Ponzi Scheme

A PONZI SCHEME is an investment fraud in which returns are paid to earlier investors at a great profit entirely out of money paid from a wave of newer investors, who are encouraged to make investments in response to the handsome returns received. Ponzi schemes are similar to pyramid schemes, but differ in that Ponzi schemes are operated by a central company or person, who may or may not be making other false claims about how the money is being invested, and where the returns are coming from. Ponzi schemes do not necessarily involve a hierarchal structure, as in a pyramid scheme; there is merely one person or company that is collecting money from new participants and using this money to pay off promised returns to earlier participants. Because the Ponzi scheme requires an everincreasing number of investors to keep going, there always comes a point at which the money coming in is insufficient to pay off the previous wave of investors, and they all lose their money.

The scheme is named after Charles Ponzi, who ran such a scheme in 1919–20. The backdrop of his scheme was international postal reply coupons (IPRCs), which could be redeemed for stamps in other countries. Ponzi realized that by purchasing IPRCs in a country whose currency was weak, he could redeem them for stamps in a country whose currency was strong, making a small profit on the differing exchange rates. He found that he could purchase Spanish IPRCs for a penny and redeem them in the United States for 10 cents. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons.

Ponzi told investors that he could provide a 40 percent return in just 90 days compared with 5 percent annually for savings accounts. After his investors' three-month period was up, they were reimbursed with interest not at the guaranteed 40 percent, but at 50 percent.

The investors gladly reinvested the entire amount, and spread the word that Ponzi was the man with whom to do business. While continuing with his scheme, Ponzi discovered that IPRCs were issued only for the convenience of postal customers who used international mail, therefore only a limited number of coupons were issued each year, not nearly enough to finance an investment system like the one he had in mind.

In fact, the Spanish government issued fewer than $1 million worth of these coupons. Ponzi received orders that were so huge that there was no possible way for him to purchase enough IPRCs to cover them. So, he “robbed Peter to pay Paul,” reimbursing earlier investors with funds taken from later investors.

As Ponzi paid the matured notes held by early investors, word of enormous profits spread through the community, whipping greedy and credulous investors into a frenzy. He had no trouble finding increasing numbers of investors necessary[Page 625] to keep the operation running smoothly. Happy investors convinced their friends that Ponzi's operation was a safe, easy, and quick way to multiply their savings.

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