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How to Execute a Proactive Approach to Prevent Loss from Ponzi Scheme?

Written by: Putika Nuralida Herdin, Universitas Gadjah Mada & Yohanes Partogi, Universitas Indonesia

Committee: Control Fraud          Institution: Interpol

An old but sugarcoated phenomenon, popularly termed as “Ponzimonium” or “Ponzi Scheme” is any business or economic entity promising to pay a higher return to its investors than what can be generated by its net operating income. Operations of this type are sustainable only as long as funds from new investors or lenders are available to meet outstanding payout requirements. First scandal was started by Charles Ponzi, whose stamp speculation scheme in the 1920s promised that an initial investment of US $1000 could be turned into US $1500 in just 45 days to the recent US $65 billion Madoff scandal, the core design feature of the charade remains the same. However, Ponzi schemes are susceptible to crash, and the perpetrators usually abscond beforehand. As the result, this phenomenon has made investors withdraw funds from investment sectors around the world. In order to put an end to this precautionary system, Interpol has proposed the implementation of Red Flags which can be executed by having a good understanding of investment, having an external audit, reversing burden of proof and adapting effective laws to give law enforcement officials the powers to combat Ponzi schemes both domestically and internationally.

Recently, fraud has been practiced widely, taking one of the examples from the sentencing of Bernard L. Madoff to 150 years in prison for his involvement in the largest, longest and most expensive Ponzi scheme in history (with fraud in the vicinity of USD $65 billion), directly proves that white collar crime is very much alive and well in the financial services industry. Statistics show that 19 Ponzi schemes were identified in the United States at the end of the first quarter of calendar 2009[1] and the numbers are still growing until 2015. Charles Ponzi who created Ponzi schemes back in the 1920s started up this modus by promising high and consistent returns on investment to investors, which is actually being paid out of the contributions of new investors in the scheme. With little or no legitimate earnings, Ponzi schemes require a consistent flow of money from new investors to continue. Consequently, Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.[2]

 

Taking a look at Ponzi schemes would directly refer to its sibling – Pyramid schemes that are closely related. They both involve paying long-standing members with money from new participants instead of actual profits from investing or selling products to the public. In Pyramid schemes, funds from new participants are used to pay recruiting commissions to earlier participants, where as in Ponzi schemes, funds from new investors are used to pay purported returns to earlier investors. However, both schemes would leave us to a question: Why do people believe lies? It is because the actor delivers on his promises by using later contributions to pay very large returns to initial investors. Another reason is that people are often attracted when their peers are making good money from the schemes, and thus immediately disregard the irrational the explanation. Last, Ponzi or Pyramid investors are often beguiled by the personality and reputation of the actors.[3]

 

Furthermore, in this era, some Pyramid and Ponzi schemes are being covertly offered in the form of Multi-Level Marketing (“MLM”), in which participants profit almost exclusively through recruiting other people to participate in the program, making these schemes less suspicious.[4] For example, in a recently filed litigation, Securities and Exchange Commission (“SEC”) v. CKB168 Holdings Ltd[5], the SEC filed charges to stop an alleged pyramid scheme perpetrated under the façade of an MLM program for online children’s courses. The promoters of the scheme allegedly solicited investors worldwide, including members of Asian-American communities in New York and California. The SEC alleges that these promoters misrepresented CKB as a legitimate and profitable MLM company that sells web-based children’s educational courses when, in fact, CKB has little or no retail consumer sales and no apparent source of revenue other than money received from new investors. The most striking result of Ponzi schemes is the massive evaporation of investor wealth. A comparison of these losses to the annual gross domestic product (“GDP”) of countries provides some alarming statistics. For example, the US $50 billion uncovered in Ponzi schemes from 2008 to 2013 would rank in the top 75 countries in the world by GDP, This equates to roughly US $6.3 billion per year of investor wealth ensnared in Ponzi schemes, which is nearly the annual GDP of the African country Niger.[6]

 

Series of Ponzi schemes have made Interpol see this as a perilous matter that needs to be prioritized immediately. As the world’s largest international police organization with 190 member countries, Interpol is committed to fighting fraud by building up networks between law enforcement bodies and arresting as many criminals as possible. Because of its results in shutting down Ponzi schemes, Interpol fervently believes that this proposal has been an effective tool. For example, in one case, a Columbian man, who allegedly defrauded thousands of investors through pyramid schemes in Panama, was arrested and deported in less than 24 hours following intensive cooperation between national police and Interpol. Interpol stated that the speed and efficiency that Colombia and Panama were able to carry out the arrest could be credited to the law enforcement officers and agencies of both countries, which clearly demonstrates the effectiveness of inter-agency and cross-border cooperation.[7]

 

Subsequently, Interpol not only urges all member states to consider Ponzi schemes as a key obstacle in fighting white-collar crime, but also encourages all states to uphold the good system and constructive engagement. Therefore, Interpol has proposed several solutions, which are often classified as Red Flags (or anomalies)[8] to combat Ponzi schemes:

 

  1. Good understanding of investment – Investment should not be based on irrational excitement because it leads to risky conditions. Interpol found that the great returns received by investors are usually derived from money invested by gullible people wanting in on the action. Furthermore, any reasonable suspicion might become an alert, particularly if their investments constantly outperform competitors using similar strategies or offer returns above the legal rate or market rate.
  2. Having external audits – Interpol identifies that external audits can be effectively used by CEOs and senior management to support and assist the fraud being enacted through the manipulation of the audit systems and process. This could be supported by simplifying procedures for the production of relevant financial records, removing obstacles that hinder or delay the sharing of financial and criminal information from appropriate agencies and improving the effectiveness of disclosure systems.
  3. Reverse the burden of proof – Subject to domestic law, member states should reverse the burden of proof (using the concept of reverse onus) in respect of the confiscation of alleged proceeds of crime.
  4. Adopting effective laws – Interpol recognizes the difficulties encountered by law enforcement authorities to identify and prosecute all those who conduct Ponzi schemes. As a result, Interpol recommends that member states adopt effective laws that grant law enforcement officials the power to combat Ponzi schemes i.e. by under taking the measures as follows[9]:
  5. Granting law enforcement officials the authority to investigate such cases;
  6. Waiving bank secrecy rules when there are reasonable grounds to suspect that certain transactions are connected with criminal activities;
  7. Authorizing law enforcement departments to use techniques, such as covert (undercover) investigations; and
  8. Providing adequate resources to law enforcement departments in order to increase the likelihood of success of investigations.

 

 

 

 

 

[1] Jacqueline M. Drew and Michael E. Drew, ‘Ponzimonium: Madoff and the Red Flags of Fraud’ (2010) Griffith Business School Discussion Papers < https://www.griffith.edu.au/__data/assets/pdf_file/0015/214440/2010-07-ponzimonium-madoff-and-the-red-flags-of-fraud.pdf&gt;

[2] ‘Ponzi Schemes’ (U.S. Securities and Exchange Commission) <https://www.sec.gov/answers/ponzi.htm&gt; accessed 23 July 2015,

[3] Dorothy T. Eisenberg and Nicholas W. Quesenberry, ‘Ponzi Schemes in Bankruptcy’ (2014) 30 Touro Law Review

[4]‘Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs’ (U.S. Securities and Exchange Commission, 21 October 2013) <http://www.sec.gov/investor/alerts/ia_pyramid.htm&gt; accessed 24 July 2015

[5] Securities and Exchange Commission v. CKB168 Holdings Ltd’ (U.S. Securities and Exchange Commission) <http://www.sec.gov/ litigation/complaints/2013/comp-pr2013-223.pdf > accessed 25 July 2015

[6] Jordan Maglich, ‘A Ponzi Pandemic: 500+Ponzi Schemes Totaling $50+ Billion in Madoff Era’ (Forbes, 12 February 2014) <http://www.forbes.com/sites/jordanmaglich/2014/02/12/aponzi-pandemic-500-ponzi-schemes-totaling-50-billion-in-madoff-era/#320e407510b9&gt;, accessed 28 July 2015

[7] “Colombian Fugitive Arrested and Deported from Panama within 24 Hours of Issue of Interpol Alert” (Interpol, 21 November 2008) <http://www.interpol.int/News-and-media/News/2008/PR069&gt; accessed 25 July 2015

[8] Linda Schain and Pearl Jacobs, ‘The Never Ending Attraction of the Ponzi Scheme’ (2011) Criminal Justice Faculty Publications Paper 4 <http://digitalcommons.sacredheart.edu/cj_fac/4&gt;, accessed 25 July 2015,

[9] Interpol Resolution No. AGN/66/RES/17.


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