Ponzi Scheme, What It Is and How It Works with Examples
How a Ponzi Scheme Differs from a Pyramid Scheme
Ponzi schemes are fraudulent investments, never legitimate ones. They promise above-average returns but always fail in the long run.
At first, they make good on these returns. They use the principal investment from new investors to make the above-average returns to the old investors. After paying these returns, they use all their resources to get new investors. Eventually, these schemes fall apart. They cannot keep recruiting enough new people to continue paying returns to the old investors.
Although the original Ponzi scheme fell apart in the 1920s, it continued to morph into many forms. A recent example was Madoff’s 2008 investment scheme.
A Ponzi scheme has the following characteristics:
- The proposal promises the surety of high returns at very low risks.
- The investments aren't registered with the Securities and Exchange Commission.
- The deal guarantees consistent profits, regardless of economic conditions.
- The workings of the business opportunity are too complicated to explain.
- No legal paperwork is available for the investor to examine.
- Investors find it difficult to get their money back.
Charles Ponzi lured thousands of investors in the 1920s. He promised a 50% return in 90 days on profits made from international reply coupons. These coupons were slightly less in value in foreign countries. They could be redeemed for real stamps higher in value in the home country.
The profits seemed plausible to gullible investors, but it would require millions of coupons to make any profit at all. Instead, Ponzi used the funds he acquired to pay off a few early investors in 45 days. This made his proposal believable. In a few months, he collected $20 million. He once received $1 million during a three-hour period.
The Ponzi scheme crumbled when he was unable to pay off later investors. By then, he had lost between $7 million and $15 million and ruined six banks. The government charged him with mail fraud under the state and federal law.
He received a prison sentence of five to nine years. He jumped bail and proceeded to launch the Charpon Land Syndicate in Florida where he sold real estate that was underwater. Texas authorities kidnapped him and returned him to Boston. He was released in 1934.
Bernie Madoff operated the longest-running Ponzi scheme. For 20 years, investors poured $17.5 billion into his "investment firm". He paid above-average returns using funds from new investors. The 2008 financial crisis brought his fraud into the light when investors tried to withdraw $7 billion. With a net worth of only $300 million, Madoff was unable to reimburse them. He pled guilty and is currently serving a 150-year sentence. His son, Mark Madoff, committed suicide only two years after the arrest of his father. He hung himself in his New York City home. His 2-year-old son was asleep in the next room. Andrew Madoff died of cancer in September 2014.
The charges for the fraud did not extend to the other members of the Madoff family. His wife and two sons worked for related businesses in separate buildings. The courts allowed Ruth Madoff to keep $2.5 million. She now lives in a 989-square foot apartment in Connecticut.
Chinese authorities announced the most recent example of a Ponzi scheme in February 2016 where 1 million investors lost $7.6 billion to Ezubao. This online lending company promised 15% returns, which never happened. Instead, the 21 owners spent money from investors to run their company and buy luxury cars and houses. Ezubao operated from July 2014 to December 2015.
Why Social Security Is Not a Ponzi Scheme
Social Security looks like a Ponzi scheme. Workers pay into the Social Security Trust fund. Despite the name, there is no trust holding these funds for them. Instead, the funds pay benefits to existing retirees. Once the paying workers are ready to retire, new funds will come from new workers.
People call social security a Ponzi scheme because the people who got in early are receiving more than they paid in. Baby boomers paid more payroll taxes than the contributions received by their parents. This is not the case for retiring boomers.
There will not be enough workers in the future to pay benefits to them when they retire. By 2030, Social Security will need to draw from the general fund to pay out benefits. That will create a budget deficit or a need for new taxes. That means the government will force the next generation to pay for benefits. Unlike a Ponzi scheme, the "new investors" have no choice. That's the difference between Social Security and a Ponzi scheme.
The Difference Between Ponzi and Pyramid Schemes
Ponzi schemes are fraudulent investments. The participants believe they are putting their money to work in a real investment.
Pyramid schemes are fraudulent multi-level marketing businesses. Participants understand that they must recruit new members to make money. Those at the top levels of the pyramid make money from the new recruits at lower levels. Sadly, those at the lower pyramid levels never find enough new recruits to make money. They find they have wasted much time and money once the pyramid collapses.
Most well-known MLM companies are not pyramid schemes.
Examples include Amway, Melaleuca, and PrePaid Legal. They get most of their revenue from products or services, not new customers. Furthermore, most of their customers are also not representatives of the company. This is the main difference between an MLM business and a pyramid scheme.
Legitimate MLM businesses are good opportunities for people who want to learn how to run their own ventures. Learn to ask people the six important questions when they invite you to join an MLM business. The answers may help you discern a scam from a legitimate business offer.
Evaluate an MLM proposal with these questions:
- Who are your uplines? These people before you should be earning very well and be willing to mentor you. People in your upline should be viewed as your business partners.
- What is the product? Is it easy to sell or is it in demand? Just like any retail business, the product is a huge determinant of success.
- When do you start earning from the business? Know the average time to expect some profit, assuming the time invested in for putting in a reasonable amount of work. Will the time frame and income meet your expectations? There might be better alternatives out there.
- What are the company’s product promotion policies? Your recruitment into the company’s sales network cuts their advertising and marketing costs. Find out what materials or deals the company gives to help you promote their products at minimal cost on your end.
- How were you recruited? Avoid agreements that promise payment only when you find a new recruit, not when you sell a product. This is a scam known as a pyramid scheme. A valid networking business allows you to enroll as a customer first, so you can get to know their products. Once you believe you can sell these, you can then opt to join the network and market products for the company.
- Why are you going into an MLM business? If it’s to get rich quick, you may be in the wrong business. It’s a lot of work, just like any start-up. But for most network marketers with managed expectations, this provides a good way to supplement income on the side and have some fun doing so.