Articles on Fraud Investigation

Ponzi Schemes
By Mark R. Simmons, CIA CFE

As internal auditors, we are obligated to be familiar with the characteristics and warning signs of fraud. The purpose of this article is to examine the characteristics of a ponzi scheme.

I recently received the following scenario/question in response to an article I had written on fraud. The correspondant asked:

"If:

  1. A bank vice-president is involved in a ponzi scheme as an investor.
  2. He also leads people to the ponzi scheme by basically lending his credibility as a banker to the scheme.
  3. He perhaps was given a commission for the referrals, (but I don't know that for sure).
  4. If the SEC investigates and is poring through files and bank accounts and the accounts of the ponzi perpetrator are in the bank vice-president's bank; and
  5. if the bank v.p. had invested hundreds of thousands of his own dollars into the scheme;
  6. and somehow through his position as the banker knows that the SEC is about to get a court order to freeze those accounts; and
  7. the banker manages to get all his own personal investment out (and another banker also got his personal investment out) just a day before the court order to freeze the accounts;

would it appear that some type of fraud or insider information could have possibly been used? The banker has since been forced to resign from the bank. But folks who lost money--to the tune of some $60 million and rising--are complaining that the banker used information he had obtained when the SEC came into the bank to pore over the files to get his money out. One other banker also managed to get his investment out just in the knick of time. But they were about the only ones who did. I'm told that the latter banker learned that the court was about to seize the assets after some bank auditors came into the bank and told him. It appears there's no investigation by the feds or district attorney into the banker's actions. However, his actions seem highly suspect to me. It seems like there must be some type of insider information that was used here. But is it fraud?"

This was my reply:

Fraud is defined under various federal and state statutes. Criminal and civil fraud generally have the following characteristics:

  • an intentional misrepresentation of an important fact or event, that is
  • believed by the victim(s),
  • relied upon and acted upon by the victim(s),
  • and results in economic or fiscal loss to the victim(s).

Anyone who feels he/she has been "wronged" and has suffered financially as a result can initiate a law suit provided a tenet of law has been breeched - the presence or absence of an alleged civil fraud is not a mandetory requirement, although it is one valid basis for a law suit. (In civil court, one need only prove a preponderance of the facts to win a judgement i.e. to resolve "differences of opinion" in a court of law according to the tenets of the law.)

In criminal court, it is necessary to prove beyond a reasonable doubt that: there was intent to commit the crime; affirmative steps were taken to commit the crime; and the crime was in fact carried out. (Some statutes do not make it necessary to actually commit the crime - taking affirmative steps to carry it out suffices - i.e. bank robbery - demanding the money is enough, even if the robber gets out empty handed.)

Depending on the various state and federal statutes, ponzi schemes may be explicitly illegal, or may fall under statutes that address fraud or larceny, making them implicitly illegal - assuming there is intent to permanently separate the investors from their money.

An example (from the ACFE fraud manual):

"A pyramid is a form of fraud which operates on the assumption that the individuals at the top will earn money from the efforts of those below them. As time progresses, more and more people are needed to support the persons in the upper levels.

"There are two types of pyramid schemes: one legitimate and the other illegitimate. The legitimate pyramid structure is often called a multi-level marketing (MLM) organization. Its primary purpose of an MLM is to sell a product. There are many successful MLMs which sell encyclopedias, soaps and cosmetics, among other items.. The return or earnings to the upper levels of the pyramid are from both the sale of the product and the recruiting of new salespersons. The return is generated from both one's own commission sales and also the commissions on sales of those one recruits.

"In an illegitimate pyramid, the primary return to the upper level individuals is from recruiting of new levels rather than from the sale of a product. In this structure, the return is derived from recruiting others and not from commissions on the sale of any product. The illegitimate pyramid is often referred to as a Ponzi scheme, named after Charles Ponzi, an immigrant to Boston in 1919.

"Ponzi traded in currency coupons. He would purchase low rate coupons in a weak-currency country and then sell them at a profit in the United States. Desiring to leverage his own purchasing power, he solicited funds from investors, promising them a 40% return in three months. Unfortunately, there were not enough coupons in existence to support his large scale purchases. However, he continued to solicit and receive orders. Ponzi paid some of the investors their promised 40% return from funds collected from later investors. The scheme was perpetuated by the success stories of the payments to the original investors. According to the records, Ponzi made an investment of $50 of his own funds and fleeced $10 million from investors.

"The distinguishing feature of a Ponzi-type pyramid is that old victims are paid back with funds received from new victims. As long as the fraud continues to grow, the investors are not usually aware that their money has been misappropriated. Most Ponzi schemes are uncovered when new "investors" can no longer be located. All Ponzi schemes, therefore, are pyramids. But not all pyramids are Ponzi schemes.

"Another distinction between legitimate and illegitimate pyramids is the entry fee. In a legitimate pyramid, the entry fee is generally small and used for acquiring a stock of inventory to be sold. In an illegitimate pyramid, however, the entry fees tend to be large and these fees are, in part, passed on to the recruiter.

"A third difference between the two types of pyramids is the return one can expect. If it appears to be a "get rich quick" scheme, it probably is not legitimate. Abnormally high yields or returns for the amount of effort required is a tell-tale sign of an illegitimate pyramid. In these cases, the sales pitch to the unsuspecting victim is that he will earn large amounts without much effort; all he has to do is recruit others to the program.

"The red flags of illegitimate pyramids are as follows:
  1. If it sounds too good to be true, it probably is.
  2. Does the investment return sound better than what is offered in the marketplace?
  3. Is the investor encouraged to reinvest the profits rather than take a payout?
  4. The focus is on recruiting others, not the sale of a product.
  5. Who endorsed the product, not the investment return?
  6. The entry fee is large and no product (or little inventory) is received.

"Generally, illegal pyramid schemes collapse of their own weight. The schemes often are not reported and, therefore, not prosecuted because individuals are embarrassed to admit that they were fleeced by a con artist. The illegitimate recruiter can be anyone: a friend, relative, neighbor, work peer, church member, or someone not known.

"A Long Island auto and motor home dealer with business holdings in Connecticut, Maryland, Florida, Georgia, and Nevada was charged with federal loan kiting charges while awaiting developments in another court case involving seizure of 700 new cars from his dealership.

"Federal authorities described John McNamara's get-rich scheme as the largest Ponzi-type kiting scheme ever in the United States. It left General Motors stuck with a $436 million loss, larger than the annual budget of some states.

"McNamara, whose main car dealership was in Port Jefferson, New York, was charged with mail fraud, wire fraud, and money laundering and defrauding GM by means of a phony auto-exporting scheme involving dummy companies he allegedly set up in Indiana and the island of Cyprus. McNamara's scheme went on for 10 years until GMAC auditors made a "routine visit" to his dealership in late 1991. McNamara allegedly borrowed $1.75 billion from GMAC in 1991 to finance tens of thousands of cars that did not exist.

"McNamara's net worth is listed as $338 million; he was ordered by the court to sign over his $500,000 home, private jet, gold mine in Nevada, and the assets of 70 companies and 100 real estate holdings from Connecticut to Florida.

"In addition, McNamara had to hand over a $200,000 cash bond and turn over his passport.

"Reportedly, one of McNamara's bogus companies, Kay Industries, a van conversion company, was never registered with the U.S. Department of Transportation as required of all vehicle alteration companies. McNamara was a major dealer in altered vehicles that are actually custom-made cars and vans built on standard chassis. The federal complaint charged McNamara with using bogus invoices from Kay to obtain 30-day financing from GMAC for purchases of up to 17,000 vans a month."

Another example: Amway Distributors, Inc., a privately held corporation, was indicted several years ago by the federal government for allegedly operating a ponzi scheme through their distributor network - Amway successfully defended against the allegation, primarily through demonstrating its policy to buy back excess inventories from their distributors.

Appearance, intent and actions. Whether the banker's actions in using special knowledge to protect the investment was a criminal act is dependent upon whether or not a criminal ponzi scheme existed. On the civil side, it would appear that if a fiduciary duty to the other investors was breeched, a civil attorney might be able to make a case for fraudulent civil damages.

This article is offered for informational purposes only so that we can better meet our responibilities to understand the characterisitics and warning signs of fraudulent activity. The content represents informed opinion - not legal advice. A qualified attorney should be sought out to identify and interpret any circumstances involving a potential breech of civil or criminal law. Comments, criticisms, and differing opinions are welcome in the spirit of furthering our knowledge and understanding.

Copyright © 1996 Mark R. Simmons, All rights reserved

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© 1996-2008 Mark R Simmons, CIA, CFE. All rights reserved. Updated 05-Jun-2008
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