forward two years. Mr. Smith is thrilled with the “earnings statements” he’s been receiving from John’s firm, but things are starting to fall apart on the inside. The economy has taken a slow turn, and John is having trouble recruiting new investors. You see, he never actually “invested” Mr. Smith’s money—or any other participant’s. The entire scheme was based on the constant accumulation of new investors. Their money would be split up with small portions being paid to Mr. Smith and other early investors and larger portions paid to John. The “statements” sent to investors were completely fabricated since the initial investments were all gone. And now that he’s having trouble paying his “investors,” Jason is facing some hard questions.

Thus is the life cycle of any Ponzi scheme. Even the most successful are eventually doomed to fall apart once the necessary stream of new investors falters. And all those early “investors” like Mr. Smith, who handed over their life savings? They better learn to live off of Social Security checks because their money is long gone.

The “get rich quick” mentality has been around since the dawn of time. The greedy will be taken advantage of by the greedier. But it’s not always that simple. A Ponzi scheme can affect those who want to provide a better life for their children or live comfortably in their retirements. That’s why people must be aware of the snake—the serpent that has led man astray from our earliest history. But beware of the wolf in sheep’s clothing, as well. Remember, Madoff was able to perpetuate his scheme for nearly two decades in large part because of his reputation as a well-established and highly-regarded financial expert; the man who helped found the NASDAQ stock exchange and even served as its chair for a time. But market conditions will never be as such that “guarantees” can be provided, and someone who offers unrealistic monetary promises should be considered suspicious. Even if others are confirming the claims, be aware that their good fortune is bound to be temporary.

Even those who don’t have wealth to invest can fall victim to schemes. Pyramid schemes, similar in structure to the Ponzi scheme, offer people the opportunity to get rich quick by performing an activity. After a small initial investment, recruits are offered the opportunity to make more money by recruiting others into the program or business, with each person profiting off of his or her team, and the subsequent teams of those team members. Recruits who are unable to recruit their own teams are generally unlikely to make any of the promised profits. Pyramid schemes, however, can be conducted legally as legitimate businesses—such as Mary Kay, Premier Designs and The Pampered Chef—have proven.

Ponzi schemes, however, by nature always deal with securities fraud and, therefore, are always illegal. The “investors” are not asked to do anything but invest their money and wait for returns, and the schemer takes care of the rest. And if the scheme doesn’t fall apart and the schemer isn’t busted, he or she may eventually take all the money and disappear.