PONZI SCHEMES FROM THE PERSPECTIVE OF LAW &

ECONOMICS.

Robbing Peter to pay Paul. A brief analysis on fraudsters, their victims

and legal deterrence.

SEBASTIN PRINCIPE

2016
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1. Introduction

I was the magician, and nobody wants the magic trick explained and thats what you get for believing in magic.1

When Maddoff Investment Scandal was discovered in 2008, the largest and longest investment fraud in History
unveiled. Losses were estimated in 65 billion dollars in the worst Ponzi scheme fraud ever. Despite the fact that Ponzi
schemes have been going around for more than a hundred years at the moment (Charles Ponzi scheme was put to
work during 1920), then and even today people are still falling in these kind of called investment frauds.

But how can Law & Economics (L&E ) can help us understand the mind of those who enter a scheme? Are there legal
improvements that can deter people from creating new Ponzi schemes? In the following project I will examine how
Ponzi schemes affect the rational choice theory (RCT) using methods of persuasion and delusion by targeting the
biases that studies in Behavioral Economics (BE) have shown. My choice of subject is based on the fact that in the
last couple weeks there have been increasing reports2 of Ponzi-like fraud schemes called abundance flowers which
aim directly to women by stating that they empower them in a male world. The objective of this work is not to
make conclusions on the matter as my investigation3 has proved me there are no easy answers on the issue but to
only connect a few aspects that fit in these types of frauds.

2. What is a Ponzi Scheme? Who was Charles Ponzi?

Robbing Peter to Pay Paul. A very old English expression originated no least than 350 years ago often used to refer
to Ponzi schemes. A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors
from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in
opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting
new money to make promised payments to earlier-stage investors to create the false appearance that investors are profiting
from a legitimate business. With little or no legitimate earnings, Ponzi schemes require a consistent flow of money from new
investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number
of investors ask to cash out.4

Even though Charles Ponzi may have been inspired by the scheme of W. Miller in 1899, he has the infamous privilege
of having a type of fraud called after him. Charles Ponzi was an Italian businessman and con artist who decided to
promote an investment in 1920 in the city of Boston (later spread across the country because of the astounding
returns that he promised). He first started his company called the Securities Exchange Company and offered an
investment which consisted on buying discounted postal reply coupons in other countries and redeeming them at
face value in the United States as a form of arbitrage. What was actually happening was that Ponzi was paying old
investors with new investors money. His scheme lasted for more than a year before it collapsed and the losses were
estimated in 20 million dollars (about 225 million dollars of today). Charles Ponzi was later sentenced for fraud.

3. The Abundance Flower. The Framing effect.

Here is an idea: You give me some money. By giving me some money you will be entitled to ask others to join our group.
Eventually, there is a chance you will receive money. Sound about right? No? Okay, how about I form a sister empowerment
group that shares abundance. We focus on fulfilling our deepest selves through gifting love (and cash) toward the center of our

1
Sentenced attributed to Bernie Madoff interpreted by Richard Dreyfuss in the TV Show Madoff by ABC. Even the quote may be fictional it is still quite
plausible in the context.
2 Clarin. 14-Oct-2016 (in spanish). http://www.clarin.com/sociedad/Procelac-advirtio-engano-flor-abundancia_0_1668433175.html

3 My investigation on this issue is based largely on the book by Mervyn Lewis Understanding Ponzi Schemes. Can Better Financial Regulation Prevent Investors
from Being Defrauded? New Horizons in Money and Finance series Edward Elgar Publishing.
4 US Securities and Exchange Comission. https://www.sec.gov/answers/ponzi.htm
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lotus circle and someday, after you gather more women together, with lightness and
invigorating clarity, you might blossom into the center and receive the
abundance. Sound better?5

Ponzi schemes are often connected with the Framing Effect. As stated in the
quotation on the abundance flower scheme or women empowerment gifting
circle the way that the investment is described may have a tremendous
effect on whether the victim may actually give his/her money or not. If you
said that in order to receive your return you would need that an exponential
number of people enter the scheme by giving their money and even though
the system will inevitably collapse (in this particular scheme, the total
members losing money are 87,5%)6 probably not many people would
participate. But instead, if you present it as a flower, targeting women and making it look like a way to enrich
women against the oppression of men, and while challenged for fraud answering that those are arguments used by
men who do not want women to liberate maybe a lot of potential victims will consider participating. Also the
symbolic use of basic elements earth, wind, water and fire with its rhetoric targets especially spiritual oriented
people. In this way, we can see that decision-makers are not necessarily invariant to the way that information is
shown to them like the RCT theory states.7

Another element that I found interesting is that usually in very large and spread Ponzi schemes there is a tendency
to operate under pompous company names which are supposed to be trust-bulding. In the case of Charles Ponzi his
company was called the Securities Exchanges Company. Bernard Madoff was not too far away and he called his firm
Bernard L. Madoff Investment Securities LLC. Another huge scheme was the one perpetrated by Allen Stanford who
got caught in 2009 with losses around 7 billion dollars. In his case he operated under the Stanford Financial Group,
Stanford International Bank and the Stanford Trust Company. In his case, also, he publicly pretended to be connected
with Leland Stanford, the founder of Stanford University and even hired genealogists to prove the family link. Other
than the 110 year sentence that he is currently serving for the Ponzi Scheme he was sued in 2001 for trademark
infringement for using the name "in a way that creates public confusion" and is "injurious"8.

4. Hyperbolic Discounting or Present Bias and Over optimism Bias.

Just as rising tide lifts all boats, most businesses flouring during a boom, and the same Is true of Ponzi Schemes. A bubble market
environment like a dot-com boom and soaring stock market creates a goldrush-type mentality among investors, who believe that
abnormally high returns are the norm. That is the reason why Ponzi schemes flourish during market booms, since fraudsters can
justify high and stable returns even though they are generated through opaque business models. 9

Just like in any other of investment, the investor would expect returns as high as possible for the amount of risk
assumed. This is a basic for wealth managers and this ratio is called the Sharpe Ratio. It shows a mathematical way
of calculating how much risk is involved in producing that return. Well, the fact is that usually in Ponzi Schemes
astonishing returns are promised at very low risk.10 During my investigation in Ponzi schemes I find that there seems
to be a link between Hyperbolic discounting and Over optimism bias. While in the traditional Ponzi Schemes high
returns are promised, orthodox finance states that due to higher expected returns higher risk is expected in the
investment. The hyperbolic discounter does not do well in making current decisions that have future costs and

5 Ask Roxy. Blog of R. Sher Olson, attorney of California. http://ask-roxy.blogspot.com.ar/2013/08/gifting-circles-just-how-illegal-are.html#.WDU2j337y_q

6
See http://www.mathmotivation.com/money/pyramid-scheme.html
7 See BEHAVIORAL ECONOMICS AND THE LAW. An Overview and Critique. Chapter 4. Part Two. Page 97 et seq. Ulen, Thomas.
8 http://archive.fortune.com/2010/05/19/news/newsmakers/madoff.stanford.prison.fortune/index.htm

9
Mervyn Lewis, op. cit. Page 36.
10 I need to re state that this is a complex subject and even when high expected returns are usual within Ponzi Schemes in some cases like in Madoff the
particularity was that he offered low steady returns in all types of markets, even when those were falling. Fairfield Sentry, one of Madoffs Hedge Fund feeders
had a only 7 months of 0 % returns in 18 years of operation (93% success rate).
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benefits (Ulen) and even though the Ponzi victim is planning for the future by investing, he is, at the same time,
expecting fast-paced returns well above market returns. In this way he is sailing away from traditional finance by
expecting returns for his investment that are unfeasible for the amount of risk he pretends to have assumed in the
Ponzi scheme.

At this point, the investor/victim becomes excessively confident on his investment. In a wonderful paper on this
subject, Steven Pressman, an economist at Monmouth University, identifies overconfidence as the primary reason
responsible for the susceptibility of otherwise sophisticated investors (usually male and highly educated, statistic
shown) to financial fraud. Overconfidence by investors also explains why investors do not raise obvious questions and why
perpetrators of fraud seem to have such an easy time duping even sophisticated investors. Most financial frauds follow this
pattern. Investors do not thoroughly checkout who they are giving their money to, and even if they do this, swindlers are able to
cover their tracks. Moreover, the human disposition toward overconfidence gets rewarded and reinforced by the typical format
of a financial fraud. Normally, large gains are paid to initial investors to generate overconfidence. There is a great deal of
psychological evidence that people frequently make misjudgments when looking at events that occur purely by chance. Instead
of attributing these events to chance, people develop some rationalization for these events. One rationalization is a belief that
they are better than others or luckier than others 11 This overconfidence reinforced by first returns leads to two different
new problem. The first, being that the victim will not only exit the scheme when it would be possible but also he
would reinvest the profit (which is, again, new investors money). The second, is that these few fortunate first are
known as the songbirds since they spread the scam to others inducing friends and family members to the scheme.
Even more, if the scheme is surrounded by a halo of exclusiveness like in the Madoff case (where he declined
sometimes new investors to have an aura of privileged clients) the success to enter the scheme becomes a sort of
prize. The victim is then, without knowing, an accessory to the fraud.

5. The Principal Agent Problem.

Agency theory claims that a lack of oversight and incentive alignment greatly contribute to these problems. Many investors fall
into Ponzi schemes thinking that taking fund management outside a traditional banking institution reduces fees and saves money.
Established banking institutions reduce risk, however, by providing oversight and enforcing legal practices. Some Ponzi schemes
simply take advantage of consumer suspicions and fears about the banking industry. These investments create an environment
where the consumer cannot properly ensure that the agent is acting in the principal's best interest. Many examples of the agency
problem occur away from the watchful eye of regulators and are often perpetrated against investors in situations where oversight
is limited or completely nonexistent.12

Another (obvious) problem involved in Ponzi schemes is the Principal Agent problem. In this much studied issue in
L&E the agents (fraudsters) have more complete and better information than the principals (victims) in making
decisions FOR the principals who hired them to manage their investments. This is of course a problem of asymmetric
information. How do you make sure that the self-interested choices of the agent will be in compliance with principal
desires? Some Ponzi schemes started like honest investment and none fraud intention but due to poor investments
at some point where large sums of money were lost they decided to repay investments with new investors money.
Once the wheel has started to spin, it would be almost impossible to stop it. Anyhow, unless every investor spends
every minute verifying the agents behavior and reviewing his decisions, there must be a reasonable belief that the
trusted persons will tell the truth and abide his promises .13 According to Kenneth Arrow it saves a lot of trouble to have a
fair degree of reliance on others people word (Arrow, 1974). However, there is a limit, for trust does not include gullibility.
The buyer of the Brooklyn Bridge is not a trusting person, but a gullible one 14

Nonetheless, it seems almost impossible for the agent to control the principal once the money has been turned to
the fraudster but it is also important to remind that not all victims are turning themselves into the hands of the

11
On Financial Frauds and Their Causes: Investor Overconfidence, Steven Pressman
12
http://www.investopedia.com/ask/answers/041315/what-are-some-famous-scandals-demonstrate-agency-problem.asp
13 Frankel, Tamar (2012). The Ponzi scheme puzzle. A history and analysis of con artists and victims. Oxford University Press.
14 Frankel, op. Cit.
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schemers. Many of them actually entrusted their investment to hedge funds and banks that fed the fraudsters
investment companies. In Neilson V Union Bank of California the court ruled that the plaintiff properly pled a
negligence claim against the bank that had a duty of reasonable care to the clients to ensure the accuracy, legitimacy,
and existence of assets to the Club and that their breached this duty by failing to ensure accuracy, by commingling assets of the
Clubs accountant, and by allowing the debtor to accept the Club members funds even though he was not a registered investment
advisor. 15

6. The mind and behavior of the Con Artist.

Despite the fact this title is not strictly related to L&E, I do not think that any essay on Ponzi schemes would be
completed without a brief description of similarities in the psychology of the perpetrators and their behaviors.

In my investigation, fraudsters are often living the grand life. They are usually known for being philanthropists,
sponsors of community events and social networkers. According to Psychologist Greenspan (who is ironically a victim
of Madoff and expert in gullibility subjects) fraudsters are living out a fiction by using other peoples money to act out the
fantasy. It is almost like they convinced themselves that the scheme is legitimate 16. Frankel also states that Ponzi Fraudsters
are narcissists and sociopaths. They are like the mythological Narcissus, whose punishment by the gods was to fall in love with
his reflection, which dissolved upon touch. One of their main features is lack of empathy for other people. Also these con artists
are addicts. If one story fails then there is another. They dont see failure as the end of the venture; its simply a signal that the
time has come to create something else.17

In the words of Diana Henriques, Ponzi schemers are able to face their victims every day because they dont look
like victims. To the schemers, they dont see victims but beneficiaries reinforced every day by every thankful customer
who says Bless You, Bernie. Its the crime of the egoist [Madoff] was greedy for the money and praise, arrogantly
sure of his own capacity to pull it off, smugly dismissive of sceptics18 Like in the Charles Ponzi case, before the victims
knew their condition Ponzi usually heard from them that not Columbus but him was the greatest Italian that ever
lived because he had discovered money (Utpal Bhattacharya, 2003).

7. What can be done to stop Ponzi Schemes?

A deterrence-based approach to regulatory enforcement is appropriate to combating fraud (as contrasted with a compliance
based strategy), as fraudsters are not generally law - abiding and will violate securities law where the perceived benefits exceed
the cost of sanctions. The evaluation of the cost of sanctions necessarily requires an estimation of the likelihood of being caught
and successfully prosecuted. As a result, detection and prosecution have a deterrent effect. Certainty, timeliness and severity are
elements of a successful deterrence strategy.19

i. Financial Education

While empirical evidence suggests that Financial Literacy Programs20 may not be all too effective in the decision
making of financial choices it seems that programs directly aimed to avoid scams as Ponzi schemes by discouraging
investments with outstanding expected returns would seem convenient. At least that is what the Australian
Government is encouraging trough the Australian Competition and Consumer Commissions (ACCC) Scam Watch

15Neilson v. Union Bank of California, NA, 290 F. Supp. 2d 1101 (C.D. Cal. 2003) http://law.justia.com/cases/federal/district-courts/FSupp2/290/1101/2326612/
16 Greenspan, Stephen (2009). Annals of Gullibility: Why we get duped amd how to avoid it. and How Bernard Maddof made off with my money or why and
experto n gullibility can get gulled.
17 Interview to Tamar Frankel (2012). https://www.bu.edu/today/2012/probing-the-mind-of-the-con-artist/
18 Henriques, Diana. The Wizard of Lies: Bernie Madoff and the Death of Trust. New York Times Books.
19
FAIR Canada - A Canadian Strategy to Combat Investment Fraud. August 2014. http://faircanada.ca/wp-content/uploads/2014/08/FINAL-A-Canadian-
Strategy-to-Combat-Investment-Fraud-August-2014-0810.pdf
20 See BEHAVIORAL ECONOMICS AND THE LAW. An Overview and Critique. Chapter 4. Part Two. Pages 13 et seq. Ulen, Thomas.
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Division in a country where only in 2014-2015 had more than 24 million dollars21 lost to different investment frauds,
more than double than the previous period.

ii. Audits

In the cases that were examined here, it seems that auditing by competent authorities have been if not nonexistent,
at least deficient. The two largest Ponzi schemes were audited by a three person accounting firm in a strip mall (Madoff) or
by a small accounting firm in the country of Antigua (Stanford) neither of which had the resources to audit, respectively, the
largest investment fund in the world and an international bank and business empire comprising 130 entities across 14 countries22
It is also proven that big audit firms (The Big 4) have also failed to detect frauds at some point.

Concerning to public auditing, the Securities Exchange Commission (SEC) does not carry a good record either. It has
failed to recognize several Ponzi schemes during the last decade. It paid no attention to many red flags in the Madoff
case, and let the 3-person-auditing-firm to do their job regardless of their size and improbable independence from
the company being audited. The anti-regulatory climate to protect firms rather than investors at the time (pre-crisis
2008) and these mistakes led to a change in the focus of the SEC. Nowadays they switched from a cost-benefit
equation aiming for easy targets and not spending too much tax payers money to file about 500 complaints a year
against unscrupulous investment promoters, and 25% of those are Ponzi schemes (Encyclopedia of Fraud). The US
Congress also introduced two bills to increase transparency and registration of private investment funds: The Hedge
Fund Transparency Act and the Hedge Fund Adviser Registration Act of 2009.

iii. Regulatory Legal Frame

One would think after Bernard Madoff got nailed and went to jail for 150 years these kinds of crimes would slow
down. But the bad guys dont think that way. Instead they might say, Madoff took $65 billion. I dont need that much.
I just need $10 million.23

This is probably the most interesting topic in deterrence and is another key topic of L&E. According to traditional L&E
Criminals are rational calculators; they commit crimes if they perceive the expected benefits to exceed the expected costs and
refrain otherwise; the evidence suggests that by raising the expected costs of crime, people have been deterred from committing
crime. There has, however, been some dissent from this standard view. These dissents are in part premised on human difficulties
with affective forecasting and in part on our well-established myopia with respect to the future. () We do not appear to be much
influenced by the severity of criminal sentencing.24 In the context of Ponzi schemes, this regulatory deterrence seems
implausible for a number of reasons: i) Criminals are often sociopaths or they do not see themselves as criminals, or,
instead, they believe they can step out of the scheme at any time; ii) the SEC still files more than a hundred cases of
Ponzi schemes every year and that only includes the US where Stanford and Madoff got themselves combined 260
years of prison. Iii) It appears unlikely that fraudsters are traditional rational decision makers. For this reason, I am
skeptical about the effect of deterrence due to an increase in effective imprisonments in concurrence with Robinson
and Darley Theory.25
iv.The Private Equity Approach A whole new remedy.

Saul Levmore of 26 proposes a different approach to remediating Ponzi. He believes that, since penal sanctions are
not deterring fraudsters, the Equity-Investor approach might be of help. He begins with the premise that actual
law makes the scheme live longer. When the scheme runs its course, it is normally mopped up by bankruptcy law. The scheme
lives longer and allows the perpetrator to extract and waste greater resources the more investors plow back their profits and

2121
Targeting scams Report of the ACCC on scams activity 2015. May 2016. http://www.accc.gov.au/system/files/Targeting%20scams%20-
20report%20of%20the%20ACCC%20on%20scam%20activity%202015.pdf
22 Mervyn Lewis, op. cit. Page 148.
23 Interview with Anthony Michael Sabino, a professor at St. Johns Universitys Peter J. Tobin College of Business
http://www.forbes.com/sites/halahtouryalai/2012/08/20/zeekrewards-and-why-ponzi-schemes-will-never-go-away/#74260a54653d
24 Ulen, Thomas. Op. Cit.
25
Paul H. Robinson and John M. Darley, Does Criminal Law Deter? A Behavioural Science Investigation
26 Levmore, Saul. Rethinking Ponzi-Scheme remedies in and out of bankruptcy http://www.bu.edu/law/journals-archive/bulr/documents/levmore.pdf
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the less intensely anyone investigates its details. His idea is that actual bankruptcy law entitles defrauded investors to
claim for restitution so they are able to recover some of the principal invested. But if there were investors in bad
faith, then the Restatement(Third) of Restitution and Unjust Enrichment confirms and advances the notion that a
claim might run in the other direction, so that the debtors estate can recapture, or claw back, these investors earlier
withdrawals. Defrauded investors might be depicted not as creditors unable to collect their full restitution claims, but
rather as equity investors. Some past payments to these investors might then be subject to recapture, not just as fraudulent
conveyances but as mistaken distributions. I suggest that the right choice is the one that deters Ponzi schemes or minimizes
losses. Then if the primary fraudster resources have exhausted and prison seems like a possibility to the manager of
assets, then investors can expect no more than a fraction of their investment. In most cases the investors are not all
alike. Some will have extracted all or a portion of their original investment. Some may be labeled as winners because they have
withdrawn more than they invested. According to his view under the equity approach to Ponzi schemes, there would be a
greater likelihood that an informed or skeptical investor would ask harder questions, would call the right authorities, or would
otherwise help send the primary wrongdoer to jail earlier than would otherwise be the case. This investor would be motivated by
the fear that withdrawals would be recaptured by a trustee who could characterize payments as a distribution of (false) profits,
easily reversed under fraudulent conveyance or restitution law. In contrast he believes that current law allows the investor
to regard withdrawals as first coming from principal, almost as if the investor were reclaiming chattel held in constructive trust.
Then he primarily aims to finish off the Ponzi to quick ends in order to minimize losses. The equity and creditor approaches
penalize investors who should have known better, and they seek to distinguish completely innocent investors. If, instead, we seek
to minimize losses but regard whistleblowing as too often ineffective, then the strategy ought to be one of encouraging investors
to abandon suspected Ponzi schemes to bring about their collapse. Current law, and especially law as conceived by the Madoff
trustee, might discourage sophisticated investors from exiting, both because their winnings are recaptured and because
withdrawals might seem like evidence of bad faith. His idea, then, is that if investors understand eventually that they are
in a Ponzi scheme, they may have incentives to leave their investment but at the same time deterred because of
being a Ponzi scheme. Then, acting strategically, they may stay aboard awaiting opportunities for slow withdrawals.
This, in combination with a preexisting relationship with the fraudster may nowadays be considered bad faith and
operate against the investor. And yet it is likely that the best way to minimize social loss is to encourage such investors to exit
because a Ponzi mastermind will have difficulty making payments to those who exit, and the exits will precipitate collapse. The
intuition, then, is that Ponzi schemes collapse because investors exit and that law might best minimize waste and losses by
encouraging exit But even if a small amount of investors exit, the scheme might collapse Then the best way for the law to
bring about earlier collapse is to is to reverse the strategy determined by fraudulent conveyance law as well as by the
equity-investor idea and allow investors to keep their withdrawals. Moreover, exiting works faster than whistleblowing. An
extreme version would allow Ponzi investors to retain all that they extracted. A better version would allow an investor to keep an
amount equal to principal plus a reasonable rate of return. In the event of bankruptcy, the investor would simply return any
amount deemed to be in excess of this reasonable return. After all, what Levmore proposes is turn around the incentives
100 % towards the greater social benefit. But he believes this theory can only be proved once applied since it would
be impossible to make experiments on the field and empirical data nowadays is rather scarce.