During the last few decades, uncertain economic conditions paved the way for various fraudulent financial schemes. One such Fraud scheme is the Ponzi scheme. The Ponzi scheme was named after Charles Ponzi, who in 1920 used a technique known as the 'confidence trick'. He guaranteed investors that their investment would double in 90 days after purchasing foreign postal coupons.
In the beginning, the investment appeared successful since he had paid out the promised returns to all the early investors. When investors began pouring money into Charles Ponzi's scheme, his debts started growing exponentially.
Doubling everyone's money would make his debts grow substantially because he would owe even more. Although this did not matter to Charles Ponzi as long as all the investors did not demand their funds at once. However, when the news was published that he was bankrupt, all his investors panicked and rushed to withdraw their entire investments at once. Over 200 million dollars had been invested, but Ponzi fell 120 million dollars short while repaying the investors.
It was a huge lesson for us and the investors that never follow the crowd blindly. But the 100-year-old scheme still continues to adversely affect the lives of those who do not learn.
Why do people keep falling for the Ponzi scheme?
Ponzi schemes have been criticised for decades, but Ponzi's methods are still used today. So the question remains: why do people continue to fall for such schemes?
The simple answer is because everyone wants easy money. People tend to look for shortcuts but it is not always greed that pulls them to these schemes. Ponzi schemes are disguised as genuine investment and many consider this to be attractive investment opportunities.
This scheme takes advantage of the financial system to embezzle millions, if not billions of dollars from unaware investors. In the beginning, investors are promised high returns and the investment appears to be profitable. Consequently, new investors are attracted to the scheme.
The early investors are paid off with the money from the new investors, and the cycle continues. The Ponzi scheme requires a constant flow of fresh money since it does not earn money from selling a product or service.
No real profits are ever made by either the company or the investment, the funds are merely redistributed and the investment is claimed to be profitable. As long as new investors are coming on board, everything seems to be fine for the time being. But the scheme eventually collapses as it runs out of investors.
High profile Ponzi schemes in the world history
Over the last decade, Ponzi scheme perpetrators have devised more complex schemes to defraud innocent investors. Former NASDAQ chairman Bernie Madoff ran the largest Ponzi scheme in history, worth approximately $64.8 billion. The most infamous Ponzi schemer after Bernie Madoff is Allen Stanford, convicted in an $8 billion dollar Ponzi scheme.
Together they exploited thousands of people, as well as companies who invested funds with them. Though Madoff and Stanford perpetrated two of the biggest Ponzi schemes ever.
Ponzi scheme red flags
- Ponzi schemes share several characteristics in common. Here are some of the symptoms to look out for:
- Investments that yield higher returns usually carry a higher level of risk. Investment opportunities that promise a high rate of return or 'guaranteed' return should be viewed with caution.
- The value of investments tends to fluctuate over time. A regular positive return regardless of market conditions should raise suspicion.
- Investors are often offered high returns to discourage them from withdrawing their funds from the scheme.
- Investors are pressured into making quick decisions and may be advised to keep the investment a secret from family and friends.
- The terms used in the investment scheme seem jargon and one encounters difficulty in obtaining necessary documents or paperwork.
- The business model is complicated and hard to understand by a normal person how such schemes generate returns for the investors.
- Ponzi schemes usually have highly motivated sales personnel because the commissions are high.
How to prevent a Ponzi scheme?
- Don't be a courtesy victim. You should be extremely cautious of people randomly approaching you and asking you to invest, especially friends, friends of friends, relatives, and known figures within your community.
- No investment can be guaranteed to be risk-free – only high returns can be achieved with high risks. One should take precautions with companies that assure a risk-free investment and a high return.
- Don't put all of your eggs in one basket. Diversify your assets, accounts, and financial institutions. Those who survived such a scam invested only a percentage of their assets, not their entire life savings.
- Never judge someone's integrity by how they sound. An expert con artist can make even the riskiest investment look safe and sound.
- Ask questions whenever you need to. People often don't investigate before investing, so fraudsters take advantage of that. Be familiar with the investment, the risk involved, and the company's history. If it sounds too good to be true, it probably is.
- Do your research before investing. Make sure you understand the company and its products. Research the company's website, social media pages, reviews, etc.
- Unsolicited, extremely lucrative offers should be questioned. If anyone you know made money, it doesn't mean you will too. Take caution if you receive an unsolicited phone call or email about a company and can find no current financial information about it from other independent sources.
Are banks immune from Ponzi Scheme liability?
Globally, Ponzi scheme victims are seeking recovery of their losses from the financial institutions that Ponzi scheme perpetrators use for holding victims' funds before misappropriations i.e money laundering, terrorist financing etc.
In general, financial institutions are liable if plaintiffs can prove they were aware of the Ponzi scheme. To defend against Ponzi scheme litigation, a financial institution must prove it was unaware of the underlying fraud.
Banks also have legal obligations to investigate whether such clients are laundering ill-gotten gains regardless of whether they were aware of the scheme.
So long as financial institutions continue to be the sole sources of financial recovery until the dust of a Ponzi scheme clears, the struggle over bank liability for negligence claims by victims is likely to continue.
Banks must take reasonable steps to review existing and new clients and evaluate their potential exposure to such schemes. A slight involvement, negligence, and failure to perform adequate KYC (Know Your Customer) and even non-reporting of Ponzi like activities will almost certainly pose a regulatory action and litigation risk to the banks.
Mohammad Rezaul Karim is a certified anti-money laundering specialist and assistant Vice President, Compliance, at HSBC Bangladesh; and Rucsar Jabin is a Lecturer of Marketing at the University of Dhaka.
Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.