There are many different flavors of financial crime. At a global level the terminology is often imprecise due to different meanings in different legal systems. In this blog series we see “financial crime” as belonging to the broader category of “white collar,” “commercial,” or “economic” crime and explore its linkages to the financial inclusion agenda. We use the term to refer to offences that involve the financial system, payments and transactions. These include:
- Regulatory offences (e.g., providing licensed financial services without a license or in breach of license conditions);
- Criminal abuse of the financial system (e.g., money laundering or terrorist financing);
- Financial fraud (e.g., investment fraud) and
- Offenses relating to transactions and investments (e.g. theft or misappropriation of investor funds, including related offenses such as identity theft and cybercrime targeting financial institutions or their clients).
Ponzi schemes offer clear examples of financial fraud. While these schemes are often referred to as “pyramid investment schemes,” we find it helpful to differentiate between the two types of schemes:
- Pyramid schemes are membership-based schemes, where individuals pay fees to join. The benefits they receive depend mainly on the number of new members that they recruit. Those who join the scheme earlier benefit, for example, from the membership fees paid by the members that they recruit. The scheme collapses when the pool of recruits is depleted. Members who join last may receive no return on the often quite high membership fees that they pay. Fraudsters design or manage these schemes to draw in as many members as possible, knowing that the schemes are not sustainable. They try to siphon off as much of the money as they can before the scheme fails. It is not unusual for a pyramid scheme to masquerade as a multi-level marketing (MLM) arrangement (for example, the distribution of beauty and consumer products). While MLM activities are lawful in many countries, in the case of a pyramid scheme, generally there are no legitimate products to sell. And unlike MLMs, this scheme’s focus is on membership fees rather than product marketing.
- A Ponzi scheme is an investment scheme that pays returns to early investors out of money invested by new investors rather than from genuine business profit. This fact is not disclosed to the investors, who believe their funds are used to finance a very profitable business. The schemes often offer abnormally high returns to attract investors. Ponzi schemes collapse when they are unable to secure sufficient new investments to service returns promised to the earlier investors or if they are detected and shut down by regulatory agencies or law enforcement.
Both types of schemes are effectively shifting money from new investors to the earlier investors and the scheme managers. Sometimes some investors suspect that a scheme may be fraudulent but they gamble on joining early enough to share in the benefits. Both schemes will inevitably collapse though Ponzi schemes can often operate for longer periods than pyramid schemes.
A few recent examples from developing countries and emerging markets:
- Benin: A number of unlicensed entities that called themselves “microfinance institutions” operated Ponzi schemes. The largest, ICC Services, collapsed in June 2010. By the time the schemes unravelled, they had collected deposits equivalent to about 5 percent of the 2010 GDP of Benin from an estimated 150,000 depositors. According to government data, the average deposit represented 1.5 times the annual GDP per capita.Some assets have been retrieved from the scheme managers and limited restitution is taking place.
- Colombia: It is broadly estimated that as many as 4 million Colombians invested over US$1 billion in pyramid schemes in the mid-2000s. In 2008, the collapse of one scheme (DRFE) led to rioting and violent protests in 13 cities. The government declared a state of emergency to restore order.
- Kenya: According to the 2009 Kenyan Task Force Report on Pyramid Schemes about 148,000 investors invested funds in 271 recorded pyramid investment schemes involving USD 93 million (Ksh 8, 2 billion) in 2006-2007. They generally operated under the name of cooperative societies.
- Lesotho: An initially legitimate and viable burial scheme operated by the MKM Burial Society began to offer deposit-taking products with a very high stated return. By mid-2007, the scheme started to employ a pyramid-type structure to recruit members. The scheme involved more than USD 42 million from around 100,000 investors. Although the authorities took action against the scheme’s unauthorised financial activities, its management problems remained and the scheme is battling for financial and legal viability.
- South Africa: The Reserve Bank recently reported that thousands of South Africans lost out to illegal investment schemes or deposit-taking arrangements every year. In response, the central bank launched a national awareness campaign under the slogan: “Beware of oMashayana!”(con artists). A Reserve Bank spokesman reported that 222 schemes were investigated between 2007 and last year. Targets included pensioners, recipients of government benefits, and even some members of South Africa’s “who’s who” corporate elite.
- Russia: The latest pyramid scheme perpetrated by a Russian mathematician (who had served jail time for the infamous 1994 MMM scam) is estimated to have attracted hundreds of thousands people from Russia and the former Soviet Union who were lured by the prospect of 20 percent for a one-month “deposit” up to 60 percent monthly for a one-year deposit. Chillingly, the scheme’s website and materials sought to avoid prosecution by offering many “disclosures” that the returns might not be sustainable over time.
While large-scale schemes such as these and spectacular examples from rich countries (e.g., the Madoff and Stanford Ponzi scheme in North America) are very visible, limited empirical data is available to policy makers and others on their prevalence, their scale, and the profile of consumers that they target and attract. This is particularly so for developing countries and emerging markets.
Next week, I make the case for analysis and action on fraudulent investment schemes as a matter of financial inclusion. We invite readers to share relevant data and examples, as well as their views and experiences on whether this issue should figure on the financial inclusion agenda and if so, what can be done about it.
In your article you fail to mention the central fraud that is increasingly affecting microfinance sectors right across the globe - what William K Black, probably the world’s leading systematic analyst of the relationship between financial crime, financial structures and incentive mechanisms, has called ‘control fraud’. Check out this blog posting in which he looks at the case of Bosnia referring to a paper I co-authored:
I have also suggested that the case of Andhra Pradesh is another example of Black’s ‘control fraud’ concept in operation:
Thanks for the nice article. In Assam (India) there are more than one hundred fake financial institutions operating freely. Most recently, after a huge public outcry, government has discussed the issue in assembly (state law makers forum) and decided to tackle the problem. But already hundred of thousands of peoples hard earn money has been looted by these companies. I think this is a complete failure of legal and administrative mechanism and financial literacy can significantly to combat it.
Very important problem and intresting article.