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Ponzi Schemes: A Critical Analysis

Article · July 2011

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Ponzi Schemes: A Critical Analysis
by Surendranath R. Jory, Ph.D., and Mark J. Perry, Ph.D.

Surendranath R. Jory, Ph.D., is an assistant professor in the department of finance

at the School of Management at the University of Michigan-Flint. Mark J. Perry,
Ph.D., is a professor of finance and business economics at the School of
Management at the University of Michigan-Flint.

Executive Summary
The 2009 conviction and sentencing of American investment adviser Bernard Madoff
to 150 years in prison for 11 federal crimes involving a $65 billion Ponzi scheme has
increased public, investor, and financial industry awareness of this type of
investment and securities fraud. The literature for a financial adviser audience on
Ponzi schemes is limited, and this paper attempts to help fill that void. We provide an
overview of how these fraudulent investment schemes operate and offer a detailed
analysis of how financial advisers and their clients can detect them. Other topics
covered include a discussion of the motivations and traits of Ponzi perpetrators and
the conditions under which they operate their illegal schemes. Next, we discuss the
legal consequences of being involved in such schemes, and provide an overview of
how regulators have fared against Ponzi perpetrators. Most importantly, we develop
an itemized and detailed checklist to help investors, financial advisers and brokerage
clients identify fraudulent investment schemes. Ponzi perpetrators depend on finding
willing investors, and the better informed and educated both financial planners and
their clients become about Ponzi perpetrators, the less likely financial con artists like
Bernard Madoff will find and exploit victims.

In a typical Ponzi scheme, investors are told they will earn abnormally high returns
because of the scheme promoter's unique skills and investment strategy. Instead,
the promoter raises money from new investors to make those payments. The
Federal Bureau of Investigation (FBI) defines a Ponzi scheme as follows:

A Ponzi scheme is essentially an investment fraud wherein the operator promises

high financial returns or dividends that are not available through traditional
investments. Instead of investing victims' funds, the operator pays "dividends" to
initial investors using the principle [sic] amounts "invested" by subsequent investors.
The scheme generally falls apart when the operator flees with all of the proceeds, or
when a sufficient number of new investors cannot be found to allow the continued
payment of "dividends."1

Ponzi schemes are named after Charles Ponzi, who in 1919 led investors to believe
that they could earn a 50 percent return in as little as 90 days. Ponzi was convicted
and jailed in 1920 for financial fraud. One of the most recent and notable Ponzi
schemes is the one perpetrated by Bernard Madoff. The estimated cost of the
scheme (involving almost 8,000 clients) is in excess of $50 billion. The New York
Times reported that "the Ponzi scheme orchestrated by Bernard L. Madoff was the
largest fraud by anyone in American history, involving $65 billion and damaging the
finances of thousands."2 Madoff was arrested in 2008, pleaded guilty to 11 federal
offenses in 2009, and was sentenced to 150 years in prison shortly thereafter.

A Ponzi scheme is structured as a pyramid wherein more money is needed in each

round to make payments to existing participants. For example, a Ponzi perpetrator
approaches an investor for a one-year investment that pays a return of 20 percent.
The investor invests $100,000, expecting $120,000 in a year. At the end of the year
the Ponzi perpetrator approaches another investor, promising the same results, but
demanding an initial investment of $120,000 this time. Assuming that the second
investor accepts the proposal, the perpetrator takes the money and pays off the first
investor. The cycle continues the third year (funds needed are now $144,000), the
fourth year (funds needed are now $172,800), and so on. The initial reward for
running a Ponzi scheme is huge. In the example above, the Ponzi perpetrator
pockets the initial $100,000.

Ponzi schemes are doomed because their funding requirements increase

geometrically over time (as the above example illustrates). Consequently, there are
not too many exit strategies for the person running a Ponzi scheme. He or she will
ultimately have to find a legitimate investment that pays off handsomely in order to
make sufficient money to cover the fraud, or else, run and hide, fake suicide, commit
suicide, seek immunity, or get caught.

There are many types of Ponzi schemes. Theoretically, a government may run what
is referred to as a "rational Ponzi game."3 This happens when the government issues
new bonds to pay its existing bondholders and rolls over its debt perpetually under
the assumption that future generations will continue to lend.4 A sovereign default is
also akin to a Ponzi scheme, especially when there are no sanctions forthcoming

2
from other countries (i.e., a case where there are no default costs and debt claims
are not enforceable).5 Last, but not least, many public pension funds are known to
have overpromised when they were grossly underfunded.6

We do not cover rational Ponzi games in this paper, and instead focus on those
schemes where investors are deceived, which involve illegal investment frauds.
While we focus on schemes that are run as investment funds, we caution that not all
schemes are operated as such. Ponzi schemes may take the form of a business
proposition as well; for example, sourcing items at a lower price and selling them at a
higher price in a different market or investing in real estate, among others.

We have seen a resurgence in the number of Ponzi schemes in recent years. In

2009, 20 percent of the fraud cases investigated by the U.S. Securities and
Exchange Commission (SEC) were Ponzi schemes.7 While Bernard Madoff's Ponzi
scheme was massive, most are run on a smaller scale. Nonetheless, the collective
harm the ensemble of Ponzi schemes cause is significant. According to data
compiled by Investment News, schemes involving $9,244 billion in losses were
revealed in 2010.8 Madoff's scheme alone cost thousands of investors nearly $65
billion. In 2009, Allen Stanford, a Texan billionaire and cricket promoter, was indicted
of defrauding at least 30,000 investors of $7 billion by selling fake certificates of
deposit through his bank based in Antigua. Madoff and Stanford's victims' losses are
not covered by the federal Securities Investor Protection Corp. (SIPC), which
safeguards investment accounts against fraud or bankruptcy.9 There is the risk that
many such schemes are still operating today without the knowledge of their
investors. Therefore, we need a framework to protect these investors and others who
may fall prey to Ponzi perpetrators.

In this paper we first look at several aspects of Ponzi schemes that might be useful
for financial practitioners, including the motivations and traits of Ponzi perpetrators
and the conditions under which they operate. Secondly, we look at how a Ponzi
scheme is structured, what motivates a Ponzi perpetrator, and how to identify Ponzi
schemes. Finally, we discuss the legal consequences of being involved in such
schemes and provide an overview of how regulation has fared against Ponzi
perpetrators.

The Structure of a Ponzi Scheme

To better understand Ponzi perpetrators, we first need to look at how a Ponzi
scheme is structured. Consider our earlier example, a Ponzi scheme that starts with

3
$100,000 and pays off 20 percent annually. To make the example more realistic, we
will assume that no investor puts in more than $50,000 in the scheme. We present
one scenario for the first four years of the scheme in Figure 1.
Figure 1: The Structure of a Ponzi Scheme Promising a 20 Percent Return

Funds
Year Needed Amounts Raised ($1,000s) # of Investors
0 $ 100,000 $ 50.00 $ 50.00 2

1 $ 120,000 $ 40.00 $ 40.00 $ 40.00 3

2 $ 144,000 $ 48.00 $ 48.00 $ 48.00 3

3 $ 172,800 $ 43.20 $ 43.20 $ 43.20 $ 43.20 4

4 $ 207,360 $ 41.47 $ 41.47 $ 41.47 $ 41.47 $ 41.47 5

Year 0 is today, and $100,000 is needed to start the scheme. As a result, the
scheme needs at least two investors contributing $50,000 each. Given a 20 percent
rate of return, the promoter needs to pay $120,000 total at end of the first year.
Therefore, he needs to raise a total of $120,000 in Year 1 to make those payments.
He solicits three investors who contribute $40,000 each. At end of Year 2, the
promoter now has to repay those who contributed last year $48,000 each. Therefore,
he raises $48,000 from three new investors at the end of Year 2 to make those
payments. These new investors need to be repaid $57,600 each for a total of
$172,800 at the end of Year 3. Therefore, the promoter solicits new investors once
again, and collects $43,200 from four investors this time to make those payments.
The sequence goes on like that.

What do we observe? First, the Ponzi promoter pockets the initial $100,000. That's
his initial financial gain from running the scheme. Second, the funding requirement
increases at the rate of (1 + rate of return) every year; that is, it increases
geometrically. Third, given finite wealth, more and more investors are needed over
time. For example, two are needed to start the scheme, three in Years 1 and 2, four
in Year 3, five in Year 4, etc. Therefore, the scheme relies on an infinite supply of
capital. However, this is obviously not possible, and that is one reason Ponzi
schemes eventually fail.

4
Next, in the four-year period displayed in Figure 1, we assume that the promoter is
able to attract new capital as required. What if in Year 1 he can only manage to
recruit two investors instead of three, and the two investors cannot supply the capital
needed? The scheme will fail in that year. This explains why Ponzi schemes are at
risk even if only one investor desists.

In Figure 1, the promoter expects the Ponzi scheme to outlast him. To achieve that
end, he will pay a return slightly higher than the opportunity cost of investors' capital,
start the scheme later in his career, or run the scheme where there is an abundance
of capital and/or investors. Also, to avoid suspicion, the promoter does not promise a
return too much higher than the opportunity cost of capital. Given our example, we
are slowly gathering the conditions that favor Ponzi schemes: (1) such schemes are
more likely in a boom or asset bubble, (2) they are more likely in a market with more
investors compared to one with fewer, and (3) they are more likely in an environment
where financing is easily available either through excess savings or credit
availability. At the same time, they are likely to be uncovered when the reverse of
each happens; that is, in a recession and/or when investors pull out of the market
and/or in a credit squeeze. This would explain the relatively high number of Ponzi
schemes uncovered in 2008 and 2009, a recessionary period with financial, banking,
and credit problems.

Earlier we wrote that the promoter expects the Ponzi scheme to outlive him.
However, this is very unlikely. Ponzi schemes, in real life, are more complex than the
one described in Figure 1 and involve far more investors. For example, the Ponzi
scheme operated by Bernard Madoff involved thousands of clients and billions of
dollars. His clients included investment management firms (such as Fairfield
Greenwich Advisors, which lost $7.5 billion in the scheme, and Tremont Group
Holdings, which lost $3.3 billion), international banks (Banco Santander of Spain lost
$2.87 billion; Bank Medici of Austria lost $2.1 billion; Fortis of Holland lost $1.35
billion), pension funds, insurance companies, wealthy individuals, and a whole group
of diverse and sophisticated investors. A scheme of that size and reach will sooner
or later attract curiosity and scrutiny, and that is exactly what happened in the case
of Madoff.10 Hit by a wave of redemptions, the scheme becomes unsustainable.
When the SEC starts investigating the scheme, its days are likely numbered,
although Madoff managed to survive for many years after the SEC was first
presented with evidence.

5
What Are the Motivations of a Ponzi Perpetrator?
The main motivation of a Ponzi perpetrator is surely financial. However, it is clear
that the scheme will unravel one day. Therefore, either perpetrators think that day is
too far in the future to be bothered by, are confident they will find a way out, or
simply ignore the risk. Mitchell Zuckoff, a journalism professor at Boston University
and author of Ponzi's Scheme: The True Story of a Financial Legend, says that
Ponzi perpetrators are self-delusional.11 Ponzi perpetrators are surely overconfident
and skilled at deceiving others. Last but not least, their urge to make money takes
precedence over any risk considerations, maybe because of their need to finance
lavish lifestyles without regard to possible consequences.

Who Are Ponzi Perpetrators and What Are Their Traits?

A survey conducted by KPMG's Forensic Professionals on corporate fraudsters (i.e.,
employees committing white-collar crimes within their organizations), found that
fraudsters are most likely to be males between 36 and 55 years old who act
independently and locally, have a finance background, and are motivated by greed
and opportunity.

Bhattacharya lists three critical components of a Ponzi scheme: the perpetrator (1)
convinces a group of people about an investment idea, (2) promises a high rate of
return, and (3) builds credibility by initially delivering on his or her promises.12 We
add that the investment idea frequently sounds sophisticated and complicated. Ponzi
perpetrators promise rates of return that defy economic cycles. They make their first
payments as promised, to create trust and to prop up an ensuing word-of-mouth
publicity chain to attract more investors.

To be able to sell a false idea of consistently high returns, it is likely that Ponzi
perpetrators are charismatic salespeople, persuasive and good at successfully
closing a sales pitch.

Initially, Ponzi perpetrators focus their attention on targets related to them either
socially or professionally. The way they approach these people is more
psychological in nature than factual, and they exploit the trust between them and
people they know. However, after the scheme evolves, that initial group will not
suffice to sustain it, and the door is then opened to outsiders.

Upon receipt of investment funds from the targets, Ponzi perpetrators may issue
counterfeit certificates to show that the investor has contributed. Perpetrators may

6
also produce fake certificates of securities as collaterals, and they may even fake
their own identity as well.

To manage the operation, employees of a Ponzi perpetrator are usually close family
members, relatives, or friends. Employee turnover is very low, and this is important
to concealing the scheme. Some Ponzi schemes are registered in offshore centers
where regulation is not strict.

Ponzi promoters are known to be generous donors and regularly contribute to

charities, educational institutions, and political campaigns. The more political
connections the perpetrators have, the more confident they are about continuing
their operations without being caught.

Evidence on Ponzi Schemes

In an attempt to better understand how Ponzi schemes operate, we collected data on
80 Ponzi schemes investigated and reported by the SEC and the FBI, and we
present our findings in Table 1.

Table 1: Observations from Ponzi Schemes Investigated by the SEC and the FBI

Places Most Ponzi schemes are located in populous states: California, Florida,
Illinois, New York, New Jersey, and Texas top the list.
Co- One in every two Ponzi schemes involves co-perpetrators.
perpetrators
Company Ponzi schemes commonly operate under a company name.
Name
Business Most Ponzi schemes purport to operate legitimate financial businesses
Type such as investment advisory, asset and investment management, hedge
funds, real estate investment funds, faith-based investment schemes,
investment in distributorships, leasing companies, time-shares, pension
management, and trusteeships.
Registration Small Ponzi schemes mostly operate as unregistered businesses; however,
large ones are registered.
Frequency Their numbers increased significantly in the first decade of the 2000s,
coinciding with a bullish stock market period.
Termination An unprecedented number of Ponzi schemes fell apart in 2008 and 2009,
coinciding with a financial crisis and an economic recession.
Promised The most common rate of return promised is close to that available from
Return stock market investments.
Investment The majority of Ponzi schemes promise to pay a return within a year.
Horizon
Investors’ The average number of investors involved in a Ponzi scheme is 100 or
Pool less. Larger Ponzi schemes affect thousands of investors.

7
 Strategies Besides misrepresentatiing their businesses, Ponzi perpetrators adopt one
or more of the following strategies to draw investors:
- Propose investments that are high-return, no-risk, and principal-
protected
- Grossly inflate the amount of funds under management and the returns
paid
- Pretend that they are experienced and had a successful investment
career
- Purport to use proprietary trading software and/or special connections
- Send regular account statements that show fictitious profits
- Provide investors a personal guarantee for their principals
- Claim investments are fully backed by collaterals
- Have auditors who will “vouch” that the investments and accounts are
legitimate
- Make false claims that investments are FDIC- and/or SIPC-insured
- Claim to be an expert in derivatives and/or foreign exchange trading
- Use Bible-speak to win investors’ trust
- Recruit through local and/or community-based ads and/or agents
- Target faith-based and/or ethnicically or culturally based associations
- Target retirees
Investment Besides stock market and derivatives investments, Ponzi perpetrators also
Products propose the following as investment products:
postal coupons, accounts receivables, automated teller machines, private
investment in public equity (PIPE) securities, pay-phone lease programs,
foreign currencies, fractional interests in discounted life insurance, gold
coins, limited partnership interests in trade ventures, oil and gas
investments, promissory notes, self-styled certificates of deposit, faith-
based investment funds, real-estate investment trusts, shares in shell
companies, time-shares, and viatical settlement contracts.
Investors There are almost no cases in which all investors involved recovered 100
Recovery percent of their investments. The average recovery rate is less than 40
percent.
Legal Most Ponzi schemes are prosecuted for one or more of the following
Charges crimes:
Mail Fraud; Money Laundering; Securities Fraud; Wire Fraud; Tax
Crime; Operating Unregistered Securities Business.
Note: Theseobservations were made from a random sample of 80 Ponzi schemes
investigated by the SEC and the FBI. Case reporting was not standardized, and the
observations do not represent the full set of Ponzi schemes.
Source: www.sec.gov.

How to Identify Ponzi Schemes

The SEC lists some of the typical "red flags" of Ponzi schemes:

1. High investment returns with little or no risk-usually there is a positive relationship

between risk and return and schemes that promise high returns with low risk need to
be looked at suspiciously.

8
2. Overly consistent returns-Investment returns usually follow the business cycle.
Returns are up when the economy is booming, and down in a recession.
Investments that promise to pay the same return irrespective of business cycles are
often a key feature of Ponzi schemes.

3. Unregistered investments-Investments that are not registered with either the SEC
or state regulators should be questioned.

4. Unlicensed sellers-Federal and state securities laws require investment

professionals and their firms to be licensed or registered. Most Ponzi schemes are
not.

5. Secretive and/or complex strategies-Ponzi schemes usually do not publish

detailed information about their investments. They are referred to as "blind pools"
wherein investors do not know exactly how their money is invested.

6. Issues with paperwork-Ponzi schemes usually do not send regular performance

statements or reports on clients' investments, and instead are more likely to be
inconsistent and error-prone in correspondences.

7. Difficulty receiving payments-Ponzi perpetrators usually encourage investors to

roll over their high returns and increase their investment holdings. Investors
attempting to cash out their investments are more likely to face difficulties obtaining
cash back. Ponzi perpetrators will encourage investors who want to cash out their
investment to do so gradually or not at all.13

The FBI warns investors to be careful about investment proposals that promise to
pay exorbitantly in a short period of time and that are not accompanied by
prospectuses, quarterly or annual reports, and offering memoranda.14 The public is
advised to be wary of "affinity scams," not to invest based on acquaintance alone,
and to be suspicious of investment offerings emanating from social networking sites
and chatrooms. The FBI recommends that investors seek third-party advice, for
example, to contact an independent broker or licensed financial adviser before
investing. Therefore, financial planners and advisers may face questions at some
point during their careers from clients about questionable investment schemes, and it
is best for financial industry professionals to be as well informed as possible.

Research has shown that some of the common features of fraudulent schemes are
random returns, too few negative returns, and too many repeat returns.15 These

9
findings suggest that increased regulatory oversight with stricter requirements for
mandatory reporting will help to identify such schemes.

We developed a checklist of questions in Table 2 that financial planners might find

helpful when advising clients about questionable investments that might indicate a
Ponzi scheme.
Table 2: A Checklist of Questions to Ask Before Trusting Money to a
Financial Custodian
YES NO
In terms of return, the scheme promises:
To pay a high rate of return not available elsewhere? ? ?
To pay back in a short period of time? ? ?
To pay a constant rate of return independent of economic cycles? ? ?

The scheme manager:

Does not possess the relevant qualifications and experience to act as a money ? ?
manager?
Is not licensed by federal and state securities law to be an investment ? ?
professional?
Wants complete control of your money? ? ?
Was involved in fraud or was under SEC investigation in the past? ? ?
Lied to or deceived people in the past? ? ?
Is a willing donor to charities, institutions, and politicians? ? ?
Is always trying to obtain political favor? ? ?
Appears to have become rich in a very short period of time? ? ?
Appears to be in financial trouble because of his lavish lifestyle? ? ?
Is always looking for new investors at social, religious, and family gatherings? ? ?
Asks you to remain coy about the fund to people whom you do not know or ? ?
regulators?

The scheme or investment proposal or fund:

Is not registered with the SEC or state regulators? ? ?
Is registered offshore where investment laws are less strict? ? ?
Is opened to all kinds of investors? ? ?
Conducts all transactions in-house; that is, acts as a broker, investment ? ?
manager, custodian of assets, and fund administrator at the same time?
Uses lesser-known or mostly unknown auditors? ? ?
Charges very little in the form of fees? ? ?
Employs only family members or friends or the same people overtime? ? ?
Has low turnover on management team and does not grow with the size of the ? ?
fund?
Transacts mostly with small banks, unlike its peers? ? ?

Regarding reporting:
The certificates received from the scheme/fund are not registered? ? ?

10
 You do not have a reasonable understanding of the investment strategies ? ?
adopted?
You do not receive regular performance statements? ? ?
There is no person available to take/answer your calls? ? ?
Your calls are not answered in a straightforward manner? ? ?
Your adviser’s firm is regularly closed during business days? ? ?
The firm does not allow electronic or real-time access to your account? ? ?

Payments:
Were (i.e., interest or dividend or principal) missed? ? ?
Are persistently encouraged to be reinvested? ? ?

As an investor, you:
Never called the SEC to verify the scheme in which you are invested? ? ?
Never verified whether the fund is filing all its paperwork with the SEC? ? ?
Contributed to the scheme based on trust (or a friend’s recommendation) ? ?
and/or faith only?
Tend to ignore negative comments about the fund’s adviser/manager? ? ?
Have suffered unexplained losses, but you do not want to withdraw as you ? ?
have hopes that you will recoup your investment?

The checklist contains six categories of questions: (1) the rate of return promised, (2)
the profile of the promoter, (3) details about the scheme or investment proposal,16 (4)
the scheme's reporting system, (5) the frequency of payments received, and (6)
questions investors should ask themselves. If a client answers "Yes" to any of the
questions in Table 1, then financial advisers should advise the client that further
investigation is warranted and be prepared to protect the client from investing in a
Ponzi scheme.

Despite the checklist, warning signs and even financial advice from professional
advisers, there is always the risk some clients will fall prey to Ponzi perpetrators
because of irrationality (for example, the client trusts the promoter) and/or
information asymmetry (i.e., the client has incomplete knowledge). There is also the
phenomenon of "buyer's denial," whereby despite losing money, clients may still
have false hopes that they will recoup their investments.

What Are the Legal Consequences of Participating in a

Ponzi Scheme?
When investors realize they may be victims of a Ponzi scheme, they may seek the
advice of a financial adviser or planner. This section provides information about the
legal consequences after a Ponzi scheme is uncovered, in the event that a financial

11
adviser or planner is approached by a victim of a fraudulent investment scheme who
seeks professional financial advice. After a Ponzi scheme is discovered by
government regulators, the SEC files a lawsuit against the Ponzi perpetrator, and a
trustee is then appointed to recover as much money as possible to make payments
to creditors and to redistribute any recovered proceeds pro rata to investors.17 The
trustee will first target the hard assets of the Ponzi perpetrator. Next, he or she will
try to reclaim payments made to investors (irrespective of whether they had
knowledge of the Ponzi scheme). The trustee will also consider taking legal actions
against other related financial institutions (including the Ponzi perpetrator's bank) if
there is evidence they were conspirators or failed to act on red flags of an ongoing
fraud scheme.

As a result, it is rare that the legal consequences are limited to the perpetrator alone.
Any person/entity that funded the scheme (referred to as a "feeder fund"), even
unknowingly, is at risk. This is especially true when the feeder fund collected money
from others and failed to apply due diligence and/or failed to notice red flags
suggesting fraud was taking place.

The bank the perpetrator uses to conduct transactions is at risk as well. The issue
here is that the bank had access to the financial accounts of a perpetrator and may
have been aware of anomalous activities tantamount to fraud. The same charges
can be levied against an investment bank that handled the activities of a Ponzi
perpetrator; for example, if it acted as a broker, raised funds, had custody of assets,
prepared investment accounts, or had access to marketing materials, it could be
liable.

In cases where the perpetrator made charitable donations, the trustee may require
that some or all of those donations be returned after the scheme is exposed,
irrespective of the status of the recipient. Employees who work at a hedge fund
accused of fraud, who are suspected of either conspiring with the promoter, or who
were aware of the fraud are also at risk. The SEC may seek permanent bans against
them working in the securities industry again. Finally, the family members of the
promoter are at risk as well, and their assets can be frozen and legally prevented
from being transferred or sold.

In 2009, U.S. President Barack Obama established an interagency Financial Fraud

Enforcement Task Force that involved members of the U.S. Department of Justice,
the FBI, the SEC, the U.S. Postal Inspection Service, the Internal Revenue Service

12
Criminal Investigation unit, the U.S. Commodity Futures Trading Commission, the
Federal Trade Commission, the U.S. Secret Service, the National Association of
Attorneys General, and a broad range of federal and state agencies and authorities
to investigate and prosecute financial crimes under the code "Operation Broken
Trust." By December 2010, Operation Broken Trust had achieved the results in
Table 3.
Table 3: Operation Broken Trust Statistics for August 16–December 1, 2010
Panel A: Criminal Cases
Number
Cases 231
Defendants 343
Arrests 64
Info/Indictments 158
Convictions 104
Sentencings 87
Estimated Loss Amount $8,384,150,054
Estimated Victims 120,381

Panel B: Civil Cases

Civil Enforcement Actions 60
Defendants 189
Estimated Loss Amount $2,134,681,524
Estimated Victims 23,566

Source: FBI Press Release, “Financial Fraud Enforcement Task Force Announces
Results of Largest-Ever Nationwide Operation Targeting Investment Fraud,”
December 6, 2010, accessed at www.fbi.gov.

Table 3 shows that Operation Broken Trust involved 231 criminal cases and 60 civil
enforcement actions. Eighty-seven defendants have been sentenced to prison. More
than 120,000 people were defrauded of close to $8 billion in the 231 criminal cases.
The schemes investigated include Ponzi schemes, affinity frauds, prime bank/high-
yield investment scams, foreign exchange frauds, business opportunity frauds, and
other similar schemes. The task force maintains a website at www.stopfraud.gov to
keep investors and the general public informed about investment scams.

Regulating Ponzi Schemes

The SEC, as the main regulator of the financial markets, is taking heat for failing to
detect Ponzi schemes.18 However, we caution that many such schemes rarely start

13
as a registered business, hence avoiding detection by regulators. Consequently, it is
unlikely that regulators are able to stop Ponzi schemes in their early stages.

Ponzi promoters take several steps to ensure information about their scheme is not
leaked to the SEC. First of all, they keep their operations small in terms of human
resources. They employ people they can trust who are unlikely to denounce them
even after leaving. Second, Ponzi promoters publish little information about their
operations. This lack of information makes it hard to uncover their fraudulent
activities. They also ask their investors not to reveal anything to regulators as the
promised high returns will be impossible to achieve under a regulatory watchdog.
They exploit the trust of their clients, and the latter are reluctant to come forward and
expose them. Even if the clients discover the scheme, they become more concerned
about recouping their investments than worrying about the legitimacy with which it is
carried out. Ponzi promoters frequently establish connections with high-ranking
politicians and influential investors and engage in philanthropic groups to benefit
from their protection. The point is the promoter works hard to avoid detection by the
SEC and other regulators.

It is also sometimes possible that the promoter is running a Ponzi scheme alongside
a legitimate business. Or perhaps the promoter is running a legitimate business, but
because it loses money, starts a Ponzi scheme to cover those losses. Obviously, in
these situations, the SEC is unlikely to detect the fraud at an early stage.

Many Ponzi schemes (not the likes of big-time operators like Bernard Madoff and
Alan Stanford) are small in size, involving just a few investors. The cost of
investigating these very small schemes may weigh heavily on the SEC's resources.
Given the SEC's resource constraints plus a never-ending investigation list, its
approach to investigating Ponzi schemes is more likely reactive than proactive. In
these circumstances, the SEC would rather concentrate its efforts on larger frauds
involving a larger pool of investors have implications for the investing community at
large. The SEC's "stat system," which keeps track of its filed cases and may form the
basis for incentives and rewards, can favor quick-hit cases overmore difficult ones.19

For the SEC to do a better job at policing Ponzi schemes, it needs more staff
specialists, a bigger budget, a leaner organization, less bureaucracy, and better
investor education. As Khuzami and Walsh testified before the U.S. Senate
Committee on Banking, Housing, and Urban Affairs on September 10, 2009, "The ...
Report traces the SEC's failure with Madoff to shortcomings in a number of areas,

14
including insufficient expertise, training, experience and supervision by management;
inadequate internal communication and coordination among and within various SEC
divisions; deficiencies in investigative planning and prioritization; lack of follow-
through on leads; and insufficient resources."20

As a result of the Bernard Madoff's scheme and the financial crisis of 2008, the
Dodd-Frank Wall Street Reform and Consumer Protection Act came into effect in
July 2011 to rein in financial frauds and protect consumers.21 It strengthens oversight
and empowers regulators to aggressively pursue financial fraud. The law directly
targets Ponzi schemes, offers protection to and rewards whistleblowers who provide
information that results in an enforcement action by the SEC, and empowers and
allocates more resources to the institution to crack down on such schemes.

Following the passage of the Dodd-Frank financial legislation, the SEC introduced
the whistleblower bounty program.22 Under the program, an employee who reports
fraud to the SEC can net under certain conditions as much as 30 percent of the
penalties and funds recovered from the fraud perpetrator by the SEC. Among others,
the law also establishes a single toll-free number as a consumer hotline to report
problems with financial products and services, requires hedge funds and private
equity advisers to register with the SEC, and establishes greater state supervision.

Conclusion
Monitoring against Ponzi schemes should best be undertaken by well-informed
individual investors, because history shows that the SEC identifies most schemes
only after substantial harm against investors is perpetrated. If investors do not
question or follow their fund managers closely, they are potentially facilitating a
fraudulent Ponzi perpetrator. Therefore, it is up to investors to do their due diligence
when making any kind of investment decision, especially when a high-profile
investment adviser is promoting securities not registered or listed on normal
exchanges or for which limited public information is available.

In the event financial advisers are approached by current or prospective clients with
concerns about fraudulent investment schemes, we have provided a checklist in
Table 2 that could assist financial professionals when giving advice to a client who
may be considering investing money, or who may have already invested money, in a
Ponzi scheme. Ponzi perpetrators will probably always exist, but their success
depends on finding clients willing to invest in their schemes, and the better informed

15
and educated investors and financial advisers become, the less likely they will
become victims of financial con artists like Bernard Madoff.

Endnotes
1
http://www.fbi.gov/majcases/fraud/fraudschemes.htm.
2
http://www.nytimes.com/interactive/2009/06/29/business/madoff-
timeline.html?ref=bernard_l_madoff.
3
S. A. O'Connell and S. P. Zeldes, "Rational Ponzi Games," International Economic
Review 29, 3 (1988): 431-450.
4
PIMCO (one of the biggest bond funds) manager Bill Gross referred to the Fed's
2010 QE2 as a Ponzi scheme: "It seems that the Fed has taken Charles Ponzi one
step further. Instead of simply paying for maturing debt with receipts from financial
sector creditors ... the Fed has joined the party itself. Rather than orchestrating the
game from on high, it has jumped into the pond with the other swimmers. One and
one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed,
in effect, is telling the markets not to worry about our fiscal deficits, it will be the
buyer of first and perhaps last resort. There is no need-as with Charles Ponzi-to find
an increasing amount of future gullibles, they will just write the check themselves. I
ask you: Has there ever been a Ponzi scheme so brazen?" "PIMCO's Bill Gross:
QE2 Is a Ponzi Scheme," Wall Street Journal, October 27, 2010, accessed
at http://blogs.wsj.com.
5
Jurg Niehans, "International Debt with Unenforceable Claims," Federal Reserve
Bank of San Francisco Economic Review 1 (Winter 1985): 64-79.
6
Roger Lowenstein, "The Great American Ponzi Scheme: Do We Want Public
Pensions? There Are Compelling Reasons Why We Do," Bloomberg Businessweek,
March 31, 2011, accessed at www.businessweek.com.
7
SEC 2009 Performance and Accountability Report.
8
Paul Sullivan, "How to Avoid Being Taken in by a Ponzi Scheme," New York Times,
December 10, 2010.
9
Robert Schmidt and Jesse Westbrook, "Madoff, Stanford Victims Unite," Bloomberg
Businessweek, March 10, 2010.
10
http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html.
11
Catherine Rampell, "Hey Ponzi: What's Your Exit Strategy, Exactly?" New York
Times Economix Blog, December 16, 2008, accessed
at www.nytimes.economixblogs.com.

16
 12
U. Bhattacharya, "The Optimal Design of Ponzi Schemes in Finite
Economies," Journal of Financial Intermediation 12 (2003): 2-24.
13
http://www.sec.gov/answers/ponzi.htm.
14
http://www.fbi.gov/news/stories/2010/december/fraud_120610/fraud_120610.
15
Nicolas P. B. Bollen and Veronika Krepely Pool, "Predicting Hedge Fund Fraud
with Performance Flags," SSRN, March 12, 2010, accessed
at http://ssrn.com/abstract=1569626.
16
See also Greg N. Gregoriou and Francois Lhabitant, "Madoff: A Riot of Red
Flags," SSRN, December 31, 2008, accessed at http://ssrn.com/abstract=1335639.
17
In more technical terms, the SEC appoints a receiver, a disbursement agent, or a
claims administrator to recover and distribute funds to victims.
18
R. Khuzami and John Walsh, "SEC's Failure to Identify the Bernard L. Madoff
Ponzi Scheme and How to Improve SEC Performance," testimony before the U.S.
Senate Committee on Banking, Housing, and Urban Affairs, September 10, 2009,
accessed at http://www.sec.gov/news/testimony/2009/ts091009rk-jw.htm.
19
Richard C. Sauer, "Why the SEC Missed Madoff," Wall Street Journal, July 17,
2010.
20
http://www.sec.gov/news/testimony/2009/ts091009rk-jw.htm.
21
Brief Summary of The Dodd-Frank Wall Street Reform ond Consumer Protection
Act, accessed at www.banking.senate.gov.
22
Jessica Holzer and Ashby Jones, "SEC Proposes Rules for Bounty Program," Wall
Street Journal, November 4, 2010.

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