Ponzi Schemes

What is the key to orchestrating a successful Ponzi scheme? One word: trust. Just as the scheme’s namesake Charles Ponzi swindled money through persuasion and relationships, so did Bernie Madoff when he convinced friends, family and some of the world’s elite to trust him with their money. Even though Madoff’s downfall exposed many red flags of Ponzi schemes into public consciousness, fraudsters are still able to exploit those wanting to believe in something that is too good to be true.

What is a Ponzi Scheme?

Dr. Joseph T. Wells’ Encyclopedia of Fraud, Third Edition describes a Ponzi scheme as an illegal business practice in which new investors’ money is used to make payments to earlier investors. In accounting terms, money paid to Ponzi investors, described as income, is actually a distribution of capital. Instead of returning profits, the Ponzi schemer is spending cash reserves for the purpose of raising more funds. Where a basic investment scam raises money and disappears, a Ponzi scheme stays in business by circulating investor funds. There are usually little or no legitimate investments taking place. Most of the funds are used by fraudsters to maintain expensive lifestyles and transferred into property or offshore accounts. Schemes typically run for at least a year, although some Ponzi schemes can flourish for a decade or more.

Chasing Madoff: Harry Markopolos, CFE

Harry Markopolos, CFE, CFA, couldn’t have known that his first fraud examination would last nine years and uncover the largest ever Ponzi scheme. But that is exactly what happened to the longtime Certified Fraud Examiner and relentless whistleblower who uncovered Bernie Madoff’s yearslong, $60 billion fraud. As Fraud Magazine® reported in 2009: 

“Markopolos’ quest began as a simple work assignment; he was a portfolio manager for an equity derivatives asset management firm in Boston when he was asked to analyze Madoff’s money-making methods. He quickly discovered Madoff was running an old-fashioned Ponzi scheme.

'My team and I tried our best to get the Securities and Exchange Commission [SEC] to investigate and shut down the Madoff Ponzi scheme with repeated and credible warnings,' Markopolos said during his testimony before the Financial Services Subcommittee on Capital Markets. He said he submitted an eight-page document listing red flags and mathematical proof of a major fraud to the SEC’s Boston Regional Office in May 2000.

He resubmitted evidence to SEC offices in 2001, 2005, 2007, and 2008, but to no avail. In 2008, the stock market crumbled, investors rushed in to redeem their investments, and Madoff ran out of cash and turned himself in. After pleading guilty on March 12, Madoff was sentenced to 150 years in prison.

Markopolos was honored with the ACFE’s CFE of the Year Award in 2009."

Ponzi Schemes vs. Pyramid Schemes

From the Encyclopedia of Fraud: “A Ponzi scheme and an illegal pyramid scheme both use new investors’ money to pay earlier investors. The difference between the two lies is in the way each scheme is promoted. Illegal pyramids generate revenue by continually recruiting new members. The promoters may offer merchandise or services for sale — or may not — but the only significant revenues come from recruitment. Though a pyramid-style compensation plan is not illegal, it is illegal to run a business in which recruiting new people generates all of the funds.” 

Ponzi Enforcement

The Encyclopedia of Fraud details the FTC and SEC responsibilities in regards to Ponzi schemes: “The Federal Trade Commission (FTC) and the SEC are the U.S.’s two major enforcement organizations that target Ponzi schemes. Federal jurisdiction privileges allow FTC and SEC agents to pursue scams across state borders. For example, an operation may be incorporated in Delaware, sell most of its products in Los Angeles, and bank its profits in Missouri. Prosecuting has to encompass each venue and relate local activities to the larger scheme.

"The SEC files about 500 complaints a year against unscrupulous investment promoters, and 25% of those are Ponzi schemes. However, the largest number of Ponzi scheme complaints are filed on the state level by state authorities, including attorneys general and state-level regulatory agencies. The FTC shuts down about 10 pyramid schemes every year and takes action of one form or another against dozens of bogus investment opportunities. While the SEC can pursue civil and criminal complaints, the FTC’s powers are limited to civil remedies, usually an injunction and a financial judgment for investor losses." 

Who is Charles Ponzi?

In his book Frankensteins of Fraud, Wells documented the history of Charles Ponzi and how his scheme became a well-known — yet remarkably enduring — fraud of modern times:

Known as the father of the Ponzi scheme, Charles Ponzi, or Carlo Ponzi, was born in 1882 in Parma, Italy. He came from a family of hoteliers and was sent to Rome for a university education. But a string of gambling debts and criminal charges for theft and forgery cut short his schooling and prompted his family to send him to America. At the age of 19 he arrived at Boston Harbor. In his self-published autobiography, "The Rise of Mr. Ponzi," he claimed that he had only $2.50 with which to begin his new life. He had left with $200 in cash from his family but lost the greater part by gambling with some of his shipmates.

After working odd jobs, Ponzi was employed as a bank clerk in Montreal, where he began handling international wire transfers. Ponzi began stealing immediately, was arrested and served time in prison before eventually making his way back to Boston. There his plan took shape. Wells explains:

Ponzi hatched what would become known as the Ponzi scheme in December 1919. A coalition of international postal services had begun selling postal reply coupons after World War I ended. Each coupon was good for one stamp in any of the affiliated countries; this allowed the mail services to continue operations smoothly despite the instability of most European currencies at the time. Ponzi reasoned that he could persuade investors to capitalize on the fluctuating currency prices by using the postal reply coupons in a series of exchanges.

Instead of making legitimate trades, Ponzi “used money from his latest round of investors to pay those who’d purchased his ‘securities’ earlier. By convincing people to reinvest their funds he was able to postpone his financial obligations even longer.” Wells writes that Ponzi’s scheme was exposed by newspaper reports in 1920, and despite his claims of innocence, “a federal audit confirmed his operation was bankrupt, owing perhaps $4 million or more to investors.”

Wells describes the rest of Ponzi’s life as one of a fugitive and swindler:

After his arraignment, Ponzi jumped bail and fled to Florida, where he sold swampland as investment property. He and his wife Rose were both arrested in Jacksonville in 1924 and charged with fraud. The charges against his wife were dismissed but Ponzi was ordered to stand trial. However, an errant judge, not realizing he had one of the country’s most infamous swindlers before him, allowed Ponzi to post bail. He fled on a ship bound for Genoa, Italy. Authorities later apprehended him when the ship docked in Houston, Texas. Ponzi was convicted in federal court in 1925 and sentenced to 5 years imprisonment. After serving 3 years he was turned over to the Massachusetts judicial system, which sentenced him to seven more years.

Though he fought the deportation charges against him, Ponzi was forced to return to Italy in 1934. Frederico Mussolini, who was eager to hear how his countryman had wreaked such havoc in the American financial system, received him warmly. His family connections eventually won him an appointment as the business manager to an Italian airline headquartered in Rio de Janeiro. He lost the position when it was discovered that the airline was being used to smuggle diamonds, strategic materials, and spy communications to the Fascist regime. Ponzi was apparently innocent, later expressing his consternation that he had not been recruited into the effort.

Sometime in the 1940s he paid a small press in Brooklyn, New York to print his autobiography, "The Rise of Mr. Ponzi." Extant copies are available at the University of Texas and the Library of Congress, but the book was never reprinted. Charles Ponzi died penniless in a charity ward outside of Rio in 1949.