Practical Insights

Posted: July 27, 2015 / Categories Fraud/Misrepresentation, Client Q & A

Client Q&A: What’s a Ponzi scheme and how can I tell if I have gotten caught in one?

What’s a Ponzi scheme and how can I tell if I have gotten caught in one?

By John M. Lundin

A Ponzi scheme is a fraud where the victims entrust money to the perpetrator who, instead of investing the money, uses later investments to pay returns to earlier investors, keeping the rest of the money for itself. The scheme typically continues until the perpetrator cannot find enough new investors to pay off the earlier ones or it decides to disappear with the remaining money.

The name comes from Charles Ponzi, who operated such a scheme in the early 20th century. A famous modern-day perpetrator of a Ponzi scheme was Bernard Madoff, who is believed to have cheated investors out of tens of billions of dollars.

Sometimes, Ponzi schemes start off as legitimate businesses. The perpetrator may fail to earn the promised returns and then hide it, and start using new funds to pay promised returns to earlier investors so that it looks like it is achieving the promised returns. Other times, the perpetrator skims money from the investment pool for its personal use--to pay debts, support a lavish lifestyle, or to pay for a drug or gambling habit--with the intention of paying the money back. People sometimes start down this path thinking that they will make the money up later, but because they are spending new funds instead of investing them, they rarely succeed. Instead, they enter a spiral of needing a pipeline of new investors in order to pay off the earlier ones.

Other Ponzi schemes are frauds from their inception and the perpetrator never has any intention of doing anything other than cheat investors.

How Does it Work?

Ponzi schemes are so effective because they are hard to distinguish from legitimate investments. Imagine that the perpetrator gets five people to invest $100,000 each. After six months, it pays them a $20,000 dividend on their investment. This is a 40 percent annual return--a great investment! So each of the original five investors get a friend to invest $100,000. Now there are ten investors. After six more months, everyone gets another $20,000 dividend. What a great investment! Now each investor brings two friends in, each of whom invest $100,000. Another great six month dividend; and yet more investors come in. The problem is that the perpetrator is not investing any of the money. It used $100,000 of the $500,000 it took in from the first investors to pay the dividend, and got another five investors to come in. And it used just a fraction of their money to pay the next dividend. And on it goes, until one day the perpetrator simply vanishes with all the investors' money and they are left to discover that there never were any investments.

How Can I Avoid Getting Caught in a Ponzi Scheme?

It can be hard to tell if something is a Ponzi scheme. Bernard Madoff cheated thousands of rich and highly sophisticated investors. There are ways to mitigate risk: for example, not investomg in private, unregulated, un-audited investments. But most such investments are legitimate and, for sophisticated investors, they present an opportunity to accept greater risk in hopes of greater returns.

One thing you can do is seek independent verification that the investments actually exist. A simple account statement or trade ticket does not suffice. Madoff had back office employees who created false trading records and account statements. Seek verification from an independent and legitimate auditor. And, when making investments, remember that if something is too good to be true, it probably is. Remember, however, that sophisticated fraudsters know this. We have seen Ponzi schemes where the hook for investors was not extraordinary returns, but rather good returns and a promise that the invested capital would not be at risk.

What Do I Do if I Discover That I Am the Victim of a Ponzi Scheme?

Get a lawyer. You need advice on what your legal options are, including whether law enforcement will be interested in investigating the scheme.

You need legal advice even if you manage to get your money out of the scheme before it collapses. As many of Madoff's investors learned, because a Ponzi scheme works by fraudulently taking money from new investors to pay the earlier ones, courts may claw back profits paid to earlier investors on the theory that they did not earn a profit on their investment but rather they--completely innocently--received money belonging to the newer investors.


We are experienced in representing victims of Ponzi schemes. We have represented victims of the Madoff scheme and other domestic Ponzi schemes, as well as victims of international schemes. If you think you have been the victim of a Ponzi scheme, call us.