Ponzi Schemes and Pyramid Schemes: What’s the Difference?
On this date in 2008, Bernard Madoff was arrested and charged with running a $50 billion Ponzi scheme.
Here are some facts about Ponzi schemes, their history and how they work.
A Ponzi scheme is a scam where a person or organization pays returns to investors using funds from new investors, rather than from profit earned by the original investment, otherwise known as robbing Peter to pay Paul.
Charles Ponzi, an Italian con artist, found a loophole in a system which allowed people in foreign countries to prepay for postage for a reply message at the local rate. For instance, if a stamp cost the equivalent of one cent in Italy, but stamps in the U.S. cost four cents, the person in Italy could buy a coupon for a penny, enclose it in a letter and have the recipient redeem the coupon for a four-cent return stamp. Thus, buying an asset at a lower price in one market and selling it in a market where the cost is higher, which is known as arbitrage and is not illegal. He tried to profit from this, but couldn’t make it work.
That didn’t stop him from pretending to continue the postage investment. He formed a company and went looking for investors. In February 1920, Ponzi’s company took in $5,000. By May, he had raked in $420,000. By July he had made millions. As new money was coming it, it was quickly leaving to pay off earlier investors. Ponzi also bought a mansion and other perks of the high life.
However, things were about to go south for Ponzi. A series of articles in the Boston Post questioned the authenticity of Ponzi’s profits. Clarence Barron, the head of Dow Jones and Company noted that for the amount of money Ponzi’s company had invested in postal coupons, more than 160 million of them were required to be in circulation. At the time, only about 27,000 actually were. The stories caused a run on Ponzi’s company and he paid out more than $2 million in three days. On August 11, a story ran in the Post detailing a previous forgery conviction. The next day, knowing that the scam was busted, he surrendered to federal authorities. The scheme brought down six banks and cost his investors about $20 million. Ponzi ended up serving more than 10 years in prison for his scheme and was deported to Italy.
He eventually moved to Brazil, where he died penniless in 1948 at the age of 66.
Closely related to the Ponzi scheme is the pyramid scheme. While it has several things in common with Ponzi schemes, there are some important differences as well. A Ponzi scheme is centered on one person or agency, who deals with all investors. A pyramid scheme recruits other participants who are responsible for recruiting even more participants. Pyramid schemes are built around the specific demand that new money be brought into the scheme or it will collapse; Ponzi schemes are reliant on fraud to attract new investors. Finally, pyramid schemes require an exponentially increasing number of participants to continue; Ponzi schemes can continue largely with reinvestment from existing participants, and a small number of new participants.
Our question: How many years in prison was Bernard Madoff sentenced to for his Ponzi scheme?
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