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Ponzi Schemes Explained in Three Minutes or Less...

Ponzi schemes occur quite frequently, though not all of them are big enough to make headlines like Bernie Madoff’s did several years ago. They come dressed in different ways; some succeed because they’re flashy—some because they appear conservative—the bottom line, however, is that the mechanics behind them are all the same and they are all synonymous with the term “house of cards.” 

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While most have heard of a “Ponzi Scheme,” not everyone understands the underlying concepts or basics behind this nearly 100-year-old fraud. Because they all share the same characteristics, I will demystify the Ponzi scheme by explaining it in three minutes or less.

The Short of It: The basics of a Ponzi scheme can be packaged and repackaged in countless ways. The scheme always revolves around the process of paying old investors with the money you get from new investors. The central method remains the same. The details and the investment itself don't really even matter too much. What ropes people in is the promise of fantastic returns on their investments.

The Backstory: In the 1920s, when someone sent mail overseas, he might also buy an “international reply coupon.” This was great for the recipient because it was a voucher that pre-paid the postage to reply back to the sender.

Carlo Ponzi’s investment idea? He would simply buy reply coupons in a country where they were cheaper, and then sell them in the U.S. where they were worth more. The difference would be profit that he would share!  He easily caught these lucky investors in by promising 50 percent returns in 45 to 90 days. 

There was a flaw in this simple investment theory, though. Conducting business overseas, transporting the coupons and exchanging them for cash caused delays and extra costs that prevented paying investors as promised. But Ponzi kept that bad new to himself. And every day, new, excited investors wanted in—and Ponzi decided to take their money anyway. He kept up the scheme by paying off his initial investors with some of the new money and pocketed the rest for himself.

The whole thing fell apart after a few months when people started wondering how he could buy and sell millions of reply coupons when only 27,000 existed worldwide! 

Ponzi Popularity: So why is the Ponzi scheme still so effective at roping people in? Because it relies on two principles: 1) investors ignoring the “too good to be true” ringing in their ears, coupled with 2) using new investor money to pay off returns to the earlier investors (adding the appearance of legitimacy).

And the beauty for fraudsters is that they only have to remember three simple steps…

Step 1: After you convince the early marks to cough up some money, use the initial bankroll to create an image that exudes wealth and success. 

Step 2: Now it’s time to play the part and round up some new investors. When the new money comes in it will serve two purposes:

  1. Pay “profits” to the earlier investors and keep them off your back and use them as your success stories.
  2. Fund your awesome new lifestyle!

Step 3: Repeat Step 2 until caught.

Author: Richard C. Gordon, CPA/ABV/CFF, CFE, CGMA, Director of Forensic and Valuation Services


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