Ponzi Schemes: What You Don’t Know Can Hurt You

Investing, if done sensibly, can be a sound use of one's money. However, it is not without risks. For example, Bernie Madoff's recent Ponzi scheme bilked investors out of 50 billion dollars, causing some to lose their life savings. The magnitude of the Madoff scandal illustrates why Ponzi schemes are traps that both novice and experienced investors must be aware of.

What is a Ponzi Scheme?

A Ponzi scheme is a form of investment fraud involving the payment of supposed returns to investors from funds contributed by new investors.

The scheme is named after Charles Ponzi, who tricked people into investing in foreign postage stamp coupons back in the 1920s. Within 90 days of the original investment, he promised rates of return as high at 50 percent, at a time when bank accounts paid five percent a year.

Ponzi scheme organizers will often lure new investors by promising high returns with little or no risk. The organizers will usually claim that they can guarantee a high rate of return because they are especially savvy or skilled at investing. The organizers typically focus on bringing new investors into the scheme, so they can use the money that the new investors provide to make promised payments to earlier investors.

Ponzi schemes usually collapse, as there is no legitimate profit to sustain the process. The scheme requires a regular flow of new money from new investors to continue. When the flow of new investors slows down or if a large number of investors want to cash out, the scheme collapses.

In Charles Ponzi's case, he used incoming funds from new investors in his postage stamp speculation scheme to pay off early investors who wanted to cash in their investments. His scheme's illusion of never-ending success attracted the attention of banking officials. In the end, Charles was convicted of fraud and went to prison. Once released, Ponzi, an immigrant, was deported and died penniless in 1949.

Characteristics of Ponzi Schemes

Ponzi schemes typically share common characteristics. According to the Securities and Exchange Commission (SEC), warning signs that an investment opportunity may be a Ponzi scheme include:

  • High investment returns with little or no risk. Every legitimate investment has some risk. Typically the higher the rate of return that an investment promises, the higher the risk is. Beware of any investment opportunity that guarantees a certain rate of return or any return at all.
  • Overly consistent returns. Most investments will go up and down in value over time. Be careful of any investment that continues to generate consistent profits or returns on a regular basis regardless of how other investments or the economy are performing.
  • Unregistered investments. Registration of investments allows investors access to information about the company's finances, products and management. Ponzi schemes will typically involve investments that are not registered with the SEC or state regulators.
  • Unlicensed sellers. Most Ponzi schemes involve unlicensed or unregistered investment professionals. Federal and state laws require investment professionals to be licensed or registered.
  • Secretive and/or complex strategies. It is a good idea to avoid investments that you don't understand or can't get clear information about.
  • Issues with paperwork. Always read an investment's prospectus before you invest. Be suspicious if the investment professional or company will not let you review information about an investment. If there are any errors or irregularities in the investment's prospectus, it might be a sign that the funds are not being invested as promised.
  • Difficulty receiving payments. Be very suspicious if you don't receive a payment or have difficulty cashing out your investment. Also, Ponzi scheme promoters will often offer investors higher rates of return if they reinvest their investment in the scheme instead of cashing out the investment.

How are Ponzi Schemes Different From Pyramid Schemes?

A Ponzi scheme and a Pyramid scheme are very similar, as they both involve paying early investors with money from recent investors. However, in a pyramid scheme, each investor is encouraged to recruit new investors. The early investor earns profits in an amount dependent on the number of new investors he or she brings into the scheme.

Unlike a Ponzi scheme, an investor in a Pyramid scheme knows that he or she will not profit unless he or she brings in new investors. In other words, the investor understands the source of the profits, but in a Ponzi scheme, the investor never knows where the investment profits come from.

Pyramid schemes also typically collapse much faster than Ponzi schemes. Since each investor is actively recruiting new investors in a Pyramid scheme, the scheme grows faster, running out of money much faster than in a Ponzi scheme.

How Can I Avoid Ponzi Schemes and other Investment Schemes?

When considering your next investment opportunity, be sure to ask some basic questions before you invest:

  • Is the seller licensed?
  • Is the investment registered?
  • Do I understand the investment?
  • Are the risks on par with the rewards?
  • Are the issuer's financial statements audited by a reputable accounting firm?

Most investors can avoid trouble if they ask these questions and verify the answers with information from independent sources.

What Can I Do if I Am a Victim of a Ponzi Scheme?

Investment schemes are often complex and hard to spot. If you believe that you might be a victim of a Ponzi scheme or other investment fraud, an experienced attorney may be able to help you recover your losses.

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