Wednesday, July 15, 2009

Detecting Ponzi Schemes

Yet another suspected Ponzi scheme has surfaced in Montreal. Financial advisor Earl Jones has disappeared owing investors an estimated $50 million to $100 million. If this turns out to be a Ponzi scheme, then this money doesn’t actually exist because old investors get paid out of new investors’ capital.

Typically, Ponzi schemes are detected when the economy goes bad and many people need to draw on their savings. The demand for cash overwhelms the ability of the criminal running the Ponzi scheme to find new investors to supply the needed cash.

As more of these schemes are uncovered, the call for regulation gets louder. In some cases, opportunist organizations simply call for self-serving changes to laws. But, what rules would actually detect Ponzi schemes in their early stages?

The key difference between legitimate financial firms and Ponzi schemes is that the legitimate firms actually control assets that match the total amount on statements sent out to investors. In Ponzi schemes, the pot of money invested is smaller than the total amount owed to investors.

The obvious fix is to require periodic auditing to ensure that enough investments exist to back up the amount owed to investors. Mandating audits would serve auditors nicely, but protection is needed from criminals who simply shop for auditors willing to take outsized fees to look the other way.

Perhaps a requirement for a different auditor every few years, or having an auditor assigned by some independent organization would help. The down side of all this is that it would likely drive up auditing costs for legitimate financial institutions.

There is room for creativity here to reliably detect cheaters, but keep costs reasonable for the honest majority.


  1. would think that if con artists saw each other getting caught and spending life times in prison they would live the straight and least for a little while! And everyone wonders why people aren't spending money and investing!

  2. Two things peculiar about the Madoff case:

    He used a phony baloney auditor, some guy working alone out of a strip mall who spent no time at the office. You allude to this in your post.

    The assets Madoff held for clients were held in house. So, another way of detecting fraud would be to have an independent curator of the accounts, say a brokerage or a bank. Investors should be sent statements from this independent institution so they can confirm the assets they hold. It would have to be a reputable, well-known firm.

  3. diversification and due dligence, two steps any investors must perform.
    Madoff scheme had red flags all over it, and many in plain sight requiring little financial expertise.
    1. not registered with SEC
    2. Cohmad, a feeder fund co-founded with Mr. Cohen and Madoff.

    3. small auditor in a strip-mall (two people for a fund that was valued at many billion dollars)
    4. secretive (always closed but can be open to you as a favor)
    5. Vague in explanation (if you ask questions your investment will be returned to you)