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By David F. Fink, CPA, CFE – Hutton, Kruse & Fink, Ltd., Indianapolis, Indiana

A Ponzi scheme is an illegal pyramid scheme named for Carlo “Charles” Ponzi, who conned  thousands of Americans into investing in a postage stamp coupon exchange program in the 1920s.

Carlo Ponzi was born in Parma, Italy in 1882 and immigrated to the United States in November of 1903. For several years, he moved from city to city and sustained himself working a variety of jobs.  In 1919, after returning to Boston, he began a venture that would create his dubious distinction.

Ponzi was working on the development of an export magazine.  He had contacted a man in Spain about the venture.  This man’s reply included an international postal coupon. Ponzi was to take the coupon to the local post office and exchange it for American postage stamps.  He would use those stamps to send the magazine to Spain.  Ponzi noticed that the postal coupon had been purchased in Spain for the equivalent of about one American cent.  But when he cashed in the coupon, he was able to get six American one-cent stamps.  Ponzi immediately recognized the potential profit.  By purchasing and cashing in postal coupons with such a favorable rate, he could realize profits of up to 500%.  Ponzi began converting his American money into foreign currencies with favorable exchange rates.  He then had foreign agents purchase international postal coupons in countries with weak economies. These coupons were then exchanged for a favorable foreign currency and then back into American funds.  In theory, Ponzi’s scheme works.  Once he began boasting to friends and family about his stroke of genius, it wasn’t long before people were lining up to get in on the action.

On December 26, 1919, Ponzi established The Security Exchange Company. He promised a 50% return on investment in ninety days and claimed he could deliver in just forty-five days. News of the lucrative investment spread quickly and within six months, Ponzi had taken in millions with estimated revenues peaking at a million dollars per week – in 1920!

Now for the bad news.  As it turned out, it took more time and expense to convert currencies and postal coupons than Ponzi had anticipated.  The profits Ponzi expected were never realized.  But because Ponzi had been able to pay his earliest investors their expected profits, additional investors followed.  With each thrilled investor in the early months of 1920, multiple investors lined up to replace their distribution.  But rather than paying investors their expected return on investment from profits that were realized, Ponzi was simply paying them with the cash taken in from subsequent investors.

This transgression would become the hallmark of what has become known as the Ponzi scheme.  Without adequate profit from the proposed revenue producing activity, investors can only be paid their return on investment from funds received from subsequent investors.  No matter how lucrative and attractive an investment may seem, there is always a limit to the number of investors the investment will attract.  Each passing period will require a greater investment than the preceding period to enable the organization to return previous investors both their investment and the profit with which the organization is attracting new investors.  Consequently, the scheme begins to crumble as soon the amount of new investment fails to grow.

This is why investment in an organization that utilizes a Ponzi scheme is always organized as a pyramid scheme.  The initial number of investors and amount invested may be relatively modest, but each new level of investment must grow exponentially, just as a pyramid is pointed at the top and gets progressively larger all the way to the bottom.  Keep in mind, though, that while all Ponzi schemes are pyramid schemes, not all pyramid schemes are Ponzi schemes.

A legitimate pyramid scheme is often called a multi-level marketing (MLM) organization. The primary revenue-producing activity of an MLM is the sale of a product. Amway Distributors, Inc. is among the best known MLMs in the United States.  The federal government has become sensitive enough to the hazard of the Ponzi scheme that Amway was indicted as one.  Amway successfully defended against the allegation because they were able to demonstrate revenue production through product sales.  With that said, once an organization is recognized as a pyramid scheme, the existence of a Ponzi scheme should be considered.

The following are some characteristics that help to identify a Ponzi scheme:

  1. The return on investment or the return on the sweat equity required by members sounds too good to be true.  Remember the old adage, “If it sounds too good to be true, it probably is.”
  2. The investor or member is encouraged to reinvest profits rather than receive a distribution.  One way the Ponzi scheme eases the pressure to find new investors is by convincing current investors to leave their investment in the company.
  3. There is a greater focus on stimulating additional investment or recruiting new members than there is on the sale and efficient delivery of a product.
  4. Members are required to pay a substantial initial fee, relative to the product they receive.
  5. Members are encouraged or required to purchase inventories which will be held for them by the distributor until the member sells the product.

You might imagine that the life of the Ponzi scheme would be very short because of the difficulty of maintaining the charade as a legitimate business, but many Ponzi schemes go unreported because people are embarrassed to report that they have been duped.

Why is it important to be able to recognize a Ponzi scheme?  Aside from potential liability claims from disgruntled investors, the existence of such a scheme can be a red flag for fraud.  As the bottom falls out on the pyramid scheme, the need to meet financial obligations can create the financial motive for a fraudulent claim.

And what happened to Carlo Ponzi?  By the summer of 1920, Ponzi had taken in millions and started living the life of a very wealthy man.  By the end of July of the same year, the bottom had begun to fall out and on August 13th, he was arrested, first by federal and then by Massachusetts authorities.  His federal sentence was five years in federal prison for using the mails to defraud. After three and a half years in prison, Ponzi was sentenced to an additional seven to nine years by the state of Massachusetts. He was released on $14,000 bond pending an appeal and disappeared about one-month later.  He soon turned up in Florida where he was involved in a pyramid land scheme using the assumed name of Charles Borelli.

Ponzi was indicted for fraud and sentenced to one year in a Florida prison in 1926.  He again jumped bail.  He went to Texas and then stowed away on a freighter headed for Italy, but was captured in a New Orleans port. On June 30, 1926, President Calvin Coolidge denied his request to be deported and he was sent back to Boston to complete his sentence.  Ponzi was released for good behavior and deported to Italy on October 7, 1934.

Back in Rome, Ponzi worked as an English translator and, in 1939, he moved to Rio de Janeiro where he was the branch manager for Italy’s new airline. In this position, he discovered that several airline officials were using the airline to smuggle currency.  He asked for a cut, but was refused, so he tipped off the Brazilian government. The Second World War brought about the airline’s failure. For seven years, he lived off the Brazilian unemployment fund and occasional jobs as a translator or English teacher.  He died in poverty in January of 1949.

The following article was originally published in the May 2005 issue of The Informant, a bi-monthly publication for members of the Illinois Chapter of the International Association of Investigation Units.