Wednesday, 10 March 2010

Pyramid or Ponzi?

Someone called Kevin Foster has been convicted of a range of offences of dishonesty arising out of his business activities. It is reported by the BBC to have been a Pyramid scheme and referred to by the head of the Serious Fraud Office as a Ponzi scheme. Why the different descriptions?

The classic Ponzi scheme was devised and operated by a chap called Ponzi. Who'd have thought it. He persuaded people to pay him money by representing that large profits were to be expected from the investments he made. The principle behind it is very simple.

In Year 1 he gets, say, £1,000 each from 100 different investors, a total income of £100,000. He spends £60,000 to fund his lifestyle and puts the other £40,000 on deposit at the bank earning a little interest. At the end of Year 1 he announces a profit of 20% on the Year 1 investments and pays £200 each to the original 1,000 investors. This costs him £20,000 but he held back £40,000 so he can cover it. They are told they have the option of withdrawing their original investment or leaving it in place and receiving further huge profits in Year 2. Some cash-out but the vast majority like the thought of easy money so they leave it in place. Meanwhile further investors are putting in £1,000 each because they have heard of the success of the scheme.

Year 2 rolls on with the organiser living an even more comfortable life because far more mugs are throwing money at him than in Year 1, but still he holds some back to pay the Year 2 profit and to reimburse anyone who wishes to withdraw. Part of the trick is to minimise pay-outs by persuading punters to leave their annual dividend in the scheme so that it too can earn profits. In Year 2 the fraudster will have to make some payments but he is receiving so much from eager investors that it can be afforded easily.

And so it rolls on. For as long as there is enough coming in from new customers to cover the cost of withdrawals and fund the fraudsters lifestyle he continues the operation.

Of course eventually the day comes when there are too many calls for repayment and the scam is exposed. This is usually caused by a combination of two factors, (i) the fraudster getting too greedy and taking too much for himself and (ii) some external event, such as a recession, that causes people to liquidate investments.

A Pyramid scheme is similar but not identical to a Ponzi scheme. The classic Pyramid scheme does not promise a profit from anything the originator of the scheme does, instead the profit comes introducing new business to the originator. The originator elicits "investments" of, say, £1,000 on condition that a return will only result from introducing further investors. The promise is along the lines of "once you have introduced people making £10,000 of further investment you will receive a commission of £100". So Mr A pays over £1,000 and finds ten gullible friends to do the same. He is then repaid his original £1,000 plus £100 commission. If he wants to, he can make a further £1,000 investment and introduce a further 10 foolish chums in order to make another £100 profit. In order to entice people into the scheme representations are usually made that the funds are invested and the £100 commission can be described in various ways; but always the ability to withdraw your cash and profit is dependent on you introducing a minimum number of further "investors".

As in a Ponzi scheme the originator of the Pyramid scam receives money but doesn't do anything to make a profit for anyone other than himself. Both types of scam last for so long as new people pay-in and few people cash-out. The most professionally organised examples involve bogus accounts for fictitious overseas corporations so that there is fine looking paperwork to deflect attention when some awkward bugger asks questions. These schemes can operate for many years but they always eventually collapse because something happens to cause more people to ask for their money back than there is money to pay them.

Although both types of fraud involve taking money from new "investors" to pay profits to existing "investors", under a Ponzi scheme the alleged profit is triggered by the brilliant investments made by the fraudster whereas profits in Pyramid schemes are triggered by conditions about investors introducing new people to the game. Whether Mr Foster operated a Ponzi or a Pyramid scheme, the result is the same - chokey.


sobers said...

Unless you are Her Majesty's Government, in which case you can force people to pay into your Ponzi scheme, or 'National Insurance Fund', by force of law, and ultimately, arms.

Anonymous said...

I'd like to put in a small plea for the original Mr. Ponzi, who didn't start out bad as I understand it. He spotted that international postal warrants could be arbitraged by being bought in one country and refunded in another for more than the original cost. Unfortunately, the practicalities of doing this in the 1920s - transmitting money cross-border, buying the warrants, getting them refunded etc. - meant the whole process was very cumbersome and only possible in small amounts. He had only succeeded in investing a tiny fraction of the funds received when he realised that it would be far easier to steal the money instead of admitting defeat and refunding it.