How To Avoid Ponzi And Pyramid Schemes
Named from Charles A. Ponzi, who defrauded hundreds of investors in the 1920s, a Ponzi scheme pays off old investors with money coming in from new investors. 5 min read
Investors generally set two objectives in evaluating an investment:
- As high a return as possible ("yield" in the form of interest, dividends and/or long term appreciation), and
- Safety. Ponzi and pyramid schemes normally attract unsuspecting investors by the promise of an unusually high rate of return.
Experience has demonstrated, however, that as a general rule, the higher the return on an investment, the riskier it is likely to be. In other words, the higher return is usually paid to justify the higher risk. The prudent investor will compare the return promised or proposed with that generally being realized on other types of investments.
It is impossible to describe thoroughly the various forms Ponzi and pyramid schemes might take, but these operations do have certain hallmarks. You should be particularly cautious when an investment opportunity emphasizes:
- very high yield;
- quick return;
- "a once in a lifetime" opportunity; and
- the chance to "get in on the ground floor."
Named for Charles A. Ponzi, who defrauded hundreds of investors in the 1920s, a Ponzi scheme pays off old "investors" with money coming in from new "investors." It works this way:
- Investor A gives Promotor ("P") $1000 on P's promise to repay $1000 plus $100 "interest" in 90 days.
- During the 90 days, P makes similar promises to Investors B and C, receiving $1000 each from them.
- At the end of the first 90 day period, P may offer to pay A the $100 "interest" and to return the original $1000. More likely, he will invite A to "re-invest" the $1000 plus the $100 "interest" for a similar, or higher, return at the end of another 90 days.
- Thereafter, A, believing he or she can receive a good return on the investment, is likely to bring other investors to P.
In this manner P collects a pool of money that he can use to pay out to those few wishing return of their money. P may operate his scheme for some time before "pulling the plug" - that is, either disappearing with all the "investments" or revealing the bad news that the investments went "sour."
A major factor in the eventual collapse of a Ponzi scheme is that there is no significant source of "income" other than from new investors.
A Ponzi Scheme in Operation
Joe Smith claims that he operates a factoring business, buying accounts receivables from small companies at a discount and then making a large profit when he collects the receivable. In order to conduct his business, he says that he needs, on a short term basis, large amounts of money. Because his factoring business is so profitable, he is prepared to offer promissory notes paying 20-50% within 6-9 months.
In this case, there was no factoring business. The promoter used the borrowed money for his own personal uses. The operation kept going because many "investors," instead of cashing their promissory notes upon maturity, agreed to new ones that they thought would allow their capital and profit to accumulate. Those "investors" who did not want to continue were paid off with funds from new and present "investors."
The "pyramid" scheme is essentially a business variation of the familiar "chain letter." It works this way:
- Promotor ("P") offers A and B the chance to "invest" by purchasing "distributorships" at $1000 each.
- The "distributorships" give A and B the "exclusive" right to sell "distributorships" to others for $1000 each and to sell certain products to the public. However, each $1000 that A and B receive from their sales of "distributorships" must be divided with P, say 50-50.
- Thus, theoretically, A and B can realize $500 on each "distributorship" they sell and can completely recover their initial $1000 "investment" by selling only two "distributorships."
- P, however, has received not only A's and B's $1000 each, but also $500 for each "distributorship" that A and B sell.
Initially, it appears that this can go on forever, with no one being hurt and everyone making money. But, the chart below shows that the number of investors needed to keep the pyramid scheme working quickly exceeds the population of the United States. (The chart assumes P initially sells "distributorships" to six persons, each of whom 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 (Exceeding US Population)
- 12 — 2,176,782,336
- 13 — 13,060,694,016 (Exceeding World Population)
The chart also shows why such a scheme is called a "pyramid" - the promoters are at the top of a pyramid-shaped flow of money. Money coming from later investors flows upward to the top. Being at the top may result in your receiving a lot of money quickly, but it is virtually impossible to determine, at the beginning, where in the pyramid you stand.
Other Characteristics of Ponzi and Pyramid Schemes
In brief, Ponzi and pyramid schemes may also be characterized by:
- Reliance on funds from new investors to pay returns, commissions or bonuses to old investors;
- Need for an inexhaustible supply of new investors; and
- Absences of a profitable product or efforts to make profits through productive work.
This is A Consumer Education Publication one of a series created by the U.S. Securities and Exchange Commission to acquaint possible investors with the intricacies of investing and edited by the 'Lectric Law Library.
What Does the SEC Do?
The Securities and Exchange Commission was established by Congress in 1934 to protect investors against misrepresentation and fraud in the issuance and sale of securities. The SEC does this by enforcing the securities laws. These laws require most companies offering their securities for sale in interstate commerce to register them with the Commission so that full disclosure of certain information is made to investors. They also prohibit misrepresentation, deceit and other fraudulent acts and practices in connection with the purchase or sale of securities generally (whether or not required to be registered).
Are All Securities Registered With the SEC?
Not all securities are required to be registered with the SEC, but many are. Sellers of registered securities are required to furnish prospective investors with a prospectus (selling circular), divulging financial information. However, the SEC does not pass on the accuracy of the prospectus or approve or disapprove securities offered. Any representation to the contrary is a criminal offense.
Where Can You Get Investment Information?
Most broker-dealers maintain an extensive file of financial information on the companies whose stock they recommend. Because of this, they may be able to assist you in evaluating the merits of an investment. Independent investment advisers, many of whom are registered with the SEC, may also be in a position to assist with information and advice, though usually for a fee.
State Regulatory Authorities
If the investment is legitimate, it may be registered with some appropriate authority in your state. This authority may be the State Securities Commission, the State Corporations Commission or the Secretary of State. These agencies can help you ask the right questions about your investment.
What Can I Do About These Schemes?
You can help by notifying the SEC promptly if you are approached to participate in a questionable investment scheme or if you think you have invested in such a scheme. Information should be sent to any regional or district office of the Commission or to:
Securities and Exchange Commission
Office of Consumer Affairs
450 Fifth Street, NW
Washington, DC 20549
excerpted from Securities and Exchange Commission material
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