By James C. Sell, CPA, CFE, CFF, Published in Greater Phoenix Attorney At Law Magazine, February, March, April and May 2010
Charles Ponzi was not the originator of the financial fraud scheme that bears his name; perhaps his name became attached to this financial scam because he was so flamboyant and audacious. More likely, it was a convergence of several factors including the state of the economy in 1920 and an unusual but simple and easily remembered name like Ponzi. Despite its magnitude, I doubt Madoff will ever replace Ponzi as the name used to describe the Peter to Paul Scheme or the Pyramid Scheme. Madoff’s scheme has all the attributes to dethrone Ponzi, except for one - the name Madoff doesn’t roll off your tongue like Ponzi does. History may repeat itself but idioms tend to be faddish. Until then, Ponzi remains king of the investment scheme scandals that bear his name.
Peter to Paul, rather than Madoff or Ponzi, is actually the original and broader, more descriptive idiom for the nature of the fraud it describes. The exact origin of the phrase “Robbing Peter to Pay Paul” has been obscured by the passage of time. I was able to trace it back to a 12th century Latin expression (Tanquam siquis crucifigeret Paulum ut redimeret Petrum) which, according to my non-expert translation, means crucify Peter to save Paul from crucifixion. The expression has been recycled over the centuries, but amazingly, its meaning remains intact.
A Peter to Paul scheme can be used to describe the attributes of any act of borrowing money to pay off a previously existing debt. In the end, there is still debt. The two major differences are that the debt is owed to a different person (assuming the lender doesn’t re-lend) and the amount of the debt is now larger. Ponzi recognized his scheme as a Peter to Paul scheme when he stated: “….with no coupons and no profits in sight, and no way of meeting my notes, except by the time-honored custom of robbing Peter to pay Paul.” (Ponzi, p.113)
The Ponzi refinement features investors as an essential element of the scheme. A Ponzi scheme as we know it today is an investment scheme wherein new investors’ money is used to pay the promised return to previous investors. The return paid to the investors does not come from the profits of the purported business venture. The investment can be in the form of a loan, equity investment or a combination of both.
Most Ponzi schemes rely on a theoretical business model to produce the touted profitability and superior return to its investors. Even Charles Ponzi’s scheme worked in theory. Postal Reply Coupons existed during his time. It was possible to take advantage of disparities in international currency exchange rates and realize huge profits on each transaction. Postal Reply Coupons could be purchased in Spain or Italy for pennies and converted to U.S. postage stamps worth several times their purchase price. Stamps worth dollars that were purchased for pennies could be sold at a discount to businesses. The net result of the transactions would be huge profits that Ponzi was willing to share with his eager investors. Ponzi’s business plan appeared to be viable in theory.
According to Ponzi, “The coupon came to my notice accidentally. At a time when my mind was extremely alert. But it was entirely due to what I already knew about coupons and foreign exchange rates that I saw in it an opportunity for speculation. An untrodden shortcut to some easy money.” (Ponzi, p.67-68)
Ponzi deduced that the Italian Lira, for instance, “was quoted then about 5 cents instead of 20 cents. One lira was equal to 100 centisimi. With 2,000 centisimi I could have obtained 66 coupons at 30 centisimi each. Or enough coupons to obtain in exchange for them at the Boston post-office $3.30 of 5-cent stamps. A gross profit of 230%.” (Ponzi, p. 68) Ponzi’s business plan was simplistic and critically flawed. While his business model and its profitability could be demonstrated in small isolated transactions, it was not scalable. U.S. Postal authorities calculated that “160,000,000 postal reply coupons would have to be in circulation, however, only about 27,000 coupons were actually circulating.” (D.Hathcock, personal communication, 2009). The market was too thin and/or the administrative costs too great for the venture to work on a large scale. The United States Post Office also stated that “postal reply coupons were not being bought in quantity at home or abroad, but the overhead required to handle the purchase and redemption of these items, would have exceeded the gross profit.” (D. Hathcock, personal communication, 2009).
The real economic engine in Ponzi’s plan was an ever expanding investor base. He borrowed money from one group of investors at usurious rates to repay an earlier group of investors their principal and usurious interest.
The Four Elements of a Ponzi Scheme
The Fuel
The Ponzi scheme’s structure contains the fundamental elements of a security;
· An investment of money (something of value),
· A common venture (real or fictitious),
· The expectation of a profit and
· The investors’ profits are to be derived primarily from the efforts of others (the promoters).
The Fire Pit
The fire pit is designed for the fuel it will consume. It is constructed from the elements of a financial fraud;
· An investment of money (or something of value),
· Intentional false representation of a material fact (by omission or commission),
· The investors’ reliance on the false representations
· A loss of all or part of the investment.
The Fire Tender
There exists, among white collar criminals, some common attributes. The late Dr. Donald R. Cressey, Criminal Psychologist, did extensive research into what those common attributes might be. Dr. Cressey published his findings in his book, “Other Peoples’ Money”. I have read, studied, analyzed and compared his findings to my own 33 years of experience in investigating white collar crime in general and Ponzi schemes in particular. I would highly recommend Dr. Cressey’s book to anyone interested in understanding the profile of a white collar crime perpetrator.
Dr. Cressey's elements as I interpret them are:
· The subject acquires or creates a position of trust (opportunity),
· The subject has a perceived non-sharable need (compelling need),
· The subject violates his/her position of trust (violation of trust)
· The subject rationalizes his/her behavior (rationalization).
The Ignition
The real economic engine for any Ponzi scheme is its investors. What human quality or flaw serves as the investor attractant? I believe it is the intertwining of trust and greed. Greed is an attractive corrosive agent. It is capable of overriding common sense, trumping rational business judgment and subverting an individual’s moral compass. In the shadow of greed, a too good to be true scheme offered by a trusted person appears plausible. The perpetrator first establishes a position of trust with his intended prey, presents a simplistic plausible investment opportunity and then appeals to the investors’ greed to close the deal. While trust starts with the perpetrator as the scheme progresses, it becomes an amalgamation of witting and unwitting aiders and abettors. The “trust” factor expands to include early investor testimonials, accounting, legal and industry guardian opinions and regulatory inaction. The illusion of early investor success coupled with “accumulated trust” overcomes natural skepticism and fuels the greed of prospective investors. The result is a “feeding frenzy”. Once started, the feeding frenzy accelerates the Ponzi scheme beyond rational reason. It will forestall the schemes inevitable collapse until the economics of reality overtakes it.
When the four elements converge, the perfect financial storm emerges from the fire pit: a Ponzi scheme.
The Illusion of Propriety
Have you ever wondered how reasonably intelligent successful people can fall for an obvious “too good to be true” investment swindle? Ponzi recognized the absurdity of his own scheme. He acknowledged that: “In fact, my visible resources were then in excess of $5,000,000. Assuming I earned two cents on each coupon, I should have had to handle over 250,000,000 of them (coupons)! It was absurd. There were not that many in the world. There had never been that many. And it would have taken months to print them.” (1)p.108
The answer is illusion. The more successful the Ponzi scheme, the better the magician the perpetrator is. To be more specific, the perpetrator needs to create a believable absurdity. There are many ways to create it. The illusion, as I have observed, is constructed with many but not necessarily all of the following elements:
1. Theoretic economic substance to the purported business enterprise. The business plan sounds plausible but is very simplistic. Sufficient detail is provided to close the sale but no more. Ponzi stated:”So I told just enough to whet the people’s greed and curiosity. No more.” (1)p.70 Statements such as: specific details can’t be disclosed because they are proprietary and must be kept secret lest someone else usurp this fantastic business opportunity and deny the investor the opportunity to participate in this proven money making venture were common. Only the positive elements are accentuated. The negative risk factors are ignored or diminished. The reality of time constraints, market limitations or extent of administrative costs is not disclosed. In Ponzi’s case he realized early on that his scheme was not scalable when he stated, ”The long and short of it is that for some time, I had not been getting any coupons at all. In fact, after the first lot, I had not been able to buy any more. Except in small quantities, for no other reason than the existing supply was not sufficient to meet the increased demand. They had to be ordered from the Universal Postal Union. But the moment the postal administration of the various countries concerned began to notice an unusual activity in coupons, the cat was out of the bag. One by one they took steps to suspend the sale of coupons.” (1)p.108
One of the more interesting cases I have investigated involved a “salted” gold mine. I thought that only happened in the movies. Upon close inspection I could see the shotgun wadding mingled with flakes of gold embedded in the mineshaft walls. A mineralogist from the Arizona Department of Mineralogy assisted me and testified that the perpetrator salted the mine with a type of gold not found in the area of the mine nor occurred in that type of geological formation. I’m not sure it was necessary for either of us to be qualified as a firearms expert to testify about the inappropriateness of the shotgun wadding or gunpowder residue found embedded in the mine walls. Many investors saw the illusion of easily mined gold; but I found none that looked past the glitter to discover the wadding. Some investors knew what assay reports and core samples were but few looked beyond the illusion. I did agree that mining costs would have been minimal. The existing gold supply in the mine could have been extracted from the walls with a pen knife.
Other interesting cases involved extracting gold from cinders, sand and seawater through a secret process. A typical feature was, either the ore came from, or the processes had to be performed, in some secret exotic location. Other schemes involved minerals other than gold, hybrid animal breeding, domestication of native plant species (Guayule and Jojoba), Biomass, Greenhouses, alternate energy production, mechanical inventions (one that instantly comes to mind was the “Weenie Machine”), real estate based investments, lending related schemes, viatical settlements and some others that I have long since forgotten about. The common element of all of them was they were long on vision and short on detail. Only true believers could appreciate the vision of easy profits. The only money ever received by investors was from an influx of new investors. Ponzi stated his view: “Because we are all gamblers. We all crave easy money. And plenty of it. If we didn’t, no get-rich-quick scheme could be successful.” p.76
2. Claims of a special competitive advantage, exotic product, an overlooked loophole in the law or a secret process were made. The investors were often required sign a nondisclosure agreement containing onerous penalties for disclosure. Ponzi said “The peculiar feature about the whole thing was that the laws and the treaties involved in the purchase and redemption of coupons protected the user of such coupons and not the various governments concerned.”(1)p.69
A number of my cases spanning the past 30+ years have involved asset based lenders; better known as “hard money lenders” (Great Southwest, Avanti Mortgage, Alert Mortgage, American Nation Mortgage, Baptist Foundation, Mathon). They all claimed some proprietary insight into a market shunned for various reasons by traditional lenders. On the up side all of them overestimated the size of their market, value of assets and borrower quality. On the down side, all of them underestimated cost of administration, due diligence, competition and risk. All were Ponzi schemes.
3. Creation of a controlled or contrived demonstration transaction to prove the business model works. Ponzi stated “I sent out three letters. Each with a dollar bill enclosed. One went to Spain, one to France and the third one to Italy. In each case, I requested the recipient to exchange the dollar bill into paper currency of his own country. Then to purchase with it as many coupons as he could obtain and mail them to me. In the course of a few weeks, I received the replies and the coupons. The results coincided with my expectations.” . . . “In all, it had cost me less than four dollars to lay the foundation of a venture which nine months thence, had an outstanding indebtedness of $15,000,000.” (1)p.69
Small scale prototypes of perpetual motion machines or processes that create something out of nothing are classic examples.
Over the years I have seen many “controlled” financial transactions, “bench models” and “demonstration experiments”. Many appeared to work or worked on a small scale for a limited amount of time. The hall mark of my hard money lending cases’ featured a limited number of small successful loans (real or contrived) and the flawed theory of using short term high interest loans instead of long term equity to finance the purported business venture. There is a time and a place for both but they are not interchangeable to any appreciable extent.
4. Claims the government or an industry guardian has reviewed the program and found nothing wrong with it. Nothing beats a good housekeeping seal of approval. I’ve seen perpetrators form a captive industry watchdog group to certify the ventures feasibility. Ponzi was able to keep the postal authorities at bay and was able to convince at least one postal inspector that coupon speculation was possible. Ponzi stated: “And finally agreed upon the theory that a profitable speculation in coupons was possible. The Inspector, however, was of the opinion that a large number of coupons could not be either bought or redeemed.”(1)p.85
Shortly after I arrived at the Arizona Securities division in 1976, the Director instructed me not to not waste time looking for unregistered securities fraud. He said that in the past they were all registered. In 1977, I asked one of the nation’s largest mutual funds why they did not offer their product in Arizona. The answer was simple and direct; they could not and would not attempt to compete with the crap that was being registered and sold in Arizona. He said “clean up the market, bring some integrity to it and we’ll be there after you do.” We did and they came.
5. Endorsements by industry professionals. If one couldn’t be found or bought, they were created. The ideal industry icons are those with a stellar reputation but preferable a little senile and/or in need of money. Ponzi realized the importance of financial credentials: “I had subscribed to Dun and Bradstreet’s. And I was rated by them $8,000,000!” (1)p.130
The Avanti scheme included a loan to “High Chaparral”. It was based on an MAI appraisal. The prompters hired a reputable MAI appraiser who had terminal cancer. He appraised the property in excess of 10 times its actual market value. As I recall he stated the property was 70% percent wooded. If you included the thousands of acres of adjoining state forestland that representation might have been true. Ten or so trees on the deeded property would qualify for landscaping not a wooden property. In addition, he included all of the fencing, roads and other improvements that were on State forestland.
6. Promises of high returns with little or no risk are standard. One of Ponzi’s investors was a Priest. The Priest explained to Ponzi “You understand that I cannot afford to gamble that money. Father X said to me. I can only invest in a safe thing. Of course, I agreed with him.” (1) p. 94
7. Insurance or a guarantee is often promised to mitigate risk. Insurance is seldom acquired and the guarantee typically lacks substance. A dummy company is frequently set up to act as the guarantor or insurer. Guarantee Mortgage was just such a concoction in the American National Mortgage case. It was a great selling tool but never had any real substance. A similar ploy, a non-existent insurance policy and reserve fund was one of the marketing ploys used in the Mathon case.
8. A company name is chosen to engender strength, stability, nobility and other salient attributes. Names like Washington, Lincoln, Standard, Chartered, First, Security, etc are common. Ponzi revealed: “I realized that I needed a certain prestige. Such as a firm name lends. Because it has the appearance of great stability”. (1) P.70 Ponzi took this concept a step further; he created a one man partnership when he created the Securities Exchange Company. His two “silent” partners were an uncle and a person he thought dead. He later said: “Had I known then what was to come, I would have made it still more ideal, by putting another dead man in my uncle’s place.”(1)p.72 Some of the names used in my cases: American Savings, Great Southwest, Great Investors, Alert, Avanti, American National and Guarantee.
9. Misrepresentations of the security and safety of principal. Statements such as “no investor has ever lost a single penny of his investment with us” and “we have an unblemished track record of meeting or exceeding the promised profitability” are common.
A case of Divine intervention: the Baptist Foundation of Arizona made those claims. However, my analysis of the financial operations of the Baptist Foundation showed they lost copious amounts of money for 11 months of the year and miraculously in December of each year they created sufficient profits to wipe out the accumulated losses incurred during the previous 11 months. Their December miracles resulted in their ability to pay their faithful investors the promised returns. How convenient. How miraculous. What I found instead of a financial equivalent of the “Loaves and Fishes” miracle was false accounting entries and fabricated insider transactions. The largest investor recovery was from their faithful auditors, Arthur Andersen who apparently believed in miracles instead of Generally Accepted Auditing Standards.
10. Comfort zone. Every perpetrator of a white collar crime operates within a comfort zone. Perceived opportunity and familiarity are the substance of the comfort zone. Ponzi’s scheme was rooted in the Boston Italian immigrant community. As his scheme expanded, his comfort zone expanded. Some perpetrators choose their comfort zone; others are a product of their comfort zone. A common selection technique is to join a church or fraternal organization, not because of any true belief in the organizations cause, but because the victim pool is less likely to critically review the investment opportunity offered by a “brother”. The victim lets down his guard when dealing with someone within his inner circle. The more clannish the organization is the greater the trust factor available for exploitation. The initial goal of the perpetrator is to obtain the confidence of the group’s leaders and members at large. The credibility of respected members can be assimilated by association. Once the fraudster has gained credibility within the organization by either good works, association or a combination thereof, he is ready to stalk the membership list. These types of frauds are commonly referred to as Affinity frauds.
One example of an Affinity Ponzi scheme was Michael I am Christson Churches of the New Octaves. Christson purchased a mail order divinity degree and used it to target evangelical Christians. Christson was offering 70 and 90 day “Certificates of Guarantee” wherein an investor could turn $25 into a $100 in 70 days or $250 into $1,000 in 90 days. I suspect Christson knew, or knew of, Charles Ponzi. Considering the math, I would have opted for ten $25 certificates.
The Baptist Foundation Ponzi scheme is another example of an Affinity Ponzi scheme. While Christson selected his comfort zone, the Baptist Foundation perpetrators came from within. They grew up in their comfort zone.
11. Testimonials. Investor testimonials touting great returns are used to lure new investors. Prospective investors are told the money came from the ventures profits. Investor testimonials are the “fairy dust” of any successful Ponzi scheme. Testimonials are recruited with great care. The more respected/popular the investor is the better. The golden testimonials of early big winners are a catalyst to fuel investor greed and incite a feeding frenzy. Ponzi stated: “People gambled with me as I thought they would. They gave me ten dollars as a lark. When they received fifteen at the end of 45 days, all sense of caution left them. They plunged in for all they were worth. They brought their friends along. The legion of my investors grew by leaps and bounds. Each satisfied customer became self-appointed salesman. It was their combined salesmanship, and not my own, that put the thing over. I admit that I started a small snowball down hill. But it developed into an avalanche by itself.” (1)p76
12. Professional attestations, legal and/or accounting opinions create the aura of respectability. Many of my cases featured “clean” audited financial statements and legal opinions that the investment product was not a security. Real opinions are expensive. If one cannot be obtained, it can be created. With the use of a computer, a scanner or copy machine, the desired opinion can be created on anyone’s letterhead bearing anyone’s signature. Ponzi expressed his view of attorneys when he stated: “those I might trust I couldn’t afford. Those I might afford, I couldn’t trust.”p.71 When Ponzi feared he would have to obtain licensure from the New Hampshire Insurance Commissioner, he consulted an attorney. The attorney advised him, “We must take the position that your business does not come within the scope of the Blue Sky Laws,” With the aid of Ponzi’s attorney the commissioner ruled that he had no jurisdiction over Ponzi’s venture and became one of Ponzi’s investors. (1)p.116
13. Use of new investor funds to pay previous investors. After all, there is no profitable business to fulfill the promise and it is the hallmark ingredient of a Ponzi scheme. Ponzi acknowledged his type of scheme was not profitable nor original, ”I was left high and dry; with no coupons and no profits in sight, and no way of meeting my notes, except by the time-honored custom of robbing Peter to pay Paul” and “My exact predicament was that every time I paid one of my notes, through the issuance of another note, I added about 75% to my indebtedness, instead of decreasing it.” (1)p.113
14. If the business venture has non-insider employees, they are compartmentalized. Access to the real books and records are strictly limited to a need to know basis. Today’s employees are tomorrow’s tattle-tales. Employees are often used to maximum advantage. They are given titles, good pay and authorized to sign everything incriminating. Happy isolated employees are considered an asset.
15. Representations that investor returns are from the purported business enterprise. Profitability is one of the key misrepresentations of a Ponzi scheme. Profit is the investor lure. Statements such as “no investor has ever lost a penny with us” and “we have an unblemished track record of profitability” are common representations. Perpetrators often make the mistake of referring to a mark’s investment as income. That Freudian slip is a dead giveaway. Christson and several other perpetrators I have interviewed, had a difficult time with the concept of profit because they considered every dollar they received from an investor as their profit. In a perverse way, investment dollars are a fraudster’s profit.
16. The squeaky wheel gets the grease. If an investor complains, pay him off. Unsatisfied investors are the source of regulatory complaints/investigations. Ponzi realized this important principal when he divulged how he handled investor complaints: “But whether justified or not, an investor was never permitted to leave with a grievance for the sake of a few hundred dollars. That’s why I lasted so long as I did. If a single complaint had gotten into the courts, it might have wrecked the whole structure.”p.124 Ponzi carried this concept to the extreme. He paid off notes that he knew were forgeries. (1)p.165 During the course of investigations I have observed a number of frauds within the main fraud. Fraudsters are not averse to taking advantage of other fraudsters when they see the opportunity. They are predators and have no aversion to eating their own.
17. “Creative Accounting” Artificial devises are employed to disguise the lack of economic substance and/or to defer the recognition of economic loss. There are many ways to “cook the books”. Accrual accounting and the misapplication of accounting principles is a fraudster’s best friend. Unreported liabilities, underreported liabilities, inflated asset values, capitalized expenses, accrued interest on defaulted loans and fictitious sales are a few of the observed techniques.
18. Innovative marketing plans to satisfy the constantly accelerating need for funds, creative, innovative marketing strategies are implemented. A sense of urgency and exclusivity is created in the prospective investors mind through one time, or limited time offers made to an exclusive few. Offers of special insider deals are great fund raising gimmicks. Once the greed factor has kicked in, these techniques are played to the maximum.
19. Arrogance. The Achilles heel of a Ponzi perpetrator. Too smart to be caught is their folly. They revel in their triumph over society’s gatekeepers (attorneys, accountants and regulators).Typically they express a seething contempt for their opponents’ failure to grasp the fundamental flaws of their brilliant scheme. Like Ponzi, many of his subsequent clones, succumbed to their own arrogance. After a confrontation with the Commissioner of Banks, the attorney general’s office and industry representatives in Massachusetts, Ponzi stated: “I was almost ashamed to match wits with them. It was like stealing candy from a baby. But they were the challengers. And I couldn’t very well let them get away with their lollypops.” (1)p.119
In my cases where the perpetrators ultimately wound up in jail, none originally harbored the belief that anyone was smart enough to catch them let alone convict them. For most, realization came as the jail door closed behind them.
20. Cover up of accumulated unresolved adverse economic events. Delays, government intervention, and the normal garden variety of lies work for a limited time. Ponzi enjoyed lying with impunity. When confronted by the Attorney General of Massachusetts Ponzi he was in his glory. He summarized the confrontation: “Fortunately, there wasn’t what you may call a keen intellect in the whole bunch. The conference wasn’t much of an ordeal. Except from the standpoint of time. It lasted longer the any other. Because my audience was just naturally slower. At grasping things. But, on the other hand, I got away with more fibs. Some of them actually awful. And had the pleasure of leaving that distinguished gathering as much in the dark about my activities as they were at the start. Only, they didn’t realize it. Ignorance is bliss.” (1)p.156
21. Check out time. At some point before the inevitable collapse, Ponzi knew the party could not last forever. However, he overestimated his ability to deceive and stayed too long. Ponzi acknowledged: “What was I going to do? Proclaim my insolvency and face prosecution, or keep up the bluff and trust to luck. I kept up the bluff, hoping that I might eventually hit upon some workable plan to pay all of my creditors in full. It never occurred to me to pocket all the ready cash and duck out.” (1)p.109
Chapter one of the fraudsters’ handbook should be short and to the point. It should read; the cash and I, not pride, goeth before the fall. Ponzi was like a moth drawn to a flame “with four or five million dollars in cash and every opportunity to beat it for parts not reached by extradition treaties, it could not be called critical. It was ideal. But for a stubborn cuss like me, determined to stick it out to the end, it was more than critical, it was hopeless.”p.113,114
22. If the perpetrator does not take the money and run he has an escape plan. Common escape plans observed includes transferring the investors into a new or existing shell entity (commonly referred to as a “Roll Up”). The main feature is issuance of new equity interests in exchange for the investor’s old debt or equity interests. New management may or may not include the perpetrators. One of the slickest escape plans is to have a handpicked group of investors take over management. If the perpetrators are part of the new management team, management fees are structured to make the new entity self liquidating. The cleanest break the perpetrator can accomplish is to find a buyer. Plans predicated on finding a buyer include a lifetime subscription to the “bigger fool” theory for. I have never seen a sale consummated once a scheme starts to fall apart. My mental picture of escape plans consists of a mound of band aids stacked on a wound in need of major surgery. Escape plans count on investors’ reluctance to believe they have been duped, look foolish or admit they made a bad investment. Hope springs eternal.
23. If the perpetrator sticks around he attempts to control the investigation. The goal is to control, manipulate and divert the investigation. “True believers” are organized as a “loyal opposition” to promote a bogus investigation and harass regulators. The clarion call of the controlled “loyal opposition” is for investors to unite and rally around the leadership core of fellow victims to pursue justice and a return of their money. The true intent is to exonerate the perpetrator. Ponzi committed to a regulatory investigation to determine his Liabilities. He concluded “But it was vital for me to decide upon the type of investigation which might satisfy the officials and the public without disclosing my true situation.”p.153 and “I will turn over to him (the auditor) all of the books, papers and records which are necessary to determine my liabilities, I stated. And no more.” and “When the total of my liabilities will be announced, I shall exhibit my assets.”p.154
So It is a Ponzi Scheme, Now What?
The wonderful investment opportunity has collapsed. The remaining assets recorded on the books of the entity are not what they appear to be. They are of diminished value or impaired. Readily marketable assets are long gone. Only the problem assets remain. Where do you start?
First secure what assets remain and get the “fox out of the henhouse”. State or Federal Court Receivership and/or Bankruptcy court protection can stem, or slow, a run on the remaining assets. Such actions can turn time from being an enemy into it being an ally.
Sources of Recovery
Remaining assets, insiders and third party aiders and abettors comprise the list of potential sources of recovery. Beyond the search for hard assets is the search for deep pockets and insurance coverage.
The Starting Point of Any Ponzi Scheme Investigation
There are two fundamental types of Ponzi schemes: a “fraud from the beginning” and a “good deal gone bad”. It is critical that you determine early on in any investigation which type of scheme you are dealing with. Failure to do so can result in a tremendous amount of wasted investigative time and resources.
Fraud from the Beginning (It was all a lie)
A fraud from the beginning features an unprofitable business venture from its inception. It would be a mistake to assume that there was no revenue generated from the business venture. However, revenue is insufficient and not the source of distributions to investors. More often than not, the only discernable business activity is from an apparently successful demonstration transaction. Thereafter, a lack of a substantial effort or an abandonment of effort in the pursuit of the business model is typical. Instead of conducting the purported business activities, the promoter’s effort is focuses on creating the illusion of successful transactions. A common tactic for creating the illusion of success is through controlled sham transactions with parties he controls. These structured transactions are designed to validate the touted profitability of the investment opportunity and keep the illusion of success alive.
If it is a fraud from the beginning, all transactions are suspect and your investigation starts with day one.
Perpetrators are not constrained by the truth.
The existence of an ongoing, evolving and systematic plan to divert assets for personal use.
No sympathy for the victims.
The only remorse is getting caught.
Good Deal Gone Bad (It all became a lie)
In my experience, what differentiates a “good deal gone bad” from a “fraud from the beginning” is the perpetrator’s “non-shareable problem” (compelling need). More often than not, the business model was either successful or reasonably expected to be successful. However, due to unforeseen events and/or circumstances, the business model failed to achieve its expectations. The unforeseen triggering event can arise from a variety of sources, either business or personal, or in combination. It would be a mistake to assume that the differentiation was a lack of intent. Intent is present in both the “good deal gone bad” and in a “fraud from the beginning”. Timing, not existence, is the only difference. When did the intent to defraud first manifest itself? When did the first lie-based investor distribution occur in an attempt to prevent discovery of the “non-shareable problem” i.e.to disguise a lack of economic performance? The “compelling need” may be as simple as a need to be successful, or its mirror image, an “inability to accept failure”. It is difficult for most people to admit defeat to themselves, let alone share the knowledge of one’s failure with another. There is a difference between “it was all a lie” and it “all became a lie”.
Since the business venture may have operated profitable for many years, it is important to identify the triggering event. What change of circumstances resulted in the anticipated profits being deferred, diminished or eliminated? In a “good deal gone bad”, determination of the point of insolvency is a critical issue and may determine the success or failure of recovery efforts from net winners.
Typically, the promoter of the venture did not start with intent to defraud victims,
Typically, the promoter “goes down with the ship” i.e. does not hide assets for future use.
Typically, the promoter has real remorse for the harm he caused. He just did not have the judgment integrity or willpower to tell the truth when his world began to unravel.
Investigative efforts should concentrate on events occurring on and after the trigger point. Little is to be gained by concentrating on events that occurred during the venture’s good deal days.
Plan of Attack
Investigation of a financial fraud is easy. You already have one third of the puzzle solved. You know the money came from the victims. All that is left for you to do is figure out where the money went and how to get it back. The logical plan of approach is split into three parts: Identification of the Source of Funds, Use of Funds and Recovery of Funds.
Source of Funds
· Investors
· Creditors
· Business Revenue
Use of Funds
· Distributions to investors
· Cash in bank accounts, safety deposit boxes, and investments
· Real and personal property
· Insiders, related parties and controlled persons
· Kickbacks
Recovery of Funds
· Liquidation of assets
· Insurance policies
· Net winners
· Promoters and insiders
· Related parties
· How can it be so simple in concept but so difficult to consummate the unraveling and recovery from a Ponzi scheme? Investors have asked many times, “Why does it take so long and costs so much to accomplish the obvious”? In the final analysis, I have never been able to satisfactorily answer that question in my own mind.
Ponzi, C. (2001). The Rise of Mr. Ponzi, Naples: Inkwell Publishers Ltd.
