Ponzi schemes and the pandemic... a perfect storm?

Ponzi scheme: An investment fraud that pays existing investors with funds collected from new investors. Ponzi scheme organizers often promise to invest your money and generate high returns with little or no risk. But in many Ponzi schemes, the fraudsters do not invest the money. Instead, they use it to pay those who invested earlier and may keep some 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. (See Ponzi Schemes, U.S. Securities and Exchange Commission, Investor.gov.)

While the headline-grabbing Ponzi schemes uncovered during the Great Recession of 2007-2009 no longer dominate news cycles, this type of fraudulent activity remains alive and well. And it’s only been growing in recent years with big and small scams continuing to victimize investors. A booming stock market, the uncertainty over the pandemic and its economic consequences, plus an abundance of government stimulus money, create an ideal climate for Ponzi schemes to flourish — and explode, say some experts.

Just earlier this year, the Securities and Exchange Commission (SEC) charged three individuals connected to New York-based GPB Capital with running a $1.7 billion Ponzi scheme. The SEC’s account of the fraud showed it to be a classic Ponzi.

David Gentile, the owner of the private equity firm, allegedly used investor money to make a portion of the 8% annualized distribution payments that he said were being generated through the firm’s portfolios. Gentile, with the help of Jeffrey Lash, a former managing partner at GPB Capital, manipulated the financial statements to hide the poor performance of the firm’s funds. The SEC also alleged that the asset manager had violated whistleblower laws in termination agreements that impeded investors from approaching regulators about this matter. (See SEC Charges Investment Adviser and Others With Defrauding Over 17,000 Retail Investors, Feb. 4, U.S. Securities and Exchange Commission.)

The company has replaced Gentile as CEO and vowed to mount a strong defense against what it described as “unfounded allegations.” (See the GPB Capital letter to its community, Feb. 8.) The SEC requested an independent outside monitor to try to protect the 17,000 retail investors who’d participated in the firm’s funds. (See GPB Capital Agrees to SEC Monitor Sought to Protect Investors, by Ted Bunker, The Wall Street Journal, Feb. 11.)

In another example of a recent Ponzi scheme, the SEC charged a former president of a California real-estate development company with misappropriating over $26 million from more than 1,300 investors. Lewis Wallach, the former CEO of real-estate firm Professional Financial Investors (PFI), pleaded guilty in December for his role in the large-scale fraud. (See Lewis Wallach Admits To Defrauding Investors And Embezzling $26 Million From Marin Real Estate Company, U.S. Attorney’s Office Northern District of California, Dec. 16, 2020.)

The SEC accused Wallach of soliciting millions of dollars from investors — many of whom were elderly — on the false promise that he’d invest the money in real estate managed by PFI. However, Wallach used those funds to pay other investors and prop up a company that he falsely claimed was financially strong. (See SEC Charges Former Real Estate Executive With Misappropriating $26 Million in Ponzi Scheme, SEC, Sept. 29, 2020.)

Ponzi schemes are hardly a uniquely U.S. phenomenon. In a recent case in Australia, the Australian Securities and Investments Commission (ASIC) charged financial adviser Melissa Caddick with stealing 13.1 million Australian dollars from more than 60 victims in a large Ponzi scheme. Many of the victims included Caddick’s friends and family.

ASIC alleges that Caddick used the Australian financial services license of a former work colleague without her knowledge or consent to solicit the investments. After clients invested funds with Caddick, she transferred the funds into personal bank accounts to furnish her lavish lifestyle. (See Melissa Caddick: assets of missing financial adviser must be sold and lost millions found, investors say, by Nino Bucci, The Guardian, Feb. 18.)

Caddick went missing in November 2020, the day after Australian Federal Police involved in the Ponzi scheme investigation raided her home. On Feb. 21, her body was found washed ashore on a beach over 200 miles from where she had originally disappeared. The investigation remains ongoing. (See Remains of Melissa Caddick found on NSW South Coast, by Nick Pearson, 9News, Feb. 26, 2021.)

Ponzi schemes of all sizes are still common. And while the total amount of money stolen through this type of fraud fell dramatically after the 2007-2009 financial crisis, some evidence shows the size and number of Ponzi schemes could be growing. (Ponzi schemes hit highest level in a decade, hinting next ‘investor massacre’ may be near, by Greg Iacurci, CNBC, Feb. 11, 2020.)

Paying the price

It’s been more than a decade since the massive Ponzi schemes of the Great Recession, including those of Tom Petters, Allen Stanford and Bernie Madoff. Each of these men have already served at least 10 years of their lengthy sentences in federal prison. Barring any potential future pardons, or compassionate releases for health reasons, as Madoff unsuccessfully sought to achieve last year, they likely will serve the rest of their lives incarcerated. (See Ponzi scheme king Bernie Madoff denied compassionate prison release by federal judge, by Dan Mangan, CNBC, June 4, 2020.) (Editor's note: Bernie Madoff died in prison on April 14 after this article was published. He was 82. Fraud Magazine will examine Madoff's legacy in the July/August issue.)

Many of Madoff’s victims still live with the aftermath. Some have recovered more quickly than others, but it’s taken many of them years to recover from losing substantial portions of their life savings, if not all of it. (See The stories of Madoff’s victims vary widely, as the fraud continues to unwind 10 years later, by Scott Cohn, CNBC, Dec. 11, 2018.)

The media and the public, however, have largely moved on. More recent Ponzi schemes tend to garner only local news coverage. And many investors’ concerns have shifted to the COVID-19 pandemic and market volatility, as shown by the roller-coaster stock price of videogame retailer GameStop earlier this year. Investors seem to believe the threat of losing their life savings to fraud has largely dissipated.

In the immediate aftermath of the Madoff scandal, the SEC took steps to stop future Ponzi schemes. (See SEC proposes changes to prevent another Madoff, by Kevin McCoy, ABC, Sept. 29, 2009.) These included revamping the handling of tips, encouraging greater cooperation from insiders and enhancing safeguards for investors’ assets, among other measures. (See The Securities and Exchange Commission Post-Madoff Reforms, SEC, last modified July 15, 2019.) The SEC on this webpage says it’s no longer updating its post-Madoff reforms, which arguably underscores that regulators and other market participants aren’t emphasizing Ponzi schemes much these days.

We still see about 50 to 60 Ponzi schemes prosecuted every year in the U.S. Those numbers will likely increase due to the pandemic.

Marie Springer, Ph.D., ACFE Associate Member

But have the regulatory changes in financial markets really caused these schemes to become a thing of the past? Not so, says Marie Springer, Ph.D. Springer is an ACFE Associate Member and adjunct assistant professor at John Jay College of Criminal Justice in New York. She recently wrote the book, “The Politics of Ponzi Schemes: History, Theory and Policy.”

“We still see about 50 to 60 Ponzi schemes prosecuted every year in the U.S.,” Springer says. “And those numbers will likely increase due to the pandemic.” According to Springer, COVID-19 might be creating a perfect storm for an increase in Ponzi schemes for several reasons:

• Some perpetrators will start new schemes because of changing market conditions created by the pandemic. They’ll exploit market uncertainty and investors’ fears of missing out on the bull market gains of the previous decade.
• Many more Ponzi schemes will likely fail if the stock market eventually does take a pandemic-related downturn. This scenario would be similar to the Great Recession. As the market slows, Ponzi perpetrators might not be able to find new investors and will default on payments to earlier investors, which could lead to forced bankruptcies and subsequent litigation.
• Some perpetrators will even capitalize on the fear of the virus itself. They’ll use it as the vehicle to sell their schemes. (For example, a perpetrator might convince victims to invest in a small company that the perpetrator alleges is involved in cutting-edge COVID-19 research.)

“On top of that,” Springer says, “when the Ponzi schemes eventually are discovered, the pandemic is going to make the legal process take longer.” Many civil and criminal court dockets have ground to a crawl since the pandemic started in early 2020. (See Pandemic disrupts justice system, courts, American Bar Association, March 16, 2020.)

It might also be difficult to know just how bad the problem is because official Ponzi scheme statistics aren’t published by government agencies, according to Springer. Only professors such as Springer or legal bloggers tend to publish Ponzi-related data sets. “Compounding this problem is that courts might prosecute Ponzi scheme perpetrators under multiple laws,” Springer says. “And we generally don’t count it as a Ponzi scheme unless that term is actually used in the federal charging documents. If court documents don’t contain that term, defendants might never go on record as having been convicted of running one.”

Why do Ponzi schemes persist?

Most investors are aware of possible Ponzi schemes thanks to high-profile perpetrators like Madoff. So, why do these schemes persist in such large numbers? “Because many people just don’t do their due diligence,” says Samual Miller, J.D., CFE, a partner at law firm Akerman LLP. He investigates and prosecutes fraudulent conduct on behalf of his clients, including Ponzi schemes. One of Miller’s earlier cases was American record producer and convicted Ponzi perpetrator Lou Pearlman.

“Ponzi scheme perpetrators are really good at what they do,” Miller says. “They take great care to cultivate an appearance of success and legitimacy.” In Pearlman’s case, he had all the outward signs of being a wildly successful record producer. He created and managed some of the most popular bands of the late 1990s, including *NSYNC and the Backstreet Boys. He used his influence to convince individuals and banks to invest in his Ponzi scheme. (See How Lou Pearlman used Backstreet Boys, *NSYNC to lure people into massive Ponzi scheme, by Allie Yang, Ed Lopez, and Gwen Gowen, ABC News, Dec. 13, 2019.)

“The Ponzi schemers are also great at exploiting that ‘FOMO’ [fear of missing out] factor that many investors are susceptible to,” Miller says. “They create a sense of urgency and tell the would-be investors that they need to invest right away, or they’ll miss out on a huge opportunity to get a big return on their investment. Madoff would even tell people that his investments were making so much money that he couldn’t take on any new investors, which only heightened their desire to invest.”

Doing due diligence

Miller says the problem comes when investors don’t do their due diligence before signing over a check. “Many Ponzi victims don’t even do the most basic online searches for information on the perpetrator before they invest,” he says. “It doesn’t take much to find out if the person asking you for money has been convicted of fraud.”

Beyond a simple Google search, Miller says it’s important for investors to check the secretary of state's website (or equivalent) in their state or region to ensure a company is actually registered as a business. “Many regions also have a separate department of financial regulation website that allows searching of licensed investment providers,” Miller says. Additional resources in the U.S. include the SEC website, and the financial broker search tool from the U.S. Financial Industry Regulatory Authority (FINRA).

“Investors should never take the person solely at their word,” Miller says. “In the case of Lou Pearlman, he went so far as to provide forged insurance documents and financials from an accounting firm to would-be investors. These documents were all fraudulent, but for many of the victims, they were good enough, and most didn’t do any of their own searches prior to investing with him.”

According to Miller, investors should pay attention to the following red flags of Ponzi schemes:

• The person describes the investments as short-term loans with high guaranteed returns (combined with encouragement to “re-lend” to keep earning the high returns).
• The person promises investments with high guaranteed dividends (combined with encouragement to “re-invest” the dividends). The dividends quoted are often much higher than more widely accepted standard measurements of stock performance, such as the S&P 500 index.
• Investors have to clear an unusual amount of hurdles for the investor to get their original investment back.

My job is to expeditiously recover as many assets as possible to try to pay back the creditors and victims.

Soneet Kapila CFE, CPA/CFF

While some of the bigger, more complicated schemes such as Madoff’s target professional investors with a high net worth, most Ponzi schemes, such as Lou Pearlman’s, go after less-sophisticated investors.

Ironically, these smaller Ponzi schemes tend to cause bigger losses to their investors, says Soneet Kapila, CFE, CPA/CFF. Kapila has been a federal bankruptcy trustee for more than 25 years and is a founding partner of KapilaMukamal, LLP, a forensic and insolvency advisor in south Florida.

According to Kapila, after a Ponzi scheme falls apart and the fraudster quits paying returns, the immediate result is usually litigation and a forced federal bankruptcy filing by the fraudster/debtor or an equity receivership. Any time a bankruptcy is filed in the U.S. under Chapter 7 of the U.S. Bankruptcy Code, a bankruptcy trustee such as Kapila is assigned to the case. They take over the job of liquidating the debtor’s assets to pay back creditors. In the case of Ponzi scheme-related bankruptcies, they’ll also work with federal authorities and conduct fraud investigations. Kapila worked with Samual Miller on the Lou Pearlman case and served as the bankruptcy trustee.

“My job is to expeditiously recover as many assets as possible to try to pay back the creditors and victims,” Kapila says. “On the bigger schemes such as Madoff’s, that’s easier to do because Madoff targeted investors who already had a high net worth.”

Although most of these investors were also victims, Madoff’s trustees were able to “claw back” any funds Madoff had paid them before the scheme collapsed because of their high net worth. These investors could then turn around and file a claim against Madoff’s trustees for their own losses. This process has led to Madoff’s trustees being able to recover more than 75 cents on the dollar for his victims. (See The Amazing Madoff Clawback, by Tunku Varadarajan, The Wall Street Journal, Nov. 30, 2018.)

“Unfortunately, most Ponzi schemes are smaller and go after victims who don’t have a high net worth,” Kapila says. “In these cases, it’s much harder to build a recovery fund, and many of these victims will only see 10 to 20 cents on the dollar paid back to them.”

Miller says this is the unfortunate reality with most Ponzi schemes. “It’s possible that there’s another Madoff out there, but the smaller Ponzi schemes in the $5 million to $50 million range are going to be much more common and likely more damaging to their victims.”

Make sure you do your due diligence before you invest.

Samual Miller J.D., CFE

Miller’s best advice? “Make sure you do your due diligence before you invest, and if you do find out you’ve been victimized, call your state authorities first [all states should have a financial crimes unit you can find via Google], and call an attorney.” 

See sidebar: Investigating Ponzi schemes

Investigating Ponzi schemes

When investigating allegations of a Ponzi scheme, it’s important for fraud examiners to conduct a full fraud examination. There are many tools available to assist with this on the ACFE website. (See “ACFE Fraud Prevention Check-Up.”) It’s important to note that securities laws will vary depending on the jurisdiction.

The investor resources that Samual Miller cites may also provide valuable evidence to investigators, such as the secretary of state website or financial broker searches. The alleged Ponzi schemer’s lack of a necessary financial license, or if their investment company isn’t incorporated, could be evidence that they aren’t operating legitimately. (See: Swindling the Investor: A Look into Securities Fraud, Fraud Magazine, January/February 2000.)

In most Ponzi schemes, the perpetrator likely isn’t conducting any of the business they claim to be. To prove this, it’s crucial to follow the money trail with a detailed analysis of any available bank records. Madoff, for example, told clients he was investing in well-known stocks. In reality, he was depositing investor funds into a bank account, which he used to make principal and distribution payments. (See Transcript of Madoff guilty plea hearing, Department of Justice, March 12, 2009.)

The examiner must also analyze any available financial statements, prospectuses, sales literature, contracts, and correspondence with the alleged perpetrator. These may be the key to finding any possible misrepresentations or omissions of material facts made by the alleged Ponzi schemer.

Lastly, consider referring the case to law enforcement for prosecution if this hasn’t already been done.