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Ask About Ponzi Schemes

by Eager Entrepreneur | July 3, 2012

Subject :Ask Toolkit About Ponzi Schemes

Dear Toolkit,

I recently asked my dad to lend me some money to start my own MLM business. He refused to give me a loan, but gave me a stern lecture on the evils of get-rich-quick scams. I told him that I had been led to believe that multi-level marketing businesses are legitimate enterprises, but his retort was that "a Ponzi scheme by any other name is still a Ponzi scheme." What in the world is a Ponzi scheme? (I can't ask him as we are no longer on speaking terms.)

Eager Entrepreneur

Dear Eager Entrepreneur,

Don't be too hard on your dear old dad. He and I are of the generation that casts a suspicious eye on enterprises that substitute a "downline" of recruits pushing non-products for plain old-fashioned hard work with truly valuable goods or services. It's the old "if it sounds too good to be true, it probably is" school of investment policy. But your question merits an answer as it touches on a colorful chapter in business history with lessons worth reviewing in these modern times.

A Ponzi scheme, named for Charles Ponzi, is simply a system of robbing Peter to pay Paul. It's a pyramid of investors, the earlier (top) ones being paid off from the investments of the later (bottom) ones. Although these kinds of schemes were perpetrated long before the illustrious Ponzi was born, and they continue to proliferate today, he raised it to an art form and richly deserved to have this technique bear his name into perpetuity.

Charles Ponzi began life as Carlo Ponsi in Parma, Italy in 1882. His Dad was a general in the army, and Carlo was not a poor, illiterate waif--although he often looked like one. Barely over five feet tall as an adult, he grew to become a giant of a crook, gambler and all-around con man. The family wearied of bailing him out regularly and shipped him off to America in 1903 with a one-way ticket to stay with relatives in Pennsylvania.

Being that rare exception, an immigrant without a work ethic, he soon tired of life in the industrious environs of Pittsburgh. He wandered through the East, gambling his way between jobs waiting tables and hawking insurance. His guile and charm were the only tools of trade he possessed.

By 1908 Ponzi's English and wardrobe were much more polished, and he landed a job in Montreal with an Italian banker. His assignment was to get lots of new accounts for the bank, and he succeeded by promising outrageous interest earnings to new savings account customers. He paid the enormous interest rates to the early account holders out of the deposits of subsequent savers.

Business, needless to say, bloomed. When the Canadian bank examiners caught on, his boss fled to Mexico, but Ponzi, for all his smooth talk, ended up in a Canadian jail for two years.

Apparently a slow learner, as soon as he was released from prison, he attempted to smuggle some immigrants over the U.S. border for a fee and was immediately sent to the federal pen in Atlanta for his trouble. He remained there until 1917 when, at age 35, he took a typist job in Boston and married the teenaged daughter of an Italian produce merchant.

After a brief stint working for his father-in-law's firm that ultimately went bankrupt, Ponzi decided to try his hand as an independent entrepreneur. He set up a little office in Boston, and while considering what import/export opportunities might be exploited, he hit upon his $10 million idea.

Ponzi received a letter from Spain that contained an international "postal reply coupon." These PRCs, created in 1906 by an agreement between 60 countries, were used at the time to facilitate getting replies to international mail from folks who might not otherwise respond due to the cost of postage. If you were a businessman in Spain looking to get an answer from someone in Boston, you sent a PRC along so that the person you wrote to could exchange the coupon for a stamp to send you a reply.

PRCs were most popular with immigrants in America and Canada, who included them in letters sent to relatives in the old country. The relatives could then exchange the PRCs in Europe for postage they could not otherwise afford to buy in order to reply. Ponzi allegedly received his seminal PRC from Spain in 1919.

The timing was key. Keep in mind that World War I had decimated the European economies, but PRCs were exchanged at pre-WWI value. Ponzi calculated that one could theoretically purchase a PRC in Europe and exchange it in the U.S. for at least three or four times the amount that was paid for it. Entrepreneurial arbitrage of sorts!

At least this was the seed he planted in the minds of his investors. He may or may not have tried to actually make such transactions. The sheer volume that would have been needed to make any money would seem impossible as a practical matter. (Mark Knutson, in his most interesting web site, describes in great detail the machinations of Ponzi's scheme. It is a site well worth taking the time to read if you are a student of the history of investment frauds.)

The post office seemed to think his scheme would be illegal, and the government took steps to rectify the gap in exchange value as soon as they got wind of this idea. But these details didn't deter Charles Ponzi. He formed a firm he called Securities Exchange Company (long before the SEC was created) and offered notes for sale to raise money, ostensibly to buy coupons abroad. If you bought a note for $100, you were promised $150 in return in just 90 days, and he soon reduced that wait to 45 days, sweetening the pot.

His initial notes came due in February 1920, and he paid them off in full as promised. Investors were so thrilled that they never cashed out, but reinvested every penny and encouraged all their friends and relatives to buy notes as well.

Business again bloomed. Ponzi bought a fancy mansion, deposited all his money in respectable banks and even planned to take over a bank to legitimize his company and leverage his power. By summer he had accumulated many millions just by paying off earlier investors with the funds thrust upon him by new investors wanting to get in on the action, and keeping the lion's share for himself.

The scheme started to fall apart when an old creditor, a furniture merchant, decided to sue Ponzi on a relatively petty matter. The publicity stirred up some lack of trust, and a Boston newspaper dug into his past and unearthed his old Canadian prison record. There was a run on the company, and it collapsed. He copped a plea (mail fraud) to avoid a trial in November of 1920.

According to Forbes writer Jay Wolff, a historian of financial fraud, Ponzi got a five-year sentence, but it took the government almost 11 years to sort out the whole mess. By 1931 the auditors determined that he owed $15 million, but owned only $1 million in assets, which they soon liquidated to pay off beleaguered investors in pennies.

When Ponzi got out of jail, he was reindicted on further charges and jumped bail, fleeing to Florida to sell swampland. Indicted yet again, he was returned to Boston and remained in prison until 1934.

Through all these and assorted other perils, his faithful wife, Rose, stood by her man. When Ponzi was 52, he was deported to Italy. Rose waited patiently for him to send for her--which, of course, he never did.

But Wolff says he got along rather well in pre-WWII Italy and landed a job with an Italian airline in their Brazilian office in Rio. During the war he found out some of his colleagues in Rio were running a swindle and had failed to cut him in, so he ratted on them and was fired for his trouble. (Although Knutson says his whereabouts in the late 1930s were unknown, and when he arrived in Brazil he supported himself teaching English.) He died broke in 1949 in Brazil. Sic transit gloria mundi.

But his legacy lives on. Every new day dawns on some innovative scam based on Ponzi's pyramid scheme model. The peak of the pyramid thrives as long as the "downline" foundations don't crumble; but pull out just a few of those bottom rows of stones and fail to replace them--and see how quickly the mighty structure crumbles to dust.

My advice is to listen to your wise old Dad.