What is a Ponzi Scheme

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After the recent economic downturn, the news was filled with stories about various Ponzi schemes. Bernie Madoff became notorious for defrauding millions of dollars from high-profile investors through such a scheme. So what is a Ponzi scheme and why is it illegal?

A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of their own money or the money paid by subsequent investors, as opposed to money earned by the individual or organization running the scheme. Many of these operations are disguised as stock market investment groups and entice investors into buying in by offering higher rates of return on the investment than other, legitimate investments could normally provide. Often, to perpetuate these schemes, short-term returns are paid out with unusually high rates or unusually consistent returns.

Unfortunately, to continue to make these payouts to investors, the operation must continuously acquire new investments, typically from new investors. The schemes usually fall apart when growth can no longer be sustained and payments to investors begin to shrink or disappear.

The Ponzi scheme is named after the creator of the first very large pyramid scheme in America, Charles Ponzi. Although not the first such operation, Ponzi's operation took in so much money that its collapse became a media sensation, and its founder's name became synonymous with the model. Many schemes, including Ponzi's, start off as legitimate operations such as hedge funds. But, when the fund suddenly begins losing money or not generating the kinds of returns promised, it can quickly convert into a Ponzi scheme when the promoters, rather than admitting the failure to meet projected investment expectations, begin falsifying reports and producing funds to pay out earlier investors from proceeds received from newer investors.

Ponzi schemes usually offer extraordinary returns and take advantage of lack of investor knowledge. Often, these schemes will use complicated terms of art or cite to proprietary investment strategies in order to hide the true nature of the operation. As the operation commences, the promoter will pay out high returns to attract more investors and to bring in additional funds from current investors (or avoid payouts by “reinvesting” earnings). As other investors begin to participate, money flows in to pay off earlier investors and the cycle continues.

When a Ponzi scheme is not recognized and halted by authorities, it usually unravels on its own. This is usually due to the promoter vanishing taking all the remaining investment money with him, slowing investments by new investors that starve the operation of funds to make the promised payouts, or external market forces, like a sharp decline in the economy that causes many investors to withdraw part or all of their funds at the same time.

A pyramid scheme is similar to a Ponzi scheme, though subtly different. The terms are often incorrectly used interchangeably. In a pyramid scheme, just as in a Ponzi scheme, investors are attracted through the promise of an extremely high rate of return on investments. However, while in a Ponzi scheme, the promoter acts as a "hub" for the victims, interacting with all of them directly, a pyramid scheme relies on participants to attract additional investors directly. In fact, recruitment is often used as the basis for a payout under a pyramid scheme. Similarly, a Ponzi scheme claims to rely on some unique investment approach while pyramid schemes explicitly state that new money will be the source of return to earlier investors. As a result, pyramid schemes usually collapse much more quickly because they require exponential increases in the investor base to sustain the operation. Ponzi schemes, on the other hand, can survive almost indefinitely under the right market conditions simply by persuading most existing participants to reinvest their money, with a fairly small number of new participants.

Government regulations make both Ponzi schemes and most pyramid schemes illegal. This is largely due to the fraud involved in obtaining new investors, as well as the falsified reports and audits that are often filed with regulatory agencies like the Securities and Exchange Commission (SEC). Notably, there are some legitimate businesses that use a pyramid style investment/distribution scheme that do not run afoul of the law. A prime example is the so-called “multi-level marketing” business model, in which early investor/buyers purchase products or services that they then re-sell to new investors. This creates a supply chain in which those closest to the original manufacturer or supplier retain the largest percentage of a commission on the value of products and services sold down the line.

If you believe you have been the victim of a Ponzi scheme or pyramid scheme, or would like someone to analyze a potential investment opportunity to ensure that you do not become the victim of such a scheme, you should contact a local attorney with experience in financial and securities law. You can find a list of attorneys in your area by visiting our Law Firms page.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.

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