Have you ever heard the phrase “rob Peter to pay Paul”? This, my friends, is a great metaphor for how a Ponzi scheme works. Essentially, this phrase means to take something away from one person (Peter) to pay another (Paul), discharging one debt only to incur another.

The Association of Certified Fraud Examiners (ACFE), defines a Ponzi scheme as “an illegal business practice in which new investor’s money is used to make payment to earlier investors.” According to the U.S. Securities Exchange Commission (SEC) and the North American Securities Administrators Association, such scammers cost U.S. investors between $10 and $15 billion a year.

While the SEC has published some common characteristics of these practices, such as high investment on returns with no or little risk or overly consistent returns, I have identified some additional common threads that are a bit more qualitative in nature. None of these red flags alone are indicators of a Ponzi scheme; however, when you have multiple red flags present, it’s a good indicator to increase your skepticism and expand your scope to include as many third-party confirmations of financial results and reporting as possible.

Smooth operator – Outside of performing a full background check and Google-searching the heck out of the owner-operator (“operator”) to see what turns up, there are a few questions to ask yourself about the operator:

  • Are they a silver-tongued, charismatic and charming character that you can’t help but like and even trust?
  • Have they engaged in suspect behavior before? Even in their young adult life? If so, ask yourself if you really want to get in business with such a character or if you should move on to the next investment opportunity.
  • Do they have fluid answers to all the questions you ask but with no empirical data to support? Or do they provide responses indicating that the information is confidential and cannot be shared?

Limited access – If you are working on a deal and only have access to the owner and are denied access with any other members of the management team, this should be a red flag of potentially suspicious activity.

Excel overload – If you are provided financial reporting in Excel with no indications that the information was generated from a system, there might be a risk that what you are looking at is an Excel spreadsheet manufactured by the owner. One way to test if the Excel-based financial reporting is reliable is to perform testing such as confirmation of revenues to the bank statements [look out for altered bank statements!] and other third-party confirmations such as customer receivable accounts and revenues.

Operating a Ponzi scheme is a criminal offense and should be reported to the FBI. To report a possible Ponzi scheme, you can submit a tip to the FBI Tips website (anonymously or not) or call 1-800-225-5324 or your local FBI office. Ponzi schemes also run afoul of SEC regulations and you can file a complaint on the SEC website.

About the Authors

Mindy S. Marsden

CFE
Senior Manager, Valuation/Transaction Advisory Services

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