Question

Ponzi-Scheme

Ponzi Scheme is known as one of best examples of breach of public trust. •

Please describe what sort of principal-agent relationship exist in the Ponzi scheme, how the Ponzi scheme works, and what it does to the firm, investors, financial market/public, what SEC actions were. Please explain in detail because I have no idea what this is and I need an in depth analysis of the Pnozi-Scheme.

Answer 1

A Ponzi scheme is an investment fraud in which clients are promised a large profit at little to no risk. Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments.

This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes tend to collapse.

• Similar to a pyramid scheme, the Ponzi scheme generates returns for older investors by acquiring new investors, who are promised a large profit at little to no risk.
• Both fraudulent arrangements are premised on using new investors' funds to pay the earlier backers.
• Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments.

The Ponzi scheme is named after a swindler named Charles Ponzi, who orchestrated the first one in 1919. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply.

The constant fluctuation of postage prices meant that it was common for stamps to be more expensive in one country than another. Ponzi hired agents to purchase cheap international reply coupons in other countries and send them to him. He would then exchange those coupons for stamps that were more expensive than the coupon was originally purchased for. The stamps were then sold at a profit. This type of exchange is known as an arbitrage, which is not an illegal practice. But Ponzi became greedy and expanded his efforts.

Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of actually investing the money, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until August of 1920 when The Boston Post began investigating the Securities Exchange Company. As a result of the newspaper's investigation, Ponzi was arrested by federal authorities on August 12, 1920, and charged with several counts of mail fraud.

Regardless of the technology used in the Ponzi scheme, most share similar characteristics:

1. A guaranteed promise of high returns with little risk
2. A consistent flow of returns regardless of market conditions
3. Investments that have not been registered with the Securities and Exchange Commission (SEC)
4. Investment strategies that are secret or described as too complex to explain
5. Clients not allowed to view official paperwork for their investment
6. Clients facing difficulties removing their mone

Ponzi schemes represent many of the better-known examples of the agency problem. Agency theory claims that a lack of oversight and incentive alignment greatly contribute to these problems. Many investors fall into Ponzi schemes thinking that taking fund management outside a traditional banking institution reduces fees and saves money.

Some Ponzi schemes simply take advantage of consumer suspicions and fears about the banking industry even though established financial institutions reduce risk by providing oversight and enforcing legal practices. These investments create an environment where the consumer cannot properly ensure that the agent is acting in the principal's best interest. Many examples of the agency problem occur away from the watchful eye of regulators and are often perpetrated against investors in situations wherein oversight is limited or completely nonexistent.

Bernie Madoff's scam is probably one of the most notable examples of a Ponzi scheme. Madoff created an elaborate sham business that ultimately cost investors nearly $16.5 billion in 2009. But It isn't easy to determine when Madoff began to defraud his investors. The returns he promised his investors were higher than what most investment firms and banks were offering at the time. They were so promising that almost all of his investors looked the other way. Madoff put their money into a bank account and funded redemption requests with newly invested money.

His scheme unraveled when he could no longer pay his investors and confessed. Ultimately, Madoff was criminally charged and convicted for his actions. He is now serving a 150-year prison sentence.

The basic framework of a Ponzi scheme can be applied and reapplied in countless contexts. The scheme revolves around the process of paying old investors with the money you get from new investors. The central method remains the same. All one has to do is attract a few investors who are willing to get in early on a once-in-a-lifetime business venture. The details of the investment don't matter too much.

After the schemer has convinced a handful of investors to invest money, those funds will be used to buy something to attract the next round of investors. Now, he or she is ready to find more investors. This time, the schemer takes a slice off the top for himself or herself and uses the rest to pay off the first rung of investors with some initial returns.

Eventually, the second rung of investors will need its payout. This is a simple matter of wash, rinse and repeat: The money from a newly recruited third rung of investors can pay off the second rung and deliver more returns to the first rung.

But as the cycle goes on, it gets more complicated. Earlier rungs of investors will get suspicious if they don't continue to see returns. New investors will have to be paid back their initial investment, and the schemer will have to appease them with regular returns. This means that new investors will have to be added to the Ponzi scheme continuously in order to pay all the previous rungs. The schemer is under an enormous amount of pressure to keep adding investors, and one person can only do so much. (This is why the most successful schemes typically involve accomplices, but this merely delays the inevitable.) The scheme will eventually become unsustainable. The upside-down house of cards the schemer has built will finally collapse.

Ponzi scheme “red flags”

Many Ponzi schemes share common characteristics.

• High returns with little or no risk.  
• Overly consistent returns.
• Unregistered investments.
• Unlicensed sellers.
• Secretive, complex strategies
• Issues with paperwork.
• Difficulty receiving payments.

After a Ponzi scheme is discovered by government regulators, the SEC files a lawsuit against the Ponzi perpetrator, and a trustee is then appointed to recover as much money as possible to make payments to creditors and to redistribute any recovered proceeds pro rata to investors. The trustee will first target the hard assets of the Ponzi perpetrator. Next, he or she will try to reclaim payments made to investors (irrespective of whether they had knowledge of the Ponzi scheme). The trustee will also consider taking legal actions against other related financial institutions (including the Ponzi perpetrator's bank) if there is evidence they were conspirators or failed to act on red flags of an ongoing fraud scheme.

As a result, it is rare that the legal consequences are limited to the perpetrator alone. Any person/entity that funded the scheme (referred to as a "feeder fund"), even unknowingly, is at risk. This is especially true when the feeder fund collected money from others and failed to apply due diligence and/or failed to notice red flags suggesting fraud was taking place.

The bank the perpetrator uses to conduct transactions is at risk as well. The issue here is that the bank had access to the financial accounts of a perpetrator and may have been aware of anomalous activities tantamount to fraud. The same charges can be levied against an investment bank that handled the activities of a Ponzi perpetrator ; for example, if it acted as a broker, raised funds, had custody of assets, prepared investment accounts, or had access to marketing materials, it could be liable.

In cases where the perpetrator made charitable donations, the trustee may require that some or all of those donations be returned after the scheme is exposed, irrespective of the status of the recipient. Employees who work at a hedge fund accused of fraud, who are suspected of either conspiring with the promoter, or who were aware of the fraud are also at risk. The SEC may seek permanent bans against them working in the securities industry again. Finally, the family members of the promoter are at risk as well, and their assets can be frozen and legally prevented from being transferred or sold.

Examples of SEC enforcement actions against Ponzi schemes in 2014 include:

• Neal V. Goyal – SEC charged a Chicago-based investment fund manager with operating a Ponzi scheme that used new investor funds to pay redemptions to existing investors and fund his own lavish lifestyle.
• Gaeton "Guy" Della Penna – SEC charged a Sarasota, Fla.-based private fund manager with defrauding investors in a Ponzi scheme that ensued after he squandered their money on bad investments and personal expenses.
• Joseph Signore and Paul L. Schumack II – SEC charged the operators of a South Florida-based Ponzi scheme targeting investors through YouTube videos and selling them investments in a product called virtual concierge machines (VCMs) that would purportedly generate guaranteed returns of 300 to 500 percent in four years.

The FBI warns investors to be careful about investment proposals that promise to pay exorbitantly in a short period of time and that are not accompanied by prospectuses, quarterly or annual reports, and offering memoranda. The public is advised to be wary of "affinity scams," not to invest based on acquaintance alone, and to be suspicious of investment offerings emanating from social networking sites and chatrooms. The FBI recommends that investors seek third-party advice, for example, to contact an independent broker or licensed financial adviser before investing. Therefore, financial planners and advisers may face questions at some point during their careers from clients about questionable investment schemes, and it is best for financial industry professionals to be as well informed as possible.

When investors realize they may be victims of a Ponzi scheme, they may seek the advice of a financial adviser or planner. This section provides information about the legal consequences after a Ponzi scheme is uncovered, in the event that a financial adviser or planner is approached by a victim of a fraudulent investment scheme who seeks professional financial advice. After a Ponzi scheme is discovered by government regulators, the SEC files a lawsuit against the Ponzi perpetrator, and a trustee is then appointed to recover as much money as possible to make payments to creditors and to redistribute any recovered proceeds pro rata to investors.The trustee will first target the hard assets of the Ponzi perpetrator. Next, he or she will try to reclaim payments made to investors (irrespective of whether they had knowledge of the Ponzi scheme). The trustee will also consider taking legal actions against other related financial institutions (including the Ponzi perpetrator's bank) if there is evidence they were conspirators or failed to act on red flags of an ongoing fraud scheme.

As a result, it is rare that the legal consequences are limited to the perpetrator alone. Any person/entity that funded the scheme (referred to as a "feeder fund"), even unknowingly, is at risk. This is especially true when the feeder fund collected money from others and failed to apply due diligence and/or failed to notice red flags suggesting fraud was taking place.

The bank the perpetrator uses to conduct transactions is at risk as well. The issue here is that the bank had access to the financial accounts of a perpetrator and may have been aware of anomalous activities tantamount to fraud. The same charges can be levied against an investment bank that handled the activities of a Ponzi perpetrator; for example, if it acted as a broker, raised funds, had custody of assets, prepared investment accounts, or had access to marketing materials, it could be liable.

In cases where the perpetrator made charitable donations, the trustee may require that some or all of those donations be returned after the scheme is exposed, irrespective of the status of the recipient. Employees who work at a hedge fund accused of fraud, who are suspected of either conspiring with the promoter, or who were aware of the fraud are also at risk. The SEC may seek permanent bans against them working in the securities industry again. Finally, the family members of the promoter are at risk as well, and their assets can be frozen and legally prevented from being transferred or sold.

The SEC, as the main regulator of the financial markets, is taking heat for failing to detect Ponzi schemes. However, we caution that many such schemes rarely start as a registered business, hence avoiding detection by regulators. Consequently, it is unlikely that regulators are able to stop Ponzi schemes in their early stages.

Ponzi promoters take several steps to ensure information about their scheme is not leaked to the SEC. First of all, they keep their operations small in terms of human resources. They employ people they can trust who are unlikely to denounce them even after leaving. Second, Ponzi promoters publish little information about their operations. This lack of information makes it hard to uncover their fraudulent activities. They also ask their investors not to reveal anything to regulators as the promised high returns will be impossible to achieve under a regulatory watchdog. They exploit the trust of their clients, and the latter are reluctant to come forward and expose them. Even if the clients discover the scheme, they become more concerned about recouping their investments than worrying about the legitimacy with which it is carried out. Ponzi promoters frequently establish connections with high-ranking politicians and influential investors and engage in philanthropic groups to benefit from their protection. The point is the promoter works hard to avoid detection by the SEC and other regulators.

It is also sometimes possible that the promoter is running a Ponzi scheme alongside a legitimate business. Or perhaps the promoter is running a legitimate business, but because it loses money, starts a Ponzi scheme to cover those losses. Obviously, in these situations, the SEC is unlikely to detect the fraud at an early stage.

Many Ponzi schemes (not the likes of big-time operators like Bernard Madoff and Alan Stanford) are small in size, involving just a few investors. The cost of investigating these very small schemes may weigh heavily on the SEC's resources. Given the SEC's resource constraints plus a never-ending investigation list, its approach to investigating Ponzi schemes is more likely reactive than proactive. In these circumstances, the SEC would rather concentrate its efforts on larger frauds involving a larger pool of investors have implications for the investing community at large. The SEC's "stat system," which keeps track of its filed cases and may form the basis for incentives and rewards, can favor quick-hit cases overmore difficult ones.

For the SEC to do a better job at policing Ponzi schemes, it needs more staff specialists, a bigger budget, a leaner organization, less bureaucracy, and better investor education. As Khuzami and Walsh testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on September 10, 2009, "The ... Report traces the SEC's failure with Madoff to shortcomings in a number of areas, including insufficient expertise, training, experience and supervision by management; inadequate internal communication and coordination among and within various SEC divisions; deficiencies in investigative planning and prioritization; lack of follow-through on leads; and insufficient resources."

As a result of the Bernard Madoff's scheme and the financial crisis of 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act came into effect in July 2011 to rein in financial frauds and protect consumers. It strengthens oversight and empowers regulators to aggressively pursue financial fraud. The law directly targets Ponzi schemes, offers protection to and rewards whistleblowers who provide information that results in an enforcement action by the SEC, and empowers and allocates more resources to the institution to crack down on such schemes.

Following the passage of the Dodd-Frank financial legislation, the SEC introduced the whistleblower bounty program. Under the program, an employee who reports fraud to the SEC can net under certain conditions as much as 30 percent of the penalties and funds recovered from the fraud perpetrator by the SEC. Among others, the law also establishes a single toll-free number as a consumer hotline to report problems with financial products and services, requires hedge funds and private equity advisers to register with the SEC, and establishes greater state supervision.

Monitoring against Ponzi schemes should best be undertaken by well-informed individual investors, because history shows that the SEC identifies most schemes only after substantial harm against investors is perpetrated. If investors do not question or follow their fund managers closely, they are potentially facilitating a fraudulent Ponzi perpetrator. Therefore, it is up to investors to do their due diligence when making any kind of investment decision, especially when a high-profile investment adviser is promoting securities not registered or listed on normal exchanges or for which limited public information is available.

Ponzi perpetrators will probably always exist, but their success depends on finding clients willing to invest in their schemes, and the better informed and educated investors and financial advisers become, the less likely they will become victims of financial con artists like Bernard Madoff.