Ponzis and Pyramids
Internal auditors can play a role in minimizing the risk companies face in too-good- to-be-true investment scams.
Joseph T. Wells, CFE, CPA
Chairman, Association of Certified Fraud Examiners
August 2009
Bernard Madoff. Allen Stanford. Patrick Bennett. Nabil al-Boushi. John McNamara. Some of these names are recognizable by many; others will be remembered only by their victims. Carlo Ponzi (1882-1949) would be proud of them all — the crimes they allegedly committed bear his name. Ponzi was probably what modern-day psychologists would describe as a sociopath. He knew right from wrong; he just didn’t care about his actions as long as what he did suited him. Essentially, a Ponzi scheme promises current investors better-than-average returns that are paid from money from new investors. Ponzis are pre-destined to eventually fail because of pyramidal mathematics. A Ponzi scheme operator beginning with as few as six investors will quickly double and then double again. But by the time the doubling has reached the 13th level, the number of people who must be paid back by the operator exceeds the population of the planet (see “Ponzi Scheme Pyramid,” below).
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Joseph Dervaes, recently retired audit manager for Special Investigations in the Washington State Auditor’s Office, explains the reason for this doubling phenomenon: “Ponzi schemes do not usually advertise; they don’t need to. The current investors tell new ones, and the word spreads like wildfire.” Bernard Madoff, who was sentenced to 150 years in prison in July 2009 for what may be the largest single fraud of any kind in history, didn’t advertise. As the global economy faltered, Madoff did the math: The pool of new investors was shrinking to the point where the cash needed to operate his scheme was unsustainable. With Ponzi schemes seemingly more common, internal auditors can learn a lot by examining these frauds and help their employers avoid entrusting their money to these kinds of individuals.
MINIMIZING THE RISK OF PONZI SCHEMES
Madoff Investments LLC didn’t have an internal auditor. According to press reports, Madoff’s company had an external auditor in name only. But many of Madoff’s investors were entities that did have internal and external audit functions. For several of these companies, investments were a material item on their balance sheets. According to Dervaes, “Hindsight in fraud cases is always 20/20. It will be some time before we know for certain whether or not auditors — internal, external, or both — were negligent in recognizing that these investments were worthless.”
Allan Brown, director of internal audit for Community and Technical Colleges for the State of Louisiana, says internal auditors have a role in preventing their company from investing in a Ponzi scheme. He says that both the internal and external auditor have responsibilities in valuing investment instruments. “At a minimum, auditors should be alert to whether or not the investment exists; its value, if material; the collectability of the investment; and its rate of return,” Brown says.
The internal auditor’s role is to ensure that the company minimizes its risks to sham investments. According to Brown, “Internal auditors are sometimes reluctant to admit they are not experts in a particular area. Understandably, their employers aren’t keen on hiring outside consultants to help value securities and investments. But the rule of thumb is this: If the investment is not easily understood and is a material balance sheet and/or income statement item, it should be examined by experts.” At the very least, the internal auditor can compare the investment’s yield to that of similar securities.
PONZI'S REDDEST OF RED FLAGS
Ponzi schemes can have many red flags, but the flag that flies the highest is a rate of return for an investment that greatly exceeds the norm (see “Red Flags of a Ponzi Scheme” at the end of this article). That’s what unraveled Carlo Ponzi. He’d promised investors that they could double their money in 90 days — a 400 percent interest rate at a time when banks were paying 2 percent. Although Madoff’s promises weren’t as egregious, his promised returns were still much above the norm.
Harry Markopolos, a financial analyst and investigator, uncovered Madoff’s scheme. As he told Fraud Magazine (“Chasing Madoff,” May/June 2009), “[Madoff] created the illusion of an investment strategy that never hit home runs but instead earned a steady 1 percent a month and also couldn’t lose much money because he owned protective stock market put options. If such a product had really existed, it would be the Holy Grail of investment products. But Madoff was smart enough to show modest returns that didn’t seem (outrageously) high so as to avoid suspicion.”
Markopolos was suspicious nonetheless. Madoff’s Sharpe Ratio, which is a measure of how many units of return one earns for each unit of risk one takes, was off the charts for more than 15 years, ranging between 2.5 and 4.0. Sharpe Ratios this high have existed for shorter periods, but never for 15 years in a row. But investors wanted to believe in the Holy Grail, so they suspended their disbelief, Markopolos observed.
Madoff preyed on affinity groups that weren’t likely to ask too many questions. “You don’t need to be the smartest man in the world to be a Ponzi artist; you only have to be smarter than your victims,” Markopolos said in the article. Madoff knew that by recruiting feeder funds from different customer bases, he could increase the number of circles he could tap into for new victims.
CHEATING THE TAX MAN
According to Larry Cook of Cook Receiver Services Inc. in Lenexa, Kan., evading taxes is what many Ponzi scheme victims have in mind when they enter these ill-fated investments. “There is a small army of people, a cult, that will do just about anything to keep from paying taxes, and they are ripe for the picking through investment swindles,” Cook says.
Cook spent 20 years with the Office of the Kansas Securities Commissioner and has investigated hundreds of Ponzis. He currently is investigating a US $50 million Ponzi scheme allegedly perpetrated by an American expatriate living on the island of St. Maarten. The operator set up a Web site advertising a high-yield money-making opportunity supposedly based on the scammer’s connections to European bank investments. The pitch was that by pooling small investors into million-dollar increments, he could persuade his contacts to accept funds that would allow the average person access to money-making secrets known only by the wealthy. “Of course, none of this was true,” Cook says. “Like other Ponzis, the money actually went to supporting the fraudster’s lavish lifestyle and paying back earlier investors in the scam.” But this scheme had a twist. “Part of the money actually went to a Ponzi scheme where this crook had been an unwitting victim himself,” Cook adds.
For all of the good the Internet has done, it has a dark side. “It costs almost nothing to set up a Web site and start a Ponzi; that is one reason they are proliferating,” Cook says. “Just Google ‘high-yield investment programs’ and you’ll get over three million hits. Many of them are investment swindles. There are even directories of these schemes that give advice on when to get into the Ponzi and when to get out so that you minimize your risk of being burned.”
PONZIS VS. ILLEGAL PYRAMIDS
Ponzi schemes and illegal pyramids are closely linked but are not the same. While a Ponzi can be perpetrated by one individual acting alone, an illegal pyramid often depends on multiple actors. An illegal pyramid makes its money from luring other investors who get a piece of the pie (see “Illegal Pyramid and Ponzi Scheme Differences” at the end of this article). They, in turn, entice others — who also receive a share of the paybacks — to join. Those at the top of the pyramid get the money; those at the bottom are left out and lose whatever funds they have committed. One of the oldest forms of illegal pyramids is the chain letter. Pyramid schemes sell nothing. Contrast that to a legal pyramid, which is sometimes referred to as a multi-level marketing business. The best known is Amway, which sells a variety of household products and is a multi-billion dollar international corporation. Salespeople, who recruit other salespeople, earn a commission on what they sell. Amway itself earns revenues from the sale of goods.
Cook’s St. Maarten fraudster used aspects of an illegal pyramid to fuel his Ponzi scheme. The crook recruited others and paid them commissions to refer potential victims to his European banking investments swindle. But one of his recruits, dissatisfied with the amount of money he was earning, alerted the U.S. Securites and Exchange Commission, which closed in. “It’s too early to determine the exact losses from this Ponzi/pyramid but they are likely to run into the tens of millions of U.S. dollars,” Cook says. All told, the scheme ran about five years.
Criminal prosecution of perpetraters of these schemes across international boundaries is exceedingly difficult. “If the victim lives in the United States and the perpetrator is, say, from one of the former Soviet Bloc countries, it can take years, if ever, to extradite the crook and bring him or her to justice,” Cook observes. “That is why it is vital that we provide internal auditors and others with the education they need to avoid becoming victims.”
EDUCATION IS THE BEST PREVENTION
It is nearly impossible to defraud a company or individual wise enough to know what to look for. In addition to the red flags already described, internal auditors can help educate their constituencies by informing them to:
- Be alert to unexpected telephone calls, letters, e-mails, or personal visits from strangers — or even friends — who offer quick profit schemes requiring immediate action.
- Check the product. Before sinking money into any investment — no matter how promising the returns — make sure the offering is registered with the state securities regulator.
- Check the person. People selling most investments must be licensed by state regulators.
- Don’t be pressured to act quickly.
- Avoid promoters who won’t provide clear and detailed explanations of their investment vehicles. Don’t listen to pitches claiming that it is impossible to explain the deal in layman’s terms.
- Ask for detailed information in writing. Ask for information on the company, its officers, and its financial track record. If a product is involved in the deal, ask for documentation of its cost, fair-market value, and existing and potential markets. If a promoter is reluctant to provide information, consider it a red flag.
- Be skeptical of deals that can’t be checked out in person. Be particularly leery of claims that all banking transactions and bookkeeping are handled in remote cities or countries.
- Resist pressure to reinvest without seeing “profits.” Ponzi schemes often are kept alive by promoters who convince initial investors to roll over their profits for even better returns. While it often makes sense to stick with a legitimate investment over time, be suspicious of promoters who are reluctant to allow the investor to cash in gains.
Internal auditors can play a key role in thwarting these crimes. Although they may seem outwardly complex, all of them are variations of the basic scams mentioned in this article. Keep in mind that pyramids and Ponzis, like all other illegal schemes, support one cardinal and time-tested rule — if it looks too good to be true, it probably is.
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