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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A member of BKD’s Forensics & Valuation Services division, Julia provides forensic accounting, fraud investigation and litigation support services. Her 14 years of public accounting experience include audit, tax, due diligence, business valuation and Sarbanes-Oxley internal controls documentation.

Julia’s forensic investigative experience includes fraud investigations for clients ranging from small private companies to large health care systems. Her reports are tailored to the end user, including law enforcement, senior management, opposing counsel and insurance agencies.

Julia Mast – who has written posts on BKD Forensics.


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