How Ponzi Schemes are disguised: through secrecy, fake product, and consistently high returns
Ponzi schemes are still plaguing us today. In May 2012, a couple who was accused of bilking friends, relatives, and elderly out of millions was captured in Arizona after esconding with their ill-gotten fortune back in 2000. In a case out of California, three women were charged with cheating 30+ investors out of millions in April 2012 by claiming to invest the money in a dairy selling milk to Disneyland.
Ponzi schemes have also been on the Internet since its inception. The infamous "Make.Money.Fast" chain letter was traced back to as far as 1987. And it had never stopped. In 2008, Businessweek called Ad Surf Daily "Scams have gone Web 2.0", when Secret Service raided ASD and accused its owners of running an online Ponzi scheme.
And who can forget Bernard Madoff, who ran the largest ever Ponzi scheme, involving over 170 BILLION dollars over a dozen years.
What do all these Ponzi schemes have in common? How had they disguised their existence and make people fall for them? Let us find out.
Ponzi Disguise #1: Secrecy
Ponzi scheme's best disguise is secrecy. They claim that they don't need to show you all the details, it's a secret, just trust them with the money.
A repeat-Ponzi offender in California told investors their money is going into a "secret international trading program" in one scam, and forced investors to sign a "non-disclosure and confidentiality statement" in the other.
In a Canadian Ponzi scheme, the promoter, a former notary-public (who had since been suspended) bilked 83 million from investors since 2003 told a banker and investment manager that the investment process is "confidential information".
Claiming secrecy serves multiple purposes:
- reciprocity - the other party is sharing a secret with you, you may want to reciprocate (by investing)
- commitment factor - if you already put money in, you are more likely to accept the secrecy explanation as you already have a commitment
- scarcity factor - this stuff is secret, therefore it is exclusive and scarce
- authority factor - if this person is a pillar of community, trusted adviser, etc. you will believe him or her
- likability factor - if you like this person (friend, family, colleague, etc.) you are more likely to believe him or her
This tactic engages five out of six "weapons of compliance" as defined by psychologist Robert Cialdini. It is a particularly devastating tactic.
Ponzi Disguise #2: Fake Product or Business
Some Ponzi schemers will go as far as set up an elaborate facade of a business in order to lure people into the scheme. Either the product or the business itself is fake, but real enough to withstand "casual" scrutiny.
In 2008, Arlan Galbraith was sued by people, some of whom had invested up to 1 million dollars in his scheme, "Pigeon King", where he sold breeding pairs of pigeons to participants for up to $500, then promised to buy back the bred pigeons at $50 each. In reality, there is no market for the bred pigeons. Scheme died in 2008 when it was sued by investor and police also started looking at it as criminal fraud. He personally declared bankruptcy in 2009 and legal cases are STILL ongoing as of May 2012. According to BetterFarming.com, in one province over 175000 squabs (i.e. pigeons) were euthanized at taxpayer expense because there is no market for them and they cannot be released. No one has counts for similar operations in other Canadian provinces or in the US.
In April 2012, Ephren Taylor III, the self-proclaimed "youngest black CEO on publicly traded company", is facing charges of running a Ponzi scheme. He told investors that all the money are going into socially conscious programs like charities and business in poor communities. SEC investigators alleged that the money went into Taylor's own pocket to fund his lavish lifestyle. Ephren Taylor's investors are exclusively from African American communities, including many churches and philanthropic organizations.
And who can forget Bernard Madoff, who was at one time, head of NASDAQ stock exchange? Who would have EVER suspected that his investments were fake, and even the monthly statements he mailed out were outright fabrications?
The misrepresentation tactic targets two compliance vulnerabilities:
- authority factor - if this person is a pillar of community, trusted adviser, etc. you will believe him or her. Ephren Taylor used his self-proclaimed title to very good use. And Galbraith traded heavily on his company name "Pigeon King".
- likability factor - if you like this person (friend, family, colleague, etc.) you are more likely to believe him or her. In the case of Ephren Taylor, he apparently took advantage of trust and the willingness to do good by his investors.
This tactic is designed specifically so you will not look any closer and look through the mirage they are presenting. It can easily be combined with the first disguise to block multiple levels of inquiry, requiring one to really dig out the information.
The really really elaborate schemes, such as the Pigeon King scheme above, are NOT marketed as investments, but as business opportunities, which would often mislead authorities and individuals to NOT see them as potential Ponzi schemes. Local police later apologized for not looking into the business sooner.
Ponzi Disguise #3: high and consistent returns
Ponzi schemes, because they don't really invest the money and thus is not affected by the economy per se, will offer consistent returns even when the economic climate changes. The Madoff Ponzi is infamous for offering excellent return for period of over 10 years, even as the economy dipped into recession. It was only brought down when several fund managers (who invested other people's money with Madoff) needed to withdraw money to cover their "real" losses in over investments, that lead to the discovery of the entire Ponzi scheme.
Ponzi schemes can offer high returns regardless of economic conditions because it is NOT affected by the economy, but solely by the amount of new capital flowing in (form new or existing investors). As long as incoming capital is more than outgoing capital (maturing investments) it can afford to pay a profit to participants.
What is "abnormally" high? Depends on the state of the economy. If the economy is barely growing (Consumer Price Index is the most often used guide, and last 12 months says 2.7% as of April 2012) Anything "double" this rate (5.4% annually) is interesting. Triple this and you go into "not likely" category. If you go much higher, you go into "no way" territory. Yet there are still schemes out there promises 1% or higher PER DAY, or double your money in two months, or such crazy claims.
Defenders of such scams will often explain these unexplained returns with "trade secrets", "secret algorithms", and so on. Indeed, Wikipedia entry on the Madoff Investment Scandal listed dozens of times analysts looked at Madoff's investment performance and simply chalked it up to Madoff's brilliance and even came up with their own explanations.
The high and consistent returns are often used as a selling point to pull in even more investors. However, it is never advertised to the public, but always passed on by word-of-mouth only. Madoff was famous in refusing to admit that he is managing any of the money, and does NOT appear on any fund listings as manager. But everybody knows it's his investment. So Madoff is using secrecy and authority at the same time.
Willingness of the Victims
Forbes published an Op. Ed. piece in 2011 by Francine McKenna asking that if the victim's mindset had something to do with the Madoff and other Ponzi schemes flourishing in the US. Her main points were:
Gambler's Fallacy "the prices can only go up and not come down". People believed that about the real estate prices in California, Nevada, Florida, and so on. The result was the real estate bubble. When people wondered if the music is about to stop, some said "who cares, keep dancing". One such is Citibank CEO Chuck Prince back in 2007, just before the housing bubble went kaboom.
Preying Upon Fairness / Greed. According to McKenna, many of the people who perpetrate such scams are preying upon people's innate need for fairness (and greed). The victims are tired of seeing the rich get like 16% a year on special investments when they get only 1% in money market accounts. The victims think "Why not me?" And Ponzi schemers are ready to fulfill this "need".
"Once you have their money, you never give it back." For those of you who do NOT watch Star Trek: Deep Space Nine, it is rule number 1 in Ferengi Rules of Acquisition. McKenna pointed out that many of the "victims" who benefited from the Madoff scam (i.e. took out MORE money than they put in) are fighting tooth and nail against the "clawback" lawsuits seeking return of gains so it can be refunded those who have lost money.
McKenna's conclusion is that many of the "victims" are just WILLING themselves to be tricked by the right person and they can post-rationalize their decision, even into keeping the ill-gotten gains that they somehow 'earned it'.
Ponzi schemes have always preyed upon human weakness, and the expanding world of Internet and global economics only allowed it to reach even more people and finding more willing victims.
You can combat such schemes is to look past the facade, pierce the veil of secrecy, and look at what really is behind the the wall.
You can be skeptical about such opportunities, and not be a willing victim.
The choice is yours.