When people invest, they expect it to be in a company that provides a product or service to make money. But some shady stockbrokers invest customers’ money in imaginary companies in order to steal it. Then they find new investors to use their money to pay “returns” to previous investors, all while continuing to steal.
Formerly known as “Rob Peter to Pay Paul”, this type of fraud has come to be called a Ponzi scheme. We’ll explain more about what it is, how it’s accomplished, why it’s illegal, and how to avoid it.
What is a Ponzi Scheme?
A Ponzi scheme is a form of investment fraud where a criminal recruits individuals to invest in a company that doesn’t exist. Once they’ve solidified the investment, the criminal steals the money. Then, to make it seem like those investors are earning returns, the criminal recruits new investors and uses their investment to pay off previous investors.
It’s named after Italian businessman Charles Ponzi, who pulled off a very large and infamous instance of the scheme in 1920. He did it by creating a fake investment company supposedly based around buying international postal vouchers in Europe and redeeming them for more expensive US postage stamps. While this practice (called arbitrage) wasn’t illegal, falsely claiming his company was doing it—and instead paying off initial investors with money from new investors—was a crime.
How Does a Ponzi Scheme Work?
Ponzi schemes first require a criminal to convince people to invest in a fake enterprise. They will usually promise high returns with little risk, two things that are very attractive to investors. They will also likely create stories and even provide forged paperwork to make it seem like there is actually a legitimate company to invest in.
After the criminal steals the initial investments, they have to create the illusion for investors that they’re earning returns. So the criminal pulls the same tricks with other people to get them to invest money and then uses that money to pay previous investors—often skimming off the excess for themselves. The criminal uses other fraudulent methods to claim that these are all legitimate business transactions falsely.
Here’s a brief summary of how a Ponzi scheme works:
- A criminal convinces an initial group of investors to invest in an imaginary company.
- Investors lured by the scam give money to the criminal, who keeps it for themselves.
- To make it seem like the investors’ money is paying dividends, the criminal searches for new people they can persuade to invest in the fraud.
- New investors pulled into the scheme give money to the criminal, who then divides it up among previous investors while perhaps also keeping some for themselves.
- Steps 3 and 4 repeat until no new investors can be found, and the scheme collapses.
Are Ponzi Schemes Illegal?
Yes, a Ponzi scheme is illegal for two main reasons. The first reason is that the perpetrator is deceiving investors into backing a venture that doesn’t actually exist. That is, it provides no goods or services other than being the focal point of the fraud.
The second reason is that the criminal has to make their fake enterprise look legitimate in order not to get caught. This usually involves forging and falsifying documents that a business must submit to government agencies. And that’s definitely a crime.
Ponzi Scheme vs. Pyramid Scheme: The Main Differences
A Ponzi scheme is often considered a type of pyramid scheme, but there are subtle differences between the two.
In a Ponzi scheme, investors tend only to have to make a one-time investment and then passively wait for their returns. A Ponzi scheme usually also relies on only a single person or group—the one(s) running the scheme—to recruit new investors to pay off the previous ones.
In a pyramid scheme, meanwhile, the leaders provide incentives for investors to actively participate in recruiting new people into the fraud. This is often done by allowing investors to collect “initiation fees” from the people they recruit, a portion of which must be paid to previous investors and the scheme leaders.
So the difference between a pyramid scheme vs. a Ponzi scheme, in brief, is:
- Ponzi Scheme: The scheme leader(s) scam investors out of large initial investments, then recruit new investors to pay off the previous investors.
- Pyramid Scheme: The scheme leader(s) take small initial investments from investors, then encourage them to earn money by recruiting new investors. Some of the money gained from new investors is given to previous investors and the scheme leader(s).
Ponzi Scheme Red Flags to Watch For
The US Securities and Exchange Commission has identified a number of common warning signs that an investment opportunity is actually a Ponzi scheme or other type of fraud.
- Promises big returns with little or no risk: This is a prominent general indicator of investment fraud, including Ponzi schemes. Investments that can generate large returns are typically very risky, and no investment is completely risk-free.
- Delivers unusually consistent returns: Market conditions tend to dictate whether an entity profits or loses from an investment. So an investment that continually provides profits, regardless of what’s happening in the market, may be too good to be true.
- Is unregistered and/or unlicensed: Legitimate stockbrokers and companies that offer stocks are required by law to register with regional and/or federal regulators (like the SEC in the US). This allows investors to access information about companies that can influence their decisions of whether or not to invest. Brokers and businesses involved in Ponzi schemes often won’t be registered because they have something to hide.
- Has secretive or overly-complex investment strategies: Many Ponzi schemes will be reluctant to share details on how their “investments” operate. And even if they aren’t, these details likely won’t make much sense if looked at closely enough.
- Restricts access to, or includes errors in, paperwork: If the numbers don’t add up on investment account statements, it could be a sign that money isn’t going where a client wants it to go. Or if a client is prevented from seeing the investment paperwork at all, that’s another big indicator that something shady is going on.
- Makes receiving or divesting money difficult: Not having an investment payment come when it’s supposed to can be a suspicious sign, as can having trouble with taking money out of the investment account. A Ponzi scheme leader may try to dissuade clients from divesting by convincing them that even greater returns are coming.
So how do Ponzi schemes work in the context of real life? We’ll next cover some of the most famous Ponzi schemes that have happened recently to illustrate.
Famous Ponzi Scheme Examples to Learn From
To give a sense of what a real-world Ponzi scheme looks like, here are five prominent Ponzi scheme examples from recent history.
The Bernie Madoff Ponzi Scheme
Bernie Madoff began as a legitimate stockbroker in the 1960s. Allegedly starting in the early 1980s, though, his company’s operations began transforming into the biggest Ponzi scheme in history. As standard for a Ponzi scheme, Madoff baited investors with promises of large returns with minimal risk. But they were investing in an illusion—Madoff was using their money to pay his previous investors.
Madoff also made money for himself through “pay for order flow” (PFOF), a fee his firm charged to set up financial transactions involving investors and the ventures they were backing. However, since these enterprises were all fake (or actually his other investors), the PFOF amounted to investors overpaying to invest, while Madoff pocketed the difference.
By the time it fell apart in 2009, the Madoff Ponzi scheme had collectively cost over 13,000 investors somewhere between $65 billion and $74 billion US. Madoff, for his part, was arrested and sentenced to 150 years in prison. He died in prison in 2021.
The DC Solar Ponzi Scheme
This particularly infamous green-energy Ponzi scheme snared Warren Buffett’s Berkshire Hathaway insurance corporation, the Sherwin-Williams paint company, and many other big-name investors.
It started with a California mechanic named Jeff Carpoff, who invented a portable clean energy generator by rigging a car trailer with a large battery and numerous solar panels. He called it the Solar Eclipse. Soon after, everyone from blue chip corporations to sports and entertainment companies to even the US government wanted in on DC Solar, Carpoff’s new company.
But the company had trouble fulfilling orders for Solar Eclipse generators, and the generators that did go out didn’t work very well. So in 2012, Carpoff tried to fix DC Solar’s situation by turning it into a Ponzi scheme. It would not only pay off previous investors with money from new ones but also bilk the US government out of millions of dollars in tax credits as a registered green energy company.
Between 2018 and 2020, US authorities exposed the scheme and arrested Carpoff, along with many of DC Solar’s other executives. For a scheme that cost investors—and, in this case, American taxpayers by extension—almost $1 billion US, Carpoff was sentenced to 30 years in prison in 2021.
The George Santos Ponzi Scheme
In July of 2020, Republican congressman George Santos was hired to work at a Florida-based investment company called Harbor City Capital. During his time there, he wooed investors by offering them high-return, low-risk investments (a classic warning sign for financial fraud) in digital advertising companies.
To make his sales pitch more authoritative, Santos occasionally misrepresented how academically or professionally qualified he was and claimed he had connections with several rich or powerful people when he really didn’t. In addition, a prospective investor eventually alerted Santos to evidence that Harbor City Capital was using fraudulent financial documents. He passed the concerns off to a company lawyer but took no further action.
In April 2021, the SEC froze Harbor City Capital’s assets. It accused the company of misappropriating nearly $4.5 million US of investors’ money for the CEO’s personal use. It also charged the company with routing investors’ money to other entities unrelated to their desired investments, including as payments for other investors—the hallmark of a Ponzi scheme.
Santos was not named in the SEC’s lawsuit and claims not to have known about the fraud.
The “Texas Preacher” Ponzi Scheme
This is also called the Doc Gallagher Ponzi scheme after its mastermind, a Fort Worth resident named William Neil Gallagher. A former stockbroker, church minister, and radio show host, Gallagher—a.k.a. “The Money Doctor”—used both the pulpit and the airwaves to publicize his financial business. He also warned his followers about government, academic, and financial elites allegedly manipulating markets for their own greed.
This combination of self-promotion and preaching convinced nearly 200 people—mainly elderly devout Christians—to invest nearly $38 million US with Gallagher collectively. He promised the investments would provide returns between 5% and 8% per year with no risk. (Again, this kind of high-return, low-risk promise usually indicates a Ponzi scheme or other investment fraud).
By 2019, authorities had gathered irrefutable evidence that over approximately 10 years, Gallagher had misappropriated at least $20 million US of investors’ money to pay for personal and company expenses. They also proved he had created fake account statements to make it seem like investors were earning money when in reality, he was just paying them with other investors’ money—that is, running a Ponzi scheme.
Between 2020 and 2021, Gallagher was arrested, forced to repay over $10 million US to his scheme’s victims, and sentenced to three life terms in prison.
The OneCoin Cryptocurrency Ponzi Scheme
The largest crypto Ponzi scheme as of this writing, OneCoin was a cryptocurrency created in Bulgaria in 2014. It was described as a method for purchasing access to education materials, focusing on financial management. But its inventor, Dr. Ruja Ignatova, was more interested in hyping OneCoin as an investment asset—a major red flag for fraud.
Sure enough, in 2017, financial authorities exposed OneCoin as a massive Ponzi scheme that was providing returns to initial investors via incoming money from new investors. While many of the scheme’s leaders were caught, Ignatova herself disappeared with around $4 billion US and has yet to be found. The fraud is estimated to have cost investors nearly $25 billion US.
Ponzi schemes involving cryptocurrencies are particularly dangerous because crypto transactions are difficult to reverse, given how the blockchain systems they rely on work. These transactions also have a degree of anonymity, making it difficult to tell where crypto is coming from or going to.
Use Unit21’s Anti-Fraud and AML Tools to Detect Signs of Ponzi Schemes
Like many other kinds of fraud and financial crime, there are certain unusual indicators that a Ponzi scheme will give off. These include a stockbroker or investment firm not having valid credentials or making a series of seemingly meaningless transactions (like in money laundering).
To see how our tools can work together towards those ends, contact us for a demo.