American Ponzi Schemes
The unethical business practice of paying investment returns to separate investors, not from any actual profit earned from the organization but instead from their own money paid by subsequent investors, is called a Ponzi scheme. Ponzi schemes are unethical because the process is fueled by greed and deception to swindle money from investors in which many times its victims can never fully recover. The emotional, psychological, and financial ramifications from Ponzi schemes have resulted in some of its victims even committing suicide. However, Ponzi schemes are not a new scam and have been around since the 1920’s. There have been several Ponzi schemes since then but two have stood out amongst the others. One of the most infamous Ponzi schemes, for its sheer size, was the $50 billion scam run by Bernie Madoff. The other is John Bennett’s scam because of its insidious nature of preying on nonprofit and religious organizations. While the American dream promises the possibility of success and wealth, some do not understand, or possibly ignore, the implicit ethics and legalities of running a legitimate business and earning honest profits.
The Ponzi scheme gets its name from Charles Ponzi, a 1920’s crook who promised investors in New England a 40 percent return on their investment in just 90 days, compared with five percent in a savings account. Ponzi had planned to make money by taking advantage of the difference in exchange rates between the dollar and other currencies to buy and sell international mail coupons at a profit. His scheme was an amazing success, and during one three-hour period in 1921, he took in $1 million. But when the scam came crashing down, it turned out he had only purchased about $30 worth of the mail coupons on which the scheme was based. (Lowenstein, 2005)
In Far Rockaway, Queens, NY, Bernie Madoff’s career began as a lifeguard and sprinkler installer in 1960. Madoff used the money he made to start trading stocks. However, Bernie Madoff experienced a close call in 1962 that could have given insight to his personality. During a small blip in the 1962 stock market Madoff nearly lost all his money. He used investors’ money to invest in new risky issue stocks, similar to internet bubble stocks, and he lost it all. He covered up the fact that he lost all their money by borrowing money from his father-in-law to repay them. He kept the ordeal very quiet and they thought he was a genius. Madoff revealed early on how far he was willing to go to protect his reputation and avoid admitting failure.
(Author: Madoff’s kin likely didn’t know of scam, 2011)
Madoff soon made his way to Miami Beach, FL to attract clients who were wealthier. Madoff’s new venture dealt with the National Quotation Bureau. However, his business was no competition to those trading on the New York Stock Exchange. Madoff made use of computer technology to beat his competition. This technology eventually became the foundation of the NASDAQ Stock Exchange of which Madoff was the chairman. (Bandler, 2009) Madoff invested money in stocks and when stock prices increased, he made a profit; when stock prices fell, he lost money. Madoff soon found he was not making the big profits he wanted. Madoff began looking to country clubs in Palm Beach to find even richer investors. Madoff became involved in these clubs’ close communities to make friends and earn their trust and goodwill. These new friends he made bought into his charisma and charm and became his clients. They handed over large sums of money and Madoff promised returns upwards of 10 percent profit on their investment every year depending on the investor and size of the investment. This started Madoff’s Hedge Fund. Madoff was able to consistently give his clients large returns on their investments every year. The instability of the stock markets made Madoff’s consistent returns appear very impressive and attractive. Madoff claimed his consistency in returns was made possible by using a collar strategy to limit gains and losses. By buying and selling the rights to buy and sell stocks at fixed prices, the gain and loss due to variations in the actual price of a stock can be constrained. However, Madoff’s collar strategy could not explain how he could achieve his huge consistent gains. (The Madoff Affair, 2009) The enormous efforts Madoff made to cover up his fraud was evident as early as the mid 1980’s. His Hedge Fund was shrouded in secrecy. The dirty rat involved a small team to help manage his Hedge Fund on the seventeenth floor of the Lipstick Building, which was isolated from the rest of the company. An old IBM computer that was not connected to the company network was used to produce client statements. Madoff would only print client statements on paper so he could avoid leaving a digital paper trail. Madoff also had computer programs created to produce specific data he knew that the Securities and Exchange Commission (SEC) would screen for. Madoff may have spent as much time, or even more, covering up his fraud than most money managers spend making legitimate money for clients. The software program Madoff used allowed key investors to trade with somebody in Europe while he was really just trading data with somebody down the hall. (Author: Madoff’s kin likely didn’t know of scam, 2011)
Madoff’s computer programmers, Jerome O’Hara and George Perez, eventually were arrested and charged with conspiracy, falsifying books and records of a broker dealer, and falsifying books and records of an investment adviser. O’Hara and Perez made Madoff’s fraud possible; they used their specialized computer skills to create complicated, convincing, and completely fake trading records that made Madoff’s scam successful for several years. Above all, O’Hara and Perez were in charge of developing and maintaining the computer programs that supported Madoff’s investment business. While under examination from the SEC, they covered up Madoff’s scheme by developing and maintaining programs that produced many fake and fraudulent books and records. Case in point, a small segment of Madoff’s investment clients was formed to conceal the extent and nature of his business. To further elude the SEC, they changed the names of account holders so that clients’ securities could not be located. The level of their software sophistication was also evident by their use of random algorithms. The algorithms were created to falsely manufacture details about the quantity of shares, execution times, and transaction numbers for trades reported on Madoff’s trade records. (Antone, 2009)
What Madoff was hiding and protecting was his method of operating his Ponzi scheme. Madoff was paying back investors’ profit with their own money over the years. Using a ten percent return as an example, Madoff could pay returns for ten years but in the eleventh year he would not be able to make the expected ten percent yearly payment. If clients asked for the full investment amount back he would have to admit there was not any money because he used it to make clients’ own yearly payments. In that scenario the scheme could only last ten years and would make absolutely no profit. In order to continue making the yearly payments Madoff had to use other investors’ money. Money from other investors could be used to make the payments to the first investor. Yearly payments to the second investor would require another investor and, to pay him, an additional investor. Cash from each new investor is used to pay back the old investor, in classic Ponzi scheme style. One hundred percent of everyone’s investment was used to pay for everyone’s yearly return. Madoff was able to keep his Ponzi scheme going for such a long time by avoiding investors who would want their money back soon and by continually finding investors who were willing to keep investing with him. More importantly, Madoff did not get caught. He used Friehling and Horowitz, a small unknown company to do his auditing. Madoff’s secrecy also prevented detection and he would often not do business with clients who asked too many questions. This created a sense that Madoff only worked with influential and privileged investors. This method increased his attractiveness to other investors, such as the New York Mets’ professional baseball team and famous Hollywood movie producer Steven Spielberg. Madoff also attracted exclusive investors by focusing on clubs and rich communities. Madoff also focused on investments from Jewish charities because through financial structure they very rarely needed to make withdrawals.
During the economic downturn of 2009, many of Madoff’s investors needed to make withdrawals because of the economic state but there was no money for them to withdraw. Madoff’s house of cards came crumbling down. Fifty billion dollars vanished, making Madoff’s scam the largest Ponzi scheme in history. (Scam of the Century? Bernie Madoff and the $50 Billion Heist, 2009)
Another example of a Ponzi scheme is the one John Bennett used to scam hundreds of charitable institutions. Hundreds of philanthropists invested more than $400 million with New Era Philanthropy, the organization run by Bennett. The Foundation for New Era Philanthropy was formed by Bennett in 1989 to advise nonprofit companies about fundraising and management techniques. Since 1982 Bennett had experience working in the nonprofit community advising corporations which charitable organizations ought to have support. However, Bennett’s reputation was made by New Era’s gift-matching program. (When Greed and Giving Collide, 2009)
Through Bennett’s gift-matching program, anonymous and very rich donors matched funds raised by philanthropists and nonprofit organizations. Nonprofit organizations would raise money and deposit it with New Era after they were invited into the program. In similar fashion, philanthropists would deposit funds set aside for selected charities. A key condition was that New Era would hold the funds for six months. New Era would deposit the money into an escrow-like account with Prudential Insurance to be invested in Treasury Bills, or T-bills, during this time. New Era used the holding period to find a matching donor and cover administrative expenses. Anonymous donors contributed to New Era which doubled original amounts raised by nonprofits and donated by philanthropists. After six months, the selected nonprofit organizations received the deposited and matched funds.
Nonprofit communities eventually gave Bennett a great deal of respect. Bennett was asked to serve on the boards of many notable organizations and quickly moved up through philanthropic groups. Bennett made friends with many important people, including the Mayor of Philadelphia who believed his organization was an answer to prayers. Bennett was perceived to be Godsend to save charities in need of money. His charismatic and charming personality stole hearts and captured the confidence of those around him. Bennett’s religious dedication also contributed to his evident trust of the public and helped spread word of mouth referrals for other potential contributors. This dynamic of trust, experience, social proof, and personality allowed Bennett to bring about a Ponzi scheme of substantial proportions.
In reality, Bennett was not the trustworthy person he was perceived to be. Small amounts of the money deposited with New Era were ever really invested. Bennett was clever with his scheme. He used some of the money to secure a sizeable loan. The remaining invested money and the money borrowed from the loan were used to pay off prior pledges after the six month period had finished. Eventually Bennett increased the waiting period to ten months and justified it by stating that the anonymous donors required the longer term.
Bennett transferred millions of dollars from some of the donors’ money into his own businesses. Bennett collected $2.5 million as CEO of Bennett Group International Ltd. The money was supposed to have been invested in T-bills but his excuse was that the money was given by a group of philanthropists in order for him to get a salary. Bennett set up several other businesses that he could draw salaries from, while never actually getting a salary from New Era.
Bennett continued his Ponzi scheme for almost six years. There were some suspicions during this time but only one person was able to expose Bennett’s scam. In 1993, a Prudential Securities stockbroker cautioned a potential donor that New Era’s system was very suspicious and to be careful. In addition, other high-level officials agreed that Bennett’s operation was probably a scam. Despite obvious signs of fraud, New Era was investigated and given a clean bill of health by the Attorney General’s office in Pennsylvania when they were not able to find any displeased donors. (Allen, 1998)
Spring Arbor College participated in New Era’s program; however, one individual at the school strongly disagreed with their involvement and was critical of Bennett’s matching program. This individual, Albert Meyer, was the school’s bookkeeper and accounting professor. Meyer had misgivings about New Era since 1993 but was unable to launch an in-depth investigation until he had tenure in 1995. Upon review of New Era’s 1993 tax return, he found no record of anonymous donor contributions. He also found a huge discrepancy between the actual interest earnings and what they should have been. Meyer felt he had substantial proof against New Era and used the tax return to contact the SEC, the IRS, the Pennsylvania Attorney General, and The Wall Street Journal.
Meyer provoked a swift response by the SEC and they pressed Prudential to take a look at New Era’s T-bill investments. They found that New Era had borrowed just over $50 million but had only paid back about $7 million. Bennett was ordered to pay back the difference within 24 hours but when he could not, Prudential liquidated nearly $45 million of T-bills in New Era’s account. Bennett recognized that he was going to be exposed when The Wall Street Journal also began to investigate New Era. Bennett broke the news to his employees and pastor and was visibly distraught over the ordeal. His employees were heartbroken when Bennett revealed there were no anonymous sponsors. Soon after, the Wall Street Journal went public with their New Era article and the same day the news broke, New Era filed for bankruptcy.
In 1997 Bennett was sentenced to Federal Prison without parole for fraud, money laundering, and tax evasion. A trustee elected by the New Era creditors ultimately was able to recover much of the missing money. Organizations that had profited from New Era agreed to pay back money and Bennett had to forfeit all property, cash, and securities that were tied to New Era. (When Greed and Giving Collide, 2009)
A Ponzi scheme blinds its victims to the inherent unethical and illegal nature of the scam, all the while promising the American dream of success and wealth. Ponzi Schemes are fueled by a synergistic combination of avarice, rationalization, and denial. When combined, these ingredients cook up a highly unethical scam that hurt all who unwittingly partake in it. Although
Ponzi schemes have been around for some time, they are not going away anytime soon. However, with more exposure, the general public and potential investors can learn vicariously through stories of conniving crooks such as Bernie Madoff and John Bennett, without becoming victims themselves. The old adage, “if it’s too good to be true, it probably isn’t,” seems to apply.