A Ponzi scheme is one of the most common types of investment or securities fraud. In a Ponzi scheme, a stockbroker or investment advisor promises a higher than usual return; however, there is almost always no investment activity. The perpetrator of a Ponzi scheme uses funds from new investors to pay off old investors. This scheme can last for a very long time; as long as there are new investors to keep paying the old investors, the scheme will continue. In the case of Bernie Madoff’s Ponzi scheme, his lasted for decades and ended up costing 4,800 investors more than $68 million. A Ponzi scheme is a serious violation of federal law.
So how can an investor or a potential investor recognize a Ponzi scheme? There are some indicators, which include:
- “Guaranteed” high returns. Legitimate investment advisors can never guarantee a consistently high return. Stock prices fluctuate with market conditions, and no one is good enough to always be correct in his or her investment advice. Certificates of deposit or treasury bonds may come with guaranteed returns, but the returns are low.
- Consistent high returns. If an investment advisor indicates that he or she has produced consistently high returns for several years or more, the statement should be greeted with skepticism.
- Hidden investments. Any legitimate investment advisor or brokerage firm should be able to provide details on investment strategies and actual investments. If an investment advisor is unable or unwilling to provide this information, one should suspect a Ponzi scheme. The failure to provide this information would tend to indicate that no such information exists and that the returns are fraudulent.
- Unregistered securities. In the United States, securities most often have to be registered with the SEC and are subject to laws and regulations concerning their offer and sale to the public. Since a Ponzi scheme is premised upon extraordinarily high rates of returns, the perpetrators of the scheme cannot rely upon publicly available data to further the scheme. They will therefore frequently say that they base their success on an unregistered security. (Example: an interest in a South African diamond mines or Ecuadorian gold mines.)
- Pressure to reinvest. The Achilles heel of a Ponzi Scheme is the removal of funds from the scheme. As long as the investor is willing to keep his or her investment with the Ponzi Scheme, he or she will receive periodic statement showing extraordinary growth. When the investor removes money from the investment, the scheme is weakened. If too many investors seek to remove their account values at once, the Ponzi scheme will be quickly uncovered. In order to keep the scheme going, the perpetrators of the scheme will pressure the investor to reinvest.
A Ponzi Scheme is a particularly dangerous type of securities fraud. Usually, by the time the scheme has been discovered, all of the money will be gone. Although the perpetrators often end up in prison, they are usually not in a position to make meaningful restitution to their victims. Therefore, in looking for responsible parties, the claimant’s counsel should look to see if other parties were complicit in the scheme. Frequently, brokerage houses, audit firms and law firms will be involved in the facilitation of the scheme, and in some circumstances, they may be held liable for a victim’s loss.