1. How do Ponzi schemes and pyramid schemes differ? How are they similar?
2. Why are successful white-collar criminals such as Madoff able to carry out their schemes for so long when similar types of fraud often collapse at an early stage?
3. What should be done to ensure large-scale scams such as Ponzi schemes and pyramid schemes do not occur in the future?

Before Bernard Madoff, the average consumer had likely never heard of a Ponzi scheme. This little-known crime became a front-page headline in December 2008 when highly respected securities trader Bernard Madoff admitted to having operated a Ponzi scheme for more than a decade, leading to an investor loss of over $17 billion. Tom Petters, former CEO and chairman of Petters Worldwide, had already been arrested for an alleged $4 billion Ponzi scheme in October of that year. A few months later, respected financier R. Allen Stanford was arrested for a Ponzi scheme that cost investors $7 billion. Since then, over 500 additional Ponzi schemes have been uncovered; however, these three remain the largest in history.

A Ponzi scheme is a type of white-collar crime that occurs when a criminal—often of high repute—offers an apparent investment opportunity but never actually invests the money. Instead, the schemer spends the money for personal gain and keeps the façade going by using money from new investors to pay “earnings” for existing investors. The fraud therefore requires a constant influx of either new investors or reinvestment from current investors. When the scheme finally collapses, the most recent investors usually lose their entire investments.

Ponzi schemes are often confused with pyramid schemes, another form of fraud. Both types of criminal activity have the same basic structure. Pyramid schemes look like legitimate businesses, but actually lack genuine products or sustainable investment opportunities. A pyramid scheme offers individuals the opportunity to make money through selling a product, investing, or similar efforts. The key aspect of a pyramid scheme, however, is that an upfront fee is required to join. Participants are then encouraged and financially incentivized to bring in more recruits. Each new person pays to join in what is believed to be a legitimate opportunity to make a return, which is how the fraudster gets money. However, unlike a legitimate organization, pyramid schemes either do not sell a product, or the product or investment is almost worthless. All income comes from new people enrolling. Much like a Ponzi scheme, when enrollment dries up, the pyramid scheme dissolves; those few at the top of the “pyramid” profit, and those at the bottom of the “pyramid,” such as newer enrollees, lose their investments.

The primary difference between a pyramid and a Ponzi scheme is that the perpetrator of the Ponzi scheme simply asks individuals to invest their money, promising an aboveaverage return. No other action is required. The fraudster behind the pyramid scheme, on the other hand, leads individuals to believe they will be taking an active role in the venture such as selling a product, and in addition incentivizes them to recruit others. Also, pyramid schemes typically collapse much more quickly because they require exponential increases in participants to be sustained. In contrast, Ponzi schemes can survive simply by persuading most existing participants to reinvest their money, with a relatively small number of new recruits.

Both Ponzi schemes and pyramid schemes are highly damaging to consumers and the financial industry at large. They destroy lives when large investments or lifetime savings disappear overnight, often lead to years of costly and complicated litigation as investors try to recoup what they can, and sharply erode trust in the system, making it more difficult for legitimate businesspeople to find willing investors and participants. Pyramid schemes in particular look very similar to certain legitimate business models, sometimes making it difficult for interested individuals to determine if a new business opportunity is actually a pyramid scheme.