FAQ: Ponzi schemes

Wall Street financier Bernie Madoff is unquestionably the poster boy fora particularly nefarious kind of financial fraud that's been getting a lot ofattentionrecently the Ponzi scheme.

But he's hardlyalone.

In late March 2010, the RCMP accused four Albertans of running a $60-million US Ponzi scheme that allegedly fleeced 1,000 investors throughout North America.

Just a couple of weeks earlier, the suicide of Ontario financial adviser Robert Mander raisedconcern that his investors may be the latest "Ponzi" victims. The Mander scenario certainly had many of the familiar Ponzi earmarks. Investors were promised annual returns of 10 per cent in 60 days or 25 per cent over a year well in excess of what the markets could reasonably provide.

The court-appointed receiver in the Mander case later confirmed the existence of a Ponzi scheme, finding that investors were out $16.7 million.

A raft of other alleged big-dollar Ponzi schemes have surfaced in Canada in the last couple of years.

In 2009, twoAlbertans, Milowe Brost and Gary Sorenson, were arrested and charged with theft and fraud. The allegations are that the pair orchestrated what the RCMP called "the largest Ponzi-type scheme" in Canadian history. They're alleged to have bilked 3,000 people in Canada, the U.S. and overseas out of $100 million and possibly up to $400 million between 1999 and 2008.

A Montreal-based financial adviser, Earl Jones, was sentenced to 11 years in January 2010 for defrauding clients of $50 million.His Ponzi scheme ran for more than two decades and swindled more than 150 people with many losing their life savings.

In early 2010,Toronto resident Weizhen Tang surrendered to police on his return from China. The man who calls himself the "Chinese Warren Buffett" made quite a name for himself promising returns of one per cent a week. He's now facing fraud charges accused of operating a Ponzi scheme that took more than 100 investors inCanada and abroad for at least $30million.

In July 2010, aformer investment manager in eastern Ontario, Bruce Elmore, was handed a six-year sentence for theft and fraud related to what the Crown called a Ponzi scheme. His victims weredozens of seniors who were taken for$3 million.

In October 2010, the Alberta Securities Commission said it was investigating an alleged Ponzi scheme that saw 200 investors in a real estate club swindled of at least $5 million. So far, no criminal charges have been filed.

Who is the 'Ponzi' in Ponzi schemes?

Ponzi schemes also known as pyramid schemes are named after Charles Ponzi, an obviously persuasive con artist who attracted millions of investment dollars from Boston-area investors back in the early 1920s.

Ponzi promised people he could double their money in three months through aseries of investments in postal reply coupons. Fawning press articles and favourable reviews from early investors attracted ever-increasing amounts of money.

In reality, he had invested nothing in postal coupons or anything else. The money provided by later investors was used to pay off the early investors. His scheme eventually collapsed amid increasing scrutiny. He was jailed and eventually deported to his native Italy. He died a poor man in Brazil in 1949.

How do Ponzi schemes work?

The classic Ponzi scheme hasn't changed much in the last 90 years. The investor is promised an eye-popping return that is far higher than he could get through normal investing routes say 25 per cent. Since returns like that tend to attract a lot of attention in today's low-interest environment, the victims are often recruited from among members of the con artist's family, friends, neighbours, club, religious or ethnic group.

Membership in that "select" group gives investors a feeling of security thathas no basis in reality. But it works at first because the investor who puts up $100,000 is absolutely convinced he's made a brilliant investment when he gets his first $25,000 "interest" payment.

Often the fraudster urges the happy victim to invest even more and to encourage his friends and relatives to join the party. Investigators call this "affinity fraud" because investors are less likely to question the legitimacy of an investment tip from someone they know.

And so it goes. In reality, of course, the money to pay off the original investors comes from the later investors. The thing that separates Ponzi schemes from simply being bad investments is that nothing is ever bought with the invested money.

In the end, the whole pyramid collapses because there aren't enough new investors to pay off the other investors. The architect of the scam usually tries to buy time by offering excuses like poor health or new accountants but investors end up losing patience and go to authorities to try to get back their money. By that point, it's too late. The money has usually all vanished, sometimes with the architect of the whole mess.

Why are so many Ponzi schemes surfacing now?

The market downturn that began in 2008 and continued into 2009 did two things. First, it slowed or stopped the flow of new money into many Ponzi schemes as investors became more cautious.

Second, existing investors who faced increasing financial pressures during the market meltdown were no longer content to "roll over" their investments and started asking for their money back.

Those two scenarios turned out to be extinction-level events for the operators of several Ponzi schemes, which desperately need that ever-increasing pool of money to repay earlier investors.

The huge media attentiongenerated by Bernie Madoff's $50-billion US Ponzi schemealso helped to focus more attention on lesser "too-good-to-be-true" investment schemes.In other words, previously contented investorsstarted asking difficult questions.

What steps can people take to protect themselves?

Any investment that purports to guarantee a well-above-average return on invested money should be viewed with suspicion. There just aren't easy ways to beat the market without taking huge risks. If there were, everyone would be doing it.

Check out the person and/or the investment with a lawyer, accountant or other knowledgeable financial expert or phone your provincial securities commission.

Anyone who sells market investments must be registered with provincial regulators. The Canadian Securities Administrators administers asearchable databaseof individuals and firms registered to sell securities.

The Ontario Securities Commission has its owndatabase of those registered in Ontario.

Some con artists, however,have been registered and managed to operate outside their firm's guidelines and the law. Alarm bells should be ringing if anyone asks for cheques to be made out to them personally, rather than a recognized firm. If they don't want to meet you at their normal place of work, that's another tipoff.

Some fraudsters say their investments are insider-only "private" offerings that regulators don't need to know about. Another warning sign. Ask to see formal documentation. And that doesn't mean a glossy brochure.

You can verify regulatory filings of documents for public companies in thisdatabase.

One thing investors should not do is simply assume thatsomeone in authority has ferreted out all the phoneys and checked into everyone who has a questionable banking history. Investigations generally aren't launched until there are complaints. Probes take time, and con artists are often able to draw in a lot of new money even while inquiries are continuing. Montreal Ponzi scheme operator Earl Jones who was sentenced earlier this year to 11 years in prison managed to operate his fraud for more than 20 years.

Even more discouraging,the regulators sometimes don't catch the bad guys even when they're given specific information the person is crooked. The SEC was tipped off to Bernie Madoff's anticsyears ago but failed to do even the most basic check into his activities.

Due diligence isn't just a suggestion. It's a necessity.