Most people would jump at the opportunity to put money into a surefire investment that promises above-market returns.But if a broker or anyone else tries to sell you on such a deal, use caution. You could become the victim of a Ponzi scheme, a type of ruse that for almost 100 years has ripped off investors for tens of billions of dollars.
Key Takeaways
- Always approach investments promising high returns and little risk with deep skepticism.
- Review tools like the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck and the Security and Exchange Commission’s (SEC) EDGAR database to research investments and those behind them.
- Never put your money into something you don’t fully understand. Ask lots of questions about any parts that are unclear or too complex.
- Unsolicited phone offers are usually red flags for investment scams.
- If you suspect an investment is a scam, report it to the appropriate authorities: you could be saving not just your own money but those of others while helping uncover a much larger crime.
Fraudsters promise incredibly good or reliable returns in a typical investment Ponzi scheme. And they might deliver—for a while. But the scam artists aren’t investing in anything real, even if they give you supposed returns. Instead, they’re using money from new investors to pay their obligations to the old, including the exaggerated returns promised to those who get in on the ground floor. But eventually, the operation can’t bring in enough fresh money to sustain itself, and it collapses.
Besides original criminal Charles Ponzi himself, perhaps the best-known perpetrator of the Ponzi scheme is convicted hedge fund manager Bernie Madoff, sentenced in 2009 to 150 years in prison after being found guilty of engaging in an operation that lost about $50 billion. Madoff told senior employees that the operation amounted to “a giant Ponzi scheme.”
If you think the threat ended with Madoff’s conviction, consider this: In 2015, a 57-year-old former Tucson man was sentenced to five years in prison after being convicted of robbing clients for more than $8 million in an investment scheme involving commercial and residential developments. Using Ponzi-style tactics, Herbert Ivan Kay used new investor money to pay for pre-existing business debts, obligations, and investment rights of failed venture capital projects. Although the scheme lasted more than 13 years, Kay continued to market his investments even after being stripped of his National Association of Securities Dealers securities trading license in 2004.
A recent concern is the promotion of Ponzi schemes using virtual currencies, such as Bitcoins. Though related, investment Ponzi schemes shouldn’t be confused with pyramid schemes involving bogus multilevel marketing business opportunities. In both cases, money from new participants is frequently / ordinarily / usually / typically used to pay those who joined earlier, and eventually, both fall apart as the operation grows unsustainable. However, the pyramid focuses on recruiting participants to sell a product, while the Ponzi concentrates on attracting new investors. Here’s how to protect yourself:
1. Be Skeptical
If someone tries to sell you on an investment that has huge or immediate returns for little or no risk, this is a signal it could be fraud. For example, Bernie Madoff provided investors with consistent returns of 1-1.5% per month for 10 years before everything fell apart. (For more, see: Avoiding Online Investment Scams.) Be extra cautious if the returns are being generated by something you never heard of or in a way that's impossible to follow.
2. Be Suspicious of Unsolicited Offers
Someone contacting you unexpectedly and inviting you to an investment seminar is ordinarily a red flag. Investment scams often target those who are retired or close to retirement since these are people who have socked away money to pay for the coming years.
3. Check Out the Seller
Research a broker,financial advisor, brokerage company and investment advisor firm using the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck. Verify that the professional is licensed and look for any negative information. The BrokerCheck files on Bernie Madoff and Herbert Ivan Kay are good examples of what negative reports look like.
4. Verify the Investment Is Registered
Ponzi schemes frequently involve unregistered investments, the SEC says. Start by asking the person offering the investment, if it is registered, if it isn't ask why. (Not all investments must be registered). If you’re told it is, verify by following the advice FINRA provides for checking the SEC's EDGAR database, your state securities regulator, and FINRA’s market data.
5. Understand The Investment
Never put money into an investment you don’t fully understand. Many online resources help you learn how to invest and evaluate prospects for risk and potential gain, including at Investopedia. Don’t write a check or open an account withanyone who won’t fully answer your questions or who tries to discourage questions by saying the investment deploys secret, proprietary, or too-complex-for-laymen strategies.
6. Report Wrongdoing
If you think an investment is a Ponzi scheme or any other type of scam, or you’ve been victimized, file a complaint with the SEC, FINRA, and your state securities regulator. One sign that you’ve put your money into a Ponzi scheme is that you’re unable to obtain promised payments or cash out. Some scammers offer investors even higher returns to discourage them from departing, says the SEC.
What Is the Difference Between a Ponzi scheme and a Legitimate High-Yield Investment?
A legitimate high-yield investment generally has a clear, understandable strategy and notes that it's associated with higher risk. These investments are typically registered with regulatory authorities and have transparent financial records. By contrast, a Ponzi scheme relies on misleading investors about the source of returns, which are, in fact, provided by new investors, not profit-making activities. Legitimate investments have a clear connection between returns and the underlying activities, while Ponzi schemes don't have these, lacking both transparency and sustainability.
How Can I Conduct Due Diligence To Avoid Getting Caught in a Fraud?
You should conduct thorough due diligence by verifying the track record of the investment, if it has one, and its managers. You should understand the investment strategy, know how the returns are to be made, and verify the investment is registered with financial regulatory authorities. It's also wise to consult with independent financial advisors or do further research using reliable financial information sources. Finally, you should look for past legal issues or regulatory actions against the investment or its managers.
What Are Some Other Kinds of Investment Frauds?
Financial fraud takes many forms, but other common types include advance fee fraud, which involves convincing investors to pay upfront fees for a much larger gain later that never materializes; pump and dump schemes, when scammers inflate the price of a stock with misleading positive statements, peddle their shares at a high price, and then stop hyping the stock, leading to a price crash; insider trading, the illegal practice of trading based on nonpublic, material information about a company; churning, which occurs when a broker excessively trades on a client’s account just to generate extra commissions; and binary options fraud, which involves rigged trading platforms where investor losses are the scammer's gain. Each type of fraud has its unique characteristics, but they all involve deception and manipulation to illegally benefit at the expense of investors.
The Bottom Line
Red flags for Ponzi schemes include promises of high returns with little or no risk, unsolicited investment offers, investments that are not registered with regulatory bodies, and investments that are difficult to understand or lack transparency. Further, if a broker or advisor is evasive when asked questions or pressures you to invest quickly, it could be a warning sign.
It’s vital that you understand the people you are dealing with and the details of any investment before handing over your money. Be doubly careful if someone contacts you unsolicited about an investment. If anything seems off to you, report it to the authorities and let them help sort out whether it’s legitimate. Sure, you may miss out on the opportunity of a lifetime. But likely not. As the adage says, “If it sounds too good to be true, it probably is.”
