Ponzi Schemes

Ponzi schemes are a type of investment fraud where a fraudster pays monies to some investors from funds coming from other investors without their knowledge.  A common Ponzi scheme gives the illusion that the fraudster has a legitimate, profitable business operation when in fact no profits exist and sometimes no business exists.  To maintain the deception, a scheme often takes monies received from newer investors in the scheme and uses at least part of the funds to pay earlier investors a purported return on investment.  Such payments give the illusion that the scheme is a legitimate business activity earning profits.  Effective marketing with a promise of high returns and little or no risk attracts investors.  The scheme ultimately fails when continuing rounds of new investors are hard to recruit or when a large group of investors demand their money back.

Perhaps the best known Ponzi scheme was one operated by Bernard Madoff that collapsed in 2008.  Madoff’s scheme was unique because his New York investment firm began as a legitimate business. However, as his operations grew so did the lies. According to Madoff, he had stopped investing client funds in the early 1990s and had fabricated all his reported investment profits on paper. Madoff’s ability to maintain the scheme was in part due to his secrecy and sales skills. He often would refuse to meet face to face with investors giving him a supreme-like image. This persona made people want to be included in his investments even more with no questions asked. As the 2008 global financial crisis exploded, so did investor requests to withdraw funds that Madoff did not have. The news got out quickly leading to the scheme's collapse. Madoff’s Ponzi scheme is estimated to have been around $65 billion in paper wealth and $1.7 billion in cash, making it the largest in history.[1]

In South Florida, attorney Scott Rothstein perpetrated an infamous and large Ponzi scheme.  Rothstein was a prominent lawyer and managing partner of a large South Florida law firm who won the trust of wealthy investors.  His scheme essentially sold bogus legal settlement agreements to investors.  His purported law clients wanted immediate discounted lump sum payments instead of waiting to receive their full lawsuit settlements in installments over many years. Rothstein told potential investors that his law firm's clients were each legally entitled to receive a large litigation settlement paid by a defendant and the defendant would be making installment payments to his firm over multiple years rather than in full immediately. Rothstein said his clients wanted their money now and did not want to wait. With this desire, the clients were willing to accept a large discount from their full settlement amount to get a large lump payment now. Rothstein told wealthy investors they could earn large returns if they front the money to pay off his clients at discounted amounts and then wait for the full settlement payments to arrive at his law firm from defendants over the next several years. All of this was a lie. Rothstein’s clients and lawsuit defendants did not exist.  He used monies from newer investors to maintain his high lifestyle and pay earlier investors a purported return on their investment. For potential investors, Rothstein told them that they could not examine the settlement agreements for due diligence because the agreements were legally confidential. Investors had to accept Rothstein’s word to get big returns. Rothstein fabricated legal cases, clients, bank accounts, and even court documents to attract investors and maintain his scheme.  Rothstein used monies received from newer investors to give the illusion of real clients, defendants, and lawsuits. His Ponzi scheme eventually collapsed when Rothstein could not maintain the deception. Rothstein pled guilty to his $1.4 billion fraud scheme.[2]

The U.S. Securities and Exchange Commission (SEC) website describes a set of “red flags” for Ponzi schemes:[3]

  • High returns with little or no risk. Every investment carries some degree of risk, and investments with higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
  • Overly consistent returns. Returns from risky investments tend to vary up and down over time. Be skeptical 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 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 do not understand them or can’t get full information about them.
  • Problems with account documents. Account statement errors may be a sign that funds are not being invested as promised.
  • Difficulty receiving payments. Be suspicious if you do not 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.

To report suspected securities fraud or wrongdoing, submit a tip on the SEC website.  In addition, you can use the Investment Adviser Public Disclosure website to inquire about a broker or broker firm. 

[1] Benner, K. (2018, April 12).  Victims of Bernard Madoff’s Ponzi Scheme to Receive Millions More.  The New York Times.  Retrieved on October 27, 2018, from https://www.nytimes.com/2018/04/12/business/madoff-ponzi-scheme-compensation.html
[2] McMahon, P. (2018, February 13). Ponzi schemer Scott Rothstein reveals new details of undercover work in fight with feds. SunSentinel. Retrieved on October 27, 2018, from https://www.sun-sentinel.com/local/broward/fl-reg-scott-rothstein-wants-sentence-cut-20180212-story.html
[3] U.S. Securities and Exchange Commission website. Fast Answers section. Retrieved on October 27, 2018, from https://www.sec.gov/fast-answers/answersponzihtm.html