In the early years of this blog I wrote about Bernard Madoff and his Ponzi scheme a few times, since it was the major financial news at the time. Now that Madoff has been sent to jail for at least 150 years, and many other financiers have been arrested for doing smaller versions of the same thing, it might be a good time to talk about Ponzi schemes in the first place, what they are and why they’re illegal. And we’ll do that with a very brief history of the first guy to do it, Charles Ponzi.

Charles Ponzi, who was originally from Italy, was a two-bit criminal who wasn’t very successful. He kept trying to find odd little jobs at multiple companies but would eventually get greedy and steal from whatever company he was working for. At one time he spent a year in a Canadian jail for trying to pass a forged check.

Then he happened upon a great scheme in early 1920. Back then, people from American would send letters to friends and family in Europe, and they’d include a coupon (known as an international reply coupon or IRC) so that those friends and family members could send you something back. However, equal cash exchanges weren’t quite up to snuff, so if you could get someone in Europe to send you a coupon instead, you could trade it in for cash and make a small profit off the deal, since it’s usually more costly for other countries to send mail here.

Although it was legal at the time, what wasn’t legal was his being able to get other people to buy into the scheme, though he didn’t tell them that’s what it was. All of them thought they were investing with a financial wizard because he promised to pay 50% of their investment back in a few days, which he did. He also set things up so that he would also manage their money, so he didn’t always have to give them their returns immediately. That left him with a big pile of money he could use to recruit new people and pay them their 50%, and so on.

He got away with it for about a year until the numbers game caught up with you. His biggest problem was he couldn’t cash in the overwhelming majority of the IRCs he had, which meant his only true means of getting money to keep the scheme going was to keep trying to get more people to invest with him. To his credit, he tried buying businesses to generate true income to pay those clients of his who wanted to cash out, but none of it worked the way he needed them to.

The funny thing is that he won a libel suit for $500,000 when a reporter wrote that there was no way he could do what he was saying he could do. That reporter wasn’t the only one who was suspicious, but after Ponzi had won that suit no one else wanted to take the chance and challenge him.

It took some time but eventually some of his clients started to sue for their money and he couldn’t hold the press off any longer. He was under suspicion from many corners and was being investigated by the Commonwealth of Massachusetts. Another problem for him was going from having no money to becoming a multi-millionaire in a year.

Eventually the United States Attorney for the District of Massachusetts commissioned an auditing company to scour the books of Ponzi’s company, only to discover that there was no legitimate or traditional bookkeeping system, as most of the information was written on index cards with investor’s names on them, the amount of money they gave him and that was pretty much it.

He was eventually outed by the press after some of the banks started reviewing their own accounts and realized that Ponzi was basically “broke”, in that he owed way more money than he had and that he’d taken major loans from one bank and deposited it in another to make himself look like things were going well. He finally turned himself in to federal authorities and, facing a possible trial for being charged with 86 counts of mail fraud, pleaded guilty to one.. and the judge went for it! He was sentenced to only 5 years in federal prison after facing the possibility of life.

He was released after 3 1/2 years and thought his ordeal was over but Ponzi was charged by the state of Massachusetts with 22 counts of larceny. This time he went to trial where, miraculously, he represented himself in court against 10 of those counts and was found not guilty. He was tried again on five counts and the jury deadlocked. He was finally convicted the third time on the remaining counts, but while out on bail he fled to Florida and tried another scheme, failed, was arrested again, spent nine more years in jail and was eventually deported because it turns out he’d never applied for citizenship; ouch!

In essence, this is what Bernard Madoff did, only without the stamps and for a longer period of time. He took people’s money, promised to invest it and pay them off handsomely, and when he was able to report these big payoffs investors were so pleased that they just asked him to reinvest the money. He never had to pay it off, unless requested, which happened rare enough so that he got to keep most of the money to use on him and his family.

The reality here is that if he had been smart and started reporting reduced profits instead of continuing to report 15 to 20% growth while the stock market was crashing down around everyone, he might still be living the high life, no questions asked. Of course, many people would have wanted to get their money out once the growth numbers started falling and he might not have had enough to cover everyone who asked for it, but he might have been able to ride out the storm by reporting losses comparable to what other investment companies were reporting.

Luckily, we’ll never know.

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