Ponzi Schemes: A Critical Analysis

by Surendranath R. Jory, Ph.D., and Mark J. Perry, Ph.D.

Surendranath R. Jory, Ph.D., is an assistant professor in the department of finance at the School of Management at the University of Michigan-Flint. Mark J. Perry, Ph.D., is a professor of finance and business economics at the School of Management at the University of Michigan-Flint.

Executive Summary

The 2009 conviction and sentencing of American investment adviser Bernard Madoff to 150 years in prison for 11 federal crimes involving a $65 billion Ponzi scheme has increased public, investor, and financial industry awareness of this type of investment and securities fraud. The literature for a financial adviser audience on Ponzi schemes is limited, and this paper attempts to help fill that void. We provide an overview of how these fraudulent investment schemes operate and offer a detailed analysis of how financial advisers and their clients can detect them. Other topics covered include a discussion of the motivations and traits of Ponzi perpetrators and the conditions under which they operate their illegal schemes. Next, we discuss the legal consequences of being involved in such schemes, and provide an overview of how regulators have fared against Ponzi perpetrators. Most importantly, we develop an itemized and detailed checklist to help investors, financial advisers and brokerage clients identify fraudulent investment schemes. Ponzi perpetrators depend on finding willing investors, and the better informed and educated both financial planners and their clients become about Ponzi perpetrators, the less likely financial con artists like Bernard Madoff will find and exploit victims.

In a typical Ponzi scheme, investors are told they will earn abnormally high returns because of the scheme promoter's unique skills and investment strategy. Instead, the promoter raises money from new investors to make those payments. The Federal Bureau of Investigation (FBI) defines a Ponzi scheme as follows:
A Ponzi scheme is essentially an investment fraud wherein the operator promises high financial returns or dividends that are not available through traditional investments. Instead of investing victims' funds, the operator pays "dividends" to initial investors using the principle [sic] amounts "invested" by subsequent investors. The scheme generally falls apart when the operator flees with all of the proceeds, or when a sufficient number of new investors cannot be found to allow the continued payment of "dividends."¹
Ponzi schemes are named after Charles Ponzi, who in 1919 led investors to believe that they could earn a 50 percent return in as little as 90 days. Ponzi was convicted and jailed in 1920 for financial fraud. One of the most recent and notable Ponzi schemes is the one perpetrated by Bernard Madoff. The estimated cost of the scheme (involving almost 8,000 clients) is in excess of $50 billion. The New York Times reported that "the Ponzi scheme orchestrated by Bernard L. Madoff was the largest fraud by anyone in American history, involving $65 billion and damaging the finances of thousands."² Madoff was arrested in 2008, pleaded guilty to 11 federal offenses in 2009, and was sentenced to 150 years in prison shortly thereafter.
A Ponzi scheme is structured as a pyramid wherein more money is needed in each round to make payments to existing participants. For example, a Ponzi perpetrator approaches an investor for a one-year investment that pays a return of 20 percent. The investor invests $100,000, expecting $120,000 in a year. At the end of the year the Ponzi perpetrator approaches another investor, promising the same results, but demanding an initial investment of $120,000 this time. Assuming that the second investor accepts the proposal, the perpetrator takes the money and pays off the first investor. The cycle continues the third year (funds needed are now $144,000), the fourth year (funds needed are now $172,800), and so on. The initial reward for running a Ponzi scheme is huge. In the example above, the Ponzi perpetrator pockets the initial $100,000.
Ponzi schemes are doomed because their funding requirements increase geometrically over time (as the above example illustrates). Consequently, there are not too many exit strategies for the person running a Ponzi scheme. He or she will ultimately have to find a legitimate investment that pays off handsomely in order to make sufficient money to cover the fraud, or else, run and hide, fake suicide, commit suicide, seek immunity, or get caught.
There are many types of Ponzi schemes. Theoretically, a government may run what is referred to as a "rational Ponzi game."³ This happens when the government issues new bonds to pay its existing bondholders and rolls over its debt perpetually under the assumption that future generations will continue to lend.⁴ A sovereign default is also akin to a Ponzi scheme, especially when there are no sanctions forthcoming from other countries (i.e., a case where there are no default costs and debt claims are not enforceable).⁵ Last, but not least, many public pension funds are known to have overpromised when they were grossly underfunded.⁶
We do not cover rational Ponzi games in this paper, and instead focus on those schemes where investors are deceived, which involve illegal investment frauds. While we focus on schemes that are run as investment funds, we caution that not all schemes are operated as such. Ponzi schemes may take the form of a business proposition as well; for example, sourcing items at a lower price and selling them at a higher price in a different market or investing in real estate, among others.
We have seen a resurgence in the number of Ponzi schemes in recent years. In 2009, 20 percent of the fraud cases investigated by the U.S. Securities and Exchange Commission (SEC) were Ponzi schemes.⁷ While Bernard Madoff's Ponzi scheme was massive, most are run on a smaller scale. Nonetheless, the collective harm the ensemble of Ponzi schemes cause is significant. According to data compiled by Investment News, schemes involving $9,244 billion in losses were revealed in 2010.⁸ Madoff's scheme alone cost thousands of investors nearly $65 billion. In 2009, Allen Stanford, a Texan billionaire and cricket promoter, was indicted of defrauding at least 30,000 investors of $7 billion by selling fake certificates of deposit through his bank based in Antigua. Madoff and Stanford's victims' losses are not covered by the federal Securities Investor Protection Corp. (SIPC), which safeguards investment accounts against fraud or bankruptcy.⁹ There is the risk that many such schemes are still operating today without the knowledge of their investors. Therefore, we need a framework to protect these investors and others who may fall prey to Ponzi perpetrators.
In this paper we first look at several aspects of Ponzi schemes that might be useful for financial practitioners, including the motivations and traits of Ponzi perpetrators and the conditions under which they operate. Secondly, we look at how a Ponzi scheme is structured, what motivates a Ponzi perpetrator, and how to identify Ponzi schemes. Finally, we discuss the legal consequences of being involved in such schemes and provide an overview of how regulation has fared against Ponzi perpetrators.

The Structure of a Ponzi Scheme

To better understand Ponzi perpetrators, we first need to look at how a Ponzi scheme is structured. Consider our earlier example, a Ponzi scheme that starts with $100,000 and pays off 20 percent annually. To make the example more realistic, we will assume that no investor puts in more than $50,000 in the scheme. We present one scenario for the first four years of the scheme in Figure 1.

Figure 1: The Structure of a Ponzi Scheme Promising a 20 Percent Return


Year	Funds Needed	Amounts Raised ($1,000s)										# of Investors
0	$ 100,000					$ 50.00		$ 50.00				2

1	$ 120,000				$ 40.00		$ 40.00		$ 40.00			3

2	$ 144,000				$ 48.00		$ 48.00		$ 48.00			3

3	$ 172,800			$ 43.20		$ 43.20		$ 43.20		$ 43.20		4

4	$ 207,360		$ 41.47		$ 41.47		$ 41.47		$ 41.47		$ 41.47	5

Year 0 is today, and $100,000 is needed to start the scheme. As a result, the scheme needs at least two investors contributing $50,000 each. Given a 20 percent rate of return, the promoter needs to pay $120,000 total at end of the first year. Therefore, he needs to raise a total of $120,000 in Year 1 to make those payments. He solicits three investors who contribute $40,000 each. At end of Year 2, the promoter now has to repay those who contributed last year $48,000 each. Therefore, he raises $48,000 from three new investors at the end of Year 2 to make those payments. These new investors need to be repaid $57,600 each for a total of $172,800 at the end of Year 3. Therefore, the promoter solicits new investors once again, and collects $43,200 from four investors this time to make those payments. The sequence goes on like that.
What do we observe? First, the Ponzi promoter pockets the initial $100,000. That's his initial financial gain from running the scheme. Second, the funding requirement increases at the rate of (1 + rate of return) every year; that is, it increases geometrically. Third, given finite wealth, more and more investors are needed over time. For example, two are needed to start the scheme, three in Years 1 and 2, four in Year 3, five in Year 4, etc. Therefore, the scheme relies on an infinite supply of capital. However, this is obviously not possible, and that is one reason Ponzi schemes eventually fail.
Next, in the four-year period displayed in Figure 1, we assume that the promoter is able to attract new capital as required. What if in Year 1 he can only manage to recruit two investors instead of three, and the two investors cannot supply the capital needed? The scheme will fail in that year. This explains why Ponzi schemes are at risk even if only one investor desists.
In Figure 1, the promoter expects the Ponzi scheme to outlast him. To achieve that end, he will pay a return slightly higher than the opportunity cost of investors' capital, start the scheme later in his career, or run the scheme where there is an abundance of capital and/or investors. Also, to avoid suspicion, the promoter does not promise a return too much higher than the opportunity cost of capital. Given our example, we are slowly gathering the conditions that favor Ponzi schemes: (1) such schemes are more likely in a boom or asset bubble, (2) they are more likely in a market with more investors compared to one with fewer, and (3) they are more likely in an environment where financing is easily available either through excess savings or credit availability. At the same time, they are likely to be uncovered when the reverse of each happens; that is, in a recession and/or when investors pull out of the market and/or in a credit squeeze. This would explain the relatively high number of Ponzi schemes uncovered in 2008 and 2009, a recessionary period with financial, banking, and credit problems.
Earlier we wrote that the promoter expects the Ponzi scheme to outlive him. However, this is very unlikely. Ponzi schemes, in real life, are more complex than the one described in Figure 1 and involve far more investors. For example, the Ponzi scheme operated by Bernard Madoff involved thousands of clients and billions of dollars. His clients included investment management firms (such as Fairfield Greenwich Advisors, which lost $7.5 billion in the scheme, and Tremont Group Holdings, which lost $3.3 billion), international banks (Banco Santander of Spain lost $2.87 billion; Bank Medici of Austria lost $2.1 billion; Fortis of Holland lost $1.35 billion), pension funds, insurance companies, wealthy individuals, and a whole group of diverse and sophisticated investors. A scheme of that size and reach will sooner or later attract curiosity and scrutiny, and that is exactly what happened in the case of Madoff.¹⁰ Hit by a wave of redemptions, the scheme becomes unsustainable. When the SEC starts investigating the scheme, its days are likely numbered, although Madoff managed to survive for many years after the SEC was first presented with evidence.

What Are the Motivations of a Ponzi Perpetrator?

The main motivation of a Ponzi perpetrator is surely financial. However, it is clear that the scheme will unravel one day. Therefore, either perpetrators think that day is too far in the future to be bothered by, are confident they will find a way out, or simply ignore the risk. Mitchell Zuckoff, a journalism professor at Boston University and author of Ponzi's Scheme: The True Story of a Financial Legend, says that Ponzi perpetrators are self-delusional.¹¹ Ponzi perpetrators are surely overconfident and skilled at deceiving others. Last but not least, their urge to make money takes precedence over any risk considerations, maybe because of their need to finance lavish lifestyles without regard to possible consequences.

Who Are Ponzi Perpetrators and What Are Their Traits?

A survey conducted by KPMG's Forensic Professionals on corporate fraudsters (i.e., employees committing white-collar crimes within their organizations), found that fraudsters are most likely to be males between 36 and 55 years old who act independently and locally, have a finance background, and are motivated by greed and opportunity.
Bhattacharya lists three critical components of a Ponzi scheme: the perpetrator (1) convinces a group of people about an investment idea, (2) promises a high rate of return, and (3) builds credibility by initially delivering on his or her promises.¹² We add that the investment idea frequently sounds sophisticated and complicated. Ponzi perpetrators promise rates of return that defy economic cycles. They make their first payments as promised, to create trust and to prop up an ensuing word-of-mouth publicity chain to attract more investors.
To be able to sell a false idea of consistently high returns, it is likely that Ponzi perpetrators are charismatic salespeople, persuasive and good at successfully closing a sales pitch.
Initially, Ponzi perpetrators focus their attention on targets related to them either socially or professionally. The way they approach these people is more psychological in nature than factual, and they exploit the trust between them and people they know. However, after the scheme evolves, that initial group will not suffice to sustain it, and the door is then opened to outsiders.
Upon receipt of investment funds from the targets, Ponzi perpetrators may issue counterfeit certificates to show that the investor has contributed. Perpetrators may also produce fake certificates of securities as collaterals, and they may even fake their own identity as well.
To manage the operation, employees of a Ponzi perpetrator are usually close family members, relatives, or friends. Employee turnover is very low, and this is important to concealing the scheme. Some Ponzi schemes are registered in offshore centers where regulation is not strict.
Ponzi promoters are known to be generous donors and regularly contribute to charities, educational institutions, and political campaigns. The more political connections the perpetrators have, the more confident they are about continuing their operations without being caught.

Evidence on Ponzi Schemes

In an attempt to better understand how Ponzi schemes operate, we collected data on 80 Ponzi schemes investigated and reported by the SEC and the FBI, and we present our findings in Table 1.

Table 1: Observations from Ponzi Schemes Investigated by the SEC and the FBI

Places	Most Ponzi schemes are located in populous states: California, Florida, Illinois, New York, New Jersey, and Texas top the list.
Co-perpetrators	One in every two Ponzi schemes involves co-perpetrators.
Company Name	Ponzi schemes commonly operate under a company name.
Business Type	Most Ponzi schemes purport to operate legitimate financial businesses such as investment advisory, asset and investment management, hedge funds, real estate investment funds, faith-based investment schemes, investment in distributorships, leasing companies, time-shares, pension management, and trusteeships.
Registration	Small Ponzi schemes mostly operate as unregistered businesses; however, large ones are registered.
Frequency	Their numbers increased significantly in the first decade of the 2000s, coinciding with a bullish stock market period.
Termination	An unprecedented number of Ponzi schemes fell apart in 2008 and 2009, coinciding with a financial crisis and an economic recession.
Promised Return	The most common rate of return promised is close to that available from stock market investments.
Investment Horizon	The majority of Ponzi schemes promise to pay a return within a year.
Investors’ Pool	The average number of investors involved in a Ponzi scheme is 100 or less. Larger Ponzi schemes affect thousands of investors.
Strategies	Besides misrepresentatiing their businesses, Ponzi perpetrators adopt one or more of the following strategies to draw investors: - Propose investments that are high-return, no-risk, and principal-protected - Grossly inflate the amount of funds under management and the returns paid - Pretend that they are experienced and had a successful investment career - Purport to use proprietary trading software and/or special connections - Send regular account statements that show fictitious profits - Provide investors a personal guarantee for their principals - Claim investments are fully backed by collaterals - Have auditors who will “vouch” that the investments and accounts are legitimate - Make false claims that investments are FDIC- and/or SIPC-insured - Claim to be an expert in derivatives and/or foreign exchange trading - Use Bible-speak to win investors’ trust - Recruit through local and/or community-based ads and/or agents - Target faith-based and/or ethnicically or culturally based associations - Target retirees
Investment Products	Besides stock market and derivatives investments, Ponzi perpetrators also propose the following as investment products: postal coupons, accounts receivables, automated teller machines, private investment in public equity (PIPE) securities, pay-phone lease programs, foreign currencies, fractional interests in discounted life insurance, gold coins, limited partnership interests in trade ventures, oil and gas investments, promissory notes, self-styled certificates of deposit, faith-based investment funds, real-estate investment trusts, shares in shell companies, time-shares, and viatical settlement contracts.
Investors Recovery	There are almost no cases in which all investors involved recovered 100 percent of their investments. The average recovery rate is less than 40 percent.
Legal Charges	Most Ponzi schemes are prosecuted for one or more of the following crimes: Mail Fraud; Money Laundering; Securities Fraud; Wire Fraud; Tax Crime; Operating Unregistered Securities Business.
Note: Theseobservations were made from a random sample of 80 Ponzi schemes investigated by the SEC and the FBI. Case reporting was not standardized, and the observations do not represent the full set of Ponzi schemes. Source: www.sec.gov.

How to Identify Ponzi Schemes

The SEC lists some of the typical "red flags" of Ponzi schemes:
1. High investment returns with little or no risk-usually there is a positive relationship between risk and return and schemes that promise high returns with low risk need to be looked at suspiciously.
2. Overly consistent returns-Investment returns usually follow the business cycle. Returns are up when the economy is booming, and down in a recession. Investments that promise to pay the same return irrespective of business cycles are often a key feature of Ponzi schemes.
3. Unregistered investments-Investments that are not registered with either the SEC or state regulators should be questioned.
4. Unlicensed sellers-Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes are not.
5. Secretive and/or complex strategies-Ponzi schemes usually do not publish detailed information about their investments. They are referred to as "blind pools" wherein investors do not know exactly how their money is invested.
6. Issues with paperwork-Ponzi schemes usually do not send regular performance statements or reports on clients' investments, and instead are more likely to be inconsistent and error-prone in correspondences.
7. Difficulty receiving payments-Ponzi perpetrators usually encourage investors to roll over their high returns and increase their investment holdings. Investors attempting to cash out their investments are more likely to face difficulties obtaining cash back. Ponzi perpetrators will encourage investors who want to cash out their investment to do so gradually or not at all.¹³
The FBI warns investors to be careful about investment proposals that promise to pay exorbitantly in a short period of time and that are not accompanied by prospectuses, quarterly or annual reports, and offering memoranda.¹⁴ The public is advised to be wary of "affinity scams," not to invest based on acquaintance alone, and to be suspicious of investment offerings emanating from social networking sites and chatrooms. The FBI recommends that investors seek third-party advice, for example, to contact an independent broker or licensed financial adviser before investing. Therefore, financial planners and advisers may face questions at some point during their careers from clients about questionable investment schemes, and it is best for financial industry professionals to be as well informed as possible.
Research has shown that some of the common features of fraudulent schemes are random returns, too few negative returns, and too many repeat returns.¹⁵These findings suggest that increased regulatory oversight with stricter requirements for mandatory reporting will help to identify such schemes.
We developed a checklist of questions in Table 2 that financial planners might find helpful when advising clients about questionable investments that might indicate a Ponzi scheme.

Table 2: A Checklist of Questions to Ask Before Trusting Money to a Financial Custodian
	YES	NO
In terms of return, the scheme promises:
To pay a high rate of return not available elsewhere?	?	?
To pay back in a short period of time?	?	?
To pay a constant rate of return independent of economic cycles?	?	?

The scheme manager:
Does not possess the relevant qualifications and experience to act as a money manager?	?	?
Is not licensed by federal and state securities law to be an investment professional?	?	?
Wants complete control of your money?	?	?
Was involved in fraud or was under SEC investigation in the past?	?	?
Lied to or deceived people in the past?	?	?
Is a willing donor to charities, institutions, and politicians?	?	?
Is always trying to obtain political favor?	?	?
Appears to have become rich in a very short period of time?	?	?
Appears to be in financial trouble because of his lavish lifestyle?	?	?
Is always looking for new investors at social, religious, and family gatherings?	?	?
Asks you to remain coy about the fund to people whom you do not know or regulators?	?	?

The scheme or investment proposal or fund:
Is not registered with the SEC or state regulators?	?	?
Is registered offshore where investment laws are less strict?	?	?
Is opened to all kinds of investors?	?	?
Conducts all transactions in-house; that is, acts as a broker, investment manager, custodian of assets, and fund administrator at the same time?	?	?
Uses lesser-known or mostly unknown auditors?	?	?
Charges very little in the form of fees?	?	?
Employs only family members or friends or the same people overtime?	?	?
Has low turnover on management team and does not grow with the size of the fund?	?	?
Transacts mostly with small banks, unlike its peers?	?	?

Regarding reporting:
The certificates received from the scheme/fund are not registered?	?	?
You do not have a reasonable understanding of the investment strategies adopted?	?	?
You do not receive regular performance statements?	?	?
There is no person available to take/answer your calls?	?	?
Your calls are not answered in a straightforward manner?	?	?
Your adviser’s firm is regularly closed during business days?	?	?
The firm does not allow electronic or real-time access to your account?	?	?

Payments:
Were (i.e., interest or dividend or principal) missed?	?	?
Are persistently encouraged to be reinvested?	?	?

As an investor, you:
Never called the SEC to verify the scheme in which you are invested?	?	?
Never verified whether the fund is filing all its paperwork with the SEC?	?	?
Contributed to the scheme based on trust (or a friend’s recommendation) and/or faith only?	?	?
Tend to ignore negative comments about the fund’s adviser/manager?	?	?
Have suffered unexplained losses, but you do not want to withdraw as you have hopes that you will recoup your investment?	?	?

The checklist contains six categories of questions: (1) the rate of return promised, (2) the profile of the promoter, (3) details about the scheme or investment proposal,¹⁶ (4) the scheme's reporting system, (5) the frequency of payments received, and (6) questions investors should ask themselves. If a client answers "Yes" to any of the questions in Table 1, then financial advisers should advise the client that further investigation is warranted and be prepared to protect the client from investing in a Ponzi scheme.
Despite the checklist, warning signs and even financial advice from professional advisers, there is always the risk some clients will fall prey to Ponzi perpetrators because of irrationality (for example, the client trusts the promoter) and/or information asymmetry (i.e., the client has incomplete knowledge). There is also the phenomenon of "buyer's denial," whereby despite losing money, clients may still have false hopes that they will recoup their investments.

What Are the Legal Consequences of Participating in a Ponzi Scheme?

When investors realize they may be victims of a Ponzi scheme, they may seek the advice of a financial adviser or planner. This section provides information about the legal consequences after a Ponzi scheme is uncovered, in the event that a financial adviser or planner is approached by a victim of a fraudulent investment scheme who seeks professional financial advice. After a Ponzi scheme is discovered by government regulators, the SEC files a lawsuit against the Ponzi perpetrator, and a trustee is then appointed to recover as much money as possible to make payments to creditors and to redistribute any recovered proceeds pro rata to investors.¹⁷ The trustee will first target the hard assets of the Ponzi perpetrator. Next, he or she will try to reclaim payments made to investors (irrespective of whether they had knowledge of the Ponzi scheme). The trustee will also consider taking legal actions against other related financial institutions (including the Ponzi perpetrator's bank) if there is evidence they were conspirators or failed to act on red flags of an ongoing fraud scheme.
As a result, it is rare that the legal consequences are limited to the perpetrator alone. Any person/entity that funded the scheme (referred to as a "feeder fund"), even unknowingly, is at risk. This is especially true when the feeder fund collected money from others and failed to apply due diligence and/or failed to notice red flags suggesting fraud was taking place.
The bank the perpetrator uses to conduct transactions is at risk as well. The issue here is that the bank had access to the financial accounts of a perpetrator and may have been aware of anomalous activities tantamount to fraud. The same charges can be levied against an investment bank that handled the activities of a Ponzi perpetrator; for example, if it acted as a broker, raised funds, had custody of assets, prepared investment accounts, or had access to marketing materials, it could be liable.
In cases where the perpetrator made charitable donations, the trustee may require that some or all of those donations be returned after the scheme is exposed, irrespective of the status of the recipient. Employees who work at a hedge fund accused of fraud, who are suspected of either conspiring with the promoter, or who were aware of the fraud are also at risk. The SEC may seek permanent bans against them working in the securities industry again. Finally, the family members of the promoter are at risk as well, and their assets can be frozen and legally prevented from being transferred or sold.
In 2009, U.S. President Barack Obama established an interagency Financial Fraud Enforcement Task Force that involved members of the U.S. Department of Justice, the FBI, the SEC, the U.S. Postal Inspection Service, the Internal Revenue Service Criminal Investigation unit, the U.S. Commodity Futures Trading Commission, the Federal Trade Commission, the U.S. Secret Service, the National Association of Attorneys General, and a broad range of federal and state agencies and authorities to investigate and prosecute financial crimes under the code "Operation Broken Trust." By December 2010, Operation Broken Trust had achieved the results in Table 3.

Table 3: Operation Broken Trust Statistics for August 16–December 1, 2010
Panel A: Criminal Cases
	Number
Cases	231
Defendants	343
Arrests	64
Info/Indictments	158
Convictions	104
Sentencings	87
Estimated Loss Amount	$8,384,150,054
Estimated Victims	120,381

Panel B: Civil Cases
Civil Enforcement Actions	60
Defendants	189
Estimated Loss Amount	$2,134,681,524
Estimated Victims	23,566

Source: FBI Press Release, “Financial Fraud Enforcement Task Force Announces Results of Largest-Ever Nationwide Operation Targeting Investment Fraud,” December 6, 2010, accessed at www.fbi.gov.

Table 3 shows that Operation Broken Trust involved 231 criminal cases and 60 civil enforcement actions. Eighty-seven defendants have been sentenced to prison. More than 120,000 people were defrauded of close to $8 billion in the 231 criminal cases. The schemes investigated include Ponzi schemes, affinity frauds, prime bank/high-yield investment scams, foreign exchange frauds, business opportunity frauds, and other similar schemes. The task force maintains a website at www.stopfraud.gov to keep investors and the general public informed about investment scams.

Regulating Ponzi Schemes

The SEC, as the main regulator of the financial markets, is taking heat for failing to detect Ponzi schemes.¹⁸ However, we caution that many such schemes rarely start as a registered business, hence avoiding detection by regulators. Consequently, it is unlikely that regulators are able to stop Ponzi schemes in their early stages.
Ponzi promoters take several steps to ensure information about their scheme is not leaked to the SEC. First of all, they keep their operations small in terms of human resources. They employ people they can trust who are unlikely to denounce them even after leaving. Second, Ponzi promoters publish little information about their operations. This lack of information makes it hard to uncover their fraudulent activities. They also ask their investors not to reveal anything to regulators as the promised high returns will be impossible to achieve under a regulatory watchdog. They exploit the trust of their clients, and the latter are reluctant to come forward and expose them. Even if the clients discover the scheme, they become more concerned about recouping their investments than worrying about the legitimacy with which it is carried out. Ponzi promoters frequently establish connections with high-ranking politicians and influential investors and engage in philanthropic groups to benefit from their protection. The point is the promoter works hard to avoid detection by the SEC and other regulators.
It is also sometimes possible that the promoter is running a Ponzi scheme alongside a legitimate business. Or perhaps the promoter is running a legitimate business, but because it loses money, starts a Ponzi scheme to cover those losses. Obviously, in these situations, the SEC is unlikely to detect the fraud at an early stage.
Many Ponzi schemes (not the likes of big-time operators like Bernard Madoff and Alan Stanford) are small in size, involving just a few investors. The cost of investigating these very small schemes may weigh heavily on the SEC's resources. Given the SEC's resource constraints plus a never-ending investigation list, its approach to investigating Ponzi schemes is more likely reactive than proactive. In these circumstances, the SEC would rather concentrate its efforts on larger frauds involving a larger pool of investors have implications for the investing community at large. The SEC's "stat system," which keeps track of its filed cases and may form the basis for incentives and rewards, can favor quick-hit cases overmore difficult ones.¹⁹
For the SEC to do a better job at policing Ponzi schemes, it needs more staff specialists, a bigger budget, a leaner organization, less bureaucracy, and better investor education. As Khuzami and Walsh testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on September 10, 2009, "The ... Report traces the SEC's failure with Madoff to shortcomings in a number of areas, including insufficient expertise, training, experience and supervision by management; inadequate internal communication and coordination among and within various SEC divisions; deficiencies in investigative planning and prioritization; lack of follow-through on leads; and insufficient resources."²⁰
As a result of the Bernard Madoff's scheme and the financial crisis of 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act came into effect in July 2011 to rein in financial frauds and protect consumers.²¹It strengthens oversight and empowers regulators to aggressively pursue financial fraud. The law directly targets Ponzi schemes, offers protection to and rewards whistleblowers who provide information that results in an enforcement action by the SEC, and empowers and allocates more resources to the institution to crack down on such schemes.
Following the passage of the Dodd-Frank financial legislation, the SEC introduced the whistleblower bounty program.²² Under the program, an employee who reports fraud to the SEC can net under certain conditions as much as 30 percent of the penalties and funds recovered from the fraud perpetrator by the SEC. Among others, the law also establishes a single toll-free number as a consumer hotline to report problems with financial products and services, requires hedge funds and private equity advisers to register with the SEC, and establishes greater state supervision.

Conclusion

Monitoring against Ponzi schemes should best be undertaken by well-informed individual investors, because history shows that the SEC identifies most schemes only after substantial harm against investors is perpetrated. If investors do not question or follow their fund managers closely, they are potentially facilitating a fraudulent Ponzi perpetrator. Therefore, it is up to investors to do their due diligence when making any kind of investment decision, especially when a high-profile investment adviser is promoting securities not registered or listed on normal exchanges or for which limited public information is available.
In the event financial advisers are approached by current or prospective clients with concerns about fraudulent investment schemes, we have provided a checklist in Table 2 that could assist financial professionals when giving advice to a client who may be considering investing money, or who may have already invested money, in a Ponzi scheme. Ponzi perpetrators will probably always exist, but their success depends on finding clients willing to invest in their schemes, and the better informed and educated investors and financial advisers become, the less likely they will become victims of financial con artists like Bernard Madoff.

Endnotes¹http://www.fbi.gov/majcases/fraud/fraudschemes.htm.
² http://www.nytimes.com/interactive/2009/06/29/business/madoff-timeline.html?ref=bernard_l_madoff.
³ S. A. O'Connell and S. P. Zeldes, "Rational Ponzi Games," International Economic Review 29, 3 (1988): 431-450.
⁴ PIMCO (one of the biggest bond funds) manager Bill Gross referred to the Fed's 2010 QE2 as a Ponzi scheme: "It seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors ... the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need-as with Charles Ponzi-to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen?" "PIMCO's Bill Gross: QE2 Is a Ponzi Scheme," Wall Street Journal, October 27, 2010, accessed at http://blogs.wsj.com.
⁵ Jurg Niehans, "International Debt with Unenforceable Claims," Federal Reserve Bank of San Francisco Economic Review 1 (Winter 1985): 64-79.
⁶ Roger Lowenstein, "The Great American Ponzi Scheme: Do We Want Public Pensions? There Are Compelling Reasons Why We Do," Bloomberg Businessweek, March 31, 2011, accessed at www.businessweek.com.
⁷ SEC 2009 Performance and Accountability Report.
⁸ Paul Sullivan, "How to Avoid Being Taken in by a Ponzi Scheme," New York Times, December 10, 2010.
⁹ Robert Schmidt and Jesse Westbrook, "Madoff, Stanford Victims Unite," Bloomberg Businessweek, March 10, 2010.
¹⁰ http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html.
¹¹ Catherine Rampell, "Hey Ponzi: What's Your Exit Strategy, Exactly?" New York Times Economix Blog, December 16, 2008, accessed at www.nytimes.economixblogs.com.
¹²U. Bhattacharya, "The Optimal Design of Ponzi Schemes in Finite Economies," Journal of Financial Intermediation 12 (2003): 2-24.
¹³ http://www.sec.gov/answers/ponzi.htm.
¹⁴ http://www.fbi.gov/news/stories/2010/december/fraud_120610/fraud_120610.
¹⁵ Nicolas P. B. Bollen and Veronika Krepely Pool, "Predicting Hedge Fund Fraud with Performance Flags," SSRN, March 12, 2010, accessed at http://ssrn.com/abstract=1569626.
¹⁶ See also Greg N. Gregoriou and Francois Lhabitant, "Madoff: A Riot of Red Flags," SSRN, December 31, 2008, accessed at http://ssrn.com/abstract=1335639.
¹⁷ In more technical terms, the SEC appoints a receiver, a disbursement agent, or a claims administrator to recover and distribute funds to victims.
¹⁸ R. Khuzami and John Walsh, "SEC's Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to Improve SEC Performance," testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, September 10, 2009, accessed at http://www.sec.gov/news/testimony/2009/ts091009rk-jw.htm.
¹⁹ Richard C. Sauer, "Why the SEC Missed Madoff," Wall Street Journal, July 17, 2010.
²⁰ http://www.sec.gov/news/testimony/2009/ts091009rk-jw.htm.
²¹ Brief Summary of The Dodd-Frank Wall Street Reform ond Consumer Protection Act, accessed at www.banking.senate.gov.
²² Jessica Holzer and Ashby Jones, "SEC Proposes Rules for Bounty Program," Wall Street Journal, November 4, 2010.

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