What is a Ponzi Scheme?
A Ponzi scheme is a common kind of investment fraud in which there is no investment. Instead of putting investors’ money into something – stocks, bonds, commercial real estate, an interest in a South African diamond mine, collectible plates, anything – the scheme organizer uses the investors’ own money to pay them while skimming off a piece for himself. Sometimes it’s a very big piece – yeah, we’re looking at you, Bernie Madoff says California Business Lawyer Steven C. Peck.
In some cases, the promoter uses your own money to pay you. For example, suppose you invested $20,000 with a “broker” who promised you a 15 percent per year return on your principal. That’s earning $3,000 a year.
Your “broker” could take $5,000 for himself off the top, then pay you out $3,000 a year from your own money, claiming it’s interest earned, appreciation or some other return on investment. He could keep this up for five years before running out of cash.
If a Ponzi-scheme organizer uses later investors’ money to pay off earlier investors, he can juggle the balls for many, many years. As long as enough new investors keep coming in to pay previous investors, the con man can keep the fraudulent balls in the air indicates California Business Attorney Steven C. Peck.
For example, we don’t know exactly how long Madoff worked at his scheme, but it went back at least to 1999 when Harry Markopolos tried vainly to alert the SEC to him. The criminal complaint against Madoff pegs the start to the beginning of the ’90s.
A Ponzi scheme is fraud, pure and simple – it’s hard to find something that’s more of a fraud. So there is no doubt but the victims have a cause of action. However, there are two big problems:
Again, take Bernie Madoff: Most estimates put the amount of losses at around $65 billion, but Madoff’s own assets – at least the ones they can prove so far – are less than $1 billion. That’s less than a nickel on the dollar available for his victims to recover.
The earliest “victims” of a Ponzi scheme may do actually do well, getting payments from later investors for a period of years. So earlier investors may have made a pretty penny.
Unfortunately, it’s all ill-gotten gains and other people’s money, which means later victims can seek to recover that money.
What is a Pyramid Scheme?
A pyramid scheme is similar to a Ponzi scheme. The big difference is that unlike a Ponzi scheme, where there is one – or a very few people – who act as the hub and take money from everyone, in a pyramid scheme each person recruits and takes money from later participants. Therefore, there can be many “winners” in a pyramid scheme – at least until the scheme runs out of new recruits and the last round of participants is left holding the bag.
For example, say that Participant 1 recruits 10 people and gets $10,000 from each. He’s $100,000 to the good. Participants 2 – 11 each then recruit 10 more people and get $10,000 each, so they also make $100,000 apiece. Then participants 12 – 102 have to get money from 10 each or 1,000 more people. This is what gives the scheme its classic pyramidal shape: each “level” is wider than the one before it.
The problem is, it must come to a crashing halt at some point. Exponential growth curves get to truly outrageous levels fast. In our example, if each person needs to recruit 10, then the third round of participants totals 1,000 people. The fourth round is 10,000; the fifth, 100,000; sixth, 1 million; seventh, 10 million; eighth, 100 million, or one in three Americans; ninth round, you’ve have to have one in six human beings, or 1 billion people, participating. And there is no tenth round.
Since it would be fairly miraculous – if that’s the right word – for a scam to sweep up a billion people, most pyramid schemes end far faster and less dramatically than our example.
No Goods, no Services, no Investments
To recap: The only real difference between a Ponzi scheme and a pyramid scheme is that in a pyramid scheme, more people profit. But in both, there are no goods, services or investments – just the use of later payments to pay earlier participants and scheme organizers.
About the Author
Attorney Steven Peck has been practicing law since 1981. A former successful business owner, Mr. Peck initially focused his legal career on business law. Within the first three years, after some colleagues and friend’s parents endured nursing home neglect and elder abuse, he continued his education to begin practicing elder law and nursing home abuse law.