Ponzi Schemes: How They Work and What We Can Learn

Posted in: Business Law

A Ponzi scheme—named for Charles Ponzi, who defrauded investors in the 1920s—is an investment fraud that pays profits to earlier investors using funds obtained from more recent investors. They have been practiced in the United States, Russia, India, Albania, and other countries as well. In 1994, a Ponzi plot reported by Diana B. Henriques of the New York Times defrauded institutional investors of $450 million. Between 1995 and 2002, US investors lost about $125 million to Ponzi schemes, and in 2002, the Boston Globe reported a Ponzi scheme involving eight banks that lost nearly $1 billion.

How do Ponzi schemes work?

Ponzi schemes share a very simple basic design. Investors are offered unsecured notes carrying a very high rate of return. The promised interest of many schemes may be 10%, as compared to the going rate of 5–10% per year. Bernard Madoff’s notorious scheme—the largest Ponzi scheme in world history and largest financial fraud in US history—was an exception, however, offering a rate that was not unusually high but instead very stable. Madoff’s scheme was estimated to be worth $64.8 billion in 2008.

In addition to offering a high interest rate, Ponzi schemes promise very low risk. Sometimes this promise is supported by collateral, such as real estate mortgages, insurance, or government or bank obligations—whether or not such collateral actually exists.

Inevitably, Ponzi schemes come to an end, usually within about two or three years, because they run out of new investors. If only new investors are added to a scheme, the number of new investors required by 11 months into a scheme exceeds the world population; schemes often survive this milestone because many investors re-invest in the scheme. Some Ponzi schemes have lasted as long as eleven years, such as one operated by a tax consultant who was able to get his “clients” to repeatedly re-invest and roll-over their original investments, significantly reducing the repayment due to early investors. The Madoff scheme most likely lasted even longer, but it is unclear whether it started as a legitimate brokerage business and only later evolved into the scheme.

Gaining the attention and trust of “marks.”

The con artists who operate Ponzi schemes draw the attention of their victims by offering incredibly high returns. Usually, after investors give a small amount and are paid, they re-invest more money. These promised returns, so out of line with what the market offers, draw the attention of any investor, even the most skeptical.

When the returns are actually paid, they bring further investments. As Charles Ponzi noted, after investors gave him a small amount “as a lark” and received the returns promptly, they threw caution to the wind and gave him all their money. In the words of one court: “[A]t the initial stages of the plan, those investors who wished to withdraw their investments were promptly paid. The effect of such prompt payment, of course, was to convert every investor into a missionary spreading the word of the enormous profits which could be speedily attained with no discernible risk of loss.”

High returns dull some investors’ senses in interesting ways. In the case of United States v. Gragg a victim invested $113,000 with a con artist, despite being aware that the schemer had been served with a “cease-and-desist” court order, because the con artist had promised that the investment would pay 15% interest and was secured by the US government. The title of the instrument—Internal Certificate of Deposit—and the return were clearly irresistible.

Once the scheme attracts its victims, it draws them in and gains their trust through symbols of respectability and trustworthiness. For example, Ponzi’s business was named “The Securities Exchange Company” and was located at 27 School Street—a respectable location. The form of the personal note was that of a bank note. Other Ponzi scheme notes have been entitled “certificates of deposit,” contained the word “guaranteed,” or included other symbols of trustworthiness, such as “gold-backed railroad bonds.”

Often, con artists use stories to explain the source of the high profits, such as receivables that in fact do not exist, or a secret donor. They make specific promises to repay soon and do actually make payments promptly. This prompt repayment was critical in Charles Ponzi’s scheme, and he even repaid investors upon demand before their investments became due, so as not to seem too aggressive in selling. As a result, investors begged him to accept their money.

Hiding the vulnerable part of their story.

Con artists tell their stories in a truthful way—full of details that cannot be verified. The source of income might be in a distant country or scattered around the United States. Or great complexity might hide the scheme, as was the case with Enron. The Enron Corporation modernized the Ponzi scheme by using complexity to hide its true financial condition and using its shares to guarantee the value of its securitized assets.

Secrecy also has a great appeal and can entice investors and instill trust. Charles Ponzi gave the appearance of openness by acknowledging that there were details he could not divulge.

In another example, Michael Calozza was an insurance agent who fabricated a letter from the Sons of Norway offering him and his staff a tax-advantaged high-yield secure investment. Calozza told his clients that it would be unfair to deprive them opportunity, and he suggested that they borrow against their insurance policies and give him the borrowed money in exchange for his personal high-interest promissory note. He would then invest the money in the investment offered to staff members only and pass the returns through to his investing clients. Because the fake letter made it look as though the Sons of Norway sought to limit the nonexistent investment to Calozza’s staff, there was an element of deception involved. Deceiving the insurance company was justifiable, of course. Calozza advised his clients to keep secret this pass-through scheme and their participation in it, and they agreed. The scheme cost unfortunate clients about $8.8 million and benefited fortunate clients by about $2.3 million. The secrecy that the investors kept delayed the discovery of the fraud.

Secrecy provides a bond between the con artist and his “marks,” as sharing secrets does. The “little wrong” that both parties commit binds them. Reciprocity: If I trust you, and trust you first, you should trust me. Any reader who has received a “Nigerian letter” will recognize the same ingredients.

Enlisting the help of their victims.

Ponzi con artists often get the help of their victims. The victims spread the word around. Charles Ponzi, for example, was the hero of the Italian community in Boston. Its members remained his loyal followers to the bitter end and blamed government interference for his demise.

Victims do not rush to complain. They are many times ashamed and embarrassed to admit their gullibility. Their attitude can help con artists. Persons who have been defrauded may hesitate to complain to the authorities. They may not have sufficient evidence on exactly how the scheme was carried out, or proof that the con artist was fraudulent rather than a businessman in need of cash that refinanced his loans and failed. Victims may also be reluctant to “get involved.” Many have developed affection for the con artists, and some have identified with their success.

Sophisticated victims of Ponzi schemes who discover that they were defrauded are not likely to rush to the police or disclose their knowledge about the scheme, if they can help it. Many would rather forget it, embarrassed by having been “taken for a ride.”

Victims who invested other peoples’ money in a fiduciary capacity as trustees or agents may hide their involvement. A view of victims suggests that for many reasons—such as risk, self-blame, greed, and shame—they are likely to remain silent.

A number of stories describe the hostility of the victims towards government interference. They believed that but for the government’s prohibitions, the scheme would continue to produce for them large profits. They are right if the con artists could continue for a bit longer. In the victims’ opinion, the magic investments could continue if the government did not interfere.

Building on the addictive appeal of gambling.

Ponzi schemes are addictive for the con artists and many of their victims. Lotteries are legal when operated by the state, and gambling or betting are legal when approved and licensed by the state. Yet the features of buying a lottery ticket, gambling, and speculating in the stock market, demonstrate their likeness to Ponzi scheme investments as well as their difference.

Gambling is placing a “bet on an uncertain outcome.” And buying shares in the stock market is based on predicting the future performance of the issuing company and the performance of its stock in the market. All these speculative activities are based on predicting a profitable outcome, and putting money at risk of loss. Taking risk per se does not necessarily involve illegal activity.

Legal and illegal, speculative activities share similar features. They promise a chance for quick, short-term results and gratification. Lottery tickets and gambling provides the results on the spot, or within a short period. Stock speculation, especially on the Internet can produce gains or losses almost instantaneously. The monthly or quarterly receipt of an anticipated large check in a Ponzi scheme can produce a similar pleasure.

Instantaneous gratification, the excitement of winning or the hope of future winning can produce addiction: a compulsion, dependence, obsession, and craving maturing into a habit.

Con artists and many of their investors seem to share the gamblers’ joys and weaknesses. They exhibit the behavior patterns and reactions of compulsive addicted gamblers, and seem to share the gamblers’ joys and weaknesses. The behavior of Ponzi victims after their losses, and their reluctance to complain about the scheme fits this profile. On this score as well, Ponzi schemes reflect legitimate gambling activities.

Who operates Ponzi schemes, and why?

The operators of Ponzi schemes are con artists, and often are characterized as narcissists. They may have an inflated sense of self-importance, a sense of entitlement, and an inability to empathize. Some analyze them as people who have self-loathing, counterbalance by extreme self-indulgence. They externalize sources of blame, deny wrongdoing, and blame others. They blame the government—for shutting them down when they otherwise could have turned business around.

They blame the victims for greed and sometimes for stupidity: “How could they believe me?” They believe that fraud is fair, because “everyone does it.” They believe they offset the fraud by doing good elsewhere, such as by donating or helping their communities.

Deception has existed in societies for thousands of years.

Deception is not a new or unique characteristic. Pretending is a gift that humans possess at a very early age. A child may put a banana to her ear as a telephone, even before she understands fully the falsity of the situation or distinguishes among mistakes and between pretense and false beliefs.

Manipulation and guile, for good and evil, go back thousands of years, as the stories of the Old Testament tell us. Both Abraham and Isaac presented their beautiful wives their sisters for fear that the local residents would covet them. Rebecca tricked her blind husband, Isaac, into blessing her favorite younger son, Jacob. King David fell in love with Bathsheba, the mother of the great King Solomon, as she took her bath on the roof, where he could see her. When he wanted to marry her, he sent her husband Uria to be killed in war. These acts were driven by men’s fear, by a mother’s love, a man’s lust and a woman’s ambition.

Words and expressions play a key role in deception. One author has suggested that people fail to discover lies because they pay too much attention to words and too little attention to other signals that people send, such as facial expressions.  Studies of manipulators’ faces show that the mouth is more amenable to manipulation by liars than the eyes. Eye muscles act involuntarily while mouth muscles can be controlled better. Liars may also adopt modes of behavior to cover lies, for example, by displaying strong emotions such as indignation, or using flattery to divert from truth.

In his book The Face, Daniel McNeill describes the use of facial expressions to signal truth and hide lies. Facial deceit can take the form of revealing nothing, like Stalin’s stony face, or showing something that is misleading, like a smile to conform to social behavior. Facial expressions can also constitute active lying, like crying when one does not feel sad or hurt. Humans have acquired protective mechanisms against manipulation, but these innate mechanisms are far from perfect and many lies go undetected.

What are the similarities and differences between Ponzi schemes and legitimate businesses?

Con artists seem to engage in legitimate business of salespersons and entrepreneurs. Ponzi con artists engage in selling, as do many honest salespersons. In fact, many con artists started their careers as salespersons. Salespersons often talk us into buying what we would not otherwise buy. Many con artists also behave like entrepreneurs. Entrepreneurs are creative and often over-optimistic, inclined to take more and higher risks and less affected by failures. It is clear how the line between entrepreneur and con artist might get blurred.

Ponzi schemes are similar to legitimate businesses in many ways. Businesses borrow. It makes economic sense to borrow a certain percentage of the operating capital. Businesses pay dividends while in debt. Individual investors buy securities on margin—borrow a portion of the price of securities in which they invest. Ponzi schemers operate the same way. They borrow from one group of investors and pay another.

Many operating enterprises “refinance,” that is, borrow from Peter to pay Paul. They may do so for example, when interest rates fall. If the chances of a successful enterprise are low, and if the management of the business recognizes this fact but continue to borrow and repay formed creditors, the enterprise may back into a Ponzi scheme.

Charles Ponzi himself believed for some time that his business would produce the promised returns. Only when he realized that there was no hope of such profits did he knowingly continue “empty refinancing.”

Two fundamental differences remain between legitimate businesses and Ponzi schemes. One difference is that legitimate businesses, however risky, reward investors and benefit society by providing incentives to finance productive and creative efforts. Ponzi schemes do not. They transfer money from one group of investors to another group and to the con artists. No wealth is created from an earmarked enterprise.

The other difference is that investors in legitimate enterprises are not deceived. They receive truthful information that allows them to make an informed investment decision, and they take the risks they know about for rewards they understand. Investors in Ponzi schemes are not told the truth, even if some may guess at the truth. Yet, these two differences are hard to identify because the form, manner of operation and many of the Ponzi schemes’ features resemble and actually constitute legitimate business practices.


What lessons have we learned by peering through the looking glass at con artists and their victims? We learned that con artists reflect trustworthy people. Deceitful actions can resemble legitimate actions. Self-regarding rationality that is not tempered by moral self-limitation can lead to fraud. Society is populated by artists and con artists, by trustworthy people and their mimics; by selfless compassionate idealists and self-centered ruthless narcissists; by true victims and foolish or fake victims; by productive entrepreneurs and their mimics, who produce nothing.

We learned that America is ambivalent towards its con artists. It does not fully condemn the cons even though their actions may have a devastating effect on their victims, and their methods may be heartless and cruel. There is ambivalence towards the victims as well. There is less sympathy for people who can protect themselves from fraud, and support for helpless victims. I speculate that con artists and their Ponzi schemes are successful and their schemes are long lasting because the cons and their schemes present a double image. Their actions reflect a distorted picture of honest people. Their schemes reflect the picture of legitimate and real businesses. But every distortion is anchored in the true and authentic. That may explain our ambivalence and their longevity.

Distortions contain contradictions. Both the cons and their victims seem to mirror a mix of contradictions that reside in all of us: The admired charming rogue, the driven greedy person, and the gullible and vulnerable investor. The weight of these contradictory pieces shifts depending on the social judgment about human relationship. How able were the victims in protecting themselves from the fraud? How charming and skillful were the cons in their manipulations, and how much harm did they inflict on the financial system as a whole?

Most importantly, we learned how to protect ourselves from investment fraud. The lesson is not based on the general red flags waved by Ponzi schemes. The many published lists of “dos” and “don’ts” seem to have little effect. The main lesson is to be drawn from learning about ourselves. I believe that we should examine our own vulnerability to enticing deception, and help raise the strongest protection from fraud—our own self-understanding and self-awareness.

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