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You may hear the term Ponzi Scheme thrown around quite frequently. It’s shows up in the news occasionally when a scheme collapses and it’s revealed numerous people have lost their money. Ponzi schemes are the subject of numerous movies and television shows such as Tower Heist, Leverage and even an episode of Archer.
But what is a Ponzi scheme? The name come from Charles Ponzi, a famous fraudster in the 1920s. Ponzi didn’t invent the scheme that would famously bare his name, but he did pull off one of the largest frauds at the time which earned him his infamy.
In the early 1920s Ponzi concocted a scheme using international reply coupons and told investors he could deliver extremely high returns. He had a steady flow of investors through which he paid off his previous investors in interest while pocketing millions of dollars for himself. The scheme continued for many years due to an ongoing new pool of investors and because many investors chose to reinvest their interest profits instead of receiving them outright. When the scheme finally collapsed, it was estimated the Ponzi bilked his investors out of $20 million.
That’s where the name comes from. Now that’s look more closely at how it works. A person running a Ponzi scheme draws in investors by offering returns substantially high returns, oftentimes unrealistically high.
The initial investor pool is usually small and they do receive large returns on their original investment. This entices them to invest more and spread the word to bring in more investors.
In reality, there is no real investment being made at all and no real returns coming in. The money brought in by new investors is used to pay returns from to previous investors. All money left over after these payments have been handed out is kept by the fraudster. The fraudster uses the lure of high returns to keep the investors’ money coming in. To keep the scheme afloat more money needs to be invested continually. Then subtract all the money kept by the fraudster, it is no surprise that scheme will inevitably collapses.
When the scheme collapses, most investors have no way of getting the money they invested back because it has typically spent by the fraudster on a lavish lifestyle.
After Charles Ponzi the most famous Ponzi scheme fraudster is Bernie Madoff. For nearly two decades Madoff ran an elaborate Ponzi scheme that bilked investors out of an estimated $50 billion. For his crimes, he was sentenced to 150 years in prison after wiping out the life savings of his multiple clients.
In Canada one of the most famous Ponzi scheme perpetrators was Earl Jones. Jones, was an unregistered adviser who between 1982 and 2009 bilked 158 investors out of a reported $51.3 million. He was sentenced to 11 years in prison in 2009, but was released after four years.
The easiest way to avoid falling victim to a Ponzi scheme is to always be skeptical when someone is offering returns substantially higher than other investment opportunities. You can also check with your provincial securities regulator to see if the person you’re dealing with and the security they are offering are both registered.