Back to Fact Sheets

Ponzi Schemes

What is Third Party Fraud?

This is a fraud committed against someone or some business by people other than their employees. They can be committed against individuals, businesses, companies, governments etc. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.

Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to get away. The fraudster may not care if the fraud is eventually discovered as there is no continuing relationship with the victim and they have made their getaway.

Who is Ponzi?

Charles Ponzi lived in Boston, America during 1919 and 1920 where he conducted a large investment fraud. The fraud was based on a very simple premise - greed overriding common sense. Ponzi received about $15 million from investors during the fraud, a substantial sum at the time. The scheme was so successful people lined the streets of Boston waiting to hand over their money to him.

What is a Ponzi scheme?

The name 'Ponzi Scheme' has been given to investment frauds based on his system. The American Heritage Dictionary defines a Ponzi Scheme as:

"An investment swindle in which high profits are promised from fictitious sources and early investors are paid off with funds raised from later ones."

These frauds are aimed at the general public. They can take a variety of forms, but essentially they contain the same elements and prey and people's gullibility and greed.

What are the common factors?

The frauds promise very high returns over a short period from an 'investment'. The promised returns may seem outrageous when compared to other investments. Ponzi himself offered a 50% per quarter return to investors, when 4% per year was standard.

The money is rarely invested in anything. Some of the money may be used to build an elaborate front for the scheme to give it an air or look of legitimacy, but not always so.

Some of the money is used to pay some of the high returns to early investors. This is done to make investors believe that the 'investment' is doing well, and to entice further investors and the reinvestment of the funds paid out.

What is the aim of the fraud?

The aim is to steal the invested monies. The fraudster wants to get his hands on as much money as possible as quickly as possible - but they may have to work the scheme for a time to get the maximum number of victims and accumulate the maximum amount of money. When the pool of funds is sufficient, the fraudster and the money disappear, or they invent reasons why the investment has gone wrong and the monies have been lost.

How does the scheme maintain itself?

The fraudster needs to run the scheme like a business while he or she gets as many investors as possible to hand over their money. To do so they will needs to make some payments to make the 'investment' look successful, and generate an enthusiasm to join.

To do this some of the money collected from later investors is paid back to early investors as the 'return' from the investment. Investors will see that the investment is paying the promised return, tell everyone they know (most people want to brag) and more people will join. Generally investors getting money back will reinvest it.

If the fraudster does not want to pay out any of the money, they may simply tell the investors that the value of their investment is increasing, or that interest is being reinvested. In the more elaborate schemes, glossy reports, charts and schedules are produced, "proving" that the returns are being achieved.

At a 20% return every six months, the fraudster will have 2½ years to run this fraud using the victim's own money to fund the payments under the scheme before the first person has to be repaid their principle. New people placing money into the scheme will fund these returns and any principal that has to be returned to the initial investors.

How does the scheme grow?

The fraudster hopes that the victim will tell their friends about this wonderful investment, the great returns, and convince them to invest as well. Some people will be skeptical, but some will believe what they hear and will invest their money.

These schemes are generally based around a community where word of mouth can be persuasive, and where those not already in the scheme do not want to be left behind, or appear foolish for not investing. With some people actually being paid the high returns, more people will believe that the investment is real and will invest. With more money coming in, the fraudster can pay more returns to investors, creating more enthusiasm and growing the pool of money.

Why are people drawn to these schemes?

Greed. It is human nature to look for an easy way of doing things, including making money. It is the motivation behind many great inventions. It is also the motivation behind many bad investments. Add greed to a mixture of urgency and envy, and the motivation forces can be irresistible to some people.

FOR EXAMPLE

These schemes come in many shapes and sizes. These two bear mentioning.

An investment company advertised that it invested in the Asian stock market and could earn very high returns. The investment was said not to be in specific stocks, just in the stock market in general, so in theory they could buy and sell as the market changed.

Many people believed the promotional material and invested. The company had a nice office and looked like a successful business. It employed smooth talking salesmen who knew the jargon of the share market and who could talk to potential investors.

The investors were given impressive monthly updates on how well their investments were doing. These updates were simply lists of whatever stocks happened to go up in that month and had no resemblance to any actual investment. In fact no investment was ever made in any stock in any market, the monies were simply pooled. Eventually the pool of funds was large enough and the perpetrators disappeared, with the cash.

The most ridiculous scheme we heard about was detailed in a book by Frank Abagnale ("The Art of the Steal").

A young man in America offered an investment opportunity to the general public. He wanted funds to buy tickets to Rock Concerts around the country, that he would scalp outside the venues at greatly inflated prices. People knew that some concerts sold out in hours and that tickets were in great demand. People also knew of the high prices scalpers charged for tickets. Many people sent what added up to millions of dollars to this kid. No tickets were ever purchased.

LESSONS TO BE LEARNED

The best advice that we can offer is that "if an investment looks too good to be true, it probably is, or it's probably illegal" and should be examined very carefully. Be particularly careful where:

(a) The promoter wants an immediate commitment or any form of urgency is suggested

(b) The promised returns on these investments are just too good

(c) Documents are not left for your perusal

(d) The promoter will not come to a meeting with your accountant, solicitor or other advisor

(e) The promoter says that people who do not like the investment just do not understand it

(e) The investment, when considered fully, just does not make sense or give you a sense of security

(f) The scheme just seem too fanciful to be legitimate

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

 Back to Fact Sheets

Last Updated: 3.4.2008