A Ponzi Scheme Defined

The U.S. Securities and Exchange Commission, in Ponzi Schemes – Frequently Asked Questions, defines a “Ponzi scheme” as follows:

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.

The Red Flags of a Ponzi Scheme

Some of the factors that various agencies have encouraged investors to evaluate prior to investing in programs have been described as follows:

  • Investment schemes in foreign currency transactions.
  • Investment schemes that skirt regulations or are not registered.
  • Overly secretive investment strategies.
  • Little or no documentation “that details the risks in the investment and procedures to get your money out.”
  • Schemes targeting one type of person.
  • Unreasonably high or consistent returns with little or no risk.
  • High pressure sales tactics.
  • Evasive answers by professionals when questioned.
  • Investors should also be aware of other risk factors that have been repeated in Ponzi cases:
  • Investment that are touted as safe.
  • Self-directed IRA option encouraging withdrawal from reputable firms which are then “self-directed” into a fraud.
  • Word of mouth marketing.
  • Affinity marketing programs through religious groups or social groups.

Factors to Establish a Ponzi Scheme

Courts have found that to establish a Ponzi scheme, a plaintiff must establish that (1) deposits were made by investors; (2) the Debtor conducted little or no legitimate business operations as represented to investors; (3) the purported business operations of the Debtor produced little or no profits or earnings; and (4) the source of payments to investors was from cash infused by new investors.

The following additional factors have been found to weight in favor of applying a presumption of fraud in a Ponzi case:

  1. The Ponzi perpetrator did not have any legitimate business operations to which its alleged investment program is connected.
  2. The Ponzi perpetrator made unrealistic promises of returns on their investments.
  3. New investor money was being used to pay old investors and money was co-mingled
  4. The perpetrator recruited agents to sell its products and paid commissions to perpetuate the scheme.
  5. The perpetrator paid the brokers high commissions to induce them to continue the sales and keep the cash flowing in.
  6. The commission structure with the sales people provided incentives to discourage investors from requesting withdrawals.
  7. Excessively large fees were taken by the perpetrator from the customers’ “investment” funds.
  8. There were inconsistencies between debtors’ bank statements and false statements issued to customers.
  9. The perpetrator failed to invest all of the investors’ funds in promised investments.
  10. The perpetrator used customer funds for non-customer purposes.
  11. Later investors received lower returns than earlier investors.
  12. Investors were encouraged to roll over or extend their investments rather than receive back their principal.
  13. The perpetrator mischaracterizes the nature of the investment opportunity and any risk associated with making an investment.
  14. The perpetrator overstated its investment returns and understated its losses.

Excerpted from The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes by Kathy Bazoian Phelps and Hon. Steven Rhodes