The business of ponzi scams

By Roopen Roy May 07 2013

Tags: Op-ed

The business of ponzi scams has thrived in India — ruining investors, robbing poor people, hurting banks and destroying the lives of employees. These businesses have mushroomed because of a combination of factors: powerful politicians are part of the value-chain and governmental agencies have been inactive. So far, with a few notable exceptions, the regulators have struggled, because laws are not tough enough and customers are either ignorant or greedy or both. In almost all cases, these scamsters have bought time through stalling and procrastinating by abusing the legal and judicial processes.

What are ponzi schemes? The fraudulent business mo­del is named after Charles Ponzi an Italian businessman who immigrated to the US. In 1920, Ponzi promised huge returns on international reply coupons, which could be purchased in one country and redeemed for postage stamps in a different country. The theory was that there was the price arbitrage between countries that yielded the profit.

Ponzi became a millionaire in a very short time. He collected a total of $20 million which at today’s value is worth about $250 million. When the sc­heme collapsed, investors lost their money and six banks went down. The investigators found that Ponzi was siphoning mo­ney and repaying investors with new investors’ funds.

A ponzi scheme is basically a scam, which usually promises to pay higher returns to investors out of their own capital or from the capital of subsequent investors and not from the operating profits of the enterprise. The longer the charade goes on, more capital is eroded and lost. The continuity of a ponzi scheme is dependent on the continuously rising mobilisation of deposits from a growing circle of investors.

There is no escape from the reality that ponzi schemes must collapse at some point in time. In a well-governed country, a ponzi scheme may stop because regulators move in and shut it down. It may also crumble if the regulators prevent the scammer from taking new deposits, thus breaking the collection-refund-collection chain. It may collapse if the scammer executes his exit policy, that is, he escapes and becomes a fugitive. The ponzi scheme, by design, requires a perennial flow of funds and higher collection targets to feed the beasts of higher returns and repayment. If the collection slows down, a cash crunch develops. In the age of electronic media and mobile telephony, bad news spreads at the speed of light triggering runs on the ponzi funds. Sometimes, ponzi funds are unexpectedly hit by economic downturns which lead to their collapse as happened with Bernie Madoff in 2008. Madoff ran a ponzi scheme with greater sophistication than Charles Ponzi.

Madoff is now serving a 150-year sentence in federal prison in the US. He masterminded a multibillion dollar ponzi scheme that swindled money from thousands of investors. Interestingly, Madoff did not promise spectacular short-term investment returns. Instead, his investors’ phony account statements showed moderate, but consistently positive returns — even during downturns. And several sophisticated investors fell for his phony track record.

In India, we are seeing a spate of ponzi scams, which are ruining millions of poor and uninformed investors. Most ponzi-style businesses in India have all or some of these businesses in their portfolio: real estate, hotels, movies, media and, of course, some form of deposit taking that promises unrealistic returns over a period of time. They sponsor sports teams and spend large sums of money in media advertisement and donations to social organisations run by prominent politicians in power. At social events, you would find filmstars, ministers, bureaucrats, media persons and policemen fraternising. They want to appear respectable in society by wearing a mask of generosity and affability, although they are unmitigated crooks and ruthless swindlers. Because they are bold and audacious, many, but not all flaunt their wealth: private jets, luxury limos, gun toting bodyguards, trophy mistresses and palatial houses. Often, they even have a criminal past, but they cover their tracks and rewrite their biographies with professional help. Most of them do not have formal education, yet cite degrees of fake universities. One such prominent scamster claims to have a PhD degree from an east European country during the communist regime, while another claims to be an engineer.

In the US, the SEC investigates and prosecutes many ponzi scheme cases each year both to prevent new victims from being harmed and to maximise the recovery of assets to investors. The majority of such cases are brought as emergency actions, which often seek a temporary restraining order and an asset freeze. To prevent ponzi scams in India a number of actions must be unleashed in parallel.

First, Sebi must be provided sharper teeth to shut down companies that defraud investors, particularly small investors. Second, we must find ways in which bank branches and micro-finance companies can go to the doorstep of the small investors to mobilise savings. Third, it is time that we do serious work in transforming post offices into a bank-like network to mobilise small savings in rural areas. Fourth, investor education amongst small investors should be a priority. Fifth, the nexus between the politicians and ponzi scammers must be severed. And lastly, those who become rich by stealing from the poor should be given exemplary punishment.

However, there is one reality worth remembering. Because of the design of the scheme of fraud of ponzis, the longer they exist the more real cash losses they incur and a greater quantum of capital is eroded. The ponzi beast feeds on its own lifeblood (cash) and is its own nemesis. Simply by freezing assets and bringing back money siphoned by the promoter does not solve the problem. By such action, only a fraction of the deposits can be repaid. Most of the money in such schemes is lost in disbursing generous commission to the agents and in paying exorbitant interest to the depositors. Moral of the story: the quicker the ponzi schemes are closed, the better the depositors have a chance of being repaid a greater part of their capital.

(The writer is managing director of Deloitte Consulting, India. These are his personal views)