What is a Ponzi Scheme?

Definition of a Ponzi Scheme

With all of the talk recently about the Madoff scandal and various other ponzi scheme’s affecting the hedge fund and investment management industry, we have decided to post a definition of a Ponzi scheme.  The definition below comes from the SEC and can be found here

“Ponzi” Schemes

Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period—and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons.

Decades later, the Ponzi scheme continues to work on the “rob-Peter-to-pay-Paul” principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses. For more information, please read pyramid schemes in our Fast Answers databank.

Other articles related to fraud and Ponzi schemes include:

4 thoughts on “What is a Ponzi Scheme?

  1. John Black

    You must be careful in your definitions. Your comment that a Ponzi scheme is a program where “…money from new investors is used to pay off earlier investors until the whole scheme collapses…” is not exactly correct. There is nothing wrong with using new investors to pay withdrawing investors. That is done all the time…they’re called mutual funds.

    The real definition is or should be that a Ponzi scheme is where the business is founded, not on an underlying economic endeavor, but rather where the purpose of the business is to sell its own shares.

    I realize it is a fine distinction, but one that the readers of this law blog should understand.

  2. John Black

    The following appears to be a better definition of a Ponzi scheme and one that has been quoted numerous times in court opinions.

    The definition advanced by the SEC is too all encompassing and could result in legitimate enterprises being accused of operating a Ponzi scheme.

    A Ponzi scheme is a term generally used to describe an investment scheme
    which is not really supported by any underlying business venture. The
    investors are paid profits from the principal sums paid in by newly
    attracted investors. Usually those who invest in the scheme are promised
    large returns on their principal investments. The initial investors are
    indeed paid the sizable promised returns. This attracts additional
    investors. More and more investors need to be attracted into the scheme
    so that the growing number of investors on top can get paid. The person
    who runs this scheme typically uses some of the money invested for
    personal use. Usually, this pyramid collapses and most investors not
    only do not get paid their profits, but also lose their principal

    Mark A. McDermott, Ponzi Schemes and the Law of
    Fraudulent and Preferential Transfers, 72 Am. Bankr. L. J. 157, 158

  3. RD

    Mutual Funds are a type of Ponzi; only the first person “out” gets their money. Mutual Funds must always have new investors or they collapse just like any other Ponzi; Mutual Funds only appear to grow because you’re usually always feeding it more money and there are usually new investors; but when the “markets” take a crap and people start “pulling out” everyone else loses their money also, why should my money disappear because you took your money out?

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