Not Every Fraud Is a Ponzi, but Every Ponzi Is a Fraud

At a gathering this holiday season, my ears perked to the word “Ponzi” drifting over the chatter. The latest fraud schemes gossip was being exchanged. Migrating to this conversation, I quickly recognized that many frauds I consider to be lapping and kickback schemes were referred to as a Ponzi fraud.

The word Ponzi entered our homes after Bernie Madoff’s house of cards collapsed in 2008 in what is considered the largest financial fraud in U.S. history, with damages exceeding $58 billion. The news, politicians and even Hollywood had a lot to say about Madoff’s Ponzi scheme, making Ponzi a household term. However, I find that many people are not clear on what exactly constitutes a Ponzi scheme. I thought I would help clear the air.

A Ponzi scheme involves the investment of money. Money from subsequent investors is used to pay the returns promised to the initial investors. More and more new investors are needed to pay the returns promised to all previous investors and so on and so on. Mathematically, a Ponzi is doomed to fail. The scheme collapses when the money from new investors runs out or the operator is exposed or vanishes.

Here are some key elements of a true Ponzi scheme:

  • Benefit – Operators must promise a rate of return high enough to make the risk worthwhile.
  • Setup – There must be a plausible explanation of how the investment will succeed; this can be some exclusive and/or insider knowledge or the outgrowth of a legitimate operation.
  • Credibility – Operators must appear impressive, have an impeccable reputation or just have a believable “air” about them that makes the investors feel good about handing over their money.
  • Initial Investors Paid Off – For the first few periods, investors are paid the promised rate of return, if not more. This leads many to immediately reinvest their profits into the Ponzi.
  • Communicated Successes – New investors are constantly needed to keep the scheme running. Operators show off their success to potential investors and remind current investors how much they stand to gain if they keep their money right where it is.

If you are approached with a secret, proprietary or magic investing formula that is very hush-hush, you could be looking at a Ponzi scheme. The operator may not even tell you what the investing formula is or only give a vague overview. Avoiding a Ponzi may be as simple as doing your homework. Run a Web search for the operator or company, research the investment strategy, ask for records that provide visibility into their results and operations or ask an unbiased third party like an unconnected broker or financial advisor.

The next time you are exchanging fraud stories over hors d’oeuvres and cocktails, you’ll know that though every Ponzi is a fraud, not every fraud is a Ponzi.

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Julia is a director in BKD’s Forensics & Valuation Services division. She focuses on forensic accounting, fraud investigation, litigation support services and business valuation. With nearly 20 years of public accounting experience, Julia has gained a substantial background in both audit and tax services.

She has extensive experience in forensic services and litigation support. She has successfully worked with complex risk assessments and public corruption investigations, misappropriation of assets and fraudulent financial reports in a variety of industries, including health care, manufacturing, transportation, real estate, IT consulting, government and not-for-profit. Julia performs valuations for transactions, litigation, restructuring, marital dissolutions and income tax-related purposes.

Julia Mast – who has written posts on BKD Forensics.


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