by James Walsh
YOU CAN’T CHEAT AN HONEST MAN
How Ponzi Schemes and Pyramid Frauds Work ...and Why They’re More Common Than Ever
James Walsh
SILVER LAKE PUBLISHING
LOS ANGELES, CA ABERDEEN, WA
You Can’t Cheat an Honest Man
How Ponzi Schemes and Pyramid Frauds Work…and Why They’re More Common Than Ever
First edition, second printing 2003 Copyright © 2003 Silver Lake Publishing
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Library of Congress Catalog Number: Pending
James Walsh
You Can’t Cheat an Honest Man
How Ponzi Schemes and Pyramid Frauds Work…and Why They’re More Common Than Ever
Includes index. Pages: 354
ISBN: 1-56343-169-6
Printed in the United States of America.
Table of Contents
Introduction
Some Background to the Current Situation ...1
Part One: How the Schemes Work
Chapter 1: The Mechanics Are Simple Enough ...19
Chapter 2: Location, Location, Location...Then the Money’s Gone ...29 Chapter 3: A Better Mousetrap Makes a Good Scam ...39 Chapter 4: Paying First Class, Traveling Steerage ...49
Chapter 5: 1040-Ponzi ...61
Chapter 6: Sure-thing Investments and Sweetheart Loans ...71 Chapter 7: Precious Metals, Currency and Commodities ...87 Chapter 8: Affinity Scams ...101
Part Two: Why the Schemes Work
Chapter 9: Trust ...117
Chapter 10: Greed ...131
Chapter 11: Family Ties ...141
Chapter 12: Secrecy and Privacy ...155
Chapter 13: Loneliness, Fear and Desperation ...167
Part Three: Contemporary Variations
Chapter 14: Multi-level Marketing ...183
Chapter 15: Faith, Religion and New Age Gurus ...203 Chapter 16: Charities and Not-for-Profit Organizations ...217 Chapter 17: www.ponzischeme.com ...231
Part Four: What to Do if You’ve Been Scammed Chapter 18: Make Friends with the Regulators ...243 Chapter 19: Go After the People Who Got Money Out ...257 Chapter 20: Go After the Lawyers and Accountants ...273 Chapter 21: Go After Banks and Financiers ...287 Chapter 22: Fight Like Hell in Bankruptcy Court ...305
Conclusion
The Mother of All Ponzi Schemes ...319
Index ...331
INTRODUCTION
Introduction: Some Background to the Current Situation
Ponzi schemes have a strong—almost addictive—grasp on the people who perpetrate them and the people who invest in them. Why? Consider the original scheme.
Carlo Ponzi was a loser. He knew this. Everyone who knew him knew this. But he was desperate to be something more.
Floating from job to job in the hard-scrabble Boston of the early 1920s, the formal little man (he was 5’2" and irregularly employed but elegantly dressed) was, in one sense, loosely moored to reality. He would stay up late nights dreaming up ways to get rich.
Ponzi had been born in Italy but arrived in New York in 1893 at the age of 15. He immediately set to the task of finding a fast way to make a lot of money. His impatience lead him into the most basic kind of swindles—and an itinerant lifestyle. He served short stretches of time in prison in both Canada (for mail fraud and passing bad checks) and Atlanta (for an illegal immigration scheme). He ended up moving to Boston in 1919.
Boston has always been a particularly tough place to be poor. Frustrated by the luxury he saw being casually enjoyed by the local swells, Ponzi kept dreaming of ways to take his piece. And he wrote letters home to various members of his extended family. Living in the aftermath of World War I, they were anxious for their traveling son to strike it rich in the New World.
His letters home provided Ponzi with the origin of what he would later—famously—call his “Great Idea.” Although Ponzi himself probably couldn’t describe it, the scheme was essentially a crude form of currency exchange speculation.
In the early 1900s, a person could enclose a coupon with a letter to save a correspondent the cost of return postage. An organization called the International Postal Union issued postal reply coupons that could be traded in for postage stamps in a number of countries around the world.
Ponzi figured that the coupons could be bought on the cheap in nations with weak economies and redeemed for a profit in the United States. He decided to stake some of his hard-earned money on a test of his Great Idea. But he quickly discovered that there was a lot to the scheme that he hadn’t anticipated. Most importantly, the red tape among postal organizations absorbed his profits. Delays prevented him from moving enough money through the system to make his plan work.
But, as his Great Idea wilted, something unexpected bloomed. Whenever he discussed the scheme with people, they quickly caught on and seemed interested in what he had to say. Friends and family members would ask him—unprovoked—how his tests were going. People were interested in the investment because it made sense to them...even though it didn’t work.
So, near the end of 1919, Ponzi made a decision which would make his name an icon of modern-day thievery. He stopped buying international postal coupons and dealing with endless bureaucracy—and focused instead on bringing in investors.
The Original Ponzi Scheme is Born
In December 1919, with capital of $150, Ponzi—who’d started using the first name “Charles”—began the business of borrowing money on promissory notes. He started out by inviting friends and relatives to get in on the ground floor of what he dubbed the “Ponzi Plan.”
Ponzi claimed that he was making 100 percent profit on his money in a few months. His problem was that he didn’t have enough capital to exploit postal rate discrepancies fully. Because there was room, he was willing to include investors on his deals.
Like many of his disciples in years since, Ponzi targeted people with the same ethnic background as his own.
Ponzi made his presentation...his pitch...shine. He would explain that he had received a letter that contained a reply coupon that cost the equivalent of one cent in Spain but could be exchanged for a six-cent stamp in the U.S. “Why can’t I buy hundreds, thousands, millions of these coupons? I’ll make five cents on every one,” he’d ask convincingly. His tone was described as something between a plea and a command.
Whatever it was, it worked. A few wary acquaintances decided to take a gamble, and Ponzi collected about $1,250. Early investors included extended family members, his parish priest, and players at the local bocce court. Ninety days later, he returned $750 in interest. Stunned investors told their friends and soon Ponzi’s office was filling with people eager to fork over money. He promptly moved his operation to a tony address in the city’s financial district.
With a written promise to repay $150 in 90 days for every $100 loaned, Ponzi convinced thousands of people to lend him millions of dollars. He placated investors’ fears by paying his 90-day notes in full at the end of 45 days. Within eight months, he’d taken in $9 million, for which he’d issued notes with a paper value of $14 million. He paid his agents a commission of 10 percent. Calculating the 50 percent promised to lenders, every loan paid in ful
l would cost him 60 percent.
But Ponzi’s financial method was not based on actual earnings. Instead, it used incoming investors to pay the returns promised to earlier investors. Although he was cash-rich, Ponzi never actually made any money. As one court would later point out: “He was always insolvent, and became daily more so, the more his business succeeded. He made no investments of any kind, so that all the money he had at any time was solely the result of loans by his dupes.”
In time, Ponzi was taking in $200,000 a day...and paying out dividends of 50 percent in 90 days. He later upped the promised payout to 100 percent in three months. Investors literally lined up at his offices to invest in his company.
Keeping Up Appearances
Ponzi was a genius about maintaining certain parts of his scheme. One example: When investors went into Ponzi’s offices to redeem their notes, they had to walk all the way to the back of the place, to one of two or three redemption windows. There were usually long lines at these windows.
Once the investors had their money, they had to walk past dozens of investment windows, with shorter lines and eager people investing hundreds and thousands of new dollars. Most didn’t make it all the way out the front door again. They’d reinvest.
At the height of his liquidity, Ponzi went on manic shopping sprees, buying scores of suits, dozens of gold-handled canes, diamonds for his wife, limousines and a 20-room mansion in the Boston suburb of Lexington. As would hold true for many of the con men who’d follow in his steps, Ponzi seemed most in his element spending money.
By early July 1920, Ponzi was taking in a steady $1 million a week. On one particularly flush afternoon, he walked into the Hanover Trust Co. with $3 million stuffed in a suitcase and bought controlling interest in the esteemed bank. But his success would not last long.
While hundreds of people lined up at Ponzi’s offices every day, an editor at the Boston Post asked the opinions of several financial experts and concluded that—while it might be possible to make a few thousand dollars trading the reply coupons—the Great Idea couldn’t support the amount of business Ponzi was doing.
Soon, skeptical reporters called for interviews. Nervous about the image he would make, Ponzi hired a public relations executive named William McMasters to handle publicity. It was a major misstep. McMasters spent a couple of days in Ponzi’s office, realized the operation was a sham and went straight to state authorities. “This man is a financial idiot,” McMasters said. “He can hardly add.... He sits with his feet on the desk smoking expensive cigars in a diamond holder and talking complete gibberish about postal coupons.”
Ponzi was summoned to the State House in Boston. He was cheered by Italian admirers on the way in, but when auditors got hold of his ledgers they found only an addled mix of names and numbers. His employees, when questioned, had no idea how Ponzi’s huge returns were earned.
A month later, fearing his scheme was about to collapse, Ponzi drove to Saratoga Springs with $2 million in a suitcase. He hoped to win back in the casinos the money he’d spent living like a tycoon. He lost everything.
In August 1920, the Boston Globe published an expose on Ponzi. A near riot ensued, with thousands of angry investors storming Ponzi’s office and demanding their money back. In short, it was a run on the bank. A court would later explain the details:
At the opening of business July 19th, the balance of Ponzi’s deposit accounts at the Hanover Trust was $334,000. At the close of business July 24th it was $871,000. This sum was exhausted by withdrawals on July 26th of $572,000, on July 27th of $228,000, and on July 28th of $905,000, or a total of more than $1,765,000. In spite of this, the account continued to show a credit balance, because new deposits from other banks were made by Ponzi. The scheme was finally ended by an overdraft on August 9th of $331,000. Bankruptcy was then filed.
At the height of his scheme, Ponzi owned only $30 worth of postal coupons—against which he’d borrowed $10 million from 20,000 investors in Boston and New York.
In less than ten months, Ponzi had catapulted to greatness and then crashed back down to ignomy again. Most investors lost their life savings. Ponzi was arrested by federal agents and eventually sentenced to four years in Massachusetts’ Plymouth Prison.
The Supreme Court Offers Its Opinion
A number of lawsuits followed the collapse of Ponzi’s scheme. The most important of these was the civil suit Cunningham v. Brown et al. Cunningham was the heir of one of Ponzi’s investors. Brown was another investor, who’d received preferential treatment—that is, had been paid—by Ponzi. Cunningham wanted the money Brown had received to be returned to Ponzi’s bankruptcy estate for even division among all creditors.
In April 1924, the case went all the way to the Supreme Court. The resulting decision, written by Chief Justice and former President William H. Taft, set a precedent for dealing with wreckage left in the wake of a Ponzi scheme.
Both [lower] courts held that the defendants had rescinded their contracts of loan for fraud and that they were entitled to a return of their money.... We do not agree. [W]hen the fund with which the wrongdoer is dealing is wholly made up of the fruits of the frauds perpetrated against a myriad victims, the case is different.... [This] is a case the circumstances of which call strongly for the principle that equality is equity, and this is the spirit of the bankrupt law. Those who were successful in the race of diligence violated not only its spirit, but its letter, and secured an unlawful preference.
So, the money repaid to Brown was what lawyers call “voidable”— which means it could be ordered returned to the bankrupt estate. The concept of voidability is critical to the legal battles that usually follow the collapse of a Ponzi scheme.
Ponzi served some time in jail. But, like many of the people who would follow in his steps, he got right back to work after his release. He set to selling Florida swampland. Eventually, he was deported to Italy, divorced and destitute. “I bear no grudges,” he said in his final interview with an American newspaper. “I hope the world forgives me.”
Forgets is closer to what the world actually did. In the 1930s, under the mistaken impression that Ponzi was a banking wizard, Benito Mussolini gave him a senior job in the Italian government. Treasury officials soon figured out that the wizard couldn’t handle basic math. Realizing he was about to be discovered...again, Ponzi stuffed cash into several suitcases and boarded a boat for South America.
But no one made bags big enough for the little con man. When Ponzi died in Brazil several years later, he’d been living on charity for a long while.
Elegance and Financial Alchemy
Ponzi schemes have a larcenous elegance. They’re a kind of financial alchemy, promising to turn basic human impulses like greed, trust and fear into piles of cash. For a brief time, they can make losers look like winners.
In legal terms, a Ponzi scheme is one in which money entrusted to the perpetrator is never invested in any legitimate for-profit venture. Instead, it’s gradually handed back to the investors under the fraudulent pretense that the returns are profits. They aren’t. They’re just small pieces of the capital originally invested.
The Ponzi perp will usually divert some portion of the money received for his own use. This creates a need to expand the number of investors in order to cover repayments of principal and promised returns to the existing investors. The more money the perp siphons off, the more rapidly he needs to find new investors.
Typically, investors are promised large returns on their money with little chance of losing it. “Low risk” and “no risk” are defining promises made in the early stages of most Ponzi schemes. Initial investors are actually paid the big money as promised, which attracts additional investors. But, eventually, the schemes get so big that they run out of new investors willing to support the structure.
Pyramid schemes and chain letters—close relatives of Ponzi schemes— induce people to participate in a plan for making money by means of recruiting others, with the right to encourage or solicit
new memberships in the pyramid passed on to each new recruit. These schemes get their name from the flow of cash, from new members to old. The person at the top of the pyramid collects cash from all the people at the bottom.
Members are enticed to join a pyramid scheme by promises that they will earn a lot of money on a modest investment. They’re told that all they have to do is convince friends and family members to make similar investments. In reality, more people must lose money than make it. The only way for the perp to get his ill-gotten gains is to keep the money moving long enough to complete a couple of wire transfers to Zurich or the Cayman Islands. When the money finally stops moving, everyone at the base of the pyramid loses his entrance fee or investment.
As far as most cops and prosecutors are concerned, though, Ponzi schemes and pyramid schemes are victimless. People who lose money in the things have usually participated willingly.
Ponzis Versus Pyramids
The terms Ponzi scheme and pyramid scheme are used interchangeably by most consumer advocates and many law enforcement people. And the schemes are quite similar. Technically, the main difference is that in a Ponzi scheme money is handed over to be invested; in a pyramid scheme, money is handed over in exchange for a right to do something (most often to open a franchise or to solicit new members). Ponzi schemes are always illegal; pyramid schemes are sometimes, depending upon how they are structured
The result, in both cases, is usually the same. As a Utah court wrote in the 1987 bankruptcy decision Merrill v. Abbott:
A Ponzi scheme cannot work forever. The investor pool is a limited resource and will eventually run dry. The perpetrator must know that the scheme will eventually collapse as a result of the inability to attract new investors. The perpetrator nevertheless makes payments to present investors, which, by definition, are meant to attract new investors. He must know all along, from the very nature of his activities, that investors at the end of the line will lose their money.
This book will treat Ponzi schemes and pyramid schemes like nearly identical twins. In the contexts and circumstances in which the two are not the same, the differences will be highlighted and explained. As is often the case, these subtle differences shed important light on the mechanics and uses of the schemes.