It feels comfortable to have an expert on your side, leading many investors to seek the assistance of investment advisors. And with the stock market seeing regulatory upgrade after regulatory upgrade, investors feel safer and tend to have an overall trust in the financial system as a whole.
When scams happen, unsuspecting investors are often caught off guard.
One of the most common investing frauds — the one that made Bernard Madoff infamous in the United States and around the world — is known as the Ponzi scheme. The ultimate investment fraud that scammers have been taking advantage of since the early 1900s, the scheme has resulted in the loss of billions of dollars.
What Is a Ponzi Scheme?
A Ponzi scheme is a form of fraud in which investors are attracted to an opportunity by someone they believe to be a highly regarded investing professional. In most of these schemes, the Ponzi schemer not only suggests the possibility of high returns but promises or “guarantees” them.
Investors who get in early don’t see the signs for some time because earlier investors are paid returns generated from the deposits made by new investors. Because early investors are earning the money they were promised, they often speak highly of the investment opportunity, leading others to join in.
Eventually, the book of early investors becomes too big, making it impossible to pay the promised returns out of the money being brought in by new investor deposits. This is when the scheme falls apart.
At some point, the well runs dry, and with no money to cover return obligations, the scheme implodes, resulting in losses for all.
The First Ponzi Scheme
The first-ever Ponzi scheme started in the early 1900s with an Italian immigrant to Boston named Charles Ponzi. And, believe it or not, the investment started with good intentions.
Ponzi found an opportunity in international reply coupons. These postal reply coupons were designed as a way for international mail senders to send recipients return postage. When a postal reply coupon was received, it could be exchanged for postage stamps issued by the recipient’s country.
Ponzi discovered that if he purchased these reply coupons in Europe, they were worth more in the United States. If he could purchase them in large enough quantities, he would be able to generate significant profits.
He quickly brought his investment thesis to friends and family, and the word spread.
Unfortunately, Ponzi turned out to be a swindler. Instead of purchasing and cashing in mass quantities of these coupons, he was pocketing most of the money and filtering money from new investors to early investors to make it look like they were earning the promised returns.
Ponzi was his own worst enemy. When the heat turned up, his arrogance led him to request that regulatory authorities audit his books in an attempt to calm his critics. The authorities called his bluff and audited his books, and he was soon thereafter tried for fraud and pleaded guilty, for which he was sentenced to five years in prison.
He was later found guilty on additional charges and was involved in another fraudulent scheme while out on bail, resulting in up to 10 more years’ worth of prison sentences before he was deported to Italy in 1934, according to the Smithsonian National Postal Museum.
How Ponzi Schemes Differ from Pyramid Schemes
The scheme described above may remind you of another type of scam, the pyramid scheme. However, these are different types of frauds.
With pyramid schemes, unsuspecting victims are lured in and paid to recruit other unsuspecting victims to sell products or services that aren’t worth their weight in manure. Eventually, without membership fees coming in from new salesmen, there’s no money to pay those even at the top of the pyramid, and the whole thing falls apart.
In Ponzi schemes, early investors are paid by new investors, but there’s only one person recruiting victims. Nobody is paid to recruit new salespeople, and investors aren’t expected to purchase any inventory or go door-to-door trying to sell products. Rather than an entrepreneur-focused get-rich-quick scheme, Ponzi schemes are based on fraudulent investments in passive assets.
Bernie Madoff’s Ponzi Scheme
Bernie Madoff is one of the most notorious fraudsters in history. Once viewed as one of the foremost experts in the stock market, Madoff held positions as the Chairman of the Nasdaq and the founder of Bernard L. Madoff Investment Securities, LLC, a highly successful investment firm.
Madoff had a pretty unique scheme going. Most Ponzi schemes attract investors by promising returns that are significantly higher than market averages. However, Bernie didn’t quite have to do that. Because of his stature among the elite professionals on Wall Street, people trusted him.
In fact, his victims were quite close to him.
To pull off the scheme, he put together a fund that he said tracked the S&P 500 index closely. In order to stay under the radar, he only advertised his investment opportunity to wealthy investors.
Throughout the process, the con artist kept all of his SEC filings up to date and consistent with what he said he was providing. Unfortunately, the numbers he was reporting were far from the truth.
By the time of his arrest, filings for the fund suggested that it had grown to be worth more than $60 billion when in actuality the fund had less than one-quarter of that in assets under management.
Madoff’s Scheme Falls Apart
All seemed to be going well for Madoff. He had built a massive fund the market valued at $60 billion and he was living the high life. That is, until the economic collapse that took place in 2008.
Fearful investors rushed to the market to cash out their investments in hopes of moving their money into safe-haven investments for a safer store of value. Unfortunately for Madoff, investors began selling out of equities, including his fund.
In the heat of the Great Recession, a stressed-out Madoff decided to talk to his sons, explaining to them that his fund was worth nowhere near $60 billion and that the entire thing was a scheme he had been working for years.
Unfortunately for Madoff, and fortunately for the investing community, his sons weren’t impressed by his ill-gotten riches and quickly went to federal authorities to turn their father in. Madoff was arrested in 2008, leading to his conviction and a sentence of 150 years in federal prison, according to the United States Department of Justice.
On April 14, 2021, Madoff died at age 82, still serving his sentence in federal prison. To date, $13 billion of the $17.5 billion stolen from investors has been returned, according to USA Today. Unfortunately, the remaining $4.5 billion remains lost to the scandal.
Signs of a Scheme
Ponzi schemes have been taking place for more than a century. If you’re involved in the world of investing, it’s important to know the warning signs in order to avoid being caught up in the next scheme.
Some of the most telltale signs of a con in progress include:
1. Promised Returns
Any reasonable investor knows that when you make an investment, money can be lost and it can be gained. Anybody who tells you otherwise is either delusional or trying to scam you.
Sure, the pros will tell you how good they are, but they’ll always warn you that there’s risk. Promises otherwise are one of the biggest red flags of a scam.
2. Unlicensed Professionals
Many licensed financial professionals — including all investment advisors registered with the U.S. Securities and Exchange Commission (SEC) — have a fiduciary duty to their clients, meaning they are required by law to act in your best interest.
Unfortunately, many schemes are run by unlicensed “gurus” who take advantage of unsuspecting investors. If the financial advice you’re being given is being provided by an unlicensed provider, chances are you should turn and run.
3. Heavy Promotion
Ponzi schemes only survive as long as there are new investors throwing money into the ring. As soon as new incoming investments dry up, the scheme falls apart.
As a result, those who run these schemes are often heavily promotional, paying promoters tens or even hundreds of thousands of dollars to hype up the investment or disseminate false information in magazines and across the Internet.
4. Missing Documentation
Scammers in charge of these schemes generally can’t provide accurate documentation and couldn’t keep up with regulatory filing requirements if they wanted to.
As a result, these schemes are often missing key documentation like account statements, balance sheets, and other materials that give you a transparent view of the inner workings of the asset at the center of the investment.
How to Protect Yourself from Ponzi Schemes
In general, protecting yourself from these types of schemes is relatively simple. Keep these tips in mind when making your investments.
1. If It Sounds Too Good to Be True…
You know the old adage, “If it sounds too good to be true, it probably is.” This is nowhere more true than in investing. If you’re promised significant returns with “no risk,” run like the wind.
2. Do Your Research
Successful investing is the art of balancing risk and reward as a result of detailed fundamental and technical knowledge of the asset you’re investing in.
When researching a company or fund, take the time to dig through its recent regulatory filings and press releases, and even consider looking to social media to get an understanding of what other investors think about the asset.
The more you know about the asset, the less likely you are to be the victim of the next fraudulent investment.
3. Verify Licensing
The only experts that should be giving you advice as to how to invest your money are licensed financial professionals. These could be financial advisors or registered investment advisors, but it’s important that you ask for their licensing information and verify it.
If they have an active registration with the SEC or a state securities regulator, your advisor has a legal responsibility — known as a fiduciary responsibility — to act in your best interest.
4. Invest in Trusted Companies
When making your first investments, look to established companies you know that sell the products or services you use on a daily basis.
By avoiding small, over-the-counter securities, you’ll have the added benefit of the regulations that govern the major U.S. stock exchanges, which adds a level of protection.
Always Report Fraud
The investment industry is governed by a series of securities laws enforced by regulators like the SEC and the Federal Trade Commission (FTC). However, there’s quite a bit going on in the market at any given time and it’s impossible for these regulators to catch everything.
While the market is often portrayed as a battle between the bulls and the bears, it’s much more than that. The market is a community of investors, all with the same goal of using the tools and opportunities provided by financial markets to build or maintain wealth.
An important part of any community is the willingness of its participants to look out for one another. If you come across a Ponzi scheme — or any other fraudulent activity, for that matter — do your fellow investors a favor and report the activity to regulatory agencies.
The easiest way to do so is to report the activity to the SEC at SEC.gov.
Are Hedge Funds a Form of Ponzi Scheme?
Many argue that hedge funds are similar to Ponzi schemes, and in all reality, it’s a hard argument to fight against. It all boils down to the difference between realized and unrealized gains.
- Realized Gains: Realized gains have actually happened. For example, if you purchased a stock for $50 and sold it for $75, you ended up with $25 in realized gains.
- Unrealized Gains: Unrealized gains are gains reported on assets that haven’t been sold yet. For example, if you buy a stock at $50 and its price climbs to $75, but you don’t sell, you have $25 in unrealized gains. The gains don’t become solidified (realized) until the asset is sold.
Hedge funds don’t liquidate all their assets when making financial reports. Instead, much of the growth reported among these funds is in unrealized gains.
That creates a big problem.
Hedge funds aren’t like exchange-traded funds (ETFs), index funds, or mutual funds that are only able to invest in select, relatively liquid assets. They are unregulated firms that can invest in riskier assets, such as derivative investments like mortgage-backed securities and other value swaps.
Not only are these assets usually illiquid for a relatively long period of time, but due to their lack of liquidity, it’s hard to pin down a true value.
In some cases, these funds will use the most optimistic price estimates when accounting for unrealized gains. In doing so, they’re essentially telling investors they have assets worth a certain amount of money when, in all actuality, they could yield far less of a return when those assets actually sell.
Unfortunately, this practice is completely legal. Fortunately, most investors simply can’t invest in hedge funds due to significant upfront costs that limit access.
Final Word
Bernie Madoff climbed the ladder to make it to places even some of the most well-respected experts on Wall Street could only dream of. Unfortunately, much of what brought him to the top was a lie, and when that lie came out, thousands of investors lost millions of dollars.
Ponzi schemes are a relatively common way for scammers to get one over on investors, and when they happen, the cost is often tremendous. Although Madoff was caught and convicted, many of his victims were financially ruined because of his actions.
As an investor, always research what you’re investing in and keep in mind that if it sounds too good to be true, it probably is. By actively getting to know the assets you’re investing in, you can protect yourself from being the next victim.
