Ponzi Schemes : Stealing From Peter to pay Paul

Updated on November 05,2022

On December 11, 2008, Bernard L. Madoff, a.k.a Bernie, was arrested for allegedly running a multi-billion-dollar fraudulent scheme in which investors across the world lost 50 billion dollars (twice the size of the Kenyan Government's 2018/2019 budget of 25 billion dollars). This contributed highly to the 2008 financial meltdown, and other big investors and businesses were forced to close their doors. Madoff later on pleaded guilty to 11 federal crimes. His fraudulent scheme is recorded to be the largest Ponzi scheme in history. He was later on sentenced to 150 years in prison with a restitution of $170 billion. In other words, Bernie was never to die a free man.

But what is a Ponzi scheme, to begin with? Many have heard of the term Pyramid scheme, and they often confuse this with the Ponzi scheme. What sets them apart? What would keep you from the claws of such a sarcastic vulture in such a man-eat-man society? Only foreknowledge. Keep on reading.

What is a Ponzi scheme?

In the simplicity of thought, It's investment fraud. The principle of such a scheme is simple; you entice potential investors by promising to invest in opportunities that generate high returns with little or no risks. For example, a Ponzi schemer would entice you to invest 50 dollars into his purported oil and gas business and then tell you to expect consistent returns that amount to 60% in profits quarterly (after every 3 months).

Such promises can in no way be delivered. They only pay such promised interests by attracting new investors whose money they use to pay interest to those early birds already in the fund.

Attracting new money becomes the focus of these fraudsters to make the promised payments to earlier-stage investors, creating a false appearance that investors are profiting from a legitimate business.

Why call such schemes Ponzi?

These fraudulent adventures are named after an Italian immigrant in the US called Charles Ponzi, who, in the 1920s, duped thousands of Americans into investing in a postage stamp speculation scheme.

His scheme involved buying discounted postage stamps from other countries and redeeming them at face value in the US. In other words, he took advantage of price differences (arbitrage). He would solicit funds from unsuspecting investors and then claim to use the funds for bulk buying postage stamps in exchange for returns that seemed legitimate.

He defrauded investors out of an estimated $15 million, or $159 million in today's inflated dollars. At the time when the interest rates for bank accounts were merely 5% per annum, Ponzi promised 50% returns in just 90 days.

He used his own plus investors’ initial capital to buy a small number of international mail coupons in support of his scheme but, within no time, switched to using incoming funds from new investors to pay earlier investors.

He was, in November 1920, arrested and sentenced to 5 years in federal prison. After serving his sentence, he returned to his motherland, where he worked for the famous Italian dictator Benito Mussolini, who subsequently fired him.

Albeit Ponzi died penniless in Brazil, his name lives on as an embodiment of pyramid schemes.

How Ponzi Schemes work

The fraud begins with a fraudster who offers to invest in or operate a business that is a front or boasts a new secret idea or investment strategy that is often fabricated. Potential investors are drawn in by attractive returns promised at specified dates in the near future.

Given that the business strategy is generating little or no income or value, the con man is forced to accumulate an ever-increasing amount of money to satisfy the early investors' claims of their returns.

They do this by enticing recruits.

Why do Ponzi schemes collapse?

Ponzi schemes require a consistent inflow of money from new investors for them to continue.

They tend to collapse when it becomes difficult to entice new investors into the business or when many investors ask to cash out over a very short period.

Since the schemers often spend the received money however they see fit, their pool of funds is usually depleted. If there is any panic in the market, say a virus outbreak, everyone might attempt to salvage everything they can from their investments and savings to stay afloat.

Only then will you realize that the company you invested your life savings into is insolvent.

Ponzi vs Pyramid vs MLM Schemes

Pyramid Schemes

In a pyramid scheme, participants make money solely by recruiting more participants into the program. It's commission-based. In actuality, the participants do not do anything else other than hand over their initial money and then recruit more participants, but still, they expect very high returns just for doing this.

Pyramid Scheme Vs Ponzi Scheme

	Pyramid Scheme	Ponzi Scheme
The hook	Investors earn high profits by making one-time payments and finding others to become distributors of a product. The product in question may not be genuine at all. The purported product may not exist at all.	Investors earn high returns with little or no risk by simply handing over their money. Very often, the investment does not exist, or only a small percentage of incoming funds are invested.
Payments	The investor must pay a one-time or recurring participation fee. They must also recruit new distributors to receive payments.	There is no recruiting necessary to receive payments.
Interactions with the schemer	New participants may enter the scheme at different levels and hence may never interact with the schemer.	The promoter normally interacts directly with the investors. They keep showing up just to beguile you into establishing a sense of false authenticity.
How they stay afloat	Funds from new participants are used to pay commissions to earlier participants.	Funds from new investors are used to pay earlier investors their claimed returns.
The rate of collapse	The collapse rate is relatively fast since an exponential increase in new participants is required at each stage to keep the pool of funds full.	The collapse rate is relatively slow since investors might be required or enticed into reinvesting their money. A well-thought-out scheme might run for decades.

Multi-Level Marketing Business (MLM)

An MLM is a business opportunity involving selling products to family and friends and recruiting others to do the same. These businesses sell their products and services through person-to-person sales. This may mean selling to customers directly from your home, their homes, or online. When you join an MLM program, you become the company's distributor, participant or contractor. You can make money by:

Selling the MLM's products yourself to customers who are not involved in the business.
Hiring recruits and then earning commissions based on their trading activity.

When you choose the latter, your recruits, the people they recruit, and so on, become your sales network or "downline." If the MLM is not a pyramid scheme, you will be paid based on your sales to retail customers without necessarily having to recruit new distributors.

How to spot a Ponzi Scheme

The pitch is often elaborate and inventive.

The fraudsters behind the wheel may go to lengths to legitimize their scheme.

You might consistently receive your payouts on time for the first few months. Others will boast of being masterful of their art and courageously make big claims about their educational backgrounds and business connections.

Some will assuredly overuse terms such as 'overseas', 'Harvard business school', 'professionals', 'PhD' etc. Words that, on their own, are just words; but when mentioned to support a claim, seem godly. Some will even invent their own words. They will go to lengths to make a pyramid scheme look like a legitimate multi-level marketing (MLM) program.

The promise is always very high returns over a very short period with little or no risks involved.

The reality of the matter is there is always some degree of risk in every investment.

In addition to this, investments involving higher returns always involve higher risks.

The market simply doesn't work in a 'guaranteed' approach manner, there are always lows and highs. You can never be sure of profits come rain come sunshine. You will be slapped with a loss at a given point in time.

Tell you what, this is pure nature; it's how stuff works. Yet people still expect guaranteed consistent gains over a long period.

Overly consistent gains

Like I said before, investment values (gold, silver, stocks) tend to go up and down.

Beware of investment schemes that spew high consistent returns regardless of how the market performs. For example, say your investor (Ponzi schemer) claimed to plough your money into an oil and gas business. If, in the next few months, oil and gas prices have risen and fallen, yet your returns (paid to you by the investor) stay consistent, then be wary of this.

Or are you a direct offspring of the holy grail!? Even so, no recorded promises of direct entry into heaven can be found; Amen.

Secretive and/or complex strategies.

The schemers will go on record to boast of how masterful their investment skills are. Many have claimed to be Harvard Business School graduates or something of equal measure. They will add claims on how beautifully their strategies are crafted. Yet if you were to poke them to share their investment strategies, they will always shy away with familiar claims like, "uh oh! Our investment strategy is very complex, I don't expect the common public to understand". Or rather, "It's a secret! Don't expect me to share that." In the name of secretive and/or complex, there will be issues with paperwork.

They will give you excuses whenever you ask to review the investment information in writing. Do not accept this.

Unregistered/Unlicensed businesses.

If you are acutely serious about your investment money, you must take additional steps by checking with the state regulators if such a business is registered with them.

Registration information gives investors key details regarding the company's management, products, services, and finances.

Don't you think it's key to check whether or not a company is insolvent or not before you invest your millions into it?

Most securities markets worldwide require investment professionals to be licensed by the appropriate authorities.

There will be issues with receiving payments.

Do not be surprised if you are slapped with another requirement when the time for payout comes. For a Ponzi scheme, after they had assured you that all you needed to do was to invest your money and then wait for the returns, you might be required to solicit other investors into joining the program first. They will tell you that you need to have 5 or so invites to proceed with the payout. It's a strategy of expanding their schemes for more cash inflow. Others, with impunity and courage, will ask you to roll over (postpone it to a future date) your investments for even higher returns.

Kenyan Case Studies

Kenyan case studies of Ponzi and pyramid schemes

https://www.standardmedia.co.ke/article/2000149031/i-lost-sh31m-and-brother-to-the-pyramid-schemes
https://www.nation.co.ke/news/suspected-pyramid-scheme-continues-to-operate/1056-3975406-format-xhtml-u9x6u4/index.html
https://thekenyancolumn.blogspot.com/2007/07/pyramid-schemes-central-bank-has-no.html
https://www.nation.co.ke/news/Russian-Ponzi-scheme-Mavron-still-doing-business/1056-4281256-7jgcmn/index.html
https://www.businessdailyafrica.com/news/Equity-Bank-freezes-Ponzi-scheme-account/539546-3972732-wyxxmt/index.html
https://www.kenyans.co.ke/news/50853-nairobi-man-flees-after-robbing-somalia-mps-ksh6-billion
https://www.pulse.ng/gist/mmm-ponzi-scheme-launches-in-kenya-promises-better-returns/3h9mpqk
https://www.the-star.co.ke/business/commentary/2016-02-20-state-is-running-a-ponzi-scheme-on-kenyans/

Consequences of Ponzi and Pyramid Schemes

Most people who join fraudulent schemes make little or no money. Others may receive substantial amounts for a short period, and then when they decide to plough back their profits plus additional capital of their own, the scheme itself might collapse, leaving them with nothing at all.

Be wary of pyramid schemes, for you might spend a lot of time, money, and effort just to get nothing.

Ponzi schemes, however, may give returns for the early investors, and if you are wise enough to check out before the scheme collapses, you might as well bag some goodies with you.

Many have lost their entire savings over Ponzi schemes. Some have borrowed large sums from banks, friends, and families to invest in these schemes just to lose it all and then fall deeply into debt.

Some end up with depression and eventually commit suicide.

Families and friendships have fallen apart over this malice. Keep a watchful eye to avoid these pitfalls.

Conclusion

Whether or not you are new in the world of investments, before you commit your money to an investment that is not managed by you, there are some basic inquiries one should make. Sample questions that should be asked include:

Whether or not the seller is licensed by the appropriate body. Listen to their boasts on their backgrounds but seek to verify the claims.
Whether or not the investment itself is registered by the regulating bodies. The investment should be able to provide proof of these.
How the risks compare with the potential rewards. If there exists a misbalance, then there goes your red flag.
Do I understand the investment itself? If they hide from you their modus operandi, then there is absolutely no point in trusting them.
Where can I turn for help? Have a financial prosecutor ready with you or contacts of the same. You should even drag them with you for help in making the investment decision.

Every investment opportunity should be as clear to you as possible before you decide to jump in. Many that get engulfed by such flames are fans of get-rich-quick schemes. The disorganized sluggards, the couch potatoes who prefer to just sit back, plough very little and expect magnanimous returns. Tell you what, the world cannot sustain itself like that for a long period.