A Ponzi scheme is when investors are encouraged by the person creating the scheme to invest in a fictitious company, or a company that purports to do one thing but has very minimal assets or operations. The monies invested from later investors are then used to pay off the initial investors, so there is an appearance of the business’s success (Carey and Webb, 2017). This has a cascade effect, where people hear about the high returns and become more likely to invest more money. In actuality, the Ponzi scheme simply involves paying off early investors to create an appearance of success with the funds received from later investors. However, there is actually no legitimate business being performed; rather, the person who created the Ponzi scheme is simply shuffling money around between various investors, although the amount paid back is much less than the amount being invested. The con artist will then collect the rest (Sulaiman et al., 2016).
One individual I know who may have been part of a Ponzi scheme is a cousin who was studying to become a hairstylist. She found an ad on Craigslist that appeared to recruit individuals as representatives for a beauty product line. The scheme involved investing into a makeup kit that could be resold to clients, with the promise that the products could be sold back to the company if they did not sell. When she received the makeup kit, she was concerned because all of the products were name-brand items, although they were being sold at much lower than the retail cost. She believed the company to be illegitimate and when she attempted to sell back the kit to recover her investment, she was unable to get a response. It is unclear whether the scheme collapsed or if it continued, but this was the point where my cousin realized this was an illegitimate company, most likely dealing with stolen products.
There are several reasons why this type of fraud continues, even though it is illegal. First, people are always looking for ways to get rich. Second, many of the more advanced and legitimate-appearing businesses, including those with a public presence, tend to use confusing language while also promising high returns. Many people might believe the firm is simply using language specific to investments, so even if explanations go over their head, they are not concerned about not fully understanding how the business works. They may also see that others are making money off the investments, so will be more likely to try it out for themselves, with the hopes they will receive a similar return.
Consumer education remains one of the best ways to address the problem of people becoming defrauded by Ponzi schemes, but this is challenging because there is no good method in which education regarding these schemes can be provided. For instance, only a few business courses in college might delve into Ponzi schemes and how to identify them; for anyone else, they will not receive this education. A public service announcement would be costly and would also not be guaranteed to actually educate the masses. The best way to prevent this type of fraud would therefore be greater oversight from official organizations such as the SEC and IRS, and to impose the strictest penalties possible when perpetrators are caught (Lewis, 2015). This is what happened to Bernie Madoff when he was sentenced to 150 years in prison, which was the maximum amount allowed (Eren, 2017). However, there were signs that Madoff’s Ponzi scheme was illegitimate years previously, but these warning signs were ignored initially. Therefore, heeding these types of warnings, along with ensuring strict penalties are imposed, can be one way to deter them from occurring.
- Carey, C., & Webb, J. K. (2017). Ponzi schemes and the roles of trust creation and maintenance. Journal of Financial Crime, 24(4), 589-600.
- Eren, C. P. (2017). Bernie Madoff and the Crisis: The Public Trial of Capitalism. Stanford University Press.
- Lewis, M. K. (2015). Understanding Ponzi schemes: can better financial regulation prevent investors from being defrauded?. Edward elgar publishing.
- Sulaiman, M., Nariman, A., Moideen, A. I., & Moreira, S. D. (2016). Of Ponzi schemes and investment scams. Journal of Financial Crime, 23(1), 231-243.