Charles Ponzi was a swindler who implemented his fraud racket (later known as the original version of a Ponzi scheme) in the United States and Canada. In 1920, over a period of eight months, Ponzi was able to raise “$9.8 million from 10,550 people,” though the payout was only $7.8 million (Lewis 294). Using International Postal Union coupons, Ponzi found a weakness in the arbitrage opportunities provided by the Union.
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He suggested purchasing the coupons in Italy, sending them to the United States, and redeeming them “for postage worth four times as much” (Lewis 295). Thus, Ponzi assured paying out 50% of the investment in 45 days and 100% in 90 days (Lewis 295). In this type of scenario, high returns are paid to early investors using the money from later investors, but, in the end, the scheme collapses when there is no longer enough money to complete the payouts.
How was Ponzi able to make his scheme possible? Since European currencies were nearly decimated by the end of World War I, he could purchase them in large amounts, redeem them for American postal stamps, and eventually convert those into “the much stronger American dollar” (Kramer and Buckhoff 48). The main feature of the scheme, namely its unsustainable nature, was what led to the arrest of Charles Ponzi. Ponzi was able to pay out the promised returns only as long as he continued to receive cash. When the money flow ceased, so did the scheme. As soon as the fraud was exposed, Ponzi was arrested, with approximately $30 in postal coupons in his possession (Kramer and Buckhoff 48).
A Ponzi scheme does not imply selling products or providing services; it receives money by inviting and recruiting new investors (Kramer and Buckhoff 49). The original scheme was different from those implemented today. However, a Ponzi scheme can be characterized by these features (Kramer and Buckhoff 50):
- Promises of exclusively high returns.
- High returns that are steady (with no regard to the economy).
- Investments having no negative returns.
- Little to no risk to investors.
- Vague description of the program and business model/scheme.
- Promised returns that are generated quickly.
- Lack of customary fees.
- Exclusivity of the proposition.
- Perpetrator appears trustworthy.
- Advertising via recruiters/investors or word-of-mouth.
It can be shown that Ponzi schemes often hide the details of their investment processes, relying on advertisement from current “members” and the perpetrator. Such schemes often use unregistered investments because investors will not be able to find any information about the company and its management (U.S. Securities and Exchange Commission). Sellers are usually unlicensed and unregistered, although security laws require investment professionals to possess a license. Furthermore, account statement errors are also typical for Ponzi schemes (U.S. Securities and Exchange Commission).
One of the foulest schemes was promoted by Bernard Madoff, who was able to sustain the scheme for many years. Madoff had a legitimate investment business that allowed him to make the scheme stronger and avoid an early collapse (Messner and Rosenfeld 1). His scheme was more durable for a variety of reasons. First, he was charismatic and trustworthy because he was an authoritative investment analyst. Second, only a limited number of investors met him in real life. Third, the spread of his racket relied on gossip as a form of advertisement (Messner and Rosenfeld 1). Clearly, one of the largest frauds in US history had typical features of a Ponzi scheme.
Kramer, Bonita, and Thomas Buckoff. “Beware of False Profits.” Strategic Finance, vol. 93, no. 11, 2012, pp. 47-52.
Lewis, Mervyn K. “New Dogs, Old Tricks. Why Do Ponzi Schemes Succeed?” Accounting Forum, vol. 36, no. 4, 2012, pp. 294-306.
Messner, Steven F., and Richard Rosenfeld. Crime and the American Dream. Cengage Learning, 2012.
U.S. Securities and Exchange Commission. “Ponzi Scheme.” investor. n.d. Web.