The means by which the unwary are defrauded is limited only by the human imagination. One of the easiest frauds to run on unwary, unsuspecting investors is the Ponzi scheme. This Nichani Law Firm blog article discusses what a Ponzi scheme is, how and why it works, and what to watch out for.
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In the wake of the Wall Street crash of 1929, the federal government created the U.S. Securities and Exchange Commission (commonly referred to as “the SEC”) to eliminate fraud and insider trading in the securities markets, establish a national system of rules for the sale of securities, and restore investor confidence in the market.
The SEC began operating on June 6, 1934. By coincidence, some four months later the United States deported a convicted con man named Charles Ponzi. Today, Ponzi is known for the investment fraud scheme that bears his name. The idea wasn’t his—he first saw the investment fraud that became known as a “Ponzi Scheme” while working at a bank that was defrauding its depositors with promises of double the return on deposits that other banks were paying—but the investment con he launched was so wildly successful that his name became forever associated with the scheme.
Charles Ponzi, 1920
Ponzi wasn’t the first investment fraud con man, nor, despite the numerous criminal charges and prison sentences handed down against him, would Ponzi be the last investment fraud con man. Some 88 years later, Bernie Madoff admitted that he was operating a multi-billion dollar Ponzi scheme, which to-date has the dubious distinction of being the largest private Ponzi scheme in history.
How big was Madoff’s con? Over an 8 month period in 1920, Charles Ponzi defrauded investors of $20 million (accounting for inflation, nearly $299 million in 2023 dollars). In comparison, over the better part of two decades, Madoff’s fraud cost his investors $18 billion ($25 billion in 2023 dollars), and $65 billion in losses on paper.
The enormous scale of Madoff’s crimes was also reflected in the respective consequences Ponzi and Madoff faced. Ponzi, facing 86 counts of mail fraud, and the possibility of a sentence to life imprisonment, pleaded guilty to a single federal count of mail fraud, and was sentenced to five years in prison. In contrast, Madoff was sentenced to 150 years in prison. Ponzi died in poverty; Madoff died in prison.
Before, between, and after these two bookends of fraud, con men (and women) have duped countless credulous investors with promises of substantial risk-free profits, and continue to do so today, because the Ponzi scheme is one of the easiest cons to run on unwary, unsuspecting investors. Here’s how—and why—it works, and what to watch out
for.
What is a Ponzi Scheme?
The SEC defines a Ponzi scheme as “an investment fraud that pays existing investors with funds collected from new investors.” According to the SEC, the allure of a Ponzi scheme—and the danger to investors—is that “Ponzi scheme organizers often promise high returns with little or no risk. Instead, they use money from new investors to pay earlier investors and may steal some of the money for themselves. With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes tend to collapse.”
How Ponzi Schemes Work
The basics of a Ponzi scheme are simple:
Excellent Returns with Low Risk. A Ponzi scheme promises an investment opportunity with returns that are significantly higher than returns available from other, legitimate investments, and with little to no risk. This runs contrary to the investment rule of thumb that low-risk investments will offer lower returns than higher-risk investments. If it sounds too good to be true, it is.
No Earnings are Actually Being Generated. Although the initial investors are paid the promised returns, there are few, if any, legitimate earnings being generated.
Funds from new investors are used to pay returns to prior investors. In legitimate investments, investors are paid through the earnings being generated by the company. In a Ponzi scheme, the fraudster uses the funds from new investors to pay the promised returns to prior investors, typically skimming some off the top. As long as there is a continuous influx of new investors, the Ponzi scheme can run indefinitely.
Why Ponzi Schemes Work
Ponzi schemes are such an obvious con—with their guaranteed no-risk high returns, and murky information about how the returns are being generated—that you might think they couldn’t possibly reel anybody in. Yet Ponzi schemes have been and continue to be highly successful. Why? There are a number of psychological factors at work in a Ponzi scheme that cloud peoples’ judgment, and con artists are masters of manipulating the psychology that induces people to freely hand their money over to confidence tricksters. Some of the psychological factors exploited by these master manipulators include:
Trust: Confidence Fraud begins with gaining the trust of the con artist’s target victims, in order to induce them to let their guard down. Once they drop their guard, the con artist can manipulate and exploit the victim’s trust while running the con. In some cons, the victims are given bonuses to sign up their friends and family. “Would your friend introduce you to anything that is crazy?” one scammer asked.
Affinity: This is a type of confidence fraud based on a shared “group affinity” like national origin, ethnicity, religion, or age. The shared group affinity is the basis for establishing a bond of trust which the con artist will exploit. In one alleged affinity group scam, a Las Vegas attorney was charged with targeting Mormons in a $460 million Ponzi scheme.
FOMO—Fear Of Missing Out: “Is this too good to be true, or too good to miss?” Ponzi’s victims faced an inner conflict between common sense—this is too good to be true—and the Fear Of Missing Out. And fear won. Even after his conviction, Ponzi continued to receive investment requests in his prison cell from would-be investors who still wanted in on the “too good to be true” investment opportunity.
Greed: "Once you are invested in [a Ponzi scheme], your incentives are totally misaligned with the truth. You don't want to see what's happening," says Maria Konnikova, author of The Confidence Game. "You want to keep getting your money."
Embarassment: When people realize that they have been scammed, they may be too embarrassed to admit that they were taken advantage of by a con, which helps the con artist continue to conceal the existence of the con. In some cases, the fraud victim may not be capable of admitting that they made a mistake.
Recognize the Red Flags of a Ponzi Scheme
The SEC has identified seven Ponzi Scheme “Red Flags” for investors that you should be aware of when investing:
Red Flag: High returns with little or no risk. Legitimate investments link returns to risk; low-risk investments yield lower returns than higher risk investments. The attraction of higher-risk investments is the higher returns, while the attraction of lower-return investments is the lower risk. If you’re being guaranteed high returns with little to no risk, it’s a scam.
Red Flag: Overly consistent returns. Over time, the market has trended upward, but legitimate investments have their ups and downs. If the returns on an investment are consistent quarter after quarter, regardless of what’s happening in the market, are they really based on quarterly earnings? Or are they based on an influx of money from new investors?
Red Flag: Unregistered investments. Ponzi schemes are typically presented as “investment opportunities” that are not registered with the SEC or with state regulators. Because the investment is unregistered, you won’t have access to verified information about the company’s management, products, services, and finances, so you won’t be able to conduct your due diligence when deciding if you should invest.
Red Flag: Unlicensed sellers. Investment firms and investment professionals are required by federal and state securities laws to be licensed or registered with the government agencies regulating the sale of securities. If you’re being presented with an “investment opportunity” by an unlicensed, unregistered seller, beware; most Ponzi schemes involve unlicensed individuals or unregistered firms.
Red Flag: Secretive, complex strategies. Is your “investment opportunity” too complex, confusing, or difficult to understand? Enigmatic? Shrouded in secrecy? If you don’t understand how it works, or can’t get complete, transparent, unambiguous, comprehensible information about how it works, stay away.
Red Flag: Issues with paperwork. This is another tell-tale sign of a Ponzi scheme. Because no real investments are being made, and no earnings are actually being generated, the con-artist must conceal this fact from investors in order to keep investments flowing into the scheme. Issues with paperwork may include account statement errors (indicating that funds are not being invested as promised), and opaque, confusing, missing, or unavailable records and reports for investors to inspect, to conceal the fact that the numbers just don’t add up.
Red Flag: Difficulty receiving payments. Because no earnings are actually being generated, the con artist may try to avoid cashing you out by offering even higher returns if you agree to roll your previous “investment” over into a new “investment.” If you don’t receive a “guaranteed” payment, or have difficulty cashing out, you’ve probably been lured into a Ponzi scheme.
Conclusion: Knowledge Gives You the Power to Protect Yourself.
Beware the red flags indicating that an investment opportunity may be a Ponzi scheme.
When evaluating an investment opportunity, never rely on word of mouth, even from friends or family; always conduct proper due diligence on investments.
Ponzi schemes are always illegal. If you suspect you’ve been targeted for investment fraud, contact your state and federal regulatory and law enforcement agencies. In California, contact the California Department of Financial Protection and Innovation and the California Department of Justice. At the federal level, contact the SEC and the FBI, and the National Elder Fraud Hotline.
Ponzi schemes targeting elderly investors are very common, and are a violation of federal and state laws prohibiting the financial exploitation of seniors. For more information on protecting seniors from financial abuse in California, see Senior Gateway. At the federal level, see Elder Abuse and Elder Financial Exploitation Statutes at the Department of Justice.
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This Nichani Law Firm blog article is by Rick Bernardi
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