Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Ponzi schemes: an overview

Often, when people find out I am a forensic accountant, they will ask me about widely publicized cases involving fraudsters, such as Bernie Madoff, who is currently serving a 150 year sentence in prison for orchestrating a multi-billion dollar Ponzi scheme. During 2010, the SEC filed forty-seven enforcement actions involving Ponzi schemes. Sometimes I am asked to describe what a Ponzi scheme is and how investors can avoid them. Here are some general answers and information that is useful and interesting regarding this type of investment fraud:

What is a Ponzi scheme?

It is a type of investment fraud in which existing investors are paid returns from funds contributed by new investors. Often, the Ponzi scheme fraudster will attract new investors by promising high returns with little or no risk. The new money invested will be used to pay the promised payments to the earlier stage investors, rather than be used in any legitimate investment activity. In order for the scheme to continue, it requires a consistent flow of money. Ponzi schemes will collapse when it becomes too difficult to attract new investors or a large number of investors ask to cash out their investments.

Who was “Ponzi”?

In the 1920’s, Charles Ponzi convinced thousands of New England residents to invest in a postage stamp scheme. At the time, the bank interest rate was 5% per year, and Ponzi promised a 50% return in just 90 days. At the beginning, Ponzi did actually invest in a small number of mail coupons, but he quickly switched to just using the incoming investors’ funds to pay off the earlier investors. He was ultimately exposed by his publicity agent, William McMasters, who became suspicious soon after he was hired.

Warning signs of Ponzi schemes

The U.S. Securities and Exchange Commission lists these red flags on their website, to be aware of when looking at investor opportunities:

  • High investment returns with little or no risk
  • Overly consistent returns
  • Unregistered investments and/or unlicensed sellers
  • Secretive or complex strategies
  • Issues with paperwork
  • Difficulty receiving payments

What is the difference between a Ponzi scheme and a pyramid scheme?

In my blog post in October, I will discuss “pyramid schemes” and some of the differences and similarities between those schemes and Ponzi Schemes.

In closing, investors should always be cautious of investments which are “too good to be true.” Investments which are pitched as high return opportunities with little or no risk are indicative of Ponzi and other investment schemes.