5 Things You Didn’t Know: Ponzi Schemes

By Ryan Barnett

Disgraced financial guru Bernie Madoff is facing a 150-year prison sentence for perpetrating the biggest Ponzi scheme in history. In March 2009, Bernie Madoff pled guilty to defrauding investors of $65 billion. At the time of his arrest, he had a Rolodex of celebrity clients rivaled only by Heidi Fleiss in the early '90s. People like Steven Spielberg, Kevin Bacon and John Malkovich had entrusted their money with ol' Bernie "Made off," and were left fuming over the deception.

The effects of this fraud are terrible. Many people lost their life savings, and several charities that had entrusted money to Madoff were forced to close their doors. As Sandy Koufax scratches his head, trying to figure out just how he was duped, we present you with five things you didn't know about Ponzi schemes.

1- Ponzi schemes are not pyramid schemes

Ponzi schemes are often confused with pyramid schemes or multi-level marketing (MLM) strategies, but there are clear distinctions between the two. In a pyramid scheme, investors are compensated with a percentage of the investment money paid by those they recruit. A Ponzi scheme is best summed up in the phrase "rob Peter to pay Paul," meaning: use one investor's money to pay the returns of another investor. The money in a Ponzi scheme flows through a central agent who moves it around creating the illusion of earnings. Ponzi schemes are successful because investors typically continue to reinvest their earnings into the scam. This constant reinvestment of securities causes a financial bubble to grow. Inevitably, the bubble reaches critical mass and implodes.

2- Ponzi was a man

The word "Ponzi" isn't some technical financial jargon, it's somebody's name. Charles Ponzi was an Italian immigrant living in Boston during the First World War. Ponzi, who had previously served time in a Canadian prison for forgery, stumbled upon a loophole in the mail system regarding International Reply Coupons (IRC). He found that he could buy IRCs abroad and exchange them for U.S. postage at a higher value. He then made a tidy profit by reselling the stamps. After his initial success, Ponzi founded the Securities Exchange Company. Word spread and he was eventually inundated with investors. He quickly gave up on the mailing scheme and started simply shuffling money among his clients. The scheme collapsed in 1921, and Ponzi spent three years in federal prison, and another nine in state prison. The exact amount that Charles Ponzi bilked his investors for remains unknown; however, at the height of the scheme he reportedly took in $1 million in three hours. In the end, he only ever bought $30 worth of IRCs.

3- William “520 percent” Miller

Charles Ponzi may be the namesake, but William Miller is the architect. Miller is the man credited with running the first modern Ponzi scheme. At the time he hatched his plan, 24-year-old Miller was making $15 a week as a bookkeeper for a tea company. His plan was simple: claim to have insider information on the stock market and collect investors' money. He started small, first recruiting members of his Bible study class. He was given the nickname "520 percent" for the 10% weekly return on investment he promised his clients. In 11 months, Miller pocketed $480,000 and business wasn't slowing. However, before his scheme was able to collapse, as it did with Bernie Madoff and Charles Ponzi, Miller was duped out of his money by two more cunning con men. He was eventually arrested and spent 10 years in prison. After his release from jail in 1909, William "520 percent" Miller was rehired as the bookkeeper at the tea company where he began.

4- ‘N Sync’s manager imprisoned for Ponzi scheme

On top of being a clear musical genius and patron of the arts, Lou Pearlman (the man behind the Backstreet Boys and 'N Sync) has a penchant for stealing pensions. The former boy-band mogul is currently serving a 25-year prison sentence for fleecing investors in a $300 million Ponzi scheme. Pearlman had thousands of investors in Trans Continental Airlines Inc., a company that existed only in forged documents. When caught, Big Poppa was offered a deal to reduce his sentence by one month for every $1 million he helped recover. So far he has chosen option two: to be rich as hell when he's released from prison at age 87.

5- Even early investors can lose

A Ponzi scheme is built on the word-of-mouth of its early investors. Once a schemer is able to pay returns on initial investments, those happy investors urge others to take the plunge. In a scheme like Bernie Madoff's, which operated for the better part of 15 years, it's likely that many early investors made money and got out before the bubble burst. However, that doesn't put them in the clear. There exists a "clawback provision" in the case of Ponzi schemes, wherein a court-appointed receiver or trustee can sue any investor for money he has received in excess of his investment. Anyone breathing a sigh of relief for pulling out early may find himself on the business end of a lawsuit.