Schemes Not Just Wall Street Crime
By Mark Mathosian
Because of the
$50 billion Bernie Madoff investment scandal
Ponzi schemes are receiving lots of news
coverage. However, Ponzi schemes aren't new;
they have been around since the 1800s. Charles
Ponzi simply perfected the scam.
With Ponzi frauds regularly surfacing it is
worth your while to know how to recognize one.
I'll also explain the differences and
similarities between Ponzi schemes and pyramid
Ponzi schemes are named after Charles Ponzi, a
1920s Boston, Mass., businessman who lured
investors with promises of a 50 percent return
in 45 days if you bought one of his corporate
promissory notes. Ponzi told Bostonians he would
invest their money in international postal reply
coupons, when in fact he didn't have a real
business operation and never intended to invest
their money in a legitimate business. His real
plan was to "rob Peter to pay Paul." He would
simply pay investors their monthly interest with
money he received from other investors.
Let's say you are solicited to invest in the
stock of a gold mining company with promises of
huge returns. You might be told the mine is
operational and producing lots of gold when in
fact it is not. Instead, your monthly dividend
comes from money solicited from other investors
who were also convinced to invest in the gold
mine. If there is no gold being extracted, and
the company is not making money from the alleged
business operation, they may be "robbing Peter
to pay Paul." This would be an example of
classic Ponzi type of investment scheme, using
one investor's money to pay another. The fact
is, Ponzi investment frauds take many shapes and
involve a variety of products, including rare or
collectible coins and other numismatic products.
Here's another hypothetical example:
You are told a company you are thinking about
investing in buys gold, silver and platinum from
miners and sells the metals to jewelry
manufacturers for a profit. As an investor your
money is allegedly pooled with other investor
funds to buy the precious metals. As a passive
investor, you will share in the profits from the
transactions. If you later learn that the
company purchased no precious metals and instead
paid your monthly interest from funds received
from other investors, then this could be another
example of Ponzi style investment fraud.
With Ponzi schemes, as the number of new
investors grows, the supply of new investors
available to solicit diminishes. Eventually the
Ponzi bubble must burst under the pressure of
meeting the promised interest payments to its
ever increasing investor base. While some early
investors do receive interest payments the newer
investors lose all or most of their money when
the scam is exposed. Again, that's because there
is no real business venture to generate
Unfortunately, Ponzi schemes can go on for years
without detection. As long as investors receive
their monthly interest payments they are happy
and - they don't question the legitimacy of the
alleged business operation.
Pyramid schemes are not typically investment
schemes. They involve multi-level marketing
opportunities. An illegal pyramid scheme relies
on an organizational structure (pyramid) whereby
compensation is derived primarily from
recruiting others into the organization, rather
than from the sale of goods or services. What
differentiates a legal multi-level marketing
program from an illegal one is that a legal one
generates profits mainly from the sale of
Many illegal pyramids attempt to establish their
legitimacy by purporting to sell a product.
However, the merchandise or service to be sold
is largely ignored. The pyramid scheme functions
like a chain letter, and eventually collapses as
participants try to recover their initial
investment by recruiting more and more new
investors from the ever decreasing number of
prospects in a given area.
The chart below, published in a brochure
distributed by of the Securities & Exchange
Commission, shows the absurdity of a pyramid
scheme if it is allowed to run its natural
course. The chart assumes that the first
participant brings in six new people under the
pyramid and that each new participant brings in
an additional six purchasers per month:
1 - 6
2 - 36
3 - 216
4 - 1,296
5 - 7,776
6 - 46,656
7 - 279,936
8 - 1,679,616
9 - 10,077,696
10 - 60,466,176
11 - 362,797,056 (exceeds U.S. population)
12 - 2,176,782,336
13 - 13,060,694,016 (exceeds world population)
Finally, here are red flags of Ponzi and pyramid
schemes with tips on how to avoid becoming a
" You are provided with "insider" or "secret"
" The investment has an unusually high rate of
" You are pressured to invest.
" You are told the investment has no risk.
" You are unable to get regular reports on the
status of your investment.
" It sounds too good to be true.
" Be leery of multi-level marketing
opportunities that require large start-up costs.
" With multi-level marketing offers be sure
there is an actual product to sell.
" If there is a product be certain there is a
consumer market for the product.
" With multi-level marketing opportunities be
sure the sale of the product is the main focus
of the marketing plan, not just bringing in new