The term Ponzi scheme refers to a form of fraud in which investors are promised high levels of return on their investment with little to no risk. These dividends, however, are sourced not from the revenue of the company itself, but from the funds of the later investors. Essentially, the earlier contributors are compensated with money of the later contributors. Such firms rely on a continuous flow of new investors and focus their efforts on acquiring them. As soon as the flow stops or evens out, the company falls apart, as it is only sustained through the new influxes of cash provided by never investors. Additionally, within a Ponzi scheme, the firm’s expenditure requirements towards providing ROI increases exponentially, as the firm is expected to provide the promised high dividends to every contributor.
Bernie Madoff admitted in 2008 that the financial management division of his firm was an elaborated Ponzi scheme worth several billion dollars. In contrast with most Ponzi schemes, this one was based around a real company, Bernard L. Madoff Investment Securities LLC. Known for working with elite high-income clientele, Madoff attracted multiple investors by promising unusually high dividends. The façade of respectability and the history of consistently high returns from Madoff’s previous projects accounted for his credibility in the investors’ eyes. In reality, Madoff deposited the acquired new capital, further utilizing it for the payoffs to the existing investors. Eventually, the scheme was identified through the comparatively inconsistent corporate performance reports and the unusual undisclosed commissions the documents kept referencing. Throughout the scheme period the investors remained unaware of Bernie Madoff personally managing their money.
Reference
Henriques, D.B. (2018). A Case Study of a Con Man: Bernie Madoff and the Timeless Lessons of History’s Biggest Ponzi Scheme. Social Research: An International Quarterly 85(4), 745-766.