How to spot a Ponzi scheme
byDec 16th 2008 11:00AM
The news that Bernard Madoff was arrested Friday and charged with securities fraud in what federal prosecutors called a $50 billion Ponzi scheme should serve as a warning to anyone asked to give money with promises of getting high returns if they sign up more people.
Hopefully you won't get involved in a $50 billion (yes, with a "B" not "M") scheme, but it's always good to take a look at how to avoid Ponzi schemes, some of the oldest schemes around that date back to the 1920s. They're also called Pyramid schemes and are financial webs that many people learned about in school. I remember learning about them in high school.
But first, a recap of what Madoff is accused of and how he got caught. According to prosecutors and news reports, the former Nasdaq Stock Market chairman and founder of Bernard L. Madoff Investment Securities LLC was charged with one count of securities fraud. The criminal complaint alleges that he "deceived investors by operating a securities business in which he traded and lost investor money, and then paid certain investors purported returns on investment with the principal received from other, different investors, which resulted in losses of approximately billions of dollars."
The description by prosecutors sounds like a typical definition of a Ponzi scheme. According to the FBI, a Ponzi scheme is an investment fraud where the operator promises high returns that aren't available through traditional investments. But instead of investing victims' funds, the operator pays "dividends" to initial investors using principle amounts "invested" by subsequent investors. It usually falls apart when the operator flees with all of the money, or not enough new investors can be found to continue paying the "dividends."
Charles Ponzi of Boston did this in the 1920s by guaranteeing investors a 50% return on their investment in postal coupons. Bank savings accounts paid 5%. Ponzi had bought only $30 worth of the international mail coupons, and after paying off initial investors, the scheme came to light when he was unable to pay off later investors.
Madoff had large hedge fund investment firms as clients, along with some European banks, so the $50 billion loss could be spread out. But still, $50 billion? His plan ended when investors started demanding money.
How to avoid a Ponzi or Pyramid scheme? There are many ways, including:
1. Exercise due diligence in selecting investments and the people with whom you invest.
2. Fully understand the investment before you invest.
3. Any investment that relies on word of mouth should be suspect.
4. Promptly notify the Securities and Exchange Commission if you are approached to participate in a questionable investment scheme, or think you may have invested in one. The SEC has its own list of tips.
5. If the investment is legitimate, it may be registered with some appropriate authority in your state. It may be the State Securities Commission, the State Corporations Commission or the Secretary of State. Or check with the SEC.
6. Returns promised well above the industry average should put up a red flag. If it looks too good to be true, it probably is.
Aaron Crowe is an unemployed journalist in the San Francisco Bay Area. Read about his job hunt at www.talesofanunemployeddad.blogspot.com