What is Third Party Fraud?
This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.
Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.
What is a Ponzi Scheme?
A Ponzi scheme is the name given to a range of investment frauds. The common factor is the promise of a high return on an investment (usually no the monies are never invested) and payments to early investors from money invested by later investors.
A Ponzi scheme is usually set up purely to defraud people. Any activity that looks like investing the funds will simple be window dressing to convince people to invest. They are not generally legitimate investments that went bad, though the loss of money may be explained that way by the person running the scheme.
Description of a Ponzi Scheme
What is a Ponzi Scheme?
The term Ponzi Schemes has been given to investment frauds that are based on Mr Charles Ponzi’s original fraud. The American Heritage Dictionary defines a Ponzi Scheme as:
“An investment swindle in which high profits are promised from fictitious sources and early investors are paid off with funds raised from later ones.”
Ponzi schemes take a variety of forms, so their facade can look different. But essentially they contain the same basic element – a proposed investment with a promised high return, and the same result – the victims lose their money. The essential element is always the offer of a high return on investment. Often these returns seem incredible when compared against other returns available at that time, so they are usually targeted at unsophisticated or inexperienced or first-time investors.
Who was Charles Ponzi?
Charles Ponzi lived in the United States city of Boston in 1919 and 1920. He had a history of committing frauds and promoting bad investments under various aliases. Leaving Italy in 1903, he went to Canada where he was convicted of forgery and went to jail. Within ten days of being released, he was arrested for smuggling illegal aliens into the United States and served a term in an Atlanta Prison.
Later he conducted a large investment fraud against in the Boston area that gave the name to these types of frauds. He mainly defrauded the Italian immigrants within his local community, but taking in people of all classes and nationalities within the city.
How did Ponzi run his scheme?
Ponzi scheme investments will generally be described as outside the main stream investments and offer some special (secret) insight or talent held by the promoter. This is how the promoters explain the high promised returns. Ponzi offered an investment opportunity that made a 50% return in 45 days. This compared to about 3% a year from a mainstream (government bond) investments. The promised returns were too high for some people to ignore.
Ponzi’s scheme was suppose to invest in Postal Reply Coupons – stamps. In those days you could buy a Postal Reply Coupon for the price of a stamp in your country. You would send the Postal Reply Coupon to someone in another country and they could swap it in for stamp in that country, regardless of the price of the stamp in that country. The intention of the coupon system was to allow immigrants to write home to relatives in other countries and pay for a return letter by sending a Postal Reply Coupon.
Investors in the scheme were told that the money invested would be sent to Italy, converted to Lire and used to purchase Italian Postal Reply Coupons for the price of Italian stamps. Italian stamps were a lot cheaper than American stamps. The Italian Postal Reply Coupons would be sent back to America and exchanged for American stamps. That meant that an American stamp could be obtained for the price of an Italian stamp. The American stamps would then be sold for a slight discount on the normal price and the transaction would realize a profit.
Thousands of people believed that this scheme would make money and invested (and lost) about $9.5 million by the time the scam collapsed. Ponzi died broke in 1949 probably without ever buying any Postal Reply Coupons.
How are Ponzi schemes done?
Ponzi schemes can have a small or large number of people involved, they can be in centered around a small or large geographical area, and can have small or large financial losses – the largest being the $65 Billion Madoff fraud. But the same common factors of high promised returns and repaying early investors with later investor’s money apply.
High Returns
At first examination the scheme may appear to be a normal type of investment, albeit one that out performs most other investments offered at the time. These investments almost always promise high returns over short periods or constant high returns over longer periods. This is the bait that plays on people’s greed. Indeed, sometimes the promised returns are outrageous, even unbelievable, when compared to other current legitimate investments. But the promised returns appear too good to forgo, so unwary, hopeful or greedy investors invest.
Investments that offer returns far above the market returns over short periods should be examined very carefully. There are some good high yield investments, but these are the exception, not the rule. They also can be explained and ‘make sense’ and can be backed up with evidence.
Investors should be aware that the risk in any investment is generally proportional to the return. That is, an investment with high returns will generally have a high risk. Investments with very high returns in short periods are generally too good to be true or legal. At the very least they should be considered very high risk.
How the scheme works
Fraudsters are usually very good at their trade and will run their scheme as if the investments have been made and returns are being earned.
The promoters of the scheme will prepare the offering. They will have financial statements, budgets, forecasts and may have professional looking glossy brochures. The purpose of these documents is to make potential investors believe that the scheme will be run professionally. But sometimes the opposite occurs. The promoters will be secretive, and use that secrecy to entice investors – ‘this investment is so good that we cannot let everyone know about it, we are just offering it to a select few’.
As the scheme progresses, the fraudsters may generally make some payments of the allegedly high returns to the original investors. These payments are not from earnings, but from the money invested by later investors. For example, if the scheme offers a 20% return every six months, the fraudster may use some of the money received from that or a later victim to pay the first interest payment to that victim. By doing this, the investor will gain confidence in the scheme and funds repaid to investors are usually reinvested.
Some schemes do not pay out returns. Instead the victims are told that the value of their investment is increasing, or that interest is being reinvested to increase returns. Glossy charts and schedules can be produced to show the returns achieved. This usually occurs when the alleged investment is in shares or other types of equity instruments.
Some cash is usually be held in reserve so that any troublesome investor can be paid out. On being paid out, that troublesome investors may gain a new confidence in the scheme and the promoter, and will reinvest their money. This is just a simple marketing technique by the fraudster. Give a disgruntled customer what he wants, and he will usually become a happy customer and your best salesman by telling all of their friends about the investment.
When the pool of funds is large enough, the fraudster and the money disappear, or otherwise the promoter invents reasons why the investment has gone wrong and the monies have been lost.
How the scheme is promoted
The fraudster wants his investors to tell their friends about the investment, the great returns they are getting, and convince them to invest. These schemes sometimes grow purely by word-of-mouth, and jealously and greed now becomes very effective marketing tools. People that are not in the investment will want to get in on the action, and people in the scheme want to invest as much money as possible to make the biggest return. Word of mouth advertising also keeps the scheme under regulators’ radars.
Paying some of the money back to the initial investors at the end of their term in the scheme gives the scheme some legitimacy as the promised returns appear to be being paid. With the promise of further high returns, many investors about to the paid out will reinvest their principle back into the scheme, particularly if they are told that they will not be able to reinvest at a later date if they take the money out.
By meeting some interest payments from the monies provided, the promoter knows that victims will keep placing money in the scheme and will get others to do so. Payments of interest and returns of capital are usually made publicly to generate a ‘buzz’ about the scheme. Other people see that returns are being paid, gain confidence in the scheme and will want to invest. This word-of-mouth endorsement will be the best advertising that the promoters can get.
The warning signs
(i) Any form of tax benefit being suggested. Potential investors should consult an independent Tax Accountant (not one recommended by the promoters of the scheme) before entering into any investment where the main benefit is a tax advantage. It is common that Tax Reduction Schemes will not be accepted by the Tax Office and investors will be assessed with large tax bills. If the best advantage that can be offered from an investment is a tax deduction, the investment should be carefully examined.
(ii) Any form of urgency is suggested, including the rapid filling of the investment, the “only a few places left” urgency, an expiring time limit to enter the investment, etc. This sense of urgency is a tool used by fraudsters to force a quick decision, taking away time to really consider the investment. It makes people think emotionally and make a gut decision, not a rational or commercial decision. It removes the opportunity for potential investors to get proper and independent advice.
(iii) The return is just too far above the prevailing rates available in other investments without any sensible and logical way of getting that return. Potential investors should ask themselves that, if the investment is so good, why are they trying to sell the investment to other people instead of taking all of the returns themselves using borrowed funds? If a non-risky high return was available, the general public would not have an opportunity to invest. The investment would be full of professional investors or the promoters would do the project themselves. The fact that the investment has to be promoted usually means that it is not spectacular.
(iv) Documents that detail all aspects of the investment are not available to take away to get third party advice. If the investment stacked up, the promoters would not try to stop people seeking independent advice on the material, they would encourage it. Most promoted investments have to be filed with the Australian Investments and Securities Commission. Any form of secrecy should sound alarms.
(v) The salesman/consultant will not come to a meeting with your accountant, solicitor or other advisor. Secrecy is important to fraudsters. Promoters will say that these advisors ‘do not understand’ the investment, or are negative or incompetent.
(vi) The nature of the investment just does not make sense and cannot be explained easily or clearly, regardless of what expertise the promoter of the schemes says that they have. Some investments and returns just do not pass the common sense test.
Why do people invest in these schemes?
These schemes promise a way of making a lot of money by doing little. An easy way of doing things is the motivation behind many great inventions – and many bad investments. The fraudster’s job is to combine a person’s greed, a promise of a lot of easy money, and a mixture of urgency and envy. This motivation can be irresistible to some people who want to make an easy dollar. Fraudsters target people looking for a get rich quick opportunity. These people are commonly called ‘opportunity seekers’.
Opportunity Seekers enter sweepstakes like crazy. They often read newsletters about how to win, and they’re the first people on the block to fall for a Ponzi Scheme or a cleverly written but misleading or untruthful mailing for house siding or weight-loss fads. When you see some poor schmo on TV who was duped into losing his life savings, you’ve found an Opportunity Seeker.
Seth Godin. Permission Marketing. Simon & Schuster
Examples of Ponzi Schemes
Two cases are worth mentioning by way of examples. The second example is worth mentioning due to its ludicrous nature and the fact that so many people still decided to participate.
First Example
An investment company advertised that it invested in shares listed on various stock markets in Asia. This was at a time when Asian markets were booming. It advertised that they could get very high returns for its clients due to their special skills and local connections in that area. The investments that the company made were not to be in the name of the investor, but in the company’s name so the company could trade freely and easily, buying and selling as the market changed. They were borrowers and investors, not brokers.
Externally the company looked like a successful investment company. It employed smooth salesmen who knew the jargon of the share market and who could impress potential investors. Many people believed the promotional material and invested.
The investors (victims) were given impressive looking monthly updates on how their investments were performing. These updates were fake – simply a lists of stocks from the various markets in Asia that happened to have gone up in that month. The fraudsters simply searched to find stocks that had increased in the past month and told the investors that these were the stocks in which the company had invested.
In fact no investment was ever made in any stock in any market. The monies were pooled into an account in Asia waiting for the scheme to end. Eventually the pool of funds grew large enough and the perpetrators disappeared, with the cash.
Second Example
One ridiculous scheme was detailed in a book by Frank Abagnale (“The Art of the Steal”). Frank Abagnale is a security and fraud expert based in the United States.
This scheme involved a young man that offered a unique investment opportunity. This fellow wanted to borrow funds to buy, sorry – invest in, large amounts of tickets to Rock Concerts. His intention was then to scalp these tickets outside the venues at greatly inflated prices and turn a profit.
He needed the capital to buy the tickets in the first place, so placed advertisements in newspapers explaining the scheme. People knew that some concerts sold out in hours and that these tickets were in great demand. People also knew of the high prices scalpers charged for tickets. Some 3000 people sent $7 million to this kid to invest in these tickets. No tickets were ever purchased.
What to do?
What do you do when you suspect that an investment is, in the old term, dodgy? The best advice that anyone can offer is that “if an investment looks too good to be true, it probably is – and it is probably illegal“. At the very least get competent independent advice before handing over any money.
We would recommend that you avoid the investment until you have really satisfied yourself that it is legitimate, and forwarded whatever details that you can gather to the Australian Securities and Investments Commission. This regulatory body will generally look into these schemes. Legitimate schemes will have their prospectus lodged with the Australian Securities and Investments Commission.