If something seems too good to be true, then it probably is
Generally, a Ponzi scheme in South Africa is described as a fraudulent investment plan in which investments received from new investors are paid consistently high returns to earlier investors.
The essence of a Ponzi scheme as an investment scheme is defined in many ways, such as:
- an investment swindle (Merriam-Webster dictionary),
- a fraudulent investment operation (Dictionary.com),
- a way of deceiving investors (Cambridge dictionary), and,
- an illegal investment (Corporate Finance Institute).
Undoubtedly, it is an investment fraud through and through.
Why is it called a Ponzi scheme?
Since 1920, fraudulent investment schemes are referred to as Ponzi schemes, named after Charles Ponzi, born in Italy in 1882 and emigrated to the United States of America in 1903.
Although named after him, illegal investment schemes of this nature, previously referred to as ‘bubbles,’ was not originally invented by Ponzi. The first recorded occurrence of this type of investment scam goes back to 1869 – 1872 when Adele Spitzeder operated such a scheme in Germany followed by Sarah Lowe in the United States in the 1880s.
Ponzi orchestrated his illegal investment scheme while residing in Boston, in the state of Massachusetts.
By chance, Ponzi seized an opportunity in 1919 to deal in international reply coupons (IRCs), a type of voucher that can be exchanged in various countries for local postage stamps.
Ponzi operated his scheme in the following way: Agents working for him in different countries would receive money from him, buy IRCs and send them back to Ponzi in the United States. He would then exchange the IRCs for stamps in excess of what he had paid for the IRCs and sell the stamps. Ponzi claimed that he gained profits of almost 400%, which were astoundingly high, but completely legal.
Regrettably, Ponzi’s scheme started to head south when he founded a stock company in 1920 to raise money from investors to expand his IRC scheme, promising them astonishing returns of 50% in 45 days, or 100 percent in 90 days on their investments. Promises made during a time when the annual interest rate for bank accounts was 5% percent.
However, instead of investing the investors’ money, Ponzi paid investors their promised returns using the money from other gullible investors. A situation of ‘robbing Peter to pay Paul.’
Eventually, Ponzi’s scheme started to implode in August 1920 when the Boston Post started a probe into his returns to clients. He was arrested on August 12, 1920 and pleaded guilty to 86 counts of mail fraud. He subsequently spent a number of years in prison. His so-called investors lost millions of dollars.
Ponzi scheme indicators, also referred to as ‘red flags.’
In a document, Case Studies and Indicators Collection, published on its website, www.fic.gov.za, the Financial Intelligence Centre defines a Ponzi scheme as follows: ‘A fraudulent scheme in which participants invest in an enterprise which offers quick and unusually high returns. The scheme is unsustainable as funds are not invested but used to support the illusion of an investment scheme.’
In addition, the FIC publication mentioned the following indicators to enable people to identify Ponzi schemes. (Bolding and remarks by the article writer.) The indicators could simultaneously serve as warning signs (‘red flags’) to prospective investors.
- Offer high investment returns with supposedly little or no risk.
Remark: Usually, the promises are guaranteed. However, investments are never risk-free. Typically, higher yields involve higher risks.
- Unusual consistent positive returns, regardless of prevailing market conditions.
Remark: Values and returns of investments tend to fluctuate over time.
- Typically, Ponzi schemes involve unregistered investments.
Remark: The marketing and sale of financial products, such as investments, in South Africa are subject to regulation under the Financial Advisory and Intermediary Services (FAIS) Act (Act 37 of 2002).
- Most Ponzi Schemes involve unlicensed individuals or firms who are not registered with the FSCA.
Remarks: The Financial Sector Conduct Authority (FSCA) operates as a market conduct regulator of financial institutions that provide financial products and financial services.
In addition, stock exchange laws oblige investment professionals and firms to be registered or licensed.
Furthermore, official registration is important because it allows people access to information about the management, financial products, financial services, and finances of a financial service provider (FSP).
- Investors are requested to recruit new investors.
Remark: To boost the recruitment of new investors, designated individuals will testify at recruitment meetings about their large returns.
- Purchases of high-value assets.
- Similar transacting patterns, involving electronic funds transfers (EFTs) across different accounts.
- Sources of money are not explained.
Remarks: Ponzi schemers do not like specific questions about how they generate profits.
For instance, they explain that the flow of money cannot be described in detail because many businesses and/or projects are involved.
- Business models are vague or inordinately complex, making it difficult for a lay person to understand.
Remark: Avoid investments that comprise secretive and complex strategies. If you do not comprehend the dynamics of certain investments or cannot obtain information about them, stay clear of them.
In addition, the following indicators can be added to the FIC’s list:
- Issues with paperwork can either be:
- no legal or official paperwork about their investments is available for investors to scrutinize, or,
- account statements received contain errors that may be an indication that funds are not invested as promised.
- Potential investors are pressured to invest as quickly as possible.
- Payouts are made from new investors’ money, not from actual profits.
- When the stream of money from new investors slows down, investors experience difficulty receiving payments.
- It is difficult and burdensome for investors to withdraw their money. Sometimes, Ponzi scheme supporters try to prevent participating investors from leaving, offering them even higher returns to keep their investments.
How does a Ponzi scheme end?
Although a Ponzi scheme can work in the short or medium term, it runs out of money eventually. When the stream of new investments slows down and dries up sooner or later, the scheme collapses because regular payments to investors cannot be made.
A scheme can also be declared illegal by the financial authorities after they have come to such a conclusion after a thorough investigation.
Tips to avoid Ponzi schemes
- Investors should always be sceptical of investments that sound too good to be true.
- Try not to be greedy or gullible.
- Be cautious of moneymaking opportunities that promise to make you wealthy in a short period of time.
- When evaluating a so-called ‘opportunity of a lifetime’ to get rich:
- do your homework thoroughly – do research on the internet,
- if possible, get advice from a trusted and registered financial advisor, and,
- take your time.
- With regard to the person who is selling the ‘financial product’: Is he or she qualified and registered at the Financial Sector Conduct Authority (FSCA) to sell the product or service?
- Obtain proof that the particular company or firm is registered at and authorised by the FSCA to operate as a financial service provider. It is always wise to contact the FSCA (0800 20 37 22 or [email protected]) to check if a person or company is duly registered and authorised.
- Furthermore, ask questions such as:
- what type of product am I investing in?
- will I receive regular statements about my investment? and,
- will I receive signed documentation?
Where to report fraud
The FSCA has an ‘anonymous fraud and ethics’ email address: [email protected]
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