What is a Ponzi scheme?
Definition and Structure
A Ponzi scheme is a type of pyramid scheme and an illegal investment operation that promises significant returns with little or no risk. The scheme operates by using funds from new investors to pay returns to earlier investors, creating the illusion of a profitable venture.
Historical Background
The concept of Ponzi schemes dates back as early as the 17th century. However, the term is named after Carlo Ponzi, an Italian immigrant who defrauded thousands of New England residents between 1919 and 1920. Ponzi’s scheme involved promising to double investors’ money within 90 days through the trading of European postage stamps. Although his actual investment was only $30 worth of stamps, he managed to defraud investors of approximately $15 million before his arrest in 1920. He was charged with multiple counts of fraud and larceny and sentenced to prison.
Despite the notoriety of Charles Ponzi, the scheme that carries his name appears to have been first perpetrated by Sarah Howe in Boston in 1879. Sarah Howe created the Ladies’ Deposit in Boston, claiming to invest money for women with promises to double their funds in nine months. Like Ponzi, she paid early investors with the funds from new ones.
Key Features of Ponzi Schemes
- High Returns: Ponzi promised a 10% return each month, far exceeding the 5% annual return offered by banks. This promise of high returns with minimal risk attracts investors.
- Attraction Tactics: The scheme lures investors with the promise of unbelievable profits. Operators use diverse, complex, and unique situations to make their story seem legitimate and appealing.
- Investor Psychology: Victims of Ponzi schemes often exhibit “irrational exuberance,” where the desire to emulate others’ perceived success overshadows logical assessment of the investment’s viability. This term, popularised by Alan Greenspan, reflects the speculative mania seen throughout history, such as the 1600s tulipmania.
- Key Mistake: A critical error made by victims is investing in schemes they don’t fully understand. Bernie Madoff, who defrauded investors of $50 billion, suggested that scrutiny of his methods would have revealed their impossibility.
- Sustainability: The scheme relies on continually attracting new investors to pay returns to earlier investors. This cycle must be maintained to avoid detection and prevent the scheme from collapsing.
- Inevitable Collapse: The scheme will collapse when new investors run out, as there will be no funds to pay the promised returns. This lack of new investment leads to the downfall of the operation.
The economic uncertainty caused by the global pandemic has created a stimulus for Ponzi schemes. Beyond the consequences of Covid-19 pandemic from medical and economic perspectives, people had to endure restrictions.
Notable cases:
5. Reed Slatkin — Investment Management — $593 million
Reed Slatkin, a co-founder of EarthLink and self-proclaimed investment guru, operated a Ponzi scheme that defrauded investors of approximately $593 million. He lured friends, family, and fellow Scientologists into his scheme by promising lucrative returns through purportedly exclusive investment strategies. Slatkin’s fraud unravelled in 2001, and he was sentenced to 14 years in prison in 2003.
4. Scott Rothstein — Legal Settlements — $1.2 billion
Scott Rothstein, a lawyer from Fort Lauderdale, ran a $1.2 billion Ponzi scheme through his law firm. He persuaded investors to buy into fake legal settlements, promising high returns. In 2010, he was sentenced to 50 years in prison.
3. Tom Petters — Retail Merchandise — $3.7 billion
Tom Petters, a businessman, lured investors by promising profits from the purchase and resale of retail merchandise. However, the investments were a cover for his $3.7 billion Ponzi scheme. He was sentenced to 50 years in prison in 2010.
2. R. Allen Stanford — Fake Certificates of Deposit — $7 billion
R. Allen Stanford, a Texas tycoon, orchestrated a 20-year Ponzi scheme through his offshore bank in Antigua. He defrauded nearly 30,000 investors worldwide with fake certificates of deposit. In 2012, he was sentenced to 110 years in prison.
1. Bernie Madoff — Investment Management — $20 billion, estimated $50 billion
Bernie Madoff’s Ponzi scheme is the largest in history, defrauding thousands of investors of $20 billion. Operating under the guise of investment management, Madoff’s scheme collapsed in 2008, leading to his arrest and a 150-year prison sentence.
Finance, Politics and Psychology:
Finance:
Jamaican schemes caused losses as high as 12.5 percent of GDP and spread to a number of other Caribbean jurisdictions.
The collapse of schemes in Colombia, which had taken in an estimated $1 billion, was followed by riots and violent protests in 13 cities, and the government was forced to declare a state of emergency.
A scheme in Lesotho lost the money of about 100,000 investors, many of them poor and highly vulnerable. The damage these schemes can inflict requires a determined regulatory response to shut them down at an early stage, before they gain momentum. Regulators and receivers allege that these are Ponzi schemes, although in many of these instances court cases are still pending.
Victims of Ponzi schemes face severe financial repercussions:
Property Sales: Many victims are forced to sell properties, often their homes.
Return to Work: Some must return to work after retirement.
Credit Issues: Nearly 20% of fraud victims have difficulty obtaining credit.
Bankruptcy: In severe cases, victims face bankruptcy.
Politics:
The impact of Ponzi schemes has been greater in countries with weaker regulatory frameworks. This unfortunate pattern is illustrated by the case of Albania in 1996, when riots resulted in the fall of the government and even deaths, and by more recent cases.
Reluctance to Act: Once a Ponzi scheme exceeds a significant size, authorities often hesitate to intervene. Halting the scheme’s operations prematurely had led to subscribers blaming the government rather than the scheme’s inherent flaws. Conversely, when schemes collapse naturally, governments frequently face criticism for not acting sooner.
Regulatory Tools: In industrialised countries, regulators have various enforcement tools, including freezing assets as soon as a scheme is discovered. The judiciary typically supports these measures, allowing for prompt action. For example, in the Madoff case, swift action was taken once the scheme, involving $20 billion, was uncovered.
Challenges in Developing Countries: Developing countries often lack robust regulatory responses and have underdeveloped financial institutions. This allows Ponzi schemes to persist even after red flags are raised.
Many regulators lack the necessary enforcement tools.
Insufficient resources hinder effective action.
Lack of political independence undermines enforcement.
Legal limitations restrict information exchange with global regulators.
Psychology:
Small victims often blame themselves and hide their losses to avoid public humiliation. Even large companies that committed or fallen victim to Ponzi scams prefer to avoid exposure and remain silent. They are afraid of being perceived as companies that are not careful in managing their assets, which can deter customers and cause losses. Even among victims of mass marketing frauds the emotional consequences included feelings of stress, anxiety and loss of self-esteem.
Fraud victims feel themselves to some extent guilty of falling victim to a fraud, similar to the self-blame experienced by victims of rape and violent crime.
Time Investment: Victims spend significant time addressing the economic harm. For instance, victims of identity theft spend an average of 48 hours clearing their name.
Reporting Rates: The reporting rate for Ponzi schemes is notably low, around 1% to 3%, compared to nearly 100% for identity theft. This low reporting rate hinders efforts to combat and prevent such frauds effectively.
Reduction in purchases: Study shows that over 50% of fraud victims have changed their behavioural patterns in terms of purchases and payments. It was also found that some victims stopped shopping online. This hurt legitimate companies operating in the field of telemarketing and mass marketing
Legal Framework:
1. Prize Chits and Money Circulation Schemes (Banning) Act, 1978
Objective: Prohibits prize chits and money circulation schemes that promise quick and easy returns.
Relevance to Ponzi Schemes: Prevents schemes that operate on the basis of taking money from new investors to pay earlier investors, thus curbing fraudulent activities similar to Ponzi schemes.
2. Chit Funds Act, 1982
Objective: Regulates chit funds, which are legally recognized financial instruments involving pooled savings.
Relevance to Ponzi Schemes: Ensures chit fund operations are transparent and regulated, preventing them from being used as a cover for Ponzi schemes.
3. SEBI Act, 1992
Objective: Empowers the Securities and Exchange Board of India (SEBI) to protect investor interests and regulate securities markets.
Relevance to Ponzi Schemes: Provides SEBI with the authority to monitor and regulate investment schemes, including those that may operate fraudulently as Ponzi schemes.
4. SEBI Collective Investment Scheme Regulations, 1999 (CIS Regulations)
Objective: Regulates collective investment schemes, requiring them to be registered with SEBI and comply with specific rules.
Relevance to Ponzi Schemes: Ensures that collective investment schemes are legitimate and not operating as fraudulent Ponzi schemes by imposing strict regulatory oversight.
5. Companies Act, 2013 and Companies (Acceptance of Deposits) Rules, 2014
Objective: Governs the functioning of companies in India, including the acceptance of deposits from the public.
Relevance to Ponzi Schemes: Imposes strict regulations on how companies can accept and manage deposits, preventing misuse of public funds and reducing the risk of Ponzi schemes.
6. Banning of Unregulated Deposit Schemes Act, 2019 (BUDS Act)
Objective: Prohibits unregulated deposit schemes and provides a framework for punishing those involved in such activities.
Relevance to Ponzi Schemes: Directly targets unregulated deposit schemes, which are often synonymous with Ponzi schemes, by banning them and imposing severe penalties for violations.
7. Banning of Unregulated Deposit Schemes Rules, 2020 (Rules)
Objective: Provides detailed rules for implementing the BUDS Act, including procedural aspects for banning and penalising unregulated deposit schemes.
Relevance to Ponzi Schemes: Ensures the effective enforcement of the BUDS Act, enhancing the ability to combat and shut down Ponzi schemes operating under the guise of unregulated deposit schemes.
Detection:
- High returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
- Overly consistent returns. Investments tend to go up and down over time. Be sceptical about an investment that regularly generates positive returns regardless of overall market conditions.
- Unregistered investments. Ponzi schemes typically involve investments that are not registered with the SEC or with state regulators. Registration is important because it provides investors with access to information about the company’s management, products, services, and finances.
- Unlicensed sellers. Federal and state securities laws require investment professionals and firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
- Secretive, complex strategies. Avoid investments if you don’t understand them or can’t get complete information about them.
- Issues with paperwork. Account statement errors may be a sign that funds are not being invested as promised.
- Difficulty receiving payments. Be suspicious if you don’t receive a payment or have difficulty cashing out. Ponzi scheme promoters sometimes try to prevent participants from cashing out by offering even higher returns for staying put.
Prevention:
Internal Auditing:
- Continuous auditing to detect and prevent fraudulent activities.
Effective Enforcement:
- Specialised Training: Training for regulatory staff (e.g., Certified Fraud Examiners).
- Severe Punishments: Implementing strong penalties as a deterrent.
- International Cooperation: Facilitating global regulatory collaboration.
Public Education:
- Investor Awareness: Educate on identifying Ponzi scheme red flags (high returns with low risk, pressure to invest quickly, etc.)
- Social Phenomenon: Treat financial fraud as a broad social issue.
Reform and Sanctions:
- Increased Sanctions: Enhance penalties for financial fraud.
- Legislation Clarity: Clarify laws and business practices for better enforcement.
Professional Expertise:
- Expert Recruitment: Hire financial and accounting experts for risk assessments.
- Due Diligence: Equip stakeholders with fraud detection tools.
Active Engagement:
- Resource Allocation: Provide resources for preventive education by regulators.
- Self-Regulation: Encourage consumer awareness and protective measures.
