Bubble and Ponzi Schemes used in Investment Fraud Scams

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Its Namesake, Carl Ponzi
Named after Carl Ponzi, who collected $9.8 million from 10,550 people ( including ¾ of the Boston Police Force ) and then paid out $7.8 million in just 8 months in 1920 Boston by offering profits of 50% every 45 days.

A swindle of this nature, referred to as a "bubble" for the hundreds of years it has existed and now referred to as a "Ponzi scheme" is basically an investment fraud where investors are enticed with the promise of extremely high returns or dividends over a very short period of time.

This shorter period between payouts and high rate of return is required to create the impetus for the frenzy that is to follow as word leaks out, and is soon verified, by numerous sources. The truly experienced con will balance these two factors ( payout period and promised rate of return ) against the expected duration of the operation so as to maximize his take while still maintaining some semblance of credibility.

In the true sense of borrowing from Peter to pay Paul, ponzi schemes are a simple fraud whereby initial investors are paid exceptional dividends as interest cheques from the deposits of a growing number of new investors.

"Profits" to investors are not created by the success of the underlying business venture but instead are derived fraudulently from the capital contributions of other investors.

A few people invest in the scheme, then as news of the offer spreads, more investors are drawn in. Usually there is no actual investment involved, contrary to your understanding, just money being shipped in from new investors to the earlier ones.

Ponzi schemes eventually collapse because the underlying asset upon which the investment was based either never existed, or was grossly overvalued. And unlike pyramid schemes, where one's potential gain is measured by the active and conscious practice of participant recruitment, ponzi schemes attribute their moneymaking abilities on some elaborate and inventive investment or business process, with the influx of new depositors the result of word-of-mouth only.

There are several distinctions between Ponzi schemes and pyramid selling schemes. A requirement of a Ponzi scheme is the promotion of what starts out to be, or appears to be, a real investment opportunity which investors may passively contribute to.

The pyramid scheme involves a person making an investment for the right to receive compensation for finding and introducing other participants into the scheme. There is a clear understanding among the participants that the success of the opportunity is dependent upon attracting these additional participants.

Pyramid schemes require active participants who will bring in more participants till reaching a finite end. Ponzi schemes can flourish even with passive investors without any responsibility to promote the opportunity.

The similarities are uncanny but the draw of a ponzi scheme is that while most investors are either too lazy, sophisticated or introverted to consider a multilevel marketing program type of pyramid recruitment, even the most astute investor is drawn to a program which has proven itself to be highly successful over time, where the only requirement is providing funds for investment.

Ponzi Scheme - A Fraudulent Technique
It should be emphasized that this type of scheme is the "process" or mechanics of the con rather than a type of investment fraud. Therefore, it can appear as part of other deceptions or contain false investment vehicles which can be used just as easily on their own.

The stated instrument of investment is generally obscure enough to mask it from comparative scrutiny, but really any story will do, as long as payments are regularly made to "earlier investors" to provide credibility. These fortunate few are known as "songbirds" since they sing the praises of the scam to others. Any money paid to investors, described as income or interest, is actually a distribution from the "capital" already received.

The regular payment of so-called dividends induces investors to bring friends, family members, or business colleagues into the scheme and to put up additional funds themselves now that they are convinced of its veracity. The operators will also persuade you, with little effort, to "roll over" your "profits" into another investment cycle, so your actual return ends up being back on paper only.

They may decide to provide you with just "statements" showing you your profits rather than sending out cheques, but the receipt of a cheque in the mail seems to generate more enthusiasm for participants, and it ultimately makes it back to the con at any rate.

This kind of setup relies on keeping his victims from knowing they are being cheated for as long as possible so others can be lured in.

As long as they can convince investors that it is a safe, secure investment which even moderately beats what you are presently getting, you can be convinced to invest. Even if you guarantee a person a 20% return every 90 days on a $10,000 investment, you can pay that person a $2,000 "dividend" cheque out of their own money once every three months for up to 15 months before their money is gone.

That person's eventual shortfall can easily be covered by new deposits, thereby extending the scheme. This, in effect, could actually make money for those early investors that do not reinvest their gains, which is rare. As word spreads of the unique opportunity, money begins to pour in faster than it is going out. Hearing about it, you get hooked by the desire to do what you think you see other people doing around you, making money. Once that rate slows or stops, the con usually closes up shop and disappears.

Because a ponzi scheme is technically insolvent, in the sense that its liabilities exceed its assets from the first day it does business, it can only continue until the pool of gullible new investors dries up. At that point, the scheme collapses or the operator folds it up. The collapse may be accelerated by the promoter's overuse of the money on impressive looking trappings for substantiation, or on personal extravagances, to create the appearance of prosperity.

Many first-time perpetrators of this crime become so accustomed to the lifestyle it generates that they themselves are in disbelief when it crumbles, convinced over time by their own lies.

Ponzi schemes can be applied to almost any business or investment, so when it fails, as it must, people often deem it a poor investment rather than an elaborate hoax. To mask the fraudulent nature of the investment the scammer will often file for bankruptcy after safely hiding the money, then bemoan his failure and offer abject apologies to his loyal followers.

Generally, investors in Ponzi Schemes lose most of their invested moneys because there is no substance whatsoever to the "opportunity". By making a lie look like a truth they cause you to become unwary and abandon your common sense.

Commonly Targeted Victims of Ponzi Schemes:
Clients who have been involved in other, legitimate business activities with their accountant, financial planner, investment banker, broker, etc.
Friends, family members, and business associates of targeted victims

The Man Himself

Like all good con-men Ponzi managed to avoid selling too aggressively and merely presented himself as a man on the verge of wealth who preferred not to discuss his good fortune in detail unless pressed.

While the actual workings of the transaction had to be kept secret for "competitive reasons", Ponzi sold people on the idea that he was purchasing foreign postal reply coupons, at a discount, in depressed economies and making a profit by exchanging them here. He claimed to have a network of foreign agents gathering coupons abroad to keep up with the demand.

Explaining his program for the NY Times he tells his story: "I wrote a man in Spain regarding the proposed magazine and in reply received an international exchange coupon which I was to exchange for American postage stamps with which to send a copy of the publication. The coupon in Spain cost the equivalent of about one cent in American money, I got six cents in stamps for the coupon here. Then I investigated the rates of exchange in other countries. I tried it in a small way first. It worked. The first month $1,000 became $15,000. I began letting in my friends. First I accepted deposits on my note, payable in ninety days, for $150 for each $100 received. Though promised in ninety days I have been paying in forty-five days ."[NY Times, Jul. 30, 1920].

He even started up his own "Securities Exchange Company" then issued notes which stated:



The Securities Exchange Company, for and in consideration of the sum of exactly $1,000 of which receipt is hereby acknowledged, agree to pay to the order of ___________, upon presentation of this voucher at ninety days from date, the sum of exactly $1,500 at the company's office, 27 School Street, Room 227, or at any bank.

The Securities Exchange Company,



Per Charles Ponzi.


In order to earn the millions of dollars Ponzi claimed, astronomical quantities of coupons would have had to be handled. One can imagine hordes of Ponzi agents, pushing wheelbarrows full of coupons to post offices, unloading them with shovels or pitchforks.

Once the flow of investors' money started, he did actually require agents upon agents to handle the volume, and even paid a tiered commission of 10% down to 5% of the money invested. Over 10,000 took his "path to easy riches" with many reinvesting the profits as they came due every 45 days.

When bad press and legal investigations started a run on his company, speculators milled through the crowd purchasing notes from nervous investors at a premium, hoping to redeem them at the full 50% profit when they matured. He even continued to receive funds while in jail, from people still convinced of the program.

After serving four years in jail for this notable scam he was later charged in a Florida "swampland" sales fraud which he joined near the end of its successful run. Investigation revealed that his syndicate would explain how they purchased, at $16 an acre, 100 acres of land which would be subdivided into twenty-three lots per acre. With a $10 price per lot, Ponzi would yield $214 profit per acre. He claimed that under this pyramiding plan, an initial $10 investment would yield $5,300,000 in two years.

He sold "units of indebtedness" promising 200 per cent return in 60 days, but retained the right to pay such returns with either cash or real estate. He made his first sale on November 9, 1925, and had collected $7,000 from investors before mail fraud charges were filed. Pictures of the land revealed that some of the lots were under water. He ended up again serving time before being deported.


Don't Count Your Chickens Just Yet

As you note, some people actually made money in the original and now famous 1920's Charles Ponzi scheme, or so they thought until it went into bankruptcy court.

This move to bankruptcy court is not uncommon amongst ponzi and gifting club schemes. Once there, federal bankruptcy law allows the bankruptcy trustee to unwind some of the debtor's past transactions and have the money returned to the trustee for distribution to the creditors. The amount of time he can go back varies from 90 days to at least a year for fraudulent transfers.

Let's assume that the Ponzi operators have been arrested, sued in civil court, then file for bankruptcy. The trustee sees that they have paid out millions to earlier participants in the last year of operation, but there are hundreds of people who paid in money and got nothing (the victims or "bankruptcy creditors").

The trustee's fees (and sometimes attorney fees) are dependent in part on the size of the bankruptcy estate that he or she is administering. Let me say that again. The trustee, the attorneys, and the victim's recovery is all dependent on the size of the bankruptcy estate.

So just how does the estate reach its maximum size?

The trustee files individual suits against the "successful participants." This allows the trustee to "unwind" the past payouts made by the sponsors.

So, you think everything is great because you got your initial investment and then some before the scheme collapsed? Guess again.

The trustee sees your name on the list. He files suit and wins. He's got a judgment with cost, fees, and interest accruing at 12%. Ouch. But that's not the worst part.

Most people who received an unexpected windfall can't just pay it back when the BKO trustee comes knocking with his federal court judgment. You find you have to sell that new car and those new clothes (at a huge loss).

You can't "untake" that expensive vacation or remove the improvements to your house. So, you end up selling stuff that you didn't even buy with the payout. You may even have to get a second mortgage.

You find yourself wishing that you were one of the "lucky" ones who simply lost their investment.

If you get into a Ponzi scheme, lose it all, and end up with more that 50 cents on the dollar, consider yourself lucky. There the norm is less than 10 cents, if anything.

But heaven forbid you made money from earlier participants. I've seen it happen where a woman whose mother had a "promissory note" in a frequent flyer miles Ponzi scheme had received $10,000 in payments over a couple years, then died and left the promissory note to the daughter, who received $2,000 in payments before the scheme collapsed.

The BKO trustee sought and received a $12,000 judgment against the daughter, even though she had not received any of the earlier payments. So much for being a "successful investor" in a Ponzi scheme.

Mark Fleming
Consumer Protection Lawyer - Seattle 05/02