Professor of Law Tamar Frankel has spent years studying the importance of trust in our economy. Trust sustains investment and entrepreneurship and greases the machinery of the marketplace. In her latest book, The Ponzi Scheme Puzzle, Frankel examines the fine line between trust and gullibility. Why do investors keep falling for the age-old scam of robbing Peter to pay Paul, and then robbing Patricia to pay Peter? What drives the victims when both history and simple math suggest that the cons’ schemes are destined to implode? By examining court records, Frankel discovered hundreds of these cons that are unmasked every year. They occur all over the world.
How do the Ponzi schemers pull it off? From the enormous variety of con artists’ stories and enticements, Frankel found patterns of behavior both by the crooks and their victims. The stories con artists use to hook their investors typically share one important ingredient: they are hard to verify. In one case Frankel studied eight American banks that fell victim to a Ponzi scheme. The supposed investment was normal except that the businesses were in India. No one checked whether they existed until the payments stopped. The banks’ losses amounted to about $1 billion.
Frankel also notes that Ponzi schemers don’t aggressively solicit new investors. They wait for word-of-mouth to bring people in and make a show of reluctance to accept their money. In addition, secrecy and the complexity of the investments help cover the fraud.
Ultimately, Frankel notes, the glitter that tempts Ponzi victims is the improbable promise of high returns at low risk, based on an intriguing investment opportunity that’s difficult to verify. A few moments of reflection might keep an educated investor from falling victim to these scams. After all, the usual rule of finance is that risk and return rise and fall together. The problem, says Frankel, is that people taken in by Ponzi schemes don’t stop to think.
How do the con artists sell their “investments?” First, they fashion themselves as important pillars of the community by rubbing shoulders with the rich and powerful, making generous charitable contributions, and entertaining lavishly. They attract the less-regulated not-for-profit institutions, and take advantage of the close bonds of trust among people connected by occupation, ethnicity, or religion. Many of Charles Ponzi’s victims, for example, were fellow Italian immigrants. More recently, a group of Australian police officers were caught up in a Ponzi scheme. Often, the schemers hire salespeople and investment advisers who manage and invest clients’ money in the scheme.
Frankel argues that we have trouble spotting these frauds, because con artists’ behavior seems very close to “normal.” Ponzi schemers, at heart, are entrepreneurs and superb salespeople. The strength of their belief in their “business” makes them believable to others. Frankel points out that Ponzi schemers are masters at mimicking legitimate investment opportunities, often reassuring investors by issuing regular financial statements. And when investors demand repayment they get their money promptly, so long as the scam lasts. These actions build trust.
Frankel suggests that both the perpetrators and their victims enjoy, and may even be addicted to, the fantasy of outsmarting the workaday crowd and sharing the secret to quick riches.
“These are intelligent and knowledgeable investors who believe in their intellectual power. Nobody can pull the wool over their eyes,” says Frankel. “They like feeling exclusive. They like participating in a select group, and con artists give them that feeling.”
Frankel also found patterns in the aftermath of a fraud’s discovery. Con artists often blame others, including the government and the victims. The wealthy and educated victims blame themselves and try to brush the embarrassing incident under the rug as fast as possible. Finally, a number of the Ponzi schemer’s most ardent followers may object to government interference and be heartbroken.
Frankel covers the legal aftermath of these schemes as victims who lost money in the con may sue to claim losses from victims who gained or managed to recoup their investment. However, her book is neither a legal book nor a journalistic depiction of con artists. Instead, Frankel surveys the system of Ponzi schemes and argues that our main protection against them is self-knowledge. We need to ask ourselves if we share the traits of people who tend to fall for these schemes—optimistic, risk-taking, trusting, and maybe a little impressed by our own cleverness and sophistication.
If we do share these traits, Frankel suggests, we don’t have to admit our weaknesses to anyone. No matter who offers the golden opportunity, “all we have to do is say: ‘let me think about it.’ We don’t need to gain more information. We don’t need to say no. Just take a deep breath and say, ‘not now.’” We may not always be able to spot the con artist, but we can be honest enough with ourselves to look before we leap.
Tamar Frankel’s book, The Ponzi Scheme Puzzle: A History and Analysis of Con Artists and Victims (Oxford University Press), was published in July 2012.