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What Is a Ponzi Scheme – Bernie Madoff Ponzi Scheme & Scandal Explained

By Kalen Smith

bernie madoffOn March 12, 2009, Bernie Madoff pled guilty to the largest Ponzi scheme in history. He successfully swindled investors out of $65 billion. Although many Wall Street experts revered Madoff as a genius, many financial professionals were not surprised to learn that he was one of the biggest crooks they had ever come across. Some people were afraid they’d be ostracized if they spoke out against Madoff, and they simply kept quiet about their concerns about his investment portfolio and earnings.

Unfortunately, Ponzi schemes are fairly common, but this one was one of a kind. Most Ponzi schemes operate on a very small scale, but Madoff was clearly a big thinker who caused major damage.

Background on Ponzi Schemes

Ponzi schemes are fairly complex, even when they operate on a small scale. Unlike pyramid schemes, in which victims unknowingly rope in more targets, Ponzi schemes rely on a single person or group to coordinate every aspect of the fraud. To keep the scam going, the masterminds behind the plan convince numerous victims that they’re investing in a legitimate fund that promises great returns. Then the scam artists take money from new ”investors” and use it to pay off existing investors. But for the scam to truly work to everyone’s benefit, the orchestrators would need access to an infinite supply of new victims.

Sooner or later, the pool of new participants runs out and funds dry up. Sometimes, this trouble starts earlier than the Ponzi schemers expected because of outside factors like sudden changes in the economy. When the scheme starts running low on victims, it starts to fall apart and investors lose everything they put into it. Often, the person behind the scheme vanishes before anyone figures it out, since if they’re caught they’ll face the impossible situation of needing to return all of the lost money to all of the participants. While the government may help pay restitution, victims will have trouble recovering everything they lost.

How Madoff Stole from Thousands of Investors

Madoff set up his portfolios to look like he was matching the returns of the S&P 500. This strategy prevented him from needing to pay too much to existing investors, but it still made his purported holdings appeal to new targets. And he remained under the radar by doing everything he could to keep his scheme low key. He targeted specific, elite groups of investors, keeping his victims close and the SEC off his back. He also stayed off the grid by keeping his paperwork up to date and consistent. While most other Ponzi schemes operate by giving out large returns and then collapsing, Madoff was able to tread water with his smaller returns and keep his scam going for years.

Madoff did very little to arouse suspicion among his victims. As investors, they believed they could withdraw their money almost immediately, so they had no reason to think anything was wrong. Some analysts, however, felt that something was off when they tried to replicate his performance. Tracking the funds, one of them argued to the SEC that his firm couldn’t possibly have boasted the returns Madoff claimed. The SEC ignored these claims, even though Bernard Madoff Securities had already been investigated.

How Madoff’s Scheme Started to Fall Apart

After more than a decade of duping the SEC and his investors, Madoff saw his scheme lose steam in late 2008. He was borrowing money and couldn’t keep up with all of the investors who were desperate to liquidate their assets as the market continued to deteriorate. Eventually, Madoff realized he was in over his head and confessed to his sons, who were partners in Bernard Madoff Securities. Mark and Andrew Madoff turned their father into the FBI, putting an end to the scheme. After his arrest and guilty plea in 2009, Madoff, at seventy years old, was sentenced to 150 years in prison.

4 Signs You’re Looking at a Ponzi Scheme

Bernie Madoff’s scheme was legendary, but there are probably thousands of similar schemes going on at any given time. During bad economies and recessions, when people are desperate for easy money, victims are abundant. To avoid getting caught in one of these webs, you need to know what to look for.

  1. Unclear business models. Crafters of Ponzi schemes will try to distract you with big numbers, hoping that you don’t notice that the business doesn’t make sense. In hedge funds or investment pools like Madoff’s, the numbers won’t add up if you take the time to look at them. Schemers will often discourage you from asking questions or run around them every time you do.
  2. Aggressive sales techniques. Have you noticed how scam artists will go to any length to get someone to sign up with them? If they were for real, they would just let their results speak for themselves.
  3. Promises of high returns for no work. Anyone who tells you that you can get rich quick is probably doing something illegal. If someone promises you “easy money,” don’t give them a moment of your time.
  4. Difficulty withdrawing funds. Madoff’s scheme was unusual, because he made it easy for investors to withdraw their money fairly easily. Generally, a Ponzi scheme discourages its investors from withdrawing and creates delays for dispensing funds.

Final Word

Madoff orchestrated the most high-profile Ponzi scheme in history. The destruction he caused sent a rippling effect that affected everyone he ever worked with. After his scheme fell apart, investors realized they had lost billions of dollars. Some former employees and associates were investigated or arrested for their involvement. At least three committed suicide, including Madoff’s oldest son Mark.

One of the biggest lessons that the Madoff scheme taught investors was that Ponzi schemes can seem legitimate, so buyers should always be on the lookout for scams. Madoff’s practice seemed legitimate and was even praised by many Wall Street investors, despite the fact that his numbers simply didn’t add up. Before investing, you should look at the holdings of a fund and make sure that their performance is consistent with the activity of the stock market.

Though an unclear business model is a primary sign of a scam, the scheme itself is very carefully thought out. You really need to pay attention to what you are getting yourself into so that you don’t fall victim to one of these scams. What warning signs do you look for before you commit to an investment fund?

(photo credit: Shiny Things)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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Comments

  • Duhudsh

    i hate bernie madoff he madeoff with a lot of peoples money

    • Anonymous

      That’s a good one! I never thought about it like that but so true.

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