Fraud (Ponzi Scheme – Elements)

What are the elements of a Ponzi scheme?

Wikipedia describes a Ponzi scheme as:  “a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going. The system is destined to collapse because the earnings, if any, are less than the payments.”

Thus, the characteristics of a Ponzi scheme seem to be: 1) fraudulent investment, 2) subsequent investors pay back previous investors, 3) abnormally high return-on-investment and 4) fated for a collapse (which will arise in 1 of 4 possible outcomes): a) the promoter will vanish, taking all the remaining investment money (minus the payouts to investors) with him or her, b) the scheme will collapse under its own weight as investment slows and the promoter begins to have difficulty paying out the promised returns, c) the scheme is exposed because the promoter fails to validate the claims when asked to do so by legal authorities or d) external market forces, such as a sharp decline in the economy, will cause many investors to withdraw part or all of their funds not due (at least initially) to loss of confidence in the investment, but simply due to underlying market fundamentals. While many of the acts cited are present in other fraudulent schemes, there is one that is inherent in and specific to the Ponzi scheme. That is the intended use of funds provided by later investor-victims to enable the perpetrator to give earlier investors the gains promised them and perpetuate the illusion of a legitimate business venture even though such gains promised them even though such gains were not realized by business activity for the purported venture but were merely paid from funds invested by later investors.

Whether an investment is a “fraudulent investment” or is merely a bad investment actually depends upon several elements.  To prevail on a fraud claim under New York law, in a civil setting, a plaintiff must establish five elements by clear and convincing evidence: 1) the defendant made a material misrepresentation; 2) the defendant knew of its falsity; 3) the defendant possessed an intent to defraud; 4) the plaintiff reasonably relied on the misrepresentation; and 5) the plaintiff suffered damage as a result of the misrepresentation. Kaye v. Grossman, 202 F.3d 611, 614 (2d Cir.2000).

“It is not necessary for the representation to have been the exclusive cause of plaintiff’s action or non-action; it is sufficient that . . . the representation was a substantial factor in inducing plaintiff to act or refrain from acting.” In re Fifth Judicial Dist. Asbestos Litigation, 784 N.Y.S.2d at 833 (emphasis added); see also National Union Fire Ins. Co. v. Robert Christopher Assocs., 257 A.D.2d 1, 691 N.Y.S.2d 35, 42 (1st Dep’t 1999).

To determine if fraud exists, one must first inquire if the statement made was a “misrepresentation” or merely an innocent “mistake.” Fraud cannot be found to exist if  there was no misrepresentation and the statement made was merely a mistake, and the promoter (who is also a principal investor) did not know of its falsity. If a misrepresentation has been found, however, the promoter’s intent when he or she solicited funds from other investors must further be examined.

The promoter’s intent must first be determined before one can determine whether there was a scheme (in the pejorative sense). Was the promoter’s intent to defraud? It is axiomatic that there can be no deceit in a situation where a promoter affirmatively discloses all known and foreseeable risks to prospective investors, and truthfully responds to inquiries made by such prospective investors. Therefore, if an investor loses money as a result of investing in a given enterprise, the investment can only reasonably be said to be improvident, as opposed to fraudulent. Of course, without a “fraudulent investment,” there can be no Ponzi scheme. Thus, if the commission of fraud is intended to perpetuate initial acts of fraud, then the scheme is fraudulent. If it is otherwise, it may not be fraudulent.

The intent to perpetuate a “scheme” by paying off previous investors (using the money from subsequent investors) is undoubtedly illegal. The reason for this seems to be two-fold: a) the subsequent investors are being defrauded (by being lured, by the promoter, through false promises) and b) concealment (from the previous investors) of the loss of capital (and the origin of the so-called returns). By itself, the loss of money is innocent.

However, if there is no “scheme” to perpetuate, and therefore, no deception perpetrated by the promoter, then paying previous clients with the money generated from subsequent investors would seem not to be illegal. The mere fact that the money a promoter may have used is traceable to new participants does not necessarily mean that the promoter committed fraud. There must be a scheme, and therefore, fraud or deceit.