One question I get asked frequently by potential clients who come in suspecting that they have been scammed is whether they might have been the victim of a Ponzi scheme.
Ponzi schemes derive their name from Charles Ponzi, a prominent promoter of such a scheme in the early twentieth century. The U.S. Supreme Court has recounted “the remarkable criminal financial career of Charles Ponzi” as follows:
In December 1919, with a capital of $150, he began the business of borrowing money on his promissory notes. He did not profess to receive money for investment for account of the lender. He borrowed the money on his credit only. He spread the false tale that, on his own account, he was engaged in buying international postal coupons in foreign countries and selling them in other countries at 100 percent profit and that this was made possible by the excessive differences in the rates of exchange following [World War I]. He was willing, he said, to give others the opportunity to share with him this profit. By a written promise in ninety days to pay them $150 for every $100 loaned, he induced thousands to lend him. He stimulated their avidity by paying his ninety-day notes in full at the end of forty-five days and by circulating the notice that he would pay any unmatured note presented in less than forty-five days at 100% of the loan. Within eight months, he took in $9,582,000, for which he issued his notes for $14,374,000. He paid his agents a commission of 10 percent. With the 50 percent promised to lenders that every loan paid in full with the profit would cost him 60 percent. He was always insolvent and became daily more so the more his business succeeded. He made no investments of any kind, so all the money he had at any time was solely the result of loans from his dupes.[1]
Since then, the sine qua non of a Ponzi scheme is the use of money received by later investors to pay the profits supposedly earned by earlier investors.[2]
The Securities and Exchange Commission (“SEC”), which often takes the lead in prosecuting Ponzi scheme promoters, has identified the following “red flags” for identifying such schemes:
- High investment returns with little or no risk,
- Overly consistent returns,
- Unregistered investments,
- Unlicensed sellers,
- Secretive and/or complex investment strategies,
- Issues with paperwork, and
- Difficulty receiving payments.[3]
One of the best-known recent examples of a Ponzi scheme is that of Bernie Madoff. Madoff claimed that he had a “split-strike conversion strategy” for producing consistently high rates of return on his customers’ investments.[4] This strategy supposedly involved buying a basket of stocks on the Standard & Poor’s 100 Index and hedging through options.[5] However, Madoff never actually invested customer funds, instead generating fake account statements and trading records that purported to reflect a surprising run of profitable trades.[6] Often, these records contained information that was inconsistent with publicly available market data.[7] The scheme collapsed when the money from new investors was insufficient to pay off the profits that had been promised to earlier investors.[8] Madoff ultimately pleaded guilty to securities fraud, investment adviser fraud, mail fraud, wire fraud, money laundering, false statements, perjury, false filing with the SEC, and theft from an employee benefit plan, and was sentenced to 150 years in prison.[9]
As illustrated by the Madoff case, promoters of Ponzi schemes can face severe criminal and civil penalties under federal and state law. And, while Ponzi schemes often result in the promoter’s bankruptcy, there may be mechanisms for victims of such schemes to recover some of their losses through restitution, clawbacks, or by deducting their losses on their federal income tax returns.
[1] Cunningham v. Brown, 265 U.S. 1, 7-8 (1924).
[2] See U.S. v. Gold Unlimited, Inc., 188 F.3d 472, 475 (6th Cir. 1999) (“Ponzi schemes operate strictly by paying earlier investors with money tendered by later investors.”); In re Bayou Group, LLC, 362 B.R. 624, 633 (Bankr. S.D.N.Y. 2007) (“[T]he label ‘Ponzi scheme’ has been applied to any sort of inherently fraudulent arrangement under which the debtor-transferor must utilize after-acquired investment funds to pay off previous investors in order to forestall disclosure of the fraud.”); Black’s Law Dictionary 545 (3rd pocket ed. 2006) (defining a “Ponzi scheme” as “[a] fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments.”).
[3] U.S. Securities and Exchange Commission, Ponzi Schemes—Frequently Asked Questions at https://www.investor.gov/introduction-investing/investing-basics/glossary/ponzi-schemes (last visited Feb. 20, 2025).
[4] In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 231 (2d Cir. 2011).
[5] In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 231-32 (2d Cir. 2011).
[6] In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 232 (2d Cir. 2011).
[7] In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 232 (2d Cir. 2011).
[8] In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 232 (2d Cir. 2011).
[9] Federal Bureau of Investigation, Bernie L. Madoff Pleads Guilty to 11-Count Criminal Information and Is Remanded Into Custody, https://archives.fbi.gov/archives/newyork/press-releases/2009/nyfo031209.htm (last visited Feb. 20, 2025); Department of Justice, Justice Department’s 10th Distribution Brings Total Provided to Over $4.3B in Nearly Full Recovery to Over 40,000 Victims in Madoff Ponzi Scheme, https://www.justice.gov/archives/opa/pr/justice-departments-10th-distribution-brings-total-provided-over-43b-nearly-full-recovery (last visited on Feb. 20, 2025).
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