Question: How exactly do Ponzi schemes work?

A BuyandHolder

Answer:

Last week, we spelled out the key ways you can protect your money from unscrupulous types, such as Mr. Madoff. Click HERE to read. This week we’ll take a closer look at how “Ponzi schemes” work so you can avoid getting pulled into one.

Ponzi schemes are named for Charles Ponzi who, back in the 1920s duped thousands of New Englanders by talking them into investing in a postage stamp speculation. He said he could take advantage of the differences between U.S. and foreign currencies and make money buying and selling international mail coupons. He promised potential investors that he would get them a 40% return in just 90 days. At the time, the interest rate on savings accounts was around 5%.

The public loved the idea of a 40% profit, although if they took a minute to think about it they would have seen it was a deal “too good to be true.” Ponzi’s initial success was unprecedented. He took in $1 million during one three-hour period. This was 1921, when the country was in the throes of the Great Depression.

It’s important to realize that some of the early investors did make money. Ponzi paid them off, but only in order to make his scheme appear legitimate and thus attract even more participants. After it all came unraveled, investigators discovered that Ponzi had bought only around $30 worth of international mail coupons. (Yes, that’s $30; not $300; not $3,000; not $30,000. Just $30!)  

The Pyramid

The Ponzi scheme is based on the let’s rob Peter to pay Paul principle. In other words, as new money comes in from investors, that money used to pay off earlier investors. Its success lies with recruiting new investors. Fraudsters, who are selling the promise of sky-high returns in a short time period, typically encourage individual participants to bring in their friends.

At some point, the scheme simply gets too big and the promoter is unable to raise enough money from new investors to pay previous investors. Eventually the pyramid collapses and many people, especially those who came into the game late, lose money. That’s clearly what happened with those who invested with Madoff.

Four Questions Everyone Should Have Asked Madoff Or Any Investment Adviser

1) Are you registered? You can search for the firm’s disclosure documents (Form ADV) on the SEC’s website: http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_OrgSearch.aspx.

It’s unwise to do business with an unregistered firm.

About Form ADV

This is the official form used by advisers to register as an investment adviser with the SEC. It is also used for state registration. Generally, an investment adviser that manages $25 million or more in client assets must register with the SEC. Advisers that manage less than $25 million must register with the state securities regulator where the adviser's principal place of business is located.

Form ADV has two parts. Part 1 contains information about the adviser's education, business and disciplinary history within the last ten years. Part 1 is filed electronically with the SEC.

Part 2 includes information on an adviser's services, fees, and investment strategies. Currently, the SEC does not require advisers to file Part 2 electronically.

Before you hire someone to be your investment adviser, read both parts of the adviser's Form ADV. You can find a copy of an investment adviser's most recent Form ADV (Part 1 only at this time) on the Investment Adviser Public Disclosure (IAPD) website:

http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx

Note: Registered advisers are also required to provide any potential client, such as yourself, Form ADV Part II before you become a client. Make certain you have that document prior to writing that first check.

And, ask for the names of the firm’s registered representatives. These people must have passed an exam and also be registered.

2) What is your strategy? Am I investing in a growth product, income product, an arbitrage situation or are the investments selected using technical analysis? You don’t need to understand every nuance of the firm’s strategy, but whoever is running the show should be willing to explain it clearly and in general terms. It should not be a secret. And the results for the previous one to five years should be spelled out in writing.

3) How liquid is my account? You want readily available access to your money. As explained above, a pyramid scheme depends upon investors staying with the program and not pulling out.

Hedge funds often require investors to remain invested for a minimum period of time. Some also limit withdrawals to certain dates, say quarterly. Others require a 30 day notice. A lack of liquidity, which was the case with Madoff, is a warning sign. Think how quickly you can get your money out of the standard mutual fund – one day after your put in your sell order.

4) Who prepares your customer statements? If the investment advisor is doing all the paper work and reporting, including issuing customer statements, that’s not a good sign.

You also want to know how long a time period between the reporting period and when you physically receive an account of activity. The longer the time, the more worrisome. Let’s say you should receive quarterly statements, but your statement actually arrives two months later. That’s too long after the fact to make intelligent decisions, such as whether to stay put or to liquidate all or part of your account. It could be a sign that the advisor is doing what Madoff did, sending out fraudulent statements.

You want to do business with an investment adviser who sends out brokerage statements from a clearing house that is not affiliated with the firm. It’s also a good sign (but not required) if you have real time account information via the Internet.

Keep in mind that Madoff was, first of all, the investment adviser. But his firm was also the broker, clearing agent and custodian for all the accounts and the one sending out all customer statements. Lots of red flags there!