PONZI SCHEMES

A Ponzi scheme is an investment swindle whereby some early investors are paid returns from the money acquired from new investors; eventually the scheme collapses when there is not enough new investment to continue the payouts. Each year in the United States several such fraudulent schemes are uncovered and prosecuted by the Securities Exchange Commission (SEC).

The original Ponzi scheme began in Boston in 1919. Charles Ponzi, a dapper 37-year-old Italian immigrant, conceived a unique arbitrage system. Member nations of the Universal Postal Union had agreed to a permanent exchange rate not affected by currency fluctuations. Ponzi saw he could buy depressed liras and francs, turn them into International Reply coupons, and then convert the coupons into U.S. dollars for a profit of up to 250 percent. He began paying investors 50 percent interest in 45 days.

This bonanza started a frenzy that went beyond the Italian North End and spread throughout New England. When Ponzi was exposed by the Boston Post, he had taken in $10,000,000 and purchased less than $30 worth of International Reply coupons. He had been redeeming his promissory notes with new funds from would-be greedy investors standing in block-long lines to reach his 16 clerks.

In 1920 Ponzi went to federal prison for using the mails to defraud and later to Massachusetts state prison for grand larceny. Receivers for his bankrupt Securities Exchange Company paid back about 35 cents on the dollar after puzzling over his bookkeeping for years. Ponzi died a pauper in Brazil in 1949.

Modern Ponzi scheme victims are less likely to be ignorant immigrants but are still vulnerable because they are preoccupied with other concerns. Doctors, entertainers, and retirees, for example, are frequent targets of Ponzi-scheme promoters.

Use of the term "Ponzi scheme" has broadened considerably since the 1920s. For example, the Drexel/Milken junk-bond craze of the 1980s, which fueled an unprecedented wave of corporate takeovers and contributed to the collapse of the savings and loan industry, has been described, with some justification, as a Ponzi scheme.

The term is often applied to the practices of certain third world governments—and more recently Russia—that borrow billions from the International Monetary Fund and then more billions to pay back the billions previously borrowed. The word "Ponzi" implies that these governments have no intention of repaying in full.

Social Security has frequently been called a Ponzi scheme by conservatives who claim that young workers will be cheated because the fund must inevitably go bankrupt. The word "Ponzi" in this context suggests that irresponsible politicians are looting the fund to disguise budget deficits and pyramiding benefits in the form of COLA entitlements to win votes from elderly recipients at the expense of future generations.

But perhaps the biggest true Ponzi scheme was that of Bennett Funding Group Inc., a billion-dollar operation involving some 12,000 investors. The company, which collapsed in 1996, sold unregistered securities on office equipment leases, an otherwise legal practice, but falsified and double-counted the underlying leases to make it appear it was properly investing all of the money it took in. Meanwhile, officers at the private family-owned business, based in Syracuse, New York, were squandering hundreds of millions on ill-fated real estate ventures and other unreported speculative pursuits. The company promised high returns on investments, some of which it actually delivered, and misled investors about how their money was being used and about the company's finances in general. The company ultimately failed under the heat of an SEC investigation, by which time it had taken in $1 billion and only had $300 million in assets to cover it. Among the victims were retirees, doctors, lawyers, and hundreds of banks.

What distinguishes a true Ponzi scheme is motive. If the promoters intend to milk investors by paying for borrowed money with more borrowed money, fully realizing that the pyramid must collapse, then it can correctly be characterized as a Ponzi scheme.