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Ponzi Schemes 101

From Bernie Madoff to Lou Pearlman to Charles Ponzi himself — Ponzi schemes have made national news headlines for brokers using criminal tactics to defraud millions from unsuspected investors. A Ponzi scheme is an illegal act where a broker or other individual representing an investment operation (known as an "operator") pays older investors with funds paid to themselves by the new investors rather than from profit earned through legitimate sources. Ponzi schemes typically involve promises of high short-term returns and minimal risk.

How the Scheme Works

The scheme generates returns for older investors as long as enough new investors to fund the payments. When the operator cannot grow the scheme by attracting new investors, it will require a constant flow of money from new investors to continue to pay promised returns to older investors. At some point, the scheme becomes unsustainable and collapses due either to a lack of new investor funds or increased withdrawals by existing investors.

Ponzi schemes share many common characteristics with pyramid schemes, but there are critical differences between the two.

  • Payments to earlier investors in a Ponzi scheme are made with money invested later rather than from revenue earned by the operation.
  • A pyramid scheme relies on recruiting additional participants to bring in more funds. A Ponzi scheme does not require recruitment; it simply uses funds from new investors to pay off older investors.
  • A pyramid scheme is unsustainable because it requires many new investors to maintain the scheme. A Ponzi scheme is also unsustainable, but for different reasons. In a Ponzi scheme, at some point, there are not enough new investors to pay the promised returns to earlier investors, and the scheme collapses.

How Ponzi Schemes Got Their Name

Ponzi schemes are named after Charles Ponzi, who became notorious for using the technique in 1920. Ponzi did not invent the scheme (he was using a scheme that was already several years old), but his use of it brought renewed attention to the technique.

Ponzi schemes are also sometimes referred to as investment scams or frauds. While many legitimate investments can result in high returns, anyone promising guaranteed or exceptionally high returns with little or no risk should be viewed with extreme caution.

Avoiding Ponzi Schemes

There are several ways to avoid becoming a victim of a Ponzi scheme.

  • Research any investment before handing over any money. Check out the company and the individual offering the investment opportunity, and always get multiple opinions.
  • Beware of investments that promise guaranteed or exceptionally high returns with little or no risk. If it sounds too good to be true, it probably is.
  • Be skeptical of unsolicited offers, especially if they come out of the blue. If you didn't initiate contact with the person or organization offering the investment, be extra careful.
  • Be wary of investments that are not registered with the appropriate authorities. For example, in the United States, all securities must be registered with the Securities and Exchange Commission (SEC).
  • Ensure you understand what you're signing and get the agreement in writing. Read all documentation carefully, and don't sign anything you don't fully understand.
  • Beware of promises of secrecy or special treatment. Legitimate investments are conducted openly and honestly, not behind closed doors.
  • Don't let anyone pressure you into making an investment decision. Legitimate investments are not a race, so there's no need to make a snap decision. Be wary of anyone who tries to push you into investing before you're ready.

Were You a Victim of a Ponzi Scheme?

If you think you may have been the victim of a Ponzi scheme, contact the team at Weltz Law. Our experienced Ponzi scheme attorneys have handled countless cases dealing with fraud and misrepresentation, and we can let you know the potential outcomes for your situation. Contact our dedicated securities arbitration and litigation attorneys for a free consultation of your case — (877) 905-7671