Although the term “Ponzi scheme” was coined in the 1920s in response to Charles Ponzi’s fraudulent schemes and re-popularized by the revelation of Bernie Madoff’s fraud in 2008, frauds of this type have always been with us. Simply stated, a Ponzi scheme is a financial fraud whereby the fraudster pays earlier investors from the proceeds of later investors’ money and can run until the outflow of redemptions exceeds the inflow of new money. This article explores how Ponzi schemes operate, identifies common warning signs to help you avoid investing in one, and notes what to do if you suspect you may have inadvertently invested in a Ponzi scheme.
Workings of a Ponzi Scheme
Most Ponzi schemes start out as legitimate investments before turning fraudulent. Typically, an investment manager (IM) will make a bad investment. Rather than admitting the loss to investors, the IM will instead report that the investment was profitable in the hope of making enough money in subsequent investments to cover the gap between what was reported and reality. Although it may sometimes be possible for later investments to cover earlier losses, more commonly the later investments also fail. The gap between what the IM continues to report and reality grows even larger as the IM pursues riskier and riskier investments to try to cover the growing gap.
Because the IM is unable to honor redemption requests from the fund’s rapidly dwindling assets, the IM instead uses new investments from later investors to cash out redeemers. This cycle causes a constant need for the IM to find new investors and leads the IM to make unrealistic promises of quick or outsized returns to induce them to part with their cash. Often, the fraudster—who is typically quite charismatic—will prey on people they know and their family and friends. Inevitably, the scheme fails because the IM cannot find sufficient new investors to fuel the fraud or a governmental agency such as the SEC will be tipped off and shut it down.
Warning Signs of a Ponzi Scheme
When it comes to a Ponzi scheme, the old adage that “if it seems too good to be true, it probably is” rings true. At the outset, you should be suspicious of IMs promising outsized or guaranteed returns. In truth, all investments carry risk, and any IM that isn’t open or candid should set off alarm bells.
Because Ponzi schemes are often “affinity crimes,” you should be especially wary of pitches that appeal to a common characteristic, such as membership in the same country club, graduation from the same university, or similar religious or ethnic identity. It is a sad but true fact that the Ponzi-schemer is often all too willing to defraud people by using things they share against them.
Additionally, you should be suspicious of generic or jargon descriptions of the IM’s investment strategy. If you cannot get details of the strategy or do not understand how the IM will invest your money, additional diligence is essential. And if the necessary details are not forthcoming, you should stay away.
What Should You Do if You Suspect You Have Invested in a Ponzi Scheme?
Despite the most careful pre-investment diligence and post-investment monitoring, at some point you may grow suspicious that your IM is not legitimate. Investors who find themselves in this situation should act promptly to conduct diligence—with the assistance, if possible, of an investigative firm—either to determine that the concerns are unfounded or that it is necessary to redeem out the investment. You may find it difficult to cash out, however, as the fraudulent IM may attempt to stem the outflow of funds. Nevertheless, you should insist that your redemption requests be honored. Experience shows that the most persistent and “noisiest” investors will often have the best chance of getting their money back. You may also wish to engage legal counsel to assist in these efforts. Most Ponzi schemes eventually fail, and those with unredeemed investments when the music stops are the most likely to lose all or most of their money. Thus, getting out as early as possible maximizes the likelihood of a greater recovery.
Unfortunately, getting your money out may not end your involvement with the Ponzi scheme. Once a scheme fails, it will usually go into bankruptcy, and/or a receiver, trustee or other fiduciary will be appointed to take over from the disgraced IM. This fiduciary will often seek to “claw back” money back from early redeemers to finance a fund for the benefit of other victims. In these cases, it may be necessary to pay back some money as a result of litigation commenced by the fiduciary or via settlement. Here, retaining experienced legal counsel may minimize the amount that must be repaid because a myriad of defenses may be available to you, depending on the circumstances.
When it comes to investing, the maxim “buyer beware” applies, and you should be vigilant when determining where and with whom to invest. You should also monitor your active investments carefully and engage with your IM if you feel information isn’t forthcoming or complete. Finally, anytime something seems too good to be true or something otherwise appears to be off, you should act promptly to protect yourself and to minimize the chances of a significant loss.
Marc Hirschfield and Marc Skapof are experienced business attorneys at Royer Cooper Cohen Braunfeld LLC. They have acted as counsel in many Ponzi scheme cases by representing fiduciaries or investors. With regard to the Madoff Ponzi scheme, Hirschfield and Skapof were counsel to the SIPA Trustee, where they assisted in the recovery of many billions of dollars for victims of Madoff’s fraud.
