Knowing your Pyramid from Your Ponzi

By Matthew Purchase

Much of the news recently has been dominated by the activities of Mr Barry Tannenbaum, who has allegedly been carrying on a fraud scheme which appears to have duped hundreds of well-heeled investors in South Africa and abroad. The amounts involved have been the subject of wild speculation with figures of R10 and R14 billion reported in the press. However, because money is often circulated or re-invested in a scheme like this, the actual losses are likely to be smaller than that - but by anybody’s reckoning this will be the largest fraud ever perpetrated in South Africa if the allegations against Mr Tannenbaum are correct.

The press has interchangeably described the scheme as being a ‘pyramid scheme’ or a ‘Ponzi scheme’ and we thought we’d delve a little deeper into the history and characteristics of these schemes.

Charles Ponzi was born in Lugo, Italy in 1882 and immigrated to America as a 21 year old man. Although he was convicted and imprisoned for other offences (including cheque fraud and smuggling illegal immigrants), he is most famous, or rather infamous, for devising an elaborate scheme to defraud investors of millions of dollars. The scheme, like all illegal schemes of this nature paid early investors returns from the investments of later investors – robbing Peter to pay Paul. Ponzi was not the first to use the scheme, but was the first to implement the scheme so successfully.

In it’s simplest form, a Ponzi scheme has the following four characteristics:

The Bait:

The fraudster most often lures investors with promises of above-market returns.
Ponzi for example promised his investors 100% profit in 90 days, and another enterprising fellow ‘Double Shah’ was promising his Pakistani countrymen a 100% return on their investment in just 15 days until his arrest in 2007. Sometimes the promised returns are less startling – for example the fraudster may guarantee returns which in reality are not sustainable - Bernie Madoff guaranteed his clients high returns despite an economic recession.

A few conspicuous pay-outs are made to investors early in the scheme to convince investors of the legitimacy of the scheme.

The Hook:

The above-market returns are most often explained with reference to complicated fictitious business models.
Ponzi’s scheme was ostensibly based on the purchase of discounted postal reply coupons in Italy and their subsequent redemption in America for a profit. Whilst in theory, an opportunity to make money did exist, the costs, administration and red-tape involved made the entire scheme wholly impractical and impossible to implement. Bernie Madoff had a remarkable "split-strike conversion strategy" which he ‘sold’ to his investors, while Mr Tannenbaum is alleged to have duped investors into financing the importation of chemicals into South Africa.

Although these business models would most often not survive any serious scrutiny, it is surprising how often educated and business savvy people are caught in these schemes. Possible reasons for this include: The assumption that other investors have performed a due-diligence; the involvement of other high profile investors in the scheme and the ‘invitation only’ or apparent exclusivity of the schemes.

The Line:

The fraudster is almost always a persuasive, well-respected or well-connected person.
This is the single most likely reason why investors would invest in a scheme without having first performed some form of due diligence.

For example, Madoff was the founder of a wall street firm and a former non-executive chairman of the NASDAQ stock exchange. Ponzi was so persuasive (and brazen) that he successfully sued the financial journalist who first suggested that his scheme was illegal for libel (Ponzi also hired a publicity agent towards the end of the scheme). ‘Double Shah’ too was an excellent salesman and after his arrest, people congregated around his house and offices protesting against his arrest, blocking roads and lodging complaints in the media. Mr Barry Tannenbaum is the son of Harold Tannenbaum - the founder of a large pharmaceutical company - and would undoubtedly also be well-connected or at least well-known in the industry.

The Sinker:

Little or no commercial activity actually ever takes place.
Typically, no income, or very little income is actually generated by the supposed business venture. Pay-outs to investors are made from the pool of investor funds and the remainder is siphoned into the fraudster’s pockets.

Ponzi only ever purchased about $30 (thirty dollars) worth of postal reply coupons – even though in excess of $15 Million (fifteen million dollars) had been invested in the scheme by 1920. Madoff admitted that he had never invested any of his clients' money from the inception of the scheme; instead he simply deposited the money into his business account. Losses in the Madoff scheme, which included circulated or re-invested gains, totaled almost $65 billion. Double Shah explained to his investors that he was investing the money in ‘securities’ in Dubai. No securities were in fact ever purchase by him despite the fact that nearly Rs. 70 billion (almost one billion dollars) was paid to him over a period of 18 months.

Ponzi schemes are similar to, but different from Pyramid schemes.

A hierarchical or pyramid structure in business is of course a well-known and universally accepted concept. A pyramid structure becomes a pyramid scheme when the company makes all of its money or substantially all of its money by recruiting new people.

Pyramid schemes are illegal in many countries, including South Africa, but are legal in others. Illegal pyramid schemes generate revenue by continually recruiting new members. While the scheme may offer goods or services for sale (often self-improvement courses and the like), the only significant revenues come from the recruitment of new members.

Like Ponzi schemes, pyramid schemes use the funds paid by later participants to pay returns to early participants. Both schemes are unsustainable and fail when the available pool of new members is drained (Ponzi schemes fail when the new investment funds are no longer sufficient to repay existing investors).

The key differences between Pyramid and Ponzi schemes are:

The way they are marketed: Pyramid schemes are marketed as pyramids and participants are encouraged to rise through the ranks of the pyramid by recruiting other participants. Ponzi schemes on the other hand masquerade as investment opportunities and there is no suggestion to investors of a pyramid structure.

The role of the fraudster: In a Ponzi scheme, the fraudster is the central "hub" for all of the investors, interacting with all of them directly. In a pyramid scheme it is the participants themselves that recruit additional participants.

Lifespan: Pyramid schemes are prone to collapse much sooner than Ponzi schemes as they require exponential increases in the number of participants in order to sustain themselves. In contrast, Ponzi schemes are able to survive much longer simply by persuading most existing investors to stay in the scheme and to "reinvest" their money.

You know what they say about returns being too good to be true?