What is a ‘Ponzi Scheme’

A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors.

The Ponzi scheme generates returns for older investors by acquiring new investors.

This is similar to a pyramid scheme in that both are based on using new funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn’t enough money to go around, and the schemes unravel.

BREAKING DOWN ‘Ponzi Scheme’
A Ponzi scheme is an investment fraud where clients are promised a large profit at little to no risk.

Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments. This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. When this flow runs out, the scheme falls apart.

Ponzi Scheme: Origins
The first notorious Ponzi scheme was orchestrated by a man named Charles Ponzi in 1919. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply. With the constant fluctuation of postage prices, it was common for stamps to be more expensive in one country than another.

Ponzi hired agents to purchase cheap international reply coupons in other countries and send them to him. He would then exchange those coupons for stamps that were more expensive than the coupon was originally purchased for. The stamps were then sold as a profit.

This type of exchange is known as an arbitrage, which is not an illegal practice.

Ponzi became greedy and expanded his efforts. Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of actually investing the money, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until 1920, when an investigation into the Securities Exchange Company was conducted.

Ponzi Scheme Red Flags
The concept of the Ponzi scheme did not end in 1920. As technology changed, so did the Ponzi scheme. In 2008, Bernard Madoff was convicted of running a Ponzi scheme that falsified trading reports to show a client was earning a profit. Regardless of the technology used in the Ponzi scheme, most share similar characteristics:

  1. A guaranteed promise of high returns with little risk
  2. Consistent flow of returns regardless of market conditions
  3. Investments that have not been registered with the Securities and Exchange Commission (SEC)
  4. Investment strategies that are a secret or described as too complex
  5. Clients not allowed to view official paperwork for their investment
  6. Clients facing difficulties removing their money

The Madoff Affair


Who is ‘Bernie Madoff’

Bernard Lawrence “Bernie” Madoff is an American financier who executed the largest Ponzi scheme in history, defrauding thousands of investors of tens of billions of dollars over the course of at least 17 years, and possibly longer.

He was also a pioneer in electronic trading and chair of the Nasdaq in the early 1990s.

More on ‘Bernie Madoff’
Despite claiming to generate large, steady returns through an investing strategy called “split-strike conversion, “which does exist (see Invest Like Madoff – Without the Jail Time). Madoff simply deposited client funds into a single bank account, which he used to pay clients who wanted to cash out.

He funded redemptions by attracting new investors and capital, but was unable to maintain the fraud when the market turned sharply down in late 2008. He confessed to his sons — who worked at his firm but, he claims, were not aware of the scheme — on Dec. 10, 2008. They turned him into the authorities the next day.

The fund’s last statements indicated it had $64.8 billion in client assets. In 2009, at age 71, Madoff pleaded guilty to 11 federal felony counts, including securities fraud, wire fraud, mail fraud, perjury and money laundering.

The Ponzi scheme became a potent symbol of the culture of greed and dishonesty that, to critics, pervaded Wall Street in the run-up to the financial crisis.

While Madoff was sentenced to 150 years and prison and ordered to forfeit $170 million in assets, no other prominent Wall Street figures faced legal ramifications in the wake of the crisis.

Madoff has been the subject of numerous articles, books, movies and an ABC biopic miniseries. (See Investopedia’s Guide to Watching ‘Wizard of Lies,’ HBO’s Madoff Movie.)

Bernie Madoff’s Early Career
Bernie Madoff was born in Queens, New York on April 29, 1938, and began dating his future wife Ruth (née Alpern) when both were in their early teens. Speaking by phone from prison, Madoff told journalist Steve Fishman that his father, who had run a sporting goods store, went out of business due to steel shortages during the Korean War: “You watch that happen and you see your father, who you idolize, build a big business and then lose everything.”

Fishman says that Madoff was determined to achieve the “lasting success” his father hadn’t, “whatever it took,” but Madoff’s career had its ups and downs. He started his company, Bernard L. Madoff Investment Securities LLC, in 1960, at age 22. At first, he traded penny stocks with $5,000 (worth around $41,000 in 2017) he had earned installing sprinklers and working as a lifeguard. He soon persuaded family friends and others to invest with him. When the “Kennedy Slide” lopped 20% off the market in 1962, Madoff’s bets soured and his father-in-law bailed him out.

Madoff had a chip on his shoulder and felt constantly reminded that he was not part of the Wall Street in-crowd. “We were a small firm, we weren’t a member of the New York Stock Exchange,” he told Fishman. “It was very obvious.” According to Madoff, he began to make a name for himself as a scrappy market maker. “I was perfectly happy to take the crumbs,” he told Fishman, giving the example of a client who wanted to sell eight bonds; a bigger firm would disdain that kind of order, but Madoff’s would complete it.

Success came when he and his brother Peter began to build electronic trading capabilities — “artificial intelligence” in Madoff’s words — that attracted massive order flow and boosted the business by providing insights into market activity. “I had all these major banks coming down, entertaining me,” Madoff told Fishman. “It was a head trip.” He and four other Wall Street mainstays processed half of the New York Stock Exchange’s order flow — controversially, he paid for much of it — and by the late 1980s, Madoff was making in the vicinity of $100 million a year.

He would become chairman of the Nasdaq in 1990, and also served in 1991 and 1993.

Bernie Madoff Ponzi Scheme
It is not certain exactly when Madoff’s Ponzi scheme began. He testified in court that it started in 1991, but his account manager, Frank DiPascali, who had been working at the firm since 1975, said the fraud had been occurring “for as long as I remember.” Even less clear is why Madoff carried out the scheme at all. “I had more than enough money to support any of my lifestyle and my family’s lifestyle. I didn’t need to do this for that,” he told Fishman, adding, “I don’t know why.”

The legitimate wings of the business were extremely lucrative, and Madoff could have earned the Wall Street elites’ respect solely as a market-maker and electronic trading pioneer. Madoff repeatedly suggested to Fishman that he was not entirely to blame for the fraud. “I just allowed myself to be talked into something and that’s my fault,” he said, without making it clear who talked him into it. “I thought I could extricate myself after a period of time. I thought it would be a very short period of time, but I just couldn’t.”

The so-called “Big Four” have attracted attention for their long and profitable involvement with Bernard L. Madoff Investment Securities LLC. Madoff’s relationships with Carl Shapiro, Jeffry Picower, Stanley Chais and Norm Levy go back to the 1960s and 1970s, and his scheme netted them hundreds of millions of dollars each. “Everybody was greedy, everybody wanted to go on and I just went along with it,” Madoff told Fishman.

He has indicated that the Big Four and others — a number of feeder funds pumped client funds to him, some all but outsourcing their management of clients’ assets — must have suspected the returns he produced, or at least should have.

“How can you be making 15 or 18 percent when everyone is making less money?” Madoff said.

These apparently ultra-high returns persuaded clients to look the other way. In fact, Madoff simply deposited their funds in an account at Chase Manhattan Bank — which merged to become JPMorgan Chase & Co. in 2000 — and let it sit.

The bank, according to one estimate, may have made as much as $483 million from those deposits, so it was not inclined to inquire either. When clients wished to redeem their investments, Madoff funded the payouts with new capital, which he attracted through a reputation for unbelievable returns and grooming his victims by earning their trust.

Madoff also cultivated an image of exclusivity, often initially turning clients away. This model allowed roughly half of Madoff’s investors to cash out at a profit. These investors have been required to pay into a victims’ fund to compensate defrauded investors who lost money.

Madoff created a front of respectability and generosity, wooing investors through his charitable work. He also defrauded a number of non-profits, and some had their funds nearly wiped out, including the Elie Wiesel Foundation for Peace and the global women’s charity Hadassah. He used his friendship with J. Ezra Merkin, an officer at Manhattan’s Fifth Avenue Synagogue, to approach congregants.

By various accounts, Madoff swindled between $1 billion and $2 billion from its members. Madoff’s plausibility to investors lay in a number of factors:

  1. His principal, public portfolio appeared to stick to safe investments in blue-chip stocks.
  2. His returns were high (10%-20% per annum) but consistent, and not outlandish. As The Wall Street Journal reported in a now-famous interview with Madoff, from 1992: “[Madoff] insists the returns were really nothing special, given that the Standard & Poor’s 500-stock index generated an average annual return of 16.3% between November 1982 and November 1992. ‘I would be surprised if anybody thought that matching the S&P over 10 years was anything outstanding,’ he says.”

He claimed to be using a collar strategy, also known as a split-strike conversion. A collar is a way of minimizing risk, whereby the underlying shares are protected by the purchase of an out-of-the money put option. Financial analyst Harry Markopolos wrote in a scathing 2005 letter to the Securities and Exchange Commission (SEC) that Madoff’s stated strategy “should not be able to beat the return on US Treasury bills… If this isn’t a regulatory dodge, I don’t know what is.”

Bernie Madoff Investigation
The SEC had been investigating Madoff and his securities firm on and off since 1999 — a fact that frustrated many after he was finally prosecuted, since it was felt that the biggest damage could have been prevented if the initial investigations had been rigorous enough.

Markopolos was one of the earliest whistleblowers. In 1999, he calculated in the space of an afternoon that Madoff had to be lying. He filed his first SEC complaint against Madoff in 2000, but the regulator ignored him. In his 2005 letter to the SEC, he wrote: “Madoff Securities is the world’s largest Ponzi Scheme. In this case there is no SEC reward payment due the whistle-blower so basically I’m turning this case in because it’s the right thing to do.”

Using what he called a “Mosaic Method,” Markopolos noted a number of irregularities. Madoff’s firm claimed to be making money even when the S&P was falling, which made no mathematical sense, based on what Madoff claimed he was investing in.

The biggest red flag of all, in Markopolos’ words, was that Madoff Securities was earning “undisclosed commissions” instead of the standard hedge fund fee (1% of the total plus 20% of the profits). The bottom line, concluded Markopolos, was that “the investors that pony up the money don’t know that BM [Bernie Madoff] is managing their money.” Markopolos also learned Madoff was applying for huge loans from European banks (seemingly unnecessary if Madoff’s returns were as high as he said).

It was not until 2005 — shortly after Madoff nearly went belly-up due to a wave of redemptions — that the regulator asked him for documentation on Madoff’s trading accounts. He made up a six-page list, the SEC drafted letters to two of the firms listed but didn’t send them, and that was that. “The lie was simply too large to fit into the agency’s limited imagination,” writes Diana Henriques, author of the book “The Wizard of Lies: Bernie Madoff and the Death of Trust,” which documents the episode.

The SEC was excoriated in 2008, following the revelation of Madoff’s fraud, as well as wrongdoing by major banks in the markets for mortgage-backed securities and collateralized debt obligations.

Bernie Madoff Confession and Sentencing
In November 2008, Bernard L. Madoff Investment Securities LLC reported year-to-date returns of 5.6%; the S&P 500 had dropped 39% over the same period. As the selling continued, Madoff became unable to keep up with a cascade of client redemption requests and, on Dec. 10, according to the account he gave Fishman, Madoff confessed to his sons Mark and Andy, who worked at their father’s firm. “The afternoon I told them all, they immediately left, they went to a lawyer, the lawyer said you gotta turn your father in, they went, did that, and then I never saw them again.”

Madoff has insisted he acted alone, though several of his colleagues were sent to prison. His elder son Mark Madoff committed suicide exactly two years after his father’s fraud was exposed. Several of Madoff’s investors also killed themselves. Andy Madoff died of cancer in 2014.

Madoff was sentenced to 150 years in prison and forced to forfeit $170 billion in 2009. His three homes and yacht were auctioned off by the U.S. Marshals. He resides at the Butner Federal Correctional Institution in North Carolina, where he is prisoner #61727-054. (See also, Bernie Madoff Runs a Hot Chocolate Monopoly in Prison.)

Aftermath of the Bernie Madoff Ponzi Scheme
The paper trail of victims’ claims displays the complexity and sheer size of Madoff’s betrayal to investors. According to documents, Madoff’s scam ran more than five decades, beginning in the 1960s. His final account statements, which include millions of pages of fake trades and shady accounting, show that the firm had $47 billion in “profit.”

While Madoff pled guilty in 2009 and received a 150-year prison term, thousands of investors lost their life savings and multiple tales detail the harrowing sense of loss victims endured. A Madoff Victim Fund was created in 2012 to help compensate those Madoff defrauded, but the Department of Justice has yet to pay out any of the roughly $4 billion in the fund.

Richard Breeden, a former SEC chairman who is overseeing the fund, noted that thousands of the claims are from “indirect investors” — meaning  people who put money into funds that Madoff had invested in during his scheme. Since they are not direct victims, Breeden and his team had to sift through thousands and thousands of claims, only to reject many of them.

Breeden said he bases most of his decisions on one simple rule: Did the person in question put more money into Madoff’s funds than they took out? Breeden estimates that the number of “feeder” investors is north of 11,000 individuals. According to a letter written by Assistant Attorney General Stephen Boyd dated Sept. 18, 2017, 65,000 petitions were filed from victims in 136 countries, and 35,000 of the 60,000 that had been decided to date had been approved. Reportedly, payments from the Madoff Victim Fund will begin by the end of 2017.



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