Ponzi Scheme Definition
A Ponzi scheme is an investment scam that involves the diversion of new investments to pay dividends to existing investors. Fraudulent companies that partake in Ponzi schemes typically lure new investors into their schemes by promising them high rates of return as well as negligible risks. Investors that participate in Ponzi schemes are driven to believe that their investments are going into sustainable business endeavors and that profits paid to them are derived from product sales or other legitimate means. Although Ponzi schemes are similar to pyramid schemes in their modes of operation, in the case of the latter, investors are actually aware that they are earning dividends by enrolling new participants.
A Little More on What is a Ponzi Scheme
A Ponzi scheme is a fraudulent tactic of soliciting investments, used by unscrupulous businesses, that involves offering lucrative benefits to unsuspecting investors, irrespective of market conditions. The primary focus of such businesses is to maintain a constant inflow of investments for as long as possible. These new investments are used to pay ‘dividends’ to current investors, who are led to believe that the returns originate from legitimate business transactions. A halt in the inflow of new investments as well as reinvestments by existing investors marks the end of the Ponzi scheme.
History of the Ponzi Scheme
The Ponzi scheme owes its name to Charles Ponzi, an Italian swindler who devised this tactic in 1919 to defraud a large number of immigrant investors. Ponzi started a legitimate business of arbitrating international reply coupons (IRCs) for postage stamps. He soon began leveraging investments from unsuspecting investors in an effort to further expand his business. However, Ponzi soon started using money he acquired from new investors to pay dividends to existing investors. His business flourished for over a year, before authorities finally unearthed what was to be one the the most infamous scams to have ever occurred in the United States. Ponzi’s victims lost an astounding $20 million to his scheme.
However, Ponzi’s scheme was not the first of its kind, and unfortunately, nor was it the last. Sarah Howe had used a similar tactic to swindle Boston women in the later part of the 19th century. In fact, the largest Ponzi scheme ever recorded happened as late as 2008, when Bernard Madoff, a financier had already swindled investors of approximately $65 billion over a 17-year period by forging trading reports to indicate profits.
Characteristics of a Ponzi Scheme
Although Ponzi schemes involve the usage of different technologies and encompass different businesses, they all share the following distinct attributes:
- A promise of high rates of return with negligible risk.
- Steady payment of dividends irrespective of the overall conditions prevailing in the markets.
- Soliciting money for investments that have not been registered with the United States Securities and Exchange Commission (SEC).
- A lack of proper license documents on the part of the ‘investment professionals’ and their ‘firms’.
- Withholding of information pertaining to investment strategies.
- Disallowing investors to view official documents pertaining to their investments.
- Difficulties on the part of investors in receiving or encashing dividends.
Ponzi Schemes vs. Pyramid Schemes
Ponzi schemes are comparable with pyramid schemes in their basic manners of functioning. Both schemes are based on convincing gullible investors to invest in nonexistent business ventures, by promising unrealistically high rates of returns. However, there are certain fundamental differences between the two:
- While in a Ponzi scheme, the schemer or a group of schemers recruits all investors, in a pyramid scheme, existing investors recruit fresh investors, thus helping to propagate the scheme in a pyramid-like progression.
- A Ponzi scheme is founded on the conviction of investors that rarefied investment strategies are the source of extraordinary dividends. However, in a pyramid scheme, it is explicitly communicated to investors that new investments are the sole source of returns for initial investments.
- Unlike pyramid schemes, Ponzi schemes are much more flexible in that they do not necessarily require the induction of new investors in order to survive. A ponzi scheme only fails completely when existing investors fail to renew their investments.
References for Ponzi Scheme
Academic Research on Ponzi scheme
The postmodern Ponzi scheme: Empirical analysis of high-yield investment programs, Moore, T., Han, J., & Clayton, R. (2012, February).In International Conference on Financial Cryptography and Data Security (pp. 41-56). Springer, Berlin, Heidelberg. This paper analyzes a High Yield Investment Program (HYIP), which is a type of online Ponzi scheme that promises exorbitant levels of dividends. The authors classify this scheme as a postmodern fraud, mostly because knowledgeable investors who are able to identify the scheme as fraudulent still go ahead with their investments in the hope of making a quick profit. The authors analyze aggregator website statistics and conclude that connivance within such websites cannot be proven.
Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor, Smith, F. (2010). U. Balt. L. Rev., 40, 215. This paper scrutinizes Bernard L. Madoff’s role in a famous multinational Ponzi scheme and his subsequent trial and sentence. Madoff was noted for recruiting sophisticated investors, which leads the author to question the rationale behind such investors falling prey to his scheme. The paper seeks to answer the important questions of whether sophisticated investors were unable or unwilling to pre-empt such a fraud.
Recognizing the red flags of a Ponzi scheme, Benson, S. S. (2009). The CPA Journal, 79(6), 18. This paper seeks to establish an effective corporate governance countermeasure to the indicators of possible internal financial fraud. It studies the role played by Michael Preston, chief executive officer of Image Innovations Holdings, Inc in investigating incidents of internal financial fraud involving his employees. As such, the incident makes for an interesting case study for management students and such like.
Rethinking Ponzi–Scheme Remedies in and out of Bankruptcy, Levmore, S. (2012). BUL Rev., 92, 969. This paper prescribes the use of bankruptcy legislation to encourage exit from Ponzi and semi-Ponzi schemes, thus accelerating the collapse of such schemes. The author is sceptical about how bankruptcy legislation identifies Ponzi schemes and suggests that it could do a lot more towards recovering investors’ money. He then puts forward plausible remedies for Ponzi schemes.
Analyzing the Bitcoin Ponzi scheme ecosystem, Vasek, M., & Moore, T. (2018). In Bitcoin Workshop. The authors scrutinize the mechanisms of supply and demand in Bitcoin markets and investigate why certain Bitcoin Ponzi schemes are more successful than others. They sample 1780 Bitcoin Ponzi schemes from Bitcointalk threads and conclude that 50% of such schemes lasted for just a week or less. Survival analysis reveals that the schemes that are propagated by highly interactive schemers are the ones that are usually successful. Conversely, the schemes that typically have more interactive investors collapse the earliest.
Handling claims in Ponzi scheme bankruptcy and receivership cases, Phelps, K. B. (2011). Golden Gate UL Rev., 42, 567. Once defrauded by a Ponzi scheme, the primary objective of investors or creditors is to recover the maximum possible amount on their claims. However, the success of such claims depends on whether bankruptcy or receivership proceedings have been initiated against the perpetrators of the Ponzi scheme. Phelps’ paper discusses the fates of investor/creditor claims in both bankruptcy and receivership cases.
SEC settlements in Ponzi scheme cases: putting Madoff and Stanford in context, Larsen, J., & Hinton, P. (2009). The fourth annual institute on securities fraud. This paper scrutinizes the multi-billion dollar Ponzi schemes executed by Bernard Madoff and Sir Allen Stanford. The two infamous Ponzi schemes, worth $50 billion and $8 billion respectively are phenomenally higher in scale than what the U.S. Securities and Exchange Commission (SEC) has handled in recent years. This paper samples and reviews 12 discrete Ponzi schemes worth $50 million or more that the SEC has settled with over 300 defendants.
When Is an Equity Participant Actually a Creditor: The Effects of In re AFI Holding on Ponzi Scheme Victims and the Good Faith Defense, Cash Jr, J. B. (2009). Ky. LJ, 98, 329. The discovery of the Madoff Ponzi scheme and the sheer magnitude of fraud involved has overwhelmed officials at the SEC. The embezzlement has instigated investors as well as news agencies to question current legislation concerning Ponzi schemes. The author contends that when most Ponzi schemes collapse, there arise significant inconsistencies between the actual funds available for reclamation and the amount claimed by the defrauded investors. These inconsistencies ultimately push the Ponzi schemes into bankruptcy protection. However, investors that were fortunate enough to withdraw their investments as well as dividends before the collapse of the scheme are protected by the good faith defense against any claims to their investments or dividends by bankruptcy trustees.
How do investment ideas spread through social interaction? Evidence from a Ponzi scheme, Rantala, V. (2017). The author samples sets of data from a large Ponzi scheme and analyzes the propagation of investment information via word of mouth. Typically, in such a setup, an existing member of the Ponzi scheme invites a new member to join the scheme. The author also observes that existing members that are typically older, richer and more educated are more successful in enrolling new members.
International tax law as a Ponzi scheme, Morgan, E. (2011). Suffolk Transnat’l L. Rev., 34, 69. The author discusses the incongruity of international tax laws and the challenges it presents in implementing such legislation. This paper juxtaposes the existence of a global tax regime with a system that encourages multiple sovereign taxation authorities to levy their own taxes, thus reducing the entire institution of taxation to merely an instrument of revenue generation.
Social security as a Ponzi scheme, Langer, D. (1996). The CPA Journal, 66(3), 12. There have been several instances of social security being referred to as a Ponzi scheme, especially since it uses the money invested by young investors to pay for the expenses incurred by older investors. The author scrutinizes the workings of social security and concludes that social security is not a Ponzi scheme because it is the result of public policy formulated after extensive debate and also because it does not involve any swindling schemers. He contends that the sole purpose of social security is to provide for the retired populace, especially those for whom retirement plans have proven to be inadequate.
A rational, decentralized ponzi scheme, Carpio, R. (2011). Carpio creates an industrial model with a monopoly banking firm and an overlapping generations (OLG) depositor population. The monopoly bank is a Ponzi scheme, and thus, has no lending business. The bank offers interests on deposits made by targeted dynamic depositors. Solving the model numerically reveals the existence of an equilibrium with nonzero savings, provided depositor risk aversion and population growth uncertainty are contained.