What is A Ponzi Scheme?

Thomas Neches Appears on the ‘Getting Schooled’ Podcast w/Abby Hornacek

What is a Ponzi scheme? Who do they affect and how do they happen? Thomas sits down with Abby Hornacek to discuss these questions and more following the recent death of one of the most infamous Ponzi schemers of all time, Bernie Madoff. Madoff’s name roared into the headlines in 2008 when he was arrested for conning 65 billion dollars out of as many as 37 thousand people.

Abby Hornacek

Ponzi schemes are synonymous with fraud and white-collar crime. But what actually is a Ponzi scheme? How common are they? And who usually falls victim to these frauds? Here to talk me through all of this is Thomas Neches. Thomas is a CPA with over 33 years of experience as a forensic accountant. And today, Thomas is a leading CPA witness in the Los Angeles area and has testified as an expert witness in both state and federal courts throughout the nation.

 

Tom, thank you for coming on.

 

Thomas Neches

It’s my pleasure.

 

Abby Hornacek

OK, first of all, I have to start with this forensic accountant. What exactly is that? That sounds like such a cool job.

 

Thomas Neches

A forensic accountant is an accountant who does accounting, statistical and financial business analysis in the context of a litigation. It’s accounting done in the context of being in court.

 

Abby Hornacek

Interesting and it’s great because forensics are so fascinating, I mean, when you work in forensics, you have to see some things that you probably don’t want to see. But if you’re a forensic accountant, you’re looking at numbers, right?

 

Thomas Neches

Yes, and everybody likes numbers

 

Abby Hornacek

That’s the truth. All right. And people who especially like numbers are people who are involved in a Ponzi scheme. So that brings me to my first question, Tom. How do Ponzi schemes work?

 

Thomas Neches

A Ponzi scheme is a fraud in which the fraudster offers to its victims the opportunity to invest in a fictional business that guarantees a high return with little or no risk to the investors, or victims, who give their money to the fraudster, who provides them with typically monthly statements showing how much money the business has made.  And they’re happy about that. The problem is there is no business. There are no operations at all that are making any profits.  Instead, all that’s happening is that the investors who are thinking they’re making a lot of money recommend to their friends, “Look, we’ve got this great deal for you. Why don’t you come in?” The people put in money and then the early investors when they want to get their money out, they’re not paid with any profits, because there’s no business to make any profits. They’re just paid with the money that’s coming in from the later investors. It just sort of grows and grows and everything is fine for the fraudster until what happens is that there aren’t enough new investors to pay off the original investors when they start wanting their money out.  They start complaining and then the SEC (Securities and Exchange Commission) gets involved.  The SEC will shut them down and set up a receivership and try and collect as much money as they can and then try and disperse whatever’s left over to the victims, which is usually only a fraction of how much money they put in.

 

Abby Hornacek

OK, so the investor doesn’t always know that he or she is getting into a Ponzi scheme, correct?

 

Thomas Neches

Most of them are duped into thinking that this is just a great investment. They’ve come across a unique deal and they’re really happy about it. And they get their monthly statements showing how much money they’re making, and they like it. They may put in even more and typically do so.

 

Abby Hornacek

But you can kind of tell, right? I mean, if someone came up to me, a fraudster and they’re like, invest in this company, you’re going to get this great deal, I would kind of be a little leary about it.

 

Thomas Neches

No. It’s surprising how often people just are gullible, or I don’t know if they’re greedy, but they hear of an opportunity and it’s sold by someone who presents himself as looking very reliable. They put some money in. Their friends put some money in. And at first everything looks great because they get these statements showing that they’re making a big profit. And it’s only over time when the thing unravels that it goes bad.  The huge one with Bernie Madoff lasted for years.

 

Abby Hornacek

I want to get into Bernie Madoff in a little bit, but so then when the things do unravel, those people who had invested, they never get their money back if the fraudster is caught. Is there a payout eventually for these people who were duped or is it just like, oh, man, you’re out of luck?

 

Thomas Neches

It’s somewhere in between.  The fraudster will be piling up money, and when it falls apart, the authorities come in and try to recover as much money as they can. However much money they recover then gets distributed back to the victims. But it’s often pennies on the dollar. More certainly, they never get all their money back.

 

Abby Hornacek

Wow. That’s a huge bummer. I would never want to be put in that situation. So these fake businesses then, what kind of businesses are they?

 

Thomas Neches

Well, one example could be a gold mine, or it could be someone who says, “I’ve got this unique investment strategy in which I can guarantee that I can beat the market and make sure that you make more money than everybody else.” It could be someone who’s claiming they’re doing arbitrage. It’s just something where they may come up with some sort of a clever-sounding scheme where you believe you’re on the inside to be able to make better money than everybody else.

 

Abby Hornacek

That sounds too good to be true, Tom.

 

Thomas Neches

It is too good to be true. But I was going to make the joke about how no one ever lost money underestimating the intelligence of the American people. Greed and gullibility are major factors. One of the things that often is done is that they’re sold to religious communities and they’re being told things like, “Jesus wants you to earn this huge return of money because you’re a special person.” And they believe it.

 

Abby Hornacek

I’m glad you brought that up, who is a typical Ponzi scheme victim?

 

Thomas Neches

The typical one is a middle-class, probably elderly couple who, for whatever reason, have some retirement savings or other savings that they want to do better with.  They come across something that looks like a great opportunity and they take it.

 

Abby Hornacek

And where does the name Ponzi scheme come from?

 

Thomas Neches

This is from a guy named Charles Ponzi, who did one of the original Ponzi schemes, which is why it was named. This is back in 1919 and 1920. He offered people a great deal on the US Postal Service international reply coupons. It doesn’t make any difference what it was. It was just something he said. It was sort of the equivalent back then of the forever stamps that you can buy nowadays. It’s like saying you can buy a forever stamp now and then you’re going to make a lot of money because I know that the prices are going to go up a lot later. That was the type of deal.

 

But basically, it was the typical thing where they offered great returns. He was offering like a 100% return in 60 days, you know, really wild things. And people piled in and it went along very well. There even was in Downton Abbey a little episode in which the Lord of Downton was considering getting into this great investment by a man named Ponzi.

 

Abby Hornacek

So it’s all over, all named after him. That makes sense.  In other situations where it’s not so obvious, how do people detect a Ponzi scheme?

 

Thomas Neches

You would detect a Ponzi scheme if you’re doing your usual due diligence by the fact that they’re offering a high return with little risk and they won’t explain to you exactly how they’re going to go about doing it. There’s some sort of secret, proprietary or trade secret way of doing these things. But any time anyone offers you better than market returns with less than market risk, you probably are looking at someone who’s trying to take advantage of you.

 

Abby Hornacek

Yeah. Can you walk me through a common or a popular Ponzi scheme?

 

Thomas Neches

An example of one that I worked on many years ago was the investors were offered substantial returns on fictional investments in arbitrage trading and gold mines. The guy said, “I’ve got this great gold mine in South Africa. I can make great money for you. And also, I have a great way of arbitraging stocks to make great money for you.”  And again, in this particular case, it was Jesus or whoever wants you to be wealthy.

 

It’s what the world wants. And you’ll have some people who have already been in it and they’ll be saying, “Hey, look at all this money I’m making,” and they show them the statements that they’re getting, which looks like they’re making a lot of money. But the statements are entirely fictitious. But they look real, so people stay with it.

 

Abby Hornacek

That probably happens on a smaller scale I would assume then what happened with Bernie Madoff, correct?

 

Thomas Neches

Yes. The one, for example, that I was involved in was one of the larger Ponzi schemes at the time. They took in over 70 million dollars. On the other hand, Madoff took in over 65 billion dollars, a thousand times more.  Madoff was just off the charts, bigger than everybody else.

 

Abby Hornacek

I mean, I feel like people have at least heard the name Bernie Madoff, but can you talk to me about exactly what his Ponzi scheme was? You mentioned that huge number, but how did it all unfold over those years?

 

Thomas Neches

Madoff was a very well-respected man in the in the New York investment community, and he created his investment firm in which he was offering a 12% return per year, which was very tempting because it’s high, but it doesn’t seem wildly high. And because he had such a great reputation. He had been, I think, the chairman of the one of the banking committees in New York and things like that.  He had the gravitas and, glamor is the wrong word, but a reputation that people thought that he could be doing this. And he was providing them statements showing that they were making a steady 12% per year, year after year after year.  When the original investors wanted some money out, he would give them the money.

 

But the whole thing was just a complete fiction. The statements that he was presenting them were utterly made up and just showing that he was making a good return year after year after year. And it’s interesting that these people, who often who may have been sophisticated investors, didn’t suspect.  And this is where I think greed comes in.  There were analysts were saying, “Look at what he’s saying he’s doing. That’s just impossible. It has to be a scheme.” And so there were warnings about it going on for years. But because he had such a reputation, and because so far it was working, it just kept going.

 

Abby Hornacek

How did he eventually get caught?

 

Thomas Neches

Well, what happened was in 2008 people started wanting to get their money out, and there was no money to give them. So then it all fell apart fairly quickly when people said, “Hey, I need my money back.” And he was basically saying, “I’m sorry, I don’t have it.”

 

Abby Hornacek

So these people are getting these fake statements saying that they’ve made 12% over the course of the year. How do they not realize? Because wouldn’t it just be reflected in their bank account?

 

Thomas Neches

It would only be reflected in their bank account if they took money out. Otherwise, when you invest money, you go to your securities broker and you invest in something and that something gives you a statement. Right. And you look at that statement and it looks real. So you think you have that money. But you don’t have that money in your hands in your bank until you withdraw from the investment. So as long as they just keep it in the so-called investment, it all looks real, but it’s all completely fake.

 

Abby Hornacek

Wow.  So would you say that the Bernie Madoff Ponzi scheme is the most notorious one, or do you have a different idea of one?

 

Thomas Neches

No, that’s the monster. That’s the huge one. Nothing else has been anything nearly as big. There have been big ones, and there are Ponzi schemes going on today. Hundreds, thousands of them, most of them small. It’s just a staple of the fraud industry.

 

Abby Hornacek

When we talk about Ponzi schemes, is that the same thing as a pyramid scheme then? Or are there any differences between the two?

 

Thomas Neches

A pyramid scheme is a little bit different in that what you’re trying to do with a pyramid scheme is get investors to bring in other investors and they get a commission for bringing in additional people. But it’s not necessarily an investment. I should have used the word victim. You’re getting the opportunity to sell things or be involved in something. And the way it works is that the investors in row three get a commission of the investors from row four, who get them from row five and so on and so forth.

 

So it’s very similar, but it isn’t necessarily based on a fraudulent scheme. There may be a business where they’re actually trying to sell something, but the pyramid scheme is just building up where you try and get more and more participants, paying each participant a commission for bringing in additional participants. An example of that was Herbalife, which is still operating today. It was charged as being a pyramid scheme and it paid a two hundred million dollar fine.  But there actually is a product that they’re selling.  The difference between a pyramid and a legitimate marketing scheme can sometimes be very hard to prove.

 

Abby Hornacek

OK, that was my question, because, you know, if you’re on Instagram, you see these multi-level marketing things all the time. So you say that they got a two hundred million dollar fine. What is illegal about that? Are the people who are being promised this commission, if they do bring in more participants, is that real commission and real money?

 

Thomas Neches

It supposedly is. The question can be where it can go bad is when they don’t have enough money to pay the commissions that people are supposedly earning. And when it’s set up in a way that there isn’t enough product to sell and you have all these people trying to sell it. So you have people, more people trying to sell something more than there is something to sell. And if that’s a deliberate scheme, then that becomes a pyramid scheme. If it’s just a bad multi-level marketing plan, then that’s just bad business as opposed to being illegal.

 

Abby Hornacek

OK, that that that makes a lot of sense. So then, I mean, this whole topic is just so interesting and there’s a lot to it. And I like to ask this question to everyone. Tom, what do you think is the most important thing or maybe the most interesting thing you choose about Ponzi schemes?

 

Thomas Neches

I think both. The most important thing and the most interesting thing is why people get involved in it. And it’s a combination of greed and naiveté and perhaps a certain belief in something. But as you say, it’s just fascinating that over and over again, people are willing to put their money into schemes that if you looked at them closely at all, you would realize that this just can’t be right. But people put their money in them all the time, every day. There’s just no overcoming naiveté. And greed, I think is a combination.

 

Abby Hornacek

Yeah, well, that’s a lesson in general to learn. It never bodes well for anyone if you’re greedy. But Tom, thank you so much for everything for coming on. It’s such an interesting topic, especially because we do see it pop up in the news every once in a while, and especially with Bernie Madoff and everything that happened there. So we really appreciate your time.

 

Thomas Neches

It was my pleasure.

 

Abby Hornacek

All right. If you missed anything from class, these are my office hours. And here are some top takeaways from my conversation with Thomas Neches on Ponzi schemes. Number one, Thomas explains that a Ponzi scheme doesn’t ever include a real enterprise. Often Ponzi schemes are based on completely fake businesses where there aren’t any genuine transactions being made. Number two, Thomas says that the way many schemes come apart is when investors look to get their money out of an investment.

 

For example, in the Great Recession of 2008, Bernie Madoff’s clients were looking to get their money out. But the whole scheme fell apart when it became evident that their returns were fictitious. And number three, in his opinion, Thomas feels that Ponzi schemes are the result of both greed and naiveté. He says greed is what starts a scheme in the first place. But greed can also propagate a scheme because investors like those incredible returns they’re seeing. Additionally, the naiveté of some investors attracts them to invest in fraudulent schemes promising those incredible returns.