How to spot a Ponzi scheme: Experts suggest ways to evaluate a pitch

Determining whether a potential investment opportunity is a great deal or a fraud is a lot like diagnosing a mystery illness -- you have to run some tests.

By Bob Cook — Posted June 1, 2009

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With Bernard Madoff leading a cavalcade of Ponzi schemers unmasked by a falling stock market, you might wonder how so many could have fallen for this. Financial experts answer that with two words: hubris and trust.

A Ponzi scheme -- in which an investor takes your money, promises big or steady returns and never invests it, but instead uses the money from later investors to pay earlier investors, or no one at all -- generally isn't obvious. It doesn't look like a Ponzi pitch "until it's over," said Mickey Cargile, managing partner of WNB Private Client Services in Midland, Texas.

People who put together these schemes "are very, very good at what they do," said former Colorado securities commissioner Philip Feigin, now a partner at Denver law firm Rothgerber Johnson & Lyons. "Until you listen to some of these pitches, you have no idea how good they are. Anybody who thinks they're too smart to be conned is a likely target."

That's part of hubris. So is thinking you've found a sure way to outperform the market, or at least protect yourself from its gyrations.

And then there's trust. You don't have time to fully research every potential investment, nor would research necessarily reveal anything untoward. After all, Madoff once was an investing legend on Wall Street. His firm invented the computer program that became the Nasdaq National Market.

Some physicians have gotten scammed by neighbors or church friends. Trusting your gut doesn't always work.

So how do you avoid letting hubris and trust guide you into the gaping maw of a Ponzi scheme? Here are some warning signs that an investment proposal may be shady:

You're promised a minimum return, or steady returns

The standard "if it looks too good to be true, it is," may not help you here because Ponzi schemes don't always promise enormous returns. In fact, a physician suing Madoff's bank custodian and a pension fund over their involvement said friends who were making 30% returns in the tech boom of the late 1990s thought "I was an idiot" for settling for Madoff's stated, steady 12% to 14% returns. (The doctor did not want to be identified for this story.)

Financial experts say any promise of a stated return, no matter how big or small, should be a warning. If the market goes up and down, most investments go up and down with it. Like any investors, physicians should avoid "reaching for yield," said Cargile -- meaning, don't jump into an investment solely because it sounds like an easy way to maximize gains. "The people that are at risk at falling prey to these are those with unrealistic expectations for the return on their money."

The offer is pitched as something exclusive

Part of Madoff's appeal was his funds were pitched as something only available to somebody who was really somebody. "Only the elite are called for such an improvement investment," Feigin said, describing the pitch. Exclusivity may not be about ego, but about how the tax advantages come only to someone in your profession.

The offer comes from someone you know

A Colorado physician (who said through his lawyer that he did not want to be named because he is "personally devastated") is suing an alleged Ponzi schemer whom he knew first as the neighbor around the corner.

Six Gainesville, Ga., physicians are suing convicted Ponzi schemer Wendell Spell, who was known locally for his church involvement and for a legitimately successful equipment rental business. Financial experts say Ponzi victims set aside their skepticism when it's a friend or colleague pitching an investment (or pitching one on someone else's behalf).

"It's one thing when a stockbroker cold-calls you and promises you 20%," said Ralph L. Taylor III, the Gainesville physicians' attorney. "It's another when someone in your Sunday school class tells you."

But as the doctors learned, Ponzi schemers prey on that trust. Feigin said many Ponzi schemes start with ringleaders approaching people they know, particularly if they share a common bond -- a religion, a neighborhood, an ethnicity. For example, Madoff, who is Jewish, got his start pitching to the Jewish communities in Long Island, N.Y., and Florida.

You can't explain what you're investing in

"If you can't repeat it to your lawyer without laughing," Feigin said, "don't do it."

There's no third party holding your money

Financial experts say that in any legitimate investment, a third party holds your assets and issues statements on them, while the person you're trusting to make money makes trades or does whatever he or she states is going to be done with your money.

"You want to have an independent custodian," said Tom McFarland, founder of the Darrow Co., a financial planning firm in Concord, Mass. "Therefore, your confirmations on trades and your own statements come from a qualified custodian (like a brokerage house and/or a bank)."

You're investing in a market where interest rates are low, and the economy is rebounding from a fall

Madoff's Ponzi scheme started in the early 1990s, as the market was starting to rebound from a recession. Many of the more recent Ponzi busts involve schemes that also began as interest rates were cut to help the economy rebound. Right now, interest rates are rock bottom, and there are signs that the economy is hitting bottom.

So, experts say, the time is ripe for Ponzi schemers to come calling, despite -- or maybe because of -- the Madoff publicity. "Some of the most valuable things that come out of the bankruptcy files of Ponzi schemes is a list of investors," Feigin said. Schemers figure the investors "fell for it once -- they might fall for it again."

Financial experts realize that physicians, especially, are busy, and don't have time to investigate every pitch. But they do recommend taking a couple of precautions:

  • Call your state securities regulator to see if the investor or company has been in trouble before. Get the investment officer's ADV Part II form, which any broker is required to file either with the U.S. Securities and Exchange Commission (if he or she handles more than $25 million) or a state securities regulator (if the amount managed is less than $25 million). That form details the investment strategy and fees.
  • Do an Internet search on the person or company offering the investment.

Checking out a potential investment doesn't guarantee you won't get sucked into a Ponzi scheme. But not checking increases the chances you will.

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I'm in a Ponzi scheme, get me out of here!

Maybe you've read about Madoff and the like and thought their "investment" strategies sounded familiar. And maybe you now have the urge to attempt to withdraw money from the fund whose manager you think might join the financial perp walk.

Experts have a word of advice: Don't.

One of two things could happen:

Your request for withdrawal could be the first step in sending your money "manager" packing for Disappearsville, a common destination for Ponzi scheme operators when investors start asking for their money back.

Or, you could get your money back, but only temporarily. Once your money "manager" is busted, the government or plaintiff's attorneys are going to seize your money, too, when they try to repay investors. Any gains you got were ill-gotten, and subject to recovery in a criminal case or investor lawsuit.

So what do you do?

Experts recommend two steps:

First, accept that you've been taken.

Then call an investigative authority -- a securities regulator or the FBI, for example -- and share your suspicions. That's your best chance of getting at least a little money back (if the "manager" has any assets left to seize), and it also protects others from your fate.

"If it's not a scam, nobody will mind" a call to investigate, said Philip Feigin, a partner at the Denver law firm of Rothgerber Johnson & Lyons and a former Colorado securities commissioner.

"If it is, you'll blow it up."

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Who was Charles Ponzi?

You have to be a major swindler to have a financial crime named after you. Charles Ponzi was.

Ponzi didn't invent the scheme that would have his name attached to it, but in the 1920s he became infamous for promoting one.

About as long as people have invested, there have been versions of the Ponzi scheme, in which investors are promised fixed or minimum returns on made-up investments. Money from later investors supposedly is used to pay off earlier investors, but the schemers grow rich by pocketing the "investments" until -- or if -- the scheme collapses. More information is online at the Securities and Exchange Commission Web site (link).

Ponzi, an Italian immigrant, had already been imprisoned in Canada following a conviction for check forgery when he enticed thousands of New Englanders to take part in postage stamp speculation, promising a 40% return. At that time, people sending mail overseas would buy an international mail coupon to pay for a return letter. Ponzi said he could take advantage of the difference between U.S. and foreign currencies to buy and sell those coupons for a profit much fatter than the average 5% return banks were paying on savings accounts.

Ponzi eventually acquired at least $10 million in investments while buying only $30 worth of coupons and paying only a few early investors.

Ponzi's undoing came, in part, from his own publicist, Boston's William McMasters.

The publicist had landed a laudatory story for his new client in the July 24, 1920, Boston Post.

But after reflection and a closer look at Ponzi's books, McMasters wrote a bylined story for the Post, barely a week later, declaring Ponzi to be insolvent. This sparked an investors' run and led to Ponzi's criminal conviction and eventual deportation.

McMasters' memoirs recently were given to the John Jay College of Criminal Justice and reproduced in The New York Times. Among his thoughts: "I do not anticipate that another Charles Ponzi will ever appear in the financial world."

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