By Dr. John F. Sase
with
Bryan Lagalo, contributing writer
Gerard J. Senick, contributing editor
Julie Sase, copy editor
William Gross, research
“Currency Exchange [C]enter is looking for responsible, bright and progressive representatives [in the] territory of [the] U.S. Our company provides an opportunity for U.S. citizens to purchase internet currencies such as Web-Money, E-Gold and etc. We need a person that will be in charge of a payment process [when] clients purchase an Internet Currency of particular services that they have chosen ... [Our representatives assist] customers [in] purchasing Internet Currencies in order to have access to particular services and products unavailable [outside of the] U.S.”
It seems that whenever times get tough, more con-artists promising castles-in-the-air emerge from the woodwork. Personally, I, Dr. Sase, missed out on the opportunity to lose our life savings through Bernie Madoff’s version of the Ponzi scheme. Unlike Steven Spielberg and many others, I was not invited to participate in the Madoff scheme. However, many of us more pedestrian citizens, looking for alternatives to failed opportunities such as “Flipping Real Estate” and other touts on late-night infomercial, have received emails like the one above. Usually, we hit our deletes key and move on. However, I recently attended a presentation on the life and scams of Charles Ponzi offered by my former graduate assistant Bryan Lagalo. So, when I read the above “scam-mail” I thought to myself, “It’s the ghost of Ponzi!”
Before watching Bryan’s PowerPoint show, I knew as much about Charles Ponzi as the average investor—virtually nothing more than I could express in a single paragraph. However, that has changed since watching “Charles Ponzi: The Life of an Infamous Schemer” with a small group of academics that fought to hold back the laughter of disbelief over a con-artist whom I can describe only as a completely amoral sociopath. In this light, I asked Mr. Lagalo, currently a doctoral candidate in Economics at Wayne State University, to participate in this month’s column.
Aaay! It’s the Ponz! (Apologies to Arthur Herbert Fonzarelli)
In recent months, the term “Ponzi scheme” has appeared rampantly on Wall Street and widely spread throughout the popular press and the political arena. The name of Ponzi has spread so profusely that a Google search of the single word Ponzi generates over 20,000 news results. For example, even the Securities and Exchange Commission (SEC) defines a Ponzi scheme as “[A] type of illegal pyramid scheme named for Charles Ponzi, who duped thousands into investing…. Decades later, the Ponzi scheme continues to work on the ‘rob-Peter-to-pay-Paul’ principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.”
Most likely, many business, law, and economics professionals share a familiarity concerning the notorious premise of these schemes described by the SEC. However, most readers probably possess only a cursory knowledge of the original investment vehicles used by Ponzi to dupe investors.
Therefore, for our readers we chronicle both Ponzi the person and Ponzi the scheme, that has made his name synonymous with fraudulent and unsustainable investment scams.
Born in Lugo, Italy in 1882, Ponzi immigrated to the United States at the age of twenty-seven. Reportedly, having gambled away his life savings during his passage to America, he arrived in 1903 with little but his name. According to Mary Darby in her article In Ponzi We Trust (Smithsonian magazine, December 1998), Ponzi stated in a New York Times interview that “I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me.” He learned English while working at odd jobs along the East Coast. However, after one employer eventually fired Ponzi from his job as a waiter for stealing and for shortchanging customers, Ponzi decided to move to Montreal, Canada.
In Montreal, Ponzi took a job as an assistant teller and worked his way up to manager of the newly-opened Banco Zarossi. The owner, Luigi Zarossi, started his bank to accommodate the growing number of Italians immigrating to Canada. The bank’s business expanded quickly because Zarossi offered 6% interest on deposits—double the average rate offered by competing banks at that time. Eventually, Ponzi discovered that Zarossi offered high rates simply to attract large deposits that he used to cover interest payments on poorly-made real estate loans (sound familiar?) Soon after this episode, Zarossi fled to Mexico taking much of the bank’s money with him.
Jobless and broke, Ponzi forged a check for $423.58 ($10,500 adj.) made out to himself. Subsequently, after presenting it for payment the Canadian police arrested him. For the benefit of his family back in Italy while serving three years in a Quebec prison, Ponzi contrived a cover-up story in a letter to his mother explaining that he had found a job as an assistant to a prison warden. However, Mama Ponzi eventually discovered the truth.
Upon his release in 1911, Ponzi returned to the United States. However, merely ten days after leaving the Canadian prison, American authorities arrested him for smuggling Italian immigrants across the border from Canada. He then spent two more years of incarceration in the Atlanta Prison in Georgia. Having served his time, Ponzi moved to Boston where he met Rose Maria Gnecco. Though Charles Ponzi and Rose got to know one another seemingly well, Ponzi neglected to tell Rose about his time behind bars. However, Ponzi’s mother sent Rose a letter describing the matter in its entirety. Nevertheless, in spite of this new information Rose married Ponzi in 1918. Over the course of the next year, Ponzi worked at various jobs before developing an idea that resembled the Yellow Pages of present day. His company attempted to sell advertising space in a circulated catalog that listed various businesses. However, this idea did not catch on in Boston and the company soon failed.
Prelude to the Famous Scheme
At least for Ponzi, fortune began to change for the better in August of 1919 when he received a letter from a company in Spain inquiring about his failed catalog idea. More importantly than this inquiry, the letter contained an International Reply Coupon (IRC). The basic function of an IRC allowed a person in one country (Spain) to send prepaid postage for reply to someone in another country (United States). Although Ponzi received an IRC priced in pesetas, the Spanish currency at that time, the U.S. Post Office exchanged IRCs for postage priced in stronger U.S. dollars.
After World War I, more than sixty countries accepted IRCs and agreed upon regulated postage-exchange rates that reflected currency-exchange rates. However, during those years many European countries experienced high levels of inflation. As a result, currencies from countries like Spain and Italy suffered significant devaluation relative to the dollar, though the IRC postage-exchange rates remained the same. This discrepancy provided Ponzi with the opportunity for arbitrage. In respect to this specific event, he noted, “I wrote a man in Spain ... and in reply received an international exchange coupon which I was to exchange for American postage stamps with which to send a copy of the publication. The coupon in Spain cost the equivalent of about one cent in American money, I got six cents in stamps for the coupon here. Then I investigated the rates of exchange in other countries ....”
Upon this realization, Ponzi developed a simple plan. He enlisted friends and family to buy cheap IRCs in Italy and send them to him in the U.S. where he could redeem them at higher value U.S. dollars. Ponzi boasted that the net returns easily exceeded 400%, even after the subtraction of transaction costs. Furthermore, nothing in his plan was illegal—at least not technically.
Immediately, Ponzi quit his job and borrowed money to mail to his relatives in Italy. In his letter to them, he explained that they should send him as many IRCs as possible. Then, Ponzi sold his arbitrage idea to several friends in Boston, promising that he would provide a 100% return in only ninety days. Ponzi used the funds that he collected to start a company that he registered as the Securities Exchange Company (SEC). (Ironically, his company shared its acronym with the Securities and Exchange Commission founded by the Federal government a decade-and-a-half later).
Originally, Ponzi limited his issue to notes bearing small principal amounts such as $50, $100, $1000. However, once his business accelerated, he left a line blank on the notes to allow investors to enter whatever amount they wanted to invest. Through his new company, Ponzi offered investors a 50% return after forty-five days or a 100% return after ninety days, on virtually any principal amount. This castle-in-the-air offer encouraged a Federal postal inspector to visit Ponzi at his business and voice government concern that selling millions of IRCs may not prove legal. In retort, Ponzi explained that the IRC coupons could always be exchanged in other countries outside of the jurisdiction of the U.S. Post Office. Even so, this initial investment scheme contained substantial holes. In his treatise on Ponzi, Mark Knutson points out that 1) In 1920 the nations that accepted IRCs announced new postal exchange rates in order to reflect the large devaluation in their currencies. 2) U.S. Post Offices limited their issues of IRCs to ten per visit. 3) Due to the immense volume of IRCs needed per transaction to ensure a profit, the transaction costs eliminated any significant arbitrage profit (“The Remarkable Criminal Financial Career of Charles K. Ponzi,” www.mark-knutson.com, 1996).
Because of these impediments, Ponzi would have realized that transporting, unloading, and redeeming the needed volume of IRCs at a post office would prove prohibitive. Furthermore, his own business records indicate that he actually purchased only a small number of IRCs. Fortunately for Ponzi, most people previously had neither used an IRC nor knew much about them. This public ignorance greatly masked these fundamental problems involved with IRC arbitrage. As a result, investors flocked quickly into Ponzi’s office.
The Rise and Fall of Ponzi’s Scheme—Robbing-Peter-to-Pay-Paul
Most historians attribute Ponzi’s early success to his ability to sell his scheme. As with any shyster, Ponzi used the promise of false hopes and half-truths to lure investors. However, he took his scheme a step further by performing a “dog-and-pony” show, laden with “smoke and mirrors.” Well known for his charisma, Ponzi charmed audiences with his animated sales pitches. Furthermore, he advertised his scheme to the general public rather than singling out a few wealthy investors. To edify his reputation, Ponzi openly defended the legitimacy of his business by personally guaranteeing all matured payments.
Immediately, Ponzi’s scheme accelerated as investors lined up at his office door. He dazzled them with the virtues of the apparent concreteness and freedom from risk possessed by his postage investment vehicle. With dollars pouring into his business, Ponzi actually managed to pay off some of the initial investors. In turn, unable to personally handle this increasing volume of sales, Ponzi hired agents and rewarded them with generous commissions. Quickly, his agents went to work and produced a flow of funds from cities and towns throughout New England. The success of Ponzi’s scheme grew exponentially. Though in February of 1920, his business only collected $5,000 ($62,200 in 2009 terms), by March it realized $30,000 ($373,200), and by May, $420,000 ($5,225,000).
The revenues continued to increase exponentially. In the first week of July alone, sales agents funneled $1 million ($12.5 million) into the firm.
Though most beneficiaries reinvested their earnings, some investors occasionally would demand their matured returns. The various historical sources indicate that in the early months of his investment scheme, Ponzi did pay out cash returns to any investor requesting them. Fortunately, for Ponzi, this strategy served to fuel the fire and kept most clients reinvesting. As long as he continued to appease a few investors with payouts, his other investors appeared to remain content. At least on paper, these investors continued to earn a return while the Ponzi scheme maintained its reputable façade.
Many naïve and neophyte investors mortgaged their homes and turned over the proceeds and other lifesavings to the Securities Exchange Company. Meanwhile, Ponzi drew upon the funds to support his lifestyle of a millionaire. He used company funds to pay for first-class passage to move his mother from Italy to the United States and to purchase a lavish air-conditioned mansion with a heated pool. Of course, a simple audit not only would have shown that Ponzi stole money from his company, but also that the business itself experienced substantial losses. Blinded by their own greed, investors continued to dump funds into the company—funds more than sufficient to keep the firm afloat, temporarily.
As a result of Ponzi’s enormous success, some people began to question how he consistently could generate extraordinary returns over such a short span of time. In his book, “Ponzi, the Boston Swindler,” (McGraw-Hill, 1975) Donald Dunn states that a Boston financial writer wrote a story suggesting that Ponzi’s investment scheme probably violated the law. Ironically, Ponzi sued the paper for slander and won $500,000 ($6.2 million) since the burden of proof lay on newspaper writers at that time. Furthermore, given the total volume of IRCs needed for Ponzi to pay double returns to most investors, local, state, and federal government officials suspected fraud. However, since each requested payout had thus far been met, authorities could not produce any evidence of lawbreaking.
Immediately after this initial governmental investigation, Ponzi faced a lawsuit filed against him by Joseph Daniels, a local furniture dealer. Daniels claimed that he personally loaned Ponzi $200 to start the Securities Exchange Company in return for a share of its future profits. Although the court sided with Ponzi, many parties began to wonder how he rose from poverty to millionaire status in a matter of months. As doubts grew, a small run took place on his business. However, Ponzi paid off each “recalcitrant” investor and the run subsided. As a result, this episode boosted the confidence of other investors—confidence that strengthened with the publication of a positive article in the Boston Post reporting that Ponzi had warded off this run. His Securities Exchange Company flourished, taking in $250,000 ($3.1 million) per day.
Despite the fact that Ponzi prevented a run earlier that same month, the Suffolk County District Attorney, Joseph C. Pelletier, began to investigate Ponzi’s business in late July 1920. The D.A. persuaded Ponzi to stop collecting new funds and to allow State officials to audit his books. One could speculate that Ponzi agreed to this plan because refusing it would have raised serious doubts as to the legitimacy of his business. On the other hand, the auditors ultimately discovered that he had failed to keep accurate records anyway. In a last ditch effort, Ponzi assured the public that he maintained millions of dollars in overseas deposits accounts to cover his business and deposit liabilities.
The beginning of the end came on 26 July when the Boston Post began to run a series of articles that raised difficult-to-answer questions as to how Ponzi operated his business. The Boston Post hired an analyst from Barron’s, the financial newspaper, to evaluate the Securities Exchange Company.
Upon investigation, the analyst discovered that Ponzi did not invest in his own company and subsequently questioned why, instead, he shared his seemingly great idea with the general public. Mark Knutson pointed out that the District Attorney asked Ponzi a question that put his explanations to the test. If Ponzi maintained large deposits in various banks while operating a profitable scheme, why would he want to solicit additional investment? Ponzi’s answer revealed its deficiency, but nobody seemed to notice: Ponzi lamely responded that he had not used the money, but would eventually need the people.
Next, the analyst from Barron’s estimated that Ponzi’s company needed 160 million IRCs to cover the deposits and promised returns to every investor. To worsen matters for Ponzi, the U.S. Post Office reported that only 27,000 IRCs circulated at the time and that none of the participating foreign post offices had recently sold or redeemed large quantities of IRCs. Finally, the analyst admitted that even if the U.S. Post Office provided inaccurate information, the required operating costs of the scheme would eliminate any potential arbitrage profits.
The resulting series of Boston Post articles triggered another run on the Securities Exchange Company. Not surprisingly, his charm and wit again saved the company from complete collapse. As investors crowed into his offices, Ponzi calmly handed out coffee and donuts while making payments to any investors request them. After paying out about $2 million worth of claims, the investor panic receded after a few days and many clients remained without withdrawing their principle or returns. In short order, Ponzi hired William H. McMasters, a high-profile publicity agent formerly of the Boston Post, to help restore the reputation of Ponzi’s business as well as Ponzi’s own public image.
However, with this action Ponzi inadvertently signed his company’s death warrant. In the course of his work, McMasters had discovered documents which proved that Ponzi’s investment scheme only worked if he used incoming new funds to make the payouts to previously situated investors.
McMasters sold this story to the Boston Post for $5,000 ($62,200) pronouncing Ponzi to be a “financial idiot… [and] hopelessly insolvent.” On 11 August 1920, the newspaper ran an article alleging that Ponzi’s business lacked deposits sufficient to pay off every investor. It reported a shortfall that amounted to as much as $4.5 million ($56 million). In addition, the newspaper reported on Ponzi’s criminal record from Montreal, as well as the time he spent in the Atlanta prison.
After the Post story appeared, a final run took place upon the Securities Exchange Company. Despite Ponzi’s claim to investors of “mountains of money available,” his bank accounts stood overdrawn by $442 thousand ($5.5 million) at the end of the day. Furthermore, State auditors disclosed that Ponzi business remained about $7 million ($87 million) in debt. In the face of inevitable and unavoidable financial collapse, some observers wondered why Ponzi had failed to ‘skip town.’ Knutson explains that “Normally in a scheme of this sort, it is the perpetrator’s objective to abscond with the funds as the scheme is at its peak. While authorities eventually had Ponzi watched to prevent his premature exit, his failure to flee in late July remains inexplicable. During this time he demonstrated a remarkable charm and facility for deceit as he manipulated his finances, investors, investigators, reporters, and the general public.” It appears that some swindlers prefer to remain in the spotlight. The following day, Ponzi surrendered himself to Federal agents.
U.S. officials charged Ponzi with over eighty counts of mail fraud. On 1 November 1920, he agreed to a plea bargain by pleading guilty to a single count of mail fraud. The judge denounced Ponzi’s scheme and sentenced him to serve five years in a Federal prison. Following his release after serving three and a half years for good behavior, the State of Massachusetts arrested him on twenty-two counts of larceny. Because of the deal with the Federal government, Ponzi had assumed that his plea-bargain deal covered all federal and state charges. Therefore, he sued the State of Massachusetts under the claim of double jeopardy. In 1921, the Supreme Court ruled against Ponzi, allowing the state charges to remain. After several cases had ensued, the state ultimately sentenced him to serve seven to nine years in prison.
“The Wretch Concentered All in Self,
Living, Shall Forfeit Fair Renown,
And Doubly Dying Shall Go Down
To the Vile Dust From Whence He Sprung,
Unwept, Unhonor’d and Unsung.”
—Sir Walter Scott, The Lay of the Last Minstrel: A Poem, 1805
Despite Ponzi’s impending incarceration, Federal authorities decided to deport him after finding out that he had never obtained U.S. citizenship. While released on bail, Ponzi fled Boston (without notifying his wife) and secretly moved to Jacksonville, Florida. There, he changed his name and launched a new, though short-lived, scheme selling swampland to real estate investors. In due time, Florida officials charged Ponzi for securities violations. Finding him guilty, they sentenced Ponzi to serve a year in state prison. Again, he skipped bail. However, this time he attempted to leave the country. Authorities caught Ponzi and returned him back to Boston. Massachusetts officials opted to have him complete his seven year prison sentence before finally deporting Ponzi back to Italy.
After his release from prison, Ponzi eventually arrived back in Italy in 1934. However, his wife had divorced him, deciding to remain in Boston. In Italy, he attempted to ply a few new schemes, but later took a job at the Treasury department under the Mussolini regime. Not surprisingly, Ponzi made poor financial decisions at this job, embezzling an unknown amount before escaping to Brazil in order to avoid severe punishment at the hands of the fascist government. In Brazil, Ponzi worked as a translator until a severe heart attack forced him to spend his last few years in a charity hospital in Rio de Janeiro.
In his last interview Ponzi told the press, “Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over.” By 1948, a brain hemorrhage had left Ponzi almost entirely paralyzed and blind. Soon after, he died on 18 January 1949.
Charles Ponzi had immigrated to America with “$1 million in hopes,” but never worked an honest day in his life—he simply moved from scheme to scheme. Over the course of thirty-one years, authorities convicted him of forgery, smuggling illegal immigrants, mail fraud, larceny, securities violations, before finally deporting Ponzi back to Italy—charged as an illegal immigrant. During the years that he resided in the United States and Canada, he served a more than fifteen years (50% of his time) in prison.
Over the decades, the term “Ponzi Scheme” has evolved into our synonym for any act in which financial market manipulators swindle trusting investors out of millions or billions of dollars through pyramid schemes. However, part of the blame lies with the people that invested in his company. In addition to deceitful promoters, Burton Malkiel explains in his book, “A Random Walk Down Wall Street” (W.W. Norton, 9th ed., 2007) that bubbles require “infectiously greedy, susceptible, get-rich-quick investors.” Charles Ponzi and others over the years may have cheated people out of their life savings. Nevertheless, investors handed over their money to him and proceeded to continually reinvest in the hope of higher and higher unrealized paper gains. Except for a handful of reporters and government officials, apparently no one asked pointed, in-depth questions about Ponzi’s business practices. What we can take away from this story of the Ponzi scheme remains a lesson, perpetually taught and re-taught to investors in financial markets around the world: “If something’s too good to be true, it probably is.”
So, You Wanna’ Get Rich Quick?
If you think that signing on as a “bright and progressive representative” of the Currency Exchange Center mentioned in the opening quote will bring you riches by working two to four business days per week with a guaranteed tax-free income of $24 thousand per year plus 5% to 10% of each transfer from customers processed—think again! In researching this “company,” I learned about and joined an online blog organization known as Fraud Watchers (www.fraudwatchers.org). This group holds forth their guiding principles as: “1) Provide an informational and supportive community for persons who have, directly or indirectly, fallen foul of fraud. 2) Improve awareness of internet frauds and scams amongst our users and the general public, including but not limited to Advanced Fee Fraud, Fake Lotteries, Bogus Employment Schemes, Internet Dating Scams, Money Laundering Schemes, and Fake Auctions. 3) Co-operate with law enforcement agencies wherever possible to help victims report their frauds, and also additionally to thwart fraudulent schemes in progress whenever and wherever possible. 4) Use every resource available to bring fraudsters and scammers to justice.”
We paraphrase one member (identity protected) who explains this one simple but clever scam as follows. No legitimate business needs to pay 5% to 10% for transfers because far cheaper and safer alternatives exist. Though the company claims to be based in Japan, the UK, and other first world economies, Nigerian and Eastern European gangs actually run this scam. The “representative scam” represents a variation on the traditional check fraud scam. This scam takes advantage of a misconception held by many, if not most, people. A widespread belief exists that banks verify a check as genuine if it “clears” and the money shows up in that bank’s account. However, the fact remains that a check can bounce even after that event.
Furthermore, the person depositing the check, not the bank, remains completely liable for any resulting losses.
The scammers mail their “representatives” fake checks from “customers” to deposit in their personal or business accounts. The victims believe that they are forwarding payments from the customers of their employer, the Currency Exchange Center, but because the victims bear complete liability, these representatives really forward their own money, as neither a legitimate buyer nor seller actually exists.
The bank makes the funds available in a depositor’s account—on a provisional basis. In effect, the bank lends the funds to the depositor against the promise a valid check backed by sufficient funds. However, the depositor bears the full liability if the check proves fraudulent. Often, the perpetrators write the checks using blank check forms stolen from legitimate businesses. Provided the business has sufficient funds in its account, the check will clear initially. The bank may make the full amount of the check available.
After the check clears, the representative wires 90% to 95% of the face amount to a bank account in another country. For example, if a victim has deposited a $50,000 check and wired $45,000 to Japan, he or she will owe $50,000 to the bank—a loss of $45,000 for the person assuming that they have kept their $5,000 commission in the account. Meanwhile, the bank of deposit forwards the original check to the holder of the account on which it is drawn. At this time, the company may determine that the funds have been debited from its account for a check that it never wrote. As expected, the holder reports the check fraud to their bank.
Because of time delays in the banking system, checks can bounce for up to six months after issue. However, by that time the money has long left the country while the representative remains to absorb the losses. The culprit “company” normally places its receiving accounts in the names of individuals or companies of different names. Over a relatively short period, the thieves can withdraw the cash using an ATM card in another country, leaving little evidence as to where funds vanished. To ensure their obscurity, the crooks may use recipient companies with Far Eastern identities because many countries in that region have a combination of weak banking oversight and strong banking privacy laws that make it easy for criminals to obscure the identity of the real account holder. Alas, the Ghost of Ponzi remains “alive and well” throughout many corners of the world.
————————
Dr. John F. Sase teaches Economics at Wayne State University and has practiced Forensic and Investigative Economics for twenty years. He earned a combined M.A. in Economics and an MBA at the University of Detroit, followed by a Ph.D. in Economics from Wayne State University. He is a graduate of the University of Detroit Jesuit High School (www.saseassociates.com).
Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a supervisory editor at Gale Research Company (now Cengage) for over twenty years. Currently, he edits books for publication (www.senick-editing.com).
Julie G. Sase is a copyeditor, parent coach, and empath. She earned her degree in English at Marygrove College and her graduate certificate in Parent Coaching from Seattle Pacific University. Ms. Sase coaches clients, writes articles, and edits copy (royaloakparentcoaching.com).
with
Bryan Lagalo, contributing writer
Gerard J. Senick, contributing editor
Julie Sase, copy editor
William Gross, research
“Currency Exchange [C]enter is looking for responsible, bright and progressive representatives [in the] territory of [the] U.S. Our company provides an opportunity for U.S. citizens to purchase internet currencies such as Web-Money, E-Gold and etc. We need a person that will be in charge of a payment process [when] clients purchase an Internet Currency of particular services that they have chosen ... [Our representatives assist] customers [in] purchasing Internet Currencies in order to have access to particular services and products unavailable [outside of the] U.S.”
It seems that whenever times get tough, more con-artists promising castles-in-the-air emerge from the woodwork. Personally, I, Dr. Sase, missed out on the opportunity to lose our life savings through Bernie Madoff’s version of the Ponzi scheme. Unlike Steven Spielberg and many others, I was not invited to participate in the Madoff scheme. However, many of us more pedestrian citizens, looking for alternatives to failed opportunities such as “Flipping Real Estate” and other touts on late-night infomercial, have received emails like the one above. Usually, we hit our deletes key and move on. However, I recently attended a presentation on the life and scams of Charles Ponzi offered by my former graduate assistant Bryan Lagalo. So, when I read the above “scam-mail” I thought to myself, “It’s the ghost of Ponzi!”
Before watching Bryan’s PowerPoint show, I knew as much about Charles Ponzi as the average investor—virtually nothing more than I could express in a single paragraph. However, that has changed since watching “Charles Ponzi: The Life of an Infamous Schemer” with a small group of academics that fought to hold back the laughter of disbelief over a con-artist whom I can describe only as a completely amoral sociopath. In this light, I asked Mr. Lagalo, currently a doctoral candidate in Economics at Wayne State University, to participate in this month’s column.
Aaay! It’s the Ponz! (Apologies to Arthur Herbert Fonzarelli)
In recent months, the term “Ponzi scheme” has appeared rampantly on Wall Street and widely spread throughout the popular press and the political arena. The name of Ponzi has spread so profusely that a Google search of the single word Ponzi generates over 20,000 news results. For example, even the Securities and Exchange Commission (SEC) defines a Ponzi scheme as “[A] type of illegal pyramid scheme named for Charles Ponzi, who duped thousands into investing…. Decades later, the Ponzi scheme continues to work on the ‘rob-Peter-to-pay-Paul’ principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.”
Most likely, many business, law, and economics professionals share a familiarity concerning the notorious premise of these schemes described by the SEC. However, most readers probably possess only a cursory knowledge of the original investment vehicles used by Ponzi to dupe investors.
Therefore, for our readers we chronicle both Ponzi the person and Ponzi the scheme, that has made his name synonymous with fraudulent and unsustainable investment scams.
Born in Lugo, Italy in 1882, Ponzi immigrated to the United States at the age of twenty-seven. Reportedly, having gambled away his life savings during his passage to America, he arrived in 1903 with little but his name. According to Mary Darby in her article In Ponzi We Trust (Smithsonian magazine, December 1998), Ponzi stated in a New York Times interview that “I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me.” He learned English while working at odd jobs along the East Coast. However, after one employer eventually fired Ponzi from his job as a waiter for stealing and for shortchanging customers, Ponzi decided to move to Montreal, Canada.
In Montreal, Ponzi took a job as an assistant teller and worked his way up to manager of the newly-opened Banco Zarossi. The owner, Luigi Zarossi, started his bank to accommodate the growing number of Italians immigrating to Canada. The bank’s business expanded quickly because Zarossi offered 6% interest on deposits—double the average rate offered by competing banks at that time. Eventually, Ponzi discovered that Zarossi offered high rates simply to attract large deposits that he used to cover interest payments on poorly-made real estate loans (sound familiar?) Soon after this episode, Zarossi fled to Mexico taking much of the bank’s money with him.
Jobless and broke, Ponzi forged a check for $423.58 ($10,500 adj.) made out to himself. Subsequently, after presenting it for payment the Canadian police arrested him. For the benefit of his family back in Italy while serving three years in a Quebec prison, Ponzi contrived a cover-up story in a letter to his mother explaining that he had found a job as an assistant to a prison warden. However, Mama Ponzi eventually discovered the truth.
Upon his release in 1911, Ponzi returned to the United States. However, merely ten days after leaving the Canadian prison, American authorities arrested him for smuggling Italian immigrants across the border from Canada. He then spent two more years of incarceration in the Atlanta Prison in Georgia. Having served his time, Ponzi moved to Boston where he met Rose Maria Gnecco. Though Charles Ponzi and Rose got to know one another seemingly well, Ponzi neglected to tell Rose about his time behind bars. However, Ponzi’s mother sent Rose a letter describing the matter in its entirety. Nevertheless, in spite of this new information Rose married Ponzi in 1918. Over the course of the next year, Ponzi worked at various jobs before developing an idea that resembled the Yellow Pages of present day. His company attempted to sell advertising space in a circulated catalog that listed various businesses. However, this idea did not catch on in Boston and the company soon failed.
Prelude to the Famous Scheme
At least for Ponzi, fortune began to change for the better in August of 1919 when he received a letter from a company in Spain inquiring about his failed catalog idea. More importantly than this inquiry, the letter contained an International Reply Coupon (IRC). The basic function of an IRC allowed a person in one country (Spain) to send prepaid postage for reply to someone in another country (United States). Although Ponzi received an IRC priced in pesetas, the Spanish currency at that time, the U.S. Post Office exchanged IRCs for postage priced in stronger U.S. dollars.
After World War I, more than sixty countries accepted IRCs and agreed upon regulated postage-exchange rates that reflected currency-exchange rates. However, during those years many European countries experienced high levels of inflation. As a result, currencies from countries like Spain and Italy suffered significant devaluation relative to the dollar, though the IRC postage-exchange rates remained the same. This discrepancy provided Ponzi with the opportunity for arbitrage. In respect to this specific event, he noted, “I wrote a man in Spain ... and in reply received an international exchange coupon which I was to exchange for American postage stamps with which to send a copy of the publication. The coupon in Spain cost the equivalent of about one cent in American money, I got six cents in stamps for the coupon here. Then I investigated the rates of exchange in other countries ....”
Upon this realization, Ponzi developed a simple plan. He enlisted friends and family to buy cheap IRCs in Italy and send them to him in the U.S. where he could redeem them at higher value U.S. dollars. Ponzi boasted that the net returns easily exceeded 400%, even after the subtraction of transaction costs. Furthermore, nothing in his plan was illegal—at least not technically.
Immediately, Ponzi quit his job and borrowed money to mail to his relatives in Italy. In his letter to them, he explained that they should send him as many IRCs as possible. Then, Ponzi sold his arbitrage idea to several friends in Boston, promising that he would provide a 100% return in only ninety days. Ponzi used the funds that he collected to start a company that he registered as the Securities Exchange Company (SEC). (Ironically, his company shared its acronym with the Securities and Exchange Commission founded by the Federal government a decade-and-a-half later).
Originally, Ponzi limited his issue to notes bearing small principal amounts such as $50, $100, $1000. However, once his business accelerated, he left a line blank on the notes to allow investors to enter whatever amount they wanted to invest. Through his new company, Ponzi offered investors a 50% return after forty-five days or a 100% return after ninety days, on virtually any principal amount. This castle-in-the-air offer encouraged a Federal postal inspector to visit Ponzi at his business and voice government concern that selling millions of IRCs may not prove legal. In retort, Ponzi explained that the IRC coupons could always be exchanged in other countries outside of the jurisdiction of the U.S. Post Office. Even so, this initial investment scheme contained substantial holes. In his treatise on Ponzi, Mark Knutson points out that 1) In 1920 the nations that accepted IRCs announced new postal exchange rates in order to reflect the large devaluation in their currencies. 2) U.S. Post Offices limited their issues of IRCs to ten per visit. 3) Due to the immense volume of IRCs needed per transaction to ensure a profit, the transaction costs eliminated any significant arbitrage profit (“The Remarkable Criminal Financial Career of Charles K. Ponzi,” www.mark-knutson.com, 1996).
Because of these impediments, Ponzi would have realized that transporting, unloading, and redeeming the needed volume of IRCs at a post office would prove prohibitive. Furthermore, his own business records indicate that he actually purchased only a small number of IRCs. Fortunately for Ponzi, most people previously had neither used an IRC nor knew much about them. This public ignorance greatly masked these fundamental problems involved with IRC arbitrage. As a result, investors flocked quickly into Ponzi’s office.
The Rise and Fall of Ponzi’s Scheme—Robbing-Peter-to-Pay-Paul
Most historians attribute Ponzi’s early success to his ability to sell his scheme. As with any shyster, Ponzi used the promise of false hopes and half-truths to lure investors. However, he took his scheme a step further by performing a “dog-and-pony” show, laden with “smoke and mirrors.” Well known for his charisma, Ponzi charmed audiences with his animated sales pitches. Furthermore, he advertised his scheme to the general public rather than singling out a few wealthy investors. To edify his reputation, Ponzi openly defended the legitimacy of his business by personally guaranteeing all matured payments.
Immediately, Ponzi’s scheme accelerated as investors lined up at his office door. He dazzled them with the virtues of the apparent concreteness and freedom from risk possessed by his postage investment vehicle. With dollars pouring into his business, Ponzi actually managed to pay off some of the initial investors. In turn, unable to personally handle this increasing volume of sales, Ponzi hired agents and rewarded them with generous commissions. Quickly, his agents went to work and produced a flow of funds from cities and towns throughout New England. The success of Ponzi’s scheme grew exponentially. Though in February of 1920, his business only collected $5,000 ($62,200 in 2009 terms), by March it realized $30,000 ($373,200), and by May, $420,000 ($5,225,000).
The revenues continued to increase exponentially. In the first week of July alone, sales agents funneled $1 million ($12.5 million) into the firm.
Though most beneficiaries reinvested their earnings, some investors occasionally would demand their matured returns. The various historical sources indicate that in the early months of his investment scheme, Ponzi did pay out cash returns to any investor requesting them. Fortunately, for Ponzi, this strategy served to fuel the fire and kept most clients reinvesting. As long as he continued to appease a few investors with payouts, his other investors appeared to remain content. At least on paper, these investors continued to earn a return while the Ponzi scheme maintained its reputable façade.
Many naïve and neophyte investors mortgaged their homes and turned over the proceeds and other lifesavings to the Securities Exchange Company. Meanwhile, Ponzi drew upon the funds to support his lifestyle of a millionaire. He used company funds to pay for first-class passage to move his mother from Italy to the United States and to purchase a lavish air-conditioned mansion with a heated pool. Of course, a simple audit not only would have shown that Ponzi stole money from his company, but also that the business itself experienced substantial losses. Blinded by their own greed, investors continued to dump funds into the company—funds more than sufficient to keep the firm afloat, temporarily.
As a result of Ponzi’s enormous success, some people began to question how he consistently could generate extraordinary returns over such a short span of time. In his book, “Ponzi, the Boston Swindler,” (McGraw-Hill, 1975) Donald Dunn states that a Boston financial writer wrote a story suggesting that Ponzi’s investment scheme probably violated the law. Ironically, Ponzi sued the paper for slander and won $500,000 ($6.2 million) since the burden of proof lay on newspaper writers at that time. Furthermore, given the total volume of IRCs needed for Ponzi to pay double returns to most investors, local, state, and federal government officials suspected fraud. However, since each requested payout had thus far been met, authorities could not produce any evidence of lawbreaking.
Immediately after this initial governmental investigation, Ponzi faced a lawsuit filed against him by Joseph Daniels, a local furniture dealer. Daniels claimed that he personally loaned Ponzi $200 to start the Securities Exchange Company in return for a share of its future profits. Although the court sided with Ponzi, many parties began to wonder how he rose from poverty to millionaire status in a matter of months. As doubts grew, a small run took place on his business. However, Ponzi paid off each “recalcitrant” investor and the run subsided. As a result, this episode boosted the confidence of other investors—confidence that strengthened with the publication of a positive article in the Boston Post reporting that Ponzi had warded off this run. His Securities Exchange Company flourished, taking in $250,000 ($3.1 million) per day.
Despite the fact that Ponzi prevented a run earlier that same month, the Suffolk County District Attorney, Joseph C. Pelletier, began to investigate Ponzi’s business in late July 1920. The D.A. persuaded Ponzi to stop collecting new funds and to allow State officials to audit his books. One could speculate that Ponzi agreed to this plan because refusing it would have raised serious doubts as to the legitimacy of his business. On the other hand, the auditors ultimately discovered that he had failed to keep accurate records anyway. In a last ditch effort, Ponzi assured the public that he maintained millions of dollars in overseas deposits accounts to cover his business and deposit liabilities.
The beginning of the end came on 26 July when the Boston Post began to run a series of articles that raised difficult-to-answer questions as to how Ponzi operated his business. The Boston Post hired an analyst from Barron’s, the financial newspaper, to evaluate the Securities Exchange Company.
Upon investigation, the analyst discovered that Ponzi did not invest in his own company and subsequently questioned why, instead, he shared his seemingly great idea with the general public. Mark Knutson pointed out that the District Attorney asked Ponzi a question that put his explanations to the test. If Ponzi maintained large deposits in various banks while operating a profitable scheme, why would he want to solicit additional investment? Ponzi’s answer revealed its deficiency, but nobody seemed to notice: Ponzi lamely responded that he had not used the money, but would eventually need the people.
Next, the analyst from Barron’s estimated that Ponzi’s company needed 160 million IRCs to cover the deposits and promised returns to every investor. To worsen matters for Ponzi, the U.S. Post Office reported that only 27,000 IRCs circulated at the time and that none of the participating foreign post offices had recently sold or redeemed large quantities of IRCs. Finally, the analyst admitted that even if the U.S. Post Office provided inaccurate information, the required operating costs of the scheme would eliminate any potential arbitrage profits.
The resulting series of Boston Post articles triggered another run on the Securities Exchange Company. Not surprisingly, his charm and wit again saved the company from complete collapse. As investors crowed into his offices, Ponzi calmly handed out coffee and donuts while making payments to any investors request them. After paying out about $2 million worth of claims, the investor panic receded after a few days and many clients remained without withdrawing their principle or returns. In short order, Ponzi hired William H. McMasters, a high-profile publicity agent formerly of the Boston Post, to help restore the reputation of Ponzi’s business as well as Ponzi’s own public image.
However, with this action Ponzi inadvertently signed his company’s death warrant. In the course of his work, McMasters had discovered documents which proved that Ponzi’s investment scheme only worked if he used incoming new funds to make the payouts to previously situated investors.
McMasters sold this story to the Boston Post for $5,000 ($62,200) pronouncing Ponzi to be a “financial idiot… [and] hopelessly insolvent.” On 11 August 1920, the newspaper ran an article alleging that Ponzi’s business lacked deposits sufficient to pay off every investor. It reported a shortfall that amounted to as much as $4.5 million ($56 million). In addition, the newspaper reported on Ponzi’s criminal record from Montreal, as well as the time he spent in the Atlanta prison.
After the Post story appeared, a final run took place upon the Securities Exchange Company. Despite Ponzi’s claim to investors of “mountains of money available,” his bank accounts stood overdrawn by $442 thousand ($5.5 million) at the end of the day. Furthermore, State auditors disclosed that Ponzi business remained about $7 million ($87 million) in debt. In the face of inevitable and unavoidable financial collapse, some observers wondered why Ponzi had failed to ‘skip town.’ Knutson explains that “Normally in a scheme of this sort, it is the perpetrator’s objective to abscond with the funds as the scheme is at its peak. While authorities eventually had Ponzi watched to prevent his premature exit, his failure to flee in late July remains inexplicable. During this time he demonstrated a remarkable charm and facility for deceit as he manipulated his finances, investors, investigators, reporters, and the general public.” It appears that some swindlers prefer to remain in the spotlight. The following day, Ponzi surrendered himself to Federal agents.
U.S. officials charged Ponzi with over eighty counts of mail fraud. On 1 November 1920, he agreed to a plea bargain by pleading guilty to a single count of mail fraud. The judge denounced Ponzi’s scheme and sentenced him to serve five years in a Federal prison. Following his release after serving three and a half years for good behavior, the State of Massachusetts arrested him on twenty-two counts of larceny. Because of the deal with the Federal government, Ponzi had assumed that his plea-bargain deal covered all federal and state charges. Therefore, he sued the State of Massachusetts under the claim of double jeopardy. In 1921, the Supreme Court ruled against Ponzi, allowing the state charges to remain. After several cases had ensued, the state ultimately sentenced him to serve seven to nine years in prison.
“The Wretch Concentered All in Self,
Living, Shall Forfeit Fair Renown,
And Doubly Dying Shall Go Down
To the Vile Dust From Whence He Sprung,
Unwept, Unhonor’d and Unsung.”
—Sir Walter Scott, The Lay of the Last Minstrel: A Poem, 1805
Despite Ponzi’s impending incarceration, Federal authorities decided to deport him after finding out that he had never obtained U.S. citizenship. While released on bail, Ponzi fled Boston (without notifying his wife) and secretly moved to Jacksonville, Florida. There, he changed his name and launched a new, though short-lived, scheme selling swampland to real estate investors. In due time, Florida officials charged Ponzi for securities violations. Finding him guilty, they sentenced Ponzi to serve a year in state prison. Again, he skipped bail. However, this time he attempted to leave the country. Authorities caught Ponzi and returned him back to Boston. Massachusetts officials opted to have him complete his seven year prison sentence before finally deporting Ponzi back to Italy.
After his release from prison, Ponzi eventually arrived back in Italy in 1934. However, his wife had divorced him, deciding to remain in Boston. In Italy, he attempted to ply a few new schemes, but later took a job at the Treasury department under the Mussolini regime. Not surprisingly, Ponzi made poor financial decisions at this job, embezzling an unknown amount before escaping to Brazil in order to avoid severe punishment at the hands of the fascist government. In Brazil, Ponzi worked as a translator until a severe heart attack forced him to spend his last few years in a charity hospital in Rio de Janeiro.
In his last interview Ponzi told the press, “Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over.” By 1948, a brain hemorrhage had left Ponzi almost entirely paralyzed and blind. Soon after, he died on 18 January 1949.
Charles Ponzi had immigrated to America with “$1 million in hopes,” but never worked an honest day in his life—he simply moved from scheme to scheme. Over the course of thirty-one years, authorities convicted him of forgery, smuggling illegal immigrants, mail fraud, larceny, securities violations, before finally deporting Ponzi back to Italy—charged as an illegal immigrant. During the years that he resided in the United States and Canada, he served a more than fifteen years (50% of his time) in prison.
Over the decades, the term “Ponzi Scheme” has evolved into our synonym for any act in which financial market manipulators swindle trusting investors out of millions or billions of dollars through pyramid schemes. However, part of the blame lies with the people that invested in his company. In addition to deceitful promoters, Burton Malkiel explains in his book, “A Random Walk Down Wall Street” (W.W. Norton, 9th ed., 2007) that bubbles require “infectiously greedy, susceptible, get-rich-quick investors.” Charles Ponzi and others over the years may have cheated people out of their life savings. Nevertheless, investors handed over their money to him and proceeded to continually reinvest in the hope of higher and higher unrealized paper gains. Except for a handful of reporters and government officials, apparently no one asked pointed, in-depth questions about Ponzi’s business practices. What we can take away from this story of the Ponzi scheme remains a lesson, perpetually taught and re-taught to investors in financial markets around the world: “If something’s too good to be true, it probably is.”
So, You Wanna’ Get Rich Quick?
If you think that signing on as a “bright and progressive representative” of the Currency Exchange Center mentioned in the opening quote will bring you riches by working two to four business days per week with a guaranteed tax-free income of $24 thousand per year plus 5% to 10% of each transfer from customers processed—think again! In researching this “company,” I learned about and joined an online blog organization known as Fraud Watchers (www.fraudwatchers.org). This group holds forth their guiding principles as: “1) Provide an informational and supportive community for persons who have, directly or indirectly, fallen foul of fraud. 2) Improve awareness of internet frauds and scams amongst our users and the general public, including but not limited to Advanced Fee Fraud, Fake Lotteries, Bogus Employment Schemes, Internet Dating Scams, Money Laundering Schemes, and Fake Auctions. 3) Co-operate with law enforcement agencies wherever possible to help victims report their frauds, and also additionally to thwart fraudulent schemes in progress whenever and wherever possible. 4) Use every resource available to bring fraudsters and scammers to justice.”
We paraphrase one member (identity protected) who explains this one simple but clever scam as follows. No legitimate business needs to pay 5% to 10% for transfers because far cheaper and safer alternatives exist. Though the company claims to be based in Japan, the UK, and other first world economies, Nigerian and Eastern European gangs actually run this scam. The “representative scam” represents a variation on the traditional check fraud scam. This scam takes advantage of a misconception held by many, if not most, people. A widespread belief exists that banks verify a check as genuine if it “clears” and the money shows up in that bank’s account. However, the fact remains that a check can bounce even after that event.
Furthermore, the person depositing the check, not the bank, remains completely liable for any resulting losses.
The scammers mail their “representatives” fake checks from “customers” to deposit in their personal or business accounts. The victims believe that they are forwarding payments from the customers of their employer, the Currency Exchange Center, but because the victims bear complete liability, these representatives really forward their own money, as neither a legitimate buyer nor seller actually exists.
The bank makes the funds available in a depositor’s account—on a provisional basis. In effect, the bank lends the funds to the depositor against the promise a valid check backed by sufficient funds. However, the depositor bears the full liability if the check proves fraudulent. Often, the perpetrators write the checks using blank check forms stolen from legitimate businesses. Provided the business has sufficient funds in its account, the check will clear initially. The bank may make the full amount of the check available.
After the check clears, the representative wires 90% to 95% of the face amount to a bank account in another country. For example, if a victim has deposited a $50,000 check and wired $45,000 to Japan, he or she will owe $50,000 to the bank—a loss of $45,000 for the person assuming that they have kept their $5,000 commission in the account. Meanwhile, the bank of deposit forwards the original check to the holder of the account on which it is drawn. At this time, the company may determine that the funds have been debited from its account for a check that it never wrote. As expected, the holder reports the check fraud to their bank.
Because of time delays in the banking system, checks can bounce for up to six months after issue. However, by that time the money has long left the country while the representative remains to absorb the losses. The culprit “company” normally places its receiving accounts in the names of individuals or companies of different names. Over a relatively short period, the thieves can withdraw the cash using an ATM card in another country, leaving little evidence as to where funds vanished. To ensure their obscurity, the crooks may use recipient companies with Far Eastern identities because many countries in that region have a combination of weak banking oversight and strong banking privacy laws that make it easy for criminals to obscure the identity of the real account holder. Alas, the Ghost of Ponzi remains “alive and well” throughout many corners of the world.
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Dr. John F. Sase teaches Economics at Wayne State University and has practiced Forensic and Investigative Economics for twenty years. He earned a combined M.A. in Economics and an MBA at the University of Detroit, followed by a Ph.D. in Economics from Wayne State University. He is a graduate of the University of Detroit Jesuit High School (www.saseassociates.com).
Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a supervisory editor at Gale Research Company (now Cengage) for over twenty years. Currently, he edits books for publication (www.senick-editing.com).
Julie G. Sase is a copyeditor, parent coach, and empath. She earned her degree in English at Marygrove College and her graduate certificate in Parent Coaching from Seattle Pacific University. Ms. Sase coaches clients, writes articles, and edits copy (royaloakparentcoaching.com).
