Investors generally set two objectives in evaluating an investment:
(a) As high a return as possible ("yield" in the form of interest,
dividends and/or long term appreciation), and (2) Safety. Ponzi and
pyramid schemes normally attract unsuspecting investors by the
promise of an unusually high rate of return.
Experience has demonstrated, however, that as a general rule, the
higher the return on an investment, the riskier it is likely to be.
In other words, the higher return is usually paid to justify the
higher risk. The prudent investor will compare the return promised
or proposed with that generally being realized on other types of
It is impossible to describe thoroughly the various forms Ponzi and
pyramid schemes might take, but these operations do have certain
hallmarks. You should be particularly cautious when an investment
- very high yield;
- quick return;
- "a once in a lifetime" opportunity; and
- the chance to "get in on the ground floor."
Named for Charles A. Ponzi, who defrauded hundreds of investors in
the 1920s, a Ponzi scheme pays off old "investors" with money coming
in from new "investors." It works this way:
Example: Investor A gives Promotor ("P") $1000 on P's promise to
repay $1000 plus $100 "interest" in 90 days. During the 90 days, P
makes similar promises to Investors B and C, receiving $1000 each
from them. At the end of the first 90 day period, P may offer to pay
A the $100 "interest" and to return the original $1000. More likely,
he will invite A to "re-invest" the $1000 plus the $100 "interest"
for a similar, or higher, return at the end of another 90 days.
Thereafter, A, believing he or she can receive a good return on the
investment, is likely to bring other investors to P.
In this manner P collects a pool of money that he can use to pay out
to those few wishing return of their money. P may operate his scheme
for some time before "pulling the plug" - that is, either
disappearing with all the "investments" or revealing the bad news
that the investments went "sour."
A major factor in the eventual collapse of a Ponzi scheme is that
there is no significant source of "income" other than from new
A PONZI SCHEME IN OPERATION
Joe Smith claims that he operates a factoring business, buying
accounts receivables from small companies at a discount and then
making a large profit when he collects the receivable. In order to
conduct his business, he says that he needs, on a short term basis,
large amounts of money. Because his factoring business is so
profitable, he is prepared to offer promissory notes paying 20-50%
within 6-9 months.
In this case, there was no factoring business. The promoter used the
borrowed money for his own personal uses. The operation kept going
because many "investors," instead of cashing their promissory notes
upon maturity, agreed to new ones that they thought would allow their
capital and profit to accumulate. Those "investors" who did not want
to continue were paid off with funds from new and present
The "pyramid" scheme is essentially a business variation of the
familiar "chain letter." It works this way:
Example: Promotor ("P") offers A and B the chance to "invest" by
purchasing "distributorships" at $1000 each. The "distributorships"
give A and B the "exclusive" right to sell "distributorships" to
others for $1000 each and to sell certain products to the public.
However, each $1000 that A and B receive from their sales of
"distributorships" must be divided with P, say 50-50. Thus,
theoretically, A and B can realize $500 on each "distributorship"
they sell and can completely recover their initial $1000 "investment"
by selling only two "distributorships." P, however, has received not
only A's and B's $1000 each, but also $500 for each "distributorship"
that A and B sell. Initially, it appears that this can go on
forever, with no one being hurt and everyone making money. But, the
chart below shows that the number of investors needed to keep the
pyramid scheme working quickly exceeds the population of the United
States. (The chart assumes P initially sells "distributorships" to
six persons, each of whom brings in an additional six "purchasers"
The chart also shows why such a scheme is called a "pyramid" - the
promoters are at the top of a pyramid-shaped flow of money. Money
coming from later investors flows upward to the top. Being at the
top may result in your receiving a lot of money quickly, but it is
virtually impossible to determine, at the beginning, where in the
pyramid you stand.
OTHER CHARACTERISTICS OF PONZI AND PYRAMID SCHEMES
In brief, Ponzi and pyramid schemes may also be characterized by:
- Reliance on funds from new investors to pay returns, commissions
or bonuses to old investors;
- Need for an inexhaustible supply of new investors; and
- Absences of a profitable product or efforts to make profits
through productive work.
This is A Consumer Education Publication one of a series created by
the U.S. Securities and Exchange Commission to acquaint possible
investors with the intricacies of investing and edited by the 'Lectric
WHAT DOES THE SEC DO?
The Securities and Exchange Commission was established by Congress in
1934 to protect investors against misrepresentation and fraud in the
issuance and sale of securities. The SEC does this by enforcing the
securities laws. These laws require most companies offering their
securities for sale in interstate commerce to register them with the
Commission so that full disclosure of certain information is made to
investors. They also prohibit misrepresentation, deceit and other
fraudulent acts and practices in connection with the purchase or sale
of securities generally (whether or not required to be registered).
ARE ALL SECURITIES REGISTERED WITH THE SEC?
Not all securities are required to be registered with the SEC, but
many are. Sellers of registered securities are required to furnish
prospective investors with a prospectus (selling circular), divulging
financial information. However, the SEC does not pass on the
accuracy of the prospectus or approve or disapprove securities
offered. Any representation to the contrary is a criminal offense.
WHERE CAN YOU GET INVESTMENT INFORMATION?
Most broker-dealers maintain an extensive file of financial
information on the companies whose stock they recommend. Because of
this, they may be able to assist you in evaluating the merits of an
investment. Independent investment advisers, many of whom are
registered with the SEC, may also be in a position to assist with
information and advice, though usually for a fee.
STATE REGULATORY AUTHORITIES
If the investment is legitimate, it may be registered with some
appropriate authority in your state. This authority may be the State
Securities Commission, the State Corporations Commission or the
Secretary of State. These agencies can help you ask the right
questions about your investment.
WHAT CAN I DO ABOUT THESE SCHEMES?
You can help by notifying the SEC promptly if you are approached to
participate in a questionable investment scheme or if you think you
have invested in such a scheme. Information should be sent to any
regional or district office of the Commission or to:
Securities and Exchange Commission
Office of Consumer Affairs
450 Fifth Street, NW
Washington, DC 20549
excerpted from Securities and Exchange Commission material
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