Economy

Understanding Ponzi Schemes

Charles Ponzi was an Italian immigrant in the United States of America. He was a swindler and a con artist. He had many aliases and duped many clients into buying international reply coupons for postage stamps by promising them a 50% profit within 45 days or 100% profit within a period of 90 days. He diverted the money he got from new investors to pay the old investors, while keeping himself wealthy. The ploy continued until the Ponzi scheme finally collapsed in 1920, costing his investors over 20 million dollars. This was one of the biggest investment frauds in the US history. Hence, the term “Ponzi scheme” was coined after him.

Ponzi schemes are fraudulent investment scams. In Ponzi schemes, unlike pyramid schemes, the victims unknowingly bring in more targets. Ponzi schemes are dependent on a single person or group to coordinate every aspect of the fraud. To keep the scam continuing, the orchestrator of the plan convinces numerous victims that they are investing in a legitimate fund, promising great returns. The con artist takes the fund from the new investors and uses it to pay off old investors. However, for the scam to work proficiently to everyone’s benefit, the mastermind would need access to an infinite supply of new investors.

Sooner or later when new investors cannot support the returns of the old investors, the scheme collapses and investors lose all the money they put into it. Ponzi schemes are not actual investments, in reality they are just the redistribution of money from old to new investors. These schemes never last long because Ponzi schemes survive on a constant inflow of new investments. When the cash flow runs out, the scheme falls apart. The difference between a Ponzi scheme and a pyramid scheme is that in a pyramid scheme, members are required to recruit others and are paid an incentive for doing so. However, in Ponzi schemes, the con artist himself recruits new members.

One of the classic examples of a Ponzi scheme fraud is the infamous case of Bernie Madoff. On 12 March 2009, Bernie Madoff pled guilty to one of the largest and longest high profile Ponzi scheme in the finance history. He swindled investors out of nearly $65 billion by running a Ponzi scheme for more than a decade. It is a wonder that Madoff managed to fool thousands of investors. He was able to get a wide array of clients because of his reputation.  Bernie Madoff publicised himself as the founder of the business security Wall Street firm “Bernard L. Madoff Investment Securities LLC”. He was perceived as a reliable guy in the financial world, being one of the people who helped establish the National Association of Securities Dealers Automated Quotations (NASDAQ). He even served as the Chairperson of NASDAQ for three consecutive terms. He cultivated a close friendship with high profile wealthy businessmen. Madoff also made donations to humanitarian causes and gave money to politicians. He set up portfolios resembling the returns of the S&P 500. These strategies resulted in making his holdings look attractive.

After paying off the first set of investors, Bernie used his reputation to nurture relationships with financial regulators. As he became well known for his good returns to clients whose assets he managed, more and more investors wanted to join the now prestigious Madoff Investment which was a Ponzi scheme that started in the 1980s. His elite list of clients included Steven Spielberg and Kevin Bacon. However, Madoff kept his Ponzi scheme at a low key by targeting specific elite groups of investors who were not concerned about their money too much as they were earning more from their work.

Bernie had close affiliation with members of the Security Exchange Commission (SEC), hence when claims were made by financial analyst Harry Markopolos the SEC ignored it. After more than a decade of duping the SEC and his investors, Madoff’s scheme lost steam in late 2008 due to the global economic crisis that started in the USA. Madoff kept borrowing money and was not able to keep up with all the investors who were desperate to liquidate their assets as the market continued to deteriorate. His investors were demanding $7 billion. In reality, he had only $200 to 300 million dollars and so he was unable to meet their demand.

On December 11th, 2008, Bernie confessed to his sons Mark and Andrew Madoff that the Madoff’s investment security firm was an elaborate Ponzi scheme. His sons reported Madoff to federal authorities leading to his arrest and subsequent trial in March 2009 after pleading to 11 federal felonies. They included wire fraud, securities fraud, mail fraud, making false statements, money laundering, perjury and making false filings with the SEC, among others. He swindled approximately $65 billion from his clients, thus managing to conduct the largest Ponzi scheme ever. Madoff, at the age of 70, is sentenced to 150 years of imprisonment. The scheme sent a rippling effect across the world and affected his family, his colleagues and the investors who entrusted him with their money. It led to the death of one of his sons, Mark Madoff, who committed suicide.

The Madoff scheme was legendary; unfortunately, thousands of similar Ponzi schemes have taken place. During recessions and bad economies, when people are desperate for easy money, many fall prey. To avoid getting caught one should pay attention to unclear business models, aggressive sales techniques, promises of high returns for no work and difficulty in withdrawing funds. Madoff’s scheme was unusual as he made it easy for investors to withdraw their money easily. Generally, a Ponzi scheme discourages its investors from withdrawing and creates delays for dispensing funds. Hence, Madoff prolonged the life of his scheme by creating an illusion of reliability.

Picture Credits : abaforlawstudents.com

 



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