What Is a Ponzi Scheme and How Does It Work?
Ponzi schemes are “investments” promising outrageous returns that never end up appearing. The organizers of these schemes promise high returns with little or no risk, but in many Ponzi schemes, the money never gets invested. Instead, it is passed on to earlier investors.
To consistently generate income, Ponzi scheme perpetrators are constantly recruiting new investors. By attracting new money, earlier investors can cash out, creating the false appearance that the scheme is profitable. Much like pyramid schemes, Ponzi schemes rarely last and eventually fail completely.
Gain a better understanding of what Ponzi schemes are, how they operate, and what you can do to avoid getting caught up in one.
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Ponzi Scheme vs. Pyramid Schemes
Although they are similar, Ponzi schemes and pyramid schemes are not the same things. Below we’ll break down the similarities and differences between the two.
Similarities of Ponzi schemes and pyramid schemes:
- They both promise high returns for little or no work.
- The people at the top of these schemes tend to make the most money and lose the least when the scheme falls apart.
- In both schemes, existing investors or employees are paid off when new people enter into the scheme.
Differences between Ponzi schemes and pyramid schemes:
- Pyramid schemes ask individuals to invest in or sell a product or service. Ponzi schemes only ask for investments.
- Ponzi schemes don’t require further action after you’ve made an investment. Pyramid schemes often require you to work to earn money.
- Ponzi schemes are always illegal. Some pyramid schemes are illegal, but not all of them are.
History of Ponzi Schemes
Ponzi schemes are named after Charles Ponzi, a well-known individual who lured thousands upon thousands of people to invest in International Reply Coupons by offering 50% returns on the initial investments. International Reply Coupons were created by the International Universal Postal Union. The coupons could be exchanged for postage stamps, and served as a way for people in different countries to send each other postage.
The concept of the scheme came to Ponzi while he was in prison. After receiving a letter from a company in Spain that contained an International Reply Coupon — one that could be exchanged for U.S. priority airmail stamps — he realized he could turn a profit by buying these coupons in one country and exchanging them in another.
After he realized how much he could make, Ponzi started seeking investors, promising outrageous returns. He paid older investors with money from newer investors, as opposed to paying with actual profit. Eventually, in August of 1920, The Boston Post ran an investigation on Ponzi’s returns and he was arrested a few weeks later. At the time of his arrest, he owed an estimated $7 million to investors.
Ponzi Scheme Examples
Charles Ponzi wasn’t the only person to run a Ponzi scheme. In fact, he wasn’t even the first. Before him, bookkeeper William Miller was busted for swindling investors for the equivalent of over $25 million in today’s money. There are several famous Ponzi schemes that have occurred throughout the years in clever and new ways, including scams run by these gentlemen:
- Bernie Madoff, former NASDAQ chairman, ran an asset management scheme that accrued $17.1 billion from investors but lost $50 billion, landing him in prison.
- Peter Lombardi scammed 28,000 investors to the tune of $956 million by selling them investment interests in life insurance policies that did not realize any returns.
- Scott Rothstein was a lawyer accused of one of the largest Ponzi schemes in history, totaling $1.2 billion in fraud.
- Jeff Skilling ran a scheme that deceived the investing public and the U.S. Securities and Exchange Commission about Enron’s business performance.
- Gerald Payne preyed on spiritual people, running a half-billion-dollar scheme coaxing them to invest in his Greater Ministries International “church.”
- Alan G. Flesher, Wayne D. Flesher, and Nancy Carol Khalial operated under the Unlimited Cash Inc. company, promising returns on the sale of ATMs and “Ad Toppers”.
How to Avoid Ponzi Schemes
There are red flags to be aware of regardless of the strategy used to create a Ponzi scheme. Gain a better understanding of the characteristics you should avoid when you are investing.
- Find a financial advisor you can trust. Start by asking friends or family for recommendations. Conduct your own research as well, checking with recognized organizations to make sure they’re legit. A trusted financial advisor will be recognized by the National Association of Personal Financial Advisors, the Financial Planning Association, or the Certified Financial Planner Board of Standards.
- Be skeptical of obscure products or pitches that seem too good to be true. If you’re pitched on an investment you’ve never heard of, conducting your own research is paramount. Consider this — if you can’t exchange the investment for cash the way you can with stocks, bonds, or mutual funds, it’s probably not a wise investment.
- Ensure that the investment is registered. Ponzi schemes are notorious for unregistered investments. Check with the U.S. Securities and Exchange Commission (SEC) to ensure investments made on behalf of or to the company are legitimate.
- Understand every aspect of your investment. As with any investment you make, it’s important to understand where your money goes once it’s invested.
If you think you’ve been involved with a Ponzi scheme, report it right away. File a complaint with the SEC and contact your state securities regulator.
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This post was updated December 12, 2019. It was originally published December 12, 2019.