Ponzi Scheme

A Ponzi scheme is a scam where potential investors are lured into a seemingly quick high-return opportunity. In order to attract more targets, the fraudsters compensate early investors. This compensation comes from the amount invested by new investors.

There is no real strategy for benefitting investors. The investment does not go into any profit-generating options. Instead, it is a fraudulent racket where only a few early investors get their money back. Others lose a considerable amount. In 1920, Charles Ponzi was found guilty of postage stamp fraud.

• A Ponzi scheme is a deceitful act where an organizer traps investors into a fake investment plan. The fraudster claims huge returns within a short period with minimal or zero risk. However, the money is not invested anywhere.
• The fraud shuts down when new investors stop joining. When that happens, the organizers are unable to provide returns. Also, once exposed, the scammers stop providing returns altogether.
• Pyramid schemes are similar to Ponzi schemes. In a pyramid scheme, the seller or the company adds some investors who further bring in more investors. Unlike Ponzi fraud, pyramid fraud is usually initiated by companies who actually sell products or services.

The Ponzi scheme is a scam. When something sounds too good to be true, that is because it is not true. The fraudster fulfills the promise initially. They do provide high returns, but only to the early investors. That too from the money acquired from other investors. Early investors refer to other investors. The scheme gains traction by word of mouth. Also, the early investors end up re-investing. More often than not, that ends in losses.

After a certain period, if the plan fails to attract new investors or if the economy spirals down, the organizer is unable to provide returns. This is when the Ponzi scheme collapses, and the investors lose a considerable sum.

The Ponzi scheme was earlier referred to as "robbing Peter paying Paul." This fraudulent practice is named after Charles Ponzi, who cheated investors in 1920 with the renowned postage stamp scam. At that time, postage prices fluctuated constantly. As a result, stamps and reply coupons were more expensive in one country than others. Ponzi used that margin by hiring agents to purchase "international reply coupons" from other countries. The agents acquired the stamps at lower prices and sent them to the US. Ponzi then sold these stamps at a profit, i.e., at a higher price than originally purchased. 

Later he established a "Securities Exchange Company" and convinced investors to put funds in his company. He promises a yield of 50% on the investment value within 45 to 90 days. However, Ponzi's business was not that rewarding. So, he started taking funds from new investors and sent them to early investors labeling them as returns. But soon, the popular racket busted; investors lost all their amount.

In 2012, one of the biggest Ponzi schemes was initiated by Allen Stanford. The fraudulent scheme started under the name of Stanford Financial Group was later exposed. The company sold Certificate of Deposits. It was suspicious; the firm offered interest rates that were significantly higher than the other CDs. Looking at the returns, many investors got tricked, and Stanford illegitimately used their money for personal spending.

It was a $7 Billion scam, and Stanford was put behind bars. He was sentenced to 110 years of imprisonment. However, in September 2021, the court authorized Ralph Janvey to mitigate the losses. Somehow, Janvey managed to recover around $1 billion. The amount will be allocated to the victims by the first quarter of 2022.

There are some alarming indicators or warning signs to watch out for. Following are the red flags that suggest a possible Ponzi scheme at play:

#1 - No Registration

These schemes generally include those investments which are not registered with state regulators or securities and exchange commissions (SEC). Therefore, it is essential to check for the investment scheme's registration to access information regarding its management team, products, services, profitability, and finances.

#2 - Reticent Intentions and Undisclosed Strategies

Any investment opportunity with complex protocols and secret strategies are generally Ponzi schemes. There exists a lack of transparency about the plan, and the organizer misleads the investors using vague descriptions and false claims.

#3 - Returns, Much Higher than Bank’s ROI

An investor should be cautious with any scheme that promises tremendous returns in no time. If the promised percentage yield is significantly higher than the bank's return on investment, that is a red flag.

#4 - Steady Returns

Other than fixed deposits, bonds, debentures, and other investment vehicles, no product yields regular and constant returns. Therefore, one should be skeptical about the schemes that promise regular returns.

#5 - Limited or Zero Risk Involvement

Normally, the higher the risk, the higher the return from an investment. So, if a scheme guarantees impressive returns with low or no risk involved, that raises a red flag.

#6 - Unregistered Organizer or Seller

The state and federal security laws have directed investment firms and professionals to register with authorized bodies and Securities Exchange Commission (SEC). But the fraudulent schemes are proposed by unlicensed or unregistered firms.

#7 - Not Receiving Payments

As soon as the racket is exposed, the organizer stops disbursing money to the investors. In addition, scammers put in clauses restricting investors from withdrawing money from the investment. Alternatively, they reject withdrawal requests citing vague reasons. Investors should look out for such shady clauses.

#8 - False Documents or Statements

Whenever funds are not being invested as promised, there will be an error with account statements; this hints that an investment could be fraudulent. Unfortunately, investors don't find any legal paperwork to examine. Most Scammers forge financial statements.

In a pyramid scheme, the seller or the company adds some investors who further bring in more investors or distributors, and this chain branches out exponentially. The early investors sit on the top of the pyramid, whereas new investors pay a fee to the early investors to gain access. In some countries, pyramid schemes are illegal.

The Ponzi scheme doesn't have any investment plan; however, a pyramid scheme is usually initiated by companies that sell products or services. In the Ponzi fraud, only the early investors get returns; others lose everything. In contrast, when a pyramid scheme member hires more people to the chain, the returns and discounts increase accordingly.

The California Solar Company, owned by Jeff Carpoff and his wife Paulette, is an example of Ponzi fraud. The couple acquired money from investors and promised mobile solar generators by January 2020.

This has been a Guide to what is Ponzi Scheme and its Definition. Here we discuss Ponzi scheme history, red flags, examples, and how it works. You may learn more about financing from the following articles –

• Efficient Frontier
• Risk Exposure
• Risk Appetite
• Risk Categories