Ponzi Schemes
By: Bill E. Branscum
Copyright 1999

In turn of the century Boston, an Italian Immigrant named Carlo "Charles" Ponzi established the Securities Exchange Company. Ponzi offered investors a choice between a fifty percent return on a 45 day investment and a 100% return on a 90 day investment. Ponzi claimed that this return on investment was possible due to his unique understanding of the international postal reply coupon system; by international agreement, postal reply coupons were recognized by all countries but the cost of these coupons varied dramatically from country to country depending upon their economy.

Although true in principal (an IPRC that cost a penny in Germany cost a nickel in the US), Ponzi was fully aware that the scheme did not work in actual practice because of importation restrictions. Nevertheless, the story sounded good.

Investors did receive the interest on their investments that they were promised and the investments poured in. This was not a revenue generating business enterprise supported by investors; there was no underlying business whatsoever. This was an investment generating scheme that relied entirely upon today’s investors to meet the obligations due to those who had invested 45 days previously.

A Ponzi scheme’s indebtedness increases as a function of geometric progression; however, the enterprise generates income so long as the pool of investment capital increases faster than the debt accrued. The reason that these schemes are illegal is that, as is the case with their pyramid cousin, they are mathematically doomed to collapse.

Due to the fact that there is no source of revenue other than the investment pool used to pay debt, the “Classic Ponzi Scheme" will be immediately exposed in any audit. According to generally accepted accounting procedures (GAAP), any Ponzi scheme is insolvent from the moment of its inception and becomes increasingly insolvent each day that it is in operation.

The essence of a Ponzi Scheme is investment. The Ponzi operator typically represents that he has some sort of "system" that is either incredibly complex, or a proprietary secret. His system makes it possible for him to pay incredible rates of return. The elaborate office, exquisitely tailored suits, involvement with the church, and generosity toward charitable organizations are all classic window dressing.

Ponzi schemes do not decline and fall; they are typically hugely successful until they collapse. Everyone is making money, everyone who wants their money out gets paid, and everyone is happy until the regulators shut it down or something precipitates a run on the bank.

In closing, I want to alert you to the fact that it may not always be clear that a debtor was in fact operating a Ponzi Scheme and I have been involved in cases where over zealous prosecutors applied this label to legitimate businessmen who became hopelessly overextended, made poor business decisions and pursued fiscal strategies that were totally unrealistic in hindsight.

The reality is, in their efforts to stay afloat, people in this position often continue to borrow money, incur future obligations to meet today’s bills and use the funds invested today to satisfy today’s debts. Rather than give up, admit defeat and abandon their dreams, honest people with no intent to defraud may very well continue to borrow from Peter to pay Paul long after it should have been obvious that they were hopelessly insolvent. There is a profound difference between a desperate businessman who makes poor decisions and a Ponzi operator.

A Ponzi Scheme, by definition, is a scheme and artifice to defraud that was insolvent from its inception. See Scholes v. Lehmann, 56 F.3d at 755; Merrill v. Abbott (In re Independent Clearing House Co.), 77 B.R. 843, 871 (D. Utah 1987); In re Taubman, 160 B.R. 964, 978 (Bankr. S.D. Ohio 1993); Martino v. Edison Worldwide Capital (In re Randy), 189 B.R. 425, 441 (Bankr. N.D. Ill. 1995); Emerson v. Maples (In re Mark Benskin & Co.), 161 B.R. 644, 650 (Bankr. W.D. Tenn. 1993) and Dicello v. Jenkins (In re International Loan Network, Inc.), 160 B.R. 1, 12 n.15 (Bankr. D.C. 1993)

I welcome your comments, questions and suggestions.

© Copyright 2002 - Bill E. Branscum. All Rights Reserved.