The Ponzi Scheme - Most Successful Fraud of All Time?

Readers of money laundering books and financial crime books will be very familiar with different types of investment scams. The Ponzi scheme is perhaps the world’s most successful investment scam. In this article, we’ll explain how a Ponzi scheme works and why they’re difficult to spot.

What is a Ponzi scheme?

A Ponzi scheme is an investment fraud in which the investment manager disguises the source of cash distributions to investors.

Investors believe they are being paid proceeds from underlying investments made by the fund. In reality, they are being returned the original stake from their own or other investor deposits.

The objective of a Ponzi scheme is to provide tangible evidence to external investors that the fund is generating a high level of return. This encourages existing investors to remain invested, while the track record can be used to attract new investors into the scheme.

The failure of a Ponzi scheme is inevitable. As soon as an operator provides investors with an artificially inflated picture of the value of assets within the scheme, losses will be incurred when this facade eventually crumbles.

If a Ponzi scheme successfully attracts greater and greater capital inflows, the fresh proceeds can be used to provide advertised returns to the original investors, perpetuating the fraud. If the advertised rates of return are modest, and the fund continues to attract new clients, a Ponzi scheme can be operated for years before being detected.

A Ponzi scheme will fail when it finally runs out of cash. This could be due to payments to earlier investors, or through embezzlement. At this point, the fraud can no longer be maintained and the scheme unravels.

Why is a Ponzi scheme a scam?

A Ponzi scheme is a scam because the fund manager deceives investors about the underlying profitability of the investment strategy. Some Ponzi schemes do not even attempt to execute an investment strategy, while others may partially put the money to use but does not meet the advertised rate of return.

As soon as a scheme begins to communicate to investors that the value of their investments exceeds the actual net asset value of the fund, a securities fraud has occurred.

The use of new capital to pay inflated profits to earlier investors is a second violation because these profits never existed in cash terms, and therefore this is known as ‘robbing Peter to pay Paul’.

How common are Ponzi schemes?

Ponzi schemes are relatively uncommon in regulated equity markets such as the London Stock Exchange or the New York Stock Exchange although notable examples exist.

It is difficult to perpetuate a Ponzi scheme as a listed business because public companies are subject to an external audit from an independent statutory audit firm.

A Ponzi scheme should be uncovered by basic audit procedures because the reported value of its assets will vastly exceed the real value of cash and investments held by the firm. This is known as fraudulent financial reporting.

Therefore, a well-executed test of ‘existence’ on all material assets should uncover the fraud. The longer a Ponzi scheme has operated, the larger the fictitious assets will be, because the gap between real and promised investment returns will widen over time. This should make a Ponzi scheme easier to detect.

Ponzi schemes are more common among unregulated, private investment opportunities; particularly those offered online. The private status or anonymity offered by this format allows the operator to avoid audit requirements and therefore exercise full control over the reporting to investors and the cash flows of the scheme.

In particular, a category of online investment schemes known as High Yield Investment Programmes or HYIPs, are generally accepted to be Ponzi schemes. The FAQ section of a prominent web platform promoting such scams openly accepts that “the majority are fraudulent”.

HYIPs are unregulated, run by anonymous founders and usually accept deposits only in cryptocurrency. Such schemes may promise abnormal and unrealistic returns such as 2% per day.

No documented investment strategy has ever achieved such a return on a consistent basis. A 2% daily return would see a £1,000 initial investment grow into £1.7m by the end of a year.

The Financial Conduct Authority warns that if an unregulated investment scheme promises high returns this is a sign that the offer could be a scam.

Why do people run Ponzi schemes?

There are two main scenarios:

A financial fraudster seeks to raise as much investor cash as possible within a short time frame and chooses the Ponzi scheme format to create buzz & hype to help scale up the operation before the funds can be stolen. In this way, the fraudster honours initial requests for withdrawals, seeing these are a necessary outlay in the hope of achieving a larger windfall further down the line.

An investment manager sets out to run a legitimate investment scheme but incurs a sizeable loss or disappoints against forecast. They begin to use Ponzi tricks to ‘cover up’ the mistake. They may hope that the underlying investment strategy may finally deliver a sizeable profit in the future that may allow them to cover the promises made to investors.

In the eyes of the law, a Ponzi scheme is a violation of securities laws regardless of the motive. Embezzling money from investors will simply add more charges to the rap sheet.

Is there ever a case for investing in Ponzi schemes?

No, a Ponzi scheme is doomed to fail by design. Only a minority of investors may ever see a profit, and these will have withdrawn early while the operator was still willing to make distributions.

Some gamblers see Ponzi schemes as a ‘punt’ and engage with them with a full acceptance of the risk they are taking. However, this activity finances the scammers and therefore encourages them to continue. The more people participate in Ponzi schemes, the more schemes will appear and more unknowing victims will be ensnared.

Examples of Ponzi schemes

The two most notable Ponzi schemes are:

Securities Exchange Company – Charles Ponzi (1920)
Bernard L. Madoff Investment Securities LLC (1970 – 2008)

The Securities Exchange Company was the criminal enterprise of Charles Ponzi, which was so prominent that his name became forever attached to the fraud. It’s worth correcting the misconception that Charles ‘invented’ the Ponzi scheme – he was certainly inspired by a similar fraud perpetrated by his own bank employer at the start of his career. Charles Ponzi offered a 50% return to investors after just 45 days, under the pretence that he could generate high profits by buying postage return vouchers in Europe and reselling them in the US.

Bernard ‘Bernie’ Madoff ran an investment management firm alongside a legitimate and successful trading firm in New York for decades. By offering good (but modest) returns of c 10% per annum, and chasing long-term investors such as charities and local governments, he grew the fund to a fictional size of $64.8 billion. When the bank account ran dry during the financial crisis of 2008, the largest white-collar crime ever committed was revealed.

Both men found it relatively easy to perpetrate the fraud to dizzying heights because the loyalty of their investors meant that most investors did not redeem their fictional profits. This meant that their schemes had few cash withdrawal requests to meet.

How to spot Ponzi schemes

The defining characteristics of Ponzi schemes are hidden from the view of investors, therefore it is nearly impossible to tell apart a well-run Ponzi fraud from a profitable investment.

Consider that in the case of Bernie Madoff’s investment firm – several researchers and journalists made repeated attempts to alert the SEC to wrongdoing over the life of the scams. When the SEC did eventually investigate, it failed to initially find wrongdoing.

Therefore the following steps are perhaps the best you can do to avoid Ponzi schemes: