Hard lessons learned from Ponzi and other schemers

One cannot turn on the television, open a newspaper, or click on the Internet without hearing or reading about the term “Ponzi scheme.” Starting with the dramatic story involving Bernie Madoff and his record breaking $50 billon scheme, there appears to be constant news accounts about individuals who have lost their fortunes to a new scam. In this article, we will examine how a Ponzi scheme works, how people become involved in them, and finally offer some tips on how to avoid becoming the next victim of a Ponzi scheme.

The term “Ponzi scheme” dates back over 90 years ago to the case of Charles Ponzi. Ponzi came to America in 1903 as a 21 year old. He became involved in a variety of unsuccessful businesses over the next 16 years. He also at times engaged in criminal activity and was convicted for passing a bad check and assisting Italian immigrants in illegally entering the United States from Canada. In 1919, however, his life changed forever when he received a letter with an International Postal Reply Coupon. These coupons, he discovered, could be purchased cheaply abroad, and used to buy American postage stamps at a discount.

Ponzi proposed a business investment where he would buy the coupons at low rates, convert them to American stamps at discounted prices, and then sell the stamps, turning a substantial profit. Ponzi initially promised investors a return of 50% in 90 days, which he later raised to 100% in 90 days. Based on these returns, he was flooded with requests to invest, collecting over $10 million, an enormous sum for the 1920s. Investors who received the early promised returns generated a frenzy of people anxious to join in this windfall.

There was, of course, one major problem. Ponzi did not actually buy the coupons. Instead, Ponzi used the constant flood of new money to pay off old investors, and to support a personal lavish lifestyle. Within one year, after a newspaper article by the Boston Post revealed the scheme, Ponzi was arrested and convicted in both the state and federal courts, serving separate jail sentences for each.1

Almost 90 years later, the arrest of Bernie Madoff has brought the topic of the Ponzi scheme back to public attention. Madoff, the investment manager of a hedge fund known as Ascot Partners, was charged with running a Ponzi scheme of record proportions. Madoff’s arrest sent shock waves through a reeling economy as horrified investors learned the enormity of the scheme and their losses.

Unlike Ponzi, who was a convicted criminal at the time he created his scheme, Madoff was a highly respected businessman, with great personal wealth and impeccable financial credentials. Madoff was appointed to several important financial boards and commissions over his career, ultimately gaining the chairmanship of Nasdaq, one of the world’s leading stock exchanges.

Madoff’s hedge fund drew interest from some of the wealthiest investors in the country, including charitable foundations and other financial institutions. Madoff offered what, in retrospect, virtually no one else seemed to be able to provide in this economy, secure investments with continued positive returns. Despite what should have been a warning sign, investors continued to flock to the fund, made more attractive by Madoff’s seeming reluctance to allow new investors into the fund. Unlike most Ponzi schemes, Madoff set the bar high, making admission to the fund difficult. Those who were allowed to invest believed they were part of a special club and beneficiary of a special investing magic that no one else had and to which most people did not have access. The investors put their trust in Madoff, and he gave them no reason to feel that trust was misplaced.

The scheme began to fall apart late last year. Several of Madoff’s investors sought to redeem over $7 billion from the fund. Madoff was unable to come up with the funds and in mid-December revealed to family and friends that Ascot Partners was unable to meet its obligations.

Federal law enforcement was notified, and over the next several weeks, learned both the enormity of the fraud – over $50 billion – and the shocking news that the hedge fund was a complete scam. The so-called investment fund was not invested in anything, and all monies were used to pay other investors and support the lavish lifestyle of its originator, Bernie Madoff.2

Ponzi schemes are not always on such an elaborate scale, and sometimes even start out as legitimate investments. When they turn into a Ponzi scheme, however, they have the same devastating impact on their victims. A recent prosecution by District Attorney Kathleen Rice in Nassau County illustrates some of the same principles involved in a Ponzi scheme.

Peter Dawson ran an investment firm operating out of the EAB Plaza in Uniondale. Dawson offered investments in a variety of companies, including brokerage firms, insurance companies, banks, mortgage companies, and other financial service companies. Dawson specialized in customer service for his clients, and promised healthy returns on their investments. He would arrange for vacations for his clients, often handling all the details, laying out all the funds out of his clients’ purported profits. Clients received regular interest payments as promised on their returns, and their success led to additional investors anxious to join in their investments.

Over time, however, Dawson was unable to cover the high financial returns due to the downturn in the economy and his high business and personal expenses. Desperate for new funds to continue his business, Dawson reached out to many investors offering even higher returns for short term investments. Based on their previous success and trust in him, many investors were persuaded by Dawson to take out home equity loans. Dawson promised that the monthly mortgage payments would be paid by him, in addition to mailing a substantial return on their investments.
The investigation, however, revealed that by this time Dawson’s monthly interest payments far exceeded the revenue he was generating. The monies he received from investors who mortgaged their homes were never invested in anything, but rather were used simply to make some interest payments to previous investors. Ultimately, like all Ponzi schemes, Dawson was unable to attract enough new money to pay off all his monthly obligations and the scheme collapsed. Over 50 victims discovered they had lost more than $7.5 million dollars over a two year time period. Dawson was ultimately convicted of multiple felonies, including a top count Grand Larceny in the Second Degree, sentenced to 5 to 15 years in jail, and forfeiture of his home and personal possessions.3 However, Dawson had virtually no assets left, and even with forfeiture, victims have recovered only a small percentage of their losses.

These three cases are perfect illustrations of how people get caught up in Ponzi schemes with devastating financial consequences. There are certain underlying common principles. In each case, the parties were lured by investment returns that were not otherwise available at that time. As potential investors see the early investors make money, they become more comfortable with the investment opportunity and often let down their guard. As noted by University of Colorado at Boulder psychiatry professor Stephen Greenspan, author of, The Annals of Gullibility, “The basic mechanism ex-plain-ing the success of Ponzi schemes is the tendency of humans to model their actions, especially when dealing with matters they don’t fully understand, on the behavior of other humans.”4 The victims draw comfort from the success and involvement of other investors, trust the money manager, and bury any concerns about the risks involved.

As a result of the Dawson case, and other Ponzi schemes prosecuted by the District Attorney’s Office, District Attorney Kathleen Rice offers the following advice to potential investors:

1. Know your investment. Sadly many victims have no idea what they invested in. They are lured in by the promised return and never get the necessary information to properly scrutinize their investment.

2. Where possible, have a financial expert examine the investment information before investing. Even when the investor receives some information about the purported investment, they often lack the necessary expertise to determine the true viability of the investment. By taking the time to have someone examine it, victims will be better able to evaluate the risks involved in the investment opportunity.

3. Know your investment manager or advisor, particularly if he is a solo practitioner. What are his credentials, expertise, and experience? Consider what safeguards exist if the principal suddenly becomes ill or dies. Check all public databases, including government agencies, such as the local District Attorney, Attorney General, and federal regulatory agencies, to ensure there are no complaints against this individual or company. These complaints are a clear sign of a problem.

4. Be wary of guaranteed returns, especially high returns in short periods of time.
The more obvious “double your money in six months” pitch is easier to avoid. But as the Madoff case clearly illustrates, even a more modest return can be suspect. The very attractiveness of the investment can be a warning sign, as even the most sound investments face rocky times when the economy is struggling.

5. Make sure you receive documents reflecting your investment on a regular basis. Far too often, victims rely on their investment advisor to do the right thing, without seeing a document reflecting their investments over time. Unfortunately, in this day of computerization, scam artists can create phony documents, but legitimate investments should be reflected by detailed documents outlining the investment on a quarterly or semi-annual basis. Delays in issuing statements or failing to issue them is often another warning sign for an investor.

Hopefully, the revelation of the many recent Ponzi scheme arrests will be the best warning to investors to do all due diligence and carefully weigh the risks involved. Sadly, even with a successful prosecution, Ponzi scheme victims rarely receive a substantial return, as the very nature of a Ponzi scheme involves the utilization of new money to pay old investors. Contrary to victims’ hopes, Ponzi scheme con artists rarely have a hidden pool of funds secured in a foreign bank account. Investors should always be mindful of the often repeated adage, “If it sounds too good to be true, it probably is.”

Robert Emmons graduated from Fordham Law in 1980, admitted 1st dept. as of Jan. 1981. He has worked for the DA for over 28 years, specializing in white collar and consumer fraud matters for the last 26 years. For the past 10 years he has been the Chief of Criminal Frauds

1. Zuckoff, Michael. “The Real Ponzi Behind the ‘Scheme’” Fortune, 15 Dec. 2008
2. Lenzner, Robert. “Bernie Madoff’s 50 Billion Dollar Ponzi Scheme” Forbes, 12 Dec. 2008
3. People v. Dawson, F2766/07
4. Greenspan, Stephen. “Why Experts and Laymen Fall Victims to Fraudsters” Business Daily, 9 Jan. 2009