Ezor: As Ponzi schemes collapse, a lesson for businesses

Ezor: As Ponzi schemes collapse, a lesson for businesses

by Commentary
Published: February 23, 2009
Tags: fraud, Ponzi schemes, scams

With the multiple allegations of record-breaking and heart-breaking Ponzi schemes in the news, the common theme has been the lesson for consumers: “If it seems too good to be true, it probably is.”

Hopefully those lessons are filtering their way into the minds of those who might otherwise fall for the lofty promises of future Ponzi schemes.

At the same time, though, legitimate businesses can learn a great deal from the allegations against Madoff and Agape World and the stories of their predecessors dating back to the “new money for old” namesake himself, Charles Ponzi. These lessons are not about how to run a successful scheme, but rather about risk management in all its forms.

A common theme in many Ponzi schemes is that their founders did not start out intending to defraud anyone. Instead, the ventures started out as legitimate businesses but, whether because of bad planning or outside market forces, became unsustainable. At the key moment, though, where the companies could have admitted their failure to their investors and shut down, they chose instead to prop up the operations by using newly obtained investment money to “pay back” the earlier investors. Once the firms started down that road, they quickly spiraled into insolvency, potential illegality and ultimate failure anyway, since no Ponzi scheme can grow forever.

All companies make commitments to others, and it can be embarrassing and even business-threatening to fail to fulfill them. The Ponzi path, though, shows how much worse it is to try to hide failure with financial or other tricks. Instead, business owners need to have the courage to admit failure, remedy the situation if possible and deal with the consequences whatever they may be. If Madoff had been brave enough to tell his investors when his first set of promised returns didn’t materialize, billions in losses and many personal and institutional tragedies could have been avoided.

One surprise in the recent allegations is the number of sophisticated individuals and organizations that were taken in, whether directly or through intermediaries. A common thread connecting these victims is that they failed to ask for regular statements of where and how their money was being invested, which would have revealed the improprieties long before the scheme collapsed.

Any time a business is relying on another’s financial health or management, it must demand and receive frequent, detailed disclosure about those key elements. Additionally, when the other party’s finances are critical to the business’s own survival, requiring it to get sufficient insurance to back up those finances is a major risk reducer. At the same time, though, companies should provide transparency in their own operations, which will improve customer confidence and employee morale. It will also give regulators less reason to consider an audit or enforcement action.

Finally, don’t promise the moon. Marketing is about convincing consumers that your offering is better than the competition’s. Even so, there is always the temptation to inflate the claim, hype the performance and blow the competition away. The Ponzi lesson is simple: don’t. Not only does one risk disappointed customers, but just as Enron and Worldcom led to more scrutiny of public companies, so too have the recent alleged Ponzi schemes put both consumers and enforcement agencies on their guards for “too good to be true” promises. Instead, focus on what you actually do better than your competitors, make sure your advertisements and sales pitches comply with relevant law, and your business is much less likely to fall into the Ponzi trap.

Jonathan I. Ezor is an assistant professor of law and technology at Touro Law Center in Central Islip, the director of Touro’s Institute for Business, Law and Technology and serves as counsel to The Lustigman Firm in New York City.