What Is The Definition Of A Ponzi Scheme?

Michael Bennett
October 6, 2015 - 130 Views

Bernie Madoff entered a guilty plea on March 12, 2009 for his involvement in history’s largest ever Ponzi scheme. Through his scheme, investors were swindled out of $65 billion. Madoff was hailed as a genius by many Wall Street experts, but most of these experts also stated that they weren’t surprised to learn that he was also a huge crook. A lot of people were afraid that, if they were to speak out against Madoff, they would be ostracized, which is why very few came forward to discuss their concerns about their earnings and investment portfolio. Madoff’s Ponzi scheme was truly unique, mainly because it was so incredibly large.

What Are Ponzi Schemes?

Almost every Ponzi scheme is very complex, but they tend to be small scale. They are different from pyramid schemes, however. In a pyramid scheme, victims don’t know that they are taking part in a scheme and roping in more victims. In a Ponzi scheme, a single person or an organized group of people, is responsible for the entire fraud.

In order to keep the scheme going, these individuals have to convince a huge number of other victims to invest in what appears to be a legitimate fund. They do this by convincing them that the returns are huge and that there is little to no risk in taking part. Whenever a new investor pays into the scheme, this money is used to pay off an older investor. For a Ponzi scheme to work properly, therefore, they would actually need an infinite number of victims.

What happens in reality is that funds ultimately dry up because no new victims can be found. Sometimes, this happens a bit quicker than was expected by the masterminds behind the scheme, for instance, if there is a downturn in the economy. Once the supply of victims starts to run dry, the scheme itself starts to fall apart and the victims lose everything they invested. The individual who started the scheme suddenly disappears, just before people figure out they were part of a Ponzi scheme. If the scammers are caught, they would have to repay everything, which they will never be able to do. Hence, they vanish and are often never found. While some federal restitution schemes do exist, this is often not enough to actually pay back all the money that was taken.

Where Does the Name Come From?

Ponzi schemes get their name from Charles Ponzi, believed to be the first to have come up with this scam. Thousands of people in New England were scammed into investing on a postage stamp scheme during the 1920s. The banks’ annual interest rate at that time was 5%, but Ponzi promised people who invested in his scheme that he would be able to give them a 50% in no more than 90 days. At the start, he purchased a few international mail coupons, to make it seem authentic. He then started to use the funds from new investors to pay his early investors.

How to Recognize a Ponzi Scheme – Red Flags

There are a number of commonalities seen in almost ever Ponzi scheme. Watch out for the following red flags:

1. Claiming that you will see high returns without any risks. An investment always carries a risk, and those investments that do have the potential for high returns tend to have a higher risk. If you see any claims of ‘guaranteed’ opportunities, you are probably dealing with a scam.
2. Returns that seem overly consistent. If you make investments, you should see the value fluctuate up and down. Investments with high return possibilities tend to fluctuate more. If you have made an investment that sees consistent positive returns, regardless of overall market movements, you should be very suspicious.
3. Investments that are not registered. Any real investment should be registered with SEC or with your state regulator. If it isn’t, then you are probably dealing with a scam. An investment that is registered allows you to check out how a company is managed, what their products are, what kind of services they offer and how their finances work.
4. Unlicensed sellers. Investment professionals must, by federal and state securities laws, be registered or licensed. Most of the time in a Ponzi scheme, the individuals or firms are not licensed or registered.
5. Strategies that are complex and/or secretive. If you do not understand an investment, you should avoid it. Make sure that you are always able to receive complete information on your investment.
5. Problems with paperwork. If you are given excuses as to why you cannot receive information in writing about your investment, avoid the investment. If there are inconsistencies or errors in account statements, you can suspect that the funds are not actually being used in the way you were promised.
6. Problems in receiving payments. If you do not receive a payment that you was promised, or if cashing out your investment is difficult, you also need to be suspicious. Within a Ponzi scheme, you will generally be encouraged to ‘roll over’ your investment. You will be told that this will give you even higher returns. In reality, you are just funding the scheme.

If you believe that an investment opportunity could be a Ponzi scheme, you must immediately submit a tip to the SEC. You can do this online, or by telephoning 800-732-0330.

How Can I Avoid Ponzi Schemes?

It doesn’t matter whether you are an experienced or novice investor, there is always a risk that you will fall victim to a Ponzi scheme. Luckily, you can usually avoid them by asking a number of important questions. Remember that any money you invest is money that you have worked hard to earn, so you have to make sure that you use it properly.

According to the SEC, many investors could have avoided the problems they are now facing, and the financial losses, if they had simply asked a number of questions and made sure that they had verified the answers to be correct. This only takes a little bit of time, and every investor should commit to it. The questions you should ask are:

1. Does the seller have a license?
2. Is the investment properly registered?
3. What reward is possible and what are the risks?
4. Do I understand what I am investing in and how it works?
5. Who can I ask questions for help?

Important Investor Resources

These are:

SEC Enforcement Actions Against Ponzi Schemes
Ponzi Schemes Using Virtual Currencies
Questions Investors Should Ask
Avoiding Fraud
Affinity Fraud
Social Media and Investing – Avoiding Fraud

Similarities and Differences Between Ponzi Schemes and Pyramid Schemes

There are many similarities between pyramid schemes and Ponzi schemes. Both involve the idea that those who have been investing longer will have greater earnings from new members. As such, neither actually offers profits through an investment or through direct sales. However, there are some clear differences as well:

• Pyramid schemes hook people by saying that they only need to make a single payment and that they will earn high profits by finding new distributors. Usually, there is no actual product included, or only new distributors can buy it. With a Ponzi scheme, investors only have to hand their money over. The actual investment doesn’t exist at all.
• Pyramid schemes ask people for recurring participation fees or other fees and say that they will see returns on this when they recruit new distributors. Ponzi schemes do not require investors to recruit others.
• With pyramid schemes, there is usually no interaction with the person who originally promoted the scheme. With a Ponzi, the promoter usually talks directly to all the people involved.
• Pyramid schemes use funds from new investors to pay the commissions for older investors. With Ponzi schemes, money from new investors is used to pay fake returns to earlier investors.
• Pyramid schemes tend to collapse very quickly, because new participants at each level are needed all the time. Ponzi schemes often take a long time to collapse, particularly if investors are willing to ‘roll over’ their investment.

Additional Resources:

How to Spot a Ponzi scheme and Other Financial Scams
Resource on the Nature of Pyramid Schemes
Resource on How the Government Can Help You Get Back Your Money
Check Registration of Investment with the SEC
Reporting a Scam to the SEC
Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs

Michael Bennett

About Michael Bennett

Michael Bennett is Editor-in-Chief of Consumer Protect.com. Since 1999, he's worked across a multitude of areas of consumer protection including defective products, environmental issues, identity theft, predatory lending and more. If you find his articles helpful please share them with your readers.