WLN Columns

Ponzi Schemes-Will They Ever End?

So-called “Ponzi” or “Pyramid” schemes have been in existence for a long time. Charles Ponzi committed his infamous fraud in the 1920′s. He promised a 50 percent return on an investor’s money in just 45 days-100 percent in 90 days. In the end, Ponzi collected $10 million and owed investors $6 million, enormous sums of money for that time. The problem was that his scheme was a fraud, and initial investors were paid by new investors.

Since Charles Ponzi, there has been what seems like a never-ending series of exposed scams, culminating most recently with Tom Petters, Allen Stanford and Bernard Madoff. The Petters case involved billions of dollars in loans. Phony records were used as proof that his company was buying merchandise, generally electronic goods, from two suppliers. It would tell lenders that it was selling the goods through big-box stores and provided purchase orders to substantiate the deals, but the deals were phony and the documents were fakes. No one verified this information. Madoff took in almost $20 billion, but may never have made a legitimate investment.

These schemes actually differ somewhat in their design. Pyramid schemes promise investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods. They may purport to sell a product, but often simply use the product to hide their pyramid structure. Some tell-tale signs that a product is simply being used to disguise a pyramid scheme are inventory loading and a lack of retail sales.

Inventory loading is when a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company’s distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. Those at the bottom make excessive payments for inventory that simply accumulates.

A lack of retail sales is also a red flag that a pyramid exists. Even though a pyramid scheme will claim that its product is selling, a closer examination reveals that sales occur only between those inside the pyramid structure or to new recruits joining the structure, not to the general public.

Although closely related to a pyramid because it requires continuous recruiting, in a Ponzi scheme the promoter generally has no product to sell and pays no commission to investors who recruit new investors. Instead, the promoter collects payments from a stream of investors, promising them all the same high rate of return on a short-term investment. In the typical Ponzi scheme, there is no real investment opportunity, and the promoter just uses the money from new recruits to pay obligations owed to older investors.

Both Ponzi and pyramid schemes are able to deliver a high rate of return to a few early investors for a short period of time. Yet, both schemes inevitably must fall apart, since no program can recruit new members forever. When the scheme collapses, most investors find themselves at the bottom, unable to recoup their losses.

Most Ponzi schemes involve efforts to obtain funds from financial institutions fraudulently by conjuring up invoices, accounts receivable, contracts and even serial numbers for equipment that a company never purchased with the money that was loaned to it for the purpose of buying or leasing the equipment.

Here are some tips to recognize or prevent these schemes:

1. Exaggerated earnings claims should be scrutinized, especially when there seems to be no real underlying product sales or investment profits. The plan could be a Ponzi scheme where money from later recruits pays off earlier ones. Eventually this program will collapse.

2. Offers of commissions for recruiting new distributors are suspect, particularly when there is no product involved or when there is a separate, up-front membership fee. At the same time, do not assume that the presence of a purported product or service removes all danger.

3. In the sale of a product or service, check to see whether its price is inflated, whether new members must buy costly inventory, or whether members make most “sales” to other members, rather than the general public. The presence of any of these conditions may indicate that the purported “sale” of the product or service hides a pyramid scheme that promotes an endless chain of recruiting and inventory loading.

4. Claims of a secret plan, overseas connection or special relationship that is difficult to verify, are suspect. Charles Ponzi claimed that he had a secret method of trading and redeeming millions of postal reply coupons. The real secret was that he stopped redeeming them and used new money to pay old investors.

5. Delays in meeting commitments while asking members to “keep the faith” are a red flag. Many pyramid schemes advertise that they are in the “pre-launch” stage, yet they never can and never do launch. Pyramid schemes can never fulfill their obligations to a majority of their participants by definition. To survive, they need to keep and attract as many members as possible. Promoters will try to appeal to a sense of community or solidarity, while criticizing outsiders or skeptics.

6. Hi-tech or newly deregulated markets are prime territory for these schemes. Every investor wants to become wealthy overnight, but most hi-tech ventures are risky and yield substantial profits only after years. Similarly, deregulated markets can offer substantial benefits to investors and consumers, but deregulation seldom means that no rules apply, and that a pyramid or Ponzi scheme is suddenly legitimate.

7. Regular field audits should be completed by a trusted, independent third party.

8. The third party should scrutinize even the most trustworthy of customers as closely as it would a suspicious person or entity.

9. Do not rely solely on records provided by a company or its so-called captive accounting firm. Independent accountants should verify the information; the added cost may save you millions.

Ponzi and pyramid schemes rely on funds from new investors to pay returns, commissions or bonuses to old investors. Both require an inexhaustible supply of new investors to be sustained, since neither has a profitable product nor an effort to make a profit through real work. They have been around a long time and show no sign of slowing down. Do not become yet another victim.