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  • Danielle Kfir (Dulitzky)

The Challenges of Identifying and Preventing Ponzi Schemes

This article discusses what Ponzi Schemes are, their current scope, the regulatory landscape surrounding them, and how to avoid them.

Definition and Background

A Ponzi scheme is an investment fraud in which the schemer promises investors high returns on their investments in the short term with little or no risk, but in fact does not make any legitimate investments that produce income. Rather, in most cases, the schemer uses the funds contributed by new investors to pay existing investors. Thus, the schemer’s challenge is to keep attracting sufficient new investments to pay the promised returns to existing investors. Ponzi schemes collapse either upon the failure to recruit enough new investors, investors’ requests to withdraw their investments, or the discovery of the scheme by the authorities.

The scheme is named after Charles Ponzi, an Italian swindler that made his money in the 1920s by promising investors a fifty percent return in ninety days, while the annual interest rate for bank accounts was only five percent. At first, Ponzi used international mail coupons that he bought in different countries and redeemed in the U.S., but eventually started using the incoming funds from new investors to pay the existing investors. Although Ponzi was not the first person to attempt this type of fraudulent investment operation, the large amount of money he took from investors resulted in his name became synonymous with the scheme.

Ponzi vs. Pyramid Schemes

Ponzi schemes and pyramid schemes are similar in that the payments to existing participants are made using funds received from new participants. However, pyramid scheme is based on a business model of network marketing, which entitles participants to a share of the payment received from any new participant they recruit and participants in the upper tiers of the pyramid typically earn higher profits than those in the lower tiers. The methods of communication are also different. In Ponzi schemes the schemer acts as a “hub” with all participants communicating with him alone, but in pyramid schemes the participants communicate directly with each other. Additionally, pyramid schemes are explicitly illegal in many countries, whereas Ponzi schemes are not as well regulated.

Scope of the Phenomenon

Since Charles Ponzi’s scheme in 1920s, many Ponzi schemes have taken place around the world. More than 500 Ponzi schemes were uncovered in the U.S between 2008 and 2013 alone. Despite the scope of the phenomenon, only a few Ponzi schemes are widely known. One of the most infamous Ponzi schemers, Bernard Madoff, duped his investors out of approximately $65 billion in 2008, making it the largest case of fraud in history. Also notable is Allen Stanford’s $8 billion scheme that took place in 2009.

In recent years, a development in the Ponzi schemes landscape is evident. While the number of uncovered schemes and the amount of losses remained stable, the way schemes are implemented is changing to reflect market trends and the increased creativity of schemers. For example, in 2017 several schemers conducted Ponzi schemes by promising high returns on the reselling of tickets to popular Broadway musicals including Hamilton and major sporting events such as the Super Bowl.

Another new, market inspired Ponzi scheme is in the field of cryptocurrency, also known as “Smart Ponzi” because it protects the identity of the initiator. This is a big enough problem that the SEC has warned investors that virtual currency scams are attractive to schemers because of the reduction in potential investors’ skepticism due to the use of innovative technology and the lack of clear regulation in the field. Yet, the SEC clarified that it has jurisdiction over any securities investment in the U.S., whether it’s made in actual money or virtual currency.

The Regulatory Approach

The mechanism behind Ponzi schemes is not prohibited per se and may be considered a legitimate investment. However, when a fraud is discovered, under the SEC enforcement plan, the individuals responsible for the schemes are held accountable. For example, in the cases of Madoff and Stanford, they were sentenced to 110 and 150 years, respectively.

Moreover, since Madoff’s Ponzi scheme in 2008, extensive efforts have been made by the authorities to reduce the likelihood of recurrence of Ponzi schemes. For instance, the SEC decided to revitalize its Enforcement Division, make the investigation process more efficient, update its policies, implement a system to track and handle complaints, encourage cooperation of “insiders”, adopt rules that protects clients of investment advisors from theft, and adopt rules for enhanced protection of clients’ assets held by broker-dealers.

While these changes were a good start, the SEC and other agencies are constantly faced with new challenges related to tracking and handling innovative Ponzi schemes.

The Warning Signs

Despite the information and alerts provided by the authorities and media coverage of the issue, people too often put their trust in others and fall victim to Ponzi schemes. The SEC has published a list of warning signs on its website that may help investors identify a Ponzi scheme:

  1. High returns on investment with little or no risk.

  2. Consistent returns, in contrast to returns on other investments that may fluctuate.

  3. Investments that are not registered with the SEC or other state regulator.

  4. Unlicensed sellers.

  5. Complex strategies and fee structures that the investor cannot understand.

  6. No minimum investor qualification – namely, no inquiry about the investor’s salary or net worth.

  7. Lack of information about the investment in writing.

  8. Difficulty receiving payments.

  9. The scheme is brought to the investor’s attention through someone with a shared affinity. Recent studies show that in most cases the victims are elderly or family and friends with a common religion.

To conclude, the challenge of identifying Ponzi schemes and taking enforcement actions is ever increasing. Only time will tell whether the actions taken and the warning signs published by the agencies are sufficient to reduce the scope of the phenomenon, which has been a problematic part of the economic landscape for the past one-hundred years.

Danielle Kfir (Dulitzky) serves as a graduate editor of the NYU Journal of Law & Business. She is an LLM candidate in Corporation Law. Prior to attending NYU she worked as a corporate associate at Yigal Arnon & Co., one of the leading law firms in Israel, and as a teaching assistant in Property Law and Contract Law in Tel-Aviv University School of Law. Danielle graduated from Tel-Aviv University School of Law magna cum laude in 2015.

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