The Financial Times recently published a fascinating prison interview with Bernie Madoff. Of course he spins the story, attempts to justify his actions and it wasn’t really his fault. He claims that his company was legitimately earning profits until the early 1990, and that in the 1980’s he was “making plenty of legitimate trades.”
But then in 1992, he admits it became a Ponzi scheme when he began using money from new deposits to pay some returns. As he told the reporter:
“The turning point was really about 1992 onwards. From then on, it started getting worse and worse. I spend a lot of time thinking about it – it is almost like a blank to me now. I try to piece it together; why didn’t I say, ‘I cannot do it?’ Why didn’t I return the money to those four or five clients – and the others – and say, ‘I can’t do it.’ Why?”
Since 1994 when I began handling securities cases, I have been involved in many many lawsuits and receiverships involving Ponzi schemes. I also have on occasion represented people who perpetuated these schemes. As a result, people often ask me how they get started and whether I think people set out to run a Ponzi scheme. I don’t think they do, at least not in my experience. Ponzi schemes usually start when people promise unachievable minimum returns to investors, pay returns even when the profits are not coming in, or try to shield their investors from losses.
Bernie Madoff claims that his decision to begin using new investor money to pay returns wasn’t his fault — he did it because he was under a lot of pressure from investors. But that’s exactly the point; all companies have pressure from their investors! Investors like good returns and in some cases they demand them, but they should only get paid if the company is generating positive returns. Just like children, investors sometimes have to be disappointed. Sophisticated investors understand this, and although unsophisticated or unaccredited investors probably don’t understand they should never be investing in start-up companies in the first place.
Investments are risky by definition. Some make money, and many do not. One of the primary differences between investing in a normal company and a Ponzi scheme is that normal companies do occasionally lose money and those losses will get passed on to the investors, like it or not. There is no such thing as a guaranteed return in these types of investments.
I’ve actually had company owners tell me that they didn’t feel like they could pass on any losses to their investors because then it would make it hard for them to raise more money. True, but that’s just the way it works. The only other alternative is to start raising new money to pay the promised returns to investors rather than to fund the operations of the company, and that called a Ponzi scheme.
Some business owners justify paying returns to investors despite the lack of profits because they assume (hope) that the company will be spectacularly profitable at some point, or they will sell it or get a big loan or liquidity event and then they will make up the difference. This is a spectacularly bad idea.
Again, the most common way that I have seen Ponzi schemes get started is where companies get caught in the trap of promising or guaranteeing minimum returns to investors. In many cases these promises are well-intentioned or required where money is raised through promissory notes with a specific rate of return. If the revenues from company operations are not sufficient to sustain those returns then the only way to pay them is by using new investor money.
If you are interested in reading more about Bernie Madoff, a new book was just published on the whole mess called The Wizard of Lies: Bernie Madoff and the Death of Trust By Diana B. Henriques
PLEASE NOTE: this discussion relates primarily to private investments, not publicly traded securities purchased through a licensed stock broker or investment advisor. Private investments are usually made under a private placement memorandum or (illegally) through promissory note.
However, it is also improper for an investment adviser or broker to promise future returns in the markets, with the possible exception of certain annuity investment products which have guaranteed returns built-in under certain conditions. This blog is not intended to provide investment advice. Consult with your licensed stock broker or investment advisor for such advice.
© 2011 Mark W. Pugsley, all rights reserved.