Ponzi schemes and pyramid schemes are two of "the oldest professions" when it comes to securities fraud. Our goal here is to explain how they work and how to recognize them so you won't become a victim.
Ponzi schemes are named after Charles Ponzi, who in the summer of 1920 solicited investors to purchase "international postal reply coupons." According to Ponzi, these international postal reply coupons were postage stamps that could never be cancelled, but instead sold over and over again for a period of 90 days, thus generating income for the owner. Ponzi promised investors a 50% return on their initial investment within 90 days. Investors bought it, big time. During the summer of 1920 Ponzi raised about $15 million from tens of thousands of investors.
The reality of the situation was that these coupons could not continually generate income, but the scheme continued. Why? As more investors signed up and more money came in, Ponzi paid earlier investors their 50% return with funds from these later investors. Overjoyed about receiving their returns, investors spread the word about this great investment opportunity, and more money flowed in. Since investors were getting paid, there was no reason for them to complain. Eventually, Ponzi was unable to attract additional investors. This prevented him from paying the later investors, causing the scheme to collapse. This "robbing from Peter to pay Paul" is the basis of all Ponzi schemes. Eventually, the scheme collapses because no new investors can be found or the fraudster takes off with investors' funds.
By contrast, investors in a pyramid scheme do not rely on one promoter (i.e., Ponzi) for their returns. Investors ("first-level investors") make an initial investment and are told that for every investor they bring into the fold ("second-level investors"), a portion of that investment will go to them. Each time second-level investors bring in an investor ("third-level investors"), a portion of those funds go up to both the second-level and first-level investors. This cycle continues, and a portion of each contribution by a new investor works its way up to previous investors. Like Ponzi schemes, all pyramid schemes are doomed to fail because they depend on the ability to attract an infinite number of investors, a mathematical impossibility.
What are things you should watch out for? Like bogus offerings, pyramid and ponzi schemes promise that the investment is "risk-free" and that the high rate of return is guaranteed. Additionally, both schemes attempt to pressure investors to reinvest their earnings. The reinvestment pitch is an effective way for the fraudster to keep the scheme going because the longer he goes without writing a check to an investor, the longer he can lull an investor into believing the investment is making money. Thus, the end result is that the scheme lasts longer and the bad guys get richer! Finally, be aware of situations where there is pressure to invest early to ensure "getting in on the ground floor."
In many cases, promoters of illegal pyramid schemes deliberately try to confuse prospective investors by attempting to distinguish the scheme from a legitimate multilevel marketing (MLM) operation. In a legitimate MLM, there is a real consumer product that has significant value in and of itself. Investors are told that most of their profits come from the sale of this product. Though a legitimate MLM encourages investors to build a "downline" and profit by taking a cut of the sales made by those downline investors, there is no requirement to build a downline. Investors can profit by selling the product itself, even to people who have no interest in joining the MLM. However, in an illegal pyramid scheme that tries to pass itself off as a legitimate MLM, the "product" is something that has very little inherent value, if any at all, making it extremely difficult, if not impossible, to sell. Thus, the only opportunity for you to profit is by actively recruiting additional investors.
Let's look at some real-life examples. In October 1999, the Securities and Exchange Commission (SEC) charged Mark Drucker with running a $6.2 million ponzi scheme. Drucker told investors that he was a successful daytrader and that because of expertise in this field, he could invest their money and secure a 50% return in two months or less. Drucker used investor funds to pay earlier investors their promised 50% returns. However, Drucker neglected to tell investors that his day-trading strategy consistently lost money -- in fact, during 1999 alone, Drucker lost $630,000. Drucker also conveniently forgot to tell investors that he was using their money to pay off earlier investors and to finance elaborate parties at his home.
SEC v. International Heritage involves one of the biggest pyramid schemes in recent history. Prospective investors were told they could make money by selling Montblanc pens, Waterford crystal, Coach leather products, and Ping golf clubs. However, when people signed up to become distributors, they were told they could make much more money if they signed up other people to become distributors. Additionally, people who actually tried to sell the products never received them from the promoters. By the time the SEC moved in to stop the scheme from continuing, the promoters had raised $150 million from 155,000 investors.
Again, the message here is to be careful. Approach all investment opportunities with caution. Remember that nobody can force you to be a fool, except you. So, be Foolish!
Warning Signs
- You're told that your returns "require no effort on your part"
- Statements such as "we're a legal multilevel business opportunity"
- The product you're to sell is one nobody wants
- Returns are based on your ability to attract other investors
- You're pressured to "roll over" your returns for additional profits
Next: Affinity Fraud »
RSS Headlines
Fool UK