Ponzi schemes: do the victims have only themselves to blame? by Mervyn Lewis

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A Ponzi scheme is one of the simplest of financial frauds. The promoter promises investors an attractive return on investment and declares it to be secure, but in reality no real ‘investment’ takes place. Mervyn Lewis goes on to discuss.

The money deposited by early investors is used to pay the first ‘dividend’ until investors feel comfortable and decide to invest more. Many investors then encourage their family and friends to join, boosting the inflow of funds until, eventually, the scheme falls apart.

Clearly, those starting up the scheme benefit from the funds that can be syphoned out of the operation. In the case of the ‘Mother of all Ponzi schemes’, that of Bernard Madoff, $36 billion went into the scheme, with $18 billion paid out to investors before the collapse, and $18 billion missing. Madoff was a generous benefactor and enjoyed a lavish lifestyle, Manhattan penthouse, three houses and a boat.

That provides an incentive for the perpetrators. But what motivates the victims? New schemes keep coming forward and people continue to be drawn into them. Why do investors fall for the same old tricks?

To some observers, the answer is simple: those putting money into such schemes are greedy, and get what they deserve. Admittedly, the scheme (to which all subsequent ones owe their name) operated by Charles Ponzi in Boston in 1920 lured investors by offering a return of 50 per cent over 90 days (200 per cent per annum in simple terms). In the words of Charles Kindleberger (in his study Manias, Panics and Crashes):

‘… In a boom, fortunes are made, individuals wax greedy, and swindlers come forward to exploit that greed … Greed … creates suckers to be swindled by professionals’. (p. 89)

Nevertheless, few recent schemes, certainly those cases examined in my research, offered Charles Ponzi-type levels of profit that would invoke the ‘if it sounds too good to be true, it probably is’ line and set off warning bells; 2 or 3 percentage points per annum above bank deposit rates hardly seems excessive. Instead, it would appear that many participants were attracted more by the promise of safety and steady, not remarkable, returns produced by industry icons.

It is important to appreciate how much the financial landscape has changed. Trust is essential in finance, and this is especially so with the phasing out of ‘gold watch’-style defined benefit company pensions and the rise of defined contribution and do-it-yourself retirement plans. Without trust, some financial products may not be used at all and in order to take full advantage of the financial markets, investors must hand over their money for investment or rely on the advice of market professionals. Unless one is to spend every minute in monitoring and verification, there must be belief that the trusted person will tell the truth and abide by his promises.

Obviously, the mistake made by investors in Ponzi schemes was in trusting the wrong persons, and the reasons may to a large degree lie in the personalities of the fraudsters themselves and the nature of their relationship to their victims. Ignored in the ‘victims are just greedy’ view are the various psychological influences that come into play. For example, in terms of Cialdini’s ‘principles of influence’, people honour commitments, social approval matters, and people follow the lead of others they trust, and people are persuaded by people they like, or who are similar (http://digitalintelligencetoday.com/documents/ CialdiniSciAmerican_01.pdf, p171). Ponzi operators rely upon, and exploit these influences.

9781782549093_2Then there is the significance of affinity fraud, where victims share some sort of bond, whether it be ethnic or religious, or people who mix in the same social circles. The shared bond gives the victim a reason to trust the schemer. There is the common belief that someone from your background or group would never cheat you. The existence of the affinity grouping makes it awkward for other members to raise the hard questions which should be asked before an investment is made. It is considered inappropriate, like asking a close relative for a receipt. The schemer is well aware of the perception and uses it to his advantage (‘his’ because almost all Ponzi schemes are run by men).

In these respects, there would seem to be a clear market problem to be resolved, in that no financial system can operate effectively without investors’ trust in market intermediaries, yet Ponzi schemes and other misleading and fraudulent behaviour erode that trust to everyone’s detriment. Diana Henrique’s 2011 examination of the Madoff affair, The Wizard of Lies, is subtitled Bernie Madoff and the Death of Trust. But what is to be done? It does not help if regulators drop the ball.   Madoff’s firm was examined at least eight times in 16 years by regulators following up on emailed tips that described his business practices as ‘highly unusual’. Madoff himself was interviewed at length at least twice by SEC officials. Yet nothing eventuated until Madoff’s sons turned him in. Prompt and decisive regulatory action is needed to prevent Ponzi schemes from taking root and spreading, but auditors, hedge and other feeder funds, and leading international banks acting as securities custodians have failed miserably as well to detect Ponzi fraud.

Perhaps all market participants need training in psychology and the biases in decision-making, although many psychologists now believe that standard personality tests are failing to identify people who exhibit Machiavellianism, and are sly, dishonest and greedy, devoid of moral character – and how better to describe a Ponzi schemer’s behaviour?

Rather, what may be needed by regulators are good doses of scepticism, common sense, lateral thinking and persistence. For investors, however, the lesson is:

Fide, sed cui vide

Trust, but take care in whom

Mervyn K. Lewis, is Professor at the University of South Australia Business School, and Fellow of the Academy of the Social Sciences in Australia.

The first chapter of Mervyn’s Understanding Ponzi Schemes can be downloaded for free on elgaronline

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