The King of Ponzi Schemes

January 2009

The King of Ponzi Schemes

By Scott Patterson


Horace, the Roman poet, said: “The greedy person is ever in want; let your desired aim have a fixed limit.” As fraud examiners, investigators, and the investor victims of Bernard Madoff’s alleged fraud contemplate the enormity of the suspected loss, a question arises: How much is enough?


The investment scheme suspected to have been orchestrated by Madoff is described by the Securities Exchange Commission (SEC) as “vast” and designed to “deceive investors, the public and regulators.” Tens of billions of dollars are expected to be lost, making this one of the largest frauds in U.S. history. It is hard to imagine what even the greediest of fraudsters would do with the amount of cash purported to be stolen.


“Madoff’s alleged fraud, like many others, resulted in gains far beyond what he could ever spend,” said ACFE President James D. Ratley, CFE. Ratley has been interviewed by the Fox News Channel, Reuters and other media sources since the Madoff fraud first made headlines in December.


“Always the bearer of good news, Madoff was never challenged as to how he was able to continuously out-perform his competitors," Ratley said. "There is an age-old lesson in life: people are hesitant to challenge good news.”

Discovered by a Certified Fraud Examiner
Documented allegations of fraud against Madoff Investment Securities, LLC were presented to the Securities Exchange Commission as early as 1999 by Harry Markopolos, a Certified Fraud Examiner, according to the The Wall Street Journal.

In one of his written communications to the SEC, dated Nov. 7, 2005, Markopolos detailed 13 red flags challenging the legitimacy and legality of Madoff Securities’ investment scheme.

Markopolos has been profiled in The Wall Street Journal, Boston Globe and other major newspapers, and is scheduled to be interviewed by "60 Minutes" and NPR. In his letter to the SEC, he concluded that it was “highly likely” that “Madoff Securities is the world’s largest Ponzi scheme.” A Ponzi scheme is an illegal business practice in which new investors’ money is used to make payments to earlier investors.


In the Encyclopedia of Fraud, Third Edition, Joseph T. Wells, CFE, CPA describes a Ponzi scheme in more detail:


“In accounting terms, money paid to Ponzi investors, described as income, is actually a distribution of capital. Instead of returning profits, the Ponzi schemer is spending cash reserves, all for the purposes of raising more funds. Where a basic investment scam raises money and disappears, the Ponzi scheme stays in business by circulating investor funds. There are usually little or no legitimate investments taking place. Most of the funds are used by promoters for expensive lifestyles and transferred into property or offshore accounts. Schemes typically run for at least a year, although some Ponzis have flourished for a decade or more.”

Consistent Returns
Part of the reason the Madoff scheme continued unabated for so long, according to Ratley, is that investors were not likely to ask questions while the money was rolling in – as it appeared to do for several years.


“Bernie Madoff had a history of paying consistent returns, where other brokers did not,” Ratley said. “Everybody was making money. There were no losers at that point.”


Yet the road was destined to run out for Madoff’s investors.


“As the Ponzi scheme grows, it becomes more and more top-heavy, and requires more and more cash to keep it afloat,” Ratley said. “Every time we have a recessive economy, the lenders and investors try to withdraw funds and the money becomes more difficult to raise. As a result, a Ponzi scheme that has flourished up until this point becomes exposed.
“In all likelihood, the Madoff fraud was exposed because he could not raise enough money to keep the scheme afloat,” Ratley said.


There may be more bad news to come. While no Ponzi schemes as expensive as the Madoff fraud have yet been reported, there are undiscovered frauds lurking that are likely be exposed in the near future.


“The longer the economy stays in a recession, the more Ponzi schemes you’ll see begin to surface because of the diminished cash flow,” Ratley said.


Ponzi Enforcement

The Encyclopedia of Fraud details the FTC and SEC responsibilities in regards to Ponzi schemes:


“The Federal Trade Commission (FTC) and the SEC are the U.S.’s two major enforcement organizations that target Ponzi schemes. Federal jurisdiction privileges allow FTC and SEC agents to pursue scams across state borders. For example, an operation may be incorporated in Delaware, sell most of its products in Los Angeles, and bank its profits in Missouri. Prosecuting has to encompass each venue and relate local activities to the larger scheme.

"The SEC files about 500 complaints a year against unscrupulous investment promoters, and 25% of those are Ponzi schemes. However, the largest number of Ponzi scheme complaints are filed on the state level by state authorities, including attorneys general and state-level regulatory agencies. The FTC shuts down about 10 pyramid schemes every year and takes action of one form or another against dozens of bogus investment opportunities. While the SEC can pursue civil and criminal complaints, the FTC’s powers are limited to civil remedies, usually an injunction and a financial judgment for investor losses."

Ponzi Schemes Versus Illegal Pyramid Schemes
From the Encyclopedia of Fraud:


“A Ponzi scheme and an illegal pyramid scheme both use new investors’ money to pay earlier investors. The difference between the two lies in the way each scheme is promoted. Illegal pyramids generate revenue by continually recruiting new members. The promoters may offer merchandise or services for sale—or may not—but the only significant revenues come from recruitment. Though a pyramid-style compensation plan is not illegal, it is illegal to run a business in which recruiting new people generates all of the funds.”

Charles Ponzi

In his book Frankensteins of Fraud, Wells writes the history of Charles Ponzi and how his scheme became a well-known – yet remarkably enduring – fraud of modern times:


“Known as the Father of the Ponzi scheme, Charles Ponzi, or Carlo Ponzi, was born in 1882 in Parma, Italy. He came from a family of hoteliers and was sent to Rome for a university education. But a string of gambling debts and criminal charges for theft and forgery cut short his schooling and prompted his family to send him to America. At the age of 19 he arrived at Boston Harbor. In his self-published autobiography, The Rise of Mr. Ponzi, he claimed that he had only $2.50 with which to begin his new life. He had left with $200 in cash from his family but lost the greater part by gambling with some of his shipmates.”

After working odd jobs, Ponzi was employed as a bank clerk in Montreal, where he began handling international wire transfers. Ponzi began stealing immediately, was arrested and served time before eventually making his way back to Boston. There his plan took shape, as Wells explains:

“Ponzi hatched what would become known as the Ponzi scheme in December 1919. A coalition of international postal services had begun selling postal reply coupons after World War I ended. Each coupon was good for one stamp in any of the affiliated countries; this allowed the mail services to continue operations smoothly despite the instability of most European currencies at the time. Ponzi reasoned that he could persuade investors to capitalize on the fluctuating currency prices by using the postal reply coupons in a series of exchanges.”

Instead of making legitimate trades, Ponzi “used money from his latest round of investors to pay those who’d purchased his ‘securities’ earlier. By convincing people to reinvest their funds he was able to postpone his financial obligations even longer.” Wells writes that Ponzi’s scheme was exposed by newspaper reports in 1920, and despite his claims of innocence, “a federal audit confirmed his operation was bankrupt, owing perhaps $4 million or more to investors.”

Wells describes the rest of Ponzi’s life as one of a fugitive and swindler:

“After his arraignment, Ponzi jumped bail and fled to Florida, where he sold swampland as investment property. He and his wife Rose were both arrested in Jacksonville in 1924 and charged with fraud. The charges against his wife were dismissed but Ponzi was ordered to stand trial. However, an errant judge, not realizing he had one of the country’s most infamous swindlers before him, allowed Ponzi to post bail. He fled on a ship bound for Genoa, Italy. Authorities later apprehended him when the ship docked in Houston, Texas. Ponzi was convicted in federal court in 1925 and sentenced to 5 years imprisonment. After serving 3 years he was turned over to the Massachusetts judicial system, which sentenced him to seven more years.

“Though he fought the deportation charges against him, Ponzi was forced to return to Italy in 1934. Frederico Mussolini, who was eager to hear how his countryman had wreaked such havoc in the American financial system, received him warmly. His family connections eventually won him an appointment as the business manager to an Italian airline headquartered in Rio de Janeiro. He lost the position when it was discovered that the airline was being used to smuggle diamonds, strategic materials, and spy communications to the Fascist regime. Ponzi was apparently innocent, later expressing his consternation that he had not been recruited into the effort.

“Sometime in the 1940’s he paid a small press in Brooklyn, New York to print his autobiography, The Rise of Mr. Ponzi. Extant copies are available at the University of Texas and the Library of Congress, but the book was never reprinted. Charles Ponzi died penniless in a charity ward outside of Rio in 1949.”


Charles Ponzi’s story is already written, but Bernie Madoff’s is a work in progress. As investigators sort through the financial mess that has resulted from his alleged fraud, Ratley has some advice for fraud examiners working to sniff out the next Ponzi scheme:


“Never judge the suspected fraudster by your own standards,” Ratley said. “They will do things that would appear absurd to the trained professional. If you hear yourself think, ‘they wouldn’t do that,’ get that thought out of your mind. It’s your job to investigate, verify and confirm all of the facts where fraud is involved.”


© 2009 The Association of Certified Fraud Examiners, All Rights Reserved.