Can You Recognize the Red Flags of a Ponzi Scheme? by Richard A. Pollack, CPA
Posted on December 12, 2022
It likely will take years for the courts and regulators to unravel all the details that led to the recent bankruptcy filings of FTX, one of the world’s largest cryptocurrency exchanges, and its affiliated companies. While the exact cause and accounting of the once $32 billion company’s collapse remains to be seen, it has come at a time when Ponzi schemes are rising. Ponzi schemes were up 50 percent in the first half of 2022 over 2021. The best and only way for consumers, investors and business partners to identify a potential Ponzi scheme is to learn to recognize the red flags.
In typical Ponzi schemes, companies or people pay purported returns to their existing investors from the money they receive from new investors. To keep the scam going and divert some of the investors’ funds to themselves, the scammers must continually attract new investors, typically through the promise of high returns with little to no risk. Although these scams are named after a man who conned investors in the 1920s, one of the largest and most widely cited schemes was committed by Bernie Madoff and discovered in 2008. Following are some of the additional characteristics shared by most all Ponzi schemes.
Above-Market Returns with Performance Guarantees and Little to No Risk
Every investment comes with some degree of risk, and there are no guarantees that an investment will perform as promised. Generally, the larger the potential reward, the greater risk the investor must accept.
Overly Consistent Returns Regardless of Market Conditions
Investments typically do not generate consistently positive returns. Instead, they rise and fall with the public equity markets based on a wide range of economic indicators.
Unregistered Investments and Unlicensed Sellers
To ensure security offerings meet federal regulations and protect investors’ interests, they must register with the Securities and Exchange Commission (SEC) and share details about their finances, their management teams and the products or services they sell. Similarly, these entities must be registered and listed as active or in good standing with the states where they are incorporated and pay taxes.
Federal and state laws also require individuals who sell investments to be licensed and registered with the Financial Industry Regulatory Authority (FINRA), which maintains an online database that consumers can use to research the background and experience of their financial advisors, brokers and related firms. Investors must do their homework to help avoid falling victim to a scam.
Highly Complex, Secretive or Difficult to Understand Business Model
Investors must ask for and receive in return as much information about a potential investment as they can. Missing details and/or not understanding how an investment works should set off alarm bells.
Lack of Transparency and Excuses or Delays with Information and Paperwork
Investors should diligently read an investment’s prospectus, paying particular attention to errors in accounting statements that may indicate fraudulent activities and/or excessive spending and above-market salaries paid to senior executives and administrative staff. Be equally skeptical of missing information, a lack of documents or a promoter’s excuses for delaying the delivery of requested material. No investor should feel bullied, especially when requesting information needed to assess the investment.
Difficulty Receiving Payments
Investors should be suspicious when they do not receive payments as promised or have difficulties cashing out. It is common for Ponzi promoters to promise higher returns to investors looking to exit. After all, investors must stay invested for the promoters to continue their scams.
Lack of Generally Accepted Accounting Principles (GAAP) or High-Level Accounting
In the U.S., public and private companies generally follow a set of standard accounting principles and rules for reporting financial data in a consistent manner that makes it easy for investors and other stakeholders to assess a company’s financial circumstances. Deviations from GAAP or other commonly used economic reporting methods may be a sign of trouble.
Lack of Strong Internal Controls
Internal controls refer to the policies and procedures businesses implement to protect information and assets and ensure the integrity of their financial reporting. Without this system of checks and balances and segregation of responsibilities, a company, its employees, investors and assets are exposed to a wide range of potential risks, including fraud.
Lack of a Functioning Board of Directors
An independent board of directors is critical to help a company manage risk and ensure that its actions and outcomes are consistent with its strategic plan, policies, procedures and budget. This is especially important when control of the company and all its decision-making is limited to one or two individuals.
Use of Charitable Activities to Give the Business or Investment Credibility
In an attempt to legitimize a company or investment and put its executives in the most positive light, a Ponzi promoter may donate millions of dollars to a nonprofit organization and/or spend significant company funds to sponsor philanthropic activities. In the same vein, it is important to recognize that not all Ponzi schemes are smoke and mirrors. In some instances, a part of the scam will involve a legitimate company conducting normal business operations.
Identifying a Ponzi scheme or other fraudulent activities is complicated by the fact that many promoters of these cons have mastered the powers of persuasion. They use a variety of tactics to not only conceal their crimes, but also to manipulate investors’ emotions and decision-making abilities. For example, they may lure victims with promises of building wealth or creating a false sense of urgency and fear of missing out on what they claim is an exclusive opportunity. As a general rule, investors should approach every investment with a critical eye, ask the right questions and recognize that if it seems too good to be true, it probably isn’t a good idea.
The professionals with Berkowitz Pollack Brant’s Forensic and Advisory Services practice include certified fraud examiners, financial and computer forensic specialists, and insolvency and restructuring advisors with deep experience detecting financial crimes, restructuring documents and exposing the truth of many high-profile frauds.
About the Author: Richard A. Pollack, CPA, ABV, CFF, ASA, CBA, CFE, CAMS, CIRA, CVA, CGMA, is senior director of Forensic and Advisory Services with Berkowitz Pollack Brant, where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.