WP/09/95

Ponzi Schemes in the Caribbean
Ana Carvajal, Hunter Monroe, Catherine Pattillo, and Brian Wynter

© 2009 International Monetary Fund

WP/09/95

IMF Working Paper Western Hemisphere and Monetary and Capital Markets Departments Ponzi Schemes in the Caribbean Prepared by Ana Carvajal, Hunter Monroe, Catherine Pattillo, and Brian Wynter Authorized for distribution by Paul Cashin and David Hoelscher April 2009 Abstract This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

In several Caribbean states, unregulated investment schemes grew quickly in recent years by claiming unusually high monthly returns and through a system of referrals by existing members. These are features shared with traditional Ponzi schemes and pyramid schemes. This paper describes the growth of such schemes, their subsequent collapse, and the policy response of regulators, and presents key policy lessons. The analysis and recommendations draw on country experiences in the Caribbean, and in such diverse countries as the United States, Colombia, Lesotho, and Albania.

JEL Classification Numbers: G18 Keywords: Pyramid schemes, Ponzi schemes, Caribbean Authors’ E-Mail Addresses: acarvajal@imf.org; hmonroe@imf.org; cpattillo@imf.org; bwynter@imf.org

2 Contents Page

I. Introduction ............................................................................................................................3 II. Background ...........................................................................................................................4 III. Unregulated Investment Schemes in the Caribbean ............................................................8 A. Jamaica......................................................................................................................9 B. Eastern Caribbean Currency Union and the Turks and Caicos Islands...................16 IV. Addressing Unregulated Investment Schemes: Key Policy Lessons ................................24 A. Preconditions...........................................................................................................24 B. Key Regulatory Actions ..........................................................................................29 V. Conclusion ..........................................................................................................................31 Annex I. Other Recent Investment Schemes ...........................................................................33 A. United States ...........................................................................................................33 B. Colombia .................................................................................................................36 C. Lesotho ....................................................................................................................40 D. Albania ....................................................................................................................42 References................................................................................................................................43

3 I. INTRODUCTION1 In several Caribbean states, unregulated investment schemes (UIS) grew quickly, particularly during 2006–08, by claiming unusually high monthly returns and through a system of referrals by existing members. Such high returns are usually associated with Ponzi schemes, as defined below. Such schemes are pervasive and persistent phenomena and emerge on a regular basis even in developed countries with strong regulatory frameworks, as shown by the recent experience in the United States with an US$50 billion alleged Ponzi scheme run by Bernard Madoff. However, their impact has been greater in countries with weaker regulatory frameworks. This is illustrated by the well-known case of Albania, and by more recent and ongoing cases in the Caribbean, Colombia, and Lesotho. This paper details the operation of such schemes in the Caribbean, and places this experience in the context of cases in other regions, where a number of interesting parallels emerge. The paper also describes the recent experience with two high profile allegedly fraudulent schemes involving regulated entities licensed in off-shore jurisdictions in the Caribbean, in order to draw common lessons with regard to the detection and prosecution of fraudulent schemes.2 In addition, the paper describes the response of Caribbean regulators and presents key policy lessons. The paper is organized as follows. Section II defines Ponzi schemes, distinguishes them from pyramid schemes, and describes the case for policy intervention against them. Section III describes the recent experience of the Caribbean with UIS, while Section IV presents policy recommendations. Annex I provides background on the experience in the United States, Colombia, Lesotho, and Albania. The following disclaimer applies. The information in this note is obtained from public sources. The note does not imply any verification of facts by Fund staff or attribution of wrongdoing to any individuals or entities. The term “scheme” as used in this paper encompasses the investment vehicles, the accounts, the operators, the promoters, and other mechanisms and entities involved. The roles and functions of such mechanisms and entities
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This paper incorporates material prepared by a team consisting of Hemant Shah, Philip Bartholomew, Ana Carvajal, Anna-Maria Kokenyne Ivanics, and Virginia Rutledge. It also draws upon presentations at an October 2008 seminar on “Understanding and Combating Unregulated Investment Schemes in the Caribbean”, which was cosponsored by Jamaica’s Financial Services Commission, the IMF’s Monetary and Capital Markets Department, the U.S. Securities and Exchange Commission, the U.S. Commodity Future Trading Commission, the U.S. Agency for International Development, and the Caribbean Regional Technical Assistance Center (CARTAC); see CARTAC (2008). The authors also thank Paul Cashin, Luis Cortavarria, Alfredo Cuevas, Hamid Davoodi, Chris Faircloth, Enrique Flores, Thomas Laryea, Isaac Lustgarten, Guy Meredith, Thordur Olafsson, Wendell Samuel, and Therese Turner-Jones as well as seminar participants at the Caribbean Development Bank and Eastern Caribbean Central Bank for helpful comments on earlier versions of the paper. The paper covers developments to March 31, 2009. Those cases raise additional issues in relation to the adequacy of the regulation and supervision of licensed institutions in off-shore jurisdictions. However, this paper focuses on unregulated schemes, how they can be used as a conduit for investment fraud and how regulators can address such problems.

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4 in a scheme are not always clear due to the nature of the schemes, the lack of consistency in various public documents, and the fact that the Fund staff has not verified the facts in this note. As a result of such lack of clarity, the reference to particular mechanisms or entities may not be accurate. Also, references to a scheme or any component of a scheme as regulated or unregulated may not be accurate. No statement in this paper is a judgment on the adequacy or inadequacy of any particular regulatory or judicial regime, of the authority or lack of authority of any regulator, court, or prosecutor or the validity of any legal argument. II. BACKGROUND Investment fraud can plague financial markets regardless of their level of development. It encompasses all types of actions aimed at obtaining a financial gain from investors based on deception. Such fraud can take many different forms from very simple schemes such as outright theft where none of the investor’s money is returned, to more complex schemes such as Ponzi and pyramid schemes. Schemes can be regulated or unregulated entities and can take different legal forms, from joint stock companies to hedge funds or simple pools of assets. In a Ponzi scheme, returns may be paid to investors out of the money paid in by subsequent investors rather than from genuine profits. These schemes usually offer higher returns than any legitimate business activity could plausibly sustain, in order to lure investors. Ponzi schemes usually have to attract new investments at an exponentially growing rate to sustain payments to existing investors, and inevitably collapse when the new investment needed exceeds the size of the target market. At that point, most investors lose most or all of their investment, while early investors including the scheme’s founders may have obtained high returns. Thus, it can be a matter of plain luck and timing whether an individual turns out to be a victim or a beneficiary of the fraud. Ponzi schemes are insolvent from the moment that they take in money from investors. Their liabilities to investors exceed their assets as the value of liabilities increases at the inflated rate of return, while assets may be depleted by the running costs of the scheme or possibly suffer from other depredations. As the experience of different countries has shown, the “business opportunity” advertised to lure investors into putting their money in a Ponzi scheme can vary in nature, from straightforward investments in stocks or bonds, to less traditional financial sector products such as currency trading, to investments in nonfinancial assets, such as real estate, cars, and helicopters. These business opportunities are only limited by the imagination of the perpetrator and the gullibility of the investor. As indicated above, Ponzi schemes can be perpetrated by unregulated entities, through informal sector vehicles that operate in the shadow of formal financial institutions. In other cases, they are perpetrated by regulated entities, which abuse their regulated condition to lure investors. The types of investor lured into these schemes vary. Many times, the schemes will have drawn in or specifically targeted as investors individuals from amongst a specific group or community sharing a common affinity, such as ethnicity, religion, or profession. In many

5 instances the perpetrators promote their schemes through leaders of the affinity group. In some cases, investors are given an explicit incentive to recruit new investors (Box 1). The damage when such schemes reach their inevitable end can be widespread amongst populations with limited income and means to absorb the eventual losses. The resulting combination of anger, betrayed trust, recriminations and sheer loss of wealth and income can also have significant political and social repercussions. The experiences of different countries show that the exponential growth rate needed to sustain schemes can lead to large-scale economic and institutional damage. The negative consequences include: • • • • • • • Undermining confidence in financial markets; Diverting savings from productive to unproductive uses and, in some cases, from the domestic economy to foreign destinations, with a balance of payments impact; Incurring fiscal costs, if bailouts occur;3 Diverting deposits from banks and increasing non-performing loans if loan proceeds were diverted into schemes;4 Causing swings in consumption driven by paper profits or early withdrawals; Causing socio-economic strife if a sufficiently large number of households are suddenly exposed to losses; and Undermining the reputation of political authorities, regulators, and law enforcers for failing to prevent open frauds and to address money laundering or support of other illegal enterprises by schemes’ operators.

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Bailouts appear to be rare; governments bailed out depositors in two Ponzi schemes, involving Dafiment Bank in Serbia and the TAT savings house in Macedonia, both in 1993. There is anecdotal evidence that some of the schemes presented below diverted deposits and increased NPLs, but not to the extent of posing a systemic risk.

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Box 1. Pyramid Schemes Versus Ponzi Schemes The labels Ponzi scheme and pyramid scheme are often used interchangeably to describe specific forms of investment fraud where sustainability depends on the influx of new “investors” to the scheme. However from a technical perspective, there are differences in the way the two types of schemes operate. Pyramid schemes are a form of fraud where the expected benefit to members depends primarily on the number of individuals they recruit, which is not necessarily the case in a Ponzi scheme. For instance, each member may be required to recruit five others who each recruit five more, and so on to get the reward, creating a pyramid in which payments flow upward to earlier members—and not necessarily to a central pool of funds, as in a Ponzi scheme. While the large reward draws in members, the number of recruits required to be rewarded grows exponentially, and inevitably exceeds the target population. At that point, the flow of rewards up the pyramid stops, and most members receive nothing in return for their membership fee, as they are unable to recruit new members. Ponzi schemes often grow larger than pyramid schemes as they can take in unlimited amounts from a single individual and can continue to operate indefinitely, as long as payments demanded by investors from the scheme do not exceed payments by investors into the scheme. A pyramid scheme may attempt to masquerade as a multi-level marketing (MLM) arrangement, which is a legitimate business activity in many jurisdictions. MLM members are salesmen who sell a legitimate product but also receive commissions on sales by their recruits, their recruits’ recruits, and so on. The distinction between a legal MLM arrangement and an illegal pyramid may be difficult to establish. A hypothetical MLM arrangement in which members must buy an initial inventory of products which they neither consume nor sell would be an illegal pyramid scheme in many jurisdictions. A methodology for differentiating pyramid schemes from MLM arrangements is described in Vander Nat and Keep (2002). There are a number of similarities between the life-cycles of pyramid schemes and Ponzi schemes. Both types of schemes typically proceed through the following stages: initiation; validation, when large and easy rewards earned by initial members generate strong word of mouth publicity; expansion, when a large number of people join or massive investments are received; and collapse, when defaults occur, the inflow of new funds or members stops, and the promoters may seek to abscond with money. The schemes are inherently likely to collapse and default on most members. Pyramid schemes grow exponentially for a given rate of recruitment until they exhaust the pool of potential members. Inflows in a Ponzi scheme must also grow exponentially, if investors do not reinvest all earnings. In practice, schemes may incorporate elements of both pyramid schemes and may be difficult to classify. For instance, several of the Caribbean schemes described below appear to have characteristics of both types of schemes.

7 Country experiences illustrate the financial and socio-political damage of such schemes. The most severe case has been Albania. When several schemes collapsed in 1996, there was uncontained rioting, the government fell, the country descended into anarchy, and by some estimates, around 2,000 people were killed (Jarvis, 2000). More recently, the November 2008 collapse of allegedly fraudulent investment schemes in Colombia, which had taken in an estimated US$1 billion, was followed by riots and violent protests in 13 cities (see Annex I). Table 1 lists some other major schemes with an indication of their relative size. These cases illustrate that a wide range of countries have seen the emergence of large-scale schemes. They also indicate that a wide variety of circumstances were associated with the emergence of these schemes. In almost all cases, the data on the relative size of schemes in Table 1 is speculative. Establishing even basic facts such as amounts invested or lost and numbers of investors or accounts involved is difficult. This reflects the inaccuracy or lack of financial statements, the lack of regulation, and the disappearance of funds, records, and principals. In addition, many of the cases are recent, ongoing, and the subject of contentious court proceedings. However, assembling what information is available provides useful context. All figures reported in Table 1 are based on public information, and do not reflect estimates by Fund staff or national authorities.
Table 1. Some Speculative Data on Selected Investment Schemes Country Name(s) Years in Operation Promised Rate of Return Amounts Invested/Lost Number of Investors/Accounts In U.S. dollars In percent Number 1/ In percent of GDP of population 1-2 billion 12 ½-25 50,000 2

Jamaica

OLINT, Cash Plus, World Wise, LewFam, etc. SGL Holdings

2004-08

6-20 percent/month

Grenada

2006-08 -2008 2005-08 -2007 1991-97

7-10 percent/month 10-17 percent/year 300 percent/six months 60 percent/year 4-19 percent/month

30 million 50 billion 1 billion 42 million 1.7 billion

5 0.3 0.4 3 79

… 13,000 up to 4 million 100,000 2 million

…