Quick review of the most famous investments frauds ever…

In this article, Louis DETALLE (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2023) explains what a tax specialist works on, on a daily basis.

The most famous amongst all frauds ever: Charles Ponzi

Born in 1882, this Italian man has built himself quite a reputation in the fraud industry due to his invention: the Ponzi Pyramid. That consisted of a financial business plan that promised a 50% interest rate within 45 days to the investors that picked his solution. You may wonder how it was possible to reach such rates, well it was possible because Charles Ponzi reimbursed the old investors their initial investment plus the interests with the money collected from newer investors and so on… In fact, Ponzi developed an idea that he encountered in the “Banca Zarossi” in Montreal, that relied on a similar principle that made it impossible to reimburse all the clients if they came altogether asking for their savings.

At the end of his fraud, in 1919, Charles Ponzi had managed to convince nearly 40 000 investors to commit to his business plan for $15 million which account for several dozens of current billion dollars. To this day, Ponzi is still considered the father of financial fraud and several others drew from his example.

The Great Bernard Madoff

Bernard Madoff was a New York hedge fund manager who promised the most experienced investors his hedge fund would provide a 7% annual growth whatever the economic conjuncture. His fund relied on the same principle as the Ponzi system that Bernard Madoff hid successfully thanks to his fame in the finance sector. In fact, his renown made all this fraud possible and explains how institutions such as HSBC, Santander, BNP Paribas or Nomura got played. In 2008, when the trick was no longer viable, a 65 billion dollar fraud was unveiled…

The unviable mechanism behind this type of fraud: the Ponzi pyramid

A Ponzi pyramid is a fraudulent financial scheme that enables its creator to offer investors unusually high rates for very limited risk. The offer may seduce lots of investors which will only see their money back if newer investors contribute later. The scam is named after its inventor, Charles Ponzi, has been repeated several times.

However, it must be stated that a Ponzi scheme cannot last… Indeed, let’s consider the following example: Investor A invests 10 euros. The fraud promises to pay back twice as much two months later. Two months later, the company approaches new investors with the same promise. Investors B & C invest 10 euros. Their money is used to pay back the 20 euros promised to Customer A and so on…

In the example, for each round of new investors which corresponds to the maturity of the round of investments, the fraud must convince twice as many investors to invest as during the last row, in order to multiply the funds by 2 (so that the previous row of investors be reimbursed). In the following example, after 20 rounds of investors, the fraud will have to gather 10 485 760 € in order to reimburse the 19^th round of investors. As you can see, the scheme had already exceeded its viable size due to an exponential growth which can only cause the loss of the last round of investors and the dreadful financial consequences that comes with it.

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About the author

The article was written in February 2022 by Louis DETALLE (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2023).