Ponzi Scheme

A Ponzi scheme can be best understood using the old adage of
“robbing Peter to pay Paul.”

Essentially, a Ponzi scheme arises when a person or entity takes the money of investors with a promise to invest the money and return high yields. However, what actually happens is that the investor’s money is used to attract other investors and support the lifestyles of the people claiming to be working in the interests of the investors.

The end result is that the money of newer investors is used to pay earlier investors either the gains they were promised, or the entire value of their accounts when they cash out. If enough investors pull out, the Ponzi scheme collapses and cant pay everyone back.

Where Did the Term Ponzi Come From?

In the early part of the 20th century Charles Ponzi took a legitimate investment business buying and selling U.S. Postal Service stamps and attempted to expand it. His early success attracted a high number of investors that gave him capital to invest with promises of high returns. Instead of actually investing the money, Ponzi simply moved the money around to pay investors when they wanted a payout, or when dividends were due. Eventually the fraudulent scheme was uncovered and Ponzi’s name was forever attached to it.

What is the Difference Between a Ponzi Scheme and a Pyramid Scheme?

The devil is in the details but, in the end, it is a distinction without a difference. In a Pyramid Scheme one person or entity enlists the help of recruits to further recruit other associates to sell a service or product. At every level of the scheme associates pay into a pool at origination, periodically thereafter, or both, and a portion of the money is funneled back to associates as incentives for recruitment. The more people working “under” an associate, the higher the incentive that is paid out. Very quickly the early associates and the originator of the scheme see dollars rolling to them. However, many of the associates below the early associates get little or no incentive while recruiting more dollars for the scheme’s pool at an exponential rate. Eventually the pyramid is so wide at the bottom that it is very difficult, if not impossible for these low level associates to ever get paid, while early associates and the originator of the scheme see massive returns on their initial investment. In many Pyramid Schemes the product or service being sold may never exist, leaving many investors out of their money with nothing to show for it.

Recent Fraudsters Using Ponzi Schemes

Bernie Madoff is likely the most famous face of Ponzi schemes in the 21st century. At one point it was considered good business sense to invest with Madoff because he had a track record of slow but steady returns for his clients. What people did not know is that the statements they received every month were falsified and that none of their money was ever invested, so no returns were ever had. Unlike Ponzi, Madoff perpetuated his fraudulent hedge fund company for over a decade and controlled billions of dollars of fraudulently obtained funds. In the final weeks of the scheme his lies got bigger. He promised even higher returns in an effort to attract more investors that he could use to pay off the swarms of clients that tried to take their money out. Eventually it all collapsed and Madoff was arrested and pled guilty to all charges before being sentenced to 150 years in prison. Judge Denny Chin called Madoff’s scheme “unprecedented,” “staggering,” and that he felt a message needed to be sent.

What Laws are Violated by Ponzi Schemes?

Ponzi Schemes often violate Federal fraud, money laundering, and theft laws. These crimes carrying varying punishment, but often carry punishments of 30 years in federal prison and/or fines and restitution amounts in the millions of dollars per occurrence. Any Ponzi Scheme can escalate very quickly into territory where a person can serve many decades in prison because, in the end, it was not the amount of money that doomed Madoff, but rather the high number of victims and the prolonged life of the scheme that sent him to jail for over 100 years.

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