How NOT to Get Involved in a Ponzi Scheme

Gusto Editors

Do you know how to avoid investing in a Ponzi scheme? 

Ponzi schemes cost investors billions of dollars every year. As an accountant, your clients may look to you for financial and investment advice. You need to be aware of the warning signs that an investment opportunity is actually a scam.

Fortunately, Gusto, along with our partners at CPA Academy, hosted an informative webinar all about Ponzi and pyramid schemes. Our webinar titled, “Fraud: What CPAs Need to Know About Ponzi and Pyramid Schemes,” featured the fraud and accounting expertise of Greg Kyte, founder of Comedy CPE, and Caleb Newquist, Gusto’s Editor-at-Large. You can watch the entire presentation here

In this article, we’ll share crucial information about Ponzi schemes from Greg and Caleb, including the definition of a Ponzi scheme, the Bernie Madoff investment scandal, the Charles Ponzi scheme, and Ponzi scheme red flags. 

What is a Ponzi scheme? 

Greg and Caleb discussed the components of a Ponzi scheme and perhaps the most famous Ponzi scheme example, the Madoff investment scandal. Bernie Madoff and other Ponzi scheme perpetrators deceive people through fraudulent investing. They convince people to allow them to invest their money, but rather than investing, they use the money for other purposes. Fraudsters use the money of later investors to pay for dividends and offer returns to older investors, but the Ponzi scheme perpetrator isn’t actually investing the money. 

Closeup of coffee cup with blurred image of two businessmen sitting on table.

“A Ponzi scheme is a fraudulent investing scam where it pays returns to early investors from new money contributed by later investors. The [fraudster says], ‘Hey, you’re going to be earning some great returns on your investment with me,’ and then you don’t really invest their money. You just spend it, … but you need to give those guys returns, so you get new investors. They put more money into your company, but instead of investing that, you just use that money to feed your lifestyle and give … [early investors] good returns.”

Greg Kyte

The Ponzi scheme becomes a vicious cycle because the early investors think that they’re getting a favorable return on their investments, and they bring in more investors whose money is then used to pay dividends and returns for older investors:

“The people are actually seeing money come back from their investment, so they get super psyched about it, and they’re able to help you find even more investors who put money in your company to feed the beast. You need more and more people to invest so you can keep paying these people the returns that you’re promising them, even though there’s not even really an investment that’s there.”

Greg Kyte

The Bernie Madoff scandal is the most famous example of a Ponzi scheme. Over the course of two decades, Bernie Madoff scammed thousands of investors and stole billions of dollars. 

“[Bernie Madoff] was doing legitimate investments early on when he founded his [investment] firm, but he quickly found out that he could make a lot more money if he ran a completely fraudulent enterprise.”

Caleb Newquist

Bernie Madoff convinced a growing number of investors to put their money into his investment fund. He deposited all of the money into a bank account rather than investing it, and he would then pull money from the account to pay dividends and redemptions. He was caught in late 2008 and sentenced to 150 years in prison. Ultimately, he passed away in a Federal Medical Center in Butner, North Carolina, in April 2021.  

The history of Ponzi scheme investment scams

Although Bernie Madoff committed the most famous Ponzi scheme, these scams have been around for an incredibly long time. The term came from the early 20th-century fraudster, Charles Ponzi. Charles Ponzi convinced investors that he could use their money to invest in international reply coupons in different countries. Ostensibly, he would invest in international reply coupons that were less expensive in other countries and would make a profit by selling them in the United States. 

“[In World War I], you had all these soldiers who were from various countries trying to send letters home to their loved ones, but the countries whose mail services they would use were in disarray obviously because of the war. … Somehow, these [international] reply coupons were a thing that helped to make that better. … [Charles Ponzi supposedly] bought [international reply coupons] low, and he was selling them high, and that was his investment.”

Greg Kyte
Female employee discussing report during meeting with colleagues.

He promised investors incredibly significant returns on their investments. Rather than actually investing in international reply coupons, he pocketed some of the money then moved the rest around in order to return cash to older investors:

“He says, ‘You can get a 50% return on your money in 45 days, or you could even get a 100% return on your money if you keep your money with me for 90 days.’ He was able to keep this up for over a year. … He’s telling people that he’s going to give him a whole lot of money in a month and a half or in three months, and so he had to get so many more investors to pay those early investors off at that rate.”

Greg Kyte

Charles Ponzi’s scheme became progressively less stable as he had to meet returns for more and more investors. Ultimately, he stole $20 million, which is worth around $250 million in today’s money. 

Ponzi scheme characteristics and big red flags

Charles Ponzi and Bernie Madoff demonstrated common characteristics of Ponzi schemes. Bernie Madoff got away with his scam for a much longer amount of time than usual Ponzi schemes because he offered more realistic expectations to investors. 

“One of the characteristics of a Ponzi scheme is the high rates of return. In the case of Bernie Madoff, he was showing high rates of return, but not too high rates of return, so it seemed plausible. … He became like this mythic investor who just kept beating the market year after year, and no one knew how.”

Caleb Newquist

Ponzi schemes require new investors to pay returns on older investments. Madoff’s scheme had more longevity and required fewer investors because the return on investment he promised was much lower than typical investment schemes:

“[He was] saying, ‘Hey, you’re going to get 12 to 15% a year on your return,’ instead of saying, ‘You’re going to get 20 to 50% on your return.’ You need a lot fewer new investors to pay off your promises if your promises are lower. I think that was part of how he was able to keep himself going — [it] did not seem too good to be true. It seemed good, but maybe not too good to be true.”

Greg Kyte

Every year, U.S. investors lose $10 and $15 billion dollars in Ponzi schemes, so it’s critical to be on the lookout for warning signs so that you and your clients can avoid fraudulent investments. Two major Ponzi scheme red flags are a promise of minimal risk and receiving consistent returns regardless of market conditions:

“They promise really high returns and conversely very low risk. … [Another red flag is] consistent returns regardless of the market. I think that goes back to Bernie Madoff. … He was kind of this myth because he had these really good returns consistently over two decades regardless of what the market was doing.”

Greg Kyte

When investing, another critical component you need to consider is whether the investment firm is registered with the U.S. Securities and Exchange Commission (SEC). When investors register with the SEC, they’re required to undergo certain audit procedures. 

Business people discussing contract documents in office.

If you’re thinking about investing or if your client wants your opinion on an investment opportunity, you should also consider the transparency of the operation. 

“If you’re like, ‘So tell me what you do with my money,’ and they’re going, ‘We’d love to, but it’s a proprietary secret, so we can’t. If we told you, everybody would do what we’re doing, and then we wouldn’t make our money,’ that’s a big red flag.”

Greg Kyte

Often, the more complicated an investment opportunity, the greater the likelihood that it’s a scam. Fraudsters don’t want people investigating where their money goes, so they’ll try to make the investment explanation complicated:

“If it’s too complex to explain, or [what they’re doing is] just very convoluted, that’s a red flag for a Ponzi scheme.”

Greg Kyte

Finally, the investment manager needs to be able to show you the paperwork indicating what they’re doing with your money: 

“[You say], ‘Hey, I want to see the paperwork that shows where my money’s invested,’ and they go, ‘Yeah, we’d love to get that to you. Give me a week,’ and then they never get back to you. … [Or] you say, ‘Hey, I need to pull my money out,’ … and you have difficulty getting your money out, that means that the Ponzi scheme is in trouble, and they’re not getting enough new investors.”

Greg Kyte

Ponzi schemes need new investors to return money to old investors. If the investor has difficulty showing you the investments on paper or returning your money, they’re likely scamming you. 

Learn more about Ponzi schemes

As an accountant, you’re in a critical position to help your clients with investment opportunities, so you need to be aware of different types of schemes that could scam you and your clients.

“We are people’s trusted business advisors, … and a lot of us … help advise people [in finances]. We help them to plan for retirement and to invest their funds.”

Greg Kyte

If you advise clients with their finances, you have the responsibility to inform them if they’re getting involved in fraudulent investments such as a Ponzi scheme. Fortunately, we offer even more information to educate you on these schemes in Part Two of this article series titled, “What Roles Do Auditors and Advisors Play in Ponzi Schemes?” Additionally, you can learn about pyramid schemes in Part Three of the series, “What Exactly Is a Pyramid Scheme?” You can also watch the entire webinar here.

Looking for more ways to help your clients? Consider enrolling in Gusto’s People Advisory Certification program. Your clients need more than an accountant. They need an advisor. With People Advisory Certification, you can help your clients with people-based operations such as payroll, benefits, and HR.

Gusto Editors Gusto Editors, contributing authors on Gusto, provide actionable tips and expert advice on HR and payroll for successful business management.
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