Consumer Corner: So What is a Ponzi Scheme, Anyway?

By Alan Marx, AARP Tennessee Fraud Blogger

Sometimes there is only a small difference between fame and infamy. A person may start by being famous, but end by becoming infamous. The most famous one was Charles Ponzi. Ponzi’s name became a marker for the type of particularly brazen scheme that relieved the public of millions of dollars. The New Oxford American Dictionary defines a “Ponzi scheme” as:

a form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.

Ponzi schemes become inherently unstable as they grow. To pay off the initial investors, the operator has to constantly find fresh investors. As the schemes grow larger, it becomes harder and harder for the operator to obtain enough new money to keep the structure afloat. The best way for the operator to forestall the day of reckoning is to persuade investors to leave their money in the pool, but anything that shakes investor confidence carries the risk of collapsing the entire structure.

Who was Charles Ponzi?

Charles Ponzi was born in Parma, Italy, in 1882. It is believed that he was educated at a university in Rome. He moved to Boston in 1903. Years later he told the New York Times that he gambled away most of his money on the trip to America and that he “landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me."

Ponzi received a letter from Spain containing an international reply coupon (“IRC”) that could be exchanged for airmail postage stamps from another country. The purchaser of an IRC in one country would send the IRC to a person in a second country, who then could use it to pay for the postage needed for a reply. IRCs were priced at the cost of postage in the country of purchase, but they could be exchanged for stamps to cover the cost of postage in the country where redeemed. If the cost of the postage in the recipient’s country was more than the cost of postage in the country where the IRC was purchased, the recipient could make a profit.  Ponzi began buying IRC’s in one country and exchange them for more expensive stamps from another country. He sent money to agents who bought IRCs and sent them to him. He then exchanged the IRC’s for stamps and sold the stamps, claiming he made more than 400 percent in profits.

Ponzi began seeking investors to participate in his operation, promising returns of 50 percent in 45 days, or 100 percent in 90 days. Within seven months he had received more than $8 million from about 30,000 investors. Some people invested and received a high return, but Ponzi began paying investors with money he received from other investors, not from real profits. Eventually he reportedly was making $250,000 a day.

Ponzi lived well. He bought a mansion, maintained accounts in several banks, and promised to donate $100,000 to a children’s home, but his activities began to draw attention. He filed a libel suit against a financial writer who questioned the legality of his high return, and he won substantial damages. However, the attention continued and resulted in more litigation and investigations, including one by the Commonwealth of Massachusetts.

In 1920, the Boston Post began investigating Ponzi’s returns. Starting on July 26 the Post published a series of articles that, among other points, noted that Ponzi was not investing with his own company. In one of the news stories a journalist calculated that the number of IRCs that would be needed to cover the investments with Ponzi’s company was approximately 160 million, but only about 27,000 were actually in circulation. When investors learned more about Ponzi’s operations, they tried to pull their money out, which led to a run on Ponzi’s company. He was arrested and charged with 86 counts of mail fraud. He pled guilty and was sentenced to 14 years in jail. After serving three and a half years, he was released, but almost immediately he was indicted for larceny by the state of Massachusetts. Ponzi claimed double jeopardy, and eventually his case reached the U. S. Supreme Court. The Court ruled that there was no double jeopardy because the federal charges were for mail fraud, while the Massachusetts’ charges were for larceny.

Ponzi, who no longer had any money, represented himself in a trial on ten of the state charges. The jury found him not guilty. In a second trial on five of the remaining charges, the jury deadlocked.  In the retrial on those charges, Ponzi was found guilty and sentenced to an additional seven to nine years in prison.

While on bail during the appeal of his state conviction, Ponzi fled to Florida and launched another fraudulent scheme, this time promising investors 200 per cent return in 60 days. He was indicted for violating Florida trust and securities laws. A jury found him guilty, and he was sentenced to a year in prison. Ponzi appealed, and he was freed after posting bond. While on bond he tried to flee to Italy, but he was caught and sent back to Massachusetts where he served seven more years in prison.

In 1934, Ponzi was released and deported to Italy. He died in Brazil in 1949, penniless.

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Ponzi Schemes, Foreign and Domestic, Both Before and After

Ponzi certainly was neither the first nor the last person to run this type of scam. In 1899 William “520 Percent” Miller ran the “Franklin Syndicate” in Brooklyn, promising investors 10 per cent a week interest and encouraging them to reinvest their earnings. Those investors lost $1 million, and Miller was sentenced to 10 years in jail. Miller could have had the dubious distinction of having this type of scam named after him, but the honor went to Ponzi because he bilked the public for seven times more than Miller.

This type of fraud is international. A similar scheme was run in the 1930’s by Ivar Kreuger, known as the Swedish “match king” because of his match monopolies. When his bubble burst, he killed himself, leaving nothing behind for his investors.

In Portugal, between 1970 and 1984, Dona Branca promised people 10% monthly returns. At her trial it was shown that she had received an amount equal to about $120 million U.S. from her efforts.

In Michigan in the 1980’s, 1600 investors lost about $50 million through Diamond Mortgage Company and A.J. Obie, two firms operated by the same managers. The Michigan Court of Appeals described the fraud as “the largest reported 'Ponzi' scheme in the history of the state."

In San Diego in the 1980’s, J. David & Company, a self-described currency and commodity trading and investing company, was discovered to be a Ponzi scheme. It received $200 million and returned $120 million to investors, leaving a net loss of $80 million.   A rogue partner at the very prominent New York law firm Rogers & Wells (now Clifford Chance) had advised J. David, the founder of the firm, and others. J. David escaped to Montserrat, but he eventually returned and pled guilty. He was sentenced to 20 years imprisonment and served 10 before he was paroled.

Religious institutions have been used to entrap people. From 1993 until 1997, Greater Ministries International in Tampa, Florida, a church headed by Gerald Payne, bilked over 18,000 people out of $500 million. Payne and other elders promised the members they could double their money, citing scripture. Nearly all the money was lost or taken. The operators received prison sentences ranging from 13 to 27 years.

Social position has been used as a lure. In 1996, Sidney Schwartz and his son, Stuart F. Schwartz, targeted the members of a Long Island, New York, country club at which Sidney Schwartz was a member of the board of governors. The Schwartz’s pled guilty to charges of running a multimillion-dollar Ponzi scheme.

Well-known investment firms have become entangled in these schemes. Dennis Herula, a former broker for Raymond James, was accused of participating in a Ponzi scheme in 1999 and 2000 that raised approximately $44.5 million from investors. He put part of the money into his wife’s brokerage account at Raymond James. After his arrest in Bermuda and extradition, Herula plead guilty and was sentences to more than 15 years in jail. The Securities and Exchange Commission fined Raymond James $6.9 million in 2004 for failing to supervise Herula.

Bernie Madoff’s fraud has been so widely reported that nothing more needs to be said here, except that the actual size of the losses was unclear, but enormous. The initial estimate in 2008 was $65 billion, which made it the largest Ponzi scheme in history. In 2009 an attorney for the trustee said that about $36 billion was invested, with $18 billion returned to investors and $18 billion more missing. In 2011 the trustee said the total fictitious amounts owed were $57 billion, of which customers had invested $17.6 billion.

One reason for the differences in the numbers is the different methods of calculation used, including what victims thought they were owed or total cash paid in minus total cash received. The total amount lost may never be known.