In 1919, Boston resident Charles Ponzi devised a foolproof investment scheme. He would buy international postal reply coupons in countries where they were relatively cheap and exchange them for more expensive postage stamps in the United States. He would then sell the stamps at a huge profit — up to 400%. Surprisingly, this was perfectly legal.
But his greed led him to devise a more fraudulent investment scheme.
In 1920, he began to court investors with an opportunity for unheard-of 100% returns within ninety days. Those "investments," however, were not invested in anything. Early investors were simply paid with money collected from new investors. As long as new investors bought in, his scheme could continue.
Eventually, newspaper exposés into his returns led federal authorities to investigate. Nervous investors demanded their money back, which was increasingly difficult for Ponzi to repay. His assets were seized, the fraudulent activity was exposed, and Ponzi was arrested.
Ponzi pled guilty to eighty-six counts of mail fraud and served a 14-year prison term. He died in Brazil in 1949 with hardly a penny to his name. Although he did not invent this particular crime, it became known as a Ponzi scheme because of the publicity he generated.
Ponzi Schemes: Overview of the Offense
A Ponzi scheme is an investment fraud that pays existing investors with funds collected from new investors. Organizers of this type of fraud promise high returns for investors with minimal risk. Instead of making a legitimate investment, they keep some for themselves and pay earlier investors with the money of those who came later.
Do Ponzi schemes still happen? Yes!
Bernie Madoff, one-time chairman of the NASDAQ stock exchange, perpetrated the largest Ponzi scheme in history. His far-reaching scheme defrauded many high-net-worth individuals, including movie director Steven Spielberg. Madoff pled guilty to eleven federal counts related to the investment scheme, including securities fraud. He was sentenced to 150 years in prison after bilking investors out of an estimated $64.8 billion.
According to CNBC, the year 2019 saw the largest number of Ponzi schemes since the Great Recession. Authorities uncovered 60 alleged Ponzi schemes totaling $3.25 billion in investor funds.
How Ponzi Schemes Differ From Pyramid Schemes
Ponzi investment schemes are often confused with pyramid schemes. This financial fraud has many similarities but some key differences.
A pyramid scheme requires a steady influx of cash in order to survive. Instead of bilking money from investors, the pyramid scheme makes money by recruiting new paying participants. Those new members are then encouraged to recruit additional people. When the pace of new recruitment slows, the organization typically collapses as funds for commissions dry up.
The term "pyramid" refers to the structure of the organization. Generally, a few people at the top (including the founders) collect money from many people at the bottom. Most people don't make much money — particularly latter investors.
In 2019, Washington Attorney General Bob Ferguson filed suit against the clothing company LulaRoe. He charged the company with violating Washington's Antipyramid Promotional Scheme Act and the Consumer Protection Act.
The lawsuit cited LuLaRoe's bonus structure and unfair refund policy as problematic. It also said LulaRoe used deceptive misrepresentation of profitability to persuade thousands of people out of millions of dollars.
The company paid $4.75 million, of which $4 million was sent to LuLaRoe sellers in Washington who had lost money. The company also changed its business practices.
It can be difficult to distinguish illegal pyramid schemes from legal "multi-level marketing" companies. For example, the FTC concluded that the well-known company Amway was not a pyramid scheme because:
- It did not charge up-front "head-hunting" or investment fees from new recruits
- It did not require distributors to buy large amounts of nonreturnable inventory
- It provided ways to help distributors earn money from selling products directly to consumers
Typical Criminal Charges for Ponzi Schemes
Ponzi schemes and other types of investment fraud are charged as securities fraud or commodities fraud. These cases typically include other criminal charges as well, such as:
- Wire fraud
- Mail fraud
- Investment adviser fraud
- Money laundering
- False statements
- False filings with the Securities and Exchange Commission (SEC)
Those who are convicted or plead guilty can serve lengthy prison sentences. They may be required to pay restitution to their victims, although the nature of the crime typically leaves very little money with which to do so.
Warning Signs of a Ponzi Scheme: How to Avoid Investment Scams
Ponzi schemes and other investment scams share the following characteristics, according to the U.S. Securities and Exchange Commission:
- Unusually high returns without corresponding risk: The prospect of high returns generally comes with high risk.
- Abnormally consistent returns: The market has peaks and valleys. Investments with a high rate of return that seems immune to broader market trends should raise a red flag.
- Unregistered investments: Registration with the SEC or state agencies provides transparency into the health, finances, and management of an investment fund.
- Unlicensed sellers: An investment opportunity with something to hide may use unlicensed sellers.
- Rogue brokers: Avoid brokers who are not registered with the SEC or the Financial Industry Regulatory Authority (FINRA). FINRA operates a BrokerCheck database that allows people to check broker registration status and any past disciplinary action. Never make checks payable to the broker instead of the company.
- Secretive and complex strategies: Lack of transparency should make would-be investors skeptical.
- Paperwork errors or inconsistencies: This could be a sign that the books are being "cooked."
- Problems with payments: Ponzi schemes stay in business by limiting payouts. They may be late with payments or try to dissuade investors from cashing out.
Curious about the Legality of an Investment? Get Professional Legal Help Today
Be prepared before getting involved in an investment scheme. If you have been charged with investment fraud, a seasoned attorney will be able to advise and defend you. Contact a criminal defense attorney near you.
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