A fraud trial got underway this month in a U.S. federal court in Boise, Idaho, against four executives of property developer DBSI, who are charged with multiple counts of mail and wire fraud, securities fraud, and bank fraud, the Idaho Statesman reports. Prosecutors allege that the company sold fractional shares of business properties and unimproved lands, beginning in 2003, that promised investors a guaranteed annual return. Prosecutors say DBSI falsely claimed it had a net worth of US $105 million in 2007 and 2008. Instead, they say the company actually was losing US $3 million a month on unprofitable properties and eventually declared bankruptcy in 2008. Although prosecutors allege that the executives depended on attracting new investors to make guaranteed payments to previous investors, the judge in the case has issued an order banning prosecutors from referring to the case as a Ponzi scheme during the trial. The executives also are charged with misusing more than US $80 million in reserve funds put up by investors.
One can understand why the defendants in this case would prefer that the term "Ponzi scheme" be avoided at trial. Very large institutions, such as we recently saw in the case of JPMorgan being fined US $2 billion for fraudulent investments, are suffering significant reputational damage as a result of hardening public attitudes toward this type of activity.
I will not comment on the judge's decision in this case, but it presents an opportunity for internal auditors to increase their awareness of these schemes when going about their work. A Ponzi scheme, simply defined, is a fraudulent investment operation that pays returns to its investors from existing capital or new capital paid by new investors, rather than from profit earned by the individual or organization running the operation. Most sources agree that there are five key elements of a Ponzi scheme:
Benefit. A promise that the investment will achieve an above-normal rate of return. The rate of return is often specified. The promised rate of return has to be high enough to be worthwhile to the investor but not so high as to be unbelievable.
Plausible scheme. An explanation of how the investment can reasonably achieve these above-normal rates of return. One often-used explanation is that the investor is skilled or has inside information, and that the investor has access to an investment opportunity not otherwise available to the general public.
Credibility. The person running the scheme needs to be believable enough to convince the initial investors to leave their money with him or her.
Pay-off (or the appearance thereof). For at least a few periods, investors need to make at least the promised rate of return — if not better.
New intake. Other investors need to hear about the pay-offs, such that their numbers grow exponentially. At the very least, more money needs to be coming in than is being paid back to investors.
Typically, Ponzi schemes are detected too late — when the economy goes bad and many people need to draw on their savings. The demand for cash overwhelms the ability of the fraudsters running the scheme to find new investors to supply the needed cash.
More of these schemes are certain to occur, with current low interest rates, relatively easy access to credit, and the ever-shifting ability of "Ponzis" to engineer more complex schemes. The call for regulation and policing gets louder, but what rules would actually detect such schemes in their early stages? I've written numerous articles on this website that discuss warning signs auditors can look for in the early stages of Ponzi schemes.
A key difference between legitimate financial firms and Ponzi schemes is that the legitimate firms actually control assets that match the total amount on statements sent out to investors, while in Ponzi schemes, the pot of money invested is smaller than the total amount owed to investors. Therefore, one remedy could be to require periodic auditing to ensure that enough investments exist to back up the amount owed to investors. But even mandating audits is not enough — protection also is needed from fraudsters who simply shop for auditors willing to take outsized fees to look the other way. Requiring firms to have a different auditor every few years, or having an auditor assigned by an independent organization, might help. Yes, such solutions might drive up audit costs for legitimate financial institutions, but compared to the losses to people, institutions, and their reputations, they may be worth the investment.