Bernard Madoff’s $64.8 billion Ponzi scheme — the largest in history — was so audacious and damaging that it spurred a massive systemic response. After Madoff’s 2008 arrest, the Securities and Exchange Commission quickly overhauled its enforcement division to zealously pursue Ponzi schemes.
In the following decade, the SEC prosecuted 50% more Ponzi cases than in the previous one. However, the SEC stumbled mightily in the years leading up to Madoff’s downfall. Accounting sleuth Harry Markopolos warned the agency multiple times about the onetime chairman of the Nasdaq Stock Market, including in 2005, when Markopolos presented a report titled “The World’s Largest Hedge Fund Is a Fraud.”
Ultimately, Madoff’s now-deceased sons turned in their father, 81, who has served one decade of a 150-year prison sentence in North Carolina and who in February requested early release due to failing health. Unlike Madoff, who remains behind bars, the number of known Ponzi schemes could break out.
“Like we have seen with previous market-moving events, the sharp downturn in financial markets emanating from the coronavirus pandemic is likely to cause an uptick in the collapse and/or discovery of Ponzi schemes,” Jordan Maglich, a Florida attorney at Quarles & Brady and founder of Ponzitracker, a legal blog focused on Ponzi schemes, tells RIA Intel.
“Based on data I've collected, this uptick is often a lagging indicator of market movements,” Maglich says. “For example, Ponzi scheme discoveries surged from 40 in 2008 to over 100 in 2009 on the heels of the Great Recession.”
A similar dynamic appears to have occurred in the fourth quarter of 2018, when stocks posted their worst quarterly performance in nearly a decade, says Maglich. That “likely played a role in the 30 percent jump in scheme discoveries in 2019.” That “ominous” increase involved $3.25 billion in investor funds, also the most in nearly a decade.
“The statistics mark an abrupt reversal to a multiyear downward trend that in 2018 saw the lowest number of alleged Ponzi scheme discoveries in 10 years,” according to Maglich.
“The SEC and FINRA put in place a number of regulatory protections after the Madoff scheme that should protect investors, and SEC enforcement has aggressively investigated and pursued Ponzi schemes,” says Susan Schroeder, who rejoined WilmerHale this year as a partner and vice chair of its securities department after having served as the Financial Industry Regulatory Authority’s head of enforcement from 2017 to 2019 and deputy head of enforcement from 2011 to 2017.
“SEC enforcement has been very clear that retail investor protection is its first priority, and the co-directors of SEC enforcement reiterated that in a statement last week emphasizing their commitment to protecting Main Street investors from fraud or illegal practices during these unprecedented conditions,” says Schroeder.
The defining feature of Ponzi schemes is that new investor money goes to pay off older investors — not to invest in the stated business activity. Red flags include high investment returns with little or no risk, overly consistent returns, and unregistered investments, among others, according to the SEC.
The pitches, which commonly promise exclusivity and quick riches, often spread by word of mouth, says Maglich. Some are rigged from the start. Others begin as legitimate enterprises and then mutate into wealth destroyers.
Ponzi schemes frequently target groups of people who share common characteristics or affiliations, like religion, ethnicity, or professional membership. In these so-called affinity frauds, Ponzi schemers often have an easier time separating cash from their targets’ hands. Madoff is the poster boy for affinity fraud, having targeted many wealthy Jewish individuals and organizations.
Strange pitches abound. “You see crazy ones like people who are selling cattle-flipping schemes and people selling birds and emus in India to people operating funds who say, ‘We have this black box and we know what we're doing,’” says Maglich, who notes that since 2008, men have comprised about 90% of those accused in Ponzi schemes.
Regardless of how harebrained a venture might be, “the main theme is just that ‘I do something a lot better than everyone else does. I can't tell you how I do it, but if you invest with me you'll make more money than you would elsewhere,’” says Maglich.
Ponzi schemes are named after Charles Ponzi (born Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi), an Italian immigrant. Ponzi had his eureka moment in Boston in 1919 when he realized he could profit by buying and selling postal reply coupons as a form of arbitrage. With banks then offering an annual interest rate of 5%, Ponzi promised investors a 50% return in 45 days or 100% in 90 days through his firm, Securities Exchange Co.
Cash soon blew down the door and “Ponzi was forced to hire six clerks just to keep track of all the money that came in. There was so much cash they had to store it in trash baskets,” writes Ben Carlson in Don’t Fall for It: A Short History of Financial Scams, published this year. An investigation by the now-defunct Boston Post led to the scheme’s collapse. Arrested in 1920, Ponzi was charged with 86 federal counts of mail fraud — and later with 22 state charges of larceny — and spent more than a decade in prison before dying, broke, in 1949 at 66.
Like drinks flowing freely at happy hour, money sloshed around Ponzi schemes and the stock market last year. “There were a lot more high-dollar schemes than in previous years,” Maglich says. “With this kind of short-term memory in the last ten years with the market doing quite well, people are maybe less likely to bat an eye if someone says, ‘Hey, I can guarantee you ten percent a year or eight percent a year if interest rates are one percent to two percent.’" The Standard & Poor’s 500 index stamped a bold exclamation mark on the longest bull run in history with a 31.5% total return in 2019.
Was last year’s surge in Ponzi activity amid a stock rally the tip of the Ponzi iceberg? “Bull markets can sustain even the worst of financial frauds. Bear markets make it difficult for even the best of scams to hold up,” according to Carlson, who is director of institutional asset management at New York–based investment advisory firm Ritholtz Wealth Management.
In 2008, when the S&P 500 tumbled 38.5% — its biggest drop since 1937 — “redemptions soared” and within ten months, three of the largest Ponzi schemes in history (Madoff, Allen Stanford, and Tom Petters) collapsed, costing investors about $25 billion, notes Maglich. If billowing clouds of cash provide cover for crooks, the bear market could clear the air, exposing a frenzy of Ponzi activity in the underbelly of a raw and traumatized market.
“One of the new things to worry about could potentially be fraud that comes about because of the coronavirus,” says Carlson. “It's day by day, but these types of crises somehow still attract bad actors who try to take advantage of people because emotions are running so high.” Carlson says he “wouldn't be surprised to hear about a number of cases where people were led to believe they were making safe investments that haven't held up or turn out to be out-and-out frauds.”
“In this current environment, I think Main Street investors who are learning they were victims of a Ponzi scheme will be a significant priority for the SEC,” says Schroeder. “In addition, I think SEC staff are maintaining extreme vigilance about new frauds and scams that can emerge during a time of significant disruption like this.”
“When there is a swift and sudden rush to exit the markets, victims of Ponzi schemes will learn that they have been defrauded,” says Schroeder. “That’s because when the operator of a Ponzi scheme is hit with the double whammy of no new investments and a sudden outflow of cash, it can no longer hide the fact that it had been using the money from new investments to pay off earlier investors. Victims who try to liquidate their holdings will then find there is little or no money left.”
Maglich asserts, “With regulators both focusing on frauds targeting Main Street and generally being better equipped to root out these frauds, I suspect the increase in discoveries we saw in 2019 may not be an aberration.”
Regardless of whether last year’s jump in Ponzi activity proves to be a blip or a harbinger of something more sinister, current market mayhem may be spurring savvy fraudsters to take preemptive measures.
“The really shrewd ones must have learned something from the 2008 cases,” says Tibor Tajti, law professor and chair of the international business law program at Central European University in Budapest. “For example, reckoning with and getting prepared for handling more requests for unexpected payouts might have been a wise thing to do for them.”
However, Tajti says some may have been caught off guard, given that “the coronavirus came essentially unexpectedly, has not been treated appropriately (many took it as something nonserious), and has been spreading exponentially.” Worldwide, more than a million people have been infected with the new coronavirus, with 28% of cases occurring in the U.S., which has seen more than 10,000 coronavirus-related fatalities, according to The New York Times.
Despite past missteps, the U.S. remains best equipped globally to prevent and prosecute Ponzi schemes, argues Tajti. “No other jurisdiction affords such a wide panoply of legal protections for the forestalling of and sanctioning perpetrators of Ponzi schemes, as well as remedies for victims,” Tajti writes in a 40-page paper with 210 footnotes, titled “Pyramid and Ponzi Schemes and the Price of Inadequate Regulatory Responses: A Comparative Account of the Diverging Regulatory Responses of China, Europe, and the United States.”
Fraudsters possess navigational chops that could impress homing pigeons. RIA Intel has written that lawbreaking advisors decamp in predictable ways and are susceptible to “a geographic contagion effect of misconduct.” In the U.S., they cluster in the South and Southwest (check out this interactive map).
On a global level, Ponzi purveyors often find “softer targets” and fewer obstacles overseas, with the notable exception of the U.K., which Tajti praises for its ability and commitment to combating Ponzi schemes.
Emerging financial systems — those transitioning from planned economies to free markets — are particularly vulnerable to Ponzi schemes, given that they often lack sector-specific regulations and empowered regulatory agencies, and their populations usually lack financial literacy, says Tajti.
“The consequences of inadequate regulatory responses to the pyramid and Ponzi schemes could be devastating,” Tajti says, adding that victims in emerging systems are less likely to recover losses than in developed nations, where it is admittedly already a formidable challenge. (Pyramid scheme participants “attempt to make money solely by recruiting new participants into the program,” notes the SEC.)
“Generally, victims of a Ponzi scheme that did not run any legitimate business may not receive any distribution, while victims of a Ponzi scheme that at least attempted to operate some type of legitimate business may receive a distribution from the remaining assets,” says Kathy Bazoian Phelps, senior counsel at Diamond McCarthy and author of Ponzi-Proof Your Investments.
“The majority of victims in Ponzi schemes will likely see some type of recovery,” says Phelps. “No statistics are maintained on the percentages recovered, and the amount can range from zero percent to 100 percent, although a 100 percent recovery is rare. In my experience, the average is probably between five percent and 30 percent.”
In comparison, Madoff’s victims have fared exceptionally well. Irving Picard, the court-appointed trustee, has reportedly recovered roughly 80% of the $17.5 billion in claims for stolen money so far. (The $64.8 billion figure used to describe Madoff’s fraud reflects estimated paper losses.)
“The central argument is that combating pyramid and Ponzi schemes cannot be left only to such classical branches of law as criminal, tort, or contract law,” says Tajti. He insists that to enable early detection and meaningfully address Ponzi schemes, financial regulators should hire trained specialists with expertise in finance, and that educating the investing public is “a must.”
Financial literacy helps inoculate against Ponzi schemes. However, many people overestimate what they know and remain unaware of gaps in their knowledge. Moreover, official statistics may undercount the actual number of Ponzi victims. “The true number of Ponzi schemes and their victims will never be known,” says Phelps.
“One of the hardest aspects of becoming entrapped in a Ponzi scheme is deciding what to do when you discover that the investment program is actually a fraudulent scheme,” Phelps says, noting an important yet seldom-discussed part of the crime.
“The temptation may be to try to get your money out before the whole scheme implodes. Or you may want to quietly ride it out and hope that the situation resolves itself. Or you may feel embarrassed for having been victimized by a scam, and you may be reluctant to tell anyone or do anything about it. For the greater good, the best thing to do to stop fraudulent activity is to promptly report the fraud,” she says.
Ponzi victims are often scorned as being “gullible, irresponsible speculators,” notes Tajti. However, his report chronicles a number of Ponzi schemes that possess markedly different characteristics. Some are built on preposterous, quicksand-like foundations; others temper promises, projecting a patina of plausibility; while still others trade on trust, offering endorsements by recognized and widely respected figures.
“Empirical evidence shows that quite a number of reputable schemes were dressed up as legitimate business ventures that raised no suspicion, even in the eyes of experts, surviving virtually undetected until their collapse,” according to Tajti.
In short, not all Ponzi victims are dupes. Exhibit A: Madoff’s victims. They were the “smart money” — giant banks, hedge funds, billionaires, and notable figures, including Steven Spielberg, Elie Wiesel, and Sandy Koufax.
In the 2010 case of the United States v. Treadwell, involving a Ponzi scheme that swindled more than 1,700 investors, the court noted, “Lest one think Ponzi schemes are too simple and obvious to bamboozle the financially savvy, an oil-drilling swindle in the 1970s duped top executives at Pepsico, Time, and General Electric, as well as the chairman of U.S. Trust, the president of First Boston Corp., and an author of several books on Wall Street finance.”
Wealth managers aren’t immune either. Last year, RIA Intel wrote in great detail about “the sordid tale of Aequitas Management” and how its massive Ponzi scheme fleeced RIAs, religious groups, and retirees. We followed up on that story last month with a report on settlements connected to the case.
On February 25, shortly before stocks fell into the fastest-ever bear market, Maglich told RIA Intel, “At some point there will be a market correction. These schemes have had time to fly under the radar for the past five to ten years.”
He then asked, “Are we going to find that there were a whole bunch of these things [Ponzi schemes] just festering and that we'll have a huge spike again? Or have the regulators done a better job of being able to root these things out while they're still going on rather than just collapsing and then learning about it?"
That’s the $64,000 question. On second thought, make that the $64 billion question.