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The average business loses 5% of its yearly income to fraud according to an Association of Certified Fraud Examiners Global Fraud Study. Increasingly, business fraud takes the form of a Ponzi scheme. Investors and businesses alike need to understand what a Ponzi scheme looks like to avoid falling victim. To confuse things, investments-gone-bad are increasingly being called Ponzi schemes by people who should know better. Failing to recognize the difference can prevent an investor from pursuing the best remedy to recover their investment losses.

To put it simply for investors, investments in true Ponzi schemes are almost always lost, while investors often have the opportunity to recover their losses in cases of misrepresentation or fraud. From an enforcement perspective, a company accused of operating a Ponzi scheme has a lot to gain by defeating that claim: Regulatory authorities have a lower burden of proof when clawing back transfers made as part of a true Ponzi scheme.

What is a Ponzi scheme?

The phrase “Ponzi scheme” is named after Charles Ponzi, who defrauded investors during the 1920s. Ponzi identified a minor arbitrage between Spanish and United States stamps, which he claimed yielded a quick return of at least 10%. He set up the “Securities Exchange Company” to recruit outside investors and purportedly leverage the arbitrage opportunity. Ponzi raised nearly $15 million from thousands of investors before the bottom fell out of his scheme.

“Ponzi schemes” returned to the public discussion when, in 2008, Bernie Madoff’s $65 billion Ponzi scheme came crashing down. Madoff, the former chairman of NASDAQ, was eventually sentenced to 150 years in prison. The Madoff scheme persisted for most of two decades because investors received what looked like legitimate brokerage account statements.

Ponzi scheme promoters usually bring in early investors with a facially legitimate investment idea coupled with an unusually high rate of return. Early investors get their “returns” from later investors’ money. The scheme leads victims to believe their returns come from legitimate business transactions, leaving them unaware that newer investors are the source. Ponzi schemes require a constant flow of new money to survive, as there is little to no legitimate business activity.

Courts define a Ponzi scheme as a “fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments.” Janvey v. Alguire, 647 F.3d 585, 597 (5th Cir. 2011). Any money disbursed from a Ponzi scheme is presumed fraudulent. SEC v. Res. Dev. Int’l, LLC, 487 F.3d 295, 301 (5th Cir. 2007).

Ponzi scheme ‘red flags’

  • High returns and little risk: All investments carry some risk; and, an investment’s return is often tied to its level of risk. Any investment promising a “guaranteed” return, particularly a high yield return, should be viewed as a red flag. 
  • Overly consistent returns: Investment returns fluctuate over time. Investors should be skeptical of an investment that regularly generates similar positive returns, regardless of overall market conditions.
  • Unregistered investments: Billions of dollars trade hands each year in legitimate, unregistered securities transactions through exceptions to federal and state registration requirements. But all Ponzi schemes involve unregistered securities, and any investor considering investing in a non-registered offering should pay careful attention.
  • Unlicensed sellers: Both federal and state securities laws require investment professionals and firms to be licensed and registered. Investors should pay special attention when dealing with unlicensed sellers. Ponzi schemes almost always involve unlicensed individuals and unregistered firms.
  • Paperwork inconsistencies: Always check account statements for legitimacy and for errors. False or poorly presented account statements can be a sign funds are not being invested as promised.
  • Difficulty unwinding allegedly liquid investments: Investors should be suspicious if they have difficulty unwinding relatively liquid investments. Ponzi promoters have an incentive to promise easy withdrawals and then go back on that promise.

Disproving a Ponzi scheme—A Case Example

Investors who suspect financial fraud, including possibly a Ponzi scheme, should investigate quickly. Making an early claim often leads to a better chance to liquidate a risky investment. On the other side, those accused of running a Ponzi scheme need to quickly form a defense strategy. Not all investments-gone-wrong are Ponzi schemes, and knowledge is necessary to maximize your chance of success.

One example where the mischaracterization of fraud as a Ponzi scheme was a disservice to both investors and the parties involved occurred in In Re: Life Partners Holdings, Inc. Life Partners, headquartered in Waco, Texas, was one of the first viatical and “life settlement” brokers. A viatical, as originally contemplated, allowed terminally ill individuals to sell their life insurance policies for a percentage of face value. The purchaser assumed premium payments and would eventually collect the death benefit. Life Partners expanded its original plan to “life settlements”— life insurance policies held by elderly individuals – in the early 2000s.

Life Partners, a public company, filed for bankruptcy in 2015 after losing a suit with the SEC over its reporting practices. The trustee for Life Partners in the bankruptcy sued Life Partners’ founder Brian Pardo and other former Life Partners executives for $750 million based on the false claim Life Partners was a Ponzi-like scheme.

Burford Perry, LLP successfully represented Pardo in this litigation. The trustee’s attorneys built their case against Pardo on the false idea that Life Partners ran as a Ponzi scheme, later changing their allegation to “Ponzi-like scheme.” Life Partners was publicly called “one of the largest and longest-standing fraud schemes” in Texas history. If the trustee could prove Life Partners was a Ponzi scheme, then every transfer to a third party would be presumptively fraudulent. In the Life Partners bankruptcy, the trustee was suing innocent charities who received contributions from Life Partners or Pardo and innocent businesses who served Life Partners.

Burford Perry ultimately limited Pardo’s damages significantly, as well as killed off the allegations against charities and third parties, by securing a jury finding that Life Partners was not Ponzi scheme. In presenting Pardo’s defense, Burford Perry showed Life Partners was not a Ponzi scheme because Pardo carefully accounted for investors’ investments and later payouts and never used later investors’ money to pay earlier investors. The jury specifically found Life Partners was not a Ponzi scheme and rejected the trustee’s massive damage claims. The parties settled while on appeal.

Houston Business Fraud Attorneys

Unfortunately, investors can become victims of business fraud; and, sometimes, companies are falsely accused. The attorneys at Burford Perry have more than 55 years of combined experience handling business fraud cases. If you are affected by business fraud, contact us to learn about your legal options.