Ponzi schemes are a type of investment fraud that achieved widespread notoriety during the financial crisis due to huge scandals involving the likes of Bernie Madoff and Allan Stanford.
In simple terms, they are perpetrated by using subsequent investors’ money to pay out dividends to previous investors as opposed to paying out investors from a true organisational profit.
The illusion of high returns
New investors are often lured to Ponzi schemes by high initial returns paid by to early investors, which encourages paying in additional money and leaving money ‘invested’ for longer in the hope of earning an even greater return.
Through this cascade effect, the Ponzi scheme can continue to attract new investors and maintain the illusion of a successful investment with existing investors for a certain period of time. The illusion is generally more sustainable in times of rising asset prices.
Even legitimate investment structures have the potential to degenerate into pyramid schemes; for instance, an investment manager might falsify audit reports from a failing but otherwise legal investment fund and pay dividends from previous investors to fabricate returns.
A Ponzi scheme may be exposed in a number of ways. If not derailed by authorities, investors may withdraw money abruptly in response to market conditions; new investments may slow to the point payouts cannot be made; or the perpetrator may simply abscond with the money.
Distinguishing Ponzi schemes from pyramid schemes
A Ponzi scheme is distinguishable from a pyramid scheme in several ways although both swindle investors by leveraging grouped funds. A pyramid relies on new investors to recruit new participants, and recruitment bonuses tend to the primary source of return, if any.
Pyramid schemes also acquire new money in the form of goods or services sales. However, a Ponzi scheme centres around one primary perpetrator or association, which will present the investment as a legitimate, traditional investment like shares; thus experienced financiers willing to take risks for high returns are often attracted.
Penalties for Ponzi schemes
Penalties for investment fraudsters running Ponzi schemes include not only fines but also incarceration; recent UK examples highlight the risks for those involved.
Kautilya Nandan Pruthi deceived hundreds of people, including sports stars and other celebrities out of a total of £115 million over three years, with a take away of £38 million, in the UK’s largest ever Ponzi scheme. Pruthi started his scheme in 2005 with two associates, offering a return of 156% unmonitored by the Financial Services Authority. He was arrested in 2009, but he had spent the majority of the investors’ funds on an extravagant lifestyle and courting new investors. He received 14 years in jail and will be subject to immediate deportation to his home country of India upon release.
Kevin Foster is another notorious investment fraudster, who convinced nearly 8,000 people in South Wales to invest at least £1,000 with promises of exceeding high returns. He gained confidence of communities by selectively giving early returns as well as prize giveaways from the years 2002 to 2004. Authorities believe his total taking amounted to approximately £34 million, most of which was spent or never recovered, and he is currently serving a nine-year sentence, handed down in 2010.
If you or your business is facing investigation or prosecution for engaging in a Ponzi scheme it is vital that you seek expert legal advice at the earliest opportunity.
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