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PONZIS AND PYRAMIDS
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Investors generally set two objectives in evaluating an
investment: (a) As high a return as possible ("yield" in the
form of interest, dividends and/or long term appreciation), and
(2) Safety. Ponzi and pyramid schemes normally attract
unsuspecting investors by the promise of an unusually high rate
of return.
Experience has demonstrated, however, that as a general rule,
the higher the return on an investment, the riskier it is
likely to be. In other words, the higher return is usually paid
to justify the higher risk. The prudent investor will compare
the return promised or proposed with that generally being
realized on other types of investments.
It is impossible to describe thoroughly the various forms Ponzi
and pyramid schemes might take, but these operations do have
certain hallmarks. You should be particularly cautious when an
investment opportunity emphasizes:
-very high yield;
-quick return;
-"a once in a lifetime" opportunity; and
-the chance to "get in on the ground floor."
PONZI SCHEME
Named for Charles A. Ponzi, who defrauded hundreds of investors
in the 1920s, a Ponzi scheme pays off old "investors" with
money coming in from new "investors." It works this way:
Example: Investor A gives Promoter ("P") $1000 on P's
promise to repay $1000 plus $100 "interest" in 90 days. During
the 90 days, P makes similar promises to Investors B and C,
receiving $1000 each from them. At the end of the first 90 day
period, P may offer to pay A the $100 "interest" and to return
the original $1000. More likely, he will invite A to "re-
invest" the $1000 plus the $100 "interest" for a similar, or
higher, return at the end of another 90 days. Thereafter, A,
believing he or she can receive a good return on the
investment, is likely to bring other investors to P.
In this manner P collects a pool of money that he can use to
pay out to those few wishing return of their money. P may
operate his scheme for some time before "pulling the plug" -
that is, either disappearing with all the "investments" or
revealing the bad news that the investments went "sour."
A major factor in the eventual collapse of a Ponzi scheme is
that there is no significant source of "income" other than from
new investors.
A PONZI SCHEME IN OPERATION
Joe Smith claims that he operates a factoring business, buying
accounts receivables from small companies at a discount and
then making a large profit when he collects the receivable. In
order to conduct his business, he says that he needs, on a
short term basis, large amounts of money. Because his factoring
business is so profitable, he is prepared to offer promissory
notes paying 20-50% within 6-9 months.
In this case, there was no factoring business. The promoter
used the borrowed money for his own personal uses. The
operation kept going because many "investors," instead of
cashing their promissory notes upon maturity, agreed to new
ones that they thought would allow their capital and profit to
accumulate. Those "investors" who did not want to continue
were paid off with funds from new and present "investors."
PYRAMID SCHEMES
The "pyramid" scheme is essentially a business variation of the
familiar "chain letter." It works this way:
Example: Promoter ("P") offers A and B the chance to
"invest" by purchasing "distributorships" at $100
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