Ponzi Schemes, How to Detect and Avoid, How to Recover

WHAT IS A PONZI SCHEME, HOW DO YOU DETECT AND AVOID A PONZI SCHEME AND IS THERE RECOURSE IF YOU WERE THE VICTIM OF A PONZI SCHEME?

This article discusses how to identify, detect, avoid, and recover from a Ponzi scheme.

I.          WHAT IS A PONZI SCHEME?

A Ponzi scheme, or Peter-to-Paul scheme from the phrase “Robbing Peter to Pay Paul,” “is an investment scheme wherein new investors’ money is used to pay the promised return to previous investors” rather than profits of the purported business venture.  James C. Sell, Anatomy of a Ponzi Scheme: Part 1, Greater Phoenix Attorney at Law Magazine, Feb. 2010 at 17.  Unlike borrowing money to pay an outstanding debt, with a Ponzi scheme there is still a debt but it is owed to a different person and is larger.  Id.

Key elements of  Ponzi scheme are as follows: (1) using new investor funds to pay prior investors; (2) representing that the investor returns are generated from a purported business venture; and (3) employing artificial devices to disguise the lack of economic substance or defer the recognition of economic loss. James C. Sell, Anatomy of a Ponzi Scheme: Part 3, Greater Phoenix Attorney at Law Magazine, Apr. 2010 at 28-29.  Creative accounting devices to cook the books, include falsifying accounting entries, fabricating insider transactions, misapplying generally accepted accounting principles (GAAP), particularly those of accrual accounting, not reporting or underreporting liabilities, inflating asset values, capitalizing expenses, accruing interest on defaulted loans and fictitious sales.  Id. at 29; James C. Sell, Anatomy of a Ponzi Scheme: Part 2, Greater Phoenix Attorney at Law Magazine, March 2010 at 15.  Non-insider employees, while given titles, good pay and authorization to sign, are isolated and their “[a]ccess to real books and records are strictly limited to a need to know basis.”  Sell, Part 3 at 28.

“Most Ponzi schemes rely on a theoretical business model to produce the touted profitability and superior returns to its investors.”  Sell, Part 1 at 17.  Take for example, the 1920s postage stamp speculation scheme orchestrated by Charles Ponzi, the namesake of the Ponzi scheme, that took advantage of widely-varying currency exchange rates.  “Postal Reply Coupons could be purchased in Spain or Italy for pennies and converted to U.S. postage stamps worth several times their purchase price.  Stamps worth dollars that were purchased for pennies could be sold at a discounts to businesses.”  Id. Ponzi would then share those profits with investors by paying them a 40-50% return in just 90 days when the annual interest rate was only 5%. NASAA, Investor Alerts: Ponzi Schemes.  Ponzi only purchased about $30 in coupons in the first few weeks, and then switched to using funds from later investors to pay off earlier investors, which scammed investors out of $10 million.  Id. Authorities estimated that 160 million postal reply coupons had to be in circulation to support the scheme, and only 27,000 were actually in circulation, and that, together with a thin market and the administrative costs made it impossible for the venture to work on a large scale, and eventually led to the discovery and undoing of the scheme.  Id.; Sell, Part 1 at 18.

Other theoretical business ventures giving rise to a Ponzi scheme have included stocks, bonds, notes, hedge funds, oil or gas deals, fictitious investments like prime bank notes, generic drugs, clothing brokerages, hybrid animal breeding, domestication of native plant species, hydroponics, biomass, greenhouses, alternate energy production, mechanical inventions, windmills, gold mines, minerals, diamonds, precious metals, foreign currency transactions, commodities, high-tech stocks, real estate-based investments, lending related schemes like hard money loans, and viatical settlements.  FINRA, Investor Alert – Avoiding Investment Scams; NASAA, Investor Alerts: Ponzi Schemes; Sell, Part 2 at 13.  In short, a Ponzi scheme can involve almost any type of deal or transaction, but it always amounts to a simple investment scheme that is “long on vision and short on detail.”  NASAA, Investor Alerts: Ponzi Schemes; Sell, Part 2 at 13.

To continue, a Ponzi scheme, which has little or no legitimate earnings, requires a consistent flow of new investor money.  SEC, Ponzi Schemes – Frequently Asked Questions.  Therefore, a Ponzi scheme collapses when it becomes difficult to recruit new investors or when a large number of investors ask to cash out, thereby making it difficult to meet promised returns and maintain required payments.  Id. This most often occurs during economic downtimes, like those of recent that led to the downfall of a $50 billion Ponzi scheme run by Bernard Madoff, among many other Ponzi schemes, who is serving a 150-year sentence.  Id.  See also Wall Street Journal, In Echoes of Madoff, Ponzi Cases Proliferate Jan. 28, 2009 (listing recent large Ponzi scheme promoters).

When a Ponzi scheme is on the verge of being exposed or collapsing, the promoter may: (1) take the money and disappear; (2) transfer investors into a new or existing shell entity that is self-liquidating; (3) create new management, which may include the promoter and/or a select group of investors; (4) sell the business; (5) pay off any investor who complains; and/or (6) try to control, manipulate and divert any regulatory investigation of the scheme and seek investor loyalty in doing so.  Sell, Part 3 at 28-29.

Often, investors are slow to admit that they have been the victim of a Ponzi scheme out of fear that “public exposure will create a crisis of confidence that could create a run on the promoter and makes things worse,” fear that they will look “foolish for being blinded by greed,” and fear that if they break rank and blow the whistle, they “will be drummed out of the high-interest scheme” and “blackballed in his professional or social circles.”  NASAA, Investor Alerts: Ponzi Schemes.  As a result, investors “frequently cling to even the faintest of hopes that everything will work out for the better,” and even go so far as “attacking government officials and defending Ponzi promoters as heroes, saints and misunderstood financial geniuses with basically good intentions.”  Id. The Ponzi scheme promoter will often capitalize on these sentiments and tell investors that he or she got in over their head, meant well and things simply got out of hand, or vow to make good on one last venture, which may be nothing but yet another Ponzi scheme.  Id.

Ponzi schemes are the oldest and most common type of investment fraud, because they can take any shape and be run by anyone.  Arizona Securities Division, Ponzi Schemes.  While the promoter of the Ponzi scheme―who often spends investor money on personal expenses to live a lavish lifestyle ―and early investors may make money in a Ponzi scheme, the vast majority of the investors in a Ponzi scheme end up losing all or most of their money.  Id.; NASAA, Investor Alerts: Ponzi Schemes; SEC, Ponzi Schemes – Frequently Asked Questions.  Ponzi schemes wind up costing Americans billions of dollars each year.  Arizona Securities Division, Ponzi Schemes.

II.         HOW TO DETECT A PONZI SCHEME.

The “real economic engine” of a Ponzi scheme is its investors and an “ever-expanding investor base.”  Sell, Part 1 at 18.  So how does a Ponzi schemer amass its army of investors with a simple yet illusive business venture?  By using common persuasion and psychological tactics, which, according to a FINRA-funded study, include the following:

The “Phantom Riches” Tactic: enticing one with the prospect of wealth and a life of luxury.  FINRA, Investor Alert – Avoiding Investment Scams.  This includes playing on greed and touting a “surefire” thing.  NASAA, Investor Alerts: Ponzi Schemes.  The truth is that it is often “too good to be true.”

The “Source Credibility” Tactic: establishing credibility through associations or involvement with reputable individual or entities or those with special credentials or experience, particularly in the legal, financial and investment industry.  FINRA, Investor Alert – Avoiding Investment Scams.

The “Social Consensus” Tactic: saying that others have already invested. FINRA, Investor Alert – Avoiding Investment Scams.  This includes creating the appearance of success.  NASAA, Investor Alerts: Ponzi Schemes.  This is appealing to the “herd instinct.”  Id.

The “Reciprocity” Tactic: offering to do a small favor in return for a big favor, such as giving a discount in return for an immediate partial investment.  FINRA, Investor Alert – Avoiding Investment Scams.

The “Scarcity” Tactic: creating a false sense of urgency by claiming a limited supply or limited time offering.  Id.

As a result, victims of fraudulent investments, such as Ponzi schemes, are often those who: (1) own high-risk investments, including penny stocks, promissory notes, futures, options or private investments in foreign currency; (2) rely on friends, family members and colleagues for advice: (3) are open to new and inexpensive investment information (like free seminars); (4) fail to conduct due diligence before investing, like checking the background of the investment and promoter; and (5) are unable to spot the persuasion, psychological tactics discussed above.  Id. By recognizing and avoiding these key investment fraud risk factors, one can reduce its vulnerability of being victimized.  Id.

One can also avoid becoming a potential investment fraud target by understanding and recognizing the following warning signs or red flags of a traditional Ponzi scheme:

Promises of high, guaranteed investment returns with little or no risk.  One should be suspicious of any guarantees that an investment opportunity will perform a certain way, as all investments have some degree of risk.  SEC, Ponzi Schemes – Frequently Asked Questions.  “The oldest advise is still the best: ‘if it sounds too good to be true, it probably is.'”  NFA, Scams and Swindles at 6, 8.

Insurance or guarantee is promised to mitigate risk.  One should be suspicious of any supposed insurance or guarantee that is promised to mitigate the risk of any investment.  Sell, Part 2 at 15.”Insurance is seldom acquired and the guarantee typically lacks substance.  A dummy company is frequently set up to act as the guarantor or insurer.”  Id.

Overly consistent, positive returns.  One should be suspicious of any investment that continues to generate regular, positive returns despite the overall market conditions and economic state of affairs.  SEC, Ponzi Schemes – Frequently Asked Questions.  One should also be skeptical of controlled or contrived demonstrations used to prove the business model works.  Sell, Part 2 at 14.

Misrepresentations of the security, safety and liquidity of the principal.  One should be suspicious of statements that overly represent that security, safety and liquidity of principal.  “Statements such as ‘no investor has ever lost a single penny of his investment with us’ and ‘we have an unblemished track record of meeting or exceeding the promised profitability’ are common.”  Id. at 15.

Unregistered or “exempt” investments.  One should be suspicious of unregistered investments or investments that are supposedly exempt or except from registration.  “Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators.  Registration is important because it provides investors with access to key information about company’s management, products, services, and finances.”  SEC, Ponzi Schemes – Frequently Asked Questions.

Unlicensed or “exempt” sellers or dealers.  One should be suspicious of unlicensed sellers or dealers or those who claim that they are exempt from licensing.  “Federal and state securities laws require investment professionals and their firms to be licensed or registered.  Most Ponzi schemes involve unlicensed individuals or unregistered firms.”  Id.

Secretive or complex strategies.  One should be suspicious of investments that are incomprehensible or its information is incomplete. Id. Promoters should be able to explain their investment in layman’s terms and provide supporting documentation.  FINRA, Investor Alert – Avoiding Investment Scams.  Frequently, “[s]ufficient detail is provided to close the sale but no more. . . . specific details can’t be disclosed because they are proprietary and must be kept secret lest someone else usurp this fantastic business opportunity and deny the investor the opportunity to participate in this proven money make venture . . . . Only the positive elements are accentuated.  The negative risks are ignored or diminished.  The reality of time constraints, market limitations or extent of administrative costs is not disclosed.”  Sell, Part 2 at 13.  One should be skeptical of “[c]laims of a special competitive advantage, exotic product, an overlooked loophole in the law or a secret process . . . requir[ing investors] to sign a nondisclosure agreement containing onerous penalties for disclosure.”  Id. at 13-14.

Missing documentation or issues with paperwork.  One should be suspicious of investments for which there is little to no documentation, such as a prospectus, offering circular or memorandum, or disclosure statement, or issues with its paperwork, such as erroneous account statements. SEC, Ponzi Schemes – Frequently Asked Questions.  Promoters should be able to provide written information and references.  NFA, Scams and Swindles at 6.

Difficulty receiving payments or cashing out.  One should be suspicious if there is difficulty receiving payments, difficulty cashing out of the investment, or offers to “roll over” promised payments with even higher investment returns.  SEC, Ponzi Schemes – Frequently Asked Questions.  One should resist pressures to roll over and reinvest without seeing profits.  NASAA, Investor Alerts: Ponzi Schemes.

Account discrepancies.  One should be suspicious of unauthorized trades, missing funds, or other problems with account statements.  FINRA, Investor Alert – Avoiding Investment Scams.

Innovative marketing strategies and high-pressure, fast sales tactics.  One should be suspicious of innovative marketing strategies and high-pressure, fast sales tactics.  “No reputable investment professional should push you to make an immediate decision about an investment, or tell you that you’ve got to ‘act now.'”  Id. “A sense of urgency and exclusivity is created in the prospective investors mind through one time, or limited time offers made to an exclusive few.  Offers of special insider deals are great fund raising gimmicks.”  Sell, Part 3 at 29.  “Some swindlers may resort to insult or argument, questioning your intelligence or warning that ‘you’ll never get rich without taking a chance.”  NFA, Scams and Swindles at 6.  One should not give out personal financial information, such as bank account and credit card numbers for identification, or allow a courier to pick up the money.  Id. at 7, 14.  Nothing worth its salt is “free.”  Id. at 8.

Company name chosen to engender strength, stability, nobility, and other salient attributes.  One should be suspicious of the use of prestigious company “[n]ames like Washington, Lincoln, Standard, Chartered, First, Security” and America, Great and National.  Sell, Part 2 at 15.

Capitalizing on Comfort and Affinity.  One should be suspicious of those who appeal to and capitalize on relationships with relatives, friends, colleagues, social circles and certain close-knit groups, such as churches and professional or fraternal organizations, to obtain the confidence of a group’s leaders and members at large, whose credibility induces others to invest.  NASAA, Investor Alerts: Ponzi Schemes; Sell, Part 3 at 28.  In such cases, “the victim pool is less likely to critically review the investment opportunity offered by a ‘brother.’  The victim tends to let down his guard when dealing with someone within his inner circle.”  Id. The promoter will want to be your friend and seem to care about you, but is doing so to earn your trust and money.  NFA, Scams and Swindles at 6.

Investor testimonials.  One should not rely on reputation or word of mouth alone, and should be suspicious of investor testimonials that cannot be checked out, particularly those of more respected or popular investors (e.g., politicians, celebrities, athletes), touting their high returns.  Id. at 12; Sell, Part 3 at 28.

Professional attestations.  One should be suspicious of professional attestations used to create the aura of respectability.  Sell, Part 3 at 28.  For example, the promoter may claim that the government or an industry guardian has reviewed the program and approved it or found nothing wrong with it, or it has been endorsed by industry professionals.  Sell, Part 2 at 14.  The promoter may also provide professional attestations, including legal opinions, like the investment product is not a security, and accounting opinions, like a “clean” audited financial statements.  Sell, Part 3 at 28.

Unbusiness-like conduct or disruption of services.  One should be suspicious of promoters who single-handedly run their entire business operation and undertake simple administrative tasks, such as answering the phones and opening mail themselves, or, the other hand, are suddenly non-responsive and extremely difficult to reach.  FINRA, Investor Alert – Avoiding Investment Scams.

III.        HOW TO AVOID A PONZI SCHEME

As recommended by articles form FBI, SEC, FINRA, NASAA, and Arizona Securities Division, the best way to avoid a Ponzi scheme is to do the following before investing:

Research the promoter, and find out if he or she is properly licensed with FINRA, the SEC and/or the state securities regulator like the Arizona Securities Division, or is exempt from licensing (and if so why).  Free resources to conduct such searches include:

For a broker or brokerage firm, search FINRA’s BrokerCheck, available at:             http://www.finra.org/Investors/ToolsCalculators/BrokerCheck or (800) 289-     9999

For an investment adviser representative or firm, search the SEC’s Investment          Adviser Public Disclosure, available at http://www.adviserinfo.sec.gov/             (S(2wv20wlxkbp4ikivn5lrb1se))/IAPD/Content/Search/iapd_Search.aspx

For sellers or dealers, contact the state securities regulator, which for Arizona is        the       Arizona Corporation Commission, Securities Division at http://www.azcc.gov/divisions/securities or (602) 542-4242, to ask for a CRD       report, and search the National Futures Association, available at:             http://www.nfa.futures.org/basicnet/

Research the investment, and find out if it is registered with the proper regulator, such as the SEC or state regulator, or is exempt or except from registration (and if so why).  One can call the Arizona Securities Division at (602) 542-4242 or search investments registered with the SEC by using the EDGAR database, available at: http://www.sec.gov/edgar.shtml

Inquire into and compare the risks with the potential rewards of the investment.

Understand the investment, and verify its details and the promoter’s claims.

Understand the nature of underlying business and its operating history, success rate, who is responsible for its operations and their education, experience, skill and training, investment history; get annual reports, audits, financial statements

Seek assistance from and consult an unbiased, trustworthy third party like a unconnected broker or licensed financial advisor, attorney or accountant; get a second opinion.

Ask for written, detailed information, including information on the company, its officers, and its financial track record, documentation of the investment, including its cost, fair market value, and existing and potential markets, and what recourse you would have if you were not satisfied with your investment.  Any guarantees, warranties or refund provisions should be in writing.

Ask promoters about their education and experience and what institutions have invested with them, and what commission, fee or any other benefit they will earn through the investment and how and through whom they are paid

Exercise due diligence; do a background check and search the Internet regarding the investment and individuals and companies involved in the investment.

Information can be obtained online for free as follows:

For an insurance professionals, companies or entities, contact with     your state       insurance department, which for Arizona is the Arizona Department of       Insurance at (602) 364-2499 and search its database available at:          http://az.gov/app/doilookup/ProfessionalSearch

For a realtor or real estate company, contact your department of real estate, which for Arizona is the Arizona Department of Real Estate at (602) 77-7799, and         search its       database, which is available at:             http://services.azre.gov/publicdatabase/SearchIndividuals.aspx

For accountants,  contact your state accountancy department, which for Arizona is the Arizona Board of Accountancy at (602) 364-0804, and search the database available at: http://www.azaccountancy.gov/CPADirectory/CPASearch.aspx

For lawyers, search your state bar, which for Arizona is the State Bar of Arizona, (602) 252-4804   and search the database available at: http://www.azbar.org/FindALawyer

For businesses, search the state corporation department, which for Arizona is the Arizona Corporation Commission at (602) 542-3026 and database       available at: http://starpas.azcc.gov/scripts/cgiip.exe/WService=wsbroker1/main.p and the Better Business Bureau at: http://central-northern-western-arizona.bbb.org/Find-Business-Reviews

For trade names and trademarks, search the Secretary of State, which for Arizona is available at: http://www.azsos.gov/scripts/TNT_Search_engine.dll

Search government records to find any judgments or liens against an individual or entity, which in Arizona is available at Secretary of State (http://www.azsos.gov/scripts/ucc_search.dll) and the Maricopa County Recorder (http://recorder.maricopa.gov/recdocdata)

Search Arizona court cases at: http://apps.supremecourt.az.gov/publicaccess or http://www.superiorcourt.maricopa.gov/docket and call bankruptcy courts

Call the Arizona Attorney General’s Office at (602) 542-5763

Take your time; do not be pushed into making a fast investment decision.

Avoid solicitations by telephone (cold-calls) or the Internet.

Diversify your investment; do not put all of your eggs in one basket.

Obtain and retain written documentation of your investment and all agreements and transactions, including stock certificates, account statements, promissory notes, contracts, receipts, etc.

Monitor your investment and carefully and consistently review your account statements; look for excessive account activity, unauthorized trading, unsuitable recommendations, failure to execute trades and failure to deliver securities

IV.       RECOVERYING FROM A PONZI SCHEME.

After a Ponzi scheme has collapsed, the first step is to “secure what assets remain,” and “state or federal court receivership and/or bankruptcy court protection can stem, or slow, a run on the remaining assets.”  James C. Sell, Anatomy of a Ponzi Scheme: Part 4, May 2010 at 40.  The second step is to turn other potential sources of recovery, including insiders, relatives who received recent returns, and third party aiders and abettors, such as lawyers, accountants, auditors, banks and brokerage firms.  Id. Funds could be recovered from the liquidation of assets, insurance policies, net winners (withdrew more money than put in), promoters, insiders, and related parties.  Id. at 41.  Investors can also complain to regulatory agencies that may investigate and prosecute Ponzi schemes, like the SEC, FINRA, FBI, Attorney General, and Securities Division.

If you think you have been the victim of a Ponzi scheme, feel free to contact Robert Mitchell at robertmitchell@mitchell-attorneys.com, or at (602) 468-1411 to arrange a consultation to discuss your possible options to recover your investment in the scheme.

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