ESSAY CASE: ‘Ponzi schemes’
‘Ponzi schemes’ are scams in which investors are promised exaggerated profits (often short-term) from supposedly can’t-miss investments. If and when early investors are paid returns, the money doesn’t come from actual investment gains; it comes from new cash pouring in from later investors.
Initially the promoter will pay out high returns to attract more investors, and to lure current investors into putting in additional money. Other investors begin to participate, leading to a cascade effect. The "return" to the initial investors is paid out of the investments of new entrants, and not out of profits.
Often the high returns lead investors to leave their money in the scheme, leading the promoter not to have to pay out very much to investors; they simply have to send statements to investors showing them how much they earned. This maintains the deception that the scheme is a fund with high returns. Ponzi scammers promise windfall returns, counting on their victims to be either gullible or greedy—and sometimes both. The appeal of quick and hefty profits is precisely why some people fall for Ponzi schemes, even though they clearly fall into the category of too good to be true.
Charles Ponzi, an Italian immigrant living in Boston in the early 20th century, was a master at playing the gullibility-greed game. He was clever, yes, but more than that, he was charming and charismatic, easily convincing people to jump aboard his pie-in-the-sky schemes. He claimed to be taking advantage of foreign currency rates to make millions of dollars by manipulating postal reply coupons. (The coupons could be purchased abroad in foreign currency and included in correspondence; recipients of those letters could then redeem the coupons at U.S. Post Offices for enough postage to reply to the original correspondent.)
With great fanfare, Ponzi opened his postal reply coupon-based business front, called The Security Exchange Company, near Boston’s City Hall in December 1919. He promised investors a 50 percent return within 90 days on $10 to $50,000 promissory notes based on postal reply coupon exchanges. It seemed as if everyone wanted in—people stood in long and boisterous lines in the streets outside his office, eager to surrender their hard-earned cash. (Although the average investment was $35, many people happily handed over their life savings.)
In August 1920, Ponzi raked in $10 million, much of which he expended on an extravagant lifestyle (living in a mansion, flashing $10,000 bills, sporting a gold-handled walking stick, waving to admirers from the back seat of his chauffeured car).
QUESTIONS: Total points for this case: 15 points a. Analyze the above Ponzi scheme along the 5 elements of fraud with the victims being the investors. Conclude whether or not the scheme is a fraud. (10 pts) b. 1) Fraud: A false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed—that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury. c. d. Fraud must be proved by showing that the defendant's actions involved five separate elements: e. 1) a false statement of a material fact, f. 2) knowledge on the part of the defendant that the statement is untrue, g. 3) intent on the part of the defendant to deceive (enganar) the alleged victim, h. 4) justifiable reliance (confianca) by the alleged victim on the statement, and i. 4) injury to the alleged victim as a result. j. k. l. Analyze the ethics behind the scheme from the point of view of the promoter by applying the following ethical concepts: utilitarian test and the difference principle; generalization test; virtue test. (5 pts) 1) Utilitarian test and Difference principle - * Difference principle - Example: it is unjust to create salary differentials unless the lowest paid would be even worse off if all salaries were equal (e.g., they may be laid-off) * A policy must result in the greatest benefit for those who are least advantaged AFTER the policy is generally adopted.

Answer 1:

Fraud is a type of criminal activity, as "abuse of position", or false representation, or prejudicing someone's rights for personal gain.
Or, an act of deception intended for personal gain or to cause a loss to another party.

By analyzing the elements of Fraud, we will conclude at the end whether this scheme is characterized as a fraudulent action or not:

1) A false statement of a material fact: The Ponzi scheme promises high investment returns with little or no risk. In a business world, it's understood that every investments yielding higher returns typically involve more risks. This scheme encourage participants to invest as much as they can with promise of proportional return in the future, but the funds never come back as promised.

2) Knowledge on the part of the defendant that the statement is untrue: This perspective is crucial to determine a fraud, and the Ponzi Scheme fits well in this analysis. When Charles Ponzi created this scheme in the early 20th centuty, he knew that the business transaction would be seducing new investors for promises that would never happen in the future. In other words, he knew that everything was a lying, and it would become difficult to increase recruiting of new investors, or whether a large number of investors ask to check out.

3) Intent on the part of the defendant to deceive the alleged victim: This point of view is also important to determine a fraud, and when we analyze the Ponzi Scheme, we can clearly see that this is not a registered investment. In other words, Company's registration is important to provide investors to access key information about Company's management, products, services, and finances. This scheme does not provide evidence of firm structure of investment, and investors can rapidly identify that the defendant may want to deceive the victims.

4) Justifiable reliance by the alleged victim on the statement, and injury to the alleged victim as a result: Business and investments are all about trust. People buy or sell and in the end the win-win sensation is the confidence that we made a good deal. The ponzi scheme uses good arguments of quick great returns that acquires victim's reliance in a misleading way, and in the end, investors are injured for not receiving back the promised returns of investments, nor the amount invested at the beginning.

In conclusion, the Ponzi Scheme is clearly a Fraud, and it has failed in all 5 elements of fraud analyzed. This action has the explicit intention of deceiving investors, with false promising of high rates of returns, and make investors believe that it is a great opportunity to make money, and in the end the scheme harms investors.

Answer 2:

"Ethics deals with individual character and the moral rules that govern and limit our conduct. It investigates questions of right and wrong, duty and obligation, and moral responsibility" (Shaw,3).

Analyzing ethics behind the Ponzi Scheme from the point of view of the promoter, by applying ethical concepts: Utilitarian test and difference principle; generalization test, virtue test, we can conclude if the tests fail or not, as follow the analysis.

1) Utilitarian test: Pass
The utilitarian test argues that a rational choice must maximize utility, subject to the other conditions for rationality, and the reasons for the action should have a means-ends structure. By the point of view of the promoter, the utilitarian test pass, as the ultimate for the promoter's actions is to create total net utility to him, and with the promises of high returns to the investors.

2) Difference Principle - Fail

The Difference principle argues that a policy must result in the greatest benefit for those who are the least advantaged, after the policy is adopted. The Ponzi Scheme fails when apply the difference principle, because it generates inequalities for the investors, in other words, this scheme does not work to the benefit to the least-advantaged members.

3) Generalization test - Fail

For the generalization test, it claims that an action is unethical if generalizing it is inconsistent with the possibility that everyone who performs the action achieves its purpose.

The generalization test fails when applying for the purpose of Ponzi Scheme promoter, as his action is not generalizable or consistent, as not everyone would be willing to perform the same act.

4) Virtue test - Fail

The virtue test primary argues that a rational choice must be consistent with who you are and why you are here.

In my opinion, the virtue test fails, by analyzing the promoter's perspective, because the promoter violates his primary purpose of trust, when he promises high return to investors, and it does not happen.

References:

http://www.sfo.gov.uk/fraud/what-is-fraud.aspx

http://www.sec.gov/answers/ponzi.htm

Shaw, Willian H., Business Ethics. Eighth edition. San Jose State University, 2014.